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Investment and the FTA

April 15th, 2004

At least one reader has asked for my views on the investment aspects of the proposed FTA between Australia and the US. The provisions aren’t that extensive. It appears that the threshold for Foreign Investment Review Board review will be raised, but this will have little direct impact since hardly any proposals are rejected.

The main issue is the “standstill” approach central to the agreement, which allows for the creation of new rights for investors in future, but makes it almost impossible to withdraw rights that have already been granted. This raises the possibility that some future agreement will create a right of foreign investors to seek ‘review’ of decisions they allege to be discriminatory against them. This provision, embodied in NAFTA and the aborted Multilateral Agreement on Investment is said to be justified on ‘level playing field’ grounds, but actually produces discrimination in favour of foreign investors, since domestic enterprises have no comparable rights.

This is a good time to comment on the more general issue of capital market liberalisation, particularly with respect to takeovers. There’s no evidence that the market for takeovers produces anything remotely related to an economically or socially beneficial outcome in general, let alone in the case of international takeovers[1].

Apart from the general evidence that takeovers are primarily exercises in rent-seeking by the management concerned, there’s the specific problem of the branch-office economy, which I’ve discussed at length. Again for rent-seeking reasons, takeovers typically lead to head offices being relocated in centres such as New York and London, to the benefit of managers and the detriment of both shareholders and the Australian economy. There is no reason to expect benefits from further deregulation of capital markets and especially not from “standstill” commitments that prevent us from ever learning and implementing the lessons of the 1980s and 1990s.

fn1. The most prominent piece of evidence in the Australian debate has been a Centre for Independent Studies paper Bishop, S., Dodd, P., and Officer, R.R. (1987) Takeovers: The Australian Evidence. Sydney, Australia: Centre for Independent Studies. This study found a lot of positive effects from takeovers and is still widely cited. Those who take the trouble to read the original study will find that the main agents of these beneficial takeovers were such contributors to economic efficiency as John Elliott, Alan Bond and Christopher Skase.

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  1. Brian Bahnisch
    May 4th, 2004 at 11:24 | #1

    That’s fine, Harry, no argument from me. As a disclosure I should have said I own some Nat Bank, CSR (and Rinker), Fosters, PaperlinX and Amcor and did in the past own Boral, Westfield and Lend Lease. I got out of the last two just after S11 as a precautionary measure. I decided at that time to stay out of all companies involved with overseas property (where people congregate), infrastructure and insurance. Now regret selling Westfield.

    Your point about paying too much is only too true and specifically true of Fosters and probably Amcor and PaperlinX. It’s the norm, unfortunately, which is why investors immediately mark down companies when they launch takeovers.

    WA News is an interesting example as they won’t buy unless it is earnings per share positive, which means they haven’t bought.

  2. Harry Clarke
    May 4th, 2004 at 13:10 | #2

    Brian, I like the idea of new trade theory (and the Linder argument) that a business knows its own local market best and so should get that right and then branch out by selling products (or in the present context buying assets) in related markets that it understands. It must enjoy enough economies of scope or scale arguments (or enough traditional advantage from better factor endowments) to offset the informational disadvantages of operating in foreign markets. Hence there should be an inbuilt bias or conservatism against buying out foreign businesses — at least firms should take care.

    But the standard story in management-controlled Aussi companies is the line ‘we have run out of expansion options in the local market so lets take on the world’. The BHP and AMP debacles an instance of this. Give income back to shareholders if expansion options are limited.

    The bias favouring overseas expansions is an agency problem in management-controlled firms.

  3. Brian Bahnisch
    May 9th, 2004 at 23:19 | #3

    Harry, there is another theory, isn’t there, of early globalisers. I imagine this works, where by nature of the business, the local market is a global market.

    One thinks of high tech in this regard, but I can’t think of any good examples. One example perhaps is Flight Centre. I know that started with a bunch of people renting a second hand double-decker bus in London and touring the Continent. Thence to Top-deck Travel. But when he started out to globalise I don’t think it was because he had saturated the local market, was it?

    Firms like Amcor and PaperlinX tend to be price takers operating in cyclical markets. I think the strategy is to become world market leaders operating in diverse markets to give them more stability and control of their destiny. Amcor is now said to be no 3 in the world. If it works and leads to long-term growth, then a few years marking time while getting set is OK with me.

  4. Harry Clarke
    April 16th, 2004 at 09:21 | #4

    I think the evidence on takeovers, if anything suggests that shareholders in target firms derive advantage from a takeover while shareholders in the purchasing firm lose. Thus foreign purchases of Australian firms on balance might be expected to benefit Australians at least from this perspective even if the losses overall outweigh the gains. (Gains to Australians here ignore the branch-office effects that you mention — I assume these refer to loss of national focus and consequent efficiency losses — any evidence for these?).

    The gains mentioned here are in addition to the advantageous effect of a capital inflow in increasing the value of complementary Australian inputs such as labour and resources — these arise even if a takeover occurs rather than portfolio investment.

    Their are exceptions to this general argument — the BHP/Billiton merger fleeced Australian shareholders well and truely but I think promotion of this silly merger reflected long-standing incompetencies in the BHP boardroom.

    I think the problem for Australia is often capital outflows rather than inflows. Takeovers of foreign businesses by Australian firms have often (usually?) been highly disadvantageous for Australia.

    I agree that standard theory suggests that takeovers are mainly motivated by managers pursuing private gains and that it is only the relatively few takeovers that pursue economies of scope or scale that do increase the social advantage. Finance economists often ignore basic production economics.

  5. April 16th, 2004 at 09:56 | #5

    Relaxing foreign investment rules could be expected to increase foreign investment – and if this isn’t offset by reduced domestic savings (unlikely) then this will have a benefit.

    Also, the fact that few are rejected doesn’t mean the previous restrictions were not having an effect on investment behaviour.

  6. Harry Clarke
    April 28th, 2004 at 23:37 | #6

    John H. does it matter a hoot whether reduced local savings occurs? This just means foreign capitalists have lower rates of time preference than locals so a deal gets done: Foreign debt gets substituted for local savings. Capital inflows almost never a problem. Those Yanks and Brits smart and yeah we like the sunshine.

    Capital outflows — now I am worried. Local entrepreneurs with limited imagination seem to have an irrepressible desire to ‘take on the world’ (‘our market so limited’ and could we ever give the money back to shareholders?’) so Australians get burnt. Boral, Pioneer Concrete, Natbank, BHP-Billiton the list goes on.

    We should have a capital exports review board not a foreign investment review board.

  7. Harry Clarke
    April 28th, 2004 at 23:37 | #7

    John H. does it matter a hoot whether reduced local savings occurs? This just means foreign capitalists have lower rates of time preference than locals so a deal gets done: Foreign debt gets substituted for local savings. Capital inflows almost never a problem. Those Yanks and Brits smart and yeah we like the sunshine.

    Capital outflows — now I am worried. Local entrepreneurs with limited imagination seem to have an irrepressible desire to ‘take on the world’ (‘our market so limited’ and could we ever give the money back to shareholders?’) so Australians get burnt. Boral, Pioneer Concrete, Natbank, BHP-Billiton the list goes on.

    We should have a capital exports review board not a foreign investment review board.

  8. April 29th, 2004 at 13:12 | #8

    HC – this comes back to the point I raised earlier, that the foreign investment is in some proportion not real but only a wealth transfer, because of the US$ being a fiat reserve currency. While the effect is small it is material because it is cumulative.

  9. Harry Clarke
    April 29th, 2004 at 13:46 | #9

    I am not sure about this PML. Are you talking about US purchases of Australian assets? So, for example, we end up holding $10m of US dollars and Americans hold claims on Australian assets worth $10m US that were previously Australian-owned. Where is the wealth transfer? For example Australian investors could use their $10m to buy stock in IBM. I am missing something.

  10. April 29th, 2004 at 20:08 | #10

    As I read it, whenever any government issues “extra” currency, that surplus causes a wealth transfer to it. Generally, the end result is inflation, which shows where the wealth got transferred from (with exceptions for real economic growth that required more money supply).

    With a reserve currency, some of that inflation gets “exported”. That’s no great problem, though it is unjust. Problems come in when “investment” happens in places like Australia. In proportion as it is only printed money, it isn’t the symbolic analogue of a real flow of resources.

    That’s where the gap is. The US$ get depreciated before the US investors get them (or Koreans, or whoever). They are not the beneficiaries; they are playing straight. But the holdings Australians are left with have been depreciated (and there are quirks of tax law too, though they don’t affect the principle). The accounting eventually sorts itself out as Australian wealth transfers going to US government spending, via middlemen. Unfortunately other countries’ middlemen are better placed to get a good deal by providing the initial services to the US government, and the end of the chain causes a small but cumulative wealth transfer.

    It’s a bit like the method Marx had in mind for debauching the currency as part of a transition to communism, and there are also many historical precedents. It always takes having a strategic hold on others’ economies; this time, that comes from having a reserve currency.

    I just offered an article on this aspect to News Weekly. I’ll paste it in below for info, reserving copyright etc.

    A SLOW LEAK IN THE FREE TRADE AGREEMENT – P.M.Lawrence

    There’s more than trade in the free trade agreement. One thing that doesn’t
    look important is the way it opens up Australia to US investment. Yes, not a
    lot of that gets knocked back even now – but now the fire doors are jammed
    open.

    The investment side of the agreement looks symmetrical and even handed, unlike
    much of the rest. There’s a catch, to do with the way the US dollar is both a
    “reserve currency” and a “fiat currency”. That means the USA can print as much
    as it likes and until the music stops other countries have to keep taking it.

    It’s easiest to understand how theory fails from history. Here’s how it was
    supposed to work.

    A century ago Britain had a reserve currency that was good as gold. British
    investors invested abroad, ending up owning Argentinian railways. This caused
    much ill will as Argentinians saw themselves paying dividends and interest all
    the time, but that was just a wrong perception. The railways had also got
    built, using British skills and materials that came in. Not only were payments
    going out, local people were benefitting from new jobs and trade.

    Here’s how the theory goes wrong.

    In North Africa the French rigged the rules so that rates of exchange favoured
    outsiders, not just in Algeria which they ruled directly but in Morocco and
    Tunisia too. That helped French settlers go in and – this is the key point -
    buy land and start their own businesses at cheap prices. They even coined a
    term for it, “peaceful penetration”. You could use funny money for long term
    gains.

    The French got the idea in the revolutionary period. They started out ripping
    themselves off, just printing their own money. But then they did a subtler
    variant in occupied countries like northern Italy and Holland and what is now
    Belgium: they “evacuated” goods and gold money with occupation money by
    letting rich locals use it to buy up local land and businesses. The occupiers
    got short term gains and the middlemen got long term gains. Everybody else
    lost.

    In both world wars the Germans returned the favour, in occupied Belgium from
    1914 to 1918 and in France as well from 1940 to 1944. That even let them get
    advantage from North Africa through the French presence, without ever needing
    to occupy it.

    It is clearest in Java. The British had occupied it during the Napoleonic
    Wars, and organised things on a more businesslike basis. When the Dutch got it
    back they introduced the “culture” or “cultivation” system, to turn the whole
    place into a cash crop plantation that ran itself for them. They required
    villagers to set aside a proportion of land for cash crops instead of
    subsistence, and they organised middlemen to collect and process these crops.
    They paid for the investment with a new issue of depreciated coinage. In
    proportion to the depreciation, the locals were really paying for it all
    themselves – and, since the new arrangements were permanent and a going
    concern, the funny money never came home to roost as a currency collapse.

    To return to the present. During the 1960s the USA practically paid for the
    Vietnam War by deficit finance, and the reserve currency side of things meant
    that inflation could be exported. With investment abroad the trick is
    sustainable, just like the way revolutionary France tapped into middlemen.

    Here’s what is beginning to happen. The USA prints dollars. Outsiders keep
    taking them since they know they can eventually get a return. Sometimes the
    dollars go into “investment” abroad; in proportion as they were only printed,
    that doesn’t bring in real things to build up production, it just transfers
    existing capacity in exchange for paper. Eventually the buck does stop and go
    back to the USA, but by then it doesn’t buy so much and the US middlemen are
    there to pay tax to cover the returning dollars from their dividends. Just as
    in Java, the locals end up paying for it all and never do get any real funds
    coming in to build up capacity to pay them back – and we are those locals
    today.

    It’s only a slow leak. Just as in Java, this only happens to a proportion of
    the “investment”. But unlike Java, where the copper coinage could only be
    watered down as a one off, it goes on all the time. We have a permanent slow
    leak, and in the end that small proportion will add up to more than 100% of
    what we have now as we sell the farm in small increments. In the not too
    distant future we will bleed out unless we do something.

  11. Harry Clarke
    April 29th, 2004 at 23:27 | #11

    PML I get it and I think you are right. When a government transfers fiat money for goods or assets it gets a real transfer and if the money depreciates in value with inflation this further effectively imposes a tax on holders of the money. And in so far as these dollars are transferred to Australians they bear the cost of the transfer and the inflation tax.

    But Australians who fear either effect can offset the seigniorage by purchasing US denominated assets. To the extent that people around the world guard against such ripoffs there won’t be much of a transfer.

  12. April 30th, 2004 at 14:05 | #12

    HC, the problem with that is the asymmetry from the USA’s strategic leverage. If you look at Brad de Long’s site http://www.j-bradford-delong.net you will see he is musing about why the US$ is overvalued compared with what it should be for a straightforward rectification of its trade imbalance over the medium term or so. I believe the markets are factoring this effect in too.

    Anyhow, the remedy you suggest is impractical, although of course we would be far better off if we improved our savings rates. Then we could be the middlemen, ripping off other countries. Of course, it would be more ethical to stop this sort of leak across the board, get the US$ to work the way sterling did a century ago, but that’s not our option.

    To summarise, your solution would work if we had it but it would be impractical domestically and it would merely shift the damage to yet other countries.

  13. Brian Bahnisch
    May 3rd, 2004 at 23:17 | #13

    Harry, back up in your second comment you mentioned companies that had not done well overseas eg “Boral, Pioneer Concrete, Natbank, BHP-Billiton”.

    I thought you were a bit unfair. There is a long list that have done well, some of them outstandingly. Start with Westfield and Newscorp. Think of Leighton in Asia, CSR in the US, James Hardie, CSL, Lend Lease (moving ahead quite well after an initial stumble), Fosters (especially in wine), Amcor, PaperlinX and not forgetting Flight Centre.

    Boral had crook management for many years, but the current demerged version seems to be going OK with good results in the US and Asia.

    Don’t know Pioneer well, but I remember an article shortly before it was taken over saying that it wqas making money in 25 countries, but not Australia.

    BHP seems to be finally sorted and moving ahead nicely. NAB is still on a growth trajectory, but you’re right, o’seas has been a disaster and is still a headache.

    I think the 1980s entrepreneurs gave us a bad name, but the current performance is not so bad.

  14. Harry Clarke
    May 4th, 2004 at 02:54 | #14

    Lend Lease, NatBank at best mixed overseas success stories and BHP’s involvements in overseas oil, copper probably involved some of the biggest losses ever incurred by an Aussi company. Fosters I think paid too much for its wine properties (time will tell but it bought at the market peak) and its ventures in China didn’t go well so I am happy to stick with my statements on these. Amcor and Paperlinx also early to tell but note poor recent profit performance.

    But, Brian, your general point is true there have been success stories overseas — Newscorp obviously. I just think Aussi entrepreneurs ‘often’ (I should have used that qualifier) pay too much for foreign assets. And no I am not opposed to Australian economies expanding overseas on the basis of economies of scope and scale.

    My general point was a response to John Q that we place inordinate emphasis on capital inflows. In management-controlled businesses where the emphasis is on being big rather than profitable we should also watch for silly capital exports.

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