NOVEMBER/DECEMBER 1987 - VOLUME 8 - NUMBERS 11 & 12
E A S T - W E S T T R A D E
Joint Ventures in Eastern Europeby Jonathan Dunn
Laws permitting joint ventures with Western companies date back to 1967, when Yugoslavia became the first country in the region to allow direct foreign investment inside its borders by Westerners. Passage of the law in Yugoslavia was an outgrowth of market oriented reforms. During the sixties and early seventies, a time of economic experimentation throughout the region, other East European countries also implemented liberal reforms. Romania and Hungary opened their borders to Western investors in 1971 and 1972, respectively. Since that time, all the other East bloc countries have enacted joint venture legislation, with the exception of East Germany. The most recent addition to the list is the Soviet Union, where a decree has been in effect only since January 1, 1987.
The Soviet decree, reflecting the dramatic shift in economic policies taking place under Mikhail Gorbachev, has inspired many Western companies to investigate the potential benefits of closer commercial ties to the East European countries. Joint ventures are the most intimate form of economic cooperation between East and West. Recent Soviet initiatives toward market-oriented reforms and fuller integration into the world economy have also inspired other East European policy-makers looking to Moscow for their cue, to pursue more extensive economic reforms and business ties to the West.
There are strong economic incentives for both the East and West to pursue joint ventures. Persistent political and economic obstacles, however, have limited the expansion of joint ventures in the region, but the recent activity in the Soviet Union suggests that a sense of cautious optimism has returned to East-West trade.
East European Motives
For the East European countries, joint ventures (TVs) with Western companies are attractive for several reasons:
In the formation of JVs, as well as other forms of economic interaction, the East European countries have favored dealing with large Western companies. Multinationals are involved in 75 percent of all JVs in Eastern Europe. The reasons for this include the following:
Western firms find joint ventures with East European partners attractive because:
Obstacles to East-West JVs
The obstacles to joint ventures, and expanded EastWest trade in general, include the inconvertibility of Eastern currencies, hard-currency shortages, Western concerns over the day-to-day management of enterprises in centrally planned economies and political barriers.
East Europeans are looking for JVs in export-oriented industries, but Western companies are primarily interested in expanding access to domestic markets in the East. However, profits from sales in the East are useless to Western partners unless the currencies are made convertible or the Eastern governments have enough hard-currency reserves to repatriate profits.
Domestic price structures have become seriously distorted because of government price policies, and only a radical reform of the price system will make convertibility of the ruble, dinar, forint and other East European currencies possible.
Hard-currency shortages reflect the imbalance of trade with the West, due to the lack of Western demand for Eastern products other than fuels, raw materials, agricultural products and a select few manufactured goods.
Some East bloc countries limit foreign equity in JVs to a 49 percent minority position. Consequently, many Western firms are concerned about their ability to influence day-to-day management of a JV enterprise. However, control over important management decisions is usually maintained by writing into the JV contract a condition that major decisions be unanimous. Western partners are usually given authority over quality control and the use of Western technology in production.
Westerners worry about lower labor productivity and effective worker discipline in East bloc countries. The concept of "worker participation" worries some Western managers, who are also concerned about having limited influence in decisions to hire or fire employees. Western companies are often concerned about the status of joint ventures vis-a-vis countries' annual and five-year plans. Questions remain as to the extent raw material and component supplies for joint ventures, as well as their finished products, are incorporated into these plans. Strict planning can limit flexibility, but joint ventures operating outside the plan may face difficulties obtaining essential supplies.
Financial issues related to capital investments and taxation are also sources of Western concern over the feasibility of joint ventures. Western companies would like to see their financial investments guaranteed by Soviet or East European banks. Complaints about excessive taxation in the East are often heard from Western partners, despite favorable tax breaks granted JVs by Eastern European governments.
The East bloc is viewed as a political and military adversary by the U.S. Consequently, many Western companies doing business there prefer lower profile direct sales or licensing schemes rather than joint ventures.
Export controls for national security objectives are restrictive and extensive enough to impose additional costs on JVs involving even basic technologies. Costs associated with licensing applications and administrative delays, not to mention the effect of a license denial, can effectively exclude many potential Western partners from entering JVs and can seriously threaten the livelihood of existing ventures.
Finally, there always exists the possibility of economic sanctions being imposed by the West, especially since JVs are a long-term commitment, and the imposition of sanctions could threaten a substantial investment by the Western partner.
Yugoslavia's 1967 JV law was an outgrowth of widespread economic reforms emphasizing a decentralization of economic decision-making and increased participation in the world economy. Passage of the original law represented a compromise between ideological conservatives, who saw direct foreign investment as "sacrificing the achievements of socialism" and those who favored unrestricted foreign investment to reduce the need for loans. The restrictions limiting foreign investors to a select few sectors and a 49 percent equity share have largely been removed, since the initial law was found too restrictive to attract Western business.
The conservative bias in the 1967 version reflected a deep mistrust on the part of Yugoslav authorities of direct foreign investment by multinationals. Prior to World War II, 95 percent of all oil refining and 90 percent of all oil marketing operations in Yugoslavia were controlled by a cartel of three multinationals: Shell, Standard and Astra(U.K.). Foreign interests also controlled 65 percent of all mining and 50 percent of all manufacturing.
The first joint venture formed under the new law in April 1968, involved the Italian company Fiat, which contributed $5 million for an 11 percent share of the capital in an automobile factory. In the following year, total capital in the JV went up to $112 million, and Fiat's share increased to about 20 percent at $22 million. Meanwhile, 25 other JVs had come into being, including one with the French automobile company Renault. Since these earliest examples, the automobile industry has continued to be an active joint venture partner in Yugoslavia, Hungary and Poland. In Yugoslavia alone, JV agreements with Western manufacturers have included Fiat, Renault, Daimler-Benz, Volkswagen, Citroen, Volvo and General Motors.
General Motors (GM) established a JV in 1974 with the Yugoslav enterprise IDA to produce parts for its West German subsidiary Opel. GM has a 49 percent interest in the foundry and machining operation which employs 700 people. According to a GM representative in Detroit, additional investments earlier this year to retool the facility will raise capacity by 30 percent. The Yugoslav factory exports parts to the Opel plants in West Germany and Austria, in return for which GM is granted the right to sell a proscribed number of its cars in the highly restricted Yugoslav domestic market. After this year's additional investment, GM's quota is expected to increase to over 4,000 cars. While GM views the Yugoslav enterprise as a .qualified low-cost producer" of its parts for Opel, the company's main interest in the JV is access to the Yugoslav domestic market, according to a company spokesperson.
Business Eastern Europe, a weekly business report focusing on East European economies, estimates the current number of registered joint ventures in Yugoslavia to be roughly 250. A recent U.S. Embassy report states there are 30 active JVs with U.S. companies. The report cites Chevron, Texaco and GM as the three largest U.S. investors in the country. The two oil companies are involved in offshore drilling operations. In addition to these three companies, the list of active U.S. JVs in Yugoslavia includes Baxter-Travenol for disposable dialysis machines, Black & Decker for handtools, Chroner for photovoltaic cells, Combustion Engineering for boilers and control instruments, CPC for wet-milled corn products, GTE for telephone switchboards, Honeywell for minicomputers (See Interview on page 16), H-R Microelectronics for computer boards, McDonald's for fast-food restaurants, Phoenix Technology for floppy and hard disks and Uniroyal-Goodrich for tires. The most recent addition to the list of U.S. investors is the hotel developer G-Square, which plans to invest $13 million in a JV with the Yugoslav tourist organization to convert a 17th century monastery on the Adriatic Sea into a luxury hotel.
One large U.S. multinational not on the list, but traditionally very active in East European markets, is Dow Chemical. In fact, Dow initiated a JV in Yugoslavia marking the largest single U.S. investment in Eastern Europe and the largest investment by a Yugoslav enterprise in any JV. Estimates for long-term investment in construction and operation of the massive petrochemical complex, a low-density polyethylene plant and a vinyl chloride plant on the island of Krk in the Adriatic, were as high as $1.2billion. In the words of a Dow employee, "This was clearly not a minor project." Annual production was expected to reach $550 million worth of output, with $200 million planned for export.
The contract signed in 1976 put Dow's initial investment at about $100 million for a 49 percent share. Dow supplied the capital in technology, equipment and cash. The Yugoslav partner, Industrija Nafte, is one of Yugoslavia's largest industrial enterprises, employing about 23,000 workers.
After a series of setbacks, including a downturn in the world market for petrochemical products, increases in the supply prices of petrochemical feedstock inputs, investment miscalculations due to Yugoslavia's high rate of inflation and delays on the part of local subcontractors supplying equipment, Dow decided in 1982 to pull out of the venture. With only the first phase of the project completed, Dow came to the conclusion that the Yugoslav economy was too weak to support plants of the size planned. A reported $410 million had been invested at the time of this decision, with the Yugoslav share including substantial investments in infrastructure for later stages of the project. A spokesman for the Yugoslav partner said they wanted to see the project finished, but Dow ended their cash investments and currently maintains only a "residual involvement" as a supplier and customer. A Dow employee said, "the reasons for discontinuing the venture had more to do with industry dynamics than it did with the situation in Yugoslavia," but added that the premature cancellation "remains a sensitive subject both within the company and with the Yugoslavs." Despite setbacks such as the Dow cancellation in 1982, joint ventures have continued to be of interest both to Western companies and Yugoslavia.
Since the "new economic mechanism" instituted in 1968, Hungary has been on the forefront of market oriented reform in Eastern Europe. As was the case in Yugoslavia, the 1972 JV law in Hungary was an outgrowth of the movement to decentralize the economy and encourage private initiative. Currently about 100 JVs with Western companies are operating inside Hungary.
The early Western entries in to the Hungarian economy included one of Western Europe's largest corporations, Seimens of West Germany, as well as the Swedish car manufacturer Volvo and the U.S. company Corning Glass. Seimens' joint venture provides servicing for their electrical and computer products sold in Hungary. Honeywell has since set up a similar service-oriented JV for their equipment in Bulgaria. Volvo's venture manufactures their Laplander cross-country vehicle for sale in Eastern Europe. Corning Glass' currently inactive JV produced blood-gas analyzers for export to East European and Western markets.
More recent U.S. entries into the Hungarian market include Eli Lilly, General Motors, C.W. International, American Writing Supply Corp., Unimpex, Bechtel, Truflex Rubber Products and Citibank. Currently, KMart and Occidental Petroleum are also negotiating to establish JVs in Hungary. General Motors is producing axles for its trucks, while Eli Lilly has jointly operated an agrochemical plant since 1981.
Citibank set up a JV in 1986 with a Hungarian bank to provide financial services for foreign trade activities, including assistance to new JVs. Citibank has an 80 percent share in the operation employing Hungarian National Bank personnel. In the first year, Citibank reported a "moderately successful" profit of about $1 million from the JV, the assets of which have quickly grown to $200 million. At an International Law Institute seminar on JVs in June, Citibank representative George Clark cited the benefits of a financial service JV: assets are more easily liquidated than plant and equipment; they are not subject to depreciation or obsolescence; and they are easily saleable.
Companies from Austria, West Germany, Switzerland, Japan, Sweden, Finland and Italy are also operating JVs in Hungary. The recently initiated Japanese JV producing fodder additives is the largest to date in the production sector, capitalized at $18 million with $27 million more expected. The Japanese partners have a 20 percent share, but have provided a much larger share of the initial capital investment. They are also obligated to buy back 50 percent of the output for sale on the world market. The JV's output will provide import substitution for Hungary, saving them $11 million annually.
Hungary is eager to attract partners in the high-tech electronics and computer industries. In 1984 Walters Microsystems (U.K.) agreed with the Hungarian enterprise Videoton to form a JV for production of computer printers. Walters provided the licenses, technology and about $1 million in cash for a 49 percent share in the JV. They continue to supply subcomponents for production of the printers which has doubled annually reaching 8,000 in 1986. The U.K. partner has options of receiving payment in dividends, sharing new technology developed by the J V or taking back finished products. And the ventures sophisticated products sell for hard-currency in other East bloc countries. The British company's director, Robert Kalman, said that this market expansion and the extension of his product's commercial life in less competitive Eastern markets were the primary motives for forming the JV in Hungary.
Standard Electric Lorenz of West Germany, part of the ITT Group, is another high-tech partner in a Hungarian JV. Since 1986 this company has had a 35 percent share in a JV for production and sales of telecommunications products, color TVs and VCRs.
Hungary has more JVs than any East bloc country except Yugoslavia. Hungarian policy-makers, encouraged by the recent market-oriented reforms in the Soviet Union, are continuously adding greater flexibility and incentives for Western partners to invest in the Hungarian economy.
Romania has not attracted as many Western companies as Hungary or Yugoslavia. One U.S. multinational that has had a successful JV since 1973 is Control Data Corporation (CDC).
With an initial investment of $1.8 million, CDC has a 45 percent share in the enterprise, Rom Control Data, which produces computer disc drives and printers for export to other East bloc countries and the West. All sales, which have reportedly reached $12 million annually, are in hard-currency. The factory employs about 200 Romanians. According to J.J. Matz, director of CDCs Austrian subsidiary, "the idea was to get local personnel through the learning curve."
Former vice chairman of CDC, Robert Schmidt, who set up the venture (See interview page 23), said negotiations with the Romanians were quite smooth, although other sources report that the incentive system proposed by CDC to encourage labor productivity worried the Romanian government. They feared that the system would drain off the best workers from local enterprises.
Schmidt, Matz and CDC's Chairman Emeritus William Norris agree that the most serious obstacle has been U.S. export control policy. Because of the restrictive controls on computer-related technology, the venture's products were obsolete or at the end of the product cycle in Western markets. The controls on disc drives prevented the TV from upgrading this particular product over time, and eventually forced the venture to change its product line to printers. According to Schmidt, "It could have been a lot more profitable and it could have exerted a much stronger influence on the Romanian economy had the United States government gotten back out of the way and let it go forward on an open market basis. Instead, they insisted on using some of the tactics and regulations for which we have been criticizing the East for along time. Instead of being willing to face up to the idea that we were behaving like some of the Eastern countries, we in fact tried to tell everybody that 'the Pope wasn't Catholic.'"
Rom-CDC, as the venture is known, has been profitable since 1978, and now is controlled almost entirely by the Romanians. Recently CDC sold off some of its share to other Western companies, which continue to assist the venture in marketing its products in Western Europe.
French, Italian, West German and Japanese companies have also established JVs in Romania. Renault's venture produces gear boxes and other parts for its 'Dacia' model automobile. Dai Nippon's $11 million venture established in 1974 produces protein-rich yeast from crude oils as a base for livestock feed. In 1973, a German firm Renk- Zahnraederfabrik took a 49 percent share of the $7.5 million investment in a JV producing industrial gears for marine equipment.
The recent decree allowing joint ventures in the Soviet Union has stimulated a great deal of excitement in the West as an unprecedented step toward economic reform. In fact, there is a precedent for JVs in the Soviet Union. Shortly after the Bolshevik Revolution, Lenin instituted the "new economic policy," to stimulate private enterprise in selected sectors to spur industrial recovery after World War I, the Revolution and subsequent Civil War. In 1920, Lenin himself signed over 200 agreements with foreign companies. One of these early joint ventures involved a youthful American doctor named Armand Hammer, whose Occidental Petroleum just signed the most recent agreement to form a joint venture under the January 1987 decree. Hammer started out trading Western medicines and food for Russian art treasures and raw materials. He also operated a successful pencil manufacturing company until 1930, when his trading privileges were revoked during Stalin's nationalization of the economy.
So far 10 ventures with Western partners have been agreed to since January 1, 1987, when the decree became effective. Four are with U.S. companies, two with Finnish, two with West German, one with a Japanese company and one with an Indian company. However, Soviet officials report that over 300 applications for JVs have been received from interested companies. Many U.S. companies have already signed letters of intent to establish JVs, including Cummins Engines, Honeywell, Nike, Dresser Industries, Monsanto, Chilewich Corp., Eli Lilly, Singer Sewing Machine, Dow Chemical and Coca-Cola.
PepsiCo, whose long-standing trade relationship with the Soviets dates back to 1959, will open two Pizza Hut restaurants in Moscow. To circumvent problems of hard currency earnings and repatriation in the domestic market, one outlet will service foreigners and only accept hard-currency payment, while the other will be for Soviet customers paying in rubles.
PanAm has established a venture with the Soviet airline Aeroflot to jointly offer direct flights between the U.S. and Soviet Union.
Combustion Engineering recently agreed to form a JV for the production of advanced process control systems for Soviet petrochemical plants. Operations are scheduled to begin at a Moscow refinery in 1988. The U.S. partner's share of the $16 million initial capital will mostly be provided in the form of equipment and services, along with some cash. Combustion Engineering's vice president, John Ackermann, announced the agreement at a Harvard University conference on joint ventures in the communist countries held on October 26. Production and assembly of the control systems will take place in four different Soviet cities, with quality control ensured by the U.S. general director. This is the first U.S.-Soviet joint venture involving advanced technology, but Ackermann stressed that his company has complied with all U.S. export controls on technology transfer to the Soviet Union.
Occidental Petroleum, in cooperation with Montedison of Italy and Marubeni of Japan, has just announced the most recent Soviet joint venture agreement, involving construction of a massive petrochemical plant for processing natural gas and sulphur into synthetic chemicals used for construction materials, packaging and housewares. The estimated $6 billion facility will be one of the largest in the world, with annual production projected at 500,000 tons of polypropylene and polyethylene and one million tons of commercial grade sulphur. Half of the output is intended for export to the world market. Construction is scheduled to begin in 1989 and will take at least three years to complete.
Along with the Combustion Engineering venture, Occidental's record-breaking investment demonstrates the vast potential for JVs combining Western technology and Soviet natural resources, particularly in the oil, natural gas and chemicals sectors. Both these recent ventures take advantage of the January removal of U.S. government sanctions on the export of oil and gas technology and equipment to the Soviet Union. Together, these two agreements send a strong signal to other Western companies monitoring commercial developments in the Soviet Union, that opportunities do exist for profitable largescale investments.
In June, the Soviets announced a partnership with the Tairuku Trading company of Japan to set up a wood products complex 600 miles north of the Siberian city of Irkutsk. The Japanese invested about $1.5 million, mainly in equipment, and hold a 49 percent share in the facility, which will export cut lumber and finished wood products to Japan and other hard-currency markets.
Following a Japanese trade delegation visit to Moscow, 36 joint venture proposals were announced, many of which follow the same pattern of using Japanese management and equipment in low-technology natural resource-based industries. Soviet natural resources, concentrated in the undeveloped Far Eastern regions of the country, offer vast potential for sensible Soviet Japanese joint ventures.
The Japanese are eager to invest their surplus capital and provide some of their technology, but they are also wary of getting too far out front of other Western countries in cooperating with the Soviets. In addition to natural resource development projects, the Soviets are also expressing interest in Japan's consumer electronics industry. Toshiba is negotiating with the Soviet Ministry of Electrical Engineering to jointly produce air conditioners, electric furnaces and household appliances.
The first JV under the new decree, signed with Finnair and its subsidiary Nordic Hotel in January, is to renovate and operate the Hotel Berlin in Moscow. The Finnish partners are investing $10 million for a 49 percent equity share in this JV with the Soviet organization Intourist. The hotel is mainly used by Western business people and tourists, so billings will be made in dollars, thereby circumventing the major problem of hard-currency repatriation from ruble revenue. This venture does not provide the Soviets any significant technology, but it will be a source of hard- currency. The Finns have established a second JV in Estonia to produce paints, thinners and sealants. The Sadolin company has a 40 percent share of the $1.5 million initial investment in the JV, which will supply Soviet construction sites.
Some of the ventures still at the stage of negotiations would, if actually formed, contribute more to the Soviets' technological advancement in some important industries. For example, the Dutch firm Phillips is negotiating a JV for production of integrated-circuit microchips and diodes, replacing imports of these and other computer related components from Finnish suppliers.
Other examples include two ventures currently being negotiated in the oil industry. A British firm, Trafalgar House Offshore, is negotiating a JV to manufacture underwater platforms used in offshore oil exploration. Also, the U.S. company Dresser Industries, active in the huge Soviet market for oil and gas technology and equipment, is negotiating a JV for production of oilfield equipment. Capital investment has been projected at $50 million. Western assistance in the Soviets' development of their oil and gas industries remains a very controversial issue, despite the lifting in January of sanctions on U.S. exports of related technology and equipment to the Soviet Union.
Monsanto's manager for international development, Michael Petrilli, described this U.S. company's ongoing joint venture negotiations with the Soviets at the Harvard conference. A venture to produce Monsanto's "RoundUp" herbicide is being considered, but there remains some conflict over the scope of the project. Monsanto wants to minimize its initial investment by having the production facility constructed at an existing chemical plant, while the Soviets want to build an entirely new plant, necessitating construction of new roads and other infrastructure. Also, Monsanto has no interest in having the Soviets export "Round-Up" to Western markets.
The list of other ventures currently being negotiated is quite diverse, with possible agreements ranging from automated dairy farms, electric welding machines and diamond tipped cutting tools, to "Hush Puppy" shoes, Armani designer clothing, lollipops, Coca-Cola and McDonald's fast food.
Long-term Soviet objectives are to expand and diversify their exports to the West, which requires a substantial improvement in the quality of Soviet products, particularly manufactured goods.
Unfortunately for Western companies interested in access to Soviet domestic markets, this policy objective along with the obstacles of currency inconvertibility and limited Soviet hard-currency reserves, mean the number of ventures servicing the domestic market in the Soviet Union will probably remain small in the near future.
However, announcements by trade officials in October indicated some important changes in Soviet policy on joint ventures. One change is that the Soviet Vneshtorgbank will be authorized to provide hard-currency credits to joint ventures during their first eight years of operation. The second change is that the Soviets will weigh more heavily the import substitution effect of a joint venture. Consequently, ventures producing a product the Soviets would have to purchase from the West will be eligible to receive hard-currency from Soviet sources.
These recent responses by the Soviets to Western companies' concern over the feasibility of JVs demonstrates that the Soviets are fulfilling their promise to be flexible in regulations. The experiences of Hungary and Yugoslavia demonstrate that JV regulations change as the broader policies of economic management evolve.
The interest generated by the Soviet JV law since its announcement in January has been impressive. However, a year is not nearly enough time to judge the longterm impact of this new Soviet law, especially considering the JV law is one part of an extensive program of reform, one Western experts have called the most comprehensive effort since 1928, when Stalin established the system Gorbachev and his supporters are currently trying to abolish.
The number of JVs with Western partners operating in the Eastern European countries remains small enough so that their current impact on East European or Western economies is not reflected in macroeconomic measures. However, on the microeconomic level they represent the most intimate form of mutually beneficial economic cooperation between Eastern Europe and the West.
The Soviet Union has traditionally been the most conservative member of the East bloc with regard to economic experimentation. Clearly, when they are supportive of market-oriented reforms in domestic and foreign economic policies, their position influences policymakers throughout the region. If this trend continues without a conservative backlash, and the domestic economic reforms necessary for the expansion of joint ventures are allowed to proceed in a stable manner, joint ventures may indeed alter dramatically the future of East-West economic and political relations.