05 Mar 2007  Research & Ideas

Risky Business? Protecting Foreign Investments

After a string of forced nationalizations of private enterprises in the 1960s and 1970s, the pendulum swung back and companies were again encouraged by host countries to build and run major infrastructure projects such as power and water. But a set of new property protections has done little to manage the risk in many of these politically unstable environments. Professor Louis T. Wells, coauthor of a new book on making foreign investment safe, discusses the current landscape. Key concepts include:

  • Although property rights protections for investors in developing nations have improved since 1980, the new instruments are failing to satisfy the interests of either host countries or their business partners.
  • Protections can be improved by developing a real consensus on the part of investors' home countries, host countries, and investors themselves.
  • Business managers must take a significant role in pushing for a multilateral agreement on foreign direct investment, or at least become active in promoting lesser changes that will lead to more balance and security in the current system. Otherwise businesses will lose profitable opportunities and find themselves in the middle of disputes that hurt their future prospects. And poor countries will fail to benefit from what investors can bring them.
  • Absent strong protections, managers must ask themselves a series of questions before investing in developing countries, such as: Is my investment project politically sensitive? If so, will the country continue to need my participation in the project?

 

Foreign investment in developing countries has always involved an element of risk. Just ask Verizon Communications, which could lose hundreds of millions of dollars in Venezuela should President Hugo Chávez follow through with plans announced in January to nationalize the country's main telephone and electricity companies.

The news headlines make the arrival of a new book on protecting foreign investment more prescient. Professor Louis T. Wells and coauthor Rafiq Ahmed recently published Making Foreign Investment Safe: Property Rights and National Sovereignty.

Using case studies, many of which involve projects by foreign companies to develop and manage large infrastructure projects in Indonesia, the book details the ways such deals can go bad both for the companies and the countries they operate in. It also examines how an evolving set of intended property rights protections has failed to gain much traction and proposes measures that will better protect the rights of property owners.

We asked Wells to discuss his research and experiences representing host governments in such negotiations, and what international managers can do to protect their foreign investments.

Sean Silverthorne: You write that Indonesia's 1980 nationalization of ITT's thirteen-year-old Indostat telecom business "marked the end of an era." What changed?

Louis Wells: In the 1980s, a new attitude toward foreign investment swept the developing world. Old policies had reflected deep suspicions of foreign investors; they evolved toward more friendly approaches. Many countries created new incentives for investors and built investment promotion agencies to attract new companies.

The causes were several: Better educated and more experienced officials had confidence that they could manage foreign investment so that it would act in the national interest. Exporting began to be seen as a route to development, and foreign firms offered both the technology and access to markets that might make exports possible. Many state-owned firms—some of which had resulted from nationalizations of foreign investors—were proving to be inefficient and were drains on the public treasury.

Business would do well to support improvements in the system that purports to protect their investments abroad.

The Thatcher and Reagan revolutions in the industrialized countries led to new views toward private investment in sectors then dominated by state owned companies. In some developing countries, officials were converted to the new beliefs. In other countries, officials were not so enthusiastic about the new ideology, but they found themselves cut off from other sources of finance as the World Bank and bilateral aid agencies embraced the new attitudes toward the private sector. They saw little choice but to turn to foreign investment.

The result was that the nationalizations of foreign investors that had characterized the 1960s and 1970s came to an end. After all, it seemed dangerous to nationalize foreign firms if you wanted to attract more!

Q: In the late 1980s and early 1990s, many developing countries sought outside infrastructure investments and even privatization of these operations. These initiatives were encouraged by world development leaders who believed foreign private funds would pay for water, transport, power, and other infrastructure needs in poor regions. Meanwhile, a new set of investor protections were developed to help protect investor property rights. What happened, and what are some of the lessons we've learned from this period?

A: First, private ownership of critical infrastructure has proved to be as controversial as was public ownership. The huge investment in infrastructure has to be paid for one way or the other, a fact that government officials in the developing world tended rather wistfully to overlook. Moreover, private investors demanded a high rate of return for the funds they and their lenders put into such projects, more than the cost of public borrowing. In many projects corruption, government incompetence, or disorganization led to deals that were terrible from the point of view of the host country. As a result, private investment in infrastructure very often meant higher charges to the public for electricity, water, or other public services. Some increases in rates were no doubt needed to get governments out of subsidies, but large increases were blamed on the new private owners. This was especially sensitive politically when those owners were foreigners.

In the somewhat special case of Indonesia, the political crisis accompanying the Asian Currency Crisis meant that no increases in rates were granted; thus the state-owned power distributor simply could not pay what had been promised to investors in the contracts that government officials had negotiated. Indonesia was, of course, not alone. Argentina is another prominent example where foreign investors in infrastructure found themselves with contracts that could not reasonably be honored.

In my view, the most pressing step is the creation of an appeals process for arbitration.

The resulting contract disputes were not supposed to happen. The 1980s saw the growth of protections for foreign investors. Official insurance agencies, such as the U.S.'s OPIC, provided political risk coverage that would reimburse investors if their deals fell apart. And an international system of arbitration, backed by bilateral investment treaties and regional trade agreements, promised further protection.

The new protections, however, had emerged without a real consensus on the part of investors' home countries and their hosts. There had been attempts to negotiate multilateral agreements on foreign investment that would parallel the GATT and the WTO for trade. They had failed, as countries that were home to multinationals and those that were hosts found their differences to be irreconcilable. The new protections emerged largely from efforts by home countries to protect their investors in the Third World, and they paid little attention to the concerns of the poor countries. When disputes arose, the new system proved largely unacceptable to the host countries. They have been angered by insurance awards in which the poor countries have no voice, but for which the rich countries in the end demand reimbursement from the poor. And they have fought arbitration decisions that they believe have not take into account the one-sided nature of deals, underlying corruption, and the impact of economic crises.

Q: What are some of the key steps companies can take to make their foreign investors safe—or at least safer?

A: In the 1990s, many foreign investors relied too much on the new protections believing that they would be protected should their investments run into trouble. Managers would be wise to ask the same questions that were relevant in an earlier era: Is my investment project politically sensitive? If so, will the country continue to need my participation in the project? That need may exist because I offer technology that isn't easily available to the country or because I offer access to export markets that wouldn't otherwise be available.

Absent these special advantages, a foreign investor would be wise to proceed very cautiously into businesses that are likely to become political footballs. And those investments are even riskier if the deals were secured through influence and corruption. The presence of corruption, by the way, should not be judged solely by the terms of the U.S. Foreign Corrupt Practices Act, which has gaping loopholes. Some of the arrangements behind the Indonesian projects seem not to have violated the law, but they didn't smell good in the light of public examination.

In the long run, business would do well to support improvements in the system that purports to protect their investments abroad. So far, business managers have not taken a significant role in pushing for a multilateral agreement on foreign investment; neither have they been active in promoting less drastic changes that might lead to more balance—and thus more security—in the current system.

Q: Not only are companies at risk when they invest in developing countries, but so, too, are the countries. Should companies work with local leaders in attempting to ensure a win-win?

A: Deals that are too good for the investor shouldn't be believed. In the past, and still in some countries, these deals can last for a while. More democratic regimes and the emergence of NGOs, however, ensure that such deals will come under attack rather soon. To take illustrations from another continent: Two large foreign companies signed concession agreements with the transition government in Liberia in 2005. Both deals have fallen apart as they came under attack by NGOs and as the country took a turn toward democracy. Wisely, both companies have decided that renegotiation is better than defending the indefensible.

Q: You predict that the new international system of investor protections in developing countries, which looks much different than it does in industrialized countries, will collapse unless revised. What needs to be done to make the system effective, and what will happen to foreign investment in developing countries if the problems aren't fixed?

A: Ideally, we should have a multilateral agreement on foreign investment that parallels the World Trade Organization. This would create a body of "legislation" and a dispute settlement mechanism that balances the needs of both rich and poor countries. Previous efforts to negotiate a multilateral regime have collapsed, however. There are several reasons.

First, countries divide themselves easily into home countries and host countries and see themselves as having conflicting interests. Yet, increasingly, they have common interests with respect to foreign investment. Both kinds of countries need to back off a bit from their extreme positions. This will require some leadership on both sides. The United States has failed to take a strong position of leadership. Second, unlike for trade, a multilateral agreement on investment will involve obligations on the part of investors themselves. Multinational enterprises have not been enthusiastic about making commitments; as a result, they have not come out in strong support of the multilateral efforts. Without managers' support, there will be no U.S. leadership and no agreement. I believe that this is a mistake on the part of managers.

Even in the best outcome it is unlikely that a multilateral agreement on foreign investment will be concluded for a number of years. In fact, there are no negotiations underway. In the meanwhile, the current system of protection can be patched up to make it more acceptable. In my view, the most pressing step is the creation of an appeals process for arbitration. The appellate body must have membership that broadly reflects the interests of the various parties involved (as does the WTO appellate process). Currently, we have no "legislation" to govern investment disputes. Arbitration tribunals reach conflicting decisions using different logic, and a few make absurd awards. They are secretive and only recently have some opened their hearings to inputs from "friends of the court." A good appellate process would encourage consistency, consideration of the interests of more parties, logical awards when awards are called for, and the emergence of a common law to govern disputes. There can be no common law without an appellate system to resolve conflicting decisions.

Even better would be a move on the part of arbitrators from their focus on monetary awards to efforts to encourage the parties to a dispute to reach reasonable agreements. In some cases, they will fail, since one party or the other wants out of the deal altogether; but in other cases, both the investor and the country would likely be better off with a new business arrangement.

Q: Venezuela plans to quickly privatize the oil industry and, over the next eighteen months, to also nationalize the country's biggest telecommunications company and the electricity and natural gas sectors. What are your thoughts on what this trend means both for Venezuela's economic development and for outside companies that currently have stakes in the country?

A: We don't know whether Venezuela plans to pay a fair price for the assets that it is nationalizing. In the ITT story I tell in my book, Indonesia nationalized ITT's telecommunications facility in 1980, but it paid a price that ITT found reasonable (after demanding much more). ITT ended up with a fine return on its investment and Indonesia avoided some really high future profits payments to a foreign owner. ITT agreed not to complain about its experience, and continued to do business in the country in other sectors. Indonesia even proved that it could run the resulting state-owned firm quite well.

Venezuela could also strike reasonable deals. It may run the resulting state-owned enterprises somewhat less efficiently than foreign firms would, but as I discovered for one of the electric power plants in Indonesia, the country may be better off with a bit of inefficiency and smaller payments abroad. Efficiency is great for a country but only if all the benefits aren't captured by a foreign investor!

Of course, it isn't inevitable that Venezuela will pay reasonable prices or manage the businesses well. This is a highly politicized decision. We will have to wait and see.

Q: You had personal experience working on the host government side in the renegotiations and nationalizations of some American subsidiaries in the developing world. What insights did that hands-on experience give you that inform the book?

A: The wise manager recognizes when it's time for graceful acceptance of renegotiation or nationalization. No government expects the investor simply to walk away from its investment. On the other hand, an absolute refusal to negotiate or to entertain reasonable offers will mean an end to that company's business opportunities in the country.

And unreasonable positions might result in exposure of some unpleasant details about how deals were obtained in the first place. In the ITT case and in several of the 1990s power projects in Indonesia, the companies involved had other interests in Indonesia. It was the managers of those firms who usually recognized—and wisely, I believe—that their broader interests were at stake and that it would be profitable in the long run for them to be reasonable when Indonesia was in the middle of a crisis.

Q: What are you working on now?

A: I am writing papers that expand on some observations in the book. For example, I am interested in explaining the fact that Japanese firms almost never (I've found one exception) take their investment disputes with host governments to arbitration. I am also writing a paper that draws lessons from the electric power experience for Indonesian officials; they're in the process of negotiating new projects, but I am not sure that they've learned all that they should learn from the experiences of the 1990s.

Since I finished the book, I've also been involved in two specific renegotiations of foreign investment agreements in another part of the world. Yes, again on the host government side. And I am working with a small group to see whether we can tighten some of the enforcement or provisions of the Foreign Corrupt Practices Act and the OECD treaty on corrupt payments.

About the author

Sean Silverthorne is the editor of HBS Working Knowledge.