Author: Invest for Impact Nepal
Original Publication Date: 15th August 2022
Regulatory Reforms for Accelerating DFI Investment in Nepal
The Foreign Investment and Technology Transfer Act, 2019 (2075) (FITTA) allows eligible foreign investors, including development finance institutions (DFIs), to make various forms of investment in Nepal. Nepal has seen a gradual rise in investments from DFI investors funding development impact-oriented projects, which are expected to contribute to improving the skills, strength and capacity of local sectors and human resources, increase innovative activities, and reach the ‘missing middle’ by supporting SME financing in Nepal.
The foreign investment regime for industrial sectors in Nepal is governed by the following key laws: The Foreign Investment and Technology Transfer Act, 2019 (2075) (FITTA); The Foreign Exchange (Regulation) Act, 1962 (2019) (FERA); The Public Private Partnership and Investment Act, 2019 (2075) (PPPIA); Foreign Investment and Loan Management Bylaws, 2021 (2078) (Foreign Investment Bylaws or NRB Bylaws); and The Industrial Enterprises Act, 2020 (2076) (IEA).
For foreign investment in non-industrial sectors, sector–specific laws apply, for instance The Bank and Financial Institution Act, 2017 (2074), The Insurance Act, 1992 (2049), and The Payment and Settlement Act, 2018 (2075).
This blog will look at: (1) The basics of foreign investment in Nepal; (2) Issues on foreign investment in Nepal with specific reference to DFI investment; and (3) Possible measures to mitigate these existing issues.
1. Basics of Foreign Investment in Nepal
FITTA 2019 envisages international origination as one of the criteria to be a foreign investor. In this regard, development financial institutions fall under the definition of foreign investor.
Foreign investment is only allowed in industrial activities, not in trading activities. Moreover, it is only permissible in sectors that are classified as an industry under the IEA (the “positive list”) and do not appear on the list of restricted sectors in the Schedule attached to FITTA (the “negative list”). So even if a sector does not appear on the negative list, if it is not classified as an industry on the positive list then foreign investment in that sector is not allowed. Additionally, the negative list is applicable only in the case of equity investment, not in cases of loan investment or if a transfer of technology is made in an industry set up together with local investment.
In this context, the following are the types of foreign investment permissible in Nepal, and the relevant authorities granting approval:
In addition to the foreign investments listed above, DFIs can make loan investments, regulated by the relevant authorities below:
2. Challenges for FDI in Nepal
The legal regime governing foreign investment in Nepal has undergone various changes in recent years, many of them creating a positive impact. Progress has been made in several legal and regulatory aspects. Like any other country, various challenges still prevail. These include:
A. Capital Investment-related Issues:
The foreign investment restrictions imposed by FITTA on certain industries are one of the challenges facing DFI investment in Nepal. Restricted industries include poultry farming, fisheries and primary agriculture-based business; cottage and small industries; travel agency, tourist guides, trekking and mountaineering guides, and rural tourism including homestay; and real estate business (excluding construction industries).
Providing easy entry and exit should be a key value addition of the foreign investment regime. FITTA mandates a statutory timeline for approval of foreign investment of seven days from the date of submission of an application (including all required documents) to the relevant foreign investment approval body. However, DFIs have been facing substantial delays in obtaining timely foreign investment approval. Furthermore, each regulatory authority requires physical submission of the same set of foreign investment documents in order to grant the relevant approval. Officials manually screen and study commercially negotiated foreign investment documents, which adds to the delay in the approval process.
Although FITTA provides for an automatic route to foreign investment approval, there is no legal provision for the operation of this mechanism. In his budget speech for the financial year 2022/23, Nepal’s then Finance Minister, Janardan Sharma, announced that an automatic mechanism for approval of foreign investment up to NPR 100m would be introduced. Implementation of such an automatic route would speed up the foreign investment process in Nepal.
FITTA also requires foreign–invested venture capital funds to obtain prior approval from the relevant foreign investment approval body or bodies before making equity investments in other entities, which can be cumbersome and time–consuming. Additionally, the timeline provided by the foreign investment regulations to bring in specific tranches of foreign investment is an additional issue for foreign investors. The right to bring in tranches of foreign investment should be subject to the requirements of each project, not strictly regulated by law.
FITTA stipulates a prescribed minimum cap on the amount of equity provided by foreign investment. In the Nepal Gazette notification of 29 May 2019, the Government of Nepal set this minimum at NPR 50m for each foreign investor. However, in his 2022/23 budget speech, Finance Minister Janardhan Sharma reduced the minimum ceiling for foreign investment in general to NPR 20m, although he did not clarify sector–specific minimum ceilings. The Government of Nepal is supposed to issue a Gazette notification for implementation of new FDI thresholds but has not yet done so. Nevertheless, except for capital intensive projects such as hydropower, construction, hotels, etc., the new ceiling may not be practical, for instance for service-based investments, software development, data processing or computer services, etc. Even in cases of capital-intensive sectors, the initial investment (for example investment by one of the shareholders during the survey period) may be less than the ceiling amount but may gradually increase and is likely to be more than the ceiling amount as the project meets the key stages for its development. Therefore, the requirement for a minimum threshold would be problematic for non-capital-intensive projects.
B. Lending-related Issues:
Most foreign loan investors check for a sovereign credit rating before extending any loan facility in any country. Nepal has not been rated on credit worthiness by a rating agency yet. Due to the lack of such a rating, foreign lenders do not have a risk-return benchmark, and for many DFIs this may prevent them from accurately assessing and extending a loan facility with appropriate terms and tenors in Nepal.
The Central Bank of Nepal (NRB) mandates a cap on interest rates of: (i) benchmark (12 months) plus 6% per annum margin in the case of a loan facility to be provided by the development financial institutions to the project company; and (ii) benchmark (12 months) plus 4.5% per annum, in the manner to include associated fees including front end fees, amendment fees, increased costs, consultation and legal fees. However, the latest amendment to the NRB Bylaws on Foreign Investment and Loan Management, 2021 excludes some of the associated fees under the interest rate ceiling which were not excluded before the amendment. These fees excluded are applicable taxes; penal interest at the maximum rate of 1%; pre-payment fees at the rate of 0.25%; and commitment fees of 0.25%. Depending on the nature of the project and the risks associated with it, higher interest may be required. However, such flexibility is not provided as an option when engaging in fixed–rate lending. Furthermore, the NRB has also disallowed payment of any expenses (such as due diligence expenses), costs, commissions and other fees associated with the loan transaction prior to disbursement. This imposes significant costs on foreign investors up-front, without any guarantee of recovery if the loan does not materialise.
Another issue regarding foreign loan investments is the implied priority to local lenders at the time of repayment. The NRB Bylaws provides priority for repayment of foreign debts and interests to local lenders over foreign lenders. Therefore, an application to the NRB seeking approval for payment of the foreign loan principal and interest to the foreign lender must also include proof obtained from the Credit Information Bureau that the borrower is not blacklisted for default of any loan obtained from a bank or financial institution in Nepal; and a self-declaration by the borrower that there is no matured loan payable to any bank or financial institution in Nepal.
However, the NRB Bylaws does not provide any provision or procedures as to how the NRB will process repatriation approval if the borrower is blacklisted. Given this lack of clarity, and in view of the requirement of the NRB Bylaws to submit proof that a borrower is not blacklisted along with a self-declaration regarding non-default of loans, the NRB is unlikely to permit repatriation approval in such cases.
In the context of secured loans, the lender requires security over assets (including immovable property) to be established before advancing a loan. Such foreign lenders must procure the approval of the Government of Nepal to create a security interest over immovable property. In the past, obtaining such approval has been time-consuming, which ultimately impacts loan disbursement. From a policy point of view, all foreign lenders are subject to regulatory approval, and cannot provide loans without prior approval. Given that the purpose of the loan is already screened by the regulatory approvals, there may be no need for additional screening and approval by the Government of Nepal to grant security in the context of secured lending. Further, foreign lenders are charged substantially higher fees for registration of mortgage of security over immovable property (which can be in the range of 1% of the loan amount).
Furthermore, there is a lack of clear regulation regarding the framework for the creation and operation of an offshore debt service reserve account (DSRA). Approval of the NRB is required to open and maintain an offshore DSRA. Similarly, in the past, the NRB has also required the project company in Nepal to obtain prior approval of the NRB before each transfer of any funds to the offshore DSRA – a lengthy and time-consuming process.
C. Sectoral Issues:
Besides assessing the general foreign investment climate of Nepal, foreign investors should also pay attention to sectoral developments and issues while investing in Nepal. With respect to the hydro-energy sector, there is uncertainty over whether project companies will necessary be granted a power purchase agreement (PPA) with the Nepal Electricity Authority (the only off-taker in Nepal). Furthermore, laws governing hedging are rather vague, causing confusion over hedging fees for energy projects. In addition, FITTA restricts foreign investment in engineering services, with the result that engineering, procurement and construction (EPC) contractors have only been able to carry out construction and procurement works through a local investee in Nepal.
FITTA also imposes restrictions on foreign investment in the agricultural industries and subsectors of the tourism-based industries. Similarly, the NPR 50m minimum foreign investment threshold has been discouraging to investors specifically seeking to invest in the IT sector, which generally does not require a large inflow of capital. As discussed above, the budget speech for the financial year 2022/23 reduced the minimum threshold for foreign investment to NPR 20m, but did not introduce a sector–based minimum cap on investment. The Government of Nepal is yet to issue Gazette notification for the reduction in the minimum threshold. Further, the requirement of a minimum of NPR 20m of foreign investment might still be too high for non-capital-intensive sectors such as IT and technology–based industries, as well as service–providing industries. Industries established in a Special Economic Zone (SEZ) may face the issue of not meeting the requirement of exporting 60% of total production or services, as mandated by the Special Economic Zone Act, 2016 (2073). Lastly, FITTA restricts production of the main goods of an industry through contract manufacturing, but permits contract manufacturing arrangements in the case of the production of auxiliary products. Consideration should be given to allowing businesses to have the liberty to manufacture goods suitable to their capacity and convenience.
3. The Way Forward
While great progress has been made, the existing issues hindering foreign investment and lending could be resolved by introducing changes to legal provisions, regulatory practices and policies in Nepal. Suggested reforms to existing laws and practices include the following:
Implementing an automatic route to foreign investment approval could eliminate various obstacles that slow foreign investment in Nepal. The automatic route would replace existing government approval requirements such as foreign investment approval, approval on repatriation of investment and earnings, registration of company, and industry registration. The budget speech for the 2022/23 financial year envisaged applying an automatic route for foreign investment up to NPR 100m. However, to implement the automatic route, the Government of Nepal should issue either an amendment to regulations under FITTA or separate specific guidelines. Alternatively, if the government were given support to formally establish a digitised system for screening, recording and maintaining files and records, government agencies such as the One Window Service Centre, Department of Industry (DOI) , Investment Board Nepal (IBN), Nepal Rastra bank (NRB), and Office of the Company Registrar (OCR) could offer improved foreign investment services. Moreover, administrative bodies could benefit from training and development related to the use of information technology and vetting of investment documents, and the information required could be limited to key data such as investor details and the investment amount.
It would be appropriate for investors, particularly DFIs, to hold policy discussions with line ministries, to draw up a timeline for bringing investment suitable to the investors’ project arrangements, and in line with a company’s capital requirements.
In the context of foreign loan investments, the Government of Nepal could proceed in obtaining a sovereign rating. In lending transactions, interest rates play a vital role; based on the nature and scope of lending transactions, bylaws could be amended and project-based interest rate caps considered. Regarding the prioritisation of local lenders and blacklisting challenges, a policy discussion could be initiated on the development of non-discriminatory provisions that enable foreign lenders to recover their loans. On the critical issue of the restriction of fees prior to disbursement, bylaws could be amended in the relevant regulations to enable certain fees to be paid to the lender prior to disbursement. Initial discussions with the Council of Ministers could be held, recommending them to grant approval for the creation of security interest within clear, predictable and implementation-friendly timelines.
In spite of these various challenges, however, we note that the last three years have seen significant progress in the foreign direct investment landscape for DFIs, and this has been met with a corresponding rise in investment in Nepal. We believe that once these challenges have been overcome, it will lead to greater investment and impact, and we look forward to the progress to be made.