Addendum 12b

Seminar on the Promotion of
Foreign Direct Investment toSoutheastern Europe

Tatsuhiko KASAI,
Senior Researcher, The Japan Institute of International Affairs

English8 November 2002, Tokyo, JIIA
Ministry of Foreign Affairs of JapanThe Japan Institute of International AffairsImportance and Elements of FDI
for Countries in Transition to a Market Economy
Tatsuhiko KASAI, Senior Research Fellow,
Japan Institute of International Affairs (JIIA)
Nov.8, 2002

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Introduction
This is a presentation paper for the Seminar on Promoting FDI in
Southeast European countries (SEE countries). The purpose of thispaper is to investigate the importance and elements of FDI for
countries in transition to a market economy, and to study paradigms
related to FDI. This paper also aims to provide a common scale for
evaluating the FDI environment of each SEE country. The author isready to improve this paper with appropriate comments from outside
parties.
SEE countries are currently in transition from socialism to market
oriented economies. However, each country had a different type andlevel of socialism in the past from which to mark its starting point(conditions vary as some countries did not have distinctive socialist
economic elements while others had very strict systems), different
historical and ethnic backgrounds, different economic elements such as
natural resources, capital formation, labor availability and different
goals for their economic transition in future. In addition, somecountries have already achieved a certain level of economic transitionand others have not. Some countries are close to the EU economic
zone and have virtually introduced the Euro currency. There are alsocountries that have seen war and/or domestic unrest. In view of theabove-mentioned differences, this author focuses on the most generaland common factors and elements of FDI in transitional economies.

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The necessity and effects of FDI and related risks in transitional
economies
2-1-1 There have been various studies on FDI that cover its necessity andeffects. This year’s OECD report, “Foreign Direct Investment forDevelopment: Maximizing Benefits, Minimizing Costs” discusses key
factors to encourage economic development, employment, technology
transfer, human capital development, integration into international trade,
promotion of competition, corporate development, and income1increases, and points out that one of the effects of FDI is to bring out
dormant capital in FDI host countries. At the same time, the reportnotes that those effects are made possible only when basic
development proceeds and appropriate policies exist in the FDI hostcountries. In short, most of the issues to be resolved in promoting FDI
lie on the recipient side. In that sense, improving the investment
environment in the FDI host country is the most important factor.
2-1-2 While investment in developing countries and transitional economies ispotentially highly profitable for foreign companies (especially withregard to natural resource development), there is a risk of capital loss
as well.
2-1-3 Risk factors in transitional economies are generally categorized into thefollowing:1) Unstable macro-economy
2) Possibility of losing assets due to the weak binding effect ofownership and contract enforcement
3) Physical destruction due to war and/or domestic social unrest
4) Insufficient domestic economic policies (including reform policies)5) Low-quality public services
6) Insufficient liberalization of the trade regime
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Bearing the above-mentioned points in mind, the elements to be
discussed in this paper are as follows:
1) Achievement and current status of transition to a market economy
2) Economic structural reform
3) Social and economic infrastructure4) Goods market
5) Labor market
6) Industrial policy
7) Reform of trade and investment regime8) Conflict resolution system
9) FDI host country’s institutions promoting FDI
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The first element: “the achievement and current status of transition to amarket economy”
A stable macro-economy is very important for foreign companies tomake investment decisions and judgments. For foreign companies,
FDI means investing a huge amount of capital into a project and
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generating more gain than the initial investment after a certain period.
Calculating the cost and profit is possible under ongoing inflation when
the inflation rate is constant, but nonetheless depreciation of the initialinvestment and assets due to inflation is a serious threat. Therefore, astable macro-economy and directly related policies, including financeand currency policies, are the biggest concerns of foreign investment
firms. A number of countries are implementing macroeconomic
measures under agreements with the IMF (such as stand-by
arrangements). Although the relevance of IMF policies to transition
economies remains controversial (reviewing the “Washington
Consensus” was a topic at the SEE seminar last March), once IMF
policies are launched, they should be pursued to some extent. Given
this, it is then especially important to show both at home and abroadthat governments and central banks in the FDI host countries arecommitted to working toward stable macro-economies in a systematicmanner. A similar argument holds for other individual reforms. In
that sense, the existence of short-, medium- and long-term economic
programs in the FDI host country is a major concern of foreign firms.
FDI host countries are required to plan a wide range of effective andhighly transparent investment policies and arrange human andorganizational capabilities to implement those policies.
It is hard to withdraw FDI once it is launched, and in the case of any
uncertainty in laws and rules, there is a large possibility that the risk
premium will increase. SEE countries are in transition from theirformer socialist economy models of contract and ownership to market
economy models to greater or lesser degrees.
It is a major,
time-consuming change requiring comprehensive changes in thelegislative system. At the beginning of the transition, some countries
suspended laws that originated under their former socialist economies
and applied a contract and ownership system under the market
economy model as an interim measure for administration alone, butsuch interim systems should be formalized after discussion by
parliamentary bodies and others at the earliest possible time. Also,
when the transition from an old system to a new one takes a long time,
the cost of collecting information to understand the situation increases,
creating another disadvantage for foreign investors.
The ownership of land plots by foreigners is also very important, sinceland can serve as an asset or collateral for FDI.
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Ｔhere are two other points to be considered, although they are slightly
different issues from the main theme of “the extent of the achievementof transition to a market economy.”
3-4-1 The first one is demographics. Population usually decreases in atransition period or domestic conflict. This often reduces the working
population. This is a long-term negative factor as it decreases

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domestic consumption and production, and increases the budget forsocial welfare and related programs.
3-4-2 Disorder and instability in federal systems is another major negative
factor. Disorder in fiscal federalism (fiscal federalist relations: disorderof budgetary relations between the federal central government andregional or local administrations) in particular complicates the tax
relationship and creates more costs for foreign companies. In addition,
foreign companies face more difficulties when federal and local laws
conflict with each other in the same field during increasing instability inthe federal system. If such disorder and instability exist, they shouldbe eliminated as soon as possible.
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The second element: “economic structural reform”
The important factors are as follows:
・ Promising industries that each country wants to bring to theattention of foreign investors
・ Industries in which each country believes it possesses a
comparative advantage

・ Formation of supporting and subcontracting industries inestablishing assembly industries
4-2This author emphasizes the following points:
4-2-1 One of the common things seen in former socialist economies withregard to privatization-related investments is large-scale state
enterprises that monopolize a market. However, a number of theseenterprises are now inefficient and have accumulated debt. They
should in principle be privatized in order to improve managerial
efficiency. This author believes that, after corporate asset evaluation,
the privatization of state enterprises should be accompanied not onlyby the conversion of the companies to joint stock ones, but also by theirbreakup. In the course of dividing up these companies, policies
should be implemented so that the production sector is either divided
vertically (mainly by area), or horizontally (mainly by field) or some4

combination of the two after separating the peripheral elements (suchas apartments for employees, schools and hospitals) from the
management entity. Each country should decide which measures totake for each industry in light of the social and economic conditions inthat country. It is worth considering concentrating accumulated debt
into a specific organization (e.g., the privatization process of the former
Japanese National Railways). Next, promising areas within eachdivision should be fostered (e.g., policy-based finance, tax incentives,incubators, etc). The role of the central and local governments issignificant in this process. Here, surplus personnel in unprofitablesectors should be absorbed and, at the same time, unprofitable areas
should be cleared (bankrupted). In that sense, solid bankruptcy
legislation is necessary and social security (including unemployment
benefits) should be planned so that this issue can be addressed overthe long term. Entrepreneurs should be actively fostered along withprivatizing state enterprises as well. Finally, competition among
companies and entrepreneurs surviving the privatization and division
should be promoted for greater efficiency and public welfare.
4-2-2 When a foreign company makes investments abroad, it quite often
forms a capital alliance with a local partner (such as establishing a joint
venture) or establishes a company with its own capital. Here, factors
such as ownership, the acceptance of foreign capital and joint ventures,
labor and employment systems, corporate governance, and land
legislation should be considered. If a company was divided due to theabove-mentioned privatization, it is easier for foreign companies to finda subcontractor-like partner when investing in fields such as machine
manufacturing (in terms of size, direction and know-how).
4-2-3 The freedom to, for example, transfer capital abroad and banking
services are minimum requirements for financial systems at the initialstage. Some countries may have policy-based finance for specificindustries or small and medium-sized companies. This is, of course,
advantageous to foreign investment but, at the same time, should bemanaged with transparency and equality to prevent it from providing ahotbed for graft and corruption. Although it is not necessary right after
the initial investment, the existence of financial and securities markets
will be important as the companies may wish to be financed by banks
in the target investment countries or to issue bonds or increase capital.
4-2-4 FDI could create a negative impact on the environment through drilling5for resources and the expansion of heavy industries. Although theimpact on the environment is usually reduced as FDI introduces more
efficient technologies to FDI host countries, sometimes investing
companies bring in machine equipment that could not be used back intheir countries due to tighter environmental standards. In that case,reducing the impact on the environment is not always possible.
Therefore, FDI host countries should establish appropriate
environmental standards as well.
4-2-5 Whether the manager has a market economy mindset for management
and foreign language skills is unexpectedly important in the initialstages of a market economy.
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The third element: “social and economic infrastructure”
The important factors are as follows:

・Roads, ports, airports, etc.
・Energy supply such as electric power・Communication facilities and services
・Basic social services such as sewage and waste disposal
5-2Social and economic infrastructure is naturally important. This authoremphasizes the following in this regard.
5-2-1 Infrastructure development should not be required of foreign investing
companies but primarily of FDI host countries. Securing energy andwater supply is essential.
5-2-2 Basic social services such as sewage and waste disposal are also
important.
5-2-3 There were some cases of countries in economic transition assigninginfrastructure development to foreign investors (e.g., when a foreign
investor wants to create a hotel facility in the city center, the cityadministration sets down the condition of building a sewage system in aremote area of the city), but many foreign companies may stop
investing due to the lack of accountability.
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The fourth element: “goods market”
The important factors are as follows;

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・Proximity to a mass consumer market
・FTA
・Transportation and logistics
These are naturally important. This author emphasizes the following
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in this regard.
6-2-1 Most of the SEE countries have concluded bilateral or multilateral FTAs
with neighboring countries. We also know that EU accession is atarget of many SEE countries.
Some countries have alreadyintroduced the Euro as their official currency even though theiraccession to the EU has not been finalized. Some countries havejoined other regional blocs (e.g., the Black Sea Economic Cooperation
Organization and CEFTA).
6-2-2 Careful consideration should be given to the facts that (i) the creation of
an FTA area has positive aspects for the participants in the FTA, but
negative aspects for non-participant countries engaging in business in
the FTA areas, and (ii) the overlap of various FTAs in a single area
complicate business. Decisions on the positioning and affiliation ofeach SEE country with certain FTA areas are issues for that country toaddress. However, these items should be discussed in-depth to avoid
problems in the future.
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The fifth element: “labor market”
The important factors are as follows:・Labor standards
・Labor force structure
・Labor discipline, diligence, wage level, quality
・Industrial and union relations
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These points are important in the investment environment. Thisauthor emphasizes the following two points.
7-2-1 Social security (labor legislation, education, technology, and medical
insurance) generally needs to attain a certain level for the country to
enjoy the benefits that FDI brings. Labor legislation is especially
important among these. On the other hand, the author is aware thatmany countries maintain an extraordinarily generous labor law system
as former socialist countries, including the requirement of union
permission for lay-offs and strict restrictions on overtime work. These
are good for workers but increase costs for companies.
It isappropriate to introduce systems that are in accord with the transition toa market economy and labor policies meeting ILO standards.
7-2-2 A number of countries draw attention to their high educational
standards and skilled workers. At the same time, technologicalflexibility is important.
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The sixth element: “industrial policy”
The important factors are as follows:

・Privatization of state enterprises and antimonopoly policies
・Resource development policies (PSA)・Investment incentive programs
・Support of scientific technology and research and development
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The importance of privatization was already explained in discussing thesecond theme, “industrial structure reform.” Antimonopoly policy isespecially important in relation to the privatization of state enterprises
mentioned above. FDI affects competition in the FDI host country’s
market significantly. Vitalized domestic competition prompts economic
growth and could eventually lead to higher productivity, lower prices,and more efficient resource allocation. However, in cases where the
FDI host countries are small or the investing companies play animportant role in the international market, or if competition laws are
weak in the FDI host countries or entry barriers are high, competition
could be hampered.
The privatization of certain companies issometimes an exception to antitrust law in a transition economy (e.g.,natural monopolies in Russia). However, minimizing exceptions at theinitial stage has a positive effect in the long run if privatization is toincrease company efficiency in the future. FDI in developing countries
and transition economies is often investment in natural resources. The
next most common example is privatization-related investment (massprivatization was carried out in a number of countries in transition in the
1990s) and some investments aim at gaining access to huge domesticor neighboring markets. The author would like to emphasize thefollowing points in relation to the above.
8-2-1 With regard to investment in natural resources, the above-mentioned
ownership issues and disordered federal systems are related to one
another. This is because the ownership of the natural resources
produced is disputed among nations, regions or companies. In thatsense, it is desirable to resolve the two problems – ownership andfederal systems – promptly. PSA (Product Sharing Agreement)
resource development is one realistic solution.
8-2-2 One of the important benefits of FDI for FDI host countries istechnology transfer. Technologies here are not just technologies for
production, but include business skills as well. Moreover, FDI has the8potential to improve environmental and social conditions in the FDI hostcountry by transferring “cleaner” technologies and introducing moresocially responsible corporate policies. However, the technologicallevel of the FDI host country should be high enough to digest thetransferred technology to maximize the effect of the technology transfer.
Also, foreign companies often impose their corporate philosophy andcorporate governance on the capital partner in the FDI host country.
These factors are very likely to drastically improve the management
efficiency of the company.
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The seventh element: “reform of trade and investment regime”
The important factors are as follows:
・Compliance with WTO and EU standards and policies for hosting
foreign investment in each country

・Regulations on foreign capital investment ratios
・Foreign investment incentive measures
・Systems related to establishing and managing foreign companies(land ownership, local hiring requirements)
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Four SEE countries have already become members of the WTO andthree have observer status.*
Moreover, some countries havevoluntarily introduced EU standards and the Euro. This authoremphasizes the following points.
9-2-1 Special measures to integrate the economies of FDI host countries into
the international trade framework using the benefits of FDI, especiallyby establishing export processing zones (EPZ)/special economic zones(SEZ)/free economy zones (FEZ), have gained considerable attention.
China, for example, gives investment incentives to foreign companies.
The author is not sure if there are similar EPZ/SEZ/FEZ in Southeast
Europe. However, if there are, and if incentives are given only toforeign companies in the zones, the negative effects should also be
considered. This includes the burden on the state and region toestablish and maintain export processing and special economic zones,
and the risk of creating unequal playing fields for domestic and foreigncompanies, though these measures could sometimes contribute toexpanding the trade of the FDI host country. Establishing incentive
measures for foreign companies in such EPZ/SEZ/FEZ is against WTO
provisions and therefore problematic (e.g., China promised to abolishsuch measures). Countries that plan to join the WTO should be
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9-2-2 If a WTO member country is divided, the new smaller countries willdevelop socioeconomic legislation separately, but even in such cases
they should remain in compliance with their WTO commitments.
*
Rumania
January 1995
MemberBulgaria
December 1996
MemberAlbania
September 2000
MemberCroatia
November 2000
MemberBosnia-Herzegovina
ObserverMacedonia
Observer
Federal Republic of Yugoslavia
9-2-3 Each SEE country should carefully consider the FTA-related policies
mentioned in 6-2 of this paper.
10-0 The eighth element: “conflict resolution system”
10-1 The important factors are as follows:・Legal systems
・Other dispute settlement agencies
10-2 Countries with economies in transition often have legal systems notsuited for a market economy. The legal systems themselves are in atransition period, and various commercial disputes could occur.
Developing settlement systems is important when that happens.
10-3 Some transition economies may have applied flexible systems toadministrate laws as an interim measure at the initial stage of thereform. Some local governments may have introduced such flexible
systems in some areas, which may cause discrepancies in central andlocal regulation, disruptions in fiscal federalism, and confusion among
foreign investors on which regulations they should obey.
It isnecessary to review and formalize interim law systems as permanentsystems in the process of putting into place the country’s basic
structure.

11-0 The ninth element: “FDI host country’s institutions promoting FDI”
11-1 The important factors are as follows:・ agency’s name・ functions of each agency
・ problems that each agency tackles
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・ contact points, etc.
Foreign companies invest in countries of which they have little
knowledge, so it is desirable to have agencies that give them guidance,
a consultative body in case of disputes, and agencies that support
foreign investors’ rights regarding indirect investment.
Suchinstitutions should be created with one center in the capital and one ineach region.

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