Foreign Direct Investment: Does the Rule of Law Matter?

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Foreign Direct Investment: Does the Rule of Law Matter?
By John Hewko

An extensive overhaul of a country뭩 legislative and institutional framework is generally not a necessary precondition for the postcommunist countries of Eastern Europe and the former Soviet Union to attract direct investment from large, multinational investors (although certain changes are generally required to retain such investment) or from smaller, entrepreneurial investors. A significantly more important factor for investors is the existence of genuine business opportunities.

The conventional wisdom within the international development community is that a transparent, modern, Western legal system is a prerequisite for foreign investors to venture into host states. The logic of this argument derives from a neo-institutional theory of the behavior of economic actors, which maintains that efficient and transparent legal systems reduce their transaction costs, including those of foreign investors. Thus because transaction costs increase the costs of direct investment, foreign investors should be averse to investing in countries with higher transaction costs, and will therefore gravitate toward states with more effective or efficient legal regimes.

Based on this assumption, governments, multilateral institutions, development agencies, and various NGOs have expended considerable resources on legal and judicial reform programs throughout the transitional and developing world in the belief that countries could implement legal reforms and establish the rule of law in relatively short order, and in the hope that once they had completed the reform process, foreign direct investment (FDI) would finally begin to flow.

The Devil뭩 in the Details

The experience of most postcommunist societies, however, demonstrates that legislative and institutional reform is an organic process not conducive to easy or quick solutions. Genuine reform requires that a new legal culture be developed and ingrained in a society, which takes considerable time뾱everal generations뾞nd effort. Unfortunately, many of the early, ambitious international development programs to, for example, "reform country X뭩 judiciary in three years," often did not appreciate the long-term nature of legal reform. Consequently, they were doomed to fail. They produced an avalanche of reviews, studies, reports, recommendations, and other beautifully produced "deliverables" that host states often did not implement. The programs created false expectations and gave rise to an entire cottage industry of NGOs, consultants, and government advisors with noble aims, but often with few results to show for their efforts.

An extensive overhaul of a country뭩 legislative and institutional framework is generally not a necessary precondition for attracting direct investment from large, multinational investors (although retaining such investment generally requires certain changes) or from smaller, entrepreneurial investors. Significantly more important factors for investors are the existence of real business opportunities, the potential for high returns, the risk of expropriation, the ability to repatriate profits, the existing tax regimes, and an often superficial "feel" about the host country.

The annual flow of foreign investment to the transition economies reached $5 billion in 1993 and increased to $11 billion in 1995 and $19 billion in 1997, well before the European Bank for Reconstruction and Development had granted many of these countries higher scores on its legal reform scale. Clearly the factor enticing foreign investors could not have been the legal systems in the postcommunist countries: in the early 1990s their laws and legal institutions were generally incapable of addressing the many issues that arise in a market-based economic system. Rather, early investors were drawn to these countries by their large, untapped markets; highly educated, yet inexpensive, labor pool; and tremendous natural resources.

Real Barriers

A common complaint among investors in those countries that were least successful in attracting FDI was that there was no one in a position of authority to take decisions. Nothing exasperates investors more than the need to shuffle from ministry to ministry or to negotiate a seemingly endless bureaucratic maze where everyone and no one is in a position to resolve issues or grant approvals. As a result, an ideal legal system is not nearly as important as the existence of a clear, consistent, and unambiguous decisionmaking process.

In countries such as Russia, the onerous tax regime and inadequate accounting standards and practices served as a much greater source of investment disincentive than the lack of an ideal legal system. Anecdotal evidence from Russia indicates that most foreign investors consider the recent tax reforms instituted under the Putin administration (for example, lowering personal and corporate tax rates, decreasing social insurance contributions, and phasing out turnover taxes) as the single most important action taken to encourage foreign investment in that country.

Legislative reform efforts should emphasize the details, not the general concepts, and the specific, very often mundane, changes that need to made for existing legislation to function within the cultural, political, and economic realities of the host countries. The international development community has traditionally focused on large, general concepts, with calls to modernize bankruptcy legislation, eliminate corruption, and establish an efficient and rule-based judiciary This approach is misplaced. When faced with an attractive business opportunity most foreign investors are prepared to accept the inadequacy of postcommunist countries?legislation and legal systems.

This is especially true with respect to legislative reform and foreign investment. Once foreign investors take the leap of faith and make an investment, they are generally not concerned about corruption in general or the need for legal reform in the abstract. Rather, they focus on how specific aspects of the law and of the legal system affect their particular business, not on the fact that the ambiguity of a single word in an existing piece of legislation puts the legality of their proposed transaction at risk or that official X at window Y at ministry Z requires a bribe to issue a routine permit. As a result, most foreign investors who have committed resources to a given country are prepared to accept that, in general terms, the legislation and legal system are inadequate. They are also prepared to accept that a given piece of legislation does not fully conform to an ideal standard. Their concerns tend to center around a short list of specific complaints about the one piece of legislation or regulation that, if rectified, would greatly facilitate the success and continued viability of their investment.

Unfortunately, many investor surveys carried out by the development community tend to focus on broad areas of concern: Is the current bankruptcy law effective? Do the courts enforce contract rights effectively? Is the pledge law incomplete? Is the failure to enforce laws consistently, expeditiously, and impartially a concern? When faced with these sorts of general questions most foreign investors will tend to respond that the situation needs improvement. Naturally they would prefer a better bankruptcy law or commercial code or favor improved enforcement mechanisms. Who would not? However, understanding what concerns foreign investors in general terms is not particularly relevant. What is important is to isolate specific legislative provisions that need to be amended, and this can only be done by providing the legal and accounting advisors of foreign investors active in the country with extremely detailed survey questionnaires that delve to the level of specific problematic clauses of specific laws.

New Approach Needed

Foreign investors and their advisors are much better suited to identify the exact changes needed in the legislative framework to facilitate FDI than a guru flying in for a weekend of diagnostic analysis. Foreign investors are a dynamic force in the forefront of the push for change and agents for such reform. This is particularly true in such areas as training personnel and reforming the legal and accounting professions. Serious foreign investors, largely multinational firms, play a vital role in training and educating individuals and in developing a cadre of citizens who understand and accept those practices and concepts that are critical to creating a civil society and respect the rule of law. Foreign investors are also effective in providing training and transferring know-how and play a role in civil service and judicial reforms.

The development community should address this situation by channeling funds into long-term and sustained programs for training young locals as a matter of priority. Thousands of a given country뭩 best and brightest university graduates should be sent to the West for one- and two-year graduate study programs (but be required to return). One shudders at the thought of how many young graduates could have been trained with the millions the development community has spent on feasibility studies, diagnostic reports, foreign consultants, and traveling delegations. The development community should also work on creative mechanisms to harness the tremendous training capability of the private sector and to use it more fully. As noted earlier, foreign investment plays a significant role in creating demand for reform of legislation and enforcement institutions, something that the literature and international institutions seem largely to have ignored.

Thus a fundamental shift in how the international development community views certain aspects of legal reform in postcommunist countries is required, particularly in the area of commercial legislation and regulations. The community should shift away from a process almost exclusively driven and created by multilateral organizations and NGOs to one that recognizes and expands the role of the private sector. Working with host countries, this new approach would establish a more direct and meaningful dialogue with foreign investors, perhaps through each country뭩 chamber of commerce; focus on specific investor concerns within the framework of existing legislation; and recognize that legislative reform is a long and tedious process subject to a continuous cycle of incremental change and trial and error.

John Hewko is a partner in the law firm of Baker & McKenzie, and has spent the last 12 years practicing law in Moscow, Kiev, and most recently, Prague. He is currently a visiting scholar at the Carnegie Endowment for International Peace. This article is a shortened version of the original Carnegie Endowment Working Paper, no. 26.