What drives Nepal’s debt dynamics: Fiscal Stance, snowball effect or the exchange rate valuation?

Abstract

This paper is motivated by the renewed debt accumulation and its increased exposure to domestic financing conditions and exchange-rate valuation after FY2015/16 in Nepal. It asks whether Nepal’s debt dynamics are shaped mainly by the primary deficits or the macro-financial conditions by combining Debt/GDP decomposition, a time‑varying fiscal reaction function, and the local projections estimates on the annual fiscal-year data (N=24) using three models. The decomposition reveals a puzzle indicating that the Debt/GDP falls despite large primary deficits before mid-2010s. The large primary deficits were more than offset by a strong denominator effect (real growth and inflation) and the sizable adjustments of stock flows. After FY2015/16, the primary deficit was accompanied by the increased vulnerability to the financing environment and exchange rate valuation. The IV/placebo and weak IV support the mechanism narrative and highlight the limited precision in small samples. Results emphasize improving debt resilience by focusing on risk management in relation to rollover, interest-rate, and exchange rate valuation shocks (not only to the headline debt levels). These channels can quickly raise the debt service burden and refinancing pressures and worsen the debt indicators even when the debt ratio seems moderate.