Direct Investment: Create the Conditions Instead of Chasing Investors

On direct investment and how to attract it

Kazakhstan's resource-based economic model is coming to an end. We have already used up the head start it gave us. Growth from the resource sector will be limited from here on, and in that sector we need to create conditions that will at least keep output at its current level. That is why developing the non-resource sector has become an urgent question for Kazakhstan.

Unfortunately, Kazakhstan has neither the industrial base nor the scientific environment to develop competitive domestic production of its own. The only way forward is therefore development through foreign companies.

The main task, accordingly, is to attract foreign capital into the country to produce goods, works and services.

As I have written before, an investor will come to Kazakhstan only in those industries where the ratio of profit to risk is acceptable. Unfortunately, an analysis of profitability shows that non-resource industry here is not among the profitable sectors (around 7%). The most profitable sectors are the resource sector and telecommunications. The sale of Kcell is an example.

As a result, given the high risks in Kazakhstan, a foreign investor goes only into projects where the risk is zero or close to it.

The driver of foreign investment today is the Government, in particular the Ministry of Industry and New Technologies (MINT) and all its agencies.

Now let us take a brief look at what could bring foreign investors to Kazakhstan without gray schemes (more on these below):

1. A strong domestic market. We do not qualify, because our population is small and our territory is vast.

2. Cheap labor. Unfortunately, living standards in Kazakhstan are such that we do not have cheap labor.

3. A favorable business environment for export production. We do not yet have one (corruption, bureaucracy, a low level of education, and so on).

4. Preferential taxation. Kazakhstan's tax burden is fairly low, but corruption, tax administration, ambiguous readings of tax law and poor judicial arbitration destroy this advantage.

Of the factors above, Kazakhstan is able to change and improve the last two.

Of course, a great deal of work is being done on these last two points. But in my opinion, the measures being taken are unsystematic. They aim at patching holes through administrative pressure and manual control.

Accordingly, the Government is expected to deliver results and is allocating large sums to finance foreign projects, mainly through quasi-public companies, including the development institutions that belong to Baiterek holding.

This is certainly necessary and should be part of the picture, but it should not be the driver of investment attraction.

Let me now give a hypothetical example of the terms on which foreign investors come to us (or will come).

Suppose a state-owned company approaches a global industry leader and proposes that it build a hydropower plant.

The following participants are needed:

1. The customer, the project owner. As a rule this is a joint venture with the foreign company the state-owned company has approached.

2. The EPC contractor, which supplies the equipment, builds the plant (in most cases on a turnkey basis) and brings the project into operation. In our case it will be the same company we approached, which will be our partner in the joint venture.

3. The lender: a state development institution, or a lender that extends credit against state guarantees.

On complex projects we have no construction experience, and we cannot verify whether the equipment and construction the foreign company offers are really worth what it says. In this case all we can do is trust.

What actually happens? To the foreign company, we are a developing country with high risks, one that has come looking for technology and needs to spend state money to boost the economy. It has been asked at the political level to take part in the project. We lack all four factors, so the company needs to arrange things so that it makes money and bears no risk.

The classic project finance scheme is 20% equity and 80% debt. Since this is a joint venture, the foreign company's exposure is 10% of the project's cost, its share of the investment. But it also wants to earn money on selling the equipment. The standard markup is 30% of cost. What will the foreign company do?

It will add a 30% margin to cost and then increase the whole amount by a further 10%. That gives a margin of 43%. Our analysts and credit officers lack the skills and the means to verify the project's cost, and with constant deadline pressure they lack the time too (results have to be shown, after all).

The foreign company agrees to the joint venture and contributes its 10%, which it then pays back to itself. It receives state loan financing, builds the plant, launches it and collects all the money. Its risk is zero, its margin on the deal is 30%, and what we get is a plant that is not competitive because it costs 43% more than a comparable one. Everyone is happy: the investor, the customer, and the state money has been spent. Admittedly, the happiness does not last long, only as long as the money holds out and, perhaps, as long as state orders and limited domestic demand last (given our population size and the presence of Russia and Belarus).

This is what I call a gray scheme. And this is exactly how we will look in investors' eyes: a rich country begging for technology to carry out government tasks.

Clearly, such an approach is doomed to constant problems in the long term, especially given that China and Russia, which have technologies of their own, are right next door.

What is to be done?

The main task should not be to chase investors. It should be to create conditions in which investors come to us on their own.

This requires systemic measures:

1. Establishing independent and transparent courts and arbitration bodies

2. Simplifying state bureaucracy

3. Fully reviewing tax and other legislation to eliminate ambiguous interpretations of the law, or publishing official interpretations of the law that have legal force

4. Simplifying tax administration

5. Creating a properly functioning stock market and securities market

6. Creating a transparent audit system in the country and reviewing the requirement to use it, for example by making audit mandatory for all large and medium-sized businesses

7. Easing procedural restrictions on banks (a separate topic)

8. Developing financing instruments further. This list of systemic areas could be extended to education, science, PPPs and so on.

This, in brief, is the idea we set out in our article in Expert magazine.