Chapter

Chapter IV.4 Foreign Direct Investment

Author(s):
International Monetary Fund
Published Date:
December 1991
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1. INTRODUCTION

Few, if any, countries offer as potentially attractive opportunities for large-scale foreign direct investment as the USSR: a vast internal market; a critical need for an efficient and expanded consumer goods industry; enormous natural resources whose efficient exploitation would yield large benefits both to the USSR and to foreign investors; new, untapped business opportunities resulting from the conversion of the defense industries; a woefully underdeveloped services sector—including the basic distribution system and business-related services—where foreign know-how would be extremely valuable; and a general need to import foreign technology, managerial skills, and experience in operating in a market environment.

This potential notwithstanding, foreign direct investment in the USSR has been minimal to date in terms of foreign capital actually invested, and is unlikely to expand significantly in the absence of a dramatic improvement in the country’s political, economic and regulatory environment. One, but not the principal, reason for this disappointing performance is the inadequacy of the regulatory framework for foreign investment. More fundamental from a foreign investor’s viewpoint are overall political and legal uncertainty, economic risk, and the lack of functioning input markets and basic infrastructure in such areas as finance and telecommunications.

Against this background, it is clear that there are great potential benefits to the USSR from increased participation of foreign investors in the development of the USSR and its integration into the world economy. Indeed, by providing favorable feedbacks to the process of economic reform, success in attracting substantial flows of foreign investment could be crucial in the transition to a market economy. It is also evident that the difficulties to be overcome in achieving this are considerable.

This chapter reviews the available statistical evidence on the activity of joint ventures established in the USSR, assesses the present climate for foreign investment, and evaluates the regulatory parameters applying to ventures with foreign participation, including proposals for reform currently under consideration. The chapter concludes by considering a number of specific recommendations with respect to foreign direct investment.

2. THE EXPERIENCE WITH JOINT VENTURES

The equity joint venture has been to date the principal form of foreign direct investment in the USSR.1 This form is characterized by an equity ownership in a separate legal entity by the foreign partner(s) of up to 99 percent, reflecting a commensurate investment of capital. As a general rule, joint ventures are subject to the same laws and practices as other Soviet business entities, but there are a variety of important exceptions in areas such as supply and distribution, taxation, wages and management rights.

a. Statistical background2

The enabling legislation for joint ventures was passed in January 1987 and by mid-1990 there were 1,754 registered joint ventures with a total registered initial capital of around rub 4 billion. This figure is, however, a poor indicator of the volume of convertible currency funds that has actually been invested in joint ventures. Although convertible data are not available in this respect, it can be reasonably estimated that the stock of foreign investors’ convertible currency contribution is unlikely to exceed the equivalent of rub 500 million, and may indeed be substantially less.3

The initial stage of joint venture development was marked by steady growth—as would be expected as the first wave of negotiations bore fruit. However, with the initial enthusiasm becoming tempered by the realization of the problems posed by economic disorganization and bureaucratic resistance, growth has slowed down noticeably since late 1989 in terms of both numbers of new ventures and, especially, initial capital investment (Table IV.4.1). Furthermore, of the 1,754 joint ventures registered at end-June 1990, only 541 are actually operating and producing goods or services; an additional 162 (mainly in the services sectors) are reportedly paying their workers but have not yet entered the production phase. All in all, the number of ventures that can be said to be operational is 703, or some 40 percent of the total registered.

Table IV.4.1.USSR: Joint Ventures and Initial Capital, 1987-90
Total Number

of Joint

Ventures
Total Initial

Capital
Increment
End-periodIncrement(In millions of rubles)
December 19872323159.37159.37
December 1988193170826.85667.48
June 19896894962,122.731,295.88
December 19891,2695803,521.991,399.26
June 19901,7544854,000.00 1478.00 1
Sources: Data provided by Soviet authorities.

Approximate figure.

Sources: Data provided by Soviet authorities.

Approximate figure.

The average size of joint ventures tends to be small by both international and Soviet standards. More than half of the operating ventures employ fifty or fewer persons (Table IV.4.2) and only eight ventures have in excess of a thousand employees. These eight ventures accounted, however, for some 15 percent of the overall volume of production recorded in the first half of 1990, while the 470 joint ventures with a workforce of up to 200 employees contributed just over half of the total production. The limited size of joint venture operations is even more evident when measured in terms of capitalization.4 Indeed, from the outset, Soviet officials have noted with disappointment that joint ventures have tended to be, from their perspective, seriously undercapitalized. The statistics (Table IV.4.3) bear out this impression.

Table IV.4.2.USSR: Distribution of Operating Joint Ventures by Size, 1990 1
Size by Number

of Employees
Number of

Joint Ventures
Number of Workers

in Each Category 2
Volume of Production
(In millions of rubles)
0-502846,416286.6
51-20018618,641442.6
201-6005016,012298.6
601-1,000139,830187.5
Over 1,000811,633209.9
Total54162,5321,425.2
Sources: Data provided by Soviet authorities.

First half of 1990.

The largest joint venture in terms of employment had a work force of 2,218. The second and third largest had 1,491 and 1,458 employees, respectively.

Sources: Data provided by Soviet authorities.

First half of 1990.

The largest joint venture in terms of employment had a work force of 2,218. The second and third largest had 1,491 and 1,458 employees, respectively.

Table IV.4.3.USSR: Distribution of Joint Ventures by Size of Initial Capital, 1990 1
Range of Initial

Capital Investment
Number of Joint Ventures

in Each Category
Initial Capital

in Each Category
(In millions of rubles)NumberPercent(In millions of rubles)
0-0.569547.02129.29
0.5-1.022515.22144.55
1.0-5.038125.78771.23
5.0-10.0865.82556.80
Over 10.0916.162,174.87
Total1,478100.003,776.74
Sources: Data provided by the Soviet authorities.

Situation as of end-March 1990. Data missing with respect to 64 registered joint ventures.

Sources: Data provided by the Soviet authorities.

Situation as of end-March 1990. Data missing with respect to 64 registered joint ventures.

More importantly, the trend has been to reduced levels of investment. Thus, the average capital investment of Soviet and foreign partners dropped from rub 4.3 million at end-1988 to rub 2.6 million at the end of the first quarter of 1990. Over that period, the proportion of ventures with initial contributions of less than rub 1 million increased from 48 percent to 62 percent5 while the percentage of operations with an initial capital in excess of rub 10 million fell from 14.5 percent to only 6.2 percent. An important factor behind the statistical decline in average capitalization has been the growth of joint ventures arranged by Soviet cooperatives, which tend to be small in size and involve modest foreign participation. More generally, it would appear that in view of the present economic uncertainties, partners tend to inject as little capital as possible in new ventures and put greater reliance on debt as a source of finance.

An assessment of the distribution of joint ventures according to economic sector or sphere of activity is particularly difficult because there is no official classification scheme for such activities and also because many ventures designate in their founding documents a very wide variety of potential activities. Although available information does not permit definitive conclusions to be drawn on joint venture involvement in the various branches of activity, there is ample evidence that the services sector plays a predominant role for the time being. Indeed, Soviet officials have expressed concern that the sectoral distribution of joint ventures had not conformed to Soviet expectations, particularly with regard to the limited size of manufacturing start-ups (especially in heavy industries) relative to investment in business and distribution services and in computer-related activities (Tables IV.4.4 and IV.4.5).6

Table IV.4.4.USSR: Distribution of Operating Joint Ventures by Area of Economic Activity, 1990 1
EmployeesValue of Production
Number of Joint

Ventures
(In thousands)(In millions of rubles)
Industry28535.7741.0
Trade and public catering644.072.0
Scientific research and project construction565.5159.7
Construction362.136.8
Other branches of the national economy23515.8387.0
Cooperatives273.528.7
Total70366.61,425.2
Sources: Data provided by the Soviet authorities.

Data through June 1990. The total figure for employees includes about 4,100 employees who are being paid but are not involved as yet in the production of goods or services.

Sources: Data provided by the Soviet authorities.

Data through June 1990. The total figure for employees includes about 4,100 employees who are being paid but are not involved as yet in the production of goods or services.

Table IV.4.5.USSR: Distribution of Registered Joint Ventures by Area of Economic Activity, 1990 1
Joint VenturesInitial Capital
NumberPercentMillions of

rubles
Percent
Fuel/energy161.1189.742.46
Metallurgy211.45167.504.58
Chemicals/timber976.70450.6112.33
Heavy machinery916.29307.928.43
Personal computer production and programming20814.37276.217.56
Construction and building materials1178.09461.6012.63
Transportation and communications271.8733.970.93
Food and agricultural products processing916.29375.6010.28
Retail trade and public dining714.91100.552.75
Tourist hotels and passenger transport services876.01227.196.22
Health and medical care563.87174.624.78
Public education20.142.350.06
Light industry533.66117.453.21
Other consumer goods1238.50331.049.06
Film and video342.3535.190.96
Concerts221.5213.470.37
Publishing4.32.9756.941.56
Research and development714.9143.891.20
Engineering584.0175.922.08
Consulting and intermediary services14910.30304.848.34
Personnel training100.697.230.20
Total1,447100.003,653.83100.00
Sources: Data provided by Soviet authorities.

Situation at end-March 1990 Data missing for 95 out of the 1,542 registered joint ventures.

Sources: Data provided by Soviet authorities.

Situation at end-March 1990 Data missing for 95 out of the 1,542 registered joint ventures.

The vast majority of joint ventures (1,256 at end-March 1990) has been set up with partners based in OECD countries, but the participation of firms from other regions is not negligible: 186 ventures have been established with CMEA countries and 116 with developing countries. Firms from Germany, Finland and the United States are the leading investors in absolute numbers (these three countries are the only ones with participation in over 100 joint ventures) while the ranking with respect to total initial capital investment places Germany and Italy in the top two positions followed by France, Finland and the United States (Table IV.4.6). It is worth noting, however, that the ranking changes significantly when only the contribution of the foreign partner is considered. In this latter case, foreign partners from the United States appear to have made the largest contribution (some rub 173 million) followed by Germany (rub 170 million), Italy (rub 167 million) and France (rub 146 million).

Table IV.4.6.USSR: Distribution of Registered Joint Ventures by Country of Foreign Partner, 1990 1
CountryNumber of Joint

Ventures
Initial CapitalRank by Total

Initial Capital
Millions of

rubles
Percent
Federal Republic of Germany214548.2212.481
West Berlin3032.170.73
Finland175367.408.364
United States172359.478.185
Austria99272.386.206
United Kingdom96190.944.359
Italy95510.7411.632
Switzerland69107.092.4412
Sweden58194.744.438
France54370.238.433
Poland54124.562.8411
Sources: Data provided by the Soviet authorities.

Situation at end-March 1990. In terms of total initial capital contribution, Bulgaria ranked seventh (rub 204.82 million), and Australia ranked tenth (rub 151.67 million).

Sources: Data provided by the Soviet authorities.

Situation at end-March 1990. In terms of total initial capital contribution, Bulgaria ranked seventh (rub 204.82 million), and Australia ranked tenth (rub 151.67 million).

The RSFSR has attracted the greatest share of foreign investment into the USSR, accounting for some 70 percent of both registrations and foreign capital invested. Moscow is by far the most popular location for joint ventures (Table IV.4.7), on account of its being the most important political and economic center and having better financial and telecommunications infrastructure than other zones in the USSR. Additional but smaller concentrations are to be found in Leningrad and in the Baltic republics.

Table IV.4.7.USSR: Distribution of Registered Joint Ventures by Location, 1990 1
RepublicNumber of

Joint Ventures
RSFSR1,072
Of which: Moscow(717)
Leningrad(113)
Other locations(242)
Ukraine99
Belorussia27
Estonia104
Latvia39
Lithuania18
Moldavia14
Georgia41
Armenia10
Azerbaidzhan10
Kazakhstan10
Turkmenistan1
Uzbekistan11
Tadzhikistan1
Kirgizia2
Unspecified83
Sources: Data provided by the Soviet authorities.

End-March 1990.

Sources: Data provided by the Soviet authorities.

End-March 1990.

Virtually all the joint ventures employ predominantly Soviet workers. Indeed, out of a total work force of 66,600 employees accounted for at end-June 1990, approximately 65,500 (or 98.4 percent) were Soviet citizens. Wage rates for Soviet joint venture workers were substantially above the national monthly average (rub 257); indeed, up to three times as high (Table IV.4.8). As to foreign trade, 166 out of the 541 joint ventures operating as of the end of June 1990 had exported goods and services abroad for an aggregate value of 88.5 million valuta rubles (80 percent in convertible currency). A larger number of joint ventures (247) had imported goods from abroad worth rub 400 million, with payments in convertible currency accounting for 48.6 percent. The vast majority (86 percent) of imports was made up of machinery and equipment, and computer technology in particular. The net convertible currency expenditure of these export-import operations amounted to rub 123.6 million.

Table IV.4.8.USSR: Wage Rates for Employees in Joint Ventures, 1990 1
Average Monthly Wage

for Joint Venture

Employees

(rubles)
Relation to

National Average

(= 100)
Industry535208
Construction678264
Trade and public catering789307
Scientific research and project construction644251
Other branches of the national economy705274
Cooperatives742289
Sources: Data provided by the Soviet authorities.

Situation at end-June 1990.

Sources: Data provided by the Soviet authorities.

Situation at end-June 1990.

b. The current investment climate

A fully comprehensive assessment of the climate for foreign investment would require a whole range of very detailed information on the operational difficulties actually encountered by foreign investors—information that is not readily available at present. On the other hand, anecdotal evidence and ad hoc research7 make it possible to single out some typical problem areas that have emerged since joint ventures began operating, and that have effectively constrained the scope of their business and limited their contribution to the development and restructuring of the Soviet economy. To shed light on the current investment climate, it may be worth considering the principal motivations underlying the decision of foreign and Soviet partners to establish joint ventures in the USSR before turning to assess the importance of the main negotiating and operational obstacles that it has been possible to identify.

(1) Motivations of foreign partners

As of early 1990, the most common motivations for engaging in joint ventures in the USSR appear to be: (1) the perceived opportunity for sales and profits in the Soviet market; (2) the desire to use the joint venture as a conduit for importing products made by the foreign parent company; and (3) the desire to establish an early foothold in the Soviet market, which could serve as a defense against future competition from other foreign companies. It is also important to note that the desire to take advantage of Soviet capabilities in basic research and applied technology, the skills of Soviet workers, and the low wage level were among the motivations least commonly mentioned in early 1990.

These perceptions seem to have undergone significant changes in the most recent period. It is probably true that the first wave of joint venture negotiations was primarily motivated on the foreign side by the perceived opportunity to operate in a new market and the desire to position oneself against future competition on that market. But the difficulties encountered in negotiating and operating joint ventures in the USSR, together with poor and deteriorating domestic economic and political conditions, have cautioned foreign investors. In particular, fewer foreign firms now expect to find in the Soviet market a short-term source of profit, and the high risks of investing in the USSR tend to offset concern about being out-positioned by the competition. At the same time, however, some of the motivations that were regarded as low-ranking during the early stages of the joint venture experience appear to be gaining in importance. Thus, the low level of Soviet labor costs has been increasingly viewed as an important incentive for foreign partners. The experience of many joint ventures operators has been that Soviet labor can be motivated—e.g. by higher wages, access to Western goods and travel, and career opportunities—to work diligently and to produce quality work. Moreover, for those firms that have taken the time to sift through the claims about Soviet strength in scientific research and engineering prowess, bright spots have appeared where Western partners now see potential for developing important new products or for producing at lower costs products that are marketable in the industrialized countries.8

One motivation that appears constant and strong is to use joint ventures as vehicles for importing goods and services from foreign partners. The joint venture would use the imports to manufacture a product that is sold for convertible currency, usually domestically, and these earnings would be used in turn to pay for the imports. The joint venture may or may not earn any significant additional profit out of these transactions, but that may not be of primary concern to the partners. The essence of the arrangement is that it will enable the Soviet partner to limit the degree of interference by government authorities and provide both partners with leverage under the laws extending certain benefits to joint ventures.

In some cases, joint ventures appear to have been set up primarily, if not exclusively, because they provide a relatively inexpensive and quick way to establish a physical presence in the USSR. This factor seems to be most important for smaller foreign companies, which often find it easier to identify a Soviet partner willing to establish foreign ties than to traverse the many bureaucratic obstacles to setting up a legal representation in the USSR. The positive economic impact of this “illusory” form of direct investment is likely to be marginal, measured only in terms of that amount of additional business that is made possible by circumventing government interference.

Given the present state of the Soviet economic system, it is not surprising that there should be cases in which the contribution of a joint venture to the Soviet economy may be perceived by some as negative. This situation occurs in particular whenever the purpose of the arrangement is simply to exploit an artificially high ruble price for certain products as compared to the world price, which is a direct result of the inconvertibility of the ruble and the distortions in the economic structure in the USSR. The proliferation of this particular type of joint venture may contribute to the image of foreign investors “profiteering” from regulatory arbitrage rather than contributing to the economic development of the country. Another consequence is that the Soviet authorities tend to overreact to the instances of such exploitation by joint ventures and promote overly broad restrictions—such as those inhibiting “intermediary” functions of joint ventures—which, in turn, reduce the scope for economically-sound operations.

(2) Motivations of Soviet partners

From a broad policy viewpoint, joint ventures are an especially attractive form of commercial cooperation from the Soviet perspective for a large number of reasons including, in particular, the consideration that: (a) initial and ongoing capital contributions by the foreign partner provide badly-needed infusions of convertible currency and goods; (b) convertible currency earnings by the joint venture may be retained in the USSR through taxation and distribution of profits (or payments for goods and services) to Soviet entities; (c) foreign investment provides a vehicle for technology transfer; (d) the cooperation between the Soviet and foreign managers of the joint venture maximizes the opportunities for the transfer of management know-how, as well as employee training; and (e) the need for most joint ventures to export a portion of their production to Western markets as a means for earning convertible currency ensures that high quality will be observed, thereby providing a source of salutary competition for domestic producers and a source of quality goods for domestic consumers.

Soviet negotiating partners are apparently not unambiguously supportive of the concept of entering into a joint venture. This results largely from the different perspectives and interest of ministry personnel—who often assume much of the negotiating responsibility—as compared to those of the subordinate enterprise, which would actually enter into the operational phase of the joint venture. It is well known that, in several instances, the enterprise concerned was not even aware that it was being positioned to take on the joint venture responsibility until serious bargaining had already begun, and it was quite common for the enterprise to be excluded—or cast in only a minor role—from the process of negotiation and preparation of supporting studies and documents.

Thus, until recently, the controlling motivations, at least at the initial stages of finding partners and beginning negotiations, were often those of the ministry or other superior bodies rather than the eventual operating partner in the venture. The situation in this regard could be expected to change noticeably due to the process of decentralization which gained momentum through 1990. In particular, if the ministries and other central bodies were to continue to lose control over the decisions of large enterprises nominally under their jurisdiction, the balance of influence in the negotiating process could shift towards the enterprises. In spite of these changes, foreign negotiators may still face a range of interests, rather than a unified position, on the Soviet side as long as many enterprises retain their monopoly position. This may appear paradoxical to the extent that it is usually assumed that monopoly power brings with it the capacity for a uniform position. However, monopolistic Soviet enterprises are also characterized by a very strong vertical organization: they may be in a commanding position with respect to producing goods for a consumer market that cannot reveal its demand through price signals, but they do not have the research or marketing base to change direction and work flexibly in a consumer-driven market economy. Consequently, to supply the necessary horizontal flexibility, a Soviet production enterprise may need to bring into the joint venture other entities, such as research institutes and foreign trade organizations for marketing and distribution. Hence, it is relatively common for a joint venture to have a number of Soviet partners and only one foreign partner. Moreover, experience suggests that several Soviet partners may not have much of a history of such cooperation. As a result, the foreign partner may face in negotiations—as well as in operations—a variety of Soviet institutions and motivations.

Notwithstanding this potential for diversity, an enduring motivation shared by Soviet partners—particularly those at the enterprise or cooperative level—is the desire to gain political leverage and legal protection for the purpose of thwarting bureaucratic interference as well as, in particular, to benefit from the tax and other advantages afforded to joint ventures (for details, see section 3). This being said, there are also more positive aspirations. A comparison of assessments by Soviet and foreign partners and experts indicates that the Soviet side is usually more optimistic about the intrinsic value of joint ventures than their foreign counterparts, and more sanguine about the future course of joint venture development in the USSR. In part, this appears to be due to the fact that the Soviet media increasingly features stories about the successes of joint ventures and the favorable prospects for new cooperative arrangements with foreign companies. This media bias is probably not the result of a systematic plan to distort reality. Rather, it is the product of the initial enthusiasm for a dramatic new turn in East-West economic cooperation and, above all, a general lack of sophistication about the difficulties of developing commercial relations under present circumstances.

Widespread cynicism about the potential of the Soviet economy to pull itself up by its own bootstraps has stimulated a trend towards a more positive and hopeful assessment of the potential role of Western economic assistance and cooperation. Thus, although there is some popular discontent over the privileged position of Soviet joint venture employees and growing concern about the supposed environmental costs of foreign exploitation of national resources, joint ventures and their potential contribution to the economy continue to enjoy periodic resurgences of interest in the context of new economic programs.

Within this generally positive assessment of the potential of foreign investment, the principal explicit motivation cited by Soviet partners is the desire to develop exports to the West. At the same time, they do not seem to place much importance on gaining a stable foothold in the world market. This apparent contradiction stems from the fact that Soviet manufacturers do not generally believe that their goods would be appealing enough to capture Western markets, even if produced in the joint venture context. They do aspire, however, to make discrete sales for convertible currency where opportunities arise.

From the Soviet perspective, personal motivations are at least as important as institutional ones. Employment in a joint venture is seen by many Soviet managers and workers (especially scientists and other experts) as a close second best to employment in the West. The perceived benefits are relatively obvious, ranging from higher salaries and perquisites, such as travel to the West or access to Western goods, to the chance for career development and an outlet for previously suppressed creativity.

(3) Obstacles to negotiation

When asked to rate potential negotiating issues—i.e., issues that were considered to be important during the negotiation stage and which proved to be difficult to deal with in the drafting of the founding documents—according to their relative importance, the predominant concern of foreign partners was the non-convertibility of the ruble. Other issues frequently cited as both important and difficult to resolve include obtaining office and work space, product quality control, management control and decision-making, and financing from foreign sources.9

Contrary to popular belief, the identification of a proper partner does not seem to rank high in the list of Western companies’ concerns. Many Western firms appear to be ready to sign on with the first reasonable candidate that shows up—particularly in the case of joint ventures set up on the basis of “foot-in-the-door” or “rule-circumventing” strategies. This tendency is reinforced by the fact that often a ministry or other central agency has been the initial contact for the foreign side and this central authority has then decided which Soviet entity to tap as the operational partner. However, as central authority diminishes and enterprise independence grows, this directing function from the center will decline. As alternatives to state enterprises—such as cooperatives, other joint ventures, and joint stock companies etc.—develop as potential partners for foreign firms, the question of finding the right partner may loom larger in the initial calculus on the foreign side. An improvement in the availability of information on investment conditions and opportunities may be expected to occur in the future as a result of greater advertising efforts on the initiative of business advisory organizations, such as chambers of commerce or business federations, and of the Soviet companies themselves.

(4) Obstacles to operation

Important operational problem areas cited by foreign partners include the hiring of Soviet workers, the sale of products in the USSR, quality control, financing from foreign sources, political risk insurance, customs duties and tariffs, and relations with local government authorities. This latter concern is generally expressed in complaints about the lack of a clear legal framework governing relations between the joint venture and government at local, republic and all-union levels. The Soviet authorities are well aware of the deficiencies in this regard, but relief has been very slow in coming and the proliferation of new reform plans has further delayed their resolution. In this connection, the absence of a key element of Western jurisprudence—administrative procedure law—is most acutely felt. Foreign partners need a regulatory framework incorporating opportunities to provide input to government administrators before they make decisions, to examine a record of the decision-making process leading to a ruling, to request administrative reviews of decisions, and to seek judicial review of administrative actions deemed contrary to law.

The most acute operational problem appears to concern, however, the difficulty of developing a reliable means of securing supplies. Given the seriousness of the overall situation in this respect, a more refined perspective can be obtained by considering several factors of direct relevance to this issue. First, supply is a major, and growing, problem for all enterprises in the USSR and many joint ventures are not in a particularly disadvantaged position in this regard—but this consideration is, of course, of little comfort to foreign investors. Even though they are formally outside the central planning and allocation systems, the negative effects of this exclusion are sometimes attenuated because, in the case of priority sectors, the Soviet partner or its superior ministry may provide the joint venture with supplies from their own allocations. As the central system breaks down, it is gradually being replaced at the margin by negotiations between suppliers and manufacturers, usually involving the same parties as under the central system.10 Other considerations pertinent to the supply problem, however, include the fact that some joint ventures (especially in the services sector) have relatively few material supply requirements and that many of them may rely on imports.

Be that as it may, the vast majority of joint ventures face severe local procurement constraints that seriously affect the scope for operating in an efficient manner. Under these circumstances, several ventures have attempted to address the supply problem by producing in-house some of the essential inputs (but this of course entails a diversion of managerial and financial resources from the venture’s core activities) and by developing horizontal linkages to strengthen interfirm cooperation. In most cases, however, these practical approaches to the supply problem are not sufficient to overcome the difficulties resulting from the narrowness of the network of suitable domestic trading partners.

Management is another problem area identified by many ventures as of equal importance with that of supply. In general, the focus of complaint about “operational management” centers on the lack of experience of Soviet managers and key employees in operating in a market environment. In particular, severe problems appear to exist in such areas as the understanding of profit as a motivating force, the need to keep looking ahead to the next product or the next marketing tool, the importance of compressing costs, and maintaining sensitivity to possible competition.

Predictably, a host of problems associated with poor economic infrastructure are targeted as critical roadblocks. No doubt, one of the most serious is confusion about Soviet accounting methods: issues concerning depreciation and allocation of pretax profits to certain funds are in the forefront in this regard.11 It is worth noting that work is underway to address some of the problems connected with existing accounting practices. Poor infrastructure, including domestic and international communications, hotel and office facilities, banking and related financial services, and housing and amenities, also are major practical barriers to foreign investment.

Finally, timely payment in convertible currency by Soviet purchasers was not a problem until late 1989, but delays have subsequently arisen in the trade area. There is as yet no clear indication that this problem has become important to the operation of those joint ventures that sell their products for convertible currency in the Soviet market, but there is some evidence that foreign partners may be becoming more circumspect in this regard.

3. THE REGULATORY SETTING

In recent years, the regulatory framework pertaining to foreign direct investment has undergone a profound transformation. Until 1987, foreign investors’ involvement in the USSR was confined to a limited range of contractual forms—such as payback, license or turnkey agreements—that did not involve the establishment of a legal entity. The first legal instrument dealing explicitly with foreign direct investment was a 1987 government decree which established the legal conditions for the setting up of joint ventures.12 The decree was subsequently modified in 198813 in response to foreign business criticism and with a view to improving the scope for inflows of foreign capital, which had not materialized to the extent anticipated by the authorities. New laws were under active consideration in 1990 at the all-union level as well as in individual republics.14

a. The present situation

(1) Authorization procedures

There are two general approaches that a country can take in determining what sectoral and/or geographical areas are open to foreign investors. On the one hand, an approach based on a “positive list” can be adopted, which would single out the sectors and areas where foreign investment is allowed. Alternatively, a “negative list” principle may be used, which specifies where such investment is not permitted. While logically these two approaches can lead to the same specification of areas open to foreign direct investment, it has generally been the case that a positive list approach turns out to be more restrictive. There is also an important philosophical distinction between the two systems in that the negative list approach conforms to the basic principle that a foreign investor should be permitted all forms of business that are not specifically prohibited by law or regulations.

The USSR has adopted a “modified” positive list approach to foreign investment by specifying the characteristics of foreign direct investment it wants. Thus, in order to be approved under the current system, a foreign investment should have several of the following characteristics: (i) it should supply goods needed on the domestic market (consumer goods in particular); (ii) it should supply needed inputs (e.g., capital, equipment, technology, management expertise); and (iii) it should contribute to increasing exports or reducing imports. These specifications are relatively broad, and for that reason may not be too restrictive in and of themselves. It is when these requirements are taken in conjunction with other characteristics of the system that they become more constraining.

The screening process to ensure that an investment meets these tests is rather complicated in practice.15 Consent is required by the “supervisory agency” (usually the sectoral ministry) that is responsible for the Soviet partner in the venture and, in addition, the joint venture has to be registered by the Ministry of Finance. These registration procedures involve a substantive review to ensure that the proposed venture meets the tests set out above as well as an analysis of the feasibility of the project and its economic and financial aspects. In the screening process, the legal form of the venture16 and the share of foreign ownership do not seem to be at issue. Foreign investors are now allowed to own 100 percent of the share capital and the foreign partner is otherwise subject to very few limitations on its shareholding in the venture. Indeed, it is up to the partners to agree on the contents and valuation of the respective contributions as well as to the respective shares in the statutory capital (“authorized fund”).

It is, of course, possible that ownership restrictions are more restrictive in practice than it would appear from the regulations. In the process of securing approval from either the branch ministry or the Ministry of Finance, an implicit restriction on ownership shares may be imposed as a condition for approval. This is a situation which arises often in those countries where approval criteria are not transparent and spelled out in detail. Indeed, lack of transparency—coupled with the absence of a requirement that the licensing authorities should make a determination on an application within a specified time limit—would appear to be a major drawback in the present Soviet authorization system.

(2) Labor and management

Foreign investors are always concerned about their ability to manage the joint ventures in which they invest. These concerns include the legal right to make decisions without interference from the government, to have management authority commensurate with ownership, to be in a position to obtain sufficient ownership resulting in management control if that is deemed appropriate in the circumstances, and to bring in their own people to be managers if that is desirable.

With regard to these matters, the USSR seems to offer a relatively favorable environment for foreign firms to participate in the management of joint ventures. Virtually any ownership structure is permitted, and representation on the Board is to be decided by mutual agreement among the partners and can be proportional to ownership. A foreign national can serve as chairman of the Board and managing director; other management positions are also open to foreigners. These provisions are liberal relative to those prevailing in many countries, where Board representation is often biased in favor of the local partner and the number of foreign nationals is made subject to specific limitations. True, some “fundamental” issues have to be resolved by unanimous agreement of all Board members regardless of Board composition, but the definition of what constitutes a fundamental issue is left up to the partners.

Ordinary Soviet laws on employment and conditions of work do not apply fully to joint ventures. Recruitment and dismissal procedures as well as wages and other material incentives can be freely determined by the partners. Foreign nationals can be employed without limit or any special permission on the basis of individual contracts, which would stipulate wages, currency of payments, leave, pension rights, etc. Salaries to Soviet citizens are not subject to any ceiling, though payments must be made in rubles. As is the case for state enterprises, joint ventures can allocate 25 percent of convertible currency profits to a fund for social development, which can be used for importing goods for employees. A joint venture is required to conclude a collective bargaining agreement with a trade union organized within the enterprise. The venture is also required to contribute to the state social security and pension systems on the same basis as for Soviet enterprises.

Taken overall, the regulatory system applying to employees and workers of joint ventures provides for a vastly superior treatment in comparison with that of Soviet enterprises. Workers can be, and indeed are, substantially better paid in terms of both basic salary and additional incentives while retaining a broad range of social protection, including representation in trade unions and a system of collective bargaining.

(3) Operational framework

According to present laws, joint ventures are free to develop their own strategic and operational plans, to purchase and sell through the local wholesale or branch supply system, and to carry on transactions on foreign markets on their own account. Payments for local inputs and sales can be made in rubles or in convertible currency on the basis of agreements with the counterpart. Another special characteristic of joint ventures is that they operate outside the state planning system. This is a clear advantage in terms of operational flexibility but it also implies that there is no government guarantee for any supply of raw materials, components or other needed inputs. The critical importance of this element has been noted previously but it is important to stress here that the present state of affairs in this regard goes a long way to explain the reticence with which potential investors consider the possibility of setting up industrial firms.

In addition to the issue of local procurement, two regulatory constraints are at the forefront of foreign partners’ concerns for the commercial viability of joint ventures. The first relates to the existing limitations on the “intermediary” functions17 in which joint ventures may engage. The second, and certainly more fundamental, concern is connected with the functioning of the present system of foreign exchange allocation.

The ability to obtain foreign exchange in order to import equipment, spare parts, and raw materials as well as to repatriate profits and capital is one of the most important elements in the investment environment for both actual and potential investors. Moreover, the need to repatriate profits is a crucial consideration in 1990 that distinguishes foreign from domestic investment. There is almost nothing in an investment environment, except perhaps a threat of expropriation, that discourages foreign direct investment more than uncertainty in this area.

The system currently in place for providing foreign exchange to foreign investors involves considerable uncertainty of supply. Basically, joint ventures have to generate all the foreign exchange they need. To do so, they are allowed to retain all the foreign exchange they earn through exports of their own products and sales against convertible currency on the domestic market. Admittedly, there is also a vague provision for the government to supply foreign exchange if local sales substitute for imports, or if the project otherwise has a high national priority; how, and to what extent, this is actually done, however, is unclear. By and large, although joint ventures are treated better under this system than Soviet enterprises, foreign investors regard this type of foreign exchange allocation system as being highly unsatisfactory and hindering the development of locally-oriented manufacturing and services activities.

In addition to the very real operational difficulties to which it gives rise, the foreign exchange allocation system provides scope for a number of structural distortions. On the one hand, the differential treatment between domestic enterprises and those with foreign participation makes it attractive for Soviet productive entities to bring in foreign investors solely to enjoy the possibility of 100 percent retention rights—and, indeed, such bias has reportedly resulted in the establishment of a large number of joint ventures with “sham” foreign participation. At the same time, foreign investors for their part are discouraged from investing in the USSR unless they plan to operate in sectors which can generate substantial foreign exchange income. Thus, the system is biased towards investment in industries where the USSR has a comparative advantage in exporting. As long as the present system remains in place, supplying the domestic market will be less interesting and will not generate much of a response from foreign investors, even though the size of the Soviet market might potentially be one of the main attractions for them.

(4) Financing

Joint ventures are required to operate on a cost-accounting and self-financing basis: they are not, therefore, entitled to state subsidies. On the other hand, financing of start-up and operating costs can be structured to include convertible currency borrowing,18 from foreign sources as well as from the Vneshekonombank (VEB), and ruble funding from Soviet banks. The VEB is entitled to extend credit to joint ventures outside its overall annual ceiling for convertible currency operations, to extend guarantees on the basis of a commercial assessment, and to grant licenses for borrowing operations on the international market. Such a license would be granted only after an examination of the terms of the transaction and related guarantees to ensure that they do not deviate significantly from market conditions.

On the whole, financial regulations do not seem to discriminate against enterprises with foreign participation, which in fact enjoy better than national treatment in several respects. Rather, the problems joint ventures have encountered result mainly from the blatant inadequacies of the financial infrastructure, especially with regard to the practical difficulties of executing foreign currency transactions in a highly centralized system, the lack of even relatively unsophisticated financial instruments and services, and operating constraints resulting from the archaic payments and settlements system currently in place.

(5) Tax and other incentives

The USSR provides several incentives to foreign investors. The tax rate on profits is lower for joint ventures than for domestic enterprises and the former enjoy a two-year tax holiday from the accounting year when a taxable profit is attained for the first time, which can be extended for priority projects.19 In addition, the import of equipment or other property that constitute a foreign partner’s contribution to the initial capital of the joint venture is exempt from import duties, and the venture’s imports of production inputs are subject to the lowest or zero duty. As already noted, joint ventures enjoy other advantages relative to Soviet firms (particularly with regard to currency retention and flexibility in hiring, wages and pricing)—although the overall level of specific incentives for joint ventures does not seem higher in the USSR than that offered in other countries where, for example, ten-year tax holidays are not unusual, cash grants are given, and imports of equipment are duty-free, regardless of their financing.

This being said, two important considerations would seem to apply to Soviet policy in the area of fiscal incentives to foreign investment. First, there would seem to be no reason for a further extension of fiscal incentives. As a rule, fiscal incentives are thought to be ineffective in influencing investment decisions, except possibly in the case of industries aimed almost exclusively at the export market. More generally, tax and other incentives are no substitute for an appropriate macroeconomic and political environment to promote foreign direct investment. In the case of the USSR, if the foreign exchange allocation system can be adjusted to provide opportunities for foreign investments aimed at supplying the domestic market, then fiscal incentives could be deemphasized. In that event, a sensible tax system based on relatively low rates and other pro-investment features such as loss carry-forward, could fruitfully replace the types of fiscal incentives now in place.

Second, existing tax incentives are a particularly strong force motivating the formation of joint ventures, irrespective of the extent to which they would actually satisfy an economic need and regardless of the real contributing of the foreign investor. This is because the benefit of the special tax treatment accrues to the venture as a whole, rather than only to the new investment. While most countries that give tax holidays relate them to the additional profits generated by the new investment, tax benefits in the USSR extend to the entire venture in which the foreign investment is taking place. This implies that, for example, a venture set up by a Soviet enterprise contributing existing assets for 70 percent of the capital (and with the remaining 30 percent being accounted for by foreign partners) can benefit from at least a two-year tax holiday and a comparatively low tax rate thereafter. As a result, the profits generated by the assets contributed by the local enterprise are taxed at a privileged rate (if at all) solely because they are in a joint venture. Such a system is clearly biased towards the establishment of “artificial” ventures, rather than encouraging productive investments.

(6) Profit remittance and repatriation of capital

The remittance of profits and repatriation of capital are not subject, in principle, to limitations or restrictions. A foreign partner has the right to transfer its share of foreign currency profit20 in any currency, and on the basis of the official exchange rate (the new commercial rate as from November 1990), without any special approval or authorization. The same applies to the repatriation of assets resulting from the sale of shares to a third party or the liquidation of the venture. Transfers of profits are subject to a 15 percent withholding tax (to be paid in the currency of transfer), but exemptions or abatements are available in cases where a double taxation agreement applies or for ventures located in developing areas or operating in priority sectors.

On the face of it, the regulations governing dividend transfers do not seem particularly restrictive, even considering that the application of the withholding tax results in a double taxation of realized profits. Foreign investors are, however, severely penalized in an indirect manner on at least two counts. First, the possibility of transfer is conditioned by the availability of sufficient convertible currency within the venture, on account of the self-financing principle. When the joint venture fails to generate sufficient convertible currency, the absence of convertibility of the ruble is likely to give rise to “artificial” transactions to improve the self-financing position in convertible currency. Second, “ruble profits” cannot be transferred abroad or, indeed, used for alternative investment within the USSR—thereby reducing the potential profitability of local market based activities.

(7) Investment protection and dispute settlement

Private property has only recently been recognized in the USSR with the approval in March 1990 by the Supreme Soviet of a law establishing the right of private ownership, although the specifics still remain to be determined by the individual republics. Moreover, joint venture decrees prohibit expropriation of joint venture property or confiscation by administrative order. This evident progress notwithstanding, it remains true that domestic legal mechanisms to protect private property have not been fully developed as yet and there continue to exist major uncertainties about the application of the law in a number of important areas.

Disputes between joint ventures and Soviet organizations, among joint ventures, or among partners to a joint venture may be resolved in Soviet courts under Soviet law or by arbitration within the USSR. However, it is also possible for partners in a joint venture to take disputes among themselves to arbitration outside the USSR if agreed by both parties. External arbitration awards are enforceable in the USSR, which is a party to the 1958 New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards.

As far as bilateral investment agreements are concerned, the USSR has negotiated 17 treaties with home countries of potential foreign investors, but none of these has been ratified to date by either the USSR or the other countries involved. In general, these agreements are based on MFN principles and provide guarantees for profit repatriation, full compensation to investors, settlement of disputes and subrogation rights. Consideration is being given to including provisions on improved market access, business facilitation measures, and intellectual property right protection.

The USSR is in the process of establishing the legal and administrative basis for adequately protecting the property of foreign investors and providing for dispute settlement mechanisms. These emerging mechanisms draw credibility from the reputation the USSR has built over the years as a reliable commercial partner in dealings with foreign firms. On the basis of this reputation, there may be a presumption of general intent to protect fully the interests of foreign direct investors. Whether this presumption works out in specific instances will depend on the future development of an adequate legal infrastructure.

b. Reform measures and proposals

A new foreign investment law has long been under consideration in the USSR Supreme Soviet. Moreover, laws dealing with foreign investment issues are also being drafted in individual republics, with the RSFSR being on the verge of adopting a comprehensive legal framework on foreign investment. Of course the fact that several laws are being considered at the same time at both union and republic levels raises the issue of potential legal conflicts. At a minimum there is a clear need to coordinate the provisions of these laws and, more fundamentally, decisions need to be made concerning the allocation of powers in this area among the union, the various republics and the local authorities concerned.

As a matter of principle, a decision to replace earlier decrees with laws would represent a positive development. The legislative process provides an opportunity to make improvements in the rules governing foreign direct investment as well as to build political support for the adoption of a liberal attitude towards foreign investment and for setting conditions in place which could contribute to a more favorable investment climate. Finally, a law provides more stability for the investor than a decree which, as experience shows, can be more easily changed.

Notwithstanding a desire to regulate foreign investment through a comprehensive law, the recently announced reform measures in the foreign investment area have once more taken the form of decrees.21 This being said, they represent a significant step towards reducing barriers to foreign investment and improving the specific legal setting within which foreign investors will operate. The new presidential decree on “Foreign Investment in the USSR” centers on the basic principle of applying national treatment to foreign investors, with exceptions being confined to a limited number of cases to be specified in the law. This implies, inter alia, that foreign investors will be allowed to be established in all legal forms existing in the USSR, viz. not only as joint ventures but also as joint stock companies, partnerships, cooperatives and associations. Moreover, the possibility of making such investment will be open not only to legal entities but to private individuals and international organizations as well.

Under the new decree, wholly-owned subsidiaries of foreign companies will be permitted, as will inward portfolio investment and the acquisition of shareholdings in Soviet enterprises and of financial assets and real property.22 The possibility of operating wholly-owned subsidiaries is of considerable importance for foreign investors in that it provides them with freedom to choose the investment modalities best suited to their particular needs. True, full ownership is by no means an essential condition for all foreign investors, but it can be crucial in certain areas, such as the protection of intellectual property rights in high-technology investments or where the management philosophy of the company (regardless of its activity) requires full control and ownership.

Consideration is being given to establishing a set of “principles” at the union level which would provide the basis for foreign investment legislation to be enacted at republic and local levels. The registration procedures would in principle be the same as those applying to domestic companies. Thus, approval by the branch ministry of a joint venture partner would no longer be required. The specific modalities of the approval process would depend on the size of the company’s initial capital (rub 100 million being the threshold) and on whether the foreign investor has 100 percent ownership. Large wholly-owned subsidiaries would probably need approval by the USSR Council of Ministers, while authorization for smaller ones would be granted by the individual republics. The registration of joint ventures would be delegated to the republics, with small ventures required to register only with local authorities and large ones with the republican ministry of finance. To limit the scope for the establishment of “artificial” joint ventures—i.e., ventures whose primary purposes are to circumvent the existing requirements for setting up a legal representation in the USSR and to obtain tax benefits—new companies with foreign participation would be required to pay in at least 50 percent of the initial capital within one year.

No doubt, the new registration process would provide foreign investors with more flexibility and greater scope for choosing the legal structure of the company, but there would still remain a number of unresolved issues limiting the transparency and predictability of the system being set in place. The most important would seem to be the degree of compatibility and coordination among the various legal provisions and the requirements of republics and territorial entities.23 Another is the absence of a well-defined decision-making process applying to the bodies in charge of granting authorizations and, especially, the lack of an appeal mechanism.

Management and labor provisions have been left largely unchanged in the new decree, which has restated the principles that top management positions are open to foreign citizens and that a company with foreign participation is required to set in place a collective agreement with labor. Similarly, no significant changes have been introduced in the area of incentives but the matter is under review in individual republics.24 On the other hand, the new decree provides explicitly for the right to repatriate dividends and profits, though it makes this right contingent on the specific provisions of Soviet laws—which have not yet been finalized.

The possibility of applying third-country law and arbitration to dispute settlement among joint venture partners, or even with other state organizations if agreed by both parties, has been made more explicit in the various draft laws which, however, do not always incorporate terminology recognized in international law. And the extent to which compensation would be granted in the case of expropriation does not seem to meet fully international adequacy standards.25

4. SUMMARY AND RECOMMENDATIONS

Joint venture activity in the USSR has so far been characterized by two major paradoxes: first, a rapid formation of new joint enterprises has not been reflected in a commensurate volume of foreign investment and, second, the progressive liberalization of policies and legal requirements has not generated any significantly greater interest in doing business in the USSR. The structure and contents of the specific legal regime governing joint ventures are not the primary disincentive to foreign investors. Rather, the main problems stem from the risks and practical difficulties of conducting business under the Soviet system, especially the uncertainties and operational vulnerabilities resulting from the coexistence of what remains of the centralized planning and allocation mechanisms with more market-oriented arrangements for the joint venture sector. Under these circumstances, joint ventures have not been integrated into the Soviet economy and operate to a large extent in quasi-enclaves, specializing in operations where high returns are possible with low levels of capital commitment by exploiting gaps and distortions in the existing system.

The relevance of these considerations is clearly borne out by an analysis of the motivations behind the decision to operate joint ventures. Soviet interest has been driven mainly by regulatory considerations, especially tax and foreign exchange availability, which are strongly favorable to this particular form of corporate establishment. Foreign interest is largely driven by possibilities of exploiting price distortions for (more or less disguised) arbitrage opportunities or foreign investment incentives currently in place. Despite these distortions, it is probable that joint ventures are making an important economic contribution by transferring ideas and skills relevant to “doing business” and diffusing initiatives and expertise. But there is also ample evidence that their contributions to developing the internal market and to exposing local enterprises to competitive conditions are dramatically underrealized.

Notwithstanding the lackluster performance to date, the positive contribution that foreign direct investment can make to the revival and modernization of the Soviet economy should not be underestimated. Its promotion should be seen as part of any program aimed at significantly improving economic conditions. Foreign investors’ involvement in the economy will be critical not only for upgrading productive capacity in terms of capital, technology and managerial skills but, more fundamentally, as a catalyst for instilling a “culture of the market” and for developing the premises for an efficient functioning of the market place by exposing domestic enterprises to competitive influences.

Looking ahead, the prospects for market-driven foreign investment to increase significantly depend crucially on the elimination, or at least sharp attenuation, of the prevailing price and administrative distortions that pervade the Soviet economy. Another indispensable requirement is the establishment of a confidence-promoting legal framework for business activities. Finally, the adoption and implementation of sound, transparent and forward-looking policies are a necessary basis for stimulating investors’ long-term commitments of capital and human resources. In other words, reform in the foreign direct investment area should be seen as an integral element of a broad program aimed at widening the scope for doing business in the USSR. This should include, inter alia, the development of competitive market structures, the introduction of modern commercial law, including the basic elements of contract law, improvements in the provision of infrastructure and financial and business services, and sustained progress towards the convertibility of the ruble—all essential prerequisites that go well beyond the framing of an appropriate foreign investment law.

A global overhaul of the Soviet economic and regulatory system might be based on a three-pronged approach encompassing: (i) the broad constitutional and legal features of the Soviet system; (ii) the economic setting within which foreign investors operate; and (iii) the specific regulatory framework pertaining to foreign investment. The following recommendations are not ranked according to a specific order of priority and many of them should be seen as complementary to, and interacting with, more fundamental reforms aimed at instilling economic rationality in the Soviet system. Although the precise sequencing of these measures depends on the pace of the more basic reforms, both the seriousness of the economic situation and the magnitude of the benefits that would accrue from substantial foreign involvement suggest that action in the foreign investment area should be undertaken on a broad front and without delay.

On the constitutional front, there is a vital need for an unambiguous determination of the status of private sector activity within the emerging legal framework, with a clear allocation of responsibilities to the different levels of government. This involves, inter alia, a resolution of the issue of the primacy of law between the union, the republics and other local authorities in the area of foreign direct investment and a determination of the extent to which an integrated internal market will be maintained in the country. To the extent that foreign direct investment will be regulated under laws emanating from different levels of government, it is imperative to ensure full compatibility among the various rules and regulations. The experience of the recent past shows clearly that legal uncertainties can be highly detrimental to the promotion of investors’ interest in entering the Soviet market. Regulatory compatibility and predictability are to be seen as essential elements for reducing such uncertainties and for confirming the authorities’ resolve to pursue liberalization in the foreign investment field.

A broadly-based and coherent recasting of the legal structure for private sector activities is critical for attracting foreign investors. This involves the establishment of a legal framework adapted to the realities of a market-based economy in areas covering private property, contract law enforcement, competition, bankruptcy, desirable labor relations, and accounting. An issue which calls for particular attention in this regard relates to the introduction of adequate legal provisions enabling foreign investors to mortgage assets and transfer leases as a means for facilitating local and foreign debt financing.

Effective steps should be taken to facilitate the creation of commercial companies and enterprises that could become viable partners in joint ventures with foreign investors and to develop procedures for restructuring ventures when local partners disappear, particularly if this is the result of government reorganizations. The clarification of responsibilities and relations between government bodies and private companies and the establishment of specific legal mechanisms to support and protect private enterprises are to be seen as preconditions for dealing with some of the most important disincentives to foreign investors’ involvement in the Soviet economy.

Foreign investors must be in a position to rely on a more assured source of foreign exchange. To this end, progress towards currency convertibility and a reduction in the existing large distortions between domestic and world prices should be pursued vigorously and as a matter of urgency. In this context, the recent decisions to set in place an auction market for convertible currency open to foreign enterprises, to introduce a more realistic exchange rate for the ruble, and to broaden the scope for profit repatriation are all important steps in the right direction. Further action will, however, be needed to ensure that the auction market is sufficiently liquid to be effectively usable by foreign investors.

Local procurement constraints constitute a major operating obstacle for foreign enterprises and this issue should be tackled as a matter of priority. The rapid development of domestic wholesale markets, the improvement and enhancement of local financial markets, and the liberalization of the foreign trade regime are all indispensable conditions for addressing this issue. While recognizing that liberalization in the trade area would be of major relevance for the proper functioning of the economy as a whole, such action may prove vital in supporting the development of enterprises with foreign participation—whose difficulties in procuring needed inputs on local markets are exacerbated by their lack of access to the state allocation system.

Urgent consideration should be given to liberalizing, streamlining and making more transparent the authorization rules and procedures applying to private foreign investment. If screening is considered necessary during the transition, it should be limited to a “negative list” of sectors where remaining domestic distortions are such that the risk of counter-productive foreign investment is particularly severe. Screening procedures should be based on transparent, clearly-specified and unobtrusive criteria. The sectoral coverage and operational modalities of the screening system should be reviewed periodically with the aim of phasing it out as economic reform proceeds.

Soviet preferences for foreign investment in “productive” rather than services sectors do not conform to the requirements of a modern economy. The social return to investment in services is likely to be high in a large number of areas. Enterprises with foreign participation can play a major role in the promotion of efficient services markets and their contribution should be encouraged through the removal of implicit and explicit impediments to investment in service industries. In this connection, and subject to the screening procedures noted earlier, early consideration should be given to lifting the existing general restrictions on intermediary activities of joint ventures.

A significant improvement in the climate for foreign investment would be achieved through a strengthening and acceleration of the process establishing the legal and administrative basis to provide full investment protection (including protection of intellectual property rights and against expropriation), to guarantee the repatriation of investment income and liquidation proceeds, and to set in place appropriate arbitration and dispute settlement procedures. The process of confidence-building would no doubt be enhanced if such mechanisms and procedures were to conform closely to internationally-agreed principles and understandings and if the USSR were to proceed with ratification of bilateral investment protection treaties and to become a full participant in international organizations providing political risk insurance and dispute resolution.

As a general principle, policies towards foreign direct investment should aim at promoting a level playing field through reliance on the principle of national treatment, whereby foreign investors would not benefit from special incentives relative to domestic investors. Although it is recognized that investment incentives cannot substitute for an appropriate economic and political environment to attract foreign capital, the maintenance of some positive discrimination in favor of foreign investors may be justified under present circumstances as a means of partially offsetting the existing distortions and structural inadequacies of the Soviet system. It is also clear that if, as a transitory device, special incentives in favor of foreign investors are to be maintained, they should be strictly limited in terms of their budgetary implications and time frame.

During the transition to a more rewarding investment environment, there may be considerable scope for mobilizing large-scale foreign investment through the structuring of self-contained direct investment arrangements, such as capital-intensive projects in energy and natural resource exploitation and possibly also in certain segments of the reconverted defense industries. Such arrangements—in which the precise parameters governing the project are fully negotiated in advance—are less dependent than other types of direct investment on the overall reform of the Soviet economy. The potential payoffs to such projects are sufficiently large to both the USSR and foreign participants that means could be found to overcome specific difficulties arising from the lack of appropriate infrastructure and other weaknesses of the present economic system. This being said, it will still be necessary to create an adequate framework for such deals, e.g., by establishing the broad terms for exploration and development in line with general practices. Furthermore, the pursuit of these opportunities should not be seen as an alternative to the fundamental reforms needed to attract foreign direct investment across a wide range of economic sectors.

NOTES

A new form of investment that may be expected to play an increasing role is the purchase of shares by foreigners in existing or new Soviet enterprises or cooperatives. Contract joint ventures—consisting in essence of a joint project between foreign and Soviet partners without ownership interests and obligations in a new entity—may also become more common. And wholly-owned foreign enterprises are permitted by the presidential decree of October 26, 1990.

The analysis in this section draws on two primary sources: the registration records of the Ministry of Finance and data based on reports submitted under law to Goskomstat by joint ventures. At present, joint ventures are required to submit on a regular basis two types of documents: (i) a quarterly accounting form providing details of output (volume of manufactured items and services rendered), labor (number of persons on the payroll and expenditures for wages), exports, imports, and sales on the Soviet market against payments in rubles or foreign exchange; and (ii) an annual report which should include the balance sheet of the joint venture, a profit and loss report, and an appendix covering, inter alia, data on the movement of capital stock, the composition of fixed assets, details on production costs, and selected financial flows. There are a number of deficiencies in both of these primary sources. With regard to the data compiled by the Ministry of Finance, available information is incomplete (records were not available for about 4 percent of registered ventures), some of the key indicators (especially those relating to capital investment) are presented in a potentially misleading form, and the description of sectors of economic activity does not follow a recognized scheme such as the International Standard Industrial Classification (ISIC). No information is currently collected on such items as the actual contribution to the capital stock made by each of the partners, the costing of technology contributed by the foreign partners, the volume of foreign credit granted to the joint venture and related interest payments, and the value of a joint venture’s direct investment in affiliated branches and subsidiaries in the USSR or abroad. Moreover, since the Goskomstat data collection system has been in operation only for a short time, it encompasses information only for the first half of 1990.

Valued at the official exchange rate, the estimate of rub 500 million can be arrived at by considering that the share of foreign investors in the initial capital of joint ventures stood below 50 percent in mid-1990 and that the convertible currency portion of such contributions is unlikely to have exceeded 25 percent. The actual inflow of convertible currency funds into the USSR may have been noticeably lower than the above estimate to the extent that not all “initial” capital has been paid in to date.

Data on “capital contribution” should be treated with caution. First, no distinction is made between a joint venture’s “statutory fund” and actual paid-in capital. According to Soviet officials, in many joint ventures the amount actually paid in is only a small fraction of the initial capital contribution provided for in the “statutory fund.” Second, the valuation of the various components of the “capital contribution” is somewhat arbitrary. Thus, the contribution of the Soviet partner often includes land and building, neither of which have established market prices and, in the case of land, may be highly inflated in view of the fact that the Soviet partner does not have ownership rights to the land. The contribution of the foreign partner may include trademarks, know-how, patents, marketing rights, market access and other intangibles that may be valued at prices intended to allow the parties to reach agreement on percentage ownership rather than through a calculation of intrinsic values. Indeed, according to market estimates, the actual convertible currency contribution is usually of the order of only 20-25 percent of the total foreign contribution. Finally, all contributions of the foreign partner are converted into rubles at the official exchange rate, a valuation which may significantly understate the foreign contribution in terms of rubles.

It should be noted, however, that several large-scale joint ventures in capital-intensive industries are under active negotiations which, if completed, could change significantly the present statistical picture.

These tables are based respectively on ad hoc sectoral classifications used by the Ministry of Finance and Goskomstat.

The assessments in this section are based, inter alia, on replies to a questionnaire addressed to a sample of joint ventures in April 1990, supplemented by interviews conducted subsequently.

These impressions are based on interviews with Western firms that were recently negotiating joint venture or other cooperative agreements in the areas of computer technology and aerospace technology, including composite materials.

Other negotiating issues viewed as important, but not particularly difficult to resolve, include the agreement on business objectives, valuation of contributions, partnership share, protection of intellectual property, financing from Soviet sources, and figuring input and output prices.

Consideration has also been given to using the new law on joint stock companies and the anticipated privatization of Soviet enterprises to create new distribution mechanisms, e.g., whereby a user would buy an ownership share in its suppliers in order to ensure reliable deliveries.

Calculation and distribution of profit is often referred to as a major issue in the context of joint venture accounting. This relates, inter alia, to methodologies concerning recognition of earnings and expenses, depreciation rules, formation of provisions, and the creation of special purpose funds, the use of which is confined to the legally defined purposes and whose distribution to shareholders is prohibited.

The initial legislative basis for the setting up of joint ventures was a decree adopted by the Presidium of the Supreme Soviet of the USSR on January 13, 1987 on “Questions Concerning the Establishment in the Territory of the USSR and Operation of Joint Ventures, International Associations and Organisations with the Participation of Foreign Organisations, Firms and Management Bodies,” supplemented by Decree 49 (January 13, 1987) of the USSR Council of Ministers on “The Order of the Establishment in the Territory of the USSR and Operation of Joint Ventures with the Participation of Soviet Organisations and Firms from Capitalist and Developing Countries.” The decree specified, inter alia, that Soviet partners should retain the majority in the joint venture, that the Chairman of the Board and the general managers had to be Soviet citizens, and that each joint venture would require special authorization by the Council of Ministers. This latter condition was modified by an amendment of September 1987, which delegated the granting of authorization to the relevant sectoral ministries.

In December 1988, a Resolution of the USSR Council of Ministers provided for the abolition of the (49 percent) maximum limit on foreign participation, the opening up of top management positions to foreigners, and the acceptance of the principle that wages could be freely negotiated between management and workers.

In addition to the decrees specifically aimed at them, joint venture activities are affected by the rules and provisions embodied in other legal acts governing economic activity including, in particular, the Law on Property (March 1990), the Law on Enterprises (April 1990), the income tax law (April 1990), the indirect tax law (June 1990), the Local Authorities Act (April 1990) and the decree on joint stock companies (June 1990).

The procedure for the establishment of a joint venture centers on the mandatory registration with the Ministry of Finance. The documentation to be examined by the Ministry includes, inter alia, copies of the agreement and charter of the venture, a statement of consent by the “supervisory agency” (e.g. the branch ministries responsible for the Soviet organizations to be partners in the venture or, in the case of joint ventures set up with the participation by Soviet cooperatives, a specified state government or local authority), the incorporation record of the foreign partner, and a statement by a foreign bank on the financial situation of, and guarantees extended to, the foreign partner. The assessment of the feasibility study, which should cover both the production/sales aspects of the venture and its financial/profit targets, is carried out by the supervisory agency but the study is also subject to examination by the Foreign Investment Division of the Ministry of Finance. In principle, no economic sector is precluded to foreign investors, other than those related to public order and security. Through the registration with the Ministry, which has the power to refuse it if the documentation does not appear to be in compliance with Soviet laws, the joint venture acquires the rights of a legal entity. An additional registration with the Ministry of Foreign Economic Relations is required to acquire the right to carry on an economic activity in the USSR. This latter registration is also a prerequisite for obtaining a blanket approval to make import/export transactions within the scope of the activities listed in the venture agreement and charter.

Only legal foreign and Soviet entities (i.e., state and cooperative enterprises, organizations and associations) are entitled to participate in a joint venture, which may be formed as a limited liability company or as a partnership such as associations, consortia and similar legal entities admitted by Soviet law. At present, no requirement exists for the initial capital of the venture or for a minimum value of foreign investment.

Concerned with the development of practices which tended to exploit the very large distortions between domestic and world prices, the Soviet authorities introduced in 1989 a decree (no. 203) that prohibits the creation of joint ventures for carrying on “intermediary” trade operations and makes all such operations subject to prior authorization by the Ministry of Foreign Economic Relations.

The overall convertible currency debt of joint ventures stood at around rub 1.2 billion at mid-1990.

For the assessment of taxes on profits, joint ventures are divided into two categories. Those with foreign participation of less than 30 percent are subject to the same tax treatment as domestic enterprises (a basic tax rate of 45 percent). Other joint ventures are taxed on the basis of a 30 percent rate, which can be substantially reduced for ventures located in the less developed regions. Thus, joint ventures established in the Far Eastern Economic Region of the USSR are subject to a 10 percent tax rate on profits, with a three-year tax holiday. Currently there are no provisions for tax relief for losses, but the possibility of loss carry forward is contemplated in the new tax law and the Ministry of Finance has the right to grant tax reductions (or a tax-exempt status) to joint ventures operating in certain priority sectors (e.g., agriculture, medical equipment, high-technology products) or for companies set up in the context of special deals. Reportedly, no such exemption has been granted so far. According to the tax law adopted on June 14, 1990, joint ventures registered January 1, 1991 will be entitled to a tax holiday only if they engage in production and provided that the foreign partner’s participation is at least 30 percent. The tax holiday would not apply to ventures engaged in oil or other mineral extraction.

Taxable profits are assessed on the basis of the surplus of earnings over production costs after deduction for imputations to the reserve and development funds. Profit allocations to the reserve fund must be made until it reaches 25 percent of statutory capital, the annual amount of the allocation being stipulated in the charter of the joint venture. The after-tax profits are allocated to the Soviet and foreign partners according to their respective shares in the venture’s capital.

Two Presidential decrees were issued on October 26, 1990 which have direct relevance for foreign investment in the USSR. The first concerns the conditions for the establishment of foreign enterprises in the USSR and the scope for investment in the country by nonresidents. The second sets a new commercial rate for the ruble (which can also be used for the valuation of new foreign investment) and provides for the establishment of a new auction system for trading foreign currencies, which will be open to participation by Soviet and foreign enterprises.

Nonresidents will not be allowed to purchase land but they will be entitled to acquire long-term leases.

Thus, the draft law of the RSFSR stipulates that companies with foreign participation of 50 percent or more should register with the republic’s ministry of finance in accordance with the law on joint stock companies, while the registration of other companies should take place with the relevant local authority. Decisions on an application for registration must be made within 90 days and if approval is not granted, the reason for rejection must be given.

The draft law of the RSFSR contains provisions for special tax breaks linked to the share of foreign ownership. Thus, if foreign investment exceeds US$0.5 million or 20 percent of the equity capital, 20 percent of the tax base is exempt for 20 years; if foreign investment exceeds US$1 million or 30 percent of the equity capital, 20 percent of the tax base is exempt for the first five years and 40 percent for the following five years; in the case of investment in sectors specified in the law, there is a tax holiday for the first five years and 60 percent of the tax base is exempt for the following five years.

In a number of areas, the draft Russian law contains specific provisions. Companies with foreign participation may use the accounting standards of the RSFSR or those of the home country of the foreign investor. Protection of the rights of foreign investors with regard to intellectual property is explicitly recognized and made subject to detailed provisions. The possibility of nationalization or expropriation is retained but investors are guaranteed compensation on the basis of the damages that may result from such measures. Compensation should be paid within two months, in the currency of the original investment.

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