General

In developing countries, the trend is that both inflows and outflows rose in 2005 although trends varied by regions. According to the study conducted by the UN, inflows into and outflows from Latin America and the Caribbean and West Asia rose in 2005. But, only inflows rose in Africa and East, south and South- East Asia in the same year. West Asia underscored both inward and outward.

Africa

In Africa, rising corporate profits and high commodity prices helped boost inflows in 2005 to $ 31 billion from 17$ billion in 2004. However, the region’s share of global FDI remained at around 3%. The inflows concentrated in mining, in particular oil and gas, although there was also investment in services from the United Kingdom, the United States, South Africa, China, Brazil and India.

With respect to manufacturing, low skill labour, fragmented markets and lack of diversification inhibited FDI in Africa.

South Africa, Egypt, Nigeria, Morocco and Sudan accounted for 66% of the region’s FDI inflows in descending order of value of FDI in 2005. Investment from China and other Asian economies increased particularly in the oil and telecom industries.

FDI inflows into East Africa fell to $ 1.7 billion from $ 1.9 billion in 2004, which represented only 5% of the inflows to Africa. Two factors are pointed out as reasons for the decline in the inflow of FDI in East Africa. These concern the fact that the sub-region is poor in resources, and there is a political instability. As a resul,t the inflow of FDI into Ethiopia, Kenya, Madagascar and Mozambique declined in 2005. On the other hand Uganda attracted more FDI due to its continued macro economic and political stability.

With regard to out flow FDI in 2005, Africa’s share fell by 44% to $ 1.1 billion from $ 1.9 billion. This comprises only 0.1% of the world FDI outflow and only 0.9% of developing countries out flows. In 2005, Nigeria, Liberia, Morocco, the Libyan Arab Jamahiriya, Egypt and South Africa were the top six countries in out ward flow FDI, accounting for 81% the region’s outflows.

Sectorial trends

The trend shows that the FDI inflows to Africa in 2005 were tilted towards primary production, particularly oil. It also shows an increase in service sector, especially in banking. Algeria (55%,) Egypt (37%,) Nigeria (80%) and Sudan (90%) attracted FDI in oil production.

Policy Developments

African countries continued to liberalize their investment environments. Most of the African countries made their environment favourable to investment although some of them made the environment less favourable. In addition, the trend towards privatization continued across Africa. African countries also attempted to change the investment climate. Countries like Egypt, Ghana, Senegal and South Africa have reformed their tax systems, and as a result they often reduced corporate income taxes. In addition, some have ensued operational conditions for TNCs. For instance, Egypt has been facilitating the entry and residence of foreigners.

Further, some countries such as Ghana, and Mali have reformed their admission procedures by introducing one-stop shops, having recognized that an investor-friendly admission phase has a beneficial effect on the subsequent  relationship between the host and the investor. Some other countries also acted to remove some of the key constraints in attracting and benefiting from FDI. South Africa, for instance, has introduced a Skills Support Programme (SSP) to enhance the supply of skilled labour.

Some policy changes have also been made with respect to regulatory framework less favourable to FDI in the extractive industries. For example, the Central African Republic introduced an indefinite suspension of the issuance of new gold and diamond mining permits and banned foreigners from entering mining zones. Zimbabwe continued its indigenization program by requiring all foreign- owned mining companies to sell a 30% stake to local businesses within a 10-year period.

African countries concluded bilateral investment treaties to regulate investment.

India: A Successful Developing Country in Investment

Since 1991, India has opened its doors to foreign investment. Prior to the implementation of the 1991 Indian economic policy, foreign investment was allowed on a case-by-case basis. However, now the Indian Industrial Policy liberalized the internal licensing requirements for business and retained only minimum procedural formalities. The policy removed restrictions on investment and it facilitated easy access to foreign technology and foreign direct investment.

The Industrial policy of 1991 was aimed at avoiding the red tape and corruption in the bureaucracy, and liberating Indian business. The policy has resulted in increasing income and improving the living standards of Indian residents over the last decade.

Labour-The local employment population is another great benefit for investment in India in addition to the liberal investment policy. India is one of “the largest domestic markets in the world and it has a large labour force available at relatively low cost”. India has very educated workers especially in the area of engineering and science. The country welcomes approximately 200,000 new engineers per year. India offers investors higher  potential rate of return than any country in the computer software sector. The people are fluent in the global language English, which offers an advantage for foreign investors in the country.  The Indian labour has a generally favourable attitude towards foreign investment. What is more, foreign investors could employ foreigners since the Indian investment law does not prohibit doing that.

Despite the fact that India offers educated workers, investors faced delays due to Indian workers failure to understand what they are expected to perform. The reason is believed to be that Indian workers are not being onsite. In addition to delays, there are also hidden costs associated with outsourcing jobs to India. As a result, investors have been forced to expend more money and hence, many companies could actively look for places cheaper than India, such as Argentina and Colombia.

Tax treatment- India has also made changes to its tax law with a view to increasing foreign investment. As a result, the rate of import duties for capital goods has been greatly reduced.

Investing in developing countries abroad

Foreign investors are encouraged by several factors to invest abroad in general and in a developing country in particular. There are also factors that pull investors to invest abroad. These factors may be categorized as pull factors and push factors. Pull factors are factors that attract the investor towards developing countries to invest. Push factors, on the other hand, are unfavourable factors in the home state of the investor that repel the investor from that country. Thus, push factors have the force to push the investor to opt for a favourable condition to invest in. Therefore, the investor will go to abroad to invest. It is worth noting that push factors are the opposite of pull factors.

The following may be the pull factors for investors to invest in a developing country:

1. Market pull factors– Investors need market for their production. Now a days, the world is divided into different economic blocks. For example, there are the common Market of Eastern and Southern Africa (COMESA), European Union (EU) etc. If the product originating from a member country of a block, it may benefit from preferential tax treatment compared to a similar product originating from another region. For example, a product originates from Ethiopia will get a preferential tax treatment in COMESA than a similar product that originated from China because Ethiopia is a member to COMESA while China is not. Thus, if the particular product has a demand in COMESA, Chinese investor may want to invest it in Ethiopia to be a beneficiary of the COMESA.Market pull factors are the most important determinants of FDI especially in host economies. Large Markets that are emerging in developing countries will be more attractive. However, the size of the market depends on the type of the product. Thus, the capacity of the consumers to buy the product is crucial.

2. Resources: An investor needs natural and human resources in a reliable manner to produce or manufacture. Thus, the investor could be attracted by the abundance of natural and human resources available in developing countries. An investor will prefer to invest in a country where natural resources needed for the manufacture of his/her/its produce are available in a large quantity and at a cheaper in price.In addition, an investor will be attracted to invest in a country where skilled, disciplined and cheap labour force is found, other factors being equal.

3. Policy frameworksof a host country also determine the direction of FDI. Liberalized economic policies and privatization policies of a host country attract FDI. Regulations and inducements encouraging FDI and investment treaties (bilateral or multilateral) facilitating FDI are pull factors.

4. Political and economic stability:Investors are investing with a view to gaining profit which would be realized through time. Thus, to gain profit, the political and economic stability of a country are essential. Therefore, investors will be attracted to invest in a country where there is political and economic stability.

5. Existence of relevant clusters:- The nature of investment requires the existence of some inputs from other enterprises. A group of enterprises feeding each other within put are known as a cluster. For example, a textile factory needs an enterprise that spins cotton and produces raw material to produce clothes. An investor will be attracted to invest in a country where inputs are available for him/her/it to produce.

6. Growth: An investor wants to invest in a country where there is a demand for the product because this may reduce cost to transport the product to such country by producing it in the country. This definitely will increase the profit from the investment. Investing in the country where there is demand for the product will also enable the investor to adapt the product to local needs and taste. The point here is that the foreign investor prefers to invest in the country if customers of a given product grow in number, the other factors being same.

Lax Environmental Laws–Developed states require investors to ensure that their investment does not affect the environment negatively. For example, they may require investors to reduce their carbon emission to a specified level. In short, the investment law of developed states is very strict in protecting their environment. On the other hand, developing countries have less strict laws in this regard. Consequently, investors would invest in developing countries to reduce additional costs due to strict environmental law.

Push factors that repel FDI in developing countries include:

1)      Market push factors- Developing countries have limited home market that may not expand as required by investors. Thus, this is a push factor since the investor may wish to go out to find market.

2)      Increases in production costs are also driving factors. Increase in production costs may be the result of rapid economic expansion, or scarcity of resources or inputs. Increase in labour costs is a crucial factor that pushes investors. In addition, inflationary pressures also are pushing factors.

3)      Home country business conditions-may be the cause for the investor to opt for international investment. For example, if the competition in the home country is stiff, the investor may need to move into a foreign market.

MOTIVATION AND STRATEGIES

Market-Seeking– FDI is the most common type of strategy for TNCs in their places of internationalization. This was confirmed by a study conducted by UNCTAD as the most significant motive for FDI. Particularly NTCs in developing countries invest to open or secure markets since the resources, like oil gas, are available in their home countries.

Efficiency-seeking–FDI is an important motive. In Asia FDI investments in electrical and electronic products, garments and IT services are made based on the principle of efficiency seeking. They mostly consider efficiency to mean low-cost labour but for Indians it means “primarily the synergies to be gained through the international integration of production and service activities, rather than “low cost inputs”.

Efficiency seeking investments depend on the nature of the product and the particular type of global production network in which it is located. The two main types of networks are:

I. Buyer driven– Large buyers control branding, marketing and access to markets and strive to organize, coordinate and control the value chain in industries such as agro-industries, garments, furniture & toys.

II. Product driven– Key companies own crucial technologies and other firms in the net work, especially supplies e.g. Electronic & automobiles. Industry clusters are also an important aspect of product-driven global production networks.

C. Resource- seeking:-is of moderate significance. FDI may be made to secure material resources abroad, e.g. China, India, Turkey.

- Due to competition, TNCs are extracting resources in countries beset with civil wars, ethnic unrest or other difficult conditions e.g. China National Petroleum Corporation (CNPC), ONGC and Patronas (Malaysia’s national oil company), are heavily involved in oil exploration and production in the Sudan where a number of conflicts are  raging.

Investment may be categorized differently. From the standpoint of an individual, two types of investment may be distinguished: investment in the means of production, and purely financial investment. Both types may provide a monetary return to the investor. However, from the standpoint of the entire economy, purely financial investments appear only as title transfers, and do not constitute an addition to productive capacity.[1]

Investment may also be grouped into foreign (international) and local (domestic) investment. The classification of investment into foreign and domestic depends on the identity of the investor because the identity of the investor would attract several legal consequences. The identity of the investor poses different policy considerations, and this in turn attracts several legal manifestations.

Foreign investment is an investment by a foreign investor while a domestic investment is an investment by a domestic investor.

Foreign Investor- who is foreign investor? See Article 2(6) of Proclamation No 280/2002.

A foreign investor is one who is a foreigner not permanently residing in Ethiopia and who invests capital obtained from foreign sources or reinvests profits accruing to her/him from investment already made in Ethiopia or

A foreigner who is an Ethiopian by origin and chooses to be treated as a foreign investor and invests capital s/he raised abroad, or reinvests profits made in Ethiopia from previous foreign investment; or

An Ethiopian permanently residing abroad and chooses to be treated as a foreign investor and invests capital obtained outside Ethiopia, or reinvests profits obtained from prior foreign investment in Ethiopia, or an enterprise owned by foreign nationals who invest capital raised abroad or reinvest profits made from previous foreign investment in Ethiopia.

In general, investment made by a foreign investor is a foreign investment.

Foreign investment “involves the transfer of tangible or intangible assets from one country into another for the purpose of use in that country to generate wealth under the total or partial control of the owner of the assets”.[2] We observe, from this definition, that transfer of intangible asset is an essential element. Intangible assets include intellectual property rights, such as patents, copyrights, know how etc. In addition, foreign investment also includes transfer of tangible assets. The purpose of transferring tangible and intangible assets to another country is to generate wealth. Generating wealth indicates that foreign investment is profitable.

The term ‘foreign investment’ may also be defined as: “A transfer of funds or materials from one country (called the capital exporting country) to another country (called the host country) in return for a direct or indirect participation in the earnings of that enterprise.”[3]

What are the essential elements of this definition? The first essential point with regard to this definition is that it involves transfer of funds or materials. Fund denotes “the sum of money or other liquid assets established for the purpose of” investment in another country [Garner; 2004:696]. The foreign investor will transfer this fund from his/her country to another. Thus, we have two countries which involve in the transaction of foreign investment. They are: capital exporting country and host country. A capital exporting country is a state (country) from where the investor sends his/her its funds/and/or materials to invest while a host country is a country where the investment is made. In other words, a country where the fund and materials reach and the actual investment takes place is a host country. A capital exploring country is also called “home state”.[4]

The main purpose of foreign investment, according to the above definition, is to participate in the earnings of the enterprise. In other words, investment is made with the main purpose to accrue a benefit from the investment.

Foreign investment may be either foreign direct investment or portfolio investment.

Foreign Direct investment (FDI) is investment that is made to acquire a lasting interest the investor’s purpose being to have an effective choice in the management of the enterprise. To be more specific, a foreign direct investment is ownership of assets by foreign residents for the purpose of controlling the use of these assets.[5] In case of foreign direct investment, the foreign investor directly controls his/her assets that are made on investment in host country. For example, John is an American investor who invests on flowers in Ethiopia. He has expended Birr 1.5 million on the investment. He recruits staff working for his investment, like the guardian, secretary, flower cutters and soon. Thus, John has exerced the right of ownership over his assets directly.  Therefore, the investment is foreign direct investment.

According to the United Nations (UN), an investor is said to have the controlling power over the investment where s/he/it has ten percent (10%) or more of the voting powers in the firm. This is to indicate the power of the investor to decide upon the affairs of the investment. In other words, controlling the investment refers to the power to exert control on the management of the affairs of the enterprise.

The power to control the management of the enterprise could vary according to the type of business organization in question. For example, in cases of partnership, all shareholders have equal voting powers irrespective of their contribution unless otherwise agreed.[6] Thus, according to the principle of management of partnership, a person who contributed 1000 Birr will have equal voting power as another who contributed 100,000 Birr. However, our commercial code gives the liberty for shareholders (partners) to agree that the voting power should be as equal as the amount of the contribution of each partner.

On the contrary, the power of voting depends on the amount of contribution of each shareholder in case of companies. For example, according to Article 535(1) of the Commercial Code, a majority is a “majority of members representing more than one half of the capital” of the private limited company. Similarly, a shareholder in a share company has a voting power depending on the proportion to the amount of capital contributed (Art. 407(1) of the Commercial Code). For example, Azeb has contributed Birr 500 to a share company while Zinash contributed Birr 150,000 to the same company. Consequently, Zinash has the power of voting 300 times more than that of Azeb.

Therefore, the UN threshold of 10% of voting rights would be meaningful with regard to companies under Ethiopian law, and it would be otherwise in case of partnerships devoid of the agreement.

The second criterion to determine foreign direct investment is that it is made to acquire lasting interests. This means that foreign investment is made for long term.

What do you understand by lasting interest? Or long-term investment? In fact, there are no specific yardsticks to determine whether or not a given investment is lasting. However, we can take into account the intention of the investor. If the intent of the investor is invest for a long period of time, that would indicate the intent of such investor is to acquire a lasting interest from the investment. The amount of investment may also indicate whether or not the investment is lasting. The sector of the investment would also indicate the nature of the investment. For example, investment made on factories in general could be regarded as a long-term one  since it could not be accomplished during a short period of time.

In a foreign direct investment, the investor is entitled to protection of both the domestic law of the host state and the diplomatic protection of the home state from which it was exported[7]

Why such double protection is granted to a direct foreign investment?

First and for most, a foreign investor uses the economy that would have been used to advance the economy of the home state. In other words, if the investor were not investing the capital in a host country, it would have been used to promote the development of the capital exporting country.[8] For example, Mike and his two friends invest on the pharmaceutical sector in Ethiopia with a capital of 5 million Birr. There is a general presumption that if Mike and his friends did not invest such capital in Ethiopia, they would invest it in their country, they are using the wealth of their country to invest in Ethiopia. In general, foreign investors use the wealth of their country. Therefore, the home state is justified in ensuring that the resources invested in a foreign country (host state) are protected.

In addition, investment by its very nature requires the continuous presence of the investor and his/her its capital in the hose state.[9] Then, this requires or necessitates the protection for the person(s) (the investor) and the capital that is invested. For example, the investors should spend a certain period in the host state so long as the investment continues. To perform the investment peacefully, legal protection is essential. We have seen that personnel and the plant for the investment should be present for a long period of time in the host state. The enterprise (or the plant),as a property needs protection. Moreover, the personnel require legal protection: their rights should be protected while they are at work.

Further, the investment is made for the good of both nations. The investment made in the host state definitely will enhance the economic development of the host state. It would create an employment opportunity for the residents of the host state. The benefits accrue from the investment will not eventuate in the absence of such investment.[10] The capital exporting state will benefit from the profits that accrue from the investment because the investor is entitled to take the profits to his/her/ its home.

Foreign direct investments are made largely by multinational corporations. Multinational corporations are large business organizations so the sum of money invested is large. Further, those multinational corporations will implement a global strategy in making foreign investment. Consequently, controlling is essential for the implementation of the global strategy[11]

We have seen that in foreign direct investment, it is necessary for the investor to be present physically in the host state. The foreign investment has to be held in the host economy since it operates there. This will create  the conducive environment for the investor to be active participant in the economic and political process of the host state.[12]

In foreign direct investment, there is a movement of people and property from one state to another, and such movement has potential for conflict between the two states. The investor needs to keep secret the competitive advantages of that state to maximize the profit. Similarly, the host state requires to acquire a lot out of the investment such competitive interests require the protection of both the interest of the investor and the host state. Personnel attract diplomatic protection wile the property requires equal protection. Thus, it is argued that the right of alien can be extended to the protection of foreign investment. At this juncture, it is important to note that the roles of international law on foreign investment lie in the effort to extend diplomatic protection to the assets of the alien. However, this argument was criticized on the ground that it leads to unwarranted interference in the domestic affairs of the host state.[13]

Portfolio Investment- “is a movement of money for the purpose of buying shares in a company formed or functioning in another country.[14] The World Bank defines portfolio flows as consisting of “bonds, equity (comprising direct stock market purchases, American Depository Receipts (ADRs), and country funds), and money market instruments (such as certificates of deposits (CDs) and commercial paper”.[15] As we can see from these definitions, in portfolio investment, the investor purchases shares from the host country business organization. The nature of portfolio investment does not offer the opportunity to control the business organization. In other words, in portfolio investment, there is a divorce between management and control of the company and the share ownership in it.[16]

Domestic Investor-Proclamation  No 280/2002 Art 2(5) defines domestic investor as:

An Ethiopian or a foreign national permanently residing in Ethiopia having made an investment, and includes the Government, Public enterprises as well as a foreign national, Ethiopian by birth, and desiring to be considered as a domestic investor.

From this definition, we can gsee that for an investor to be regarded as a domestic investor s/he or it must either be 1) An Ethiopian national; or 2) A foreigner who is a permanent resident of Ethiopia; or 3) A person of Ethiopian origin who is no longer an Ethiopian national even where s/he does not live in Ethiopia so long as s/he chooses to be treated as a domestic investor; Or 4) Public enterprises which according to Proclamation No. 25/1992, business entities owned by the Ethiopian Government or  regional governments or other state entities in Ethiopia. In short, they are publicly owned business entities.[17]

In general, we have seen that investment may be categorized as foreign and domestic. Foreign investment may further be classified into foreign direct investment and foreign portfolio investment.

FACTORS THAT AFFECT THE DIRECTION OF FOREIGN DIRECT INVESTMENT

Why do you think investors wish required to invest abroad? Researchers have examined this issue almost for forty (40) years and the following three points have been forwarded as reasons for foreign investment. The first reason is that multinational companies own assets that can be profitably exploited on a comparatively large scale, organizational and managerial skills, and marketing net works. In other words, foreign investment is attractive to those who own a large amount of money and managerial skills. Secondly, the profit that could be gained from investing abroad is greater than that could be gained from the home country. Thirdly, investors decide to undertake foreign direct investment (FDI) where it is preferable to licensing the production.[18] In general, foreign investment is more profitable to the investor than domestic investment, and this attracts foreign investors.

There are also economic factors that determine the FDI. They are: A) market-seeking-FDIs are made in seeking market for goods and services; B) Resource/asset seeking-investors require resources or assets to produce, and therefore, they will invest in locations where resources or assets are available; C) Efficiency seeking is another factor stimulating foreign direct investment. Thus investors will undertake investments where the production is efficient in terms of cost.[19]

Economists have developed different theories to explain the factors that affect the direction of foreign investment. What are these theories? Let us discuss the most important ones.

Transportation costs-it becomes unprofitable to ship some products a long distance when transportation costs are added to production costs. For example, Cemex has undertaken FDI rather than exporting the product.  It is essential to note that transportation costs have little impact on the relative attractiveness of FDI on electronic components, personal computers, medical equipment, computer software, etc because transport costs are very minor.[20]

2) Market Imperfections (internalization theory) - Market imperfections provide a major explanation of why enterprises may prefer FDI to either exporting or licensing. What are market imperfections? Factors that inhibit market from working perfectly are called market imperfections. A market imperfection that is favoured by most economists is referred to as internalization theory.[21]

Market imperfections may arise where there are impediments to the free flow of products between nations. Thus, impediments to the free flow of products between nations decrease the profitability of exporting the products. Whenever there are market impediments, investors may opt for FDI.[22]

3) Competition strategy –Another theory that explains FDI is that FDI flows are a reflection of strategic rivalry between enterprises in the global market. If one enterprise cuts prices, another competitor will also do the same. On the other hand, if one raises prices, the others follow to retain their market share. Knicker Bocker argued that the same kind of imitative behaviour takes place in FDI. For instance, Toyota and Nissan responded to investment by Honda in the United States of America and Europe by undertaking their own FDI in the countries.[23]

It is also observable that Fuji is compelled to follow Kodak to ensure that Kodak does not gain a dominant position in the foreign market. Therefore, Fuji invests in a country where Kodak invests with the intention of not allowing Kodak to take the advantage of FDI.[24]

4) The Product Life Cycle –Raymond Vernon’s product life-cycle theory is also used to explain FDI. According to Vernon, an enterprise that is a pioneer in its home markets may undertake FDI to produce a product for consumption in a foreign market. For example, Xerox which produced photocopier in the United States of America, invests in Japan (Figi-Xerox) and Great Britain (Rank Xerox) to serve those markets. Then they shift their production to developing countries to satisfy the demands where labour costs are lower to produce.[25]

According to Vernon’s theory, firms invest in a foreign country when demand in that country will support local production, and they invest in low-cost locations. Thus, investors  invest in developing countries where production cost is low. However, it is worth noting that a large demand in a foreign country does not necessitate foreign direct investment. It may be more profitable to license instead of FDI for the production of the product.[26]

5) Location –Specific advantages –According to John Dunning, location specific advantages can help to explain FDI in addition to the various factors we discussed above. Location specific advantages are advantages that arise from using local natural resources and know-how that helps the investor to produce. Dunning refers to this argument as the eclectic paradigm.[27]

For example, an investor will invest in a country where oil as a natural resource is abundant. In addition, an investor may invest in a country where there is low-cost highly skilled labour.

{slide=click here for citation}

[1] The New Encyclopaedia Britannica; Vol  6, 2003, Pp.  363

[2] M. Sornarajah; The International Law on Foreign Investment, Grotius Publications, Cambridge University Press, New York, 1996, p 4

[3]

[4] II SD Model International Agreement on Investment for Sustainable Development; 2005, Art. 2(I)

[5]Sornarajah; Ibid, p. 4

[6] Commercial Code  of the Empire of Ethiopia, Proclamation  No. 166 of 1960, Negarit Gazeta, 19^th Year No. 3, Addis Ababa, 5^th May 1960, Art. 234

[7] M. Sornarajah; Ibid, p. 5

[8] Ibid

[9] Ibid.

[10] Ibid, p 5-6

[11] Ibid, p. 6

[12] Ibid

[13] Ibid, p. 8

[14] Sornarajah; Ibid, p. 4

[15] Bhalla and Ramu; Ibid, p. 516

[16] Sornarajah,  Ibid, p. 4

[17] See Seyoum; Ibid, p. 5-6

[18] (?), Trade and Foreign Direct Investment: (?), P. 50

[19] Gibrehiwot Ageba, Investment; (Unpublished), 1999, Pp.10-11

[20] Charles W. L.  Hill; International Business: Competing in the global Market (Fourth Edition), Tata McGraw-Hill Publishing Company Limited, New Delhi, 2003, p. 213

[21] Ibid, p. 214

[22] Ibid

[23] Ibid, p. 216

[24] Ibid, Pp. 216-17

[25]Ibid, p.27

[26] Ibid

[27] Ibid, p 218

{/slide}

Elements of Investment

There are three factors that are considered as elements of investment.

a) Reward (return);

b) Risk and return; and

c) Time [1]

A. Reward

We have seen above that investment is made with the intention to gain profit. Thus, investors, generally, may expend their fund to earn a return on it. The return is known as reward from the investment, and it includes both current income and capital gains or losses which arise by the increase or decrease of an investment.

Let’s say, Ayal has started producing bread in a modern way at Arat Kilo and distributes it to the customers in Addis Ababa. The capital for the investment is Birr 10,000. She invested on the sector with the expectation of profit. Moreover, let us assume that she has got Birr Two thousand within six months of her investment. This is a reward from the investment.

B. Risk and Return

The second element of investment is risk and return. Risk may be defined as the chance that the expected or prospective gains, or profit or return may not materialize. It also includes the fact that the actual outcome of investment may be less than the expected outcome. It is important to note that the greater the variability or dispersion in the possible outcome, the greater the risk will be.

In addition, risk means estimation about the degree of happening of the loss. Risk and return are inseparable. Return is an expected income from the investment. It represents the benefits derived by an investor from his/her investments. The rate of return required by the investor largely depends on the risk involved in the investments. Thus, the investment process must be considered in terms of both aspects of risks and return. Risk can be quantified by using precise statistical techniques. Therefore, risk is a measurable element.

Example: Hailu has invested on flower on the road to Jimma. He must assess the risks involved in the investment. For instance he should consider the possible pests that may cause damage to the flower, the risk of the market failure, the risks involved in transporting the flower to Bole, and then the air transport to export it to foreign countries and so on. On the other hand, Hailu should estimate the expected return, i.e. profit from the investment. We have seen that risk and return are inseparable. Thus, Hailu should consider both the risks and return of his investment together.

C. Time

Time is the third element of investment. It offers several different courses of action. Conditions change as time moves on and investors should re-e valuate expected return for each investment.

An investment could not be materialized within a very short period of time. In other words, investment is of long-term in nature. For example, if one needs to invest on a cement factory, s/he should conduct market research to ensure the viability of the investment. Conducting research needs a certain period of time. After the research is done, machineries should be imported and installed. This also is to be done through time. Then, the factory should produce sample cement, distribute the product, and collect the feedback from the customers. Then, the factory would start production and distribute cement to customers. All the above-mentioned activities need to be done through time.

Let us consider another example. Almaz wishes to invest on the textile. First, she saved a certain amount of money, and let us also assume that she was granted a loan from the Commercial Bank of Ethiopia. Secondly, she has to import necessary machineries from, say, German, Italy or any other country. The machineries should reach Ethiopia and an installation is necessary. Then, the factory starts production. The production process needs a certain period of time. In general, investment by its very nature is of a long-term process. During this time, the investor has the opportunity to re-e valuate the risks involved in that particular investment, and take necessary measures to minimize the degree of risk.

Further, investment requires a continuous flow of decisions. As we can observe from the above examples, the investors should decide on each and every level of the investment. Thus, investment is the result of a series of decisions.

Moreover, investors should from time to time reappraise and revaluate their various investment commitments in the light of new information, changed expectations and ends.

Investment decisions are based on data which represent the observable environment and the general and specifics of a given investment. It takes the ability to analyze the data and specifications properly to make an appropriate decision. Thus, investment is the result of a series of decisions.

Thus, investment is an art and depends on the art the individual investor employs to be successful. An investment may be successful where the investor employs a suitable art. On the other hand, investment is a science because there are rules and principles developed through time. In general, investment is an art and a science.

ECONOMIC PRINCIPLES OF INVESTMENT

We have seen that investment is both an art and a science. As a science, there are fundamental principles applicable to investment. Under this part of the material, we shall discuss the essential ones.

Safety of Investment

An investment needs safety since the investor invests his/her fund and time. Thus, adequate protection should exist against the risk of loss of capital. Investing in the form of shares is said to be relatively safe because the risk is spread due to diversification among different scripts of companies.[2]

For instance, if Abebe invests his fund alone, the risk of loss is higher compared with the investment made together with others in the form of Share Company. In general, what is required is maximizing the chance of getting profit in any manner.

Liquidity

Liquidity is the second principle of investment. Any investment is said to be liquid, if it can be converted into cash or sold as and when required. A liquid investment would enable the investor to encash his/her investment whenever the need arises. It would also permit the investor to sell off an unremunerative investment, there by minimizing the losses, and switch over to a more prommising investment. Thus, the liquidity of an investment offers flexibility in the face of changing economic and political environment.[3]

For instance, Dendir was investing on food processing in Eritrea before the prevailing regime came to power. Investment on this sector is safe since the return is very high in that particular area. However, Dendir has sold it easily and came to Ethiopia as the political conditions changed dramatically. Thus, the investment Dendir has made is liquid since it was possible to encash it whence it was required.

Profit

We have seen that profit is an element of investment. The main reason of investment is to accrue profit. Profit can be realized in either or both of the  capital appreciation yield[4]

Capital appreciation occurs when an investment is disposed of at a higher value compared to the price for which it was purchased. Where the difference between the net selling price and the purchase price is positive, it is said to be capital appreciation.[5]

Yield, on the other hand, is derived in the form of interest or dividend. The rate of dividend may fluctuate from year to year, depending on the profitability of the area in which money has been invested where as the rate of interest is usually fixed.[6] If for example Kedir invests on purchasing shares, such shares are expected to yield a dividend at the end of the year. This is an investment for Kedir i.e  a capital appreciation or yield.

Tax Implications

The investor may be required to pay tax on his/her income.[7] According to Proclamation No. 286/2002, Article 4, “every person having income as defined here in shall pay income tax in accordance with this Proclamation”. Income is defined as “… Every sort of economic benefit including nonrecurring gains in cash or in kind, from whatever source derived and in whatever form paid credited or received.[8]

In addition, an income from business activities is taxable income under Proclamation No 286/2002 (Art. 6(b)). We have seen that investment is made to gain profit. An activity recognized by the Commercial Code of Ethiopia as trade and is made to gain profit is known as business activity.[9]

The rate and manner of business income tax is regulated by the provisions of Income Tax Proclamation No 286/2002.[10] According to this proclamation, business organizations shall pay 30% of their income as tax.[11]

Inflation

Inflation erodes the value of money invested. To earn a rate of return, the money should be properly invested. We have seen that investment is a business activity. Business is undertaken  for profit, and the investment must at least compensate for the rate of inflation.[12]

What do we mean by inflation? The term generally means, “increase in prices coinciding with a fall in the real value of money”.[13] The increase of price and the decrease of the real value of money definitely will have a negative impact upon the investment. For instance, the capital of the investor is Birr 220,000. If inflation occurs, the real value will decrease and the capital will not have the power that it was at the time of investment. Therefore, the investor might be forced to increase the capital.

Government Control

Government controls certain economic sectors and that may affect investment. For instance, pursuant to Article 5 of Proclamation No 280/2002, it is only possible to invest on electric energy under a joint investment with the Ethiopian Government. Thus, Government control affects investment and it must be considered.[14]

Legality

The investor is required  to invest on areas that are allowed by law. S/he should also fulfil other requirements like license etc. For instance, grinding mills, retail and brokerage, among others, are areas exclusively reserved for domestic investors.[15] Therefore, no foreign investor is allowed to invest on areas that are reserved only for domestic investors.

Pre- requisite for investment

To have an investment, the income during one period of time should produce earning in future periods. In order to obtain a greater return in the future, consumption in the current period is foregone. In general, for an economy as a whole to invest, total production must exceed total consumption.[16] In other words, there must be saving. Saving is the process of setting aside a portion of current income for future use. Saving may take the form of increases in bank deposits, purchases of securities, or increased cash holdings.[17]

Saving is important to the economic progress of a country because of its relation to investment. An individual should be willing to abstain from consuming his/her entire income and save. The preference of individuals for future over present consummation, their expectations of future income and to some extent the rate of interest affect the extent of saving by individuals.[18]

Once individuals do saving, they must be willing to invest their money so as to increase productive capacity.[19] To invest, it is essential to fully understand the principles of investment we have discussed hereinabove.

Investment increases an economic capacity to produce. In addition, investment is the factor responsible for economic growth. For growth to occur smoothly, It is necessary that savers intend to save the same amount that investors wish to invest during a time period. It is worth noting that if intended saving exceeds intended investment, unemployment may be the result. In addition, inflation may occur if investment exceeds saving.[20] Therefore, it is essential to balance the saving with investment. In general, saving is an essential pre-requisite for investment. A saving should be properly invested otherwise, inflation may occur.

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[1]V.  Gangadhar and Ramesh Babu; Investment Management including Portfolio Management And Security Analysis, Anm Publications Pvt, Ltd, New Delhi,2003, Pp. 3

[2] Gangadhar and Babu, Ibid, p 15

[3] Ibid

[4] Ibid, p. 16

[5] Ibid

[6] Ibid

[7] Ibid

[8] Proc. No 286/2002, (as amended), Ibid, Art. 2 (10)

[9] Ibid, Art. 2(6)

[10] See ibid, Arts. 17-30

[11] Ibid, Arts  2(2) and 19(1)

[12] Gangadhar and Babu, Ibid

[13] Bryan;  Ibid, p. 794

[14] Gangadhar and Babu, Ibid

[15] Council of Ministers Regulations No 84/2003, Federal Negarit Gazeta,     Year, No……, Addis Ababa, Schedule

[16] Encyclopaedia of Britannica; vol. 10, Pp. 837-38

[17] Ibid, p. 482

[18] Ibid

[19] Ibid

[20] Encyclopaedia of Britannica ,Vol. 6, P. 363

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The term ‘investment’ may mean different things in different disciplines and contexts. Thus, it may mean “expenditure to acquire property or assets to produce revenue”.[1] Fisher and Jordan[2] define investment as commitment of funds made in the expectation of some positive rate of return. According to them, the return will commensurate with the risk the investor assumes if the investment is properly undertaken. We observe from this definition that investment is a commitment of funds. Thus, a person would commit fund on something. In addition, the commitment is made with the expectation of some positive rate of return. This positive rate of return is a profit gained from the commitment of the fund. However, it is important to bear in mind that investment carries with it a risk, i.e. the commitment of the fund might end up with no profit. Thus, the investor needs to properly manage the investment to make sure that it will be profitable.

From the legal point of view, investment is defined as:

Every kind of asset and in particular shall include though not exclusively:

a) movable and immovable property and any other property rights such as mortgages, liens and pledges;

b) shares, stocks and debentures of companies or interests in the property of such companies;

c) claims to money or to any performance under contract having a financial value;

d) intellectual property rights and goodwill;

e) business concessions conferred by law or under contract, including concessions to search for, cultivate, extract or exploit natural resources.[3]

According to many international investment agreements investment is something established in accordance with the laws of host countries.[4] This is intended to ensure that the investment has been properly registered and licensed and that it complies with the laws and regulations of the host countries.

Under a bilateral investment treaty to which Ethiopia is a party, investment is defined as: “Any kind of asset and any direct or indirect contribution in cash, in kind or in services, invested or reinvested in any sector of economic activity.”[5] As per this Agreement though not exclusively, it includes:[6]

movable and immovable property and rights in rem like mortgages, liens, pledges, and usufruct;

shares;

bonds, claims to money and to any performance having an economic value;

copyrights, industrial property rights, technical processes, trade names and goodwill;

concessions granted under public law or contract to explore, develop, extract or exploit natural resources.

In general, investment may be defined as making an outlay of money or capital for profit. The definition given under our investment law is in line with this definition. The provision of Art 2(1) of Proclamation No. 280/2002 (as amended) reads as:

“Investment” means expenditure of capital by an investor to establish a new enterprise or to expand or upgrade one that already exists.

There are some essential elements in defining the term investment under our law. Now let us consider them turn by turn.

A. Expenditure of capital- To have an investment there must be an expenditure of capital. ‘Capital’, according to Article 2(3) of Proclamation No 280/2002 (as amended), means “local or  foreign currency, negotiable instruments, machinery or equipment, buildings, initial working capital, property rights, patent rights, or other business assets.” Capital includes currency. What does currency mean? Currency is a system of money used in a country or sometimes an economic block. In other words, currency is money or cash as represented by notes, which are known by various designations in different countries. A currency could be local or foreign. Local currency means Ethiopian Birr whereas foreign currency denotes money other than Ethiopian Birr such as Euro, the Chinese Renminbi (people’s money), the Israeli Shekel, US Dollars Nigerian Naira, etc. Thus, money is capital, and expenditure of money is investment so long as all other elements of the definition of the investment are fulfilled.[7]

In addition to money, negotiable instruments also constitute capital according to the definition of the term under our law. Have you taken the law of banking and insurance? If you have, you must be familiar with negotiable instruments.

The word ‘negotiable’ means ‘transferable by delivery’, and the word, ‘instrument’ means ‘a written document by which a right is created in favour of some person’. Therefore, the term ‘negotiable instrument’ literally means ‘a written document transferable by delivery.’[8]

Negotiable instruments are defined as “documents representing legal claims which are regarded by law as transferable and which give to the purchaser in the ordinary course of business a  good title even though that of the seller may have been defective”[9]

In light of this definition, a negotiable instrument transfers a good title to the purchaser. Good title means better right, better protection. It is only a holder in good faith, a holder in due course who can acquire better title, better rights, and better protection than the transferor can. A transferor is one who transfers/sells/the negotiable instrument to the holder. For example, W/o Almaz has a cheque from Ato Melaku after paying the price, in good faith. She is a holder.

What is essential is that it is possible for a person to contribute a negotiable instrument, i.e. a bill of lading, a document of title to goods shipped, warehouse certificate, a cheque, a promissory note instead of contributing the goods or money to an enterprise.

What is more, things like machinery, equipment, buildings are regarded as capital according to Article 2(3) of Proclamation No 280/2002 (as amended).

Furthermore, incorporeal things, like patent right, are also considered as capital under our law. Thus, business assets like trademark, trade name, goodwill etc… are regarded as capital. In general, what is important is that the thing being contributed or otherwise invested should have economic value and help in the attainment of the purpose of the enterprise, i.e. making profits.

An Investor- A person who invests in Ethiopia is an investor. The person may be local or foreign investor.[10]

‘Domestic investor’ is defined as “an Ethiopian or a foreign national permanently residing in Ethiopia, who has made an investment, and includes the Government, public enterprises as well as a foreign national, Ethiopian by birth and desiring to be considered as a domestic investor.”[11]

An Ethiopian is a domestic investor so long as s/he invests in our country. A foreign national may also be regarded as domestic investor if s/he is Ethiopian by birth and willing to be considered as a domestic investor. Persons who are Ethiopian by birth may acquire foreign nationality. Such persons may invest in Ethiopia. If they need to be treated as domestic investor, the Ethiopian Government will consider them as domestic investors. On the contrary, if they are not willing to be considered as domestic investor, they could not be considered as domestic investor. Thus, the option is given to them to choose whether to be treated as a domestic investor or not because they have foreign nationality and they are Ethiopian by birth.

Nevertheless, what is the advantage of being considered as a domestic investor? There are some advantages to being considered as a domestic investor related with the privileges granted under the investment law. Therefore, if a foreigner who is Ethiopian by birth chooses to be considered as a domestic investor, s/he would be legible to exercise the privileges granted to domestic investors while they are not granted to foreigners.

Foreign investor is “a foreigner or an enterprise owned by foreign nationals, having invested foreign capital in Ethiopia, and includes an Ethiopian permanently residing abroad and preferring treatment as a foreign investor.”[12]

According to this definition, a foreign investor could be an individual or an enterprise (business organization) who has foreign nationality. An enterprise that is owned by foreigners is a foreign investor. This means the enterprise may be established in Ethiopia according to our law(s). An enterprise that is established here in Ethiopia is considered as Ethiopian. However, such enterprise is regarded as a foreign investor notwithstanding its establishment in Ethiopia. What is important, according to our law, is that the enterprise should be owned by foreign nationals. Here it is essential to raise a question: should the enterprise be owned wholly or partially by foreigners? This is not clear from the law. However, the intention of the legislature seems that the enterprise should be wholly owned by foreigners.

The definition also includes an Ethiopian who permanently resides abroad and chooses to be treated as a foreign investor, i.e. s/he is a foreign investor. Here nationally does not seem to be a criterion to categorize a person as foreign investor, because an Ethiopian who permanently resides in a foreign country may not necessary be a foreigner. Here, what is the determining factor is the choice of the Ethiopian who resides permanently abroad to be treated as a foreign investor. Consequently, an Ethiopian who permanently resides abroad and chooses to be treated as a foreign investor is not allowed to invest in the financial sector, for example. However, what do we mean by an Ethiopian? Does it include an artificial person, i.e. an enterprise or only an individual? The law of investment does not clearly respond to this issue.

C. Enterprise- is another essential term in the definition of the term investment. What does an enterprise mean? The term “enterprise” is defined as “an undertaking established for purpose of gaining profit”.[13] In other words, an enterprise is an undertaking whose purpose is profit making. This means the enterprise should accrue an economic benefit for those who invest upon the sector. An enterprise whose purpose is profit is a trader according to Article 5 of the Commercial Code of Ethiopia. However, if an enterprise is established for the purpose of cultural, religious or political goals, but not obtaining economic benefits for the person(s) who make capital available for it, such an entity is not an enterprise. Consequently, expending capital in such entity cannot be regarded as an investment.

D. Expansion and upgrading- is also regarded as an investment under our law of investment.[14] There could be an expenditure of capital on an already existing enterprise to expand it or upgrade the same. “Expansion /upgrading” means increasing in value, by more than 25% the full production of service capacity of an existing enterprise, be it in variety, volume, or both.”[15]

Let us assume that XYZ Share Company is an enterprise established with Birr 200,000 to produce leather products, such as bags. Now, the sector is promising and the demand of the consumers increases. Thus, the owners decided to upgrade the production capacity of the Share Company by more than 25%. Accordingly, the capital of the company is increased to Birr 275,000. Such an upgrading or expansion of the company is regarded as an investment.

Let us consider another example. Cheque Share Company is an enterprise investing on flower on the road to Nazareth on 2,500 hectares. The capital of the Company is 2.5 Million Birr. Now the owners of the Company reached a decision to invest more to expand the investment. The Government has granted them 1,000 square hectares for expanding the investment on flower. The shareholders agreed to expend some 325,000 Birr for each the expansion. This expansion of the investment with Birr 325,000.00 on additional 1000 square hectares is an investment pursuant to Article 2(2) of the Investment Proclamation No 280/2002(as amended).

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[1] Bryan A. Garner,(Editor-in-Chief), Black’s Law Dictionary,(Eight Edition), Thomson, West, United States of America, 2004, p.844

[2] Fisher and Jordan

[3] ASEAN Agreement for the Promotion and Protection of Investments, Article 1(3), from UNCTAD, 1996a, Volume II, p. 294.

[4] UNCTAD International Investment Agreements, Volume I, (2004), p 122

[5] The Reciprocal Promotion of Investments Agreement between The Belgian-Luxemburg Economic Union and the Federal Democratic Republic of Ethiopia, Article 2.

[6] Ibid

[7] See Seyoum; A Partial Work, (unpublished),  2007, Pp. 2-3

[8] M.C. Kuchhal; Mercantile Law, Vikas Publishing house PVT LTD, New Delhi, 1992, P 359

[9] A lecture by Zekarias, 2005

[10] Proc. No 280/2002 (as amended). Re-Enactment of the Investment Proclamation, Federal Negarit Gazeta, 8^th Year No. 27, Addis Ababa, 2^nd July, 2002, Art. 2(4)

[11]Ibid; Art. 2(5)

[12] Proc No 280/2002, Ibid, Art. 2(6)

[13] Proc. No 280/2002 (as amended), Ibid, Art. 2(2)

[14] Ibid, Art. 2(1)

[15] Ibid; Art. 2(8

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