E-Kantipur

JAN 30 -

A friend of mine recently sent me an email asking whether I had or knew the data on the “Country Risk Premium” (hereinafter CRP) for Nepal. He was working on an investment prospectus, and needed, among others, information on the CRP—a premium that foreign investors associate with a particular country when making their investment decisions. While I did not have any such information at that time, given the importance that foreign investors assign to such risk premium, I went to the internet and started looking around if there were any such data pertaining to Nepal.

The concept of a CRP refers to an increment in interest rates that would have to be paid for loans and investment projects in a particular country compared to some standard. One way of establishing the CRP for a country is to compare the interest rate that the market establishes for a standard security in the country, say the central government debt, to a comparable (same maturity and issued in the same currency, say US dollars) security in the benchmark country, say the US. The interest rate that is relevant is the market-determined yield to maturity rather than the coupon interest rate. Given that Nepal and other developing economies don’t issue foreign currency denominated bonds, it is difficult to calculate the CRP using this method for such countries.

In that case, another way of figuring out the CRP is via the country’s sovereign rating, which, in turn, is a function of a host of factors such as the GDP growth rate, inflation, foreign debt, debt servicing capacity and the rule of law, among others. Sovereign rating is generally issued by Standard & Poor’s (S&P), Moody’s and Fitch, the three leading international rating agencies. As Nepal is yet to be rated by any of these three rating agencies, it is quite difficult for international investors to gauge Nepal’s riskiness. This becomes especially important when foreign investment decisions are mutually exclusive. For example, it’s common knowledge that investing in Nepal is “risky”, but the question is “how risky it is” when the alternative to Nepal for a foreign investor could also be another “risky” country. In such a scenario, without sovereign rating and commensurate CRP, Nepal can lose out to another equally or “riskier” country.

Given such potential problems in attracting capital flows for unrated countries, a recent paper by the World Bank’s Poverty Reduction and Economic Management (PREM) unit came out with shadow sovereign rating for such countries. Using a set of factors that these rating agencies use to come up with sovereign rating, the paper estimated such shadow rating for 58 countries.

According to that paper, Nepal’s shadow rating is CCC+ (Caa1 for Moody’s), which puts Nepal in the “High Default Risk” category. As per S&P’s and Moody’s official rating, other countries with the equivalent rating are the Kyrgyz Republic, Gambia and Malawi. With a shadow rating of CCC+, the commensurate CRP for Nepal comes out to be a whopping 10.5 percent (as per the calculation done in January 2012 by Aswath’s Damadoran’s, a faculty at New York University’s School of Business).

Why is the CRP important? The shadow rating and CRP corroborates the notion that investing in Nepal is a risky proposition. With a CRP of over 10.5 percent, it’s no wonder that most of the proposed investments fail to meet the net present value (NPV) or internal rate of return (IRR) criteria that foreign investors invariably apply when making their investment decisions. This provides a readymade answer to why Nepal has failed to attract significant foreign direct investment (FDI).

Looking beyond the quantitative aspect of the CRP, other factors such as political instability and fickle policies also exacerbate the problem. For example, in 2010, Nepal got only US$ 87 million in FDI while (other countries with similar sovereign ratings) Malawi got US$ 140 million and the Kyrgyz Republic got US$ 437 million (as per the World Bank). When ranked in terms of FDI to GDP, Nepal’s performance pales in comparison to that of other similar rated countries.

With Nepal Investment Year round the corner, there has been a lot of talk about attracting foreign investment, especially in infrastructure projects. As recently as last week, there were reports in the media that the government was planning to bring foreign investment of around US$ 1 billion within this fiscal year. Without any significant improvement in addressing sovereign risks, that might just be wishful thinking.

(The writer is associated with a private bank. The views expressed are personal.)

Posted on: 2012-01-30 09:39

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