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PolicyResearchDepartment TheWorli Bank March1993 WPS 1111

ForeignInvestmentLaw in Centraland EasternEurope

'. Gray Chery"w and WilliamJarosz

Policymakersshouldfocuson reducinguncertaintyandtransaction costs throughclear and simplelegislation,the enforcement of contracts,the use of arbitrationandother altemativedispute resolutionmechanisms,stronger protectionof property rights, the dissemination of information on laws and on business opportunities,andan end to unnecessarybureaucraticintervention. andencourgetheexchangeofidcasamongBarkstaff nd s dnminatethefindntgs of wv mpi PolicyReseach WWokingPapg Theepapus,dis tedbythcReserchAdvisoy Staff,canythen mcsoftheautho,reflect in d&velopMne aliothemincd Oflytheirviewa.andshouldbeusedandcitedacdingly.Thcfndirdngpnmutions.andnclusionsarctheautholeowLkTheyshould not be atributed to the WorldBank,its Board of Dirxeo, its management,or any of its membercoimtiea.

Policy Remmrch

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TransitionandMacro-Adjustment WPS 1111

This paper -a product of the Transition and Macro-Adjustment Division, Policy Research Department - is part of a larger effort in the departnent to analyze the economic impact of legal reform in Central and Eastern Europe. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Maxine Berg, room NI 1-057, extension 31450 (March 1993, 21 pages). One of the most remarkable developments in Central and Eastern Europe (CEE) has been the region's opening to foreign direct investment. CEE states saw foreign investment climb from minuscule amounts in 1989 to more than $7 billion in 1992. All CEE states have enacted new laws on foreign investment as well as related legislation in areas such as taxation and company and environmental law.

investors, it can quickly outlive its usefulness. The incentives it fosters may not only bleed domestic treasuries, but may also lead to bureaucratic structures that complicate the investment environment and elevate information and transaction costs for foreign investors. As quickly as possible, the transforming economies should dismantle the enclave and put domestic and foreign investors on an equal footing. This may no well mean that foreign investment laws longer needed. The Czech and Slovak Federal Republic was the first CEE country to abolish specific foreign investment legislation in favor of a broad commercial code covering all investors. r-re

Gray and Jarosz describe these efforts at legal reform and assess their impact on foreign investment in light of what is known about investor motivation. They concentrate on the role of foreign investment law, referring occasionally to other aspects of law that apply to domestic and foreign investors. They find that specialized foreign investment laws can jn'lay a useful role during the transition to a maiKet economy. Of particular importance is their role in sending a strong signal to foreign entrepreneurs that the host country is serious about economic reform and is willing to work with investors to establish mutually beneficial arrangements. Foreign investment laws are also often used to target special incentives to foreigners and create an island of legal development that may differ from - and sometimes outpace - other legal development In such ways they tend to create investment "enclaves." But to the extent that an enclave separates foreign from domestic

If an enclave does exist, policymakers should focus on the concerns critical to foreign firms. In the design of investment laws to date, the CEE countries have perhaps paid too much attention to preferential tax schemes, ignoring other costs foreign investors face. Policymakers should focus on reducing uncertainty and transaction costs through clear and simple legislation, contract enforcement, arbitration and other altemative dispute resolution mechanisms, stronger protection of property rights, dissemination of information on laws and on business opportunities, and an end to unnecessary bureaucratic intervention. Complex regulations not only increase investor uncertainty but divert bureaucratic resources that the host country cannot afford to squander.

The PolicyResearchWorkingPaperSeriesdisseminatethe findingsof workunderway inthe Bank.An objectiveof the series is to get these findingsout quickly, even if presentationsare les than fully polished.The fmdings,interpretations,and conclusionsin these papersdo not necessarilyrepresentofficialB ankpolicy. Producedby the PolicyResearchDisseminatioii'-enter

Foreign Investment Law in Centraland Eastern Europe

Cheryl W. Gray and William Jarosz CECTM The World Bank

Contents I.

The Importanceof Foreign Investmentto the Region

1

II.

Why Do Firms Invest Abroad?

4

III.

How Do CEE Laws Affict InvestmentDecisions of Foreign Firms?

7

SignalingPotential Investors Developing the Legal Framework

8 9

Making new investments Acquiring ongoing businesses Repatriatingprofits Protecting against governmentexpropriation Obtainingrights to real property Protecting intellectual property Enforcing agreements Hiring and firing workers

IV.

9 10 12 13 13 14 15 16

Providing Special Incentives

17

Conclusions

20

FOREIGNINVE3STMENT LAW IN CENTRAL AND EASTERN EUROPE Rarely in economic history has change been as rapid and dramatic as that which has occurred in Central and Eastern Europe (CEE) since 1989. Four years ago private enterprise was not only unknown but illegal in many of the CEE states. Isolated behind regulations imposed by communist governmentsand Western bans on trade, these states were largely cut off from the wo~rldeconomy. One of the most remarkable developmentsduring this period has been the openingof the region to foreign direct investment (FDI).1 CEE states saw foreign investment climb from minusculeamountsin 1989to over $US 7 billion in 1992. Legal reform has been central to this process. All CEE states have enacted new laws on foreign investment as well as related legislation in areas such as company law, taxation, and environmentallaw.2 After briefly outlining the importance of foreign investmentto the region, this paper describes these efforts at legal reform and attempts to assess their impact on foreign investment in light of what is known about investor motivation. The paper concentrateson the role of foreign investmentlaw per se, although other aspects of the legal frameworkthat apply to both domestic and foreign investors may occasionallybe referred to.3 The Importance of Foreign Investmentto the Region A report issued in 1992 by the United Nations Centre on Transnational Corporations 4 labels transnationalcorporations, and the investmentsthey make, as "enginesof development."

1. All discussion of foreign investment in this paper refers to foreign direct (as opposed to portfolio) investment. 2. Czechoslovakia adopted a new foreign investment law soon after its 1989 revolution, but such legislation was subsequently superceded by the new Commercial Code, which took effect in January, 1992, and covers both domestic and foreign investors. 3. For a survey of underlying legal frameworks for private sector development in CEE, see Gray et.al., "The Legal Framework for Private Sector Development in a Transitional Economy: The Case of Poland," Georgia Journal of Intemational and ComParative Law 22:2 (Spring 1992); Gray, Hanson and Ianachkov, 'Romania's Evolving Legal Framework for Private Sector Development," The American University Journal of International Law and Policy 7:3 (Spring 1992); Gray and Stiblar, "The Evolving Legal Framework for Private Sector Activity in Slovenia," University of Pennsylvania Joumal of Business Law, forthcoming (Spring 1993); Gray and Janachkov, "Bulgaria's Evolving Legal Framework for Private Sector Development," The Intemational Lawver, forthcoming (Winter 1993); Gray, Hanson, and Heller, "Legal Reform for Hungary's Private Sector," The George Washington Journal of International Law and Economics, forthcoming (March 1993); Gray, 'The Legal Framework for Private Sector Activity in the Czech Republic," Vanderbilt Journal of Transnational Law, forthcoming (May 1993). 4. United Nations Centre on Transnational Corporations, World Investment Report 1992: Transnational Corporations as Entines of Growth; New York: United Nations, 1992.

2 In the secondhalf of the 1980s,foreigninvestmentgrewthreetimesfasterthandomesticoutput, and for many countriesit is a strongertie to the worldeconomythan trade. In 1991, over 35,000tansnationalcorporationsinvestedapproximately $US 154billionin theworldeconomy. Developingand transitionalcountriescapturedabout 16 percentof this--some$US25 billion. Since abandoningcentral planningand turning to marketreforms in 1989, the CEE countrieshaveenthusiastically soughtthe capital,technology,and managementskillsofferedby foreigninvestors. Foreigninvestmentin thesecountrieshasgrownrapidlyfroma verylowbase and nowaccountsfor about9% of totalFDI flowsto developingand transitionalcountries (Figure1). Thelatestavailablefigures,albeitquiterough,showsteadygrowthin bothnumbers of directinvestmentsand cumulativevalueacrossthe region, with Hungaryleadingthe way in bothtotalFDI and FDI per capitaterms(Figures2 and 35). Severalstudiesforecastthatin the 1990sthe countriesof CEE and the for1ner SovietUnion(FSU)couldattractas muchas $US 6 50-75billionin foreigninvestment. Despitethis auspiciousentryinto the worldeconomy,the level of foreigninvestmentin the CEE regionis only a tiny fractionof what is needed. New investmentis neededto turn Figure1: Valueof ForeignInvestment (cumulativeuntilmid-1992) Central and Eastern Europe 90/o LatinAmerica 38 %

MiddleEast 5% Sub-Saharan Africa 5% SouthemEurope 3%

Asia 40%

Source:WorldBank,"Attracting PrivateInvestment,'EMENATechnical Department, September, 1992

5. It is very difficult to obtain accurate data on foreign investment commnitments and flows. Data are not readily comparableacross countriesbecauseof differentaccountingmethodologies,and evenwithin a singlecountry differentsources give highlyvariable figures. Figures2-4 show the authors' best estimates,compiledfrom various sources. They should be treated as rough indicatorsonly.

6. Studiescitedin UnitedNations, suvRanote 4, p. 32.

3 around CEE economies,whichare Figure 4.5-

2:

Value Ct1V*t

of W

Foreign Monfl9|

Investment

now suffering from a production

decline that surpasseseven that of the yreat depression of 1928-32. Furtnermore, foreign capital is

9_

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§

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1.:

/%

neededto financeprivati?ationand restructuring of state owned enterprises. For example, /////director

Jaroslav Prochazka, the former of foreign relations at the

Ministry of Industry of the Czech and Slovak Federal Republic a ~~~~~~~~~(CSFR), estimated that .- ~Iy c1l. POIWWrestructuring in 1992 alone would require between $US 1.8 billion and $US 2.2 billion, and that domesticsources could cover only 40% of the total. Prochazkanoted that "foreigninvestmentis one of the essentialconditionsfor the effective restructuring of industry and also of the future prosperity of the country."7 The Russian Deputy Prime Minister, Alexander Shokhin, declared that the Russian government would seek $US 5 billion in foreign investmentby mid-1995. This is more than double the total foreign investmentin Russia since 1987,8but it is very little in the context of Russia's gigantic need for restructuringand new investment. In comparison,in the first 2 years after reunification Germany poured over $US 100 billion into its eastern half.9 While the need for foreign investment is up sharply in CEE and the FSU, the global environmentfor direct investmentis growing more competitivefor two reasons. First, while absoluteflows of foreign investmentcontinue to grow, the rate of increase has fallen due to the sluggisheconomic growth in th_ United States, Japan, and Western Europe. Increases in direct investmentsby Japanese corporationsprovided much of the growth in foreign investmentflows in the 1980s. From 1985 to 1989, Japanese corporations increased tiheir foreign direct investmentsat an average annual rate of 62 per cent. However, direct investment fell in the early 1990s. In the year ending March 1992, Japanese foreign direct investment was $41.6 billion, comparedto $56.9 billionin the previousyear, and Japan's overall Europeaninvestment was down $5 billion.'0

7. J. Prochazka, *Unfreezingthe flow of capital to the Czech Republic,"Central Eurogean,no. 14 (July/Aug. 1992), p. 34. 8. Agence France Presse, July 17, 1992. 9. L. Gay, 'Point of no return," The AtlantaJournal and Constitution,May 24, 1992,p. G-7. 10. Reuters, June 5, 1992.

4 Second, just as the growth Investment Foreign 3: Per Caoita Figure of the supply of direct investment Cmiatlvto1,ge is decreasing, crmpetition for 1W_ investment funds is pickilg up across the world as a new group of countries attempt to hitch on to the growth engine of FDI. New players, such as Laos and Vietnam in East Asia, India in South Asia, and Cuba in the Caribbean, have revised their regulationsrestricting foreign investment and opened P77771 '!'-p-i their economies to flows of ... cLVwa And wellforeign funds. established players, such as the ASEAN countries, are growing even more competitive as their economies continue to expand and their investmentclimates become even more favorable. O

As noted earlier, the strongestmagnet for foreigninvestmentin the CEE region has been Hungary, attracting almost two-thirds of the investmentin the region since 1989. But when growth of investment in Hungary is compared to the levels of investment in other successful developing states--suchas the special economic zones of China and some of the more recent entrants into the global economy, India and Venezuela--thecompetition that CEE faces in attracting investment to CEE becomes clear (Figure 4). In sum, the CEE cot;ntriesface a dauntingchallenge. Their need for foreign capitaland know-howto repair their economiesand stimulategrowth is immense. Yet the rate of expansion of global investment has decreased, and competition for foreign funds, technology and management skills is tighter than ever. How are the CEE states restructuring their foreign investment regimes Lo promote investment? Do their laws appeal to the concerns of foreign investors? Before tuming to the legal framework, we take a brief look at investor motivation, because designing an appropriate legal frameworkconducive to foreign investment requires at least a basic understandingof what motivates investors. Why Do Firms Invest Abroad? The subject of investor motivationhas receiveda great deal of attention in the academic literature and in policy circles, spawninga vigorous debate which has continued since the

5 Figure 4: Value of Foreign Direct Investment October 1991 - March 1992 ShenzhenllllI Fujian , Hainan _s India , Hungary

Venezuela 0

1 Source:Seenote5

2

3

4

5

6

7 8 -in U.S.Sbillion

1960s.'1 This research has found, above all, that motivationswhich lead firms to invest abroad are complex and are likely to vary from manufacturingto service industries, from acquisitions to greenfield investments, and from export to import-substitutingindustries. Much of the discussionimplicitlyborrows from the standardmodel of foreign trade, the Heckscher-Ohlin-Samuelson(HOS) model. The HOS model argues that differences in factor endowmentsdrive trade. Countries rich in capital export capital intensivegoods, and countries rich in labor export labor intensive goods. An analogous model is then applied to foreign investment:production moves abroad in response to lower costs, due either to lower factor prices or other specific "locational"cost advantages. One such "locational"cost advantagethat drives many investmentdecisions is that caused by host country tariff barriers, which protect domesticproductionfrom trade competitionand therebyforce foreign firms to invest if they are to service the host country market. To take a CEE example of "locational" advantages, the Gerber division of H.J. Heinz recently committed$US 25 million to acquire a 60 per cent stake in Alima SA, a leading baby

11. For a review of the state of the literature, see John Cantwell, 'A survey of theories of international production,"in C. N. Pitelis and R. Sugden,eds., The Nature of the TransnationalFirm, New York: Routledge, 1991. In writingthis paper, this literaturehas been supplementedby questionnairesand follow-upinterviewswith a sample of American firms who have consideredinvesting in the CEE region.

6 food and fruit juice maker in Poland.'2 Alima was an attractive target for investmentbecause of its relatively modem machineryand its locationnear suppliesof fruit and packaging and near growing mark.ts (in CEE as well as Western Europe). Accordingto one analyst, purchasing Alima and shippingthroughoutEurope will cost one-tenthas much as attemptingto service the European market from plants in the United States." Althoughspecific "locational"advantagesare clearly important,they do not fully explain patterns of foreign investmentflows.'4 Indeed, direct investmentis not the only way firms can reap the benefits of differentialfactor prices. Rather than investdirectly, foreign firms can trade infonraallyor through long-term contracts, or they can license technology .J foreign firms for production abroad."5 In deciding to invest in production abroad, the firm is calcul-ting that there is a net benefit to bringing the operationinsidethe structure of the firm, rather than buying the producton the market and re-sellingit or licensingtechnologyto foreign producers. In other words, the foreign firm believes that it possesses specific advantagestbat enable it to produce and/or market at lower cost than domestic firms. Economistshave classified the potential advantagespossessed by foreign investors into two types: ownership advantagesand internalizationz4vantages.'6 Ownership advantages are those assets that are specific to the foreign firm itself, such as superior technologyor special management skills. Internalizationadvantagesare those benefits that accrue to any modern corporation from organizing and coordinatinga variety of tasks in a single organization, most notably a reduction in transactioncosts. Thus, to return to the exampleof Gerber, it is notjust that wage, input, and transport costs are lower in Poland. Polish firms also operate with these same factor prices. It is also that Gerber possesses some specific advantages: ownership advantages, in that it has a recognized brand name that differentiates its product, and internalizationadvantages, in that its combiningof manufacturing,marketing and distribution in a single corporate structure lowers costs and increases efficiency. The legal framework affects all three types of advantages--thosegained from location,

12. IntemationalHerald Tribune, July 28, 1992;Bill Vlasic, 'Gerber gobblesup big Polish baby food firm," The Detroit News, October 4, 1991, p. E-1. 13. Interview, Washington,D.C., July 28, 1992 14. Cantwell, supra note 11. 15. These alternative strategies are arrayed along a spectrum from pure market transactions (trade) to hierarchicaltransactions(direct investment). O.E. Williamson,Markets and Hierarchies: Analysisand Antitrust Implications,New York: Free Press, 1975. 16. For a summary, see J. H. Dunning, J. A. Cantwell, and T.A.B. Corley, "The Theory of International Production: Some Hi:torical Antecedents," and M. Casson, "GeneralTheories of the MultinationalEnterprise: Their Relevanceto BusinessHistory," in P. Hertner and G. Jones,Multinationals: Theory and History, London: Gower, 1986.

7 fromownership,and frominternalization.Miuchof the academicdiscussionto date hasfocused on the effectof governmentpoliciesand legal rules and regulationson the first type, i.e., the cost of variousfactorsof production. 'Theeffectscan be pro or con--forexample,minimum rules can drive up labor costs and thus deter investment, wage or other employment-related whiletax incentivescan lowerthe cost of capitaland thus attractinvestment.But policiesand regulationsthat affect the ability of foreign firms to apply their ownershipadvantagesor advantagasalso affectthe profitabilityof multinationalenterprisesand thus their internalization decisionsto expandabroad. For example,weak legal codes that fail to protectproprietary intellectualpropertydiscouragethe applicationof firm specificassetsand thusdeterinvestment. antimonopolylaws can vitiate the internalizationadvantagesof Similarly,overly-aggressive firmsand therebydiscourageinvestment.As discussedbelow,CEEpolicymakers multinational shouldcarefullyconsiderthesevariousdimensionsof investormotivationwhen developingthe legalframeworkfor foreigninvestment. How Do CEE Laws AffectInvestmentDecisionsof ForeignFirms? Prior to the first WorldWar, foreigninvestmentwas a prominentfeatureof the regional CEEeconomy.Thelegalcodesin thesecountriesgenerallysupportedthe institutionsof foreign investment, and many of the major industries in the region were built by foreign 17 The communist governmentsthat came to powerafter the secondWorldWar entrepreneurs. effectivelylimitedforeigninvolvementin the region'seconomiesto co-productionagreements or the purchaseof turn-keymanufacturingplants. By the end of the 1970s there was an awarenessthroughoutthe Eastern bloc that the technologygap with the West was growing larger, and that the old methodsof purchasingtechnologywere not effectivelyraising the technologicallevel in the region. Thus, in 1971Romaniabegan to changeits regulations govermingforeigninvestmentin the hope of luring technologicalchange. OtherCEE states slowlyfollowedsuit, butgivenres.Actionson foreignownership,lack ofcurrencyconvertibility, and a host of otherroadblocks,Westerninvestmentremainednegligiblethroughthe 1980s. Onlyafter the dissolutionof communistpowerin 1989did thesestatesbeginto change their investmentclimatesin a concertedeffort to attract foreign investment. Yet, at the periodthere was a somewhatschizophrenicqualityin their beginningof the post-communist legal regimes governingforeign investment. Leaders were keenly aware of the need for investmentyet sensitiveto politicalchargesof "sellingout" to foreigners. On a statevisit to Britainin the springof 1991,Lech Walesathe Polishpresidentsoughtto drum up investment in an interviewwith thZFinancialTimes: "Youin the West have over-production.You can we have plentyof that. . . Comeand makemoneyout of our shortagesand our stupidity--and

17. In CEE, many old laws that technicallygovernedforeigninvestmentremained on the books throughout the Communistperiod, althoughtheywere overruledor replacedin practiceby governmentdecreesand regulations. In the post-communistperiod many of these old laws have comeback to life. The commercialcode of Poland, for example,is basicallythe law of the 1930s.

8 set up a factory here. Make money.""8 As encouraging as Walesa's remarks sounded, th. Polish investmentlaw in force at the time allowed foreign enterprises to repatriate only 15 per cent of the profits they earned in Poland. Even now, as GDP levels continue to decline across the region, foreign investmentremains a target for seme oppositionpoliticians. For example, although the CSFR (and its successor states, the Czech Republic and Slovalia) have pushed ahead with legal reforms and attractedreasonableamountsof investmentto date, ZbynekKozel, deputy international secretary of the Social Democratic Party, recently charged that foreign investmentis "a dangerous sellout.""9 The origin of much of the anti-foreignsentimentwhich surfaces from time to time in the CEE states is the separate and often privileged treatment that has been granted to foreign investors. One of the central characteristicsof the first stage in the transition from a socialist to a market economyhas been the creation of a special "enclave" for foreigners. The enclave typically serves at least three purposes. First, it provides an important information--or "signaling"--functionto potential investors. Second, it provides a limited sphere in wnich legal developmentcan proceed differentlyand often more rapiely, thus bypassingmany of the hurdles to legal and institutionaldevelopment in the economy at large. Third, it allows for special incentives to be targeted to foreigners--thosewho are perhaps seen to be most influencedby them. All three purposes apply to some extent in developingcountries more generally--where ever the underlying legal and incentive frameworks for private sector activity are unclear or weak. However, their rationale is particularly strong in the CEE context because of the magnitudeof the systemic changes needed to meet the needs of foreign investors. Wnilethese purposes may be valid, the enclaveapproachentailsmajor costs, as discussed later, that must be weighed against its benefits. The sooner a country can move to dismantle the enclaveand provide equal treatment for domestic and foreign investors, the better. SignalingPotentirl Investors Interviews with multinational firms consistently indicate that uncertainty is a prime impedimentto invqtment in the CEE region. Firms may not be familiar with the legal regimes or with potentialjoint venture partners, and getting informationis costly. A valuableand often overlooked function of foreign investment law is to send a strong, positive signal to potential investors. Whilevaguely worded declarationsmay not assuage investor's concems, the passage of clear and supportiveforeign investmentlegislationdoes convey the message that investment is welcome. Recognizingthe important signalingeffects of changes in the legal regime governing foreign investment, all of the CEE countries issued declarations early in their transitions guaranteeing the security of foreign investment. These declarations were accompanied or 18. "Visionaryseeks an equal chance," FinancialTimes, April 23, 1991, p. 19. 19. Robert Cohen, "Czechoslovakia'sWall Street brigade," New York Times, June 21, 1992, p. 1.

.9

quicklyfollowedby new or amendedforeigninvestmentlaws, changes in the tax regimes 20 applicableto foreigners,and bilateralinvestmenttreatieswith investors'homecountries. Evenwith theseearly steps, firms face continueduncertaintyin the broad legal regime governingforeigninvestmentin the region. Acrossthe regionthe lawsin manyareas--fromthe rights of formerlandownersto recovertitle, to rules on liabilityfor previousenvironmental damage,to regulationsgoverningthe financialsector--remainin flux. Foreignentrepreneurs recognizethe risk inherentm investingin any reformingeconomy. Yet theyalso recognize,as one businessmannoted, that "if you wait for the risk to disappear,the opportunitywill also disappear."21 Foreign investors'attitudestowardrisk are highlyvariable,but it does appear thatthepassageof legislationthatindicatesthatthe governmentis seriousaboutencouragingand protecting investmentis an importantfirst step. Developingthe LegalFramework A secondrationalefor the enclavestrategyis to providea separatelegal frameworkfor foreigninvestors. On the one hand, sucha frameworkmay be neededto police accessto the incentivesdiscussedbelow. This is the reason, for example,for specialentry regulations,as discussedbelow. On the other hand, such a frameworkcan providea semblanceof order, predictability,and enforceabilityin an otherwise highly uncertainand undevelopedlegal environment. Such a legal frameworkdoes little to lower factorcosts, but it can go far in creatingan environmentin whichfirms can realizeownershipand internalizationadvantages. Whileprogresshas been madein this area in all CEE countries,there is stil a long way to go. The legal and regulatorycosts of organizingand operatingjoint venturesor wholyowned Cbsidiaries in a host country fall into two broad categories: ex ante costs and ex post

costs. Ex ante costs are the costs associatedwith setting up the venture. These include negotiationcosts and aU of the costs incurred in obtaininggovernmentapproval for the transaction.Thecostsin shepherdingan investmentthrougha tangleof governmentprocedures for licensingand registrationcan be significant,and can discouragefirms from enteringthe market. Ex post costsare thoseincurredin runningthe organization.Most typically,ex post costsarise in policingthe originalagreement,protectingpropertyrights, and settlingdisputes. Legal developmentsthat reduce these various costs help firms to realize ownershipand internalizationadvantagesand thus improvethe overallinvestmentclimatein a country. Makingnew investments. Most co'intriesin the region have significantlyeased the processof establishingnew, or "greenfield"investments.All countriesallow foreignfirms to setup wholly-ownedsubsidiaries,thuseliminatingtherequirementto find domesticpartnersand 20. For example,Americaninvestorsare furtherprotectedin Poland, the former CSFR, and Bulgariaby those countries' bilateral investmenttreaties with the United States, and investors from EC countries are protected by certain provisionsin the EC AssociationAgreementswith Hungary, Poland, and the former CSFR. 21. Interview, Washington.D.C., August 4, 1992.

10

negotiate joint venture arrangements. While all countries in the region prohibit foreign investmentin specific sectors (defense,energy, domestictelecommunicationsand banking being the most common), the process is now quite easy in other cases, typically very similar to that applicable to domestic firms. Hungary led the way in streamliningthe procedures necessary for governmentapproval of foreign investments. In 1990, Hungary amendedits InvestmentAct and eliminated the need for prior government approval of foreign investments, including wholly-owned foreign investments. Fims now must meet incorporation requirements applicable to all firms and register within thirty days of the adoptionof their articles of incoiporation. Poland followedsuit in new foreign investmentlegislationenactedon June 14, 1991, and CSFR did the same in the enactment of its new CommercialCode that went into effect January 1, 1992. The Bulgarian foreign investmentlaw rules that went into effect on February 1, 1992, drop previous minimum investment requirements of $US 50,000 and require prior government permission only for investments in natural resources, defense, banking, and insurance. Of all the CEE countries, only Romaniacontinuesto require prior governmentapproval of all foreign investment,but even here approval is deemed granted if no decision is rendered in 30 days. Acquiring ongoing businesses. While accurate figures on the relative numbers of greenfield investment are not available, it appears that they are heavily outnumbered by joint ventures or buy-outs of existing host country firms. Foreign firms generally prefer to operate throughjoint ventures or acquisitions,because working with domestic firms or acquiring their assetsis easier than startingfrom scratch. Domesticmanagersoftenpossess valuable knowledge of local markets, familiaritywith establishedsuppliers and customers, and contacts within the government that are difficult for the foreign firm to duplicate. Only when a foreign firm is 22 introducing a new product is greenfieldinvestmentgenerally more advantageous. Unfortunately, from the perspectiveof foreign firms, investingin an ongoing enterprise draws them into the quagmire of privatization regulations. The details of the privatization programs differ in each country. In Poland and the former CSFR, the process has been split into separate procedures for "large" and "small" enterprises. However, in all countries there is direct government intervention in the process. While this is understandable given that governmentsare indeed the "sellers" of the firms being privatized, the direct involvementof the governmentin the selectionof foreign partners and the approval of privatizationproposals has caused confusion and uncertainty for many foreign investors. Administrativelaw remains one of the least developed areas of law in the CEE countries. Regularizedprocedures for official decisionmakingare often lacking; there are few established channels for public input into the process; decisionmakingif often opaque; and those turned down in the privatizationprocess are generally given neither a statementof cause nor any opportunityto appeal the decision. 22. For example,Levi Strausshas committed$US 20m over four years to manufactureLevi's jeans in Poland. The ventureincludesnot only a greenfieldmanufacturingplant, but also integrationforwardinto retailing. The cost of converting local garment plants to modem manufacturingwas prohibitive, and franchising retail outlets was impracticaldue to lack of domesticcapital.

11

The experience of McDonnell Douglas in Poland illustrates the frustration felt by many foreign firms in the wake of what appear to be arbitrary procedures. In June, 1991, following a decision by a special government commission,McDonnell Douglas signed a letter of intent with LOT, the Polish airline, to deliver nine MD 80 aircraft.23 The letter of intent contained an "offset" clause in which McDonnell committeditself to invest $US 85 million in Poland's aircraft industry. Then in August the governmentreversed itself and gave authority to LOT to choose its supplier directly. Over the objections of the Solidarity trade union, LOT picked McDonnell'scompetitor, Boeing, despitethe fact that Boeing had only promised offsets of $US 30 million. McDonnellclaimed it had started to produce the airplanesand stood to lose several millions of dollars. Although there could have been justifiable reasons for the reversal, no official government explanationwas given. Experiences like these are now common throughout the region. In Hungary, the State Privatization Agency rejected Colgate-Palmolive'sbid for a Hungarian cosmetic firm. After acknowledgingthat Colgate's bid was the "most serious" it had received, SPA refused to give a reason for the rejection. Noting the 18 months Colgate had spent on the proposal, a Colgate official complained, "It was lengthy, it was expensive, it was involved, and it was unsuccessful. The chapter is closed." 24 Similar experienceshave occurred in Hungary involvingPepsiCo and R .J. Reynolds.25One American attorney argued that experiences like these have caused some 26 U.S. firms to pull out of the market completely. The lack of established, regularized procedures for the inclusion of foreign investment in privatizationalso may open the door to real or implied corruption in the host country. This may lead not only to possible economic losses, as projects are given approval on the basis of sidepaymentsrather than economicefficiencyor feasibility, but also to politicallosses. Charges of bribery and corruption can easily erode popular support for economic reform in general and foreigninvestmentin particular. Despiteits having been the h' t bidder, Gerber's investment in the Polish firm Alima has been criticized in the Polish press as tantamount to theft, because the decision process was largely hidden from public view and comment.' There are growing signs that governmentsin the region are increasingly sensitive to the need to maintain political support for the reform process, even at the expense of foreign investment. The Hungarian Minister in charge of privatization,Tamas Szabo, recently announced that domesticbids would

23. Miroslaw Glogowski, "New Boeings for LOT," Warsaw Voice, September 22, 1991; Christopher Bobinski,"Polish aircraft workers near strike over Boeingorder," FinancialTimes, September20, 1991,p. 3. 24. Ken Kasriel, 'Hungary's troubled business ties," Christian ScienceMonitor, July 7, '992, p.2. 25. The Bureau of National Affairs, Inc., InternationalTrade Reporter, v. 9, no. 33, August L, 1992, p. 1402. 26. Interview, Washington,D.C., August 17, 1992. 27. Patricia Koza, 'U.S. seeks smootherpath for investmentin Poland," United Press International,June 3, 1992.

12 now be preferred in the privatizationprocess over similar foreign bids. Price alone would no 28 This change of policy may have little practical effect, given the longer determine ownership. lack of domestic capital, but it does send a signal which may create further uncertainty in the minds of foreign investors. The relative ex ante costs of making an investmentoverseas can be significant.2' Rather than focusing on tax incentives (discussedbelow), which are of questionableutility in attracting foreign firms, CEE countriesshouldexert more effort in reducing the transactioncosts faced by firms seeking to identify opportunitiesand make investments. Instead of constantly changing tax rates in an effort to optimize locational incentives, these states should concentrate upon creating stable, transparent environments in which foreign entrepreneurs can more easily calculate the costs and benefits of investingand make the actual investments with a minimum of time and effort. The issue of national economic sovereigntywill continue to be important. But the CEE states can best guard againstopposition to foreign ownership by establishingclear, xcviewable procedures that are transparent to both the interested public and the relevant foreign firms. In this way the public can be protected from bureaucraticcorruption, and the firms can be assured that their efforts to invest will be fairly evaluated. Repatriatingprofits. Ownership and intemalizationadvantagesof foreign firms cannot be fully reaped unless profits can be repatriated to the investor's home country. Indeed, profit repatriation is consistentlycited by studies of investor motivation as being among the highest concerns of potential investors. In the early period of reform, the inability to repatriate profits was a significant hindrance throughout the region. Foreign exchange was scarce, and CEE governments reacted to this scarcity by limiting the rights of foreign investors to repatriate profits. Lack of currency convertibilitymade it relativelyeasy to enforce these restrictions. All domestic investment had to take place in local currency, and foreign firns were required to convert hard currency at a state-controlledbank. Poland and the former CSFR set limits on profit repatriation of 1530and 25 percent of profits, respectively, while Romania set sector-

28. 'New privatizationmeasures," East European BusinessLaw, June, 1992. 29. Accordingto some analyses,these costsare responsiblefor the regionalclustering of direct investmentby the industrializedcountries. The United States is more likely to invest in Latin America, and Japan prefers south east Asia, becausecultural similarityand past experiencecause their firms to have relative advantagesin reducing the transction costs that accompanyinvestment. This may be one reason for the predominanceof German and Austrian investmentsin CEE. U.N. Centre for TransnationalCorporations,sunra note 4. 30. This limitdid not apply if the firm generatedsufficientnet foreignexchangeearnings to cover the amount repatriated.

13 specific limits ranging from 8-15 percent.31 Improvementsin the balance of paymentsenvironmenthelpedlead to changes in the law. Full repatriationof profits is now allowed in all CEE countries. Romania was the last to lift its limits--in May, 1992. All of the states except Hungary permit full repatriation of wages of foreign employees. Hungary limits wage repatriationto 50 per cent. Protecting against government expropriation. The most severe cost imposed upon investmentsex post, and the most extreme threat to any ownership advantage, is government expropriation. All of the governmentsin the region have moved swiftly and effectivelyto deal with this concern. First, governments have sought to extend protections in their domestic legislation. All now provide guarantees of compensation in the event of nationalizationor expropriation. Secondand more significantlyfrom the viewpointof Americaninvestors, Poland, the former CSFR, and Bulgaria have concluded bilateral investment treaties with the United States, and a treaty with Hungary is being negotiated. The investment treaties are important because they outline the procedures to be used in determining compensation in the event of 32 Third, fears of expropriation without compensation are nationalization or expropriation. further quieted by the membershipof the former CSFR, Hungary, and Poland in the Multilateral Investment Guarantee Agency (MIGA). MIGA, constituted in 1988 as an independent self supporting member of the World Bank Group, offers insurance covering currency transfer restrictions, expropriation, war and civil disturbance, and breach of contract to private firms doing businessin member states.33 In sum, the fear of unanticipatedcosts due to expropriation has been greatly diminished through this interlockingset of guarantees provided by domestic legislation, bilateral treaties, and insurance. Obtaining rights to ial property. The inability to acquire ownership rights in real property can impose significantcosts on foreign investors. Not only must they continually renegotiateuse rights, always potentially subject to rival claims to the property, but they also face the possibility of an "expropriation"of economic rents by the party with full property rights. Supposeforeign investor F enters into a joint venture with host H to manufacturepins, and F installs a specializedpin-making machine on property controlled by H. F's position is much weaker than H's position, because F's asset is more specificto that particular investment. F cannot easily transfer specializedequipmentbecause no altemative use may exist. This is not the case with the landowner. Without legal rights to real property, F cannot prevent H from

31. Article 16 of the Foreign InvestmentAct set out a series of limits: (1) 15 per cent of profits in industries the Council of Ministers designatesas important to the national economy; (2) 12 per cent for investmentsin agriculture, natual resources, industrial and agricultural production, construction, communications, and transportation;(3) 10 per cent for finance, bankingand insurance;(4) 8 per cent in all other cases. 32. The EC AssociationAgreementswith Poland, Hungary, and the former CSFR provide guaranteesof nationaltreatment, but are not explicitas to steps to be taken in the event of expropriation. 33. MIGA recently extendedprotection to Coca-Cola's $US25m investmentin a bottling facilityin Poland.

14 threateningto breach thejoint venture agreementand thus forcing a redistributionof the profits. Under these circumstances, foreign investors will be deterred from investing in capital that cannot be secured against this type of "holdup." Rules on land ownership by foreign parties continue to evolve across the region. In Bulgaria, foreign persons or companiesin which foreignershave a stake greater than 50% may not own agricultural land, forests or water resources. The other CEE states generally prohibit ownershipof land by foreigners,but whollyor partially foreign-ownedfirms incorporatedunder domesticlaw are treated flexibly. Althoughrules are still somewhatunclear and untested, such firms are generally considered to be domestic legal persons and thus legally permitted to own land.3' Protecting intellectual property. Foreign firms often invest abroad to exploit technologicaladvantages they hold over their rivals. Technologyis an asset and a key to their competitiveness--amajor "ownership" advantage. Investors will be less likely to invest in countriesthat do not safeguardintellectualproperty, just as they will be hesitant to invest where there is a danger of expropriationof physical assets. Recent reforms in the intellectualproperty legislation of most CEE countries, taken in part under pressure from the U.S.35 and other Western countries, have generally brought the legal protectionof intellectualproperty more or less up to internationalnorms. For example, patent protection has typically been extended to previously-excludedproducts, such as drugs, chemicalcompounds, and plant or animal varieties, and copyrightprotection has been extended to computer software. The terms of patent and copyright protection have typically been lengthenedto the internationalnorms of 20 and 50 years, respectively. Althoughprotection for new inventions may be relatively clear, however, many issues loom in the transition from the old to the new system.

34. In Poland, the Minister of Internal Affairs has the authority to approve foreign ownershipof land by individuals,though this is rare. Foreign-ownedfirms must seek governmentapproval for land purchases,but this is not generally denied. In Hungary, only a Hungarianperson, legal or natural, may buy real property. Foreign individualsmay not acquire property. Companieswith a head office in Hungaryand subjectto Hungarianlaw are defined as legal persons under the law, even if they are wholly or partially owned by foreigners. However, companieswith foreignparticipationmust seek approval from the Councilof Ministers and show that the property is necessaryfor businessoperations. In practice, this law has been treated quiteliberally, extendingto office space and living quarters for formignemployees. Romaniaand CSFR follow the general pattem of prohibitingland ownershipby foreign individuals,but allow ownershipby foreign firms. 35. Bilateralinvestment treaties between the United States and Poland, Bulgaria, and C.S.F.R commit the signatories to adhere to most major internationaltreaties on intellectualproperty. The U.S.-Hungarian treaty is stalled on the issue of intellectual property protection, particularly protection of computer software and pharmaceuticals. EC Association Agreementswith Hungary, Poland, and the former CSFR require the CEE signatorycountriesto improve the protectionof intellectualpropertyrights to reachthe EC level of protectionwithin five years.

15

All of the CEE countries are signatories to the major international conventions on intellectualproperty, including the Paris Conventionfor the Protection of Industrial Property, the Madrid Agreement Concerning the International Registration of Marks, and the Berne Convention. These conventionsprovide little protection, however, in the absence of welldesigned and enforced domestic laws. Enforcement capacity is an issue in all areas of intellectualproperty law. Although a registration procedure exists, can a holder of intellectualproperty rights actually protect those rights if another person infringes them? In the socialist state this was not much of an issue, because most rights--particularlyin the case of patents and trademarks--wereheld by the state. Enforcement of intellectual property legislation will emerge as a critical issue as the private sector and foreign investment grow. Giving true meaning to these rights will require institutionalstrengtheningin the registrationagenciesand the courts to insure that infringements can be identified, halted, and punished as appropriate and that the aggrieved party can be adequately compensated. Enforcing agreements. The difficulty of enforcing contracts can be a significant impediment to foreign investment, particularly in developing countries where formal legal systems are often weak. The CEE states have made significantprogress in this area, using a combinationof external and internal institutions. Bilateralinvestmenttreaties play an important role in reducing ex post transaction costs by providing guarantees of third party arbitration. Most CEE foreign investment laws also permit third-party arbitration. The availability of arbitration helps to alleviate the concerns of many investors that the host country legal system may not be capable of predictable and timely contract adjudication. Yet arbitration does not substitutecompletelyfor a well-functioningjudicial system, because it will be effective only if localjudicial institutionsare willing and able to recognizeand enforce arbitral awards if needed. The opportunity for arbitration is expanded still further through participation in the Conventionof the International Centre for Settlementof Investment Disputes (ICSID). The former CSFR, Hungary and Romania have signed and ratified the ICSID convention. The convention provides a mechanism for arbitration between private investors and host governments. Becauseof the high level of governmentinvolvementin the privatizationprocess, the governmentis often a party to investmentcontracts. Most third party arbitration mechanisms do not allow for arbitration when one of the parties to the contract is a government. Becoming a party to the ICSID conventionadds another level of assurance to foreign investors. Anecdotal evidence suggests that CEE domestic courts are often willing to follow establishedglobal businesspracticesand upholdcommonWestern interpretationsof contractlaw. In 1990 a dispute arose in Hungary between the American firm Pratt & Whitney and the ungarian state airline Malev.3 6 Pratt alleged that Malev had entered into a binding contract

36. 'Pratt & Whitney's dispute with Malev continues, Business Eastern EuroDe, v. 20, no. 41, October 14, 1991, p. 349-50.

16 for the purchase of aircraft engines by returning a letter of acceptance. In January, 1992, a Hungariancourt ruled in favor of Pratt, applying the Vienna Conventionfor InternationalSale of Goods.37 The Pratt case is important because Hungarian courts moved quickly and effectivelyto resolve the dispute despite Hungary's lack of a bilateral investmenttreaty with the U.S.. The applicationof the Vienna Conventionis a positive sign to Western firms that the Hungariancourts will apply commonlyrecognizedstandardsof conduct in adjudicatingbusiness disputes. Similarly, CEE countries are lookingto Western norms as they design their commercial legislation. For example, the new commercialcode of the former CSFR, which took effect on January 1, 1992, parallels parts of the U.S. Uniform Commercial Code, especially Article 2 governingcontracts. Resolving conflicts among contracting parties is a complex task and requires welldevelopedinstitutions. Given the developingdomesticlegal system and the growing acceptance of third party arbitration, it appears that dispute resolution may be receding as a major impedimentto investmentin the region. Hiring and firing workers. Labor relations are a potentiallyexplosiveissue for foreign investment in CEE. Decades of central planning and the lack of hard budget constraints on firms led to serious overstaffingin many cases. Western companies, as either sole owners or joint venture partners, want the freedom to restructure the work force to make these CEE firms competitive in global markets. Political leaders are naturally concerned that high levels of unemploymentwill quickly sap support for reform. So far, CEE legislationdoes not restrict the rights of foreign companies to hire, train, or fire local workers, althoughforeign firms must of course comply with existing social security legislationand pay social security taxes defined by statute. In a number of cases, as part of specific privatization agreements, Western companies have committed themselves to a moratorium on reducing the work force in plants they control.3 8 Given the sensitivities involved, an ad hoc approach developed through privatization negotiations is likely to be preferable to an across-the-boardrule. In some cases, foreign subsidiaries want to hire employees from their home offices to help transfer firm-specific knowledge and techniques, and thus reap specific ownership or internalization advantages. CEE countries have been fairly accommodating to this need, although foreign employees must often pass through a maze of regulations to obtain work permits and find housing. Romaniais the only CEE state that specificallyrestricts the types of positionsforeigners can hold. Romanianlaw allows foreigners to work only as managersor as 37. "Hungarian court rules for Pratt & Whitney," Business Eastern Europe, v. 21, no. 5, February 3, 1992,

p. 53. 38. Interview, Washington, D.C., July 21, 1992.

17 otherspecializedemployees. ProvidingSpecialIncentives A third rationalefor the enclavestrategyis to direct incentivesto foreigners,often implicitly if not explicitlyin the belief that foreignersare more likely than domestic entrepreneursto be decisivelyinfluencedby them. The emphasison tax creditsand subsidies to lure investorsfollowsin part fromthe view thatforeigninvestmentrespondsto factorprices. emphasison incentivesoverlooksthe otherreasonsfor foreigninvestment, Yet a single-minded i.e. that foreignfirmsmaystill investif theycan readilyapplytheownershipand internalization advawitages they possess. The primaryincentivesusedin CEE to attractforeigninvestorsare tax-related.As seen in Box 1, all CEE countriesnow offer generoustax incentivesto foreignfirms, incentivesthat are generallynot availableto domesticinvestors. These incentivessignificantlylower the effectiverates of taxation. A recent studyby the ForeignInvestmentAdvisoryService(FIAS, part of the World Bank group)39 estimatedthe followingeffective tax rates as of mid-1991 on

typicalforeigninvestmentsin manufacturingin the region: Country Bulgaria CSFR Hungary Poland Romania

EffectiveTax Rate(percent) 10 22 6 8 12

Of courseeffectivetax ratesvaryfrominvestmentto investment,bothbecausedifferentprojects have differentcost characteristicsthat affectthe definitionof taxableincome,and becausetax regimesthemselvesoftenvary by investment. Tax regimesare often specificallynegotiated betweenforeignfirmsand host governmentsas part of the overallforeigninvestmentpackage. Investmentcan be re-classifiedinto categoriesthat qualifyfor tax holidays,and the lengthof holidayscan alsobe extended.Thisdiscretionis in facta characteristicof the enclaveapproach. Hungarywasthe first CEEcountryto offertax incentives,and its incentivesare still the mostgenerous.It is temptingto lookto Hungary'slowestimatedeffectivetaxrate and conclude thatpreferentialtax treatmentis behindthe largeshareof foreigninvestmentthathas flowedinto Hungary. Sucha conclusion,however,is doubtful.Taxrates mayaffectshort-termprofits,but the evidencethat they dominateor even significantlyaffectthe investmentdecisionof foreign

39. J. M. Mintz and T. Tsiopoulos,'Corporate IncomeTaxationand Foreign Direct Investmentin Centraland Eastern Europe," Foreign InvestmentAdvisoryService OccasionalPaper 4, 1992.

18 B

Tax Ince.fives _forFp_reignInvestment in CEE Countries

*.-'ari Altlhovugh Bulgariasubstantiallyre-vampedits policieson foreigninvestmentits new ,oregn investment,,law of: anuary 16, 1992, taxes are governedby the much'olderDecree,56. ecree -5-6i.ssed by th State.Council in 1989, sets a corporate tax rate of 40. per cent. Ventures-withforeig.n participationexceeding$US 100,000or 49% of total eapitalare'tedat.' 3:per cent.--Jo.intventureswithforeignfirms are exemptfrom all profittaxes for five years if -th:eyoperat'.eispcial hig}-technologysectors designatedby the Councilof Ministers,o'.r in: agricdulturer ood -processing. .£.:C.S.F..:*. Corp,orationspay a tax rate of 20 percent on the first Kcs. 200,000 of'-corporate profits, andrda rate.of 55 percent thereafter. Corporationswith foreignequityparticipationof atleast 30-per-cent p:ay-areducedtax rate of 40 per cent. In addition, companieswith *breign .:-participatio my .,pply to te MinistryofFinance for two or.more years of tax holiday. 'ng t T'' e eneralrate of corporate tax is 40 per cent,. If`capitalizationexceeds:HF50 mnillion$U.S. 634,000), 30per cent of the capitalis supplied.byaforeign investor.,and moredtian50 per ce'n't ftotalincom'e-is"derived from manufacuring,the base rate isr ''t f,o,,r. thestv,e,ye,a,r,s..Th.at.is; foreipg-investors,meeting -these.criteriapay corrate ta rates

'f onl 1a6-.pe:. cent.f'.r th' firest'fivyears......., ,r,..,sX ing t

4prcn

frtescn

ive years

her if the apitaliza'ti,onxrequ'irements; are,met and the busiessne of rteen priorityector, the firm granteda five yatx holiday, followe by a e a 'f 16percetfr the neve years; Reinvested"proftsare exemptfrom itheprofit's tax. .hes speciincebeing phasedOutandwillno be availablet' fir-- investn atr1993."'. ~I

..:~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~.. : ::-. :

:' Th=bsiorpora.te

.. .....

taxate-isZ 40per cen't.'..The'198.8foegn.inetmn

la e forign invsorhrey ara oldy whichcouldbe xended thre ditionlyear by ~~~~~~. MinisterofFinarie. 'Ibemnorerecent la-wofJune . 1991e a tis bl ligibl1 . ....

' .. Holidays may stil

be granted'if

o-he oreigntribution

... ...

. -

. y -i.h... .. .. .. . . A ,-v i-*feE

excpeeds 2m ECU ($US48m)'

'introdcsnew' tehologyor ex"ports'lat lat 20%'.ofitstotaloutput.-'::"--.'''.'-''

"'''"'

~Romama: RX:omanan law grants sector-specifc tax exemptionsto foreigainvestors.- Freign .in,vestmentinmanufacturing,agricultural'or constructionare eligible for.5-year tax holidays; 'thoseinmnaturaresource -production,transportation,or communicationsare etligiblefor 3year holidays;ad tose in trade.tour.is'm, banking,and otherservicesare eligiblefo, 2-yearholidays. Ail of theseitaxholidys may be extendedwith governmentapproval. Followingthe'period of .tax xetn base tiaxon-corporateprofits is 30 per cent up to Len. m,and 45.percent

entrepreneurs is decidedly mixed.4 0 The majority of larger firms are investing in CEE for the

40. Fora summary of the literature proandcon, see WorldBank,'Attracting PrivateInvestment: Capitalists' Perceptionsof the investmentClimatein Europe,the MiddleEast and North Africa," EMENATechnical Department, September1992.

19 long term. Tax rates are important, and investorswill be deterred if taxes are set at exorbitant levels, but it is not likely that the complexpackagesof reduced rates and tax holidayscurrently in place in CEE tip the balance for many prospective investors. Many investors cannot even use the tax holidays they are offered. For example, General Electric's $US 150mpurchase of 50 per cent of the Hungarian lighting manufacturerTungsram occurred in 1989. Almost three years later, Tungsram has yet to show a profit.4 ' The emphasis on incentiveshas uncertainbenefitsbut many clear costs, as has been noted in analogousdiscussionsof tax incentivesthroughoutthe developingworld. A first obvious cost is in governmentrevenue, and this is important given the fiscalproblems throughoutthe region. Another cost is uncertainty. In their effort to fine tune the incentivesin the tax codes, the CEE countrieshave changed their tax regulationsfrequently. This has created muchconfusionamong foreign investors and compoundedtheir already difficult task of estimating future profit flows. Moreover, the administrativecosts of incentivesare high. Complicatedtax codes demand sophisticatedbureaucracies to administer them. Preferential tax systems that grant benefits to foreigners must set administrativecriteria to define "foreign" investment. Investmentshave to be screened to see if they meet the minimum levels of investment needed to qualify for preferential treatment. Monitoring mechanismsmust be establishedto audit joint ventures to ensure that foreign participationis genuine and not just an illusion to escape corporate taxes. All CEE governments suffer from a shortage of skilled administrators. Diverting personnel to administercomplex incentivesof questionableworth is unlikelyto be an efficient use of scarce resources. The creation of tax incentivesalso creates loopholes and ambiguitiesin the law which firms can use to their advantage, leading to further revenue loss, creating further uncertainty, and demanding further bureaucratic interventionto control them. For example, many of the investmentlaws in the region allow for credits for re-investmentof profits or for research and developmentcosts. Expenses can be easily be re categorized to fit the tax-exemptedclasses. Or firms can manipulate the date they "start" operations to extend the tax holiday beyond the normal numberof years. Furthermore, firms are adept at transferringincome into and expenses out of the holiday period to minimize tax liability after the holiday expires. Finally, preferentialtax codes for foreign investorsmay also exacerbatepoliticaltensions in the region, both internally and externally. As noted above, charges repeatedly surface throughoutthe region that politicians are "selling out" to foreign interests. A clear tax code, 41. The FIAS study noted aboveconcludedthat the tax rates of Bulgariaand Romaniamaybe so high that they would deter investmentin the absenceof tax holidays. The tax regimes in Hungary, Poland, and CSFR would be unlikelyto deter investmenteven in the absenceof special incentives.

20 with reasonablerates and equallyapplicableto domesticand foreign firms, may not only be 42 more efficientbut may also removea potentiallytroublingissue from the politicalagenda. Furthermore,as the CEE statesbegin to enter into associatemembershipwith the Eluropean Community,theirpreferentialtreatmentof foreigninvestorsmaycomplicatetheprocess. inthe springof 1992, the EC protesteda decreeby the Hungariangovernmentthat gave customs 43 The Hungarian preferencesto the Ford Motor Companyin return for domesticinvestment. governmentagreed to repeal Ford's preferentialtreatment,and a Ford officialrespondedby noting, "thereare easierplace in the worldto do businessthanHungary."4 Conclusions Specializedforeigninvestmentlaws have a usefulrole to play in the initialperiodof transitionto a marketeconomy.Theysenda strongsignalto foreignentrepreneursthat the host countryis seriousabouteconomicreformand is willingto work with investorsto establisha mutuallybeneficiallegalregime. Theselawstendto createinvestment"enclaves"that not only serve this signalingfunctionbut also may targetspecialincentivesto foreignersand create an "island"of legaldevelopmentthat maydifferfrom--andsometimesoutpace--development in the rest of the domesticlegal framework. Yet to the extentthe enclaveseparatesforeignfrom domesticinvestors,it can quickly outliveits usefulness.The incentivesit fostersnot onlybleeddomestictreasuries,but theylead to bureaucraticstructuresthat may unnecessarilycomplicatethe investmentenvironmentand raise informationand transactioncosts for foreigninvestors. As quickly as possible, the transformingeconomiesshoulddismantlethe enclaveand put domesticand foreigninvestorson 45 This may well mean that foreigninvestmentlaws are no longer needed; an equal footing. indeed,CSFRwas the first CEE countryto abolishspecificforeigninvestmentlegislationin favor of a broadcommercialcode coveringall investorsin the economy. Furthermore,if an enclavedoesexist,policymakersshouldtry to focuson the concerns criticalto foreignfirms. In the designof investmentlaws to date, the CEE countrieshave perhapspaid too muchattentionto preferentialtax schemeswhileignoringothercosts facedby foreigninvestors. Policymakersin reformingeconomiesshouldfocusprimarilyon reducing uncertaintyandtransactioncoststhroughclearand simplelegislation,dismantlingof unnecessary 42. In Czechoslovakia,public protestwas voicedagainsttax concessionsdemandedby MercedesBenz in return for foreign investment. EBRD Watch, v.2, no. 4, February 3, 1992, p.4 . 43. NicholasDenton, "Hungary accusedon van tariff," FinancialTimes, Many 30, 1992, p. 2. 44. Ken Kasriel, sunra note 24, p.2 . 45. Similarconclusionsare embodiedin the Guidelineson the Treatmentof Foreign Direct Investmentrecently publishedby the World Bank Group. Legal Framework for the Treatment of Foreign Investment, Vol. II: Guidelines,World Bank Group, 1992.

21 bureaucraticintervention,contract enforcement,support of arbitrationand other alternative protectionof propertyrights, and activeeffortsto disputeresolutionmechanisms,strengthening disseminateinformationon the legal frameworkand on business opportunities. Cornplex regulationsnot onlyincreaseinvestoruncertainty,but theydivertbureaucraticresourcesthatthe host countrycannotaffordto squander. The CEE states have shown remarkable willingnessto restructure their legal environmentsto attractinvestment.Thereare signsthat increasingattentionis now beingpaid to lowering transactioncosts for foreign investors. In early 1992, for example, Poland announcedthecreationof a new investmentagencywhosegoalis to disseminateinformationand provide help to foreign investorsin navigatinginvestmentsthrough the bureaucracy. The adoptionof theseand similarmeasuresin theotherCEEstateswouldfurtherimprovethe overall positionin the growingworldwide investmentclimateand place themin a moreadvantageous competitionfor scarceinvestmentcapital.

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