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 countrys 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.
Nepals 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.
Nepals 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 funds 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 governments 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

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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 Nepals 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 regulatorsNRB 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 1015
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 intermediariessuch as fixed-income brokerage houses, bond research
analysts, or credit rating agenciesto facilitate secondary market transactions in bonds, with
the result that market opportunities are not reported to potential investors.

3
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
FY2006FY2010, 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, FY2008FY2010. 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 Nepals 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
Period
20082011
20112016
20162021
20212026

Power
510
1,710
3,620
6,527

Telecom
77
166
219
277

Airport
8
37
90
172

Road
367
1,064
2,045
3,524

Irrigation
132
244
282
329

Social
Infrastructure
Investment
1,849
4,146
5,609
7,242

Total
Investment in
all Sectors
2,942
7,367
11,866
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

1
2

3
4

Government of Nepal, Central Bureau of Statistics. 2009

Government of Nepal, National Planning Commission. 2007. Three Year Interim Plan, FY2008FY2010.
Kathmandu.
ADB. 2010. Asian Development Outlook 2010: Macroeconomic Management Beyond the Crisis. Manila.
The 7% desired rate of growth had been specified in the Brussels Programme of Action for Least Developed
Countries for FY2001FY2010, 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).
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 governments 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,
Nepals 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.

PublicPrivate 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
publicprivate partnership (PPP) approach are not new in Nepal. The use of Build, Own,
Operate, and Transfer frameworks for infrastructure was envisaged in Nepals 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.
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.
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.

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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 deliverablesincluding 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 designsruns the risk that bidders may artificially reduce the bid
9

Tripartite agreements allow the public sector sponsor to monitor issues under subcontracts.

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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 committees efficiency and effectiveness.10 The lack of an annual budgeting
processcompounded by the absence of detailed regulations, guidelines, and standard tender
documentsis 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. Nepals 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--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.