External Demand, Domestic Monetary Conditions, and Remittance Dynamics in Nepal

TL;DR

This paper analyzes how external demand and domestic monetary policy influence remittance flows in Nepal, using advanced econometric models and machine learning to forecast future trends and policy implications.

Contribution

It introduces a novel integration of PCA-derived external demand and monetary indices within an ARDL-ECM framework for small samples, applied to Nepal.

Findings

External demand has a strong positive long-term effect on remittances.

Tighter domestic monetary conditions significantly reduce remittance inflows.

Remittances are projected to remain a key part of Nepal's GDP, around 28.3% by 2030.

Abstract

This study investigates the macroeconomic determinants and dynamic behaviour of personal remittances as a share of Gross Domestic Product (GDP) in Nepal, emphasizing external demand in major destination countries and domestic monetary policy. Using annual data (1993-2024), we construct composite indices via Principal Component Analysis (PCA) for multi-country external demand and a domestic Monetary Conditions Index (MCI). Our small-sample econometric pipeline includes Autoregressive Distributed Lag (ARDL) bounds testing, Engle-Granger cointegration, Dynamic OLS (DOLS), and a two-step Error Correction Model (ECM). We also employ Granger causality tests and multi-model forecasting using machine learning and ECM scenarios. The analysis reveals a strong positive long-run effect of external demand on remittances and a significant negative impact of tighter domestic monetary conditions. The ECM confirms a stable cointegrating relationship, correcting approximately 26% of disequilibria annually. Medium-term projections indicate remittances will remain structurally important, reaching around 28.3% of GDP by 2030 under baseline conditions, while exhibiting high sensitivity to external demand shocks. This study advances the literature by integrating PCA-derived external demand and monetary conditions indices within a unified ARDL-ECM framework for small samples. Focusing on one of the world's most remittance-dependent economies, it offers actionable insights for monetary policy calibration, migration diversification, and the productive utilization of remittance inflows.