Nepal’s new government enters office with a powerful democratic mandate. The March 5 elections delivered a degree of political consolidation the country has not seen in years. The conflict in the Middle East has become an immediate external test. Its significance goes beyond the short-term shock. It has exposed the country’s structural vulnerabilities that had been accumulating well before the crisis.

The conflict and its transmission

For Nepal, the impact of the ongoing conflict is transmitting through three channels: energy prices, remittances, and connectivity.

Energy price hikes. Nepal imports all its petroleum through India, which in turn sources roughly 40% of its crude through the Strait of Hormuz. Domestic fuel prices have been raised five times in 31 days, with diesel prices up 56% since March 15 and aviation fuel prices have more than doubled. Consequently, transport fares on inter-provincial routes and freight charges on hilly routes have both risen by nearly 20%, hitting rural and hill households hardest in a landlocked economy with difficult terrain and already high logistics costs.

Disruptions to new labor migration and prospects for remittance inflows. Remittances account for nearly a third of Nepal’s GDP, with about 40% of inflows coming from Gulf countries. Any sustained weakening in Gulf labor markets would therefore transmit directly into household incomes, constraining consumption and local demand.

Constrained air connectivity. Middle Eastern carriers account for nearly 29% of passenger traffic through Tribhuvan International Airport. Cancellations during the peak March–May tourist season are already weighing on arrivals and foreign exchange earnings.

New pressures compound old vulnerabilities

Nepal is facing the crisis with external strength but domestic fragility. Remittance inflows rose 37.7% in the first eight months of fiscal year 2026, while both the current account and balance of payments surpluses more than doubled. The fiscal deficit is contained, and public debt remains at low risk of distress.

Yet these buffers mask deeper weaknesses. Nepal’s staggeringly high foreign exchange reserves, enough to cover 18.5 months of imports, are driven largely by remittances rather than productive exports or investment returns. This savings surplus, without a corresponding investment dynamic, is visible across the financial system. Businesses are not borrowing even as banks sit flush with liquidity, while high non-performing loan ratios make banks reluctant to lend, constraining credit particularly to MSMEs and smaller firms with limited collateral.

The country’s near-total reliance on imported petroleum—the channel through which the conflict has hit hardest—reflects decades of underinvestment in domestic energy alternatives. While hydropower has seen progress, traditional energy sources still dominate.

These challenges are compounded by weaknesses in state capacity, marked by chronic budget underspending. By April 2026, only 23.6% of the nine-month capital allocation had been spent. The conflict now adds extra pressure, with fuel and bitumen shortages stalling key infrastructure projects.

Three structural priorities

The budget due on May 29 offers the first concrete opportunity to advance the structural reform agenda. Managing immediate pressures will be necessary, but it should not crowd out structural reform. Three distinct priorities emerge:

 First, fix the investment climate. Resolving Financial Action Task Force compliance issues, ending retroactive taxation, and removing the regulatory unpredictability that keeps productive credit low are essential preconditions. The government’s 100-point reform agenda is a promising statement of intent, with emphasis on single-window approvals, faster land acquisition, and streamlined environmental clearances. Execution will determine whether it marks a genuine break from past reform cycles.

Second, diversify the economy and create better jobs. Outward migration is a rational response to limited domestic livelihood opportunities. Migration itself is not the problem; compelled migration at scale into low-wage, high-risk destinations is. Building productive capacity in hydropower-linked industries, tourism, IT, agro-processing, and more niche areas like the care economy and solid waste management can reduce that compulsion over time. Investments in human capital can also shift migration pathways toward higher skills, higher wages, and lower-risk destinations.

Third, improve the quality and speed of public spending. Chronic capital budget underspending reflects weak project preparation, procurement bottlenecks, and limited subnational absorption capacity. Containing recurrent spending to create fiscal space, improving project readiness, and holding line ministries and provincial governments to execution standards are critical.

Nepal now has many of the conditions needed for reform: strong external buffers, a clear democratic mandate, and a shock that has made the cost of inaction visible. The budget due on May 29 will be an important test of whether the government can use these conditions to accelerate structural transformation.