Opinion in lead

Is it time to consider opening outward FDI?

For nearly six decades, strict capital controls, which prohibit outward investment, have been a constant policy in Nepal. While the authorities have been loosening the grip in small steps, the question is how long Nepal can hold on to the strict capital control regime in this highly globalized world.

Since 2016, the Nepal Rastra Bank (NRB)—Nepali central bank and foreign exchange regulator—allowed any exporting firms to set up their branch or liaison office or showrooms in foreign countries. Both goods and services exporters are eligible to open such offices. However, the condition is that these firms need to have a proper plan for at least following three years and could only spend up to 5 percent of their total foreign exchange earnings as an annual expense at their foreign outposts. Thanks to this provision, a few Nepali firms have established their branch offices and showrooms outside Nepal.

This provision was reiterated in the budget announcement for the fiscal year 2023/24. The announcement especially targeted the Information Technology service providers that earn income in foreign currency. The budget increased the total expense limit from 5 percent to 10 percent for such firms. It is not clear whether the increased ceiling is applicable only to the IT sector or to all exporters. The monetary policy might clarify this. The need for the budget announcement to highlight the policy that is already in existence signals that many even within policymaking quarters were unaware of such an important policy instrument.

Nepal’s restriction on outward channelling of funds is still governed by Foreign Exchange (Regulation) Act, 2019 (1962) and Act Restricting Investment Abroad, 2021(1964). There have been voices calling to relook at these six decades-old laws that were promulgated at the time the global economic order and even Nepal’s economic and political landscapes were completely different. In the increasingly intricate and symbiotic economic and financial world, does an outright prohibition on the outbound investments still make economic sense to Nepal?

The ban on foreign investment has not succeeded in completely stopping the capital flight from Nepal. Successful industrial conglomerates have been implicated in such activities as demonstrated by the 16 Nepali names being outed in Pandora Papers. These individuals belonging to prominent business families have established companies in the tax haven—the British Virgin Islands, clearly indicating that capital flight is happening. According to the Global Financial Integrity report, between 2004 and 2013, such illicit financial outflows from Nepal amounted to more than US$5 billion. The amount could be higher because the report’s estimates are based on misinvoicing of trade and leakages from the balance of payments. The report does not include countries like Saudi Arabia, the United Aras Emirates and Qatar—three of the major destinations for Nepali migrant workers. The informal hundi system used to remit the money home is also considered to be one of the tools used for capital flight.

Opening up outward investment helps domestic businesses to expand to new markets and access new technologies, managerial expertise, and best practices. This would help upgrade local industries, enhance productivity, and improve competitiveness. Moreover, knowledge spillovers can occur when local firms interact and learn from foreign investors, stimulating innovation and development. Similarly, domestic firms that invest abroad can gain exposure to international markets, enabling them to compete globally.

However, for a country like Nepal with limited sources of foreign exchange income and already facing capital flight, prospects of opening up the outward FDI come with the risk of excessive outflows. Such excessive outflows could negatively impact its domestic investment and economic stability. Considering the limited capital formation in Nepal, allowing outward FDI could result in capital constraints or limited resources for domestic investment. This could be detrimental to employment and the firms could shift their manufacturing bases to lower-cost location

Despite all these risks, Nepal needs to consider the post-2026 scenario as Nepal graduates to developing country status from the least developed country. Losing the privileges accorded to LDC would mean Nepal having to eke out more agreements and treaties for trade and investment. Since trade and investment are intricately intertwined, countries and regions are increasingly opting to enter comprehensive economic partnerships (CEPAs) instead of traditional trade agreements. CEPAs typically cover a broad range of areas, including trade in goods, trade in services, investment, intellectual property rights, and various other economic issues in order to enhance economic cooperation and promote trade and investment between countries or regions. The question is can Nepal afford to cling to its strict capital control mechanism while trying to attract foreign investment and establish trade relations with other countries?

Loosening capital control comes with benefits and could also reduce illegal financial outflows. But for countries like Nepal, where the risk of excessive capital outflows outweighs any benefits in the short run, it is not surprising that policymaking bodies are reluctant to open up. At present, it is difficult to estimate if allowing outward FDI from Nepal could be beneficial for the economy or not. This would require an extensive exercise between the NRB, the Ministry of Finance and the Ministry of Industry and Commerce along with the private sector of the country to assess the potential benefits and costs without letting their own interests and dogmas cloud the judgements. Nepal can start small, in line with the existing policy that allows opening branches for exporters, as a test case. However, it is important to establish appropriate regulations and oversight mechanisms to ensure that outward FDI aligns with their national interests, promotes sustainable development, and respects the laws and regulations of host countries. By striking a balance between promoting outward FDI and safeguarding national interests, countries can harness the benefits of international investment while managing potential risks.

Ms. Singh is Programme Coordinator at SAWTEE. This article was published in Trade, Climate Change and Development Monitor, Volume 20, Issue 05, May 2023.