Differentiating Extractive, Manufacturing and Service Investments in LDCs.

The problems facing foreign investors in LDCs depend on the type of investment, whether in an extractive industry, manufacturing for the host market or for export, or a service industry. Differences arise from the objectives of MNCs, capital investment, timeframe, balance-of-payments, currency stability and operating controls in the host country. An awareness of these differences is important/or the multinational investor's pre-in vestment planning and negotiating with a host government.

Extractive, manufacturing and service investments create different types of problems for companies planning foreign direct investments (FDIs), especially in less developed countries (LDCs). For manufacturing, there are differences between plants producing primarily for the host market and those seeking low-cost labor to produce exports. The problems affecting EDI have not previously been presented systematically, and there is a need for a comprehensive scheme that multinational executives can use to analyze different types of investments.

Exhibit 1 highlights the different characteristics under four categories of investments. The exhibit illustrates how issues that are highly controversial for one kind of investment are less controversial for others.

MNC Objectives

Extractive. A foreign investor's primary concern when setting up an extractive facility is a reliable source of raw materials to feed downstream operations. The majority of mining and petroleum companies are highly integrated, and the extractive operations are the first in a long series of processing facilities. Hence, the concern is to control costs, not necessarily show a profit.

Manufacturing for host market. An import-substituting investment is motivated by a desire to make a profit or preserve and gain market share. Multinational corporations (MNCs) try to head off competition by negotiating subsidies or tariff protection from a host government, and they may have the bargaining power to gain more protection than is possible in industrialized countries. However, this type of investment is particularly sensitive to economic conditions and political pressures in LDCs, which makes the objectives more problematic.

Manufacturing for export. In export operations, MNCs seek low cost operating locations. They want cheap labor for labor-intensive operations, primarily assembly of components into standardized products. The products tend to be mature and price-competitive, so cost control is an important objective. Foreign companies typically are concerned about quality assurance and reliability of supply. They are also concerned that their investments be free of administrative costs and hassles when setting up and operating plants.

Services. The most common types of FDI are hotels and financial services, mostly banks. Both types of foreign operations frequently focus on serving the needs of the international community, i.e, foreign travelers in the case of hotels and local affiliates in the case of banks. When foreign hotels service locals, they are usually the wealthiest and most internationalized citizens. The services rendered by foreign banks relate to foreign borrowings and transfers of funds.

Host Country Objectives

Extractive. The most important benefits that host LDCs hope to obtain from extractive industries are foreign-exchange earnings, government royalties, tax revenues and jobs for host citizens. Technology transfer and downstream marketing may be significant, although these supporting services are increasingly available in "unbundled" form on the open market.

Manufacturing for host market. The benefits host countries seek from foreign import-substituting plants are varied and diffuse. MNCs are likely to bring in a "package" of goods and services, including technology transfers, employment opportunities, capital inflows, training of host citizens as managers, technicians and laborers, and opportunities for local producers to supply raw materials and services to the foreign plant. There can be a demonstration effect whereby local companies learn manufacturing and management skills from the foreign plant and eventually compete with it.

The host government hopes that foreign plants will become cost efficient and develop sufficient quality to export products. However, unskilled workers, inadequate transportation and communications facilities, small-scale and inefficient production facilities, and costly government rules and red tape often hamper a plant's operation. Consequently, many are unable to export significant amounts at competitive, unsubsidized prices. Host governments may also try to persuade foreign investors to place plants in remote or politically sensitive regions to further regional development or gain political support.

Manufacturing for export. Benefits from export-oriented assembly plants include primarily jobs and foreign exchange earnings. There may be some technology transfer, but it is relatively slight because most plants are labor-intensive, low technology operations. Host LDCs may want the plants to purchase inputs from local suppliers, but foreign companies often do not get the necessary quality and reliability from local producers. Governments may also hope for tax revenues, although they tend to bargain them away in the competition to attract desirable plants.

Services. Hotels are desirable investments for host LDCs because they bring in foreign exchange. Hotels increase the inflow of foreign tourists and business people if there are sufficient attractions and opportunities in the host country. Hotels are labor-intensive and create employment opportunities for low-skilled, entry-level workers. Benefits do not depend on who owns the hotels, but foreign participation helps significantly in marketing, management and technical support. Hotels bring in some new technology, but it is usually not highly proprietary in nature. They also create some managerial positions, but most jobs are menial.

Foreign banks can have a substantial demonstration effect on domestic competitors and thereby increase capital resources and efficiency of the host's financial markets. Benefits depends on how freely the host government allows foreign banks to compete with local banks, because LDCs often protect domestic banks against such competition. Foreign banks are likely to have strong links to international financial networks and capital sources that enhance the host's international financial flows. They create a few jobs and bring in a little new technology. In general, the benefits to host LDCs are less obvious and more dependent on government policies than other types of FDI.

Capital Investment

Extractive. Extractive installations usually require more capital and take longer to establish than other investments. They require high initial expenditures for locating new deposits, setting up processing facilities, building infrastructure, and establishing downstream processing plants and marketing networks. They have to go where mineral deposits are or where soil and climatic conditions are suitable for plantations, making them location dependent and vulnerable to political and economic risks.

Manufacturing for host market. The cost of establishing manufacturing plants depends on the capital intensity and the availability of suitable sites. Manufacturing investments are usually smaller in scale than extractive ones and, depending on the industry, may he located in less specialized buildings or even rented space. The set-up costs are generally less than for a mine or an oil field, and the timeframe is much shorter.

Manufacturing for export. The costs of setting up export assembly facilities are significantly lower and the timeframe shorter than for import-substituting plants, because they are less capital intensive, more likely to be in low-cost facilities or receive government support. It is easy to move machinery and equipment into or out of a host country, making plants "footloose." A major cost and time factor is the training of workers who have low industrial skills, are often illiterate and are accustomed to the rhythms of agricultural jobs.

Services. Local partners or lenders in many LDCs increasingly supply the capital required to establish hotels and banks, so foreign capital commitments are relatively modest. The costs and time required to set up service industries depend on the construction needed. Once a facility is built or remodeled, the biggest remaining expense is training employees. While not negligible, it is not as demanding as training engineers or technicians for jobs in extractive or manufacturing plants.

Balance-of-Payments

Extractive. Foreign extractive companies are not concerned about weaknesses in a host's currency or balance-of-payments position because their returns are raw or semi- processed materials. They almost always produce a net foreign-exchange inflow for the host country, which helps reduce any balance-of payments deficit and strengthen the currency.

Manufacturing for host market. The demands of import-substituting plants on a host's currency reserves include financing machinery and equipment, importing raw materials and components, expatriate salaries, licensing technology and administrative fees plus dividend payments and capital repatriations. The majority of plants do not export enough to cover their foreign-exchange costs; hence, they are likely to aggravate a host's balance-of-payment deficit.

Plants that import components from the parent company to produce products for sale in the host country are especially suspect because they have the greatest potential for manipulating transfer prices. In this case, the host government may screen the investment applications more carefully and regulate the operations closely.

Manufacturing for export. Manufacturers normally are not concerned with the host's balance-of-payments position or the strength of its currency because the bulk of their production is exported. This type of plant seldom needs to convert local currency since it seldom repatriates profits. As a corporate cost center, it may bring in modest amounts of hard currency to pay its workers and other local expenses.

Services. Successful hotels usually generate enough foreign exchange earnings to cover the costs of imports and still contribute to the host country's foreign-exchange reserves. On the other hand, banks may not be net foreign- exchange earners and may facilitate capital outflows. Consequently, host governments often regulate their activities very closely.

Investment Incentives

Extractive. Governments grant tax holidays or royalty abatements during the construction of new or expanded facilities, frequently until the foreign investor earns enough profit to recover the initial investment. They may finance the construction of supporting infrastructure and cover the expenses of training and housing workers. In the last two decades, foreign companies have typically requested that the host government or local partners assume a substantial part of the risk and up- front costs of a facility. In exchange, the MNCs have given up substantial equity ownership. This trade-off creates a bargaining situation where the specific character and value of the incentives vary substantially depending on each party's contribution and bargaining strength.

Manufacturing for host market. There is a variety of incentives for import-substituting investments. They range from tariff protection and low-interest loans to subsidies for plant sites or worker training. In the last two decades, LDCs have granted fewer incentives, and most no longer grant them automatically or across the board. Rather, they are tied to specific performance requirements such as hiring or training host citizens, local sourcing of supplies, exporting a minimum percentage of the output, and locating plants in underdeveloped regions.

LDC governments do not have to give generous incentives when their economies are strengthening, markets are growing, political systems are stable and the treatment of FDI is fair. On the other hand, they still grant generous incentives for import-substituting investments considered desirable, such as those creating new jobs or bringing in new technology.

Manufacturing for export. LDCs have granted increasingly generous incentives for export-oriented investments, including subsidized plant sites in special economic zones, low-interest loans, improved transportation and communications infrastructure, guaranteed utilities and lengthy tax holidays. Policy makers believe that incentives are necessary to attract desirable investments that create jobs and foreign exchange earnings. Bidding wars are more common for this kind of investment than any other. National and provincial! state governments of many industrialized countries also compete in granting incentives to job-creating investments. LDCs often create a special fast-track approval procedure for export-oriented investments, thereby reducing the time, expense and aggravation of an approval. They are also more willing to grant 100% equity ownership.

Services. Government incentives for FDI in hotels are similar to those for manufacturing, although less generous. Government agencies may assume part of the ownership, provide financial concessions or guarantee the borrowings of local private partners. Governments frequently assist in tourism campaigns that benefit hotels. For banks, LDCs normally give relatively few incentives for FDI.

Operating Controls

Extractive. Mining and petroleum extractive installations are a vital first link in a highly integrated chain of refining and processing facilities. Downstream processors are dependent on the first links in the chain and consequently concerned about maintaining ownership or at least tight control over the extractive facilities.

Host LDCs believe a certain degree of control is necessary to safeguard national interests and prevent financial abuses. They frequently want to preserve at least the appearance of national control; hence, they may mandate or negotiate for majority equity ownership and seek to place host citizens in top corporate positions. However, most are sensible enough not to disrupt efficiency or raise costs unnecessarily, so they allow their foreign partners to exercise a great deal of operating control and place expatriates in top managerial and technical positions.

Manufacturing for host market The markets for manufacturing are different from extractive facilities. Manufacturers' downstream operations are more flexible in sourcing, and downstream sales usually go to a wider range of end-users. However, manufacturing MNCs often believe that a high degree of operating control is necessary to maintain efficiency and quality, safeguard proprietary technology, prevent financial misappropriations and earn profits. Consequently, they are more flexible than extractive producers about equity ownership, but they are very concerned about maintaining operating control.

Host LDCs seek a high degree of equity ownership in joint ventures with private corporations when the ownership will accelerate the rate of technology transfer, increase the technical training of host citizens, prevent transfer pricing abuses or reduce the outflow of dividends. In recent years, host governments have been more willing to allow a high degree of operating control to foreign partners. Realism and willingness to compromise have largely replaced the confrontational approach of the 1960s and 1970s.

Manufacturing for export. Control of export-oriented assembly plants has historically not been as contentious as control of import-substituting plants. Production for export is a recent phenomenon, although Hong Kong and Singapore sought export-oriented plants as early as the late 1960s. Most LDCs concentrated on import-substituting investments until the late 1970s or 1980s, by which time they were more comfortable with FDI. Export-oriented FDI is less threatening to LDC governments since there is less chance of interfering in host politics. Export-oriented investors have greater bargaining power because of competition among LDCs to attract plants. These investments are usually not considered a drain on scarce foreign exchange.

Services. Governments in LDCs regulate banks closely because of the impact on their financial systems. However, LDCs often have difficulties with regulation because of weak institutions, bureaucratic inefficiencies and loose linkages among financial actors. LDCs frequently favor local competitors in order to limit foreign banks' propensity to abuse or circumvent their monetary systems. Thus, the governments try to exert tighter operating control over foreign banks or force them to take in local partners. For hotels, LDCs have relaxed their efforts to control FDI after attempts to nationalize or forbid foreign hotels in the 1960s.

Technology Issues

Extractive. Technology has historically not been a highly contentious issue in extractive facilities. Facilities are usually technology intensive, but the technology is less proprietary and more widely diffused than in manufacturing. Extractive facilities tend to be large scale and location specific; thus, there is less need to guard proprietary knowledge. Furthermore, MNCs and local partners recognize that it is in their best interests to maintain the lowest costs and most efficient scale possible, which will encourage foreign companies to bring in modern technologies and host governments not to interfere.

Manufacturing for host market Technology has been a contentious issue in import-substituting manufacturing FDI since the 1950s. Many LDCs believe foreign MNCs bring obsolete technology into local subsidiaries at inflated prices. They argue that the major justification for allowing FDI is to obtain modern technology, while foreign companies claim they have to protect their proprietary technology against local partners who might steal it and pass it along to competitors. Also, they argue that LDCs do not have the capacity to absorb and use modern technologies, the labor force does not have sufficient skills to handle state-of-the-art machinery and equipment, and local industries and the infrastructure cannot support high-tech plants. The scale of manufacturing is too small to justify the investment and costs of establishing and running large-scale, technologically sophisticated operations.

The MNCs argue that they bring in appropriate technology for the host environments. LDCs believe that "appropriate" is really an excuse for passing off second-rate or obsolete machinery, equipment and processes. The conflict continues.

Manufacturing for export. Technology has not been a major issue for export-oriented assembly and manufacturing plants. The plants generally produce mature products using labor-intensive and relatively low-tech processes. LDCs recognize a need to compete for these investments by not imposing costly requirements on foreign companies and a need for plants to control costs to remain competitive.

Services. Hotels and banks both contribute relatively little proprietary technology to their overseas operations, so disputes over technology are not common for this type of FDI.

Pre-Investment Planning

The types of FDI are important when preparing investment applications and negotiating with government officials. MNCs planning to establish plants to produce goods for sale in the host market will need to pay more attention to the balance-of-payments position than those planning extractive or export-oriented assembly operations. Host country tariffs are important for import-substituting FDI but not some other types. Tax holidays are important to all investors, but they are likely to be more contentious for import-substituting plants than other investments.

Categorizing FDIs provides a framework for processing investment applications. Foreign companies seeking to invest in mining or oil production facilities can expect to spend a lot of time dealing with ministries responsible for government finance and infrastructure and less time with the central bank. Those seeking approvals for import-substituting factories will spend more time with the central bank and ministries responsible for industry, technology and labor. Foreign extractive companies and product assemblers will have an easier time getting government subsidies for infrastructure and training of workers than manufacturers for the local market.

MNC executives must recognize issues that are important to host LDCs but of secondary concern to them. The balance-of-payments impact is a prime example. An import-substituting manufacturer's concern is whether the country will have adequate reserves to pay for needed imports and allow the repatriation of profits. The host government has much broader concerns about protecting and enhancing its overall foreign exchange position.

Bargaining Power

MNCs should use the categorization of FDIs when planning and conducting investment negotiations with LDC governments. Different topics will be important to both at different stages in the investment process. Issues that involve one sides' core objectives are less negotiable than those peripheral to the objectives, but the core objectives will vary depending on the kind of investment. For example, an MNC applying for an export-oriented assembly plant will negotiate tighter cost-control powers than one planning an import-substituting factory in a protected market.

Some issues will be more important to one side than the other. LDC governments may be concerned about the appearance of national control of major extractive operations, while MNCs may be more concerned about operating control. An LDC with a severe balance-of-payments deficit may be concerned about foreign exchange drains from an import-substituting plant, while a foreign manufacturer might delay repatriation of earnings or capital investment in exchange for greater freedom of operation within the country. A foreign hotel might be more willing than an extractive or manufacturing investor to accept reduced equity ownership in exchange for a local partner taking on more of the capital risk.

Differences in priorities create possibilities for compromise. Each side can concede points that are "non-negotiable" to the other but less important for itself. Furthermore, the bargaining might be directed at issues that are relatively marginal to both sides. An obvious example is investment incentives. LDCs and MNCs can bargain at length about the percentage tariff protection granted to an import-substituting factory, the value of subsidies for an export-oriented assembly plant or the number of years of tax holiday for a foreign-invested hotel. Both sides know, however, that bargaining is part of the game and will not make or break an investment proposal that is otherwise desirable.

EXTRACTIVE, MANUFACTURING AND

SERVICE INVESTMENTS IN LDCS

Extractive Manufacturing for

Host Market MNC Objectives * Natural resources * Maximum profits

* Minimum competition

* Cost controls Host Country * FX earnings * Jobs Objectives * Jobs * Training

* Technology * Technology

* Local sourcing Capital Investment * Long-term investment * Little capital

* Hard currency * Short time

financing * Local financing Balance-of-Payments * FX for raw materials * Hard currency for

* No BOP concern components and

profits

* FX drain Investment Incentives * Tax holidays * Tariff protection

* Assumption of risk * Loans

by host * Plant subsidies

* Training

* Export to remote

regions Operating Controls * Assurance of supply * MNC control

* Cost controls * Efficiency

* Prevention of abuses * Technology

* Top jobs for host * Finances

citizens * Local ownership Technology Issues * Diffused technology * Modern vs. appropri-

* Critical engineering ate technology

knowledge

Manufacturing for Services

Export MNC Objectives * Cheap labor for * Hotel: attract

labor-intensive businessmen

operation * Bank: serve MNCs Host Country * FX earnings * Hotel: attract tourists Objectives * Jobs * Bank: international

* Technology linkages

* Local sourcing Capital Investment * Little capital * Little capital from

* Plant subsidies foreign partner

* Short-term payback Balance-of-Payments * Export of finished * Hotel: net FX earners

goods * Bank: facilitate

* No BOP concern capital outflow Investment Incentives * Plant subsidies * Hotel: aid tourism

* Tax holidays * Bank: few incentives

* 100% foreign own-

ership

* Hassle-free

approvals Operating Controls * Control for foreign * Hotel: control not

company issue

* Not major issue * Bank: concern about

locals Technology Issues * Mature products * Little proprietary

* Diffused technology technology

* Not major issue * Not major issue FX=foreign exchange; BOP=balance of payment