Small State Capabilities in Managing Multipolarity: Case Study of Nepal

Ms. Apekshya Shah

This paper is part of a series of analyses of small-state strategies in navigating large-power competition. The experts were commissioned in Bangladesh, Bhutan, the Maldives, Nepal, and Sri Lanka to produce papers examining how those countries have managed relations between large powers such as China, India and the United States, which are increasingly vying for political and economic influence across Asia.

The papers each examine three case studies that illuminate the strategies small states use to pursue their interests vis-à-vis large powers. In particular, the papers examine the domestic political considerations that shape the countries’ actions, an underexplored dynamic in international relations research. A summary paper synthesizes the findings of the country papers and advances macro analysis and findings about the options and limitations for small states to maximize their positions relative to competing large powers.

Introduction

Many studies have examined how small states act and what powers they can employ to achieve their foreign policy goals. This has led to the discovery of strategies like alignment, 1 bandwagoning, 2 and balancing,

their interests. Small states have numerous tools to gain and wield power and influence. Some are structural, such as location, geology, and natural resources. Others are flexible, such as political systems and compliance with norms.4 This makes the pursuit of dynamic and strategic policies feasible. Thus, researchers have tried “shifting the focus from the power that states possess to the power that they exercise,” through diplomacy and foreign policy, avoiding the question of power definition.5 Instead, they analyze small states’ behavior case by case using different levels of analysis to examine the strategies they employ to influence asymmetrical relations to secure their interests.

Moreover, especially when geopolitical competition is present, major powers must devote disproportionate time and resources to cultivating and maintaining relationships with small powers.6 Big power behavior during intense geopolitical competition—which is always present in interstate relations but can vary—shapes small state policies. Thus,

especially beneficial for understanding how geopolitics unfolds in different regions. Since China and India went to war in 1961 over territorial disputes, South Asia has been aims. However, a state’s bargaining power is influenced far more by the availability of alternatives than by its economic and military resources.10 Thus, Nepal’s geostrategic position between China and India presents Nepal with options from different powers during geopolitical competition, giving it room to maneuver. The policy space Nepal creates and the actors it engages determine the options available to the country.

According to the late U.C. Berkeley Professor Leo Rose, Nepal wanted to be a “link” and establish its own identity “to avoid eventual absorption into the Indian mother culture” after opening relations with China in 1954.11 Nepal’s cultural identity, positioned as a bridge between Southeast and South Asia, has influenced its diplomatic stance. The 1962 India-China War dashed Nepal’s hopes, and the Indo-Sino War made it a buffer state with competing powers.

13 The mistrust and border dispute between India and China have influenced their regional rivalry. China has retained significant influence in Southeast Asia, whereas India has actively pursued its regional ambitions in South Asia.

The regional dynamics and Nepal’s strong social and economic connections with India position Delhi as Nepal’s most influential external stakeholder. Nepal’s asymmetrical relationship with India renders it susceptible to Indian influence, compelling it to adopt a 14 Nepal has been adamant about preserving its relationship with China, which is thought to be close enough to provide Kathmandu with support when needed but too distant geographically and culturally to threaten Nepal’s independence. India has largely adopted a zero-sum approach to Nepal-China relations, viewing it as a blackmail tactic used by Nepal against India. However, historically, India’s overt attitude and perceived threats from Delhi have pushed Nepal to seek alternatives with China. While the limitations of Chinese assistance have been apparent in the past, the rise of China is changing the dynamics in the region and beyond.

Geopolitics appears to be returning to the region because of China’s recent economic growth, and the relative calm that followed the Cold War appears to be fading as major powers compete for influence. Nepal also became a republic in 2015, following several changes to the government since 1990. The civil war that began in 1996, the rebels’ entry into mainstream politics, the removal of the monarchy in 2008, and the promulgation of the constitution, as envisioned by the peace process, meant that the country had been in political transition for nearly three decades.

During this period, political instability, poor governance, and slow economic growth made Nepal more vulnerable to external shocks and influence. At the same time, interaction and reliance on the international community and its two neighbors have

Methodology

The paper examines three case studies that have been considered in various contexts. The criterion for selecting the first case study was changing government strength—a time when the government was weaker than other times. Nepal’s transit agreement with China amid India’s economic blockade has been selected as the first case study. The second case study on Nepal-India hydropower cooperation agreements was chosen based on political economy analysis (PEA), especially where domestic power consolidation or elite financial gains are the main drivers. The third case study examines development assistance coming to Nepal through the U.S.-backed Millennium Challenge Corporation. Development assistance was chosen to maintain sectoral diversity from the two cases above.

This analysis will examine Nepal’s foreign policy qualitatively. The theoretical aspects of the study will be primarily based on secondary sources, specifically literature on geopolitics and small states in international politics. The theoretical investigation focuses on the strategies used by Nepal. Primary and secondary data will be examined for the case studies. The primary data for the case studies will be gathered through personal interviews with Nepali experts. Secondary sources will largely come from regional publications, including those from Nepal, India, and China. The case studies examine how Nepal has made strategic decisions by creating policy space for itself during periods of geopolitical competition in the region.

Case Study 1

Nepal-China Transit Transport Agreement 2016

Nepal and China signed the historic Transit Transport Agreement in March 2016, but it had been in the works for a year, as Nepal was short on supplies due to a blockade by India. Nepal’s economy is closely linked to India’s, with both countries sharing an open border and a pegged currency. The blockade dealt a blow to Nepal’s economy, which was still recovering after the 2015 earthquakes. India was the only country providing Nepal with transit rights until the agreement was concluded with China. The case study also serves as a foundation for subsequent case studies examined in the research, as it delves into the 2015 blockade and the series of foreign policy decisions made by Nepal, specifically regarding its relations with its neighbors in the face of intensifying geopolitical competition.

The relationship between India and Nepal has experienced a decline since the ratification of Nepal’s constitution in 2015. Meanwhile, relations with China have experienced unprecedented improvement.

All that has followed a blockade that Nepal accused India of imposing because Nepal’s newly ratified constitution did not satisfy the demands of the Madheshi people, an influential ethnic minority in the southern plains and socially close to India. The Madheshis criticized the constitution for marginalizing them and not addressing recovery.26 Besides, as was discussed in the Indian parliament, this was not the first time that India had used economic sanctions to achieve its political objectives in Nepal.

India has blockaded Nepal four times since the 1950s, including the one in 2015.

Parties to domestic political struggles often reach out to outside powers for support and leverage. India has often been Nepal’s external partner due to social and political ties. Given the history of relations between the two nations, India has begun to view itself as largely duty-bound on Nepal-related issues, not knowing when to stop, according to Dr. Bhattari.29 Aggressive behavior from not only a major power but also a neighbor has caused anxiety among political elites, and anti-Indian sentiment is widespread.30 After the constitution was adopted, Prime Minister KP Sharma Oli, leader of Nepal’s secondlargest party, the Nepal Communist Party—United Marxists Leninists, or UML—and a staunch supporter of the constitution, formed the government, which was also dubbed the left alliance. Oli lambasted the Indian blockade in international forums, 31 while relations remained tense because Oli suspected India of conspiring to prevent him from becoming prime minister and vowed not to visit India until the blockade was lifted.

The new government quickly requested fuel from China and signed a historic agreement

products, thus breaking India’s monopoly.33 The UML appeared determined to seek alternatives with China, regardless of the potential consequences of such actions, and By 2013, China launched its Belt and Road Initiative (BRI), a trade and development program along the ancient Silk Road routes between Asia, the Middle East, and Europe. Before signing the transit agreement with Nepal in 2016, China had secured infrastructure deals in Pakistan, Bangladesh, and Sri Lanka, which were later added to the BRI. Along with the transit agreement, Nepal’s admission to the BRI—strengthening connectivity and improving land transport infrastructure, including cross-border railways—laid the groundwork for the free trade agreement and energy cooperation dialogue. The Nepali Government also encouraged Chinese investment and financing for development projects.39 The transit agreement was the most significant and symbolic step in Nepal-China relations, and the countries concluded the implementing protocol in 2018.

While transit protocol negotiations were timely, the results were disappointing, partly because of slow infrastructure development at Nepali border points and the government’s failure to encourage traders to use northern points. The COVID-19 pandemic also slowed momentum.

The agreement, however, helped Nepal gain leverage over its southern neighbor. Instead of being just an alternative, it was a way for Nepal to increase its trade and connectivity options. Delhi appeared to have two reactions to the transit agreement: displeasure with Prime Minister Oli for pursuing ties with China and a need to address Nepal’s economic issues.

Sainju noted that after Nepal and China finalized the protocol, India was eager to offer inland waterways for transportation during a 2018 transit meeting and reassess trade

the transit arrangement with China as they investigated the possibility of establishing industries in Nepal.

Through the transit agreement, meaningful dialogue with China was possible. Post-2016, Nepal-China relations improved across the board, from politics to the economy.

As a symbol of the changing times, President Xi visited Kathmandu in 2019, elevating At the same time, Delhi has vetoed Chinese investments in Nepal if it is to participate in those projects. For example, India has so far refused to grant permission for the operation of the two international airports in Nepal that were built with Chinese assistance, and it also refuses to purchase hydropower that has been developed through Chinese investment.47 However, as previously stated, closer relations with China resulted in a positive economic response from India, and significant improvements in connectivity between Nepal and India occurred after 2016.

Still, India is worried about losing influence in Nepal. According to one analyst’s assessment, after supporting the political movement against the King in April 2006, India believed the monarchy had always played the China card and that Maoists and other key parties would be a better experiment without it.48 Also, India believed it would lead Nepal’s politics for a long time. Both proved wrong in 2015. Furthermore, India was wary of the BRI and China’s growing presence in the Indian Ocean and South Asia. It was especially vocal about the China-Pakistan Economic Corridor.

Strategy Applied: Hedging

Nepal has long recognized its limitations in exercising autonomy amid regional power asymmetries. Yet, engagement with great powers has afforded Nepal policy space to Similarly, the 2016 Transit Agreement with China helped Nepal balance India’s influence and deepened engagement with Beijing. While Nepal has historically turned to China to counterbalance India, Beijing’s influence has been limited due to geographical barriers, cultural differences, and China’s broader foreign policy priorities. Still, Nepal’s China policy—often dubbed the “China card”—is less about countering India outright and more about creating strategic options in response to the threat that Nepal sees emanating from India.52 Despite growing Chinese engagement, India remains Nepal’s primary partner, and the notion that Nepal is actively pivoting away from India is overstated. China, at least in the near future, does not present a viable alternative.

Nonetheless, Nepal’s most significant asset in fostering relationships with China is its vulnerability. Nepal lacks the capacity to influence the power dynamics between India and China. Nepal’s independent foreign policy involves fostering relationships with both sides of the balance of power to facilitate economic development. This makes sense, given that the development of Nepal’s economy does not threaten to upset the power dynamic between India and China. The balancing policies of smaller powers, however, are dangerous because great powers support weak states to improve their standing in relation to other great powers. India believes this regarding Nepal-China relations. India has accused Nepal of being ungrateful for its special relations and calling its balancing policy blackmail.53 Implementing balancing strategies may lead to political tensions and unintended consequences for smaller powers, potentially resulting in the loss of economic benefits if the larger power responds with punitive measures. As previously noted, Nepal is especially exposed to India’s sanctions.

The transit agreement with China has enabled Nepal to assert some independence and enhance its bargaining power in relation to Delhi, leading to concessions in connectivity projects. However, India remains cautious of the increasing Chinese influence in Nepal, particularly in light of China’s expanding presence in South Asia. China’s diplomatic relationships with all South Asian countries are increasingly influencing its strategic objectives, thereby impacting the balance of power with Delhi. Thus, Nepal must be aware of Indian concerns about China’s rise and keep in mind that balancing can be costly. Furthermore, Nepal might not have as much agency as it believes. The possible liberalization of India’s trade and transit policies, because of the transit agreement, could be influenced by Nepal’s agreement with China or by China’s attempts to reduce Nepal’s historical dependence on India. Thus, the two powers may equilibrate independently without Nepal needing to engage significantly in balancing efforts.

Case Study 2

Nepal Hydropower

Nepal has always tied its hopes of economic growth to selling hydropower to India and often has had to bandwagon with India to gain from its market. Nepal’s 1990s hydro dream was dominated by foreign expertise and used a top-down approach that viewed hydroelectricity as a commodity to be exported rather than a primary input to domestic production.54 Since Nepal could generate so much hydropower but consume little, the assumption was that the surplus should be exported to generate government revenue. This plan required massive investment, expertise, and the right environment. Post-Cold War liberalization and privatization were introduced to address concerns with landmark policies on the sector: the 1992 Hydropower Development Policy (HDP), Water Resources Act, and Electricity Act, which supported private power sector investment.

The early 1990s were promising, but the restoration of multi-party democracy and vibrant civil society politicized water and hydropower. The 201-megawatt World Bankled Arun-3 1994 and the Mahakali Treaty 1996 were particularly controversial.

The 1990s boom added 268.7 MW between 1997 and 2002, meeting 91 percent of the government’s goal. The Nepal Electricity Authority (NEA), the government-owned utility responsible for electricity generation, transmission, and distribution, failed to add a single MW between 2002 and 2007, while the private sector added 33.93 MW, meeting decreases and power prices fall, Nepal can import if necessary.59 The Indian government also approved the establishment of a regional power exchange to help SAARC countries develop their power markets, signaling a move toward liberalizing electricity trade in the region.60 However, the 2015 blockade soured relations between the two countries, ending the celebrations.

Since 2016, India has imposed restrictions on the energy it imports from its neighbors.

In the case of Nepal, this clearly aims to restrict Chinese investment in the hydro sector. The Guidelines for Import/Export (Cross Border) of Electricity by India’s Power Ministry only allow Indian entities to import electricity from companies that do not have any links to China.62 India’s zero-China policy makes it difficult for Nepal to legally discriminate between countries that want to invest in Nepal, but it does hinder Chinese investment. India seemed to have two strategies to maintain its influence in Nepal’s power sector: import conditionality for its growing energy market to discourage Chinese investment and increase bilateral cooperation.

Nepal’s political elites have also shown renewed interest in boosting electricity trade with India to repair relations and maintain exports to Indian markets since 2015. To reconcile with India, Prime Minister Oli gave the Lower Arun hydropower license to an Indian company without bidding.64 Oli’s decision to give SJVN Lower Arun was wise politically and economically. The Lower Arun was a natural extension of SJVN’s Arun 3 cascade, awarded in 2008, and the benefit-sharing arrangement, which includes 21.9 percent of the electricity generated from both projects going to Nepal for free, including royalties, India has also been gradually increasing its imports from Nepal through bilateral agreements and has committed to importing 10,000 MW in a landmark long-term power agreement signed by the two countries in 2023.72 The agreement allows for longterm and medium-term contracts. In the most recent development, India has opened a new and third market for Nepal by allowing Indian distributors to include imported hydropower in the renewable energy quota required by the Renewable Purchase Obligation policy, a critical initiative launched by the Indian government to promote renewable energy. According to estimates, up to 522MW has been cleared for sale in India’s exchange market, including day-ahead and real-time markets for Nepal in 2023.

Electricity trade between Nepal and India has increased from 39 MW approved by India in 2021 to more than 700 MW in 2024.

Nepal has unprecedented access to India’s energy market and increased electricity supply, but India refuses to purchase electricity from the 456 MW Upper Tamakoshi project, which was funded by Nepali domestic investment but used Chinese civil contractors.75 Developers complain that India’s strict power import approval process and requirement that companies disclose all project documents seem to dictate what can be built in Nepal. With India’s conditionality, Nepal’s political elites have understood the geopolitics of the hydro sector.76 Oli gave lower Arun to India. The Nepali Congress took over in 2022, and Sher Bahadur Deuba became Prime Minister. Deuba accelerated Indian company projects after becoming prime minister. Another Indian state-owned development, has gone silent in response to India’s disapproval.85 India wants to build Upper Arun itself, reports say. However, India-backed companies funding Upper Arun projects near China will cause geopolitical tension. According to government plans, five river projects have been surveyed: Kimanthanka Arun; Upper Arun, which Nepal wants to build and was proposed for World Bank financing; Arun 4, which Nepal and India are building together; Arun 3; and Lower Arun, which India is developing.

After years of improvement, Nepal has connected 99 percent of the country and become an electricity exporter in 2023–24. Nepal’s total electricity production capacity is 3,157 MW, with a peak demand of 2,467 MW.87 However, only approximately half of this capacity is generated during the winter season, leading to a surplus in the wet season

season, Nepal sends 700 MW of power to India, but 600 MW of surplus energy is wasted because it does not meet Indian import requirements.88 Given that the average Nepali consumes only 325 kWh of electricity annually—far below the global average of 3,180 kWh per capita—claims of Nepal having surplus energy warrant scrutiny.89 Furthermore, because the country was experiencing load shedding until 2018, there has been little industrial consumption. The low domestic consumption suggests that what is termed ‘surplus’ may result more from limited internal demand rather than genuine excess production. Thus, power trade agreements with India have drawn criticism. India-backed

Indian-backed companies have secured nearly 4,600MW of combined capacity nationwide, and 80 percent of bilateral electricity exports in the next decade will come Development of hydropower in Nepal should be pursued for reasons other than trade with India. Nepal’s reliance on India renders it vulnerable when forming alignments with India in a critical sector, as demonstrated in the initial case study. The political elites of Nepal have used hydro agreements to gain favor with India, overlooking the opportunities for domestic development. Aligning with India could provide immediate benefits for Nepal; however, it is crucial to evaluate the potential long-term implications to prevent adverse consequences. Considering the prevailing geopolitical dynamics, India aims to limit Chinese influence in Nepal, and one strategy employed is to obstruct China’s involvement in Nepal’s energy exports. It demonstrates the power India has as the only importer and the dangers it poses to significant hydropower projects in Nepal that are being developed for export.

The threat holds validity when electricity is exported to India; however, it diminishes if the electricity is utilized domestically or exported elsewhere. Furthermore, as noted previously, regional initiatives may serve as a viable solution to this predicament, as India can limit Nepal’s interests, but it cannot simultaneously suppress the interests of Bhutan, Bangladesh, and Nepal. As a result, smaller South Asian nations possess the opportunity to collaborate to counterbalance Indian influences and advance a more liberalized regional electricity market.

Case Study 3

The MCC Compact Nepal

The Millennium Challenge Corporation (MCC) is an independent U.S. government agency that aids developing nations in economic growth to reduce poverty. The Executive Office of the President and Congress directly oversee it. The George W.

aid’s efficacy, mostly due to donors funding unprofitable activities and investments. Development partners struggled to justify and analyze cost-effective activities, and aid-receiving countries had no ownership. In this context, the United States created the MCC to ensure aid effectiveness and fund only projects expected to increase local income by more than the implementation costs.92 Countries were required to compete for MCC conditional aid, with host governments fully participating in this bipartisan, transparent initiative. The recipient country would “own” the project and assign a ministry or senior official to coordinate the development of a compact agreement—akin to an international treaty—and project implementation.

Nepal knew about the Bush administration’s plan to increase U.S. grants to developing countries, and once the MCC was formed, Nepal began talking about joining. In The MCC compact was first tabled in parliament for ratification in 2019.101 Initially presented as a development partnership, the process later became politicized after a U.S. State Department official stated that the MCC was part of the Indo-Pacific Strategy—a broader U.S. policy aimed at promoting security, economic growth, and political stability in the Indian and Pacific Oceans.102 The United States launched the strategy in 2017, declaring its intent to protect Asia from Chinese aspirations. The strategy emphasizes military maritime patrols and regional prosperity through economic efforts. The 2019 report, “A Free and Open Indo-Pacific,” states that all nations, large and small, should be secure in their sovereignty and able to grow economically in accordance with international rules, norms, and fair competition.103 It also seeks regional cooperation and sustainable, private-sector-led development through USAID and the MCC.

Left-leaning political leaders criticize the MCC compact as a tool of U.S. geopolitical strategy, arguing that it serves to counter China and could lead to a military alliance under the Indo-Pacific Strategy.104 The strategy was controversial because it mentioned Nepal, and the United States emphasized it in Nepal relations. The misunderstanding in Nepal stemmed from a lack of clarity about the strategy’s purpose. The Indo-Pacific Strategy was not a call to join; rather, it was the driver of U.S. foreign policy in the region, in which Nepal was perceived as playing a critical role.105 There were concerns that the United States was attempting to involve Nepal in its strategy against China, resources to be used for military purposes, and that the agreement was not superior to Nepal’s constitution.112 In addition to clarification, high-level U.S. visits ensured no miscommunications. To break the political impasse in Nepal, the MCC compact and an interpretive statement based on U.S. responses were eventually presented in parliament.113 This was necessary because the Maoist leaders who had opposed the compact were now part of a coalition government and needed to assuage public concerns and save face.114 After much delay, parliament ratified the MCC compact and the interpretive declaration in February 2022, days before the U.S. government’s second deadline.

The episode demonstrated to Nepal how geopolitics were altered by U.S.-China competition. Due to the expected involvement of nations like India and others on China’s periphery, the Chinese government opposed the Indo-Pacific Strategy from the beginning.115 China also worries about the strategy’s military focus and claims the United States is playing a zero-sum game with China in the region. According to the Chinese foreign minister, the United States is “provoking China on issues concerning China’s core interests” and taking steps to form small blocs to suppress China.116 Meanwhile, U.S.-India relations have improved over the last decade, and the strategy has placed a high value on India’s role. While India’s history can be described as a series of cautious alliances that maintain autonomy while not acquiescing to other major powers, the development of the U.S.-India partnership has been significant on the security front, and it would not be incorrect to argue that India has been inclined to align with the United States, particularly in complementary initiatives to counter the rising Chinese influence that India views as a threat to its security and regional ambitions.

Nepal joined the MCC before the Indo-Pacific Strategy, but its adoption by the United States in 2017 caused controversy. China strongly opposed the MCC, and Nepali politicians seemingly opposed it at China’s request. The United States has claimed that China actively promoted a disinformation campaign against the MCC in Nepal.

Nepal should the MCC be dismissed.

The evidence presented in various case studies indicates that Nepal’s relationships with its long-standing allies are experiencing strain as a result of increasing regional competition. The escalating geopolitical competition, coupled with Nepal’s evolving foreign policy landscape, necessitates thorough deliberation on every foreign engagement. This dynamic places considerable pressure on the government and policymakers to exercise awareness and avoid impulsive decisions. During this period, the MCC and diplomatic ties with China were subjected to a great deal of scrutiny.

Strategy Applied: Hedging

When big powers compete, small states have to navigate several asymmetrical relationships, as the MCC compact case demonstrates. The state must hedge its bet, as Nepal seems to be doing, if it does not wish to align with any major power. Nepal’s diplomatic endeavors and foreign policy have consistently emphasized the systematic management of great powers, necessitating collaboration with various actors to fulfill its objectives. States have the capacity to circumvent the dilemma of balance, bandwagoning, or neutrality by adopting a hedging strategy.120 When a great power’s power is uncertain, smaller states hedge by betting on multiple positions to protect against unfavorable outcomes. Smaller states try to avoid becoming too dependent on one great power.121 Southeast Asian states have successfully used indirect balancing to give regional powers like Japan a stake in the regional order, engage in complex political, economic, and strategic engagement with China, and counter Chinese regional influence by fostering U.S. ties. The aim is to shift the emphasis of regional rivalry from considerations of power dynamics to matters concerning the balance of influence.

The strategy of non-alignment throughout the Cold War allowed Nepal to broaden its alliances and reduce reliance on its neighboring nations. The policy’s two main objectives—preventing the use of Nepal’s territory against neighboring countries and attaining foreign policy autonomy—constitute a fundamental aspect of Nepal’s foreign policy. Nonetheless, escalating geopolitical tensions threaten its viability. The military aspects of the Indo-Pacific Strategy faced significant criticism due to concerns that Nepal’s involvement in a military alliance might damage relations with its northern neighbor. This element is also essential to hedging, a tactic used by smaller states to steer clear of aligning their security interests with those of a larger power.

A notable element influencing the concern in Nepal was China’s reaction to the Indo-Pacific Strategy. China exhibits little concern over India’s relationship with Nepal, but the deeper tie between Nepal and the United States causes anxiety for Beijing. China’s apprehensions are heightened by the potential collaboration between the United States and India aimed at curbing Chinese influence. Therefore, if Nepal seeks to safeguard its interests with all its allies, it must adopt a calculated approach to fostering bilateral relations through diplomacy and negotiations. All significant nations will engage in geopolitical considerations when interacting with Nepal. Thus, it is imperative for the country to understand its priorities and advantages. Since 2015, geopolitical competition in the region has complicated Nepal’s multiple asymmetrical relationships. All powers— including Nepal—are concerned about influence in Nepal.

Conclusion

Nepal, characterized by its small size and vulnerability, has historically acknowledged its constraints in asserting autonomy in relation to major powers. Engaging them has, however, allowed Nepali policymakers policy space in times of challenges. The three case studies above also reflect that. The study identifies three instances in which Nepal had to evaluate its policy options in light of increasing geopolitical rivalries. The policies ultimately implemented were not the result of well-structured strategies but rather tactical responses to the challenges encountered.

Nepal demonstrates significant vulnerability to external shocks and pressures, primarily due to its internal political instability and economic limitations. Nepal’s small-state status means it can generally interact with various powers without being perceived to have any ulterior motives. Nepal-India relations have endured challenges, yet Nepal’s reliance on India renders it vulnerable to pressure from its southern neighbor. The emergence of China and its objective to contest India’s influence in South Asia has significantly transformed the geopolitical landscape, positioning China as a viable alternative for the smaller South Asian nations.

The initial case study reveals that, despite Nepal’s expressed intent to recalibrate its strategic dependence on India, this ambition has not translated into effective policy initiatives. This policy inertia can be attributed not only to a lack of domestic political consensus and commitment but also to the structural constraints imposed by Nepal’s asymmetric relationship and deep-rooted economic interdependence with India. Consequently, Nepal’s capacity to reduce Indian influence remains constrained by both internal and external factors. Still, the power dynamics between its two neighbors compel them to seek influence over Nepal, thereby providing Kathmandu with alternatives to safeguard its interests. Additionally, since the two powers may balance themselves, Nepal may not need to exert much effort. Furthermore, the balancing behavior of these regional powers may inadvertently reduce the urgency for Nepal to actively pursue aggressive foreign policy shifts, allowing it to navigate its geopolitical challenges with a degree of tactical flexibility.

The second case study illustrates that, given its ample water resources and hydropower potential, Nepal has aligned itself with India in pursuit of revenue generation through power exports. The fact that India is the sole market for Nepal has provided India with considerable leverage, which it has strategically employed to hinder Chinese investment in Nepal’s power sector. Simultaneously, India is advancing significantly in its efforts to purchase and establish a dependable market for Nepali power. The regional initiatives endorsed by India represent a significant development, indicating that if Bangladesh, Bhutan, and Nepal collaborate effectively, they may press India to adopt a more liberalized approach to the regional energy market. Hydro development in Nepal must prioritize not only export potential but also the promotion of domestic growth.

The political elites appear to leverage hydro projects for diplomatic gains with neighboring countries, yet there seems to be a lack of a comprehensive strategic framework for sector development. In the situation concerning China, Beijing will continue to be at a disadvantage until it begins to import power from Nepal.

The MCC case came at a time of heightened politicization of foreign policy in Nepal. As a result, the implementation of the compact quickly became enmeshed in controversies. The compact, which Nepal ratified in March 2022, nearly four years after it was introduced in parliament, symbolized the polarized state of Nepal. Nepal needs to adjust to the new reality of heightened geopolitical competition after the relative calm of the post-Cold War era. The search for common ground amongst rival powers is

powers. Nevertheless, the present geopolitical landscape is characterized by a multipolar structure, with power dynamics exhibiting greater intensity and interdependence than during the Cold War, leading to rapid shifts in strategic calculations. As was indicated in the last case study, smaller powers need to manage and navigate big power rivalries strategically.

Nepal’s non-alignment policy requires a revision to align with contemporary realities, similar to the adjustments made by nations like India. Strategic partnership and strategic autonomy represent contemporary variations of realpolitik, enabling states to engage in a pragmatic evaluation of their interests and make decisions that align with their objectives. Strategic behavior is a newer type of non-alignment policy in which the country seeks alignment on an individual issue basis. Strategic engagement involves the thoughtful process of addressing issues that are in alignment while simultaneously negotiating or countering those that are not congruent. To achieve this, Nepal must initially endeavor to clarify its foreign policy priorities through a comprehensive analysis and thoughtful discourse. Negotiations and diplomacy will be crucial in Nepal’s bilateral relations with major powers, but a broader comprehension of how geopolitics is developing is also essential.

Ms. Apekshya Shah Ms. Apekshya Shah is an Assistant Professor and serves as the Head of Department at the Department of International Relations and Diplomacy (DIRD) at Tribhuvan University. The DIRD is the first academic institution in Nepal to offer a degree in foreign affairs and is one of the most sought-after academic programs in the country. Diplomacy and foreign policy are her areas of expertise, and she has over nine years of experience in the fields of research and education in international relations. In addition to her responsibilities at the University, she is actively involved in collaborations with government agencies, research institutes, and think tanks. She is currently a senior fellow at the Nepal Economic Forum, a think tank in Kathmandu dedicated to Nepal’s development discourse.

Notes

7. The China-India rivalry shapes the geopolitics of the sub-continent to a large extent. Thus, South Asian small states present an interesting cross-section of global and regional competition among great powers.One such country is Nepal, the region’s oldest sovereign state. Due to its strategic location between China and India, Nepal has a long history of diplomatic practices and experience with geopolitics.
8. Nepal has a bigger population and a larger landmass than Bhutan, the Maldives, or Sri Lanka, and it has enormous hydropower potential, all of which give it significant leverage in South Asia.Bordered by India on three sides and China on the northern side through the Tibetan plateau, Nepal has been called several things, including a small state, a buffer state, and a landlocked developing country.
9. Thus, due to its landlocked geography and asymmetry with its larger neighbors, Nepal remains a small or weak power regardless of the parameters used to define it.Nepal is particularly dependent on its neighbors for trade and transit due to its landlocked geography, which puts it between two Asian powers that want to maintain influence in Nepal. Nonetheless, as rival powers—and not just any rivals, but two Asian giants—India and China provide Nepal with options and leverage. The policy options available to smaller states are determined by the impact that their actions can have. For instance, smaller states with nuclear weapons can better negotiate and achieve political 49 increased significantly.
15. As democratic forces took power and multiple parties and interests focused on Nepal’s foreign policy, issues became politicized, hurting diplomacy and foreign policy. Also, political uncertainty has quickly enslaved state actors and institutions, reducing their effectiveness. In this context, the paper explores how small states like Nepal manage the current geopolitics in South Asia.50 their demand for ethnic federalism,
16. and India insisted that Nepal should resolve the
17. The Indian government even sent a special envoy, including then Foreign Secretary S. Jaishankar, two days before the ratification to counsel Nepali political leaders to postpone the endorsement.
18. Nepal’s Constituent Assembly promulgated its new constitution on September 20, 2015, marking the end of an eight-year drafting process. The Constituent Assembly, representing Nepal’s diverse ethnic, religious, and social demographics, ratified the constitution with more than 80 percent of its members.
19. Prior to the document’s promulgation, violent protests erupted in the southern plains, resulting in significant casualties.
20. India, expressing its dissatisfaction, simply noted the endorsement and claimed that the constitution lacked sufficient inclusivity.
21. On September 22-23, the Indian government urged Nepal to amend the document to address the grievances of marginalized groups.
22. The diplomatic intervention heightened tensions between the two countries. Furthermore, during his November 2015 visit to London, Prime Minister Modi publicly addressed the issue, prompting the Nepal government to protest the action.
23. Soon after the constitution was promulgated, goods entering Nepal from India halted. While India maintained that it was due to the protests at the border points, Nepal accused India of imposing an unofficial trade blockade.
24. 25 Nepal viewed India’s overt attempts to influence the constitution-making process and blockade as hostile behavior. Nepal ran out of essential supplies within days, causing chaos during post-earthquake 52 the two countries signed the Transit Agreement in 2016.
34. The prime minister and his coalition partners justified their moves by citing non-alignment policy, saying it was for the country’s benefit to diversify its trade and transit reliance and improve connectivity with its neighbors.
35. The prime minister’s visit to India in February 2016, after the blockade was lifted, demonstrated that the Oli government was equally serious about connectivity with India. Still, the fact that no joint statement was issued after the visit showed that tensions remained between the two countries.
36. The lack of a long-term economic vision to strengthen Nepal-India relations, poor implementation of India-backed development projects, and untapped hydropower potential have hurt Nepal’s economic goals.
37. Delhi’s meddling in Nepali politics led many to believe it wanted a weak, controllable state. China, on the other hand, had grown to become the world’s second-largest economy and was pursuing an outwardlooking foreign policy. Since the blockade had cornered Nepal, turning to China for assistance was the only viable option, no matter how limited it was. For instance, relying on China for fuel during the blockade was impractical due to China’s low supply. Also, poor infrastructure and transit routes limited the volume of trade.Still, the transit agreement opened a policy space for Nepal that was previously 2000s. China began developing parts of East and South Asia to create an external environment conducive to its economic growth. China sought to create a “stable periphery” by attracting countries for economic benefits, interdependence, and Chinese benevolence.38 53 the relations between the two countries to a strategic partnership.
43. Still, Nepal has not made enough progress in reducing its dependence on India and integrating with China through its policies.
44. Most agreements with China have been characterized as more rhetoric than actionable outcomes. No meeting of the joint mechanism as agreed in the transit protocol has taken place, and the BRI agreement protocol, which Nepal joined in 2017, has not been finalized.
45. Similarly, the country has yet to secure a reserve of petroleum products sufficient to last six months in the event of a supply disruption. Additionally, the government has not diversified its trade routes with India, and more still heavily dependent on India for essential commodities and economic trade despite economic blockades almost every other decade since the 1960s.
46. 54 explore alternatives.
50. As Womack notes, “Autonomy and deference are complementary in a normal asymmetric relationship, which is negotiated between unequals.”
51. While larger powers benefit from shared interests in such relationships, smaller states like Nepal can use them to assert agency and pursue change.Nepal’s age-old pursuit of relations with China, supported by its non-alignment policy during the Cold War, reflects this approach. Two key goals—ensuring Nepal’s territory is not used against its neighbors and preserving foreign policy independence—have made non-alignment a cornerstone of its foreign policy and enabled it to hedge between two neighbors. For smaller states, hedging is a strategic tool: rather than fully aligning with any single power, they maintain relationships with multiple actors to reduce dependency and increase flexibility.This was evident during the 2015 blockade when Nepal’s political elite called for reducing dependence on India—similar to responses during earlier blockades. Yet, it is noteworthy that there are currently no substantial policies being enacted to alter Nepal’s long-standing dependence on India. This has repercussions for Nepal’s relationship with China because it may convey signals about the country’s continued reliance on India, which Nepal might not want to give up. Thus, Nepal’s engagement with China is not a strategic shift but a pragmatic effort to counterbalance India’s dominance. This reflects a textbook hedging strategy: Nepal is not choosing sides but carefully managing ties with both powers to preserve autonomy and advance national interests within a structurally asymmetric environment.55 only 10.78 percent of the government’s target.
56. Nepal’s civil war cost the country critical years, and when its regime changed in 2008, political actors again became interested in the hydro sector. That coincided with power shortages in the country due to rising demand, which peaked in 2016 with up to 18 hours of power cuts in the winter dry season. The interim Nepali government licensed Indian companies Satluj Jal Vidyut Nigam (SJVN) and GMR Group to develop attractive hydropower sites like the Arun-3 and the Upper Karnali, respectively, for exporting electricity to India. The decision to grant licenses to Indian companies was made in hopes of gaining access to the Indian
57. The arrangement gave Nepal a market for its excess power and India lucrative hydroelectric dam construction contracts. To improve power exchange with India, the government also decided to build Dhalkebar-Muzaffarpur cross-border transmission lines financed by Indian companies. However, India’s two projects were not kicked off until 2014, when Prime Minister Modi signed a power development agreement for Arun 3 and Upper Karnali. A market for Nepali power in India was opened as well in 2014 by the historic Power Trade Agreement (PTA), which allows licensed producers to trade electricity in India.
58. This development was significant because it is commonly held that Nepal’s hydropower cannot be developed sustainably without an export market to India. Nepal generates three times as much electricity during the four-month wet season as during the eightmonth dry season, which has been an ideal situation for trade with India because India requires more power during the wet season, and in the dry season, when Indian demand 57 was a bargain.
65. In 2021, the project was awarded as the country produced a surplus in the wet season, and the completion of the Dhalkebar-Muzaffarpur cross-border transmission lines allowed exports in the wet season.66 India opened its day-ahead power exchange market for Nepal to sell electricity developed with Indian assistance in 2021, and since 2023, Nepal, Bangladesh, and Bhutan can trade in India’s Real-Time energy market.
67. 68 Along with its intentions to invest in hydro projects in Nepal, Bangladesh has been investing in hydro projects in Bhutan, and India has also authorized Nepal to export 40 MW to Bangladesh via Indian transmission lines.
69. India appeared to shift regional cooperation to BBIN, a subregional grouping of Bangladesh, Bhutan, India, and Nepal after a diplomatic rift with Pakistan slowed the South Asian Association for Regional Cooperation.
70. Since India separates the three BBIN countries, geopolitical disputes between India and Pakistan do not affect these countries, which are geographically adjacent, giving India the chance to lead regional initiatives that resonate with the aspirations of its smaller neighbors—as Bhutan, Nepal, and Bangladesh have consistently advocated for enhanced regional integration.
71. the stage for future energy liberalization in South and Southeast Asia by endorsing regional power exchange. 58 company, NHPC Limited, received West Seti and Seti River-6,
77. while SJVN once
78. The West Seti reservoir project had stalled for 20 years because India opposed buying power from plants that had received investment from Australia and China.
79. Since 2016, Chinese companies have canceled many projects, including the Tamor Hydropower project agreed upon during President Xi’s visit to Nepal.80 The rapid transfer of hydropower projects by executive decision has drawn criticism and suggests political calculations. Critics argue that the parliament should discuss critical natural resources like water, which political actors have avoided by exploiting an Investment Act loophole.
81. Poor project management has made it harder to attract investors in a volatile geopolitical environment. In 2017, the Nepali Maoists awarded the 1,200MW Budi Gandaki power project to the Chinese company Gezhouba Group without bidding. A few months later, the Deuba-led Nepali Congress government revoked the award. The left-alliance government under Oli awarded the project to Gezhouba again in 2021, but the Deuba-led government revoked it in 2022.
82. Indian policy has hindered Chinese investment in Nepal, putting many projects at risk, including BRI ones, and preventing Nepal from using Chinese funds and expertise. India’s proposal makes geopolitical sense because buying electricity built with Chinese help in Nepal increases Chinese influence, which India doesn’t want.
83. The main issue in Nepal is not preventing Chinese investment but rather India’s attempts to micromanage the sector’s development and dictate export-oriented projects.
84. According to one analysis, the World Bank, which had expressed interest in financing Upper Arun’s 59 from those companies.
90. Fears that India wants Nepal’s water rather than electricity are also widespread.
91. Mainly, concerns exist that hydro sector development is being viewed solely from an export perspective, with little discussion of increasing domestic demand to revive Nepal’s economy.Strategy Applied: Bandwagoning The preceding discussion indicates that Nepal has opted to align with India in the hydropower sector, primarily to leverage advantages from India’s electricity market. The demand for affordable, clean energy is increasing in India. Despite India’s significant hydropower production and consumption, Nepal’s primary and largest export market remains India, as China does not import power from Nepal. Opportunities for regional power integration have also been made possible by power exchanges with India. Nepal’s bandwagoning with India is aimed at securing economic benefits instead of facing costs, which contrasts with the strategy of balancing. Although Nepal has gained access to the Indian market and beyond, there is still a long way to go before it can turn a substantial profit.60 2010, Nepal began formally applying for the grant.
94. The MCC Board chose Nepal its threshold program in 2012. Nepal’s Ministry of Finance, particularly the foreign aid division, led the initiative and began developing support options with the MCC.
95. The threshold agreement with the MCC was completed in 2014, and Nepal’s finance minister and the MCC signed the final agreement for USD 500 million to support Nepal’s power and transportation projects in 2017. The government of Nepal chose to pledge an extra USD 130 million as a sign of its dedication to the MCC partnership.
96. This was the biggest upfront contribution ever made by any partner government in MCC history. Energy sector projects included high-voltage power lines, along with a crossborder transmission line with India. The project aims to increase domestic electricity consumption by improving grid availability and reliability and exporting surplus electricity to India to boost government revenues. Nepal and the MCC also agreed to a road maintenance project to maintain road quality nationwide.97 The MCC compact required recognition as an international accord governed by international law, facilitating its efficient execution as the project needs to be implemented within five years. While the compact states that it will supersede Nepal’s domestic laws in Provision 7.1, experts emphasize that this only applies to conflicting laws, of which there were none. However, Provision 7.2 of the Nepal MCC compact required a signed legal opinion from a government legal representative acceptable to the MCC before the compact could be implemented. As instructed by the compact,
98. a legal opinion was sought, and the agreement was sent for ratification as per the Nepal Treaty Act, as the agreement prevailed over domestic laws in conflict.
99. 100 62 and the economic assistance was perceived as a response to Beijing’s BRI.
106. The Nepal government also clarified that it has not agreed to join any U.S. initiative and had not been asked to. Damage, however, was done. As the MCC Compact was scrutinized, many questions arose about its provisions. Apart from the Indo-Pacific Strategy, many issues were debated, including whether the document was above the constitution, MCC officials’ immunity from Nepali laws, auditing, and intellectual property rights.
107. Senior left-aligned politicians began speaking out against the agreement and lobbying against its ratification, polarizing the country.
108. Misinterpretations and misinformation complicated the issue further.
109. The prime minister attempted to ratify the agreement by the first deadline but failed, leading to diplomatic tensions between Nepal and the United States.
110. The compact was in the works for years, and all political parties across five governments had worked to advance it. The MCC compact was Nepal’s largest bilateral development partner grant, so its failure threatened the country’s international credibility.
111. As one of Nepal’s oldest allies, the United States has provided economic, social, and security aid since 1947. The U.S. government firmly stated that amending the agreement was not feasible, but it was ready to address any concerns raised by Nepal’s government. The U.S. government responded to the issues raised by the Nepal government, assuring it that the MCC predated the Indo-Pacific Strategy, that the MCC Compact did not allow Nepal’s 63