The balance of payments (BoP) and the overall external sector balance are naturally subjects of public concern. Economic theories and historical events have shown that if a country’s BoP remains persistently negative, it can destabilize the external sector and ultimately impact the entire economy.

However, discussions on the external sector are often influenced by incomplete and incorrect interpretations rather than well-established theories or historical facts. Periodic fluctuations in the BoP, which are normal in economic cycles, sometimes receive undue attention from stakeholders and media, creating an exaggerated sense of crisis. Such instances have been observed globally, including the Latin American financial crisis of the 1980s, the 1994 Mexican (Tequila) crisis, the 1997 Asian financial crisis, and the 2022 Sri Lankan economic collapse, where extreme external sector imbalances played a key role.

While historical financial crises are important lessons, equating normal cyclical fluctuations with extreme financial distress leads to unnecessary panic. This article aims to provide an objective analysis of key aspects of the external sector, presenting economic principles and factual data for better understanding.

1) Adequacy of Foreign Exchange Reserves

To determine the required level of foreign exchange reserves for a country, it is essential to understand their purpose. No country is entirely self-sufficient in all goods and services, making international trade an economic necessity. This principle was well established by Adam Smith’s Theory of Absolute Advantage and later refined by David Ricardo’s Theory of Comparative Advantage, which argue that nations should specialize in producing goods they are best at and import the rest.

Thus, foreign exchange reserves serve as a means to ensure smooth imports of essential goods and services rather than being an end goal in themselves. Various economic benchmarks define reserve adequacy, with the International Monetary Fund (IMF) providing widely accepted guidelines.

• Import Coverage Ratio: The IMF suggests that a country should hold reserves covering at least three months of imports. However, specific country circumstances may require different thresholds. For Nepal, the IMF’s latest Article IV report recommends a reserve level sufficient to cover 5.2 months of imports.
• External Debt Repayment Capacity: The IMF and World Bank conduct annual Debt Sustainability Analyses (DSA) to assess a country’s ability to meet its external debt obligations. The 2023 DSA classified Nepal’s external debt risk as low, with external debt at only 13.1% of GDP—well below the IMF’s 55% threshold. Nepal’s total debt stands at 44% of GDP, significantly lower than the IMF/World Bank’s 70% upper limit. Furthermore, nearly 87% of Nepal’s external debt comes from concessional sources such as the IMF and World Bank, with an average interest rate of 1% and a repayment period of 36 years.

Comparing Nepal with Sri Lanka highlights key differences. In 2020, Sri Lanka’s external debt stood at 48.2% of GDP (total debt at 101.2%), with 61% of it being commercial (non-concessional). Additionally, 14.69% of Sri Lanka’s external debt was short-term, compared to Nepal’s mere 3.8%. When Sri Lanka faced a financial crisis, its reliance on short-term, high-interest borrowing severely worsened the situation—a scenario Nepal has avoided.

Two major metrics assess a country’s foreign exchange reserve adequacy concerning debt repayment:

• Greenspan-Guidotti Metric: Suggests that a country’s reserves should at least cover its short-term external debt due within a year.
• Expanded Greenspan-Guidotti Metric: Extends this measure to include both short-term debt obligations and the current account deficit.

A study published in Nepal Rastra Bank’s Mirmire journal in 2024 found Nepal’s Expanded Greenspan-Guidotti Metric at 156% in 2022 and 587% in 2023—indicating a highly secure reserve position. Moreover, Nepal’s reserves as a percentage of total external liabilities (71% in 2022 and 83% in 2023) far exceeded those of Sri Lanka (3% in 2022, 6% in 2023) and Pakistan (9% in 2022, 6% in 2023), further reinforcing Nepal’s external sector stability.

2) Foreign Investment Perspective

According to Nepal Rastra Bank’s latest Foreign Investment and External Debt Report (FY 2080/81):

• Approved foreign investment: NPR 319.20 billion
• Recorded foreign investment: NPR 138.33 billion
• Repatriated dividends: NPR 180.99 billion

Many stakeholders misinterpret these figures, arguing that since repatriated dividends exceed recorded investments, foreign investors have benefited at Nepal’s expense. However, this perspective ignores the fundamental purpose of foreign direct investment (FDI).

Foreign investment is primarily attracted to economies that offer long-term profitability. Higher dividend repatriation indicates that investors have earned returns on their investments, which can enhance Nepal’s investment climate. If investors were unable to repatriate profits, it would discourage future investment inflows, negatively impacting economic growth. Furthermore, foreign investments contribute significantly to job creation, infrastructure development, and technology transfer.

Instead of focusing solely on repatriated profits, Nepal should aim to improve investor confidence, ease bureaucratic hurdles, and provide a more conducive investment environment to attract sustained FDI inflows.

Nepal’s external sector remains stable, with sufficient foreign exchange reserves, low external debt risk, and a growing investment landscape. However, misinterpretations and misinformation often fuel unnecessary concerns. A rational, data-driven approach is essential to accurately assess economic conditions and make informed policy decisions.

While historical economic crises serve as important lessons, drawing incorrect parallels between normal economic cycles and extreme crises only hampers confidence. Nepal must continue strengthening its external sector through prudent fiscal policies, strategic foreign investments, and a balanced approach to managing reserves and debt.