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Asia Frontier Capital's Country Report: Nepal

AFC Country Report: Nepal

In line with focussing on a country from AFC's investment universe in each month's newsletter this month we cover Nepal to discuss its economy and future prospects.
Nepal is best known as an alluring tourism destination, boasting 8 of the 10 highest mountains in the world. The small, landlocked country bordering India and China is home to nearly 28 million people and is the most rural country in South Asia, with 80% of its citizens living in rural areas. The country is rapidly urbanizing, however, as evidenced by Kathmandu becoming increasingly crippled by pollution and gridlock - an overpopulated city stretched well beyond its means.

Nepal remains desperately poor, and with an average annual income of USD 646, it is in the poorest 10% of countries in the world according to the IMF. The country's GDP stands at just under US $19 billion, and GDP growth has remained relatively low in comparison with the region, hovering around 3-4% per year, although it increased to 4.9% in 2012. Nepal became only the second Least Developed Country (Pending:LDC) after Cambodia to gain entry to the World Trade Organization in 2004.

As a landlocked, mountainous nation, Nepal is heavily reliant on India for its seaport access, and India is the country's largest trading partner, accounting for over 55% of its trade. The Nepali Rupee is pegged to the Indian Rupee at 1.6 NPR/INR, and has suffered from the depreciation that recently afflicted India in the aftermath of the Fed's tapering of quantitative easing. Historically, Nepal has had closer ties with India than China, but the new Maoist leadership has gotten cozier with China as Beijing has increasingly discussed financing large hydropower projects and road construction to help alleviate the country's desperate power shortages. China, however, still keeps a close eye on the Sino-Nepali border due to its ongoing tensions with Tibet.

The country has struggled to attract substantial foreign direct investment, especially in comparison to other countries in South and Southeast Asia, and a number of challenges exist. Repatriating capital or withdrawing investments requires foreign investors to receive central bank permission and selling Nepali currency requires letters of credit. State monopolies control the electricity distribution and petroleum sectors, and a number of sectors are still closed or restricted for foreign investors. The Nepal Stock Exchange (NEPSE) is effectively off limits to foreign investors, although NEPSE signed an agreement with Bloomberg in March to internationalize the stock market and take steps towards attracting interest from foreign investors.

India has been the largest source of foreign investment in Nepal, and many Indian companies are moving towards expansion in the country, especially due to the fixed currency peg that eliminates foreign exchange risk for Nepali subsidiaries. There is also free flow of labor (an open border) between India and Nepal, and many cultural similarities in terms of marketing Indian goods towards Nepali consumers. Other top countries for FDI in Nepal include China, the US, and South Korea, with energy being the largest sector.

Remittances from Nepalis working overseas have been a vital contributor to the Nepali economy and have become quite a contentious topic in recent years. More than 2.2 million Nepalis are estimated to work abroad, primarily in India, UAE, Saudi Arabia, Qatar, and Malaysia, and it is reported that nearly 1,500 Nepalis migrate abroad for work every day, primarily working on construction sites and in factories.

The sheer impact of remittance inflows in Nepal is massive. Inflows grew 14% YoY to US $4.8 billion in 2012, according to the World Bank, and were estimated to reach US $5.21 billion in 2013. Nepal has the third highest level of remittances as a percentage of GDP after Tajikistan and Kyrgyzstan, accounting for 25% of GDP. The inflow of remittances has assisted in the economic development of Nepal and has helped reduce poverty, shore up foreign exchange reserves, and expand local banks and financial institutions.

The news has not all been rosy, however. Numerous advocacy groups and human rights organizations have shed light on the poor overseas working conditions for Nepali migrant laborers, and a recent piece by The Guardian estimated that 185 Nepali migrant workers had died in 2013 alone working on World Cup projects in Qatar.

Additionally, development economists have warned of Nepal's overreliance on labor migration and remittance inflows to keep its economy afloat, with one economist stating that "the mass migrant outflow is a reflection of the complete collapse of Nepal's economy". Much of the money in Nepal is earned outside of the country, and is in turn spent on imported goods that were produced outside of Nepal - meaning that there isn't much of a "value-add" by Nepal on either end. The large inflows of cash coming in from overseas workers contributed to asset valuation bubbles and were largely blamed for the crashes in the country's real estate market and stock market in 2011.

Hydropower is one area that is attracting attention. Nepal has hydropower potential of 83,000 megawatts, but will require large megaprojects to reach that anything near that capacity. Currently, hydropower accounts for only 2% of all energy consumed in Nepal. In-country energy demand could reach 10,000 megawatts in the near future, which would allow ample overcapacity for regional export, particularly to India, if Nepal were able to scale up and develop its hydropower capacity. A number of the projects, however, especially those being financed by China, have come under scrutiny for potentially negative environmental consequences. Nepal's per capita electricity consumption of 93 units is the lowest in Asia, contrasted with India (644), China (2,942), and Sri Lanka (445).

Tourism is another key sector of the economy. Nepal's mountains attract many mountaineers, adventure thrill-seekers, and Hindu/Buddhist pilgrims. The Mount Everest disaster in April 2014, however, highlighted the dark side of the growth in tourist arrivals and the often harsh conditions that many of Everest's Sherpas face.

The tourism industry accounted for 3% of Nepal's GDP in 2012 and is the second largest source of foreign exchange for the country after remittances. Nepal attracted more than 600,000 foreign tourists in 2012, a 10% YoY increase and its tourism industry employs more than 550,000 people. Nepal has launched a renewed focus on attracting Asian tourists, with 75,000 Chinese tourists arriving in 2012, a 60% increase YoY.

Agriculture is the traditional mainstay of the Nepali economy and the source of livelihood for 80% of the population. It accounts for more than 1/3 of GDP, with major exports including rice, wheat, maize, millet, barley, coffee, and tobacco. Nepal also has a small but growing textile and tapestry sector. Production of ready-made garments (RMG), carpets, and pashminas has grown steadily due to Nepal's duty-free export provisions. Exports to the EU in particular have benefited from the country's Least Developed Country (LDC) status and the recent depreciation of the Nepali Rupee.

Looking forward, Nepal will need to overcome a number of significant challenges to continue to grow its economy and attract foreign investment. The liberalization of key industries, opening of its stock market, and reduction of corruption will all help towards that goal. Political stability has improved dramatically with the end of the civil war in 2006 and the completion of the peace process in 2013. Domestic job growth is vital to ensure that there are enough in-country opportunities for Nepal's rapidly urbanizing population, and the country cannot continue to rely on remittance inflows to prop up its economy. Nevertheless, Nepal stands to benefit from its strategic location nestled between two economic powerhouses, and Asia Frontier Capital expects to keep a close eye on developments in the country and positive signals that might indicate that Nepal is serious about liberalizing its stock exchange

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.