Foriegn Investment in Post Conflict Environment (November 2004)
I - FOREIGN INVESTMENT IN POST CONFLICT ENVIRONMENT:
Social and economic well-being is an essential pillar in successful post-conflict reconstruction. In this context, foreign direct investment is often reduced to a declaration that private-sector investment should be encouraged. But not all forms of private investment are good in such an environment. In many cases foreign investment becomes a new source of tension, grievance, discrimination, and instability. Structuring healthy foreign direct investment should be viewed as prevention of future conflict.
This paper presents recommendations for the conditions needed for attracting foreign investment, and sets-up guidelines for the contractual relationship between the business and the host government that are most beneficial for the economic and social well-being of the local population and its government. Two forms of foreign investment will be discussed separately: natural resources and foreign investment in manufactured goods. For each, the potential sources of tension, the needs of the investor and the ways to maximize social and economic well-being will be discussed.
II - NATURAL RESOURCES -
II.A - SOURCES OF TENSION:
Several factors can cause tensions between a host government, local population and foreign extraction companies. First, collective memory of colonial history sustains grievances over gun-boat diplomacy and past exploitation. Second, a sense of national patrimony leads to feelings of 'oil is god's gift to Iraq' and therefore no foreigner has the right to extract it. Third, the issue of subsoil rights brings tensions over the ownership of possible natural reserves. Fourth, the fact that natural resources are exhaustible raises the already high stakes - there is only one chance to get it right. Fifth, most natural resources are in an enclave location, in which the host government has limited enforcement capacity; therefore for the local population it appears as if the foreign company is the sovereign. Finally, obsolescing bargaining can lead to increased tensions and instability.
Obsolescing bargaining describes the dynamics in the system of bilateral monopoly between the company and the government as risk and uncertainty evolve in a natural resource project. Before the investment is sunk, risk and uncertainty are high and the company holds a quasi-monopolistic power over expertise and resources - without the company the country cannot utilize its natural treasure. However, once development is done and the project proves successful, power shifts to the government as it holds monopolistic power over access - by the threat of nationalization - and the company's monopoly over expertise diminishes.
Conditions in a post-conflict environment combined with obsolescing bargaining offer great opportunities for healthy reconstruction. The reconstruction agency can pressure both the host government and the foreign company to structure their relationship in a way that will be both beneficial to the company and enhance the stability and well being of the local population and the government while minimizing potential sources of tension.
II.B - NEEDS OF THE INVESTOR:
The most dominant consideration for a natural resource investor is that of risk sharing. Before the investment is sunk and development is made, risk and uncertainty are extremely high. Whether an extraction project proves to be financially viable depends not only on the reserves found, but also on extraction costs and world supply and demand. The potential for profit materializes a long time after the investment is sunk.
In this context, tax regimes play a crucial role. Royalties, unlike income taxes, keep the risks of production on the shoulders of the extracting company. Royalties are paid as soon as there is revenue, while income taxes are due only when and if there is profit. In addition to production risks, fixed royalties are independent of market demand, keeping the risk of price volatility on the company alone.
The investor's first priority is therefore a tax regime that leans on income taxes and allows the sharing of risks with the host government.
The second most dominant consideration is that of control. Joint ventures tend to lead to financial inefficiencies and conflict of interests. While the company's prime interest is maximizing its long-term profits, the government's interests are much more complex. Beside the interest of maximum profits, the government is interested in staying in power, maintaining public support, and running other state's affairs. This mismatch can lead to conflicts in issues of labor, investment, re-investment and marketing.
The investing company is looking to ensure its control over the decision making process in order to avoid conflict of interests and inefficiencies. This concept is called insulation.
The isolated nature of natural resources extraction allows immediate progress to be made in a post-conflict environment, even before basic micro and macro economic conditions, legislation and infrastructure are in place. This can shorten the time-gap before the public feels benefits.
II.C - MAXIMIZING SOCIAL AND ECONOMIC WELL-BEING:
Contrary to intuition, income-tax regime is beneficial to the host government more so than royalties. Notwithstanding being paid at a later stage, income taxes help the comparative advantage of the country's natural reserves, by avoiding the addition to fixed costs. In addition, income taxes evade the potential for premature abandonment of projects due to high fixed costs, therefore increasing the government's revenue. By nature, royalties are more prone to corruption. Income taxes, on the other hand are more difficult to enforce and therefore require the help and experience of a foreign agency.
A tax regime that leans on income taxes is therefore better for the host government and can help in attracting more investors.
Similarly, insulation is a more beneficial and stabilizing structure for the host government than joint ventures. A marriage between the government and the extraction company, denies the government's ability to side with the public when faced with unpopular decisions. The government, for profit sake, wants the company to make unpopular decisions but also wants it to take the blame for it. In addition, when it comes to investment and re-investment, the government's access to capital is more costly and limited. Its budgetary priorities are most likely different than the company's, yet if the government is a part-owner it has to put down the money.
Insulation, in comparison with joint venture, offers more stability for the government and at the same time helps maximize its profits through income taxes by avoiding inefficiencies in the project's operation.
Tying the income from a natural resource project to investment in the local population will lead to improved stability. Creating a trust fund that receives percentage of the income taxes directly from the project can do this.
For further readings on natural resources please refer to:
- Theodore H. Moran, Foreign Direct Investment and Development: The New Policy Agenda for Developing Countries and Economies in Transition , Institute for International Economics, Washington DC, December 1998, Chapter 9.
- Financial and Fiscal Aspects of Petroleum Exploitation , UN Centre on Transitional Corporation Advisory Studies, pp 8-17.
- Michael Shafer, Capturing the Mineral Multinationals: Advantage or Disadvantage ? Multinational Corporations; the Political Economy of Foreign Direct Investment, Georgetown University.
III - FOREIGN INVESTMENT IN MANUFACTURED GOODS -
III.A - SOURCES OF TENSION :
Attracting foreign investment in manufactured goods comes with a long list of associated sources of tension and destabilizing forces. Working conditions and the treatment of workers in low-skill plants can potentially suggest exploitation, harm and abuse of workers. Issues such as living wage, living conditions, health conditions, coercive employment, limited training, child labor and women's rights, can lead to workers' unrest, grievances and eventually instability and eruption of violence.
Foreign direct investment in higher-skill plants can lead to economic stagnation, negative spillovers, weak backward linkages and "screwdriver jobs". Multinational companies might exploit the local market by establishing subsidiaries that serve only to recycle profits of aging-technology products by using cheap labor for production and uncompetitive local market for selling. These "cash cow" operations cause unrest as they deny enhancement of labor's skills, and cause stagnation in the local economy.
III.B - NEEDS OF THE INVESTOR:
Attracting foreign investment in manufactured goods requires several conditions. First, investors need realistic macro and micro economic conditions. These include: realistic exchange rates, laws that establish property rights, laws and regulations to define workers' rights, and laws of bankruptcy. Second, investors need a well-functioning infrastructure. A post-conflict environment offers great prospects to rebuild infrastructure as it provides immediate supply of jobs. Third, potential investments need access to labor. The targeted location should be close to a population center or offer new housing for internal migration.
Fourth, foreign investors are looking to have wholly owned subsidiaries and unambiguous control over their investment. Freedom to source from wherever they please, for instance, will enable investors to lower their price of production and guarantee their products quality. Fifth, investors need to have valid backward-linkage conditions. This means that supporting businesses exist or have good conditions to develop.
In order to make it easier for an investor to choose the country for investment, the host government should take a few additional steps. First, offer tax breaks and free trade zones. Second, establish an investment promotion agency that will welcome potential investors and offer them a one-stop shop for all of their needs. Third, offer risk protection, as political-risk is extremely high in post-conflict environment.
III.C - MAXIMIZING SOCIAL AND ECONOMIC WELL-BEING:
The effects of foreign investment on a local population are not primarily through job creation, but rather through integrated packages that include technologies, business techniques, management skills, human-relations policies and marketing capabilities. These goals can be achieved if the foreign investment project is tightly integrated into the parent multinational's competitive strategy. This gives the investor self-interest in maintaining the project's technological and quality standards.
Traditional tools such as joint venture requirement, domestic content requirement and import substitution policies, lead to negative spillovers, "screwdriver jobs," and cause stagnation in the local economy. In order to avoid technological transfer, or intervention in their operations, businesses will shy away from joint-ventures or use them only for "cash-cow" operations. Domestic content requirements add quality and price uncertainty for the investors. Finally, import substitution policies, such as import quotas and import duties, lead investors to concentrate on local markets resulting in small-scale operations and lower investment.
Once again, contrary to intuition, the traditional tools should be abandoned. Instead, wholly owned subsidiaries, unambiguous control, freedom to source inputs from abroad and export oriented policies, should be offered. These will encourage investors to integrate their investment into the parent's global competitive strategy.
Enforcing laws and regulations to guarantee labor rights is difficult; especially in dire economic conditions and weak state institutions such as in a post-conflict environment. There are, however, market forces that can push towards healthy worker-employer relations. Competition over labor is a centerpiece in this strategy. The dangers of worker abuse are greater when one plant or one free trade zone dominates the local labor market. As companies need to compete for labor, standards and treatment will improve.
Developing multiple investment areas or free trade zones and attracting numerous investors creates market forces that foster healthy labor-employer relations and avoid potential destabilizing tensions. Moreover, if plants are integrated in the company's global competitive strategy, quality standard requirement will encourage employers to treat workers fairly.
Enhancing workers' productivity is in the interest of both the government and the investor. Tax breaks for vocational training can be a great incentive for these kinds of programs. Increased productivity leads to higher wages and better treatment of workers.
For further readings on foreign investment in manufactured goods, please refer to:
- Theodore H Moran, Beyond Sweatshops; Foreign Direct Investment and Globalization in Developing Countries , Brookings Institution Press, Washington DC, 2002. This book includes several case studies.
- Harvard Business School, Mexico and Microcomputers , 2003.
- Bernard Wasow, The Benefits of Foreign Direct Investment in the Presence of Price Distortions: The Case of Kenya , May 2003.
- Theodore H. Moran, The Product Cycle Model of Foreign Direct Investment, Multinational Corporate Strategy, and Parent Control . Institute of International Economics, Washington DC, August 2001.
- Huan Ngo, Mekong Corporation and the Viet Nam Motor Vehicle Industry , Richard Ivey School of Business, The University of Western Ontario. September 1996.
IV - RECOMMENDATIONS -
Smart structuring of the relationship between a host government and a foreign company can be the difference between war and peace, stability and chaos, growth and stagnation. Understanding the motivations and challenges of foreign investment in a post-conflict environment, the coordinator office for reconstruction and stabilization should take the following steps:
IV.A - NATURAL RESOURCES:
A window of opportunity opens immediately post conflict. The faster projects are implemented, the quicker local populations will feel the benefits. Therefore, CRS should:
1. Provide a consulting team to the host government in order to support and structure their negotiations with potential investors. This will help level the playing field as well as allow CRS to influence a healthy structured project.
2. Encourage the local government to pursue income tax leaning regimes, and offer complete insulation. These two important policies will attract investors as well as guarantee higher revenues and better stability to the government.
3. Encourage the local government and the foreign company to establish trust funds in order to directly connect revenue from projects to benefit the local population.
IV.B - MANUFACTURED GOODS:
Unlike natural resources, foreign investment in manufactured goods comes with prerequisites. CRS should therefore:
1. Coordinate immediate infrastructure rehabilitation and expansion in targeted zones. Targeted zones should be close to population centers. These projects will provide short-term jobs as well as prepare the ground for foreign investment.
2. Ensure the leadership and guidance of an international financial institution in providing legislative and regulative support in establishing realistic macro and micro economic prospects. The umbrella of an international financial institution is enough to jump start foreign investors' interests.
3. Provide a consulting team to the host government in order to establish an investment promotion agency that will focus efforts on potential investors and serve as a one stop shop.
Once the prerequisites are in progress, CRS should:
4. Encourage the local government to allow investors to have wholly owned subsidiaries, unambiguous control over their projects, freedom to source from abroad and export oriented policies. This will attract investors as well as advance the project's integration into the parent company's global competitive strategy.
5. Encourage the local government to provide first-mover incentives in order to create a demonstration effect. Once the first zone or the first company operates, others will follow the leader. Developing several zones and pursuing numerous investors will create competition for labor and prevent workers abuse.
6. Encourage the local government to implement policies such as tax-credit for vocational training and negative income-tax, in order to enhance workers productivity and promote backward-linkage initiatives.
Following these guidelines will help attract foreign investors and at the same time help structure these investments to promote long-term stability and growth by avoiding the potential tensions associated with foreign direct investment.