Foreign Aid and Government’s Fiscal Behaviour in Nepal: an Empirical Analysis**This paper is based on chapter 8 of my PhD dissertation, accepted by the University of Western Sydney. I am grateful to my principal supervisor Prof. Anis Chowdhury for his overall guidance and encouragement. I also would like to thank my co-supervisor Dr. Mallik for guiding me with econometrics. Thanks are also due to Prof. PN. Junankar and my external examiners for their helpful comments. However, any remaining shortcomings are mine.

Using the cointegration technique, this paper examines the revenue and expenditure behaviour of the Nepalese government in the presence of foreign aid for the period 1975–2002. The results show that aid positively affects both development and non-development expenditure in the long run. However, the long-run relationship between aid and non-development expenditure is found to be stronger than that between aid and development expenditure. Since aid is generally given for development expenditure, these results indicate the possibility of diversion of aid to non-development expenditure. Thus, the long-run relationship between aid and non-development expenditure may indicate aid fungibility. On the other hand, no evidence is found in favour of the hypothesis that aid availability makes the government lazy in terms of domestic revenue mobilisation.