SECTOR ASSESSMENT (SUMMARY): Multi sector

Capital Market and Infrastructure Capacity Support Project (RRP NEP 43490-01) SECTOR ASSESSMENT (SUMMARY): Multi sector A. Overview of the Financial and Capital Markets in Nepal 1. Nepal began its first financial sector reform in the mid-1980s by opening the banking system to the private sector and paved the way for the proliferation of financial institutions since then. At present, Nepal has a reasonably diversified financial sector, with the number of financial institutions licensed by the country s central bank, Nepal Rastra Bank (NRB), increased from 98 in 2000 to 242 in 2009. The total comprises 26 commercial banks (class A), 63 development banks (class B), 77 finance companies (class C), 15 microfinance development banks, 16 savings and credit cooperatives, and 45 microfinance non-government organizations (NGOs) (class D). 2. In fiscal year (FY) 2009, the banking system dominated the Nepalese financial system with assets amounting to 73% of the gross domestic product (GDP). The equity market has grown in recent years accounting for 53.4% of GDP but the domestic bond market, in contrast, has had no noticeable growth at merely 13% of GDP in FY2009, respectively. 3. Nepal s capital market is still at an early stage of development. The country has one stock exchange, the Nepal Stock Exchange (NEPSE) with 23 member brokers. The bond market in Nepal consists of a government securities market and a corporate securities market. The Securities Board of Nepal (SEBON) was established in 1993 as an apex regulator of securities markets, with responsibilities for the stock exchange and capital market participants pursuant to the Securities Exchange Act of 2006. 4. Nepal s bond market is underdeveloped and dominated by government securities. To meet short term financing needs, the government issues short-term treasury bills and national savings certificates. The share of treasury bills in the domestic market has increased from 61% in FY2004 to 70% of outstanding domestic debt as of mid-april 2010. The government also issues longer tenor instruments, the Development Bonds, and are admitted for trading through NEPSE. However, development bonds are rarely traded and the size of the bond is quite small to satisfy demand for investment of institutional investors (including insurance companies, the Employees Provident Fund, and Citizen Investment Trust). Moreover, under the prevailing market conditions, fixed deposits with banks provide the highest rate of return compared to government securities and are thus an obvious choice for the fund s investment managers. As such, commercial banks are the largest investors in government securities holding approximately 54% of outstanding government securities, which they use for meeting statutory liquidity requirements. 5. The government bond market lacks breadth and depth as issuance tends to be erratic, undermining the government s credibility as a borrower and depriving the bond market of the volume of liquid debt instruments needed to develop a sovereign benchmark yield curve. As such, there are no active secondary market or benchmark yield curves, and thus, market pricing of corporate bonds is absent. As of mid-april 2010, corporate bonds constituted just 5% of the total bond market. Only nine issues have taken place in the past 10 years, and were mainly issued on private placements by banks to meet tier 2 capital requirements. There are almost no corporate debentures due to a lack of investor confidence, attributed to the default on two past debenture issues of two major corporate entities in the late 1980s and 1990s. The lack of corporate governance standards, poor transparency in companies financial statements, and lack of a credit rating system make investing in corporate debt dubious. 6. The development of a liquid and deep bond market has important spillover effects in an economy. In the case of Nepal, bond market development will mitigate the potential maturity

2 mismatch of a bank-dominated financial sector, reducing financial sector fragility and providing much-needed long-term capital for infrastructure development. Yet, some of the critical factors affecting the slow progress of Nepal s bond market are outlined below. 7. Lack of capacity for efficient public debt management. Nepal Rastra Bank (NRB), the central bank, lacks coherent cash management processes to guide decisions on the volume and maturity of each issuance of government debt securities. Issuances of government debt securities are based on immediate or short-term financing needs. NRB also lacks the capacity to perform debt and cash management functions and evaluate risks inherent to the existing government debt structure. 8. Weak legal, regulatory, and institutional framework. In general, the overall policies and regulations governing the financial markets, banking sector, and government securities tend to make it difficult to develop the bond market in Nepal. There is little competition in the financial market, which is dominated by state-owned commercial banks. Though recent laws provide a legal and regulatory framework for oversight of the debt securities market, the remaining substantial weaknesses in corporate governance, accounting, and auditing standards undermine investor confidence. Moreover, Nepal's financial market regulators NRB and the Securities Board of Nepal (SEBON) have overlapping roles and few regulations have been established for the bond market. 9. Lack of a credible benchmark long-term yield. Nepal lacks an established sovereign yield curve due to lack of trading data on longer-term bonds. NRB issues domestic short-term government securities in the form of treasury bills on an auction basis. The share of short-term treasury bills in domestic government debt has been growing steadily compared to the benchmark 364-day treasury bill, the share of which has been consistently decreasing. Without trading data on longer-term bonds, it is difficult to establish a yield curve for pricing of long-term corporate bonds. The lack of a reliable issuance calendar, minimal volumes in the primary market, and negligible liquidity in the secondary market all contribute to the lack of a liquid sovereign benchmark 10. Lack of issuers and insufficient investor base. Nepal's institutional investor base is not sufficient to support an active debt securities market. Regulations and guidelines constrain institutions such as pension funds and insurance companies from investing freely in the bond market. The lack of mutual funds in Nepal means small investors cannot pool funds and thereby participate in the debt securities market. 11. Lack of primary dealer system and secondary market. Nepal has no established primary dealer system. Treasury bills (which are sold on an auction basis) and bidding are normally open to any interested party; however, commercial banks and financial institutions dominate the auction. Secondary market activities in treasury bills are low and the repurchase facility is not used by the NRB in its open market operations. 12. Inadequate bond market infrastructure. Nepal has inadequate central market infrastructure to support a well-functioning bond market. It lacks a central depository system and a scripless clearing and settlement system. Processing transaction information takes 10 15 days on average, and there are no electronic links for sharing information with NRB departments for the purposes of debt management. 13. Absence of specialized market intermediaries and credit rating agency. There are no specialized market intermediaries such as fixed-income brokerage houses, bond research analysts, or credit rating agencies to facilitate secondary market transactions in bonds, with the result that market opportunities are not reported to potential investors.

14. High cost of trading and differential taxation. Interest income from bonds is taxed at 6% for individual bond holders and 15% for institutions. This causes a problem in the deduction of tax at source on interest payments during settlement after trades; such transactional issues limit the trading of listed bonds from institutional buyers to individual buyers and vice versa. B. Overview of Nepal Infrastructure Sector 15. Nepal's gross domestic product (GDP) growth decelerated to 3.5% in fiscal year 2010 from 4.0% in FY2009. 1 While GDP growth has been stable in the 2.8% 5.8% range during FY2006 FY2010, the Government of Nepal targeted sustained GDP expansion of around 5.5% to enable achievement of the poverty reduction target of 24% by end of 2010, as articulated in the Three Year Interim Plan, FY2008 FY2010. 2 However, achieving GDP growth targets is contingent on political stability, sound macroeconomic policies, and infrastructure development. 16. The poor state and quality of infrastructure are critical constraints to Nepal s inclusive economic growth and development prospects. Investment in infrastructure is of critical importance, and has implications for the larger economy as infrastructure supports manufacturing, trade, and tourism. Road density in Nepal is the lowest in South Asia (0.59 km per 1,000 people) and only 36% of the population has access to all-weather roads. Despite its large hydropower potential of around 80,000 megawatts, half of which is economically viable, Nepal is a net importer of electricity. The electrification rate (56% in 2008) is one of the lowest in South Asia, and means that more than 12 million mainly rural people lack access to electricity. 3 There has been little investment in airports or airlines, hampering the development of tourism, which is a significant source of foreign exchange. 17. While GDP growth of 5.5% is targeted in the interim plan, an average GDP growth rate of 7% is needed to achieve sustainable and inclusive growth. 4 Estimates suggest that for 2009 2025, Nepal will need investments of $40 billion (Table 1) to achieve the required growth target. 5 Table 1: Infrastructure and Social Sector Investment Requirements ($ million) Economic Infrastructure Investment Social Infrastructure Investment Total Investment in all Sectors Period Power Telecom Airport Road Irrigation 2008 2011 510 77 8 367 132 1,849 2,942 2011 2016 1,710 166 37 1,064 244 4,146 7,367 2016 2021 3,620 219 90 2,045 282 5,609 11,866 2021 2026 6,527 277 172 3,524 329 7,242 18,072 Source: Feedback Ventures. 2008. Feasibility Study and Business Plan for Setting up an Infrastructure Financing Institution in Nepal. Kathmandu. 18. However, development expenditures as a percentage of GDP declined by two-thirds between 1990 and 2007. Government spending on electricity, gas, and water as a percentage of total government expenditures declined by 58%; for agriculture, by 49%; and for transport, by 32%. While expenditure levels have been declining, investment requirements have risen rapidly 3 1 Government of Nepal, Central Bureau of Statistics. 2009 2 Government of Nepal, National Planning Commission. 2007. Three Year Interim Plan, FY2008 FY2010. Kathmandu. 3 ADB. 2010. Asian Development Outlook 2010: Macroeconomic Management Beyond the Crisis. Manila. 4 The 7% desired rate of growth had been specified in the Brussels Programme of Action for Least Developed Countries for FY2001 FY2010, and is an outcome of the Brussels Declaration in May 2001. Its basic objective is to achieve substantial progress in meeting the Millennium Development Goals (i.e., halving poverty by 2015 and promoting sustainable growth). 5 Feedback Ventures. 2008. Feasibility Study and Business Plan for Setting up an Infrastructure Financing Institution in Nepal. Kathmandu (August).

4 due to delayed investment and damage to infrastructure during the conflict. It is estimated that $129.6 million worth of physical infrastructure was damaged during the conflict. 6 19. Infrastructure investments in Nepal have been primarily in the public domain with investments supported through budgetary provisions. The period of political transition (since 2008) has negatively impacted the government s fiscal situation with a commensurate decline in infrastructure-related investments. Under the International Monetary Fund's fiscal consolidation program, the fiscal deficit declined to 2.0% of GDP in FY2004 before increasing to around 5% in FY2005. Despite improvements in revenue administration, the fiscal deficit has been increasing and is estimated at over 2.8% of GDP in FY2010. 7 20. Private sector investment in infrastructure has also been low. From 1990 to 2003, Nepal s private foreign investments as a percentage of GDP grew by just 0.3% on aggregate. The low levels of investment also had an impact on the overall quality of infrastructure. Private sector investment is hampered due to multiple and interlocking constraints as a result of (i) the absence of a well-developed capital market for raising long-term funds, such as bond and equity financing; (ii) the inability of banks and financial institutions to channel available liquidity and investments toward infrastructure projects owing to their short-term funding profile and lack of capacity for project structuring and financing; and (iii) the inadequate policy and regulatory framework conducive for private sector participation in infrastructure. C. Public Private Partnership Modality for Infrastructure Financing 21. Given the challenges in supporting infrastructure financing through the public budget, the government has been promoting the role of the private sector in infrastructure. Variations on the public private partnership (PPP) approach are not new in Nepal. The use of Build, Own, Operate, and Transfer frameworks for infrastructure was envisaged in Nepal s development plan document as early as 1992. Private sector participation in infrastructure started with hydropower, after enactment of the Hydropower Development Policy, 1992 and Electricity Act, 1992. Subsequent government approvals included (i) the Build Operate and Transfer Policy on Roads in 1999; (ii) a comprehensive umbrella policy called Public Infrastructure Build Operate and Transfer Policy, 2057 (2000); (iii) the Private Investment in Infrastructure Build Operate and Transfer Policy, 2060 (2003); and (iv) the Private Financing in Build and Operation in Infrastructures, 2063 (2006), commonly referred to in Nepal as the BOOT Act. 8 Despite these initiatives to promote private sector investment in infrastructure development, no PPP project in Nepal has yet materialized. The lack of enabling policy, institutional and financing frameworks for PPP in Nepal remain a significant hurdle. 1. Policy Constraints 22. To encourage the private sector to use its capacity for the provision of public infrastructure and service delivery, a comprehensive policy framework must be developed covering (i) all types of PPP projects, and (ii) the specifics of each type, in terms of regulatory, financial, institutional, technological, and procurement aspects, indicating (a) the commitment of the government, and (b) the facilities extended to the private sector. Given the public nature of services provided by a PPP infrastructure facility, the public sector sponsor requires a legal, regulatory and policy framework to enter into contracts based on (i) transparent and objective 6 Asian Development Bank, Department for International Development, and International Labour Organization. 2009. Country Diagnostics Studies. Nepal: Critical Development Constraints. Manila. 7 Nepal completed a 3-year Poverty Reduction and Growth Facility program from the International Monetary Fund (IMF) in FY2007 following an Enhanced Structural Adjustment Facility from the IMF in 1992, which provided a framework for continued economic adjustment. 8 While the Private Financing in Build and Operation in Infrastructures, 2063 (BOOT Act, 2006) first came into operation in the form of an ordinance on 22 August 2003, it was ratified as an act on 14 December 2006; for procedural reasons it was presumed to have been in operation since 12 August 2006. The regulations under the act were published in the Nepal Gazette on 20 September 2007.

processes for project and concessionaire selection, with value for money being a factor; (ii) clearly defined approval, compliance, and oversight jurisdiction over PPP projects, especially with regard to the rights of municipal and local government authorities; and (iii) clear definitions of the roles, responsibilities, and rights of parties in the governing instruments (concession agreement, regulations, etc.). The PPP legal, regulatory, and policy framework empowers the private sector to collect revenues and seek revision of user charges. 23. This legal, regulatory, and policy framework underlines the need for the public sponsor to (i) scope projects, (ii) manage the bidding process, (iii) identify potential risks, and (iv) allocate risks to those project participants best placed to manage them. The public sector sponsor will need to design a suitable procurement timetable, process, and documentation framework, especially for proposal requests. Ideally, the request for proposals should set out details of the project, requirements, and deliverables including legal, financial, design, and technical criteria. In a successful PPP project, the government sponsor is required to appropriately allocate risk in project documents with an awareness of bidder, financier, and equity issues, as private firms will resist taking on risks that they cannot manage. This requires finalization of project documents, including (i) the project deeds, which grant the right to the private firm to develop the project and govern the risk allocation between the government and the project vehicle; (ii) engineering and procurement contracts, which govern the relationship between the project company and the contractor; (iii) operation and maintenance contracts, which govern the relationship between the project vehicle and the operator and set out the noncore services of the asset and its maintenance for its useful life; and (iv) tripartite agreement(s) including the government sponsor, the project vehicle and the financiers, engineering and procurement contractors/other parties. 9 2. Legal Constraints 24. The current PPP policy framework does not include provisions for PPP arrangements such as annuity contracts, special project or purpose vehicle contracts, service contracts, and user community groups or NGO-based contracts. Existing policies and acts have no provisions to encourage greater roles for local contractors and consultants from within and outside the country. The BOOT Act, although basically built on the principle of transparency and competition, may result in non-transparent procurement due to the provisions for BOOT award through direct negotiations. Further specific commitments under the BOOT Act may be required since provisions in other acts (such as the Industrial Enterprises Act, 1992) are unlikely to attract investors to invest in infrastructure. 25. The BOOT Act provides detailed guidance on various aspects of developing PPP projects, including guidelines on submission of expressions of interest, submissions of proposal, bidding criteria, contract award, and conditions for the termination of the license. The BOOT Act also contains provisions for dispute resolution between stakeholders (e.g., government and concessionaire) and also contains various aspects to be included in the concession agreement between the government and the concessionaire. 26. The BOOT Act requires that the proposal submitted by the bidder include the feasibility studies as well as cost estimates for developing the project. It also requires that proposals include project implementation arrangements as well as a preliminary engineering design of the project. Typically, PPP projects are bid for on the basis of a project information document, which contains a pre-feasibility study and feasibility study as well as a detailed project report prepared by independent consultants. Having bidders submit both a cost estimate and feasibility study particularly in the absence of an independently developed detailed project report to guide the development of engineering designs runs the risk that bidders may artificially reduce the bid 5 9 Tripartite agreements allow the public sector sponsor to monitor issues under subcontracts.

6 price and submit project implementation plans that may not be technically optimal. Furthermore, in the absence of a master concession agreement for each sector, the concession agreements are proposed to be developed through a process of negotiation. However, there is no prescribed risk-sharing arrangement between various stakeholders, based on best practices, on which to structure individual concession agreements. This compounds the risk from the submission of artificially low bids, as the open-ended process of developing a concession agreement would distort risk-sharing arrangements. Finally, the BOOT Act enables government cancellation of the concession agreement without compensation to the concessionaire, adding an element of unallocated risk in the project development process. 3. Institutional, Administrative, and Capacity Constraints 27. The BOOT Act has made provisions for a nine-member coordination committee comprising the vice chairman of the National Planning Commission (NPC), a member of the NPC, the chief secretary to the government, and secretaries of several ministries; the secretary of the NPC serves as the member secretary for the committee. While the committee is supposed to secure prompt decisions on multi-sector project issues, it has been difficult to organize such high-level meetings without a dedicated and well-resourced secretariat, compromising the committee s efficiency and effectiveness. 10 The lack of an annual budgeting process compounded by the absence of detailed regulations, guidelines, and standard tender documents is an additional constraint to the award of PPP projects. 28. At present, key line ministries, including the Ministry of Physical Planning and Works, Ministry of Energy, and Ministry of Local Development are pursuing PPP ventures but are lacking a uniform approach. Understanding of PPPs, and how they can be used to spearhead infrastructure development interventions in various sectors, is limited. 4. Financing Constraints 29. A dedicated source of long-term funding tailor-made for the infrastructure projects having long gestation periods is required to mobilize infrastructure investment. Nepal s present commercial banking system is inadequate to meet this objective. The first constraint is the very small deposit base of the country and is of less than one year tenure, thus creating an upfront mismatch between the liability profile of banks and financial institutions vis-à-vis needs and nature of infrastructure financing. Banks in Nepal are ill-equipped to provide a large quantum of long-term finance at a reasonable cost owing to: (i) short-term liability profile of banks prevents asset creation of maturity periods beyond 7 years whereas maturity periods of infrastructure loans exceed 7 years; (ii) sector prudential norms limit the exposure of banks to individual sectors; and (iii) absence of a well-developed capital market for long-term debt instruments, such as bonds, and equity financing limits the banks ability to provide funding for the long term. Large infrastructure projects need project finance (usually on non-recourse or limited recourse terms) based on cash flow projections of the project. Given the peculiar and unique nature of each type of infrastructure project, banks and financial institutions need to possess and procure specialized technical, commercial, and financial skills to appraise infrastructure projects. Both commercial banks and public sector entities in Nepal lack the technical and commercial skills needed to identify and appraise infrastructure projects based on its technical, financial, and commercial viability. 10 For example, policy and implementation coordination is weak, and agencies such as the Department of Roads and Department of Local Infrastructure Development and Agricultural Roads do not function in a flexible, autonomous, and commercial environment in seeking to expand the road network through PPPs.