FDI, Exchange Rates: Determinants, Policies & Nepal’s Role

TAKEAWAYS

• FDI ≠ Portfolio Investment: FDI involves long-term control (10%+ ownership) of assets abroad (e.g., Marriott’s hotel in Kathmandu), while portfolio investment is short-term (stocks/bonds). Nepal’s FDI inflows (2022: $1.2B) focus on hydropower, tourism, and manufacturing.
• Exchange Rates Are Market-Clearing: The nominal exchange rate (e.g., NPR/USD) is determined by supply (exports, remittances) and demand (imports, FDI). A depreciating rupee (NPR weakened by 10% in 2023) hurts importers (e.g., Daraz) but helps exporters (e.g., Nepal’s jute, carpets).
• FDI Multiplier > Trade Multiplier: A $1B FDI in hydropower (e.g., Arun III Dam) creates $3B+ in GDP via backward/forward linkages (steel, cement, labor), while a $1B export boost adds only $1B (no multiplier).
• Policy Tools Matter: Nepal uses managed float (central bank intervenes via forex reserves) to stabilize the rupee, while China’s yuan is de facto pegged to the USD. Capital controls (e.g., 20% tax on FDI repatriation) can attract FDI but distort markets.
• Real-World Tradeoffs: Pathao’s FDI (Singapore-backed) boosts ride-hailing but crowds out local taxi drivers. NTC’s telecom FDI (Ncell, SmartCell) improved infrastructure but led to job losses in small shops.
• Exam Focus: Derive multipliers (FDI, trade, tax), draw exchange rate shifts, and link FDI to Nepal’s BOP deficits (imports > exports + remittances).

1. Foreign Direct Investment (FDI): Definitions and Types

FDI is a cross-border investment where a firm (or investor) from one country (home country) acquires lasting ownership (≥10%) in a business in another country (host country). Unlike portfolio investment (stocks, bonds), FDI involves direct management control.

Types of FDI

mindmap
  root((FDI Types))
    Horizontal FDI
      Definition: Investment in a foreign country **without** closing domestic operations.
      Example: **Marriott’s hotels in Nepal** (uses local suppliers but HQ in US).
    Vertical FDI
      Definition: Investment to **control supply chain stages** abroad.
      Example: **Daraz (Alibaba-backed)** sources goods from China to sell in Nepal.
    Conglomerate FDI
      Definition: Investment in **unrelated industries** for diversification.
      Example: **Nepal’s NMB Bank** investing in fintech (eSewa) and real estate.
    Portfolio vs. FDI
      Table:
        | Feature          | FDI                          | Portfolio Investment       |
        |-------------------|------------------------------|----------------------------|
        | **Ownership**     | ≥10% control                 | <10%, passive               |
        | **Duration**      | Long-term (≥1 year)          | Short-term (trading)        |
        | **Risk**          | High (political/operational) | Lower (liquid assets)       |
        | **Example**       | Tata Motors (India → UK)     | Nepali buying US Treasury bonds |

Why Does FDI Matter for Nepal?

• Capital Inflow: Nepal’s FDI (2022: $1.2B) funds hydropower (40%), tourism (25%), and manufacturing (15%).
• Technology Transfer: FDI brings modern tech (e.g., Ncell’s 5G infrastructure from South Korea).
• Job Creation: Pathao’s FDI created 50,000+ jobs (drivers, support staff).
• But…: FDI can lead to brain drain (skilled workers leave for MNCs) and monopoly risks (e.g., Khalti dominating digital payments).

2. Determinants of FDI: What Attracts Investors?

FDI flows depend on pull factors (host country) and push factors (home country). Nepal’s FDI inflows are driven by:

A. Host Country (Nepal’s) Pull Factors

pie
  title Nepal's FDI Attractiveness (2023)
  "Market Size (GDP: $38B)" : 20
  "Natural Resources (Hydropower, Timber)" : 30
  "Labor Costs (Low wages: $150/month)" : 15
  "Government Incentives (Tax holidays, land grants)" : 10
  "Stability (Improving post-2015 constitution)" : 10
  "Regional Access (China-Belt & Road, India trade)" : 15

1. Market Size and Growth:

   • Nepal’s GDP growth (5-7% annually) attracts FDI in consumer goods (e.g., Unilever’s FMCG expansion).
   • Remittances ($10B/year) create high purchasing power for imported goods.

2. Natural Resources:

   • Hydropower (42,000 MW potential): Arun III Dam (India’s Satluj Jal Vidhyut Nigam) is Nepal’s largest FDI project ($600M).
   • Timber and Agriculture: China invests in cardamom and tea plantations.

3. Labor Costs:

   • Low wages ($150–$300/month) attract textile and garment FDI (e.g., H&M suppliers in Chitwan).

4. Government Policies:

   • FDI Board of Nepal: Approves projects with tax holidays (10 years), land grants, and repayment holidays.
   • Special Economic Zones (SEZs): Bhairahawa (India border) and Kathmandu Sub-Metro offer 100% FDI in manufacturing.

5. Stability and Risk:

   • Post-2015 constitution improved political stability, reducing perceived risk.
   • China’s BRI (Belt & Road Initiative) provides infrastructure financing (e.g., Kathmandu-Terai highway).

B. Home Country (Investor’s) Push Factors

• Saturation of Domestic Markets: Japanese firms invest in Nepal due to aging population reducing demand.
• Lower Production Costs: South Korean firms move electronics manufacturing to Nepal (cheaper than Vietnam).
• Avoiding Trade Barriers: EU firms use Nepal as a gateway to India (lower tariffs than direct investment).

WORKED EXAMPLE: Why Did Marriott Choose Nepal? Marriott’s $50M FDI in Kathmandu (2022) was driven by:

1. Tourism Growth: 1.2M foreign arrivals/year (pre-pandemic).
2. Low Labor Costs: Hotel staff earn $200–$400/month vs. $1,000+ in India.
3. Government Incentives: 10-year tax holiday on profits.
4. Regional Hub: Proximity to India (high tourist demand).

3. Exchange Rates: Supply, Demand, and Policy

Exchange rates (NPR/USD, NPR/EUR) determine the cost of imports and revenue from exports/remittances. Nepal’s rupee is managed float (central bank intervenes).

A. Exchange Rate Determination: Supply and Demand

1. Demand for NPR (Why does USD → NPR?)

   • Imports: Nepal imports $12B/year (oil, machinery, electronics).
   • FDI Repatriation: Profits from hydropower projects flow back to investors.
   • Debt Servicing: Nepal pays $500M/year to China/India for loans.

2. Supply of NPR (Why does NPR → USD?)

   • Remittances: $10B/year from Nepalis abroad (India, Gulf).
   • Exports: $1.5B/year (jute, carpets, hydropower).
   • FDI Inflows: $1.2B/year (hotels, manufacturing).

3. Equilibrium Exchange Rate:

   • If demand > supply → NPR depreciates (e.g., NPR 150 → 160/USD).
   • If supply > demand → NPR appreciates (e.g., NPR 150 → 140/USD).

REAL-WORLD EXAMPLE: NPR Depreciation in 2023

• Cause: Rising oil imports ($3B) + FDI profit outflows ($400M).
• Effect:
  • Daraz’s costs ↑ (imported goods become expensive).
  • Exporters (jute, carpets) gain (cheaper for foreign buyers).
  • Tourism suffers (foreigners spend less NPR).

B. Exchange Rate Regimes: Fixed vs. Floating vs. Managed Float

Nepal’s Managed Float in Action

• Tool 1: Forex Reserves: Nepal’s $10B reserves (2023) are used to buy/sell USD to stabilize NPR.
• Tool 2: Interest Rates: Higher rates attract foreign capital (e.g., Nepal Rastra Bank raised rates to 8% in 2023 to curb NPR fall).
• Tool 3: Capital Controls: 20% tax on FDI repatriation to retain NPR in the economy.

WORKED EXAMPLE: How NTC Handles USD Demand Nepal Telecom (NTC) needs $50M to buy US equipment. If NPR depreciates:

1. Without Intervention: NTC must sell NPR 8,000M (at NPR 160/USD) → NPR supply ↑ → NPR appreciates slightly.
2. With Intervention: NRB buys $50M from NTC using reserves → NPR supply ↓ → NPR depreciates further.
   • Result: NTC pays more NPR, but NRB stabilizes the currency.

4. FDI and Exchange Rates: The Link

FDI affects exchange rates via:

1. Capital Inflows (Supply of NPR ↑):
   • Hydropower FDI (e.g., Arun III Dam) brings $600M → NPR supply ↑ → NPR appreciates.
2. Capital Outflows (Demand for NPR ↑):
   • Profit repatriation (e.g., Marriott sends $5M profit to US) → NPR demand ↑ → NPR depreciates.
3. Trade Effects:
   • FDI in exports (e.g., textile factories) → more NPR supply (exports earn USD).
   • FDI in imports (e.g., Daraz warehouses) → more NPR demand (imports need USD).

FDI Multiplier vs. Trade Multiplier

WORKED EXAMPLE: FDI in Hydropower vs. Export Boost

• Scenario 1: $500M FDI in hydropower (MPC = 0.7).
  • GDP Boost: $\Delta Y=\frac{1}{0.3}\times 500=1,667M$.
  • NPR Supply ↑ (exports of electricity earn USD) → NPR appreciates.
• Scenario 2: $500M export boost (same MPC).
  • GDP Boost: $\Delta Y=\frac{1}{0.3}\times 500=1,667M$.
  • But: If exports are oil imports, NPR demand ↑ → NPR depreciates.

5. Exchange Rate Policies: Nepal’s Tools

Nepal uses three main policies to manage the rupee:

A. Monetary Policy (NRB Tools)

1. Interest Rates:
   • Higher rates → Foreign capital inflows (e.g., 2023: 8% rate attracted $300M FDI).
   • Lower rates → Cheaper loans for exporters (but NPR may depreciate).
2. Open Market Operations (OMO):
   • Sell government bonds → Absorbs NPR from market → NPR appreciates.
   • Buy bonds → Injects NPR → NPR depreciates.

B. Fiscal Policy (Government Tools)

1. Tax Incentives for Exporters:
   • 0% VAT on jute exports → More USD earnings → NPR supply ↑.
2. Import Tariffs:
   • 20% tariff on Chinese electronics → Reduces USD demand → NPR depreciation slows.

C. Capital Controls

1. Repatriation Taxes:
   • 20% tax on FDI profits sent abroad → Retains NPR in Nepal.
2. Foreign Exchange Regulations:
   • Nepalis must convert 50% of remittances to NPR → Increases NPR supply.

REAL-WORLD CASE: NTC’s USD Needs NTC needs $200M/year for equipment. To avoid NPR depreciation:

1. NRB allows NTC to borrow USD directly (instead of selling NPR).
2. NTC issues bonds in USD (attracts foreign investors).
3. Government negotiates supplier financing (e.g., Huawei offers 3-year payment terms).

6. Balance of Payments (BOP) and FDI

FDI affects Nepal’s BOP via:

1. Current Account:
   • FDI in exports (e.g., textiles) → Surplus in trade account.
   • FDI in imports (e.g., Daraz warehouses) → Deficit in trade account.
2. Capital Account:
   • FDI inflows → Credit in capital account (+$1.2B in 2022).
   • FDI outflows (profits, dividends) → Debit in capital account (-$400M in 2022).

Nepal’s BOP Crisis (2023)

• Current Account Deficit: $4B (imports > exports + remittances).
• FDI Inflows: $1.2B (partially covers deficit).
• Solution:
  • More FDI in export-oriented sectors (e.g., pharmaceuticals, IT).
  • Reduce non-essential imports (e.g., luxury cars, gold).

In the Real World

1. eSewa (FDI + Exchange Rates)

   • FDI Link: eSewa (backed by Nepal Investment Bank) uses foreign tech (payment gateways from India/US).
   • Exchange Rate Impact: Remittances via eSewa add $2B/year in NPR supply, reducing depreciation pressure.
   • Policy: NRB allows eSewa to hold forex reserves to settle international transactions.

2. Daraz (FDI + Imports + NPR Depreciation)

   • FDI: Alibaba’s $100M investment in Daraz Nepal.
   • Exchange Rate Risk: Daraz imports $500M/year in goods → NPR demand ↑ → NPR depreciates.
   • Solution: Daraz hedges currency risk by locking in NPR/USD rates with banks.

3. NEPSE (Stock Market + FDI)

   • FDI in Stocks: Foreign institutional investors (FIIs) buy $50M/year in Nepali stocks (e.g., NMB Bank, NTC).
   • Exchange Rate Effect: FII inflows supply NPR → reduces depreciation.
   • But: If FIIs sell stocks, they demand USD → NPR depreciates.

4. Pathao (FDI + Job Displacement)

   • FDI: Singapore’s Grab invested $20M in Pathao.
   • Exchange Rate: Pathao’s USD loans for expansion increase NPR demand.
   • Social Impact: 10,000 taxi drivers lost jobs (Nepal’s yellow taxi industry collapsed).

Exam Tip

What Examiners Want to See

1. Multiplier Derivations (50% of marks)

   • Always show steps:
     • Start with equilibrium: $Y=C+I+G+(X-M)$.
     • Substitute C = a + bY, M = m + nY.
     • Differentiate to find ΔY/ΔFDI, ΔY/ΔX, ΔY/ΔT.
   • Example: For FDI multiplier, assume MPC = 0.8, MPM = 0.2.
     • $\Delta Y=\frac{1}{1-0.8+0.2}\Delta FDI=\frac{1}{0.4}\Delta FDI=2.5\Delta FDI$.

2. Exchange Rate Diagrams (20% of marks)

   • Draw supply/demand curves with:
     • Equilibrium point (e.g., NPR 150/USD).
     • Shifts:
       • Right shift (depreciation): More imports, FDI outflows.
       • Left shift (appreciation): More remittances, exports.
   • Label axes: Y-axis = NPR/USD, X-axis = Quantity of USD.

3. Policy Recommendations (20% of marks)

   • For NPR depreciation:
     • Short-term: Sell USD from reserves, raise interest rates.
     • Long-term: Attract FDI in exports, reduce import dependence.
   • For low FDI inflows:
     • Improve ease of doing business (e.g., fasten FDI approvals).
     • Offer tax holidays (e.g., 10 years for hydropower projects).

4. Real-World Applications (10% of marks)

   • Link to Nepal:
     • FDI: "Nepal should focus on hydropower and IT FDI to boost exports."
     • Exchange Rates: "The 2023 NPR depreciation hurt Daraz but helped jute exporters."

Common Mistakes to Avoid

• Ignoring multipliers: Always compare FDI vs. trade multipliers.
• Wrong shift direction: If imports rise, demand for NPR ↑ → NPR depreciates (shift right).
• Assuming fixed exchange rates: Nepal uses managed float, not fixed.
• Forgetting BOP links: FDI affects both current and capital accounts.

Quick Revision Table

Final Worked Example (Exam Style)

Question: "Nepal’s economy has the following functions:

• $C=200+0.7Y_d$ (Y_d = Y - T)
• $T=500+0.2Y$
• $I=200$ (autonomous)
• $G=400$
• $X=100$, $M=50+0.1Y$
• FDI inflow = 300 (new investment in hydropower).

Calculate: (a) The FDI multiplier. (b) The new equilibrium income after FDI inflow. (c) Explain how this FDI affects the exchange rate."

Solution:

(a) FDI Multiplier

1. Find MPC and MPM:

   • $C=200+0.7(Y-T)$.
   • $T=500+0.2Y$ → $Y_d=Y-500-0.2Y=0.8Y-500$.
   • So, $C=200+0.7(0.8Y-500)=200-350+0.56Y=-150+0.56Y$.
   • MPC = 0.56 (slope of C vs. Y).
   • MPM = 0.1 (slope of M vs. Y).

2. FDI Multiplier Formula: $$\text{FDI Multiplier}=\frac{1}{1-MPC+MPM}=\frac{1}{1-0.56+0.1}=\frac{1}{0.54}\approx 1.85$$

(b) New Equilibrium Income

1. Initial Equilibrium (Y₀): $$\begin{gathered} Y=C+I+G+(X-M) \\ Y=(-150+0.56Y)+200+400+(100-50-0.1Y) \\ Y=300+0.46Y \\ 0.54Y=300 \\ {Y}_0=555.56 \end{gathered}$$

2. After FDI (ΔFDI = 300): $$\begin{gathered} \Delta Y=1.85\times 300=555 \\ {Y}_1=555.56+555=1,110.56 \end{gathered}$$

(c) Exchange Rate Effect

• FDI in hydropower → More USD inflows (investment + future export earnings).
• NPR supply ↑ → NPR appreciates (e.g., NPR 150 → 145/USD).
• But: If hydropower imports machinery, NPR demand ↑ → partial offset.
• Net Effect: NPR likely appreciates, helping importers (Daraz) but hurting exporters (jute).

GRAPH: