Masters Program for International Development Policy

Foreign Direct Investment Term Paper - 2010

Attracting Attracting Attracting Attracting Foreign Direct Investment in NepalForeign Direct Investment in NepalForeign Direct Investment in NepalForeign Direct Investment in Nepal

Submitted to: Prof. Hwy-Chang Moon Submitted by: Khagendra Prasad Rijal

Spring 2010

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Executive Summary Table of Contents Title Page

1. Introduction 3

2. Foreign Direct Investment: Theoretical Overview 2.1. Market Failure The 2.2. Eclectic Paradigm 2.3. Diamond Model and Imbalance Theory 2.4. Double Diamond Model

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3. Key Determinants Of FDI 5-6

4. Foreign Direct Investment in Nepal 4.1. Key Economic Indicators 4.2. Trends of the Flow of Foreign Direct Investment

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5. Policy Initiatives and Institutional Arrangement for FDI Promotion in Nepal 5.1. Policy Initiatives 5.2. Institutional Arrangement

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6. Assessing the Competitiveness of Nepal 6.1. Environment for Investment and Doing Business

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7. Existing Business Condition and Problems of FDI promotion in Nepal 13-14

8. Prospects of Attracting FDI 14-15

9. FDI Strategies 15-16

10. Conclusion 16-17

References

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Abstract FDI is viewed as an instrument for exploring the resources, promoting industrial growth, enhancing the competitiveness of the domestic firms; and also promoting export particularly in developing countries. FDI maintains relatively open economies, stable macro-economic conditions and limited restrictions on foreign exchange transactions. It frequently stimulates competition, productivity and innovation. Further, it generates income and employment opportunities resulting in higher wages, competitive price, more revenue, skills and technology transfer and increased foreign exchange earnings. Similarly, it enhances entrepreneurial capability when the foreign firms bring with it some firm specific knowledge in the form of technology, managerial expertise, and marketing know-how. It also allows new local entrants to learn about exports markets, provide training for workers and stimulates competition with local firms. FDI plays significantly vital role for the country like Nepal which development efforts has been constrained by a number of factors.

Key words: Foreign direct investment, competitiveness, entrepreneurial capability, know-how, technology transfer

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Introduction In this more competitive and globalized world today, no countries are self-sufficient and self –reliant. Most economic theorists, development advocates and experts accept that external capital is necessary along with the mobilization of domestic resources for accelerating growth and industrialization. Today, every developing country irrespective of their size and political systems tries to attract foreign investment. A large number of developing countries have been trying to attract foreign direct investment by the multinational firms through creating conducive environment for investment. Countries are also concentrated on liberalizing their FDI policies by providing either incentives or deregulation. The establishment of Economic Zones (EZ) by some countries also reflects their efforts to attract foreign direct investment. Foreign Direct Investment (FDI) is one of the most important factors of economic development in the contemporary world. Today, FDI is a basic mechanism of capital flows in the globalized economy, and the key factor for economic development in many countries. Foreign investments are of substantial importance for both the host country and foreign investors. For the host country, foreign direct investment contributes to the growth of business activities, increase of export, and employment, transfer of technology and know-how, management skills as well as to initiation or acceleration of the economic growth and development of the country. Firm specific assets, such as capital, technology, technical, managerial and human resource skills, according to some estimation are scarce and lacking in the most part of developing countries. So, FDI is a valuable source of capital, but also an advantageous source of new technologies, technical and managerial know-how, and in this way it represents the source of human capital improvement.

Foreign Direct Investment: Theoretical Overview Until the 1950s, international direct investment was entirely explained within the traditional theory of international capital movements. Like other forms of international investment, FDI was seen as a response to differences in the rates of return on capital between countries.

Market Failure Theory: Structural Market Imperfection Theory is regarded as a dominant theory of FDI which was raised by Hymer (1960) and subsequently explicated by Kindelberger. So, it is called the ‘Hymer- Kindleberger Theory’. The theory proposes that the structure of imperfect competitive market makes the prerequisites for multinational corporations to foreign direct investment. This imperfect competitive advantage results in a monopoly market for MNEs (such as knowledge assets, economies of scale, etc.). And this advantage will access higher profits than the local businesses of the host country to cover higher production cost and organization cost than local enterprises when implementing overseas business commitments.

In this respect, the Natural Market Imperfection Theory of Internalization by P. J. Buckley, M. Carson, and A. M. Rugman is also important. This theory holds that the failure of the market transaction caused the rational allocation of its resources through the internal market when alienating products in order to ensure the enterprises to obtain the largest economic benefits. The determining factor for the internalization of market is transaction costs. If the advantages from the process of internalization can be offset or more than the costs charged, the company will decide foreign direct investment; otherwise choose exports.

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The Eclectic Paradigm The ‘OLI’ or ‘Eclectic’ approach to the study of foreign direct investment (FDI) was developed by John Dunning. OLI stands for three potential sources of advantage that may underlie a firm’s decision to become a multination: Ownership, Location, and Internalization. Ownership advantages can be understood as the capabilities for businesses to meet their current or potential customers’ demand. Ownership that is firm-specific advantage includes patent and trade market, technology, brand recognition, core competency of a firm or an ability meeting with the potential customers’ demand.

Location advantage is external advantages to the firm and is mainly characteristic in three aspects: the immovable factor and endowment of the host country, such as natural resources, convenient geographical location, a large population; the host country's political system, policies and regulations with flexible, concessive, and other favourable conditions (i.e., free tariff barriers), as well as the formation of good infrastructure and gathered economy. It is not owned by enterprises but by the host country; therefore, enterprises cannot control discretionally, but adjust and take this advantage. Dunning had his view that the enterprises having the ownership advantages of intangible assets, through the expansion of their own organizations and business/management activities and the use of internalizing these advantages, will obtain more than non-equity transfer potential or real profits. The fundamental premise of Dunning's eclectic paradigm or the OLI model is that returns on foreign investment as a basic motive for FDI can be explained by three groups of factors: the ownership advantage of the firm (O), location factors (L), and by internalisation of transaction costs (I). Since assuming that foreign investors already posses certain competitive (ownership) advantage, and they are able to internalize transaction costs, the key remaining factor in decision-making process are the location advantages of the host country. Ownership advantages address the question of why some firms but not others go abroad, and suggest that a successful MNE has some firm-specific advantages which allow it to overcome the costs of operating in a foreign country. Location advantages focus on the question of where an MNE chooses to locate. Finally, internalization advantages influence how a firm chooses to operate in a foreign country, trading off the savings in transactions, holdup and monitoring costs of a wholly-owned subsidiary, against the advantages of other entry modes such as exports, licensing, or joint venture. A key feature of this approach is that it focuses on the incentives facing individual firms. Diamond Model As Dunning’s Eclectic Paradigm explains about how Ownership and Location advantages are coined for the internalization by means of FDI, the MNCs decision for investing in a host country depends on how competitive and conducive environment is prevailed in a particular country. This concept was developed by Michael Porter in his Diamond Model. He has incorporated four components like Factors conditions, Demand conditions, Strategy, structure and rivalry and Related and supporting industries to explain the competitiveness of a host country for attracting FDI.

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Double Diamond Model The Conventional Theory of FDI or Porter’s Diamond Model was a masterpiece in explaining the upward flow of FDI but the explanatory power of the Diamond Model came into question as the current trend of FDI from less developed countries to more developed countries could not be explained by this model. Therefore, Moon Hwy Chang and Jeffrey Alan Roehl extended the Diamond Model into Double Diamond Model explaining that the motivation factor for foreign investment by the MNCs is not only the potential advantages but also disadvantages. They explain if an MNC realizes some deficiencies in terms of competitiveness compared to its competitors, then it goes to invest abroad so that it could get access with high skills, technology and be able to fix its disadvantages. Therefore, Double Diamond Model explains more clearly about the current trends of FDI flows.

Key determinants of FDI Theoretically, FDI can benefit both the home country and host country in many ways. But, MNCs decision to go to invest in a country will be determined by a number of factors. They will be motivated when the business environment in the host country is conducive and their investment is secured. From the home country perspectives, the main objective of the MNCs to go abroad is to gain profit. FDI originates from the decision of a transnational corporation (TNC) to locate or relocate part of its activities in a selected host country. This decision is underpinned by the desire to exploit its specific advantages in the form of technology, managerial expertise, marketing know-how, etc. Although, countries do offer financial incentives and various concessions to attract such investment, they are thought to be relevant to TNCs' decision making only if the general business environment is conducive for making profit (Wells and Allen, 2001; Caves, 1996). Assuming that a favourable investment environment exists, it is important to figure out the motives of the TNCs to operate in the host countries. So, the decision of the MNCs to invest in a host country depends on these motives as well as their firm-level advantages and country-level advantages too. The following table presents the key determinants of FDI.

Key determinants and factors for FDI inflow

Economic

Conditions

Markets Size, income level, urbanization, stability and growth prospects, access to regional markets, distribution and demand patterns

Resources Natural resources, location

Competitiveness Labour availability, cost, skill, trainability, managerial, technical skills, access to inputs, physical infrastructure, supplier base, technological support

Host C

ountry

Policies

Macro policies Management of crucial macro variables, ease of remittance, access to foreign exchange.

Private sector Promotion of private ownership, clear and stable policies,, easy entry and exit policies, efficient financial markets

Trade and industry Trade strategy, regional integration and access to markets, ownership control, competitive policies, support for SMEs

FDI policies Ease of entry, ownership, incentives, access to inputs, transparent and stable policies

MNEs

Strategi

es

Risk perception Perception of country risk based on political factors, macro management, labor markets, policy stability

Location sourcing, integration transfer

Company strategies on location, sourcing of products/ inputs, integration of affiliates, strategic alliances, training, technology

Source: Lall (1997)

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Before making decision to invest in a particular country, the MNCs analyse the possible risks and benefits factor of their investment and if they find the investment environment is favourable, they decide to enter in the host country as a form of FDI. But, the MNCs have to choose the mode of entry.

Foreign Direct Investment in Nepal

Key Economic Indicators Nepal is a landlocked developing country with an area of 147181 Sq.km; sandwiched between two giant economies, India and China. Nepalese economy is agro-based; and is comparatively a small economy. Though, the country has some natural resources and also possesses comparative advantage on some products, but the economic growth is constrained by a number of factors like landlockedness, lack of resources and infrastructures, skill and technology deficiency, policy inconsistency and so on.

On the one hand the GDP growth rate is quite low and even not sustainable. On the other hand, increasing import has been resulting the increase in the trade deficit continuously.

Factors

Country Specific Factors

Firm Specific Factors

Product Specific Factors

Industry Specific Factors

Typical Model of Mode of Entry Decision Decision

Mode of Entry Decision

Exporting (Direct, Indirect)

Contractual Agreement (Licensing, Franchising)

Joint Venture (Majority, Minority Strategic Alliance)

Greenfield Merger & Acquisition

Source: Journal of World Business, 1997

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Trends of the Flow of Foreign Direct Investment After pursuing an inward-looking development strategy for over three decades, Nepal embarked on outward-oriented policy reforms in the mid-1980s. The Industrial Policy and Industrial Enterprise Act, promulgated in 1987 (GoN, 1987), marked the beginning of Nepal’s attempt to attract FDI. The Act provided a legal framework for facilitating FDI in medium and large-scale ventures in every industry with the exception of environment and defence-related activities. The Act contained a new set of incentives that were similar to – or even more attractive than - those in other developing countries. For instance, full remittance of profits from FDI ventures in convertible currency was permitted and employment of foreign workers was allowed if domestic workers were not available. A Five-year tax holiday was introduced for export-oriented projects.

The importance of FDI and technology transfer in the country’s development process was more emphasized after 1990. In 1991, the tax holiday period was extended to ten years for investments in national priority activities, which were defined to include industries producing goods that meet basic needs (such as food, clothing and housing and so forth), export promotion activities (where exports are 50% or more of total sales) and hotels and tourist projects. The Foreign Investment and Technology Transfer Act of 1992 opened up foreign investment in all industries except in defence, cigarettes, bidis and alcohol and, 100% foreign ownership was permitted. The development of hydropower was also opened up to foreign investment. The Act guaranteed 100% repatriation of equity, dividends and the payment of principal and interest on foreign loans in convertible currencies. Under the Foreign

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Investment and Technology Transfer Act of 1992, the approval and licensing procedures were simplified with a view to approving investment applications within a stipulated time period of 30 days following the receipt of the application. A One-window Committee was set up at the Ministry of Industries to take charge of the provision of all institutional facilities and services (infrastructure-related and other) under one roof.

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, 2003 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 SAARC member countries and other landlocked countries (World Bank, 2003). A comparison of other South Asian countries, Nepal indicates a poor performance of FDI (UNCTAD, 2003). The inflow of FDI in Nepal from 1980 to 2008 is presented in the table below.

Net FDI inflow (BoP Current US$)

The above table shows that the share of FDI in GDP in Nepal is lower than comparing to the other countries of South Asia, i.e. less than 1 percent. Likewise, the graph shows that the FDI inflow has been fluctuating and even decreasing in Nepal whereas the receipts of FDI by other countries have been increasing over the year.

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It can also be seen from the following graph that Nepal has the lowest FDI stock compared to the SAARC countries.

FDI by Sectors According to Nepal Industrial Statistics 2007/2008(CBS, Nepal) there were 1,423 firms operating with foreign investment from 139 countries. These firms employ 121,484 people. India has the largest number of investment in Nepal consisting 393, China 179, Japan 132, South Korea 94, UK 94, Germany 61 and Switzerland 27. Manufacturing sector has the largest number of FDI involved sector (565) and hotel and resort sector (370) second. Textile and garment 210 and energy, water and gas sector has 32 companies.

While, according to the statistics from the Department of Industry, Nepal (2008/2009 Tourism dominates the FDI inflow in Nepal (30%). Service industries (27%) and manufacturing industries (25%) are next largest FDI involved industry. Energy and mineral sectors have least numbers of FDI. The FDI inflow in agriculture sector is quite low i.e. only 6%. On the basis of scale of firms majority of the FDI are small and medium scale firms. India has the highest number of FDI in Nepal, US investment is second largest amount of FDI, China third, South Korea fourth, Norway fifth, Japan sixth and British Virgin Islands, seventh in Nepal. 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%. 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. Most of the FDI in Nepal is Greenfield-type investment rather than acquisition.

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Policy Initiatives and Institutional Arrangement for FDI Promotion in Nepal Policy Initiatives In the pre-liberalization period, i.e. before 1990s, the investment regime was more restrictive. Investors had to obtain a government license before undertaking any production and business activities. The FDI was almost nil before 1980. Nepal started its effort to attract foreign investment since early 1980s during the sixth plan (1980-1985). The industrial policy of 1981 has made a separate provision relating to foreign investment. In order to make legal provision for a promotion and for the regulation of the foreign investment and technology, a separate act entitled “Foreign Investment and Technology Act 1981, was introduced in 1992. The act was again reviewed and a new act entitled “Foreign Investment and Technology Transfer Act (FITTA), 1992 was brought into practice.

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, 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. Likewise, Nepal passed the Copyright Act in 2002. As Nepal joined in the WTO in 2004, the Industrial Policy has been revised in 2010 realizing the need for strengthening its industrial capabilities to face the potential challenges and aiming to get optimum benefits from world trade.

Although some attempts to liberalize the investment policy were made from the beginning of the 1980s, it was speeded up only after 1990. Government of Nepal has adopted an open and liberal policy to pave the way for the accelerated economic and social development of the country. Especially in the field of industry and trade, the government policy is aimed at giving the private sector a dominant role. The private initiatives and enterprises are expected to increase efficiency and productivity. The government's role will be that of a facilitator providing infrastructure and creating conducive environment for investment.

Institutional Arrangement The Government of Nepal has been trying to promote foreign investment through the establishment of some institutions. Government’s efforts are also concentrated on encouraging the private sectors and working in collaboration within the country for the building investment-friendly environment. Major institutions and their functions regarding for the promotion of FDI in Nepal can be summarized in the table below.

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Major institutions for promoting FDI in Nepal Institutions Objectives Main Functions

Ministry of Industry, Commerce and Supply

Industrial Promotion Formulation of policy frameworks

Department of Industry Industrial Administration

− Registration of Industries − Providing incentives and facilities to the industries under industrial Enterprise Act and Foreign Investment & Technology Transfer Act

Company Registrar’s Office Company Administration

Incorporation of Companies

Nepal Industrial Development Corporation

Provides financial supports

Provides term loans and credits for industrial development

National Productivity and Economic Development Centre

Feasibility Study Prepares feasibility reports and provides policy feedbacks to the policy makers.

Industrial District Management Office

Infrastructural support

Provide infrastructures like utility services and other facilities.

Investment Promotion Board

Investment promotion and looking for potential investors

− Helps in creating investment friendly business environment

− Provide policy recommendations − Find potential investors and recommends to the government

Federation of Nepalese Chambers of Commerce and Industry

Industrial and business promotion

− Provide policy feedback to the government

− Facilitate private sector investment.

Assessing the Competitiveness of Nepal Environment for Investment and Doing Business Despite significant liberalization of the foreign investment regime and the introduction of attractive investment incentives, Nepal's achievements, both in terms of the volume of FDI and its developmental impact, failed to match national expectations. Nepal obviously has intrinsic disadvantages arising from its geography and other typographical characteristics in attracting FDI. Although, Nepal possesses some incentives for the MNCs to invest, the investment is quite low compared to other countries. The Nepali market is very small for big investment with per capita consumption being extremely low. However, in Nepal, it is felt that the flow of FDI is still quite low in comparison to other developing countries given the huge potential of adjoining markets, favourable climate, cheap labor, vast natural resources, etc. Even when compared to other South Asian countries, Nepal does not have the best regulatory procedures, investment facilities and infrastructure. Policy inconsistency, poor monitoring mechanism, ineffectiveness of institutional arrangements, lack of promotional measures, adequate infrastructure and skilled manpower and bureaucratic hassles are some of the major impediments to the flow of FDI.

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High transport costs arising from its unique geography are obviously a significant constraint faced by Nepal and put it at a disadvantage compared to many other low-wage countries in attracting export-oriented FDI. Apart from the long distance to Indian ports (the port of Calcutta is about 1,000 kilometres away by the shortest route), inefficiencies of the Indian railways and ports add to the cost of transport for potential exporters from Nepal. It is also alleged that shipments from Nepal are given low priorities at the highly congested Indian ports. Investment Guide to Nepal has explained the reasons behind the slow flow of FDI to Nepal. They include, among other things, the Nepali labor law, which is excessively pro-labor, complex tax administration, slow and negative implementation, discouraging exchange system and poor infrastructure facilities, etc. The following table presents a comparison among some countries about the indicators for business facilitation. Nepal is relatively better in comparison with India and also in comparison with the landlocked country Lao PDR. But this does not mean that its business environment in satisfactory because its overall score is quite low compared to the country like South Korea. Investment Competitiveness Indicators

EconomyDoing Business Rank

Starting a Business

Dealing with Construction

Permits

Employing Workers

Registering Property

Getting Credit

Protecting Investors

Paying Taxes

Trading Across Borders

Enforcing Contracts

Closing a Business

Nepal 123 87 131 148 26 113 73 124 161 122 105India 133 169 175 104 93 30 41 169 94 182 138South Korea 19 53 23 150 71 15 73 49 8 5 12Bangladesh 119 98 118 124 176 71 20 89 107 180 108China 89 151 180 140 32 61 93 125 44 18 65Lao PDR 167 89 115 107 161 150 182 113 168 111 183

Source: www.doingbusiness.com In 2003, UNCTAD had conducted a survey regarding the business environment investment competitiveness of Nepal. The survey has explored and highlighted not only the key factors contributing for promoting foreign investment but also mentioned the factors hindering the business environment of Nepal.

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Existing Business Condition and Problems of FDI promotion in Nepal In spite of possessing some potentialities for economic development, Nepal has been 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. Nepal had attracted modest FDI in niche sectors such as tourism, herbal products, mineral deposits like lime stone, and light manufacturing apparel; hydro power; and that it had positive impacts on exports, particularly in garments. FDI has also enabled the country to export non-traditional manufactured products such as micro transformers and personal consumer products (UNCTAD, 2003). Investment is mainly in low-technology, labor-intensive production. The impact of FDI had also been modest, primarily in job creation. According to a study conducted by UNCTAD, FDI inflow was constrained by political instability, outdated foreign investment law, rigid labor regulations and poor physical infrastructure. This situation remains current due to political instability and political transition. There is no doubt that Nepal has gone a long way in liberalizing its investment regime. However, very few reforms have taken place in factor markets, in particular the labour market. For example, under the Labour Act of 1992, firing a worker is extremely difficult and costly. Electricity distribution is still regulated by the State-own enterprises, namely, the Nepal Electricity Authority, which suffers from inefficiency and poor management. Despite having a considerable potential for producing hydroelectricity, the country suffers from chronic shortages of electricity. In the late 1990s, on average, almost half of the production capacity in manufacturing remained unutilized due to the shortage of electricity. While some progress has been made over the years in developing the transport networks, many parts of the country are still not connected with major cities. Also, there are very few flight connections between the capital, Kathmandu, and places of tourist attraction. Many foreign firms have ceased their operations or indefinitely postponed implementation of newly approved projects as the political instability persisted and security situation deteriorated rapidly. Most participation of foreign firms in tourism – an activity where Nepal has a huge potential – has not been much due to the lack of efficient transport networks and frequently disturbing political movements. But, it does not mean that Nepal has only the dark side for the foreign investors but some opportunities and potentialities also. The strengths and weaknesses of Nepal’s competitiveness for investment can be summarized by the Diamond Model.

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Analysing the business condition in Nepal applying Diamond Model

Prospects of Attracting FDI 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 the member of World Trade Organization (WTO) 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.

Another major inducement for Indian investors has been the opportunities for profit-making created by Nepal’s low tariffs. Because of the successive tariff cuts from the late 1980s, tariffs on many imported intermediate products in Nepal are much lower than in India. This difference, combined with a virtual open border between the two countries, has made simple processing industries for a number of products (including vegetable ghee, copper wires and some cosmetics) geared to the Indian market highly profitable. As India and China have been enormously raising their global business as well as both inflow and outflow of FDI, it can be a good strategy for the other neighbouring countries like Nepal to get benefitted from these economies. Like many other emerging market economies, South Asian countries have also taken a number of steps to liberalize FDI regimes by augmenting the automatic approval route, lowering sectoral caps, simplifying exchange controls and intensifying investment promotion. They have been initiating more promising FDI policies in terms of pre-entry and post-entry treatment of foreign investors. Indeed, the South Asian Countries are aiming to expand the cooperation among them for attracting more FDI and to get mutually benefitted.

Nepal

Strategy, Structure & Rivalry § Promotional policies & institutions § Openness

∗ Inconsistent policies ∗ Political instability

Related & supporting sectors § Positive public attitude § Supportive social networks

∗ Poor infrastructure ∗ Inefficient management

Factor condition § Cheap labour § Natural resources

∗ Unskilled labour ∗ Underdeveloped resources

Demand condition § Big neighboring markets § Increasing middle class

∗ Small domestic market ∗ Low purchasing power

Legend § Strengths ∗ Weaknesses

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For this purpose, most countries have adopted an “FDI targeting approach”. In that context they are aiming at FDI in certain priority sectors. As shown in the table below, it clearly shows that most countries are marking investment in light and labour intensive industries where regional firms have developed competitive advantages. That’s why; Nepal has to explore the ways how it can get benefitted complementarily from the countries of proximity. Countries Priority Sectors Pakistan Priority industries: tourism, housing, engineering, chemicals and construction. “Value

added export industries”: manufacturing categories such as garments, bed linens, surgical instruments, and sporting goods. High-Tech and Information Technology industries: chip manufacturing, software development and precision equipment manufacturing.

Bangladesh Textiles, Electronics, IT, natural gas based industries, frozen foods, leather, Ceramics, Light engineering and agro based

Nepal Tourism, Medicinal and aromatic plants, agro based (mushroom., spices, vegetables, fruits), Dairy, Tea, Sericulture, Hydro power, leather, Poultry and textiles

Sri Lanka Electronics, light engineering, Textiles, Rubber, mineral and processing, Tourism, IT, Gems and Jewellery, Health care and Pharmaceuticals, ceramics, services

Bhutan Hydro power, agro processing, tourism, medicinal plants, Maldives Marine based industries, Tourism, Infrastructure and air and sea transport

FDI Strategies FDI is permitted in all industries in Nepal except for those reserved exclusively for national investors and in statutory State monopolies. This reflects the caveats in the 1992 policy statement, which despite its stated goal of introducing an “open policy”, provides that 100 per cent foreign ownership will be permitted only in large and medium-scale enterprises. Formally, the entry of FDI is governed by the Foreign Investment and Technology Transfer Act of 1992 (“the foreign investment law”). FDI is permitted except in industries contained in the ‘negative list’ including industries sensitive to national security; cottage (i.e. craft) industries; personal services of a kind that would normally be performed by self-employed people; and real estate business and also the business like retail business; travel agencies; cigarette, tobacco and alcohol production other than for export; a range of small tourist-related activities.

Nepal has the potential to attract significantly more FDI. Compared with most other low income countries, it has a surprisingly long list of advantages. These include a large and friendly neighbouring country that offers market potential, a flourishing local entrepreneurial culture in both small and large business and established international recognition and image. But this potential is severely constrained – wasted, to put it bluntly – by the poor investment framework. In these circumstances, a Nepal needs to apply a range of strategy for promoting foreign investment. These usual elements of an FDI strategy, including establishment and development of infrastructure, restructuring of institutional and legal frameworks, deregulation as well as general programmes of investment promotion, linkages with national firms, and some longer-term plans to improve competitiveness. Basically, Nepal's FDI strategy must consist first and foremost of a firm and orderly process of relieving the constraints in the investment framework.

Source: Compiled from the FDI promotion agency of each country

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The three themes of Nepal's FDI strategy should be: − Immediate and high-level start on improvement of the investment framework; − Creation of Industry Promotion Packages to gain early winners; − Formation of an atypical investment agency within the Government.

In this context, adaptation and implementation of the basic strategies explained in the following TP Matrix will be useful for the Government of Nepal in order to promote its competitiveness for investment.

Term-Priority (TP) Matrix for Improving Weaknesses

• Political stability • Maintaining industrial relations

• Assuring the security of investments

• Implementation of policies

• Industrial restructuring • Development of infrastructure • Deregulation • Human resource development • Competitive tax and regulatory regime

• Medium-size hydropower generation

• Tourism hub and regional sub-hubs

• Renovation of cultural attraction

• Technological development • Enhancing bureaucratic ethics

• Maintaining social harmony

• Corruption control

• Autonomous IPA • Policy consistency • Revising the Labor and Land Law • Non-discrimatory treatment among investors

• Enhancing social safety networks • Autonomous Privatization Agency

• ICT-based service • Establishment of industrial estates

• Privatization of the SOEs • Promoting economic diplomacy

• Providing minimal incentives

• Collaboration and partnership

• Investment Promotion Package • Restructuring tax administration • Extending business networks

• Increase export • Increasing GDP • Treaty and negotiation

But these points mentioned in the matrix are not the rules of thumb. They can still be more simplified, more intensified and more specified based on the need of the investors. The most important thing of each of these recommended points is to maintain its strengths; and fix the deficient factors for creating an investment-friendly environment for the foreign investors.

Conclusion Nepal has made a promising start in implementing market-oriented reform and promoting FDI, but it has a long way to go in reaping the benefits from integration into the global economy through FDI. Under the new policy regime, foreign firms had played a significant role in some sectors like carpets and garment exports, but their exports were largely motivated by some incentives such as the Generalized System of Preferences and MFA quotas rather than the country’s comparative advantage. A large numbers of foreign investment projects are also based on shaky foundations, motivated by import deflection opportunities created by vast tariff differentials between Nepal and India. The overwhelming majority of foreign firms are involved in import substitution activities characterized by high capital intensity. Consequently, the contribution of FDI to employment generation has been negligible. It seems that FDI attracted to “easy profit” activities (import-substitution

High

Low

Short Medium Long

Priority

Term

Medium

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manufacturing as well as the quota-protected garment industry) has failed to make a significant contribution to productivity growth in the Nepalese manufacturing sector. The foreign firms are located in the Kathmandu Valley or in the Terai belt, while the geographic spread of the gains from foreign investment has been rather skewed. Most participation of foreign firms in tourism – an activity where Nepal has a huge potential – has not been much due to poor infrastructure, lack of efficient transport networks and frequently disturbing political movements like strikes and riots..

An obvious, but important, inference coming from this analysis is that trade liberalization and generous investment per se in the absence of basic pre-conditions cannot achieve anticipated developmental objectives. The provision of required supportive services, political stability, policy certainty and efficient administrative mechanism has an equally – perhaps even more - important role to play. Nepal obviously has disadvantages arising from its geography in attracting FDI. However, comparative international experience suggests that her lacklustre record as a host to foreign investors cannot be explained in terms of its geography alone. The overall investment climate does matter.

Based on the analysis, it can be noticed that Nepal has some potentialities for attracting more FDI. Also, it is true that Nepal is deficient in many aspects of attracting FDI. It is very important to know that Achieving political stability, reviving investor confidence, and overcoming low agricultural productivity are critical challenges that will have to be overcome before economic performance improves. A more manageable approach based upon creating havens of good facilities and practice for investors is needed.

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References:

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