Forex risk management: A must to attract FDI

To develop an enabling environment for FDI in the infrastructure space in Nepal, it is imperative for the government to coordinate with all relevant stakeholders to develop a pragmatic, accessible and replicable hedging solution

As a developing country striving for rapid infrastructure development, Nepal’s need to boost Foreign Direct Investment (FDI) is unquestionable. The Office of Investment Board of Nepal has highlighted the need to implement eight key infrastructure projects across multiple sectors that require a cumulative investment of $19-$21 billion. A 2013 World Bank report suggests that Nepal needs annual investments worth $13-$18 billion between 2011 and 2020 to bridge the existing gaps in the infrastructure sector. The devastation caused by the 2015 earthquake has only increased the infrastructure deficit in Nepal.

However, with a total lending capacity of around Rs 2,400 billion across all banking and financial institutions, Nepal certainly doesn’t have the internal capacity and capital base to finance large-scale infrastructure projects. As a result, there is a critical need for FDI to provide impetus to infrastructure development in the country.

Exposure to long-term foreign exchange variations has served as a major impediment to FDI inflows in Nepal. The foreign exchange market is volatile, largely unpredictable and is driven by a wide array of global macroeconomic parameters.

The absence of viable currency hedging instruments in the Nepali market to mitigate currency risks has dissuaded foreign investors and served as a major bottleneck to FDI in Nepal. To that end, there is a critical need to develop a hedging solution in Nepal that protects foreign investors from foreign exchange exposure.

When analysing foreign exchange variations, it is important to break the currency risks into two distinct components: USD/INR and INR/NPR. The INR/NPR component of the risk is predominantly set and driven by Nepal Rastra Bank (NRB), but the decision is dependent on Nepal’s macroeconomic parameters relative to that of India. The USD/INR portion of the risk is driven by the global currency markets, and Nepali authorities have no control over that movement. There are market solutions to hedge this risk, albeit at prohibitively expensive prices.

Risk mitigation strategies can loosely be defined into two categories: risk selling and risk sharing.

Risk selling involves selling the risk to a counterparty (typically a bank or a financial institution) that offers to buy the risk for a premium.

This form of risk buying and selling is a common practice in the global derivatives market in the form of swaps, forwards, futures and options. Risk sharing, on the other hand, typically involves developing a “hedging fund’ with contribution from various stakeholders, which will then continue to absorb losses due to foreign exchange rate variations as and when it happens.

Risk selling strategies can only be implemented by relying on foreign financial markets in cities such as Mumbai, London or Singapore. As of now, Nepal doesn’t have an active operational derivatives market that can execute such transactions. Tapping into foreign financial markets may have regulatory hurdles that NRB needs to overcome by coordinating with the central bank of the concerned foreign country. Risk selling strategies for USD/INR component of the risk are currently being offered at fairly expensive premiums. As a result, in the context of the investment profiles of the infrastructure projects that are in Nepal’s pipeline, the cost of selling the USD/INR risk to a counterparty may seem very expensive.

Risk sharing mechanisms, on the other hand, can be more easily implemented in Nepal without having to depend on foreign financial markets.

However, risk sharing mechanisms pose the challenge of having to house such a significant risk within the country. Moreover, in trying times for the local currency such as this year, there is also a chance of the hedging fund running out, thereby leaving the project risk management strategy in despair. The proportion of contribution of each of the stakeholders of the project to financing the fund can also lead to contentions.

Given the absence of currency hedging instruments in the local financial markets, policy level hurdles in accessing foreign financial markets, and prohibitively expensive pricing of existing solutions, it is clear that some form of government intervention is necessary to devise a reasonable and practical hedging solution. In the context of Nepal, a customised solution that amalgamates the features of risk sharing and risk selling mechanisms may prove to be the most viable solution.

As there are limited market-driven solutions to hedge the INR/NPR component of the risk and the pegged rate is controlled by NRB, it seems only fair for the INR/NPR component of the risk to be borne by the Government of Nepal. While an affordable portion of the INR/USD risk must be sold to international derivates markets as much as possible, the remaining portions could be managed through a combination of risk sharing, government subsidy and/or consumer pass-through mechanisms.

To develop an enabling environment for FDI in the infrastructure space in Nepal, it is imperative for the government to coordinate with all relevant stakeholders to develop a pragmatic, accessible and replicable hedging solution.

Pant is a financial analyst at VRock and Company