Image: Kit Bentley
Few policies shape an economy’s prospects as much as the management of money that crosses borders. Since the mid-1980s global capital flows have ballooned, fuelling growth and spreading technology. They have also triggered crises when poorly handled. Nepal, whose balance of payments remains tightly managed and whose currency is pegged to the Indian rupee, has so far stood aside from this great experiment in financial openness. The time has come to reconsider.
Nepal’s capital account (the rules that control how money for investment moves in and out of the country) is amongst the most restricted in Asia. Foreigners face limits on portfolio investment. Nepalis cannot easily invest abroad. Borrowing from global markets is constrained by central-bank discretion. These restrictions, together with a fixed exchange rate against the Indian rupee, amount to a financial quarantine. That stance reflects caution. Officials recall the sudden stops in Latin America or the Asian crisis of 1997, when liberalisation without safeguards caused havoc. But Nepal’s insulation has come at a price: a shallow financial sector, limited innovation and persistent reliance on remittances rather than productive foreign capital. Moreover, the peg is killing its exports at a horrifying rate, via an appreciation of the real exchange rate.
The first argument for easing controls is plain. Capital should flow from places where it is abundant to those where it is scarce. Nepal, with weak domestic savings and giant infrastructure needs, is an obvious candidate. Liberalisation would make it easier for hydropower projects, cement factories or start-ups in Kathmandu to tap global finance. Beyond cash, foreign direct investment brings technology and managerial expertise that domestic firms struggle to acquire. The country’s growth strategy, which hinges on exporting electricity to India and beyond, will falter if projects cannot mobilise funds at scale.
Second, freer capital movement disciplines policymakers. Economists have argued open capital accounts reward good policy and punish bad. Investors who can exit quickly deter fiscal excess or monetary mischief. For Nepal, where fiscal laxity and state-owned-bank patronage remain temptations, the prospect of market scrutiny could strengthen institutions. Many emerging economies have found that access to global markets forces reforms in corporate governance and financial supervision that would otherwise be endlessly postponed.
Sceptics warn liberalisation exposes fragile banking systems to destabilising inflows and outflows. That is true when controls vanish overnight. It is less so when opening is sequenced. The sensible path begins with encouraging foreign direct investment, which is sticky, and then expanding access to bond and equity markets under clear prudential rules. Chile once imposed a levy on short-term inflows to discourage hot money. India phased in its liberalisation over decades. Nepal could follow a similarly cautious sequence.
More contentious is the currency peg. Since the 1990s the Nepali rupee has been fixed at 1.6 to the Indian rupee. The arrangement has delivered stability in trade and tourism, given that India is Nepal’s biggest partner. But it also leaves Nepal hostage to monetary conditions set in Delhi. When India tightens policy, Nepal must follow, even if its own economy requires looser credit. When India experiences inflationary pressure, Nepal imports it. Maintaining the peg while liberalising capital flows would be treacherous. History is replete with crises triggered by that combination, from Mexico in 1994 to Thailand in 1997.
This is the dilemma known as the “impossible trinity”. A country cannot simultaneously enjoy free capital mobility, a fixed exchange rate and an independent monetary policy. At most it can have two. Nepal currently opts for a fixed peg and some monetary autonomy, which requires tight restrictions on cross-border capital. If it wishes to open the capital account, it must sacrifice the peg. A more flexible exchange rate—whether managed float or crawling band—would give policymakers space to adjust to shocks without running down reserves.
The benefits of a flexible regime are not abstract. Bangladesh, with a managed float, has used currency depreciation to keep exports competitive. Vietnam has blended capital inflows with an adjustable band, enabling rapid industrialisation. Nepal risks being left behind if it clings to a rigid peg that suits yesterday’s remittance-fuelled model but not tomorrow’s investment-driven one.
None of this implies a headlong rush. Liberalisation should be paced alongside improvements in banking supervision as well as fiscal discipline and data transparency. The IMF’s experience suggests that premature opening is costly, but permanent closure is costlier still. As trade expands and digital finance erodes borders, Nepal’s capital controls are leaking in any case. It is better to channel flows through transparent markets than to watch them seep through informal remittance networks and trade mis-invoicing.
The political case will be harder than the economic one. Ending the peg may be seen as undermining ties with India. Yet sovereignty over money is part of sovereignty itself. A controlled liberalisation, paired with a shift towards a flexible currency, would place Nepal in command of its own financial destiny. Global capital has never been more mobile; keeping it at bay is neither feasible nor desirable. ■
