In the National Interest
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Contrary to popular belief,foreign investment is generally in rather than against the national interest.

Foreign investment in Australia is a highly emotional issue for many people, as the reaction to the proposed merger of the Dutch-UK multinational Shell with the Australian gas company Woodside has demonstrated. Yet the North West Shelf Joint Venture, at issue in the merger, would not have been developed to its present stage without the contribution of foreign capital and expertise. More broadly, it is hard to imagine AustraliaÕs economic and social development over the past 200 years without the massive amounts of capital thatÑuntil the late 1960sÑ came in from overseas virtually unimpeded.

Against capital xenophobia1

Orthodox economic analysis holds that the acquisition of a countryÕs assets by foreigners through voluntary exchange (with or without the transfer of control) may generally be presumed to benefit both parties. Like the free flow of goods and services, free international capital flows promote economic welfare on both sides of the borderÑat least in all normal circumstances.

This orthodox view of foreign investment is reflected in the Australian GovernmentÕs approach to foreign investment policy. The general stance of policy is to welcome foreign investment because of the Ôstrong economic benefitsÕ it confers upon Australia.

ÔForeign investment provides scope for higher rates of economic activity and employment than could be achieved from domestic levels of savings. Foreign direct investment also provides access to new technology, management skills and overseas markets.Õ2

Notwithstanding this generally positive view of foreign investment, there are circumstances in which the host countryÕs interests may not be served by unfettered access to its capital markets. Such circumstances are envisaged by the Foreign Acquisitions and Takeovers Act 1975, which reserves the right of the Australian Government (through the Treasurer) to block foreign investment proposals deemed contrary to the national interest.

The TreasurerÕs approval is thus not contingent upon a finding that the proposal is in the national interest. Rather the Treasurer is empowered to block a proposal (or to approve it subject to conditions) only if the proposal is found to be contrary to the national interest. Yet the Act does not define the term Ônational interestÕ, even though it obliges the Treasurer to protect it!

The most natural definition equates the national interest with national economic welfare. For a foreign acquisition or takeover to be Ôcontrary to the national interestÕ it must reduce, on balance, the economic or material welfare of the people of AustraliaÑeither absolutely or relative to the level we might otherwise have enjoyed without the foreign acquisition or takeover.

Some might object that this definition is too narrow. They might favour a broader definition centred on national sovereignty or even national pride. But less tangible definitions of the national interest provide no escape from the basic issue. Even if we decide that national sovereignty is of paramount importance, it is still necessary to calculate the economic cost of blocking a foreign takeover that reduces national sovereignty. Or are we prepared to pay any price to preserve national sovereignty?

The presumption of innocence

International capital flows resulting from both portfolio and direct foreign investment represent a form of economic integration. Since at least the time of Adam SmithÕs Wealth of Nations, economists have understood the potential for economic integration to generate higher levels of material well-being. There are three primary sources of this increase in economic welfare:3

Comparative advantage.

Countries differ in their endowments of natural resources and factors of production. These differences together with differences in the economic policy framework underpin differences in the costs of producing goods and services. Economic integration allows countries to direct resources, both real and financial, towards those activities in which they possess a comparative cost advantage. Countries can supplement the range of goods and services they consume with imports.

Similarly, in capital markets, countries with a wide range of profitable investment projects need not be constrained by their own savings but can import the savings of other countries in return for a share in the investment proceeds. By specialising in those activities in which they possess comparative cost advantages (or where comparative returns are higher), countries improve their own material circumstances as well as those of the countries with whom they are integrated.4

Economies of scale.

Countries may have comparative cost advantages which became even greater at higher levels of output; that is, they are subject to economies of scale. The specialisation in production that is facilitated by economic integration increases the scale at which individual countries are able to produceÑthey no longer produce just for local consumption. Production at scale may unlock efficiencies that are not attainable when production is spread across a range of countries each with a comparatively small output.

Competition

Economic integration widens markets and, in doing so, enhances the competitive pressure that naturally accompanies larger numbers of buyers and sellers. Small countries can be especially prone to anti-competitive practices because of the small size of their domestic markets. Opening such markets to competition from imports and the possibility of direct entry by foreign competitors, already producing at scale in other markets, can help to counter local monopoly power.

The above economic benefits arise when markets for goods and services or capital are liberalised. It should also be pointed out that foreign direct investment, as distinct from portfolio investment, confers additional benefits when it facilitates exchange that does not normally take place on open markets.

Ideas, technical competencies, managerial styles and other Ôknowledge intensiveÕ goods and services tend not to be easily commoditised and traded on markets. It has long been recognised that foreign direct investment is one means by which such non-marketable goods and services can be exchanged.5 The exchange takes place within the confines of the multinational firm where it can be protected more readily from theft or imitation. Perhaps the only means by which such valuable exchange can take place is through the admission of multinational corporations to the domestic economy.

In a similar vein, foreign direct investment may be the only feasible means of gaining exposure to risk-return combinations available uniquely in particular locations. Financial markets may operate inefficiently or not even exist, so that the only way in which investors can gain exposure to the diversification opportunities is to invest directly. Local equity participation in a multinational enterprise offers opportunities for wealth-enhancing investment that may not be available otherwise to the residents of a local economy. It may not be possible to access financial markets across borders or at least not at reasonable cost.

The economics literature recognises yet further benefits from economic integration that Ôspill overÕ from cross-border exchange between market participants or from the internal non-market exchange that takes place within multinational firms.6

Despite the best efforts of market participants to capture the full economic benefit of their exchange and those of multinationals to internalise their knowledge exchange, there are inevitable spillovers to local firms and individuals. These primarily take the form of the transfer of skills and general know-how (as opposed to specific knowledge) from foreigners to domestic residents.

Learning by doing is also a significant element of technology and skills transfer. Even if the knowledge can be bought, there is often no substitute for the opportunity to apply new knowledge and skills working alongside an experienced practitioner.

Exceptions to the rule

While the presumption (among economists at least) is that foreign investment is generally beneficial to the host country, it is possible to identify potential costs as well. These may be sufficiently large in any given instance to outweigh the benefits, and to justify the conclusion that the specific instance of foreign investment is contrary to the national interest.

There are various ways in which foreign direct investmentÑwhere foreigners control the ventureÑmight diminish rather than enhance national economic well-being. The concerns raised over the merger between the Australian company Woodside and the Dutch-UK multinational Shell are a case in point. These have ranged from fears that Shell would avoid or at least minimise tax through Ôtransfer pricingÕ to predictions that once Shell acquired the Australian company Woodside, Shell would favour its international investments over its stake in the North West Shelf Joint Venture, letting the development of AustraliaÕs gas resources fall by the wayside. It is therefore revealing to examine the circumstances in which foreign investment might be contrary to the national interest with reference to the specific instance of ShellÕs ultimate merger with Woodside.

Development and marketing of AustraliaÕs natural resources.

A foreign-owned firm may show less interest in developing local assets at their optimal rate for the host country, or may even deliberately slow their rate of development to suit their own purposes. In other words, foreign firms are simply out for what they can get.

The concerns over ShellÕs potential influence over the North West Shelf Joint Venture echo this view. Many have argued that Shell would choose not to develop AustraliaÕs gas resources at the optimal rate for AustraliaÕs long-term benefit but to suit its own timetable. In particular, Shell has other gas resources under its control that it could favour over the merged entityÕs Australian reserves so as to maximise ShellÕs global interests.

Yet the proposed merger gives Shell not more than one-third interest in the North West Shelf, not enough to decide unilaterally to alter the pace of development. Nor does Shell have a controlling interest in any other gas resource within our region. Without the ability to manipulate gas resources to suit its own commercial advantage, Shell has every incentive to develop each resource as rapidly as market conditions will allow. Moreover, it is inconceivable that co-venturers would permit Shell to indulge its own commercial interest at their expense.

A foreign takeover may erode the national tax base.

A foreign firm, especially a multinational corp-oration, can shift profits from its activities in one country into another jurisdiction for the purposes of paying income tax. This generally occurs through the deliberate manipulation of internal Ôtransfer pricesÕ, that is the notional prices at which goods and services are exchanged between different national subsidiaries of the foreign firm.

For instance, a foreign firm may understate the true economic profit from its activities in the host country by paying artificially low transfer prices for goods and services purchased by the parent from its foreign subsidiary. In this way, profits earned within the host country would be artificially low, attracting a low tax liability.

Such activity is attracting increasing attention from tax authorities around the world as business becomes increasingly international in its scope. The Australian Taxation Office actively seeks to ensure that Australia gathers a fair and appropriate share of the tax paid by multinationals.

While it is possible that the extent of tax avoidance may be sufficient to outweigh the benefit to the Australian people of allowing a specific foreign takeover to occur, blocking the takeover on these grounds is at best a temporary solution. Rather than the fault lying with the foreign investor, ineffectual or poorly enforced tax laws are usually to blame.

In the case of the Shell/Woodside merger tax avoidance would only become an issue if it were likely that ShellÕs takeover of Woodside produced substantially less tax revenue for the Australian government. This in turn would only occur if it could be shown that Shell consistently paid less tax than Woodside on a comparable set of activities. Yet Shell has paid more than 70% of its economic value added in tax to various levels of Australian government in recent years and has an effective tax rate as high as that of Woodside and BHP. Allowing Shell to merge with Woodside would thus make no difference to the Australian tax base.

Competition concerns.

A foreign acquisition or takeover can be contrary to the national interest if it reduces competition in local markets. This might occur when the merged entity becomes sufficiently large to influence local market prices through its output decisions, or when the foreign company is able to transfer its power in international markets to the local economy. This reduces economic welfare because domestic consumers are unable to enjoy the lowest prices consistent with costs of production.

Apart from the inefficiency imposed on the domestic economy by a firm with market power, economic rentÑ Ôpure economic profitÕÑis redistributed from the customers of the firm with market power to its owners. When the customers and owners are all domestic residents, the net effect on the aggregate national interest is zero. When the owners are foreigners, this transfer of rent is a net loss to the domestic economy.

The Australian Consumer and Competition Council (ACCC) has investigated the proposed Shell/Woodside merger, concluding that it would make no difference to existing levels of competition in any Australian market.

Employment effects.

Concern is sometimes expressed about the impact of FDI on the level of employment in a host country. Some fear that foreign firms expatriate workers who ÔstealÕ the jobs that should have been offered to local residents. Such as view misconstrues the forces that determine local employment conditions. These are almost wholly independent of the level of FDI.

Specifically, local employment is determined by what is known as the ÔnaturalÕ rate of unemployment, which in turn is a function of fundamental labour market conditions, including the matching of job seekers with job openings, the rigidity of employment conditions, the generosity of unemployment benefits and the extent and nature of trade union activity. FDI has little, if any, influence on these basic features of the labour market.

Of greater relevance is the quality of jobs on offer. A foreign firm may seek to remove the high valued-added activities and high-paying jobs from the host to the home country, or elsewhere. A special version of this concern arises when the foreign firm moves the corporate headquarters of its newly acquired subsidiary out of the host countryÑthe so-called Ôbranch office effectÕ.

Corporate headquarters are a particularly rich source of high-paying jobs, while high value-added activities are important because they underpin a high living standard. The higher the value added in a countryÕs industries, the higher its GDP, and, for a given population, the higher its GDP per capita. High value-added activities also attract talented individuals while the presence of high-paying jobs helps keep talented youngsters in a country. Certainly, the replacement of high value-added activities with low value-added activities and high-paying jobs with low-paying jobs, even if there are lots of them, is potentially against the national interest.

In the case of the Shell/Woodside merger, the national interest would, on the contrary, be served. Greater access by Woodside employees to the Shell Group via Ôopen resourcingÕ should enhance the possible quality of jobs for those employees and the opportunity to further their training and development in overseas locations.

Research and development.

Some argue that a foreign firm might seek to strip the research and development capability of the local firm and relocate it overseas, resulting in the host country losing direct and spin-off benefits. A related concern is that the potential for royalties and licence fees from new inventions is lost to the host country, which must then import this intellectual property.

R&D is subject to economies of scale, derived from the use of sophisticated laboratory facilities and the Ôcritical massÕ of talented individuals often required.R&D is therefore nearly always highly centralised.

While this means that the host country may access R&D through the foreign firm more cheaply than it could undertake such activities itself, this may only partly mitigate the loss of spillover benefits and potential royalties from homegrown inventions. Both Shell and Woodside, however, already share access to R&D produced by The Shell Group in The Hague and Houston. Woodside will also gain access to the new Shell-funded Ôcentre of excellenceÕ technical services facility to be established in Perth.

Impact on local content.

Foreign-owned firms are often thought to rely more on imports for sourcing goods than their domestic counterparts. If this were true, then other things being equal, foreign acquisitions of local firms would permanently weaken the exchange rate for the Australian dollar as market forces sought to match larger import volumes with larger export volumes or additional foreign capital inflow.

The permanent reduction in the value of the Australian dollar represents a permanent loss of wealth to Australians when measured in foreign currency. Such a wealth loss would need to be reckoned with against any benefit of foreign investment to determine the net national benefit.

A merger between Shell and Woodside would make no difference to the sourcing of large items of capital equipmentÑthey would continue to be purchased at tender, and so long as Australian tenderers are too expensive, sourced from foreign suppliers. Concerns about Australia Ôimporting too muchÕ can only be met by addressing the reasons why our suppliers cannot match their international competition on price.

Environmental concerns.

Some claim that foreign firms are less protective of the local environment than domestic firms. This may reflect the fact that their primary allegiance lies elsewhere and, therefore, that they are just out for what they can get.

Even if this were true, the appropriate remedy is not to block foreign investment but to tighten local environmental laws and enforcement more effectively. Foreign firms will then be obliged to meet the same environmental standards as domestic firms.

In any event, Shell is no less vigilant than Woodside in its efforts to protect the Australian environment. Moreover, the multinationalÕs commitment to cleaning up after an accident was recently demonstrated by its rapid response to the oil spill at Gore Bay in Sydney Harbour in August 1999.

National security

Whenever strategic resources come under the control of foreigners, the question of national security arises. Can access to those resources be assured in times of national emergency? Will the foreign owners act as a Ôfifth columnÕ, serving the interest of a national enemy or at least failing to rally to the national cause? The strongest safeguard against such possibilities is the emergency powers of the government. In extreme circumstances, a government can regulate, direct, commandeer, confiscate, or nationalise resources within its territory and mobilise them for national defence. In such a scenario, it makes no difference who owns the resources.

In any event, trade with foreigners arguably lessens the probability of open conflict, as countries bound together by commercial ties have good reason to resolve their differences in ways other than military conflict. Similarly, foreign owners have every interest in assisting a national government to defend itself against third party aggressors. After all, they have assets at stake.

Clearly, AustraliaÕs gas resources are of strategic value. In the event of conflict, the Australian government would wish to ensure that this fuel resource was reserved for exclusive use by Australia and her military allies, and not accessible by enemy forces.

A more likely scenario, perhaps, is that Australia might be called upon to embargo exports of oil and gas to countries with whom one of our allies (most obviously, the United States) were in conflict. Since such circumstances fall short of national emergency, the Commonwealth could not invoke its powers to direct compliance by foreign and domestic companies in the national interest.

In such circumstances, it may be true that a Shell-controlled Woodside would be less easily convinced to accede to the Australian governmentÕs request than an Australian-controlled Woodside. This may occur because of ÔcollateralÕ damage to ShellÕs other interests outside Woodside were Woodside to renege on contracts at the request of the Australian government. On the other hand, Australian commercial interests would also be compromised by such action, and one should not easily dismiss the inclination of Australians also to resist the governmentÕs ÔrequestÕ.

Conclusion

It is questionable how seriously claims that foreign takeovers or acquisitions of domestic firms undermine the national interest should be taken, not least because of the difficulty of defining what is actually in the national interestÑespecially in a rapidly globalising world. Indeed, as one observer points out, Ôit is likely that the distinction between ÔnationalÕ and ÔinternationalÕ interests will become increasingly blurred, making the grounds for preventing or limiting takeovers of domestic firms by foreign companies increasingly narrowÕ.7

Endnotes

1 The term Ôcapital xenophobiaÕ is borrowed from a book of the same name. See Wolfgang Kasper, Capital Xenophobia: AustraliaÕs Controls of Foreign Investment, Policy Monograph 6 (Sydney: The Centre for Independent Studies, 1984).

2 ÔSummary of AustraliaÕs Foreign Investment PolicyÕ (Canberra: The Treasury, December 1991), 1.

3 Edward M. Graham and Paul R. Krugman, Foreign Direct Investment in the United States (Washington DC: Institute for International Economics, 1989), 45-46.

4 For further discussion, including evidence, of the welfare-enhancing effects of liberalising trade and investment flows, see Productivity Commission, Annual Report 1999-2000 (Canberra: AusInfo, 2000), 1-22, URL: http://www.pc.gov.au/ research/annualreport9900/annualreport9900.pdf

5 See for example Maurice D. Levi, International Finance, 3rd ed (McGraw-Hill, 1996), 489.

6 Graham and Krugman, 46-47.

7 Samuel Gregg, Understanding Corporate Governance: A Return to First Principles [working title] (Sydney: The Centre for Independent Studies, forthcoming).

a Australian Bureau of Statistics (ABS) ÔForeign Ownership of EquityÕ, Balance of Payments and International Investment Position (Canberra: December quarter, 2000).

b A T Kearney, Foreign Direct Investment Confidence Index 2000.

c Ernst & Young, Mergers and Acquisitions Index 2000 (Sydney: Ernst & Young, 2000)

d As above.

Ian Harper is Professorial Fellow at the Melbourne Business School,and a member of the CIS Academic Advisory Council. This article is based on a report for JP Morgan,on behalf of The Shell Group,by Harper Associates Australia in February 2001.

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