notes of last chapter of finance II

Problems and Prospects of FDI in Nepal

Nepal had attracted modest FDI in niche sectors such as tourism, herbal products, mineral deposits (lime stone), and light manufacturing apparel; hydro power and that it had positive impacts on exports, particularly garments.

FDI has also enabled the country to export non-traditional manufactured products such as micro-transformers and personal consumer products (UNCTAD, 2003b). Investment was mainly in low-technology, labour-intensive production. The impact of FDI had also been modest, primarily in job creation. According to the study, FDI inflow was constrained by political instability, outdated foreign investment law, rigid labour regulations and poor physical infrastructure. This situation remains current due to political instability and political transition.

FDI is considered beneficial in view of its contribution to technological transfers, enhancement of managerial capability and new opportunities for market access. FDI, particularly in the form of equity investment, adds to the capital stock of the country and thus enables the recipient country to achieve faster economic growth through momentum in capital formation. Increases in FDI are also seen as leading to increases in exports by creating international markets through new marketing and organizational skills.

The inflow of FDI in Nepal began in the early 1980s through the gradual opening up of the economy. From 1980 to 1989, FDI inflows to Nepal were minimal with an annual average of US$ 500,000. FDI inflow showed a distinct acceleration during the 1990s averaging US$ 11 million per annum during 1990-2000, peaking at US$ 23 million in 1997 (UNCTAD, 2003b and 2006). This was primarily due to Nepal’s more liberal trade policies, which comprised tariff rate reductions, the introduction of a duty drawback scheme, the adoption of a current account convertibility system and liberalization of the exchange rate regime. A reversal in the rising trend took place from the beginning of the 2000s. All in all, FDI inflow is the lowest in Nepal even when compared with other landlocked countries (World Bank, 2003). A comparison of other Asian countries, Nepal indicates a poor performance of FDI (UNCTAD, 2003b). The fact that Nepal is landlocked, coupled with its infrastructure and low level of labour productivity has also constrained FDI inflow into the country.

Many foreign investors in Nepal are individuals rather than corporate entities. Most of the FDI projects are of small size 72%, medium-sized 16.5% and large-sized industries 11.5%. Much of the FDI inflow is for joint ventures because of non-commercial risks by offering shares to local partners.


FDI is highly concentrated in the manufacturing sector, which accounted for slightly more than 45 per cent of approved FDI projects. Within the manufacturing sector, the textile and garment industry accounts for 28 per cent of total foreign investment, followed by the chemical and plastic industries at 25.3 percent. Tourism is second, accounting for almost 25 per cent of total FDI projects, followed by the service sector with 20 per cent of FDI projects. Although the electricity, water and gas sector has just a few FDI projects, it ranks fourth highest in terms of the size of FDI inflow.

In total, FDI comes from 50 countries. But the scale and number of projects by each country vary considerably. Of that total, in terms of investment, India alone accounted for more than 40 per cent, followed by the United States and China. Those three countries alone account for two-thirds of cumulative FDI in Nepal. In terms of number of FDI projects, India ranks first, followed by China, Japan and the United States. Nepalese and Indian nationals do not need passports or visas when traveling between their countries. Similarly, the Indian currency is freely convertible in Nepal. A special relationship with India regarding preferential trade arrangements also provides an additional incentive to Indian investors.

Legal and Institutional Framework

Nepal can not be far from the benefits of Foreign Direct Investment (FDI). So Nepal has been given priority for the attraction of FDI and its development by different polices and rules in national and international level to promote foreign investment and technology transfer for making the economy viable, dynamic and competitive through the maximum mobilization of the capital, human and other natural resources.

Global Level

Today, Nepal is one of the most liberalized countries in the South Asian region. However, growth performance has been very poor in recent years. In this context, a closer examination of the linkages between foreign direct investment and growth is critically important from a policy point of view. There are highly liberal FDI and GDP-related policies supplemented by important Acts. In the aftermath of liberalization that began in the early 1990s, FDI increased substantially. However, that could not be sustained for long. After becoming a World Trade Organization (WTO) member in 2004, Nepal has been pursuing further opening up and liberalization policies on the FDI. Nepal is also a member of the South Asian Preferential Trade Arrangement (SAPTA) and the Bay of Bengal Initiative for Multi-Scrotal Technical and Economic Cooperation-Free Trade Area (BIMST-EC FTA). New initiatives on FDI have been taken with the aim of enhancing sustained growth and reducing poverty.

Incentive Level

Although the Government of Nepal (GON) is open to foreign direct investment, implementation of its policies is often distorted by bureaucratic delays and inefficiency. Besides this, Nepal is still facing some problems for FDI because of lack of direct access to seaports, difficult land transport and lack of trained personnel, scarce raw materials, inadequate power insufficient water supply, non-transparent capricious tax administration inadequate and obscure commercial legislation, and unclear rules regarding labor relations.

In the pre-liberalization period, the investment regime was more restrictive. Investors had to obtain a government licence before undertaking any production and business activities. The FDI was almost nil before 1980. Although some attempts to liberalize the investment policy were made from the beginning of the 1980s, it was speeded up only after 1990. To ensure investment, both domestic and foreign, the Government adopted various liberal policies, which are still in operation. These policies include the Industrial Policy, 1992, Industrial Enterprises Act, 1992 (first amendment, 1997), Foreign Investment and One-window Policy, 1992, the Foreign Investment and Technology Transfer Act, 1992, the Finance Act of 2002 and the recent Finance Ordinance 2004 (an annual budget act); the Immigration Rules of 1994; the Customs Act of 1997; the Industrial Enterprises Act of 1997; the Electricity Act of 1992; and the Patent, Design and Trademark Act of 1965. In a positive development, Nepal passed the Copyright Act in 2002 etc.


Development Level

Nepal is trying to attract FDI with the different rules and policies. Besides this, FDI has been involved in every five year‘s Government plan and also some institutional arrangements for FDI promotion have been implanted for its development.

In the recent decade, Nepal is well coming FDI and has been benefited .Some of the literature suggests that the FDI inflows have a positive impact on economic growth of host countries and other literature suggests not at all. However, FDI in itself is not a development but may act as a catalyst for the needed progress and therefore, warrant further study.

Foreign Portfolio Investment

Foreign Portfolio Investment

Investment made (usually in another country) in bonds and shares. An alternative form of foreign investment is direct investment, buying commercial assets such as factory premises and industrial plant.

The purchase of stocks, bonds, and money market instruments by foreigners for the purpose of realizing a financial return, which does not result in foreign management, ownership, or legal control.

Some examples of portfolio investment are:

• purchase of shares in a foreign company.
• purchase of bonds issued by a foreign government.
• acquisition of assets in a foreign country.
• purchase of stocks in a foreign company.

Factors affecting foreign portfolio investment:

• tax rates on interest or dividends (investors will normally prefer countries where the tax rates are relatively low)
• interest rates (money tends to flow to countries with high interest rates)
• exchange rates (foreign investors may be attracted if the local currency is expected to strengthen)

Portfolio investment is part of the capital account on the balance of payments statistics.

A foreign portfolio investment is in contrast to a foreign direct investment.

                                                        

                                                        

Foreign-Exchange Risk

The risk of an investment's value changing due to changes in currency exchange rates. In other words, it is the risk that an investor will have to close out a long or short position in a foreign currency at a loss due to an adverse movement in exchange rates. Also known as "currency risk" or "exchange-rate risk".

This risk usually affects businesses that export and/or import, but it can also affect investors making international investments. For example, if money must be converted to another currency to make a certain investment, then any changes in the currency exchange rate will cause that investment's value to either decrease or increase when the investment is sold and converted back into the original currency. 

Techniques for Managing Foreign Risks

In this section we consider the relative merits of several different tools for hedging exchange risk, including forwards, futures, debt, swaps and options. We will use the following criteria for contrasting the tools.

First, there are different tools that serve effectively the same purpose. Most currency management instruments enable the firm to take a long or a short position to hedge an opposite short or long position. Thus one can hedge a this risk using a forward exchange contract, or futures or perhaps a currency swap. In equilibrium the cost of all will be the same, according to the fundamental relationships of the international money market. They differ in details like default risk or transactions costs, or some fundamental market imperfection.

Secondly, the countries  have to adopt a sound foreign exchange management policy compatible to and acceptable in the international trade. A foreign exchange management act will be the guide for establishing the foreign exchange management system of the country.

The departments and the officials managing the foreign exchange transactions have to be well-experienced in the trade. The foreign exchange management manual becomes the essential reference for the management of foreign exchange management risk. The staff members of the departments may have to take the foreign exchange management course to be well oriented with the foreign exchange transactions.

Nature and Exposure of exchange rate risk

There are three types of exchange rate risk exposure for a Financial Planner or a Risk manager:-

• Translation exposure
• Transaction exposure
• Economic exposure

Translation exposure is the change in accounting income and balance sheet statements caused by changes in exchange rates. Under the rules of Financial Accounting Standards Board, a US company must determine a functional currency for all and each of its offshore subsidiaries. If such a subsidiary is a stand alone firm with vertical or horizontal integration with the particular country, the functional currency can be the local currency otherwise it has to the dollar.

Transaction exposure is the gain or loss that might occur during settlement of foreign exchange transaction. Such a transaction could be the sale / purchase of product or services lending or borrowing of money or any other transaction involving mergers and acquisitions.

Economic exposure, the most important of the three, is the change in value of a company that accompanies an unanticipated change in the exchange rates. There is a clear distinction between the anticipated and the unanticipated change of exchange rates. The anticipated change has already been factored into the valuation of the company by the market forces. The unanticipated comes as an unforeseen risk.