Masters Program for International Development Policy

Foreign Direct Investment

Term Paper - 2010

Attracting Foreign Direct Investment in Nepal

Submitted to: Prof. Hwy-Chang Moon

Submitted by: Khagendra Prasad Rijal
Spring 2010
Executive Summary

Table of Contents
Title Page

1. Introduction 3

2. Foreign Direct Investment: Theoretical Overview 3-5

2.1. Market Failure The
2.2. Eclectic Paradigm
2.3. Diamond Model and Imbalance Theory
2.4. Double Diamond Model

3. Key Determinants Of FDI 5-6

4. Foreign Direct Investment in Nepal 6-9

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

5. Policy Initiatives and Institutional Arrangement for FDI Promotion in Nepal 10-11
5.1. Policy Initiatives
5.2. Institutional Arrangement

6. Assessing the Competitiveness of Nepal 11-12

6.1. Environment for Investment and Doing Business
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

1
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
Markets Size, income level, urbanization, stability and growth prospects,
access to regional markets, distribution and demand patterns
Conditions
Economic

Resources Natural resources, location

Competitiveness Labour availability, cost, skill, trainability, managerial, technical
skills, access to inputs, physical infrastructure, supplier base,
technological support
Macro policies Management of crucial macro variables, ease of remittance, access to
foreign exchange.
Host Country

Private sector Promotion of private ownership, clear and stable policies,, easy entry
Policies

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
Risk perception Perception of country risk based on political factors, macro
Strategi
MNEs

management, labor markets, policy stability

es

Location sourcing, Company strategies on location, sourcing of products/ inputs,

integration transfer 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.

Typical Model of Mode of Entry Decision

Decision
Factors

Country Specific Industry Specific Firm Specific Product Specific

Factors Factors Factors Factors

Mode of Entry
Decision

Exporting Contractual Agreement Joint Venture (Majority, Merger & Greenfield

(Direct, Indirect) (Licensing, Franchising) Minority Strategic Alliance) Acquisition

Source: Journal of World Business, 1997

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.

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 4

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
7
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, Industrial Promotion Formulation of policy frameworks
Commerce and Supply
Department of Industry Industrial − Registration of Industries
Administration − Providing incentives and facilities to
the industries under industrial
Enterprise Act and Foreign
Investment & Technology Transfer
Act
Company Registrar’s Office Company Incorporation of Companies
Administration
Nepal Industrial Provides financial Provides term loans and credits for
Development Corporation supports industrial development
National Productivity and Feasibility Study Prepares feasibility reports and
Economic Development provides policy feedbacks to the
Centre policy makers.
Industrial District Infrastructural Provide infrastructures like utility
Management Office support services and other facilities.
Investment Promotion Investment − Helps in creating investment friendly
Board promotion and business environment
looking for potential − Provide policy recommendations
investors − Find potential investors and
recommends to the government
Federation of Nepalese Industrial and − Provide policy feedback to the
Chambers of Commerce business promotion government
and Industry − 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

Doing Dealing with Trading
Starting a Employing Registering Getting Protecting Paying Enforcing Closing a
Economy Business Construction Across
Business Workers Property Credit Investors Taxes Contracts Business
Rank Permits Borders
Nepal 123 87 131 148 26 113 73 124 161 122 105
India 133 169 175 104 93 30 41 169 94 182 138
South Korea 19 53 23 150 71 15 73 49 8 5 12
Bangladesh 119 98 118 124 176 71 20 89 107 180 108
China 89 151 180 140 32 61 93 125 44 18 65
Lao 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
Strategy, Structure & Rivalry
§ Promotional policies & institutions
§ Openness
∗ Inconsistent policies
∗ Political instability

Factor condition Demand condition

§ Cheap labour § Big neighboring markets
§ Natural resources § Increasing middle class
Nepal
∗ Unskilled labour ∗ Small domestic market
∗ Underdeveloped resources ∗ Low purchasing power

Related & supporting sectors

§ Positive public attitude Legend
§ Supportive social networks § Strengths
∗ Weaknesses
∗ Poor infrastructure
∗ Inefficient management

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.
14
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
Source: Compiled from the FDI promotion agency of each country

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)
12
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.

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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 • Industrial restructuring • Medium-size hydropower
• Maintaining industrial • Development of infrastructure generation
High

relations • Deregulation • Tourism hub and regional sub-

• Assuring the security of • Human resource development hubs
investments • Competitive tax and regulatory • Renovation of cultural
• Implementation of policies regime attraction
• Technological development
• Enhancing bureaucratic • Autonomous IPA • ICT-based service
Medium

ethics • Policy consistency • Establishment of industrial

Priority

• Maintaining social • Revising the Labor and Land Law estates

harmony • Non-discrimatory treatment among • Privatization of the SOEs
• Corruption control investors • Promoting economic
• Enhancing social safety networks diplomacy
• Autonomous Privatization Agency
• Providing minimal • Investment Promotion Package • Increase export
incentives • Restructuring tax administration • Increasing GDP
Low

• Collaboration and • Extending business networks • Treaty and negotiation

partnership

Short Medium Long

Term

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
13 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
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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.

17
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