Kathmandu -Nepal Rastra Bank (NRB) has concluded that the country's economy is gradually recovering, supported by the expansion of the services sector, strong remittance inflows, record high foreign exchange reserves and improving private investment. However, it has warned that rising non performing loans, sluggish credit growth and weak government capital spending remain the biggest challenges facing the economy.

According to the central bank's 'Macroeconomic Report: Analysis and Outlook, July 2026', Nepal's economy is expected to grow by 3.85 per cent in the current fiscal year 2025/26.

The report says the services sector has been the main driver of economic growth, while the industrial and agricultural sectors have made comparatively weaker contributions. NRB estimates Nepal's potential economic growth at 4.2 per cent, indicating that the economy is still operating below its full capacity.

The central bank said last year's Janaji Movement, which damaged public and private infrastructure, along with the conflict in West Asia and the resulting energy crisis, weighed on economic activity. Despite these challenges, strong private consumption helped private investment increase by 39.6 per cent. Public investment, however, declined by 29.3 per cent.

Inflation, which had eased sharply at the beginning of the fiscal year, has started rising again. Consumer price inflation increased from 1.1 per cent in November 2025 to 5.04 per cent in May 2026, mainly due to higher international petroleum prices, increased transport costs and rising food prices. Fruits, edible oils and vegetables contributed the most to food inflation, while transport, education, housing and other services recorded notable price increases among non food items.

Despite abundant liquidity in the banking system, credit expansion has remained weak. The report says continuous remittance inflows have left banks with ample loanable funds, but demand for borrowing from the private sector has remained subdued. Commercial banks alone have the capacity to extend more than Rs 600 billion in additional loans, yet lending has failed to pick up.

The report identifies deteriorating asset quality as a major concern for the banking sector. As of April 2026, the overall non performing loan ratio of banks and financial institutions had risen to 5.6 per cent. The share of watchlist loans also increased from 6.7 per cent to 11.1 per cent, signalling a higher risk of further loan defaults. NRB attributed the trend to excessive reliance on land as collateral, sluggish property transactions and difficulties in loan recovery.

The report says Nepal's external sector remains strong. The current account posted a surplus of Rs 729.3 billion, while the balance of payments surplus reached Rs 863.6 billion. Foreign exchange reserves stood at Rs 3.704 trillion, equivalent to US$24.19 billion, enough to cover 19.1 months of goods and services imports.

Remittance inflows surged by 41.2 per cent, helping maintain a strong external position despite higher imports. However, the central bank warned that the reserve position remains heavily dependent on remittances and may not be sustainable unless exports, tourism and productive investment expand. It noted that the current level of reserves reflects reliance on foreign employment rather than a structurally stronger productive economy.

NRB also expressed concern over the government's fiscal management. During the first 11 months of the current fiscal year, only 32.5 per cent of the annual capital expenditure target, or Rs 132.7 billion, had been spent. In contrast, debt servicing and interest payments reached Rs 305.7 billion, more than double the amount spent on capital projects. The report said this indicates that government borrowing is increasingly being used to service debt rather than finance development.

Looking ahead, the central bank said the reform oriented budget for fiscal year 2026/27 could help accelerate economic activity. It said tax incentives, higher capital spending, stronger private sector confidence and improved consumption and investment could support the government's target of achieving 7 per cent economic growth.

NRB projects average inflation to remain around 5.5 per cent in the coming fiscal year. However, it warned that renewed tensions in West Asia and higher than expected inflation in India could pose risks to the economic outlook.