With a few new projects signed, including a Power Trade Agreement (PTA) with India, the expectation is that once a new constitution is written, Nepal will be host to plenty of foreign direct investment (FDI). Making Nepal a favourite place for multinationals, however, will need more than finding political equilibrium; it will require monumental changes in policies and institutions. My attempt here is to lay out a framework of such changes.

First and foremost, Nepal needs to transition from its present status as one of the worst countries in the world for doing business to one of the best. Furthermore, Nepal should turn into an investment-friendly country where both domestic and foreign businesses can thrive, as opposed to being a destination for a couple of grandiose hydro projects. Such changes are necessary, not only to mobilise but also to reap full benefits from FDI, such as promoting innovation and technology transfer, deepening international trade, creating a competitive business environment, and enhancing corporate restructuring and governance.

Fortress to frontier

In this era of globalisation, unlike many developing countries, Nepal has received a negligible amount of FDI. In 2013, Nepal had $514 million FDI stock (not including the recent hydro project commitments of $2.5 billion, which, even if they materialise, will take several years to flow into Nepal). Three-quarters of this amount came in the last six years. India is the largest investor, accounting for 40 percent of this FDI, followed by China (11 percent), South Korea (seven percent), and the US (six percent).

In Nepal, the share of FDI stock in GDP is about 2.8 percent, far smaller than 12 percent for India and 11 percent for China (Hong Kong has 550 percent and Singapore has 255 percent). Every year, Nepal receives only about 0.5 percent of GDP as inflows of FDI, whereas China and India receive four times larger percentages.

Given that China is a manufacturing powerhouse and India is emerging as a high-tech services centre, unless Nepal can be more cost effective than its neighbours, investors may want to invest in these larger markets and serve Nepal through their exports. Compounding the problem, Nepal is more corrupt and expensive for business than China and India. A back-of-the-envelope calculation using data on four indices—ease of doing business, cost of start-up business, corruption perceptions and global competitiveness—shows that doing business in Nepal is 23 percent more expensive than China and 15 percent more expensive than India. Add to this the disadvantages incurred due to the country’s landlocked nature, its small size, unskilled labour force, and frequent strikes and Nepal has insurmountable barriers hindering foreign investment.

Policy reforms are urgently needed to make Nepal not only better than China and India but one of the best in the world. Inviting FDI will also require well-defined and transparent investment rules, rule of law, national (same) treatment of domestic and foreign companies, more competitive corporate tax regimes, and a clear rule for repatriation of original and earned investment. Furthermore, it is essential to have a well-educated labour force and a flexible labour market that balances the rights of both employers and employees, and to establish institutions that reward innovative and entrepreneurial activities and penalise rent-seeking ones.

From biased to broad-based

In addition to these deep structural reforms covering the whole spectrum, including political, economic and social institutions, to make Nepal an investment-friendly country, the following policy changes are required.

Except those sectors that are related to national security, all others should be opened for FDI. And there should not be any sectoral bias in providing higher incentives for some sectors over others, unless there are convincing reasons to believe that the social benefits of $1 FDI is higher in those sectors. While Nepal has a niche market in hydro-generation, in no way should the government persistently provide incentives to divert FDI from other sectors to hydro. Rather, in mobilising FDI, job creation and technology transfer to the local labour market should be the priority irrespective of the sectors.

That brings us to another policy issue: once the minimum threshold for FDI is determined, investment policies for both domestic and foreign companies should be size-neutral, such that there is no bias by size of investment. Development requires businesses of all sizes. But small businesses fare worse compared to large ones in government treatment, property rights, and financing. Government subsidies and tax credits go with size. Smaller firms violate property rights more. For example, small restaurant owners in urban areas frequently donate to, and feed for free, several groups of gangsters almost on a daily basis, whereas that is not the case for large industries or big hotels. Finally, small businesses have more difficulty in getting bank loans. This size-biased policy distorts the market by not allowing small firms to enter.

There seems to be an undercurrent that investment from Non-Resident Nepalis (NRNs) should receive more concession. But treating investors differently based on country of birth is a bad policy. All foreign investors, irrespective of their nationalities, should be treated equally. Providing better incentives to NRNs will be detrimental to Nepal’s effort to bring in FDI, as this will discriminate against the huge pool of capital that exists in the world. Investors are working at the margins; a slight favour to one nationality will bar others from competing, ultimately costing Nepal. NRNs do not need special treatment; they already have advantages, as they are familiar with Nepal’s culture, language, and surroundings.

Lastly, match rhetoric with action; do the homework and develop a well thought-out action plan. Even in one of the most promising sectors for FDI—hydro—there does not seem to be a mechanism developed even for cost-benefit analyses. For Nepal’s major rivers, a strategy covering the entire span of the river from the perspectives of multi-use (drinking water, irrigation, electricity, aquarium, tourism, environment, etc) and multi-locations (maximising the sum of upstream and downstream capacities) is long overdue. The present practice of showcasing a crown jewel, neglecting the potential of the rest of the river, is turning what would have been an economic, social, and environmental boon into a catastrophe.

Bottom line

Nepal’s problem is not a lack of funds, but a lack of demand for investment. Therefore, Nepal should eye joint ventures so that the depressed domestic investment demand is also boosted. For that to happen, the prevalent preferences for investment in real estate, private education, and private healthcare facilities should end, shifting investment from these wealth-transferring to other wealth-creating sectors.

As a precursor, an agency like the Investment Board Nepal (IBN) that deals with FDI greater than $100 million, might be an icebreaker, but this does not provide a long-term solution. Moreover, it is not entirely clear whether the present modalities adopted by IBN in granting hydro projects are drawn from comprehensive and competent analyses. These reports should be made publicly available so that an informed debate can be carried out, which will help adopt better practices subsequently.

In designing investment policy, as a rule of thumb, do not target projects, companies, sectors, size, or the origins of an investor. But target training the labour force, job creation, ease-of-doing business, equity, and economic growth rates. Focus on education, employment, investment, fiscal, and monetary policy in achieving these targets, aligning one policy instrument with one target.

Acharya is a Canada-based economist who conducts research on economic policies