Investing in the future- Nepali Times

Well functioning financial systems are central to generating foreign direct investment (FDI) which in turn accelerates economic growth. The success of any economy is judged by the free flow of capital and the extent of openness of the financial market.

Globalisation of the financial sector has led to the integration of emerging economies to international capital markets. South Asian countries all commenced reforms in the 1990s and while some nations are ahead of others, all are undergoing similiar problems or are in the process of solving them.

India has been notable in developing capital markets since the mid-1990s, and its external sector development has been marked by strong capital flows. Although Nepal's liberalisation drive commenced in the mid-1990s capital flows have not played a major role. Besieged by unstable political regimes, lower growth rate of macroeconomic indicators, unskilled and militant labour, Nepal has not been able to attract significant FDI compared to other South Asian countries. It is losing its competitive advantage for foreign investments due to lack of clear policies and implementation factors.

The World Trade Organisation (WTO) mandated that Nepal open up its financial sector to wholesale banking to international players from January 2010. Opening up should have theoretically boosted the economy by injecting foreign funds for investment. A year later, nothing has happened.

Although the Nepali Rupee was made fully convertible in current account transactions in 1993, Nepal has not yet adopted a capital account convertible policy, except for the repatriation of income. While FDI inflows are encouraged, debt flows in the form of external borrowings and portfolio investment in government securities, corporate bonds, and in the stock market are subject to restrictions. The non-financial sector is not allowed to invest abroad or acquire companies.

According to a 2010 Central Bureau of Statistics survey, there were 1,897 firms operating with foreign investment from 139 countries. India had the largest investment in Nepal with 393 companies, followed by China with 179, Japan 132, South Korea 94, UK 94, Germany 61 and Switzerland 27.

Manufacturing has most FDI investments, which stood at 565 companies followed by the hotel and resort sector with 370 firms. Textile and garments had 210 investors and energy, water and gas sector had 32 companies. The total capital outlay of these industries was nearly Rs 120 billion.

Tourism dominates FDI inflow in Nepal with nearly one-third of all investment followed by the service industry and manufacturing. Energy and the mineral sectors constitute only six per cent. Most FDI are small and medium scale. The largest numbers of investors are from India followed by the United States, China, South Korea, Norway, Japan and the British Virgin Islands.

The advent of international partnered banks in the 1990s added enormous value to the banking system in Nepal, which was otherwise dominated by poorly managed state sponsored banks. Joint venture banks improved the quality and efficiency of the financial systems by introducing best practices and standards, where consumers are the main beneficiaries. However, capital injection as investment from abroad was nominal. If higher integration to world capital markets was pursued with sound domestic systems in place, that would have enhanced the development of domestic financial markets by raising bank credit, total assets of the banking system, reducing net interest rate margins and increasing stock market capitalisation.

The recent volatility of capital flows in emerging Asian economies has had a negative impact on the exchange rate, overheating of the economy and asset price bubbles. Large capital flows can stress economies through exchange rate appreciation and sterilisation.

However, a continued focus on financial market development can mitigate the challenges of capital flows. The need for FDI in Nepal is enormous since resource mobilisation capacity is limited, and in recent years the economy has faced a liquidity crisis which has led to lack of credit flows in the economy. Without total capital account convertibility, the prospect of capital inflows will be incomplete. A lack of domestic factors, such as strong macroeconomic fundamentals, a resilient financial sector, deep and liquid capital market compounded by political instability have been the main reasons for dismal FDI investments.

Siddhant Raj Pandey is the CEO of Ace Development Bank.