In-house investment

    • It would be prudent for Nepal to attempt to finance small hydropower projects through domestic bonds and derivatives

    AUG 13 –

    investThe Energy Minister, along with a majority of Constituent Assembly members recently made arguments against signing Power Purchase Agreements (PPAs) denoted in US Dollars (USD). This hotly debated issue has those expressing negative views citing past agreements on the Khimti-1 and Upper Bhotekoshi Hydropower projects. The fact that the nation’s power monopoly, the Nepal Electricity Authority (NEA), uses approximately 40 percent of its revenue to service these two USD PPA projects, with a paltry generation capacity of 105 MW, only adds substance to their argument.

    Currency risks

    Nepal’s currency regime is pegged to the Indian Rupee (INR). This arrangement has had consequences on Nepal’s energy production. When India gained independence in 1947, its currency was on par with the USD. Since then, the INR has depreciated 65 fold, mostly due to a burgeoning demand for imports and weak domestic equities. Accordingly, the Nepali Rupee has witnessed a sustained depreciation of approximately 9 percent per annum ever since private sector investment in the energy sector was encouraged by the Electricity Act 1993. A PPA signed on Nepal’s currency terms would pay out substantially less to a foreign investor today, when the USD exchanges at Rs 98, than in 1990, when the rate hovered around Rs 45. Thus, in the long term, this entails much risk for foreign investors investing on local currency terms.

    The NEA has been dealing with the burden of a depreciating currency by passing on its costs in the form of gradual increases in tariffs to consumers and taxpayers. At Rs 7.3-11 per unit, Nepal’s grid-based electricity tariffs are already amongst the most expensive in Asia. Tariffs have been made cost reflective, as in Kenya, where exchange rate-related costs are directly passed on to consumers and industries. However, increased tariffs are more likely to impact economic activities with inflationary pressure. With the Nepal Rastra Bank (NRB) struggling to limit inflation to single digits and the currency continuously depreciating, this is not a long-term solution.

    What is certain is that Nepal requires power in abundance. However, hydroelectricity is also amongst the most expensive forms of energy to develop. If Upper Tamakoshi is considered as the cheapest benchmark in Nepal, it still costs Rs 80 million to generate 1 MW of energy. Forget exports, Nepal’s internal capital resources are not even adequate to address the acute domestic shortfall. Hence, we are under a compulsion to attract foreign investment. But we will not attract adequate foreign direct investment (FDI) if we don’t provide the security of USD-denoted PPA’s.

    Regardless of differing opinions, the following alternatives, if executed well, are available to us.

    Capital market instruments

    Domestic sovereign bonds and corporate bonds are viable alternatives for the kind of long-term investments required by power projects. For instance, the 10-year Kenyan Shilling Bond, released in 2009, was oversubscribed—testimony to the true potential of these instruments. Multilaterals like the International Finance Corporation (IFC) have started pushing the concept of local currency bonds. In Nepal, IFC, which is credit rated AAA, has received a permit from the government to issue five-year local currency bonds worth Rs 50 billion (USD 500 million). This is a positive step, considering that many Nepali banks are small and unable to make a difference by investing substantially in energy projects.

    However, it should be noted that the size of a country’s capital market is proportionate to the size of the country’s economy. While the US, the world largest economy, has the largest capital market, the same cannot be said of Nepal’s tiny economy with a non-convertible capital account that places restrictions on debt inflows. Also, previous attempts to issue diaspora bonds by NRB in 2010 and 2011 with long term maturities, targeted at energy investment, were severely under subscribed. Among the many reasons cited were a lack of trading on the secondary market, low interest rates and cumbersome procedures.

    Attracting foreign investment to Nepal’s capital market will require a sovereign credit rating. The absence of the same, or a shadow rating of CCC+, which signals a high probability of default, will simply not help. If the government focuses and succeeds in improving the country’s credit rating, a steep task no doubt, it would be wise to start targeting wealthier Nepali diaspora living in the US and other OECD countries. Hence, the short term goal should be to focus on issuing local currency bonds to develop small-sized hydroelectricity plants. Under the current circumstances, we can put aside the possibility of constructing mega projects using domestic sources. However, constructing small projects of up to 50MW by issuing bonds is a real possibility.

    Derivatives instruments

    We have by now established that foreign investment is necessary. The problem lies in managing dollar investments. Hedging for foreign currency risk is common practice around the world. The concern is whether hedgers are willing to conduct long-term hedges, as in the case of power and infrastructure projects.  However, such practices do exist, with firms like TCX among many others, involved in such long-term cross-border transactions.

     Derivative instruments can be customised to suit the needs of clients. For instance, an effective solution, conditional upon the approval of regulators, would be to tailor swaps in such a way that currency payments from investors to recipients exactly offset payments on the original foreign currency loans to be made by the recipient. This is in practice around the world in long-term swap markets in the form of overlay currency swaps. Also, multilaterals like IFC have not only provided loans in local currency using local derivative instruments but have also successfully used swap dealers to extend loan maturities.

    Nepal’s risk appetite for the use of derivative instruments is quite low, considering regulatory ambiguity and the lack of market expertise. Nepal so far allows limited derivative transactions in the form of forwards for non-speculative purposes, but it is still possible to reduce currency-related losses using derivative instruments available to us.

    Nepal has the potential to generate vast amounts of electricity through the mobilisation of local resources and foreign investment. However, the success rate of policies and solutions depends on their execution. We cannot wait for market forces to act in favour of Nepali currency or wait for the Indian government’s election manifesto promise of strengthening the INR to take effect. The solution has to come proactively and from within Nepal. If two USD PPA projects with 105 MW capacity can wreak havoc on the NEA’s financials, just imagine the post-construction consequences of four additional USD PPA projects with a cumulative generation licence of 300 MW, which the nation has already signed up for. To avoid a disastrous situation, all we have to do is emulate successful utilisations of financial modalities from around the world. After all, problems created by finance have solutions within finance.

    Siddhartha Mainali is a banking professional with an MBA from Faculty of Management Studies, New Delhi (

    Source : eKantipur