Nepal's Public Debt: Should We be Worried?

The origins of public debt can be traced back to pre-modern states when it was exclusively used to finance the costs of warfare. Public borrowing was institutionalized (i) after the existence of institutions necessary to issue public debt: towns, cities, states and nations with well defined borders; contract laws recognizing polities as entities capable of borrowing; and ledgers for payment and repayment, (ii) demand for credit by polity with large number of individuals have sufficient wealth to lend to the polity (Eichengreen et al. 2019). States had to lend funds from merchant bankers, temples to support prolonged campaigns.¹ With the emergence of modern fiscal states, the traditional use of public borrowing shifted from wars to public goods. The most prominent example is Britain’s industrial revolution which was fueled by the borrowing. The government’s debt rose from 5% of GDP in 1700 to over 200% in 1820. Debt contributed industrial revolution by (i) shifting investment from low return investments such as agriculture sector to new, rising ones such as textiles and iron and, (ii) freeing up the labours employed in agriculture sector which lowered the real wages - a boon to industrialists (Ventura and Voth 2015).

The legitimacy of public debt as a policy instrument was established aftermath the Great economic depression of 1929. Classical economists believed that the markets automatically bring necessary adjustments if left freely. However, it didn’t happen during the crisis of 1929. The economy nosedived and never came back up again itself. It was because businesses were not investing enough but holding cash or short term securities to earn interest. Hence, government had to intervene by taxing the uninvested corporate income and invest to increase productivity and output. Keynes argued government had to increase spending because private consumption and investment was not enough to increase the aggregate demand during recession. He further argued that people hoard cash because the propensity to save exceeded propensity to invest in recessionary period. He viewed that public debt as a fiscal tool to absorb excessive savings by the public and boost the aggregate demand especially in recession. The Keynesian prescription challenged the two established orthodoxies among economists (i) Laissez-Faire market system resolves all economic problem, (ii) paradigm shift from surplus or balanced budgets to deficit financing.

During the Second World War, countries invested heavily into the industries that produced different goods required for the war. Even after the war, government continued to implement Keynesianism which resulted into long period of growth, slowdowns in 1950s until Keynesian system collapsed in late 1960s. The failure of Keynesian methods didn’t stop countries from deficit fiscal policy. Public borrowing had already become opium for countries. Though public debt enabled countries to fund the investments in health, education, and infrastructures, the continued accumulation of debt increased the fiscal vulnerabilities and sovereign debt defaults.² The growth of debt in both developed and emerging economies has worried economists, investors and policymakers amid the global shocks such as 2008 financial crisis, COVID 19 pandemic, and rising geopolitical tensions.³ As per IMF Global Debt Monitor Report 2025, the global public debt has reached 92.8 % of GDP while Global Total Debt stands at 235.5% of GDP (including private debt). In most of the advanced economies, the public debt has sharply risen after the financial crisis of 2008 (See Appendix 1).

Nepal has not remained immune to this global trend. The rapid rise of public debt of Nepal has worried the policymakers, bureaucrats, economists and the public like. Public debt to GDP ratio was around 15-20% of GDP pre-earthquake period has reached 44% in 2025. The public debt is continuing to grow due to resource gap. Increased recurrent expenditure after the federalism, stagnant revenue growth, financing infrastructure projects have increased the country’s financial needs. Though Joint World Bank - IMF Debt Sustainability Analysis, 2024 of Nepal showed low risk of debt distress with strong debt carrying capacity, the issue of rising public debt periodically resurfaces in public discourse, and is often criticized due to the lack of return on debt. The concerns of debt sustainability have risen following the debt crisis in Sri Lanka and Pakistan fearing Nepal’s similar fate. The question is how does a country that culturally dislikes debt has reached this stage where the debt per capita is a national concern. This essay discusses: (i) Theoretical foundations of public debt sustainability, (ii) Situation and drivers of Nepal’s public debt, (iii) Nepal’s fiscal policy reaction to rising debt.

Theoretical Foundations of Public Debt Sustainability

David Hume was one of the earliest contributor to understand public debt. In Political Discourses, he argued public debt to be dangerous and unsustainable that weakens the state. He criticized the modern state for mortgaging the public revenue and relying on future generations to pay of their ancestors debt. The taxes levied to service the debt could harm the economy and social welfare through (i) reducing the incentives to invest, innovate, and thus production weakens, (ii) rise in the labour cost as labours demand higher nominal wage to maintain their real income which would ultimately affect production, (iii) burden is disproportionately shouldered by poor households because of regressive nature of tax. He provided stark warning about the sustainability of public debt and that could ultimately destroy the nation. He states “I must confess…….neither this nor any future ministry will be possessed of such rigid and steady frugality,……It must, indeed, be one of these two events; either the nation must destroy public credit, or public credit will destroy the nation” (p.94).

Like Hume, Adam Smith was skeptical about public debt. In Wealth of Nations, Book V, Chapter III: On the Public Debts, Smith explained that public debt arises due to failure of frugality of states. He called a “commercial country” that spends a large part of revenue in purchasing luxuries, a shift from earlier states that used to practice parsimony. Absence of frugality in time of peace, the state has to borrow in times of war or emergencies. Smith argued that this same commercial country that creates need for the debt also provides means to borrow it. A commercial country abound with merchants and manufacturers have large sum of fund to lend to the government. The trust towards the government and the liquidity of the government securities encourages them to lend excessively. Smith viewed that this change in hand of financial resources from merchants and manufacturers to the government diverts productive capital into unproductive uses. He viewed that sinking fund government created to pay old debt, facilitated accumulation of new debt. He further argued that government imposes taxes to service the debt,which remains even after the end of the war. He reached similar conclusions to that of Hume, eventually the enormous debts would ruin all great nations.

David Ricardo was the first to discuss government debt neutrality⁴ and intergenerational distribution of debt burden (Reinhard and Sturm 2008). Ricardo in Funding System, emphasized expenditures (war) financed through borrowing would shift the burden of higher taxes to future generations. He argued that current expenditures should be matched by current taxation, not through debt. He claimed people would try to save the whole cost of war from current income because of war taxes, preserving national capital. But they would only save the amount of interest with government debt, diminishing national capital. About Sinking fund, he called it an instrument of mischief and delusion that would make no progress in the reduction of debt. It would only provide a false sense of relief to the public about government debt. Hume, Smith and Ricardo viewed public debt to be unsustainable in the long run.

After the depression of 1929, Keynes prescribed the use of fiscal policy to maintain a certain level of public investment during the depression. He was supportive of governments borrowing to invest.[^5] Domar (1944) introduced the first mathematical analysis of public debt sustainability by introducing debt to GDP ratio. He challenged the fear posited by Ricardo, Smith and Hume that continuous borrowing would require ever higher tax rates to service the debt which eventually destroys the economy. He showed mathematically that sustainability of debt depends on growth rate of national income. Debt burden is stable if the national income grows exponentially (See Appendix 2).

Buiter (1983), Blanchard (1985) and Hamilton and Flavin (1985) introduced government budget constraint. Hamilton and Flavin (1985) used the government borrowing constraint to test if governments could run perpetual deficits on US post war data (See Appendix 3). They rejected the idea that governments could run permanent budget deficits because creditors would expect the government to balance the budget in the long run. Trehan and Walsh (1988) operationalized the IGBC using cointegration test.They argued that government’s expenditures (inclusive of interest), tax revenue and seignorage should be cointegrated for government’s budget to be balanced in present value terms. Unlike Hamilton and Flavin (1985), they argued that stationarity of the net of interest deficit is neither necessary nor sufficient for intertemporal budget balance.

Bohn (1995) claimed that IGBC tests that discount future primary balances at risk free rate would only hold if (i) private agents are risk neutral, (ii) perfect foresight i.e. no uncertainty, (iii) primary fiscal balances are uncorrelated with future marginal utilities of consumption. Instead, he focused on using stochastic discount factor (marginal rate of substitution of consumption). In stochastic, risk averse economy, IGBC has covariance term. Discounting primary balance at risk free rate is only correct if this covariance term is 0 (See Appendix 4). A sufficient condition for IGBC to hold is for a linear fiscal reaction function (FRF) to have positive and significant response of primary balance to outstanding debt (Bohn 1998).

In non-stochastic economies, the governments could issue debt and roll it over forever when the interest rates are lower than the growth rates (Blanchard and Weil 2001). However, actual economies are stochastic so, it is misleading to compare average riskless rate with the growth rate to study the whether governments can rollover debt. Blanchard and Weil (2001) showed ponzi games might be infeasible even when average riskless rate is less than the growth rate, while feasible when riskless rate is greater than the growth rate. The government is able to play Ponzi game if bonds provide insurance and require low rate of return.

Most of these past studies focused on the discount rate, present value of debt, growth rates to study the debt sustainability. Kraay and Nehru (2003) argued that institutions and policies of an economy can determine the probability of debt distress of that economy. They found that low income countries are more likely to experience debt distress because of poor quality of institutions, policies and political instability. IMF introduced Debt Sustainability Framework in 2002 to detect, prevent and resolve potential debt crisis (Barkbu et al. 2008). IMF Debt Sustainability uses Country Policy and Institutional Assessment (CPIA) ratings, macroeconomic variables, debt structure - maturity, interest rates, concessionality to assess the probability of debt crisis of an economy.

Footnotes