How not to expropriate investors

One of the most basic problems to solve before you can have a successful economy is, how do you reassure investors that they won’t be expropriated? This problem arises because of the combination of two features of most investments.

First, they take time. If you could generate profits instantly, without any time lag, then there would be no capital invested that would be at risk. The cost of expropriation would be limited to profits foregone.

Second, some of the investments made are non-reversible. Economists call these “sunk costs”, which is similar to fixed costs but not the same. A fixed cost is one that is invariant to the scale of production, which means that whether you produce one or a thousand widgets, you need a minimum amount of cost. A computer is a fixed cost, in that you can’t buy a proportion of a computer, which scales up as your revenues grow. (I know that computer services, bandwith and related things can be bought on such a scalable basis, but a basic PC normally can’t). But if you could withdraw that PC from one business and use it in another, or sell it for its fair second hand value, then the cost would not be sunk.

Sunk costs arise in almost all businesses, even as trivial as painting a van with a logo, since the logo is specific to the business and if you wanted to re-use the van you’d need a new logo. But they are most important in capital intensive businesses like oil and gas exploration or energy networks. You quite literally sink huge amounts of money in hydrocarbon exploration and it is then gone forever, whether or not you find resources.

So rational investors would not commit to a large, sunk cost investment, especially one that takes a long time before any chance of generating cash, unless they are confident they won’t be expropriated just when the investment is about to pay off. A government might promise not to expropriate when the investment is proposed (time t = 0). But after say five years of investment when the gas field is about to generate large amounts of money, (time t = 5), the government might rationally conclude it should expropriate.

It is critical to the problem that the government might have genuinely intended to keep it’s word at t=0. But the incentives have changed by t=5. This feature of decision making is known in economics as time inconsistency. The classic example is anti-inflation policy. A new government pledges to keep inflation low, even it means temporarily high unemployment. But a few years later, facing high inflation and an approaching election, the government’s short term incentive is to allow inflation to rise because high interest rates, necessary to depress inflation, risk losing it the election. So, many governments delegate their inflation decisions to an independent central bank, which is deliberately insulated from the political process, totally in the case of the European Central Bank, partially in the case of the US Federal Reserve Board.

The delegation decision is one way of making a credible promise. Rich countries have found ways to make such promises, which allow investors to invest with confidence. Poor or under-achieving economies typically have not. The rule of law, enshrined in legally enforceable contracts, is the main way used in rich countries. But even then governments can, within limits, break their promises. The British Parliament is sovereign and may not commit its elected successors. So when the utility companies were privatised in the 1980s and 1990s, there was a risk that later governments would either tighten regulation or renationalise the companies on unfavourable terms. This risk was made acceptable by the utilities being awarded long term contracts which were enforceable in the courts. Even an elected government (in the UK) cannot arbitrarily break a contract, though it may do so if fair compensation is paid. This provided enough assurance to investors, who then bought shares in the privatised gas, water and electricity companies.

And in 1997 they were expropriated, at least in small part, through the passage of a one-off £3bn “windfall tax” on their profits (in which I played a very modest part). Investors weren’t happy but they were reassured that this was indeed a one-off tax that would not change their long term incentives to invest, as it has (so far) proved.

The nationalisation this week by the Argentinian government of the oil company YPF (privatised in the 1990s with help from JPMorgan) is, as John Gapper points out in today’s Financial Times, very badly timed. If you’re going to expropriate investors, the optimal time to do it is when they have committed their capital and the profits are about to flow. The risk is at a minimum, the prospective reward known. You may not even have to completely expropriate them, just increase the tax rate (as UK governments have done with North Sea oil). The investors will be unhappy but if the future return is still acceptable they’ll keep going (the ex post return on a proven investment is much lower than the ex ante return required, when you don’t know for sure if it will work out).

But Argentina, which lacks access to international capital markets owing to a previous default (i.e. breach of contract), has siezed YPF when the country needs a great deal of investment and technical expertise. This is, as Mr. Gapper says, to use a technical term, stupid. There are various reasons for President Fernández’s timing which may politically be very intelligent but the economics of the matter are not. Argentina’s large shale gas reserves will likely be exploited less quickly, if at all, without foreign investment, to the long term detriment of the economy.

And more generally, Argentina’s government has reinforced the impression, created over a century, that it cannot make credible promises to investors, foreign or domestic. This is one of the reasons why the country has had one of the worst long term economic performances in the world.

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