In the first part of this article, titled "Tapping into foreign debt markets", published on March 28, we highlighted the necessity of tapping into foreign debt markets to secure funding for Nepal's energy ambitions. We delved into the obstacles of needing an issuance history. In this piece, we lay out the strategies for initiating the pivotal first step, while also addressing the elephant in the room: Will the rise in commercial foreign public debt and private sector bond borrowing, influenced by the country's credit rating, exhaust foreign currency reserves or plunge the nation into a debt trap?

Looming concern

As the fresh memories of the Sri Lankan crisis loom large, this concern becomes even more straightforward when we consider that the total payments on a loan will always exceed the amount received due to interest. However, loans are inherently neither good nor bad—their value lies in how they are utilised. All is well if the income generated from borrowed funds surpasses the repayment cost. This principle applies to nations and individual businesses alike. Yet there's an additional consideration to foreign currency borrowing—we must ensure the availability of enough foreign currency. Simply put, paying in dollars while earning in the Nepali currency may not be sustainable. While individual businesses needn’t fret, it’s the aggregate surplus that matters. Fortunately, the export potential of renewable energy alleviates the concerns in this case.

With that matter addressed, let's focus on resolving the obstacles hindering Nepal's entry into international bond finance.

The perceived high investment risk in Nepal and the absence or potential lowness of credit ratings could result in either a lack of interest in lending by international bond investors or inflated pricing. However, there's a silver lining: Guarantees stepping in as the cavalry. These guarantees may originate from development finance institutions or other guarantee-providing entities involved in the issuance process. However, this peace of mind comes with a price tag. Therefore, the issuer must strike a delicate balance between the higher coupon payments due to perceived higher risk and the premium paid for the issuance.

Pooling together smaller hydroelectric projects to create a larger issuance could provide an initial step in establishing a track record for bond issuance in Nepal. This diversified pool helps mitigate overall default risk. These initial steps mustn’t be overly radical, as building a yield curve requires careful progression.

The government guarantee mentioned earlier is essential for the Power Purchase Agreements (PPAs). It can be incorporated while signing the PPA with Project Development Agreements (PDAs). While similar guarantees are already commonplace in PDAs for large hydroelectric projects, extending such provisions to smaller projects is essential.

To make the first step even more cushioned, initial issuances can focus on refinancing operating hydropower. The construction risk associated with greenfield projects may be too significant and so can drive the price of bonds higher. This enables the experienced local Nepali lenders to undertake new projects with freed-up funds.

In such cases, traditional PDAs may not be suitable for the projects already developed. Regardless of the terminology, implementing the guarantees—whether through addendums to PPAs or government letters—is necessary. The government should explore offering these facilities on a conditional basis to facilitate projects and funds to proceed with bond raising. It's crucial to avoid the pitfall of requiring international bond financing as a prerequisite, thus preventing a "chicken versus egg" dilemma.

Nepal should consider blending finances at the source or issuing multiple tranches, provided they're sizable enough to attract investors. This will bring the costs down. International development finance institutions (DFIs) or the Nepal Government could opt for junior equity-esque tranches. Alternatively, the government could proactively establish mechanisms to procure such capital, given Nepal's lag in leveraging blended finance. In 2023, Nepal participated in only seven out of 167 transactions worth $23.5 billion, surpassing only Afghanistan and Bhutan.

Currencies

Let's now delve into the realm of currencies. On average, the Nepali Rupee (NPR) has depreciated by 3 percent annually against the dollar. For international bond raises, the deepest currency is generally the US dollar. We need development finance institutions and multilateral development banks (MDBs) to offer products and programmes with concessional exchange rate guarantees, especially for developing nations like Nepal grappling with currency depreciation. After all, currency depreciation isn't unique to Nepali rupee alone.

In the short term, we can focus on INR-denominated issuances. With India's recent inclusion in the GBI-EM index, bond investors are drawn to the allure of INR exposure. In collaboration with the central bank, the government could implement mechanisms to mitigate de-pegging risks, thereby facilitating INR bond issuances from Nepal. Although the INR market is shallower than the USD, for now, this strategic move would circumvent the prohibitive costs associated with hedging against the US dollar in the case of USD issuances.

The high taxes (15 percent) deducted at source on the interest payments increase the price of the bonds. These taxes are baked into the interest rate as the lenders seek to ensure they earn their target return net of tax. Tax waivers on such bonds in the initial days will help lower the cost and start the momentum. DTAAs could also be handy in such cases. The Nepal Government should proactively negotiate double taxation avoidance agreements (DTAAs) with countries where investors with deep bond pockets are domiciled. However, to ensure the credibility of these agreements, Nepali tax authorities must consistently uphold existing DTAAs signed with various nations.

Projects should explore opportunities to leverage the voluntary carbon credit market by claiming avoidance credits, albeit priced less favourably than removal credits. They can bolster the projects' ability to service bonds sustainably. This, in turn, improves their creditworthiness and reduces the default risk premium associated with bond issuance, making the bonds cheaper.

The projects and their developers should also strongly focus on meeting the Environment, Social and Governance (ESG) standards, especially for greenfield projects. International bond investors are unlikely to associate with projects that aren’t environment-friendly or have weak governance structures. Such associations would defeat the purpose of green investing for international bond investors.

Supporting initial bond issuances will build momentum, making international bond markets more accessible in favour of Nepal and Nepali projects. Green bonds offer financing for an array of environment-friendly projects beyond energy, including waste management, pollution control and biodiversity conservation. However, due to the high demand for energy resources and growing interest in green investments, starting with energy sector issuances appears to be the logical first step.