By Alan M. Field

When the Canadian government rejected a proposed $40 billion hostile bid for fertilizer maker Potash Corp. of Saskatchewan Inc. by Australia-based BHP Billiton in 2010, fears spread across the North American business community that Canada was turning inward precisely when it needed fresh foreign investment to improve the country’s productivity to address slower global growth.

Under the terms of the Investment Canada Act (ICA), the federal government reviews all foreign acquisitions of companies with assets valued at more than $312 million, and it can reject transactions that don’t provide a “net benefit” to Canada. In the past, the federal government rarely took advantage of its right to turn thumbs down on foreign investments. Since the Investment Canada Act took effect in 1985, the federal government had not previously rejected a single foreign acquisition in Canada apart from the 2008 bid by Minneapolis-based Alliant Techsystems to acquire the aerospace division of Vancouver-based MacDonald, Dettwiler & Assoc­iates Ltd.

From 1985 through 2008, the federal government had approved some 11,214 foreign acquisitions based on the requirements of the ICA legislation. In all, some 98 per cent of attempted investments by foreign companies in Canada were approved, including takeovers of steel, nickel and aluminum firms. Notable investments include a US$2.3 billion investment by Abu Dhabi-controlled International Petro­leum Investment Co. (IPIC) in Nova Corp; a US$1.5 billion purchase of a substantial voting interest in Teck Resources by China Investment Corporation; and investments by Abu Dhabi state-owned enterprises in the oil producing sector in western Canada.

And yet, the failure of the government to approve BHP’s takeover of Potash has stirred lingering concerns about the possibility that the process of approving new investments is so opaque, it may be dissuading investment proposals from companies that might bring advanced technology that provide a significant “net benefit” for Canada. Lawrence Herman, attorney at Cassels Brock & Blackwell, a law firm in Toronto, is concerned about the lack of transparency in the process for approving large-scale foreign investments. “In the case of Potash, we should have had at least had some general statement about why the Canadian government disapproved the deal,” argues Mr. Herman, a leading expert on foreign investment.

Rejecting the acquisition on the vague grounds that it does not provide a “net benefit” for Canada leaves prospective foreign investors with no detailed guidelines for deciding about how the government might react to their own investment proposals. “We need more detailed guidelines” about what constitutes a net benefit, adds Mr. Herman. “We need transparency. The government should issue the reasons. Now we have no idea what factors led to their rejection” of the BHP-Potash deal.

What foreign investment means for productivity

The stakes for Canada’s productivity and competitiveness are huge. Louis Thériault, Director of the Industry Sector Economics Group at the Conference Board of Canada, said that inward foreign direct investment (FDI) not only helps expand trade but “can also boost productivity by providing access to new technology, business and manufacturing processes, and management know-how, as well as by fostering a competitive and innovative business environment.” For years, the Conference Board of Canada has argued that one of the key factors behind Canada’s “slipping economic performance relative to its peers and to emerging economies is insufficient inward FDI,” according to a report by that institution.

In this era of growing economic integration and trade, global supply chains are driven by increased volumes of foreign investments aimed at reducing transportation and transaction costs at various points along the chain. Between 1990 and 2007, when global GDP increased by an annual average of 5.5 per cent and exports grew by 8.5 per cent, the annual flow of FDI worldwide grew by a whopping 14.6 per cent. Although many factors affect labour productivity – including investment in machinery equipment and the skills of labour forces – there is also a positive relationship between inward FDI stock as a share of GDP and labour productivity, noted the Canada-based Business Roundtable.

According to research by the Organisation of Economic Co-operation and Development, “knowledge-related spillovers from FDI vary considerably across sectors,” but the productivity-enhancing effects of FDI are clearly strongest in the service sector. In Canada, the services sector accounts for over 70 per cent of GDP, so “boosting inward FDI would therefore have a positive impact on Canada’s labour productivity,” said the Business Roundtable report.

Is Canada attracting enough foreign investment to raise its labour productivity sufficiently to become truly more competitive in global markets? Or, on the contrary, has the federal government’s opaque process for granting approval to foreign investment proposals contributed to discouraging many foreign investors from bringing their capital into Canada?

A declining share of FDI

This much is certain: Canada’s share of global FDI has dropped significantly in recent years, even as inward FDI has increased in absolute numbers as the global economy has expanded in terms of dollars. According to the UNCTAD World In­vestment Report 2011, Canada’s annual volume of inward FDI dropped from an average of C$66.87 billion, between 2005 and 2007, to just $21.4 billion in 2009 and $23.4 billion in 2010, after the worst of the recession had passed. As a percentage of gross fixed capital formation in Canada, foreign direct investment plunged from an average of 14.5 per cent from 1995 to 2004; to just 7.4 per cent in 2009, and then 6.8 per cent in 2010. Canada’s share of global inward foreign direct investment flows dropped from 16 per cent in 1970 to 3 per cent in 2009.

To be fair, other developed ­nations have also experienced a declining share of global FDI. The U.S. share of global FDI, which rose from 8 per cent in 1970 to 29 per cent in 1986, plummeted to just 12 per cent in 2009. As a whole, developed countries (excluding the U.S. and Canada) experienced a small decline – from 51 per cent of world FDI inflows in 1970 to 45 per cent in 2009. Meanwhile, China’s share of global inward FDI flows grew from almost zero in 1970 to 11 per cent in 2009, as global companies invested heavily in Chinese facilities critical to their increasingly global supply chains. India’s share increased as well, but not nearly as spectacularly. Other emerging nations that have only recently joined the global economy have increased their share of inward FDI as well.

Does this mean that Canada could do a lot better at attracting foreign investment? Some critics argue that Canada is no longer attracting its “fair share” of global inward FDI. For an objective indictor, they cite Canada’s ‘inward FDI performance index’ – the ratio between its share of global FDI and its share of global gross domestic product (GDP). This index accurately captures each country’s relative success in attracting global FDI. (If a country’s share of global inward FDI matches its relative share of global GDP, the country’s inward FDI performance index is equal to 1. A value greater than 1 means the country is attracting more inward FDI than its economic size would warrant. A value of less than 1 indicates it is attracting less inward FDI than it should, based on the size of its economy.)  Using that indicator, Canada’s ability to attract inward FDI peaked in 1970 at a rating of 6, when Canada attracted six times more inward FDI than its GDP would otherwise warrant. Since 1995, however, Canada’s index has hovered between 1.1 and 1.2, which means Canada’s share of global inward FDI is still larger than its share of global GDP, noted Philippe Bergevin, Senior Policy Analyst at CD Howe, a Toronto-based think tank. By that standard, Canada’s share is a “fair” one – but just barely so, unlike the good old days when Canada’s share far exceeded what was “fair.”

Canada’s relative decline is inevitable, note economists, because Canada (like the U.S.) is becoming a smaller player in the overall global economy, as the emerging nations of Asia and Latin America expand their manufacturing facilities and infrastructures at a more rapid pace than Canada – or other developed countries. Starting from a much lower base, there is no way that Canada can expand its economy – and its stock of foreign investment – at a pace that rivals the new emerging nations. However, Canada doesn’t really need to expand its foreign investment as rapidly because it already has the essential infrastructure that many emerging nations – including China – still need to build, with the aid of foreign investments in those countries.

More troubling, perhaps, Canada ranks poorly among developed countries when it comes to business investment in R&D as a share of GDP. Canada also ranks poorly on the OECD’s FDI Restrictiveness Index – which measures regulatory restrictions on FDI, such as “equity restrictions, screening and approval requirements, restrictions on foreign key personnel, and other operational restrictions (such as limits on purchase of land or on repatriation of profits and capital).” Among developed countries, Canada had the second-highest FDI Restrictiveness Index in 2010 (the higher the index, the higher the restrictiveness to FDI) – after Japan. One of those restrictions is the controversial Investment Canada Act, which provided the federal government the authority to reject BHP Billiton’s proposed merger of Potash. “To attract FDI, Canada should focus on creating a business environment that is more open to competition and conducive to innovation – especially in key industries such as telecom and air transportation,” said Mr. Thériault.

Does the Investment Canada Act really discourage FDI?

Is it accurate to say that the Investment Canada Act discourages FDI? Might the process be reformed in such a way that Canada gets a larger share of the FDI pie? Mr. Bergevin believes that the ICA is part of the problem. Its approval process, he said, “throws the net wide” by asking for confidential information about every foreign investment above the threshold above $312 million, and applying a vague formula – ‘net benefit to Canada’ – as a standard for approval. This process requires foreign investors to share their confidential plans with the federal government and to demonstrate how these plans would be of net benefit to Canada, based on job growth, export growth or improved productivity. “As a condition of approval, investors might have to make legally binding promises, or undertakings, concerning the net benefit of the investment over a period of a few years,” explained Mr. Bergevin. The problem with that, he said, is that it is not possible to quantify the difference that the ‘net benefit’ standard would makes on foreign investment “because we don’t know what future economic activity would have occurred had a blocked acquisition taken place.”

Mr. Bergevin argued that although the “net benefit” test sounds like an objective standard, “it is very opaque and very difficult to prove … it is secretive and unpredictable, and often prevents the government from clearly articulating why it would oppose a proposed investment.” No one knows how many investors, discouraged by these proceedings, cancel their plans to invest in Canada, he argued. “There could be some foreign investors who refrained in the first place from investing in Canada out of fear of triggering this test,” he added.

Although there is no way to prove that changing the “net benefit” test could result in a greater volume of inward FDI, Mr. Bergevin noted that Canada’s share of global FDI used to be 8 per cent but is now only 2 to 3 per cent; about the same as Canada’s share of global GDP. “If we could attract more investment, that would be a positive,” he said. By changing the process in such a way that Canada attracts more foreign investment, said Mr. Bergevin, Canada would “dramatically increase the pool of potential investors and send a positive message that we are open to doing business. After all, we are competing for investments with emerging nations,” at a time when the strong Canadian dollar makes it more expensive for foreign firms to buy significant shares of Canadian companies. “Canada is lagging in productivity, and Foreign Direct Investment is one of the major channels for enhancing productivity. Large multinationals are more innovative and more productive, and pay higher salaries,” he added.

Roads toward improving the process

How might the approval process be altered? One alternative to the ‘net benefit to Canada’ test, said Mr. Bergevin, would be to create a ‘national interest test.’ “Rather than asking companies to prove that their proposed investment would be of ‘net benefit to Canada,’ a national interest test would require the federal government to articulate the public policy reasons that would prompt it to intervene,” he said. Why would such a test encourage foreign investors?

Mr. Bergevin argued that using the ‘national interest test’ would have a significant implication: in cases where foreign investments have no likely negative public policy implications, it would mean that “the government would no more intervene in a private transaction involving foreigners than it would in a transaction involving Canadians in similar circumstances.” Such a stance “would significantly reduce or eliminate obstacles to beneficial direct investment into Canada,” he said.

For his part, Mr. Herman argues against replacing the “net benefit test” with any new standard such as the “national interest test.” Noting that a recent report by Canada’s Com­petition Policy Review Panel showed that “there is no evidence that the ICA has impeded Foreign Direct Investment” in Canada, Mr. Herman argued that a better approach is for the federal government to provide “more detailed guidelines” about what constitutes ‘net benefits,’ and provide more details whenever a proposed foreign investment is either approved or disapproved. “They should issue the reasons why they are taking action,” said Mr. Herman. “Right now we have no idea what factors” were behind their decision. “We can do better. We should have at least some general statement about why the Canadian government disapproved.”

Currently, said Mr. Herman, “The process of Canada’s investment review regime remains too opaque, too discretionary and too secretive, with only perfunctory public explanation, as has been the case over most of the 25 years of the ICA’s operation. This has added to perceptions that the review process is arbitrary and politicized and thereby tarnishes Canada’s reputation as a capital-friendly host country.” Returning to BHP Billiton’s failed bid for Saskatchewan-based Potash Corp., Mr. Herman noted how numerous observers inferred that the government of Prime Minister Stephen Harper rejected the proposal in order to improve the Conservative Party’s electoral prospects in Saskatchewan, where many voters disapproved of the foreign takeover. “There was a lot of gnashing of teeth then, but if the Canadian government had stated the reasons, it would have reassured foreign investors,” said Mr. Herman. Although such political inferences have never been proved – or disproved – this much is clear, he added: “The current process is opaque and cloaked in secrecy, leaving Canadians and foreign investors alike in the dark about what factors lead to a given decision – either for or against an acquisition. Surely we can do better.”

Added Mr. Herman, “Contrary to the assertions that the net benefit test is a subjective one and purely in the eye of the beholder – meaning the federal cabinet – the reality is that there are broadly objective factors set out in the statute, not adequately defined or sufficiently precise but nonetheless generally stated as legal criteria. The task is to make those factors much better defined and more specific and less arbitrary and open-ended.”

Mr. Herman added that the nationwide debate about whether – or how – to reform the process for approving major foreign investments is not going to subside anytime soon. With the trend to globalization of capital markets and the growing influence of sovereign wealth funds (SWFs) and state-owned enterprises (SOEs), Canada’s approach to reviewing large corporate takeovers will become an even tougher challenge in the future. More and more foreign investment proposals from countries like China will emerge not only from their country’s state-owned enterprises and sovereign wealth funds, but from third or fourth locations owned by other parties whose identities may be difficult to trace. For example, said Mr. Herman, a prospective investor could be a fund in New York controlled by an investor in Dubai, who has indirect ties with Iran or China. That’s one reason why Industry Canada, the government agency, has established “a large group of sophisticated people in charge of investing FDI proposals,” said Mr. Herman.

Overall, a major challenge for Canada, he added, is to maintain a balance between total transparency, and the current policy in which “nothing is made public” about the decision-making process. Whenever a foreign investment proposal is approved or disapproved, the Canadian government needs to be able to point to a document that provides a summary of the investment proposal, and which gives a “satisfactory explanation of its decision. Right now, everything is cloaked in secrecy,” he added.

Other best practices encouraging FDI

What other steps can Canada take to encourage the most desirable foreign investors? In its October 2010 report about best practices for promoting inward FDI, the Conference Board of Canada suggested pursuing “public policies that are conventionally associated with promoting productivity and real economic growth” from a broader perspective. These would include encouraging “a reliable and transparent legal and regulatory regime, an educated and skilled workforce, good transportation and telecommunications infrastructure, and an environment that encourages innovation.”

Beyond that, however, the report warned against governmental subsidies and tax breaks, and other policies that specifically target foreign investors. Such subsidies and tax breaks “are not necessarily best practices for attracting investment,” the report said. “The evidence is not clear that such fiscal incentives promote FDI in the longer run. Such policies could even reduce any spillover productivity effects from that investment.  This is particularly true if subsidies or tax breaks result in FDI that geographically disperses industrial and scientific capacity.”

The report also noted that “evidence suggests that best practices for promoting outward direct investment are largely similar to those for attracting inward direct investment. Contrary to popular conception, an environment favourable for inward direct investment is not unfavourable for outward direct investment. This is because policies promoting improved productivity and real economic growth ultimately strengthen the competitive advantages of domestically owned firms. This, in turn, encourages and enables domestic firms to expand internationally, including investing abroad.”

Because outward direct investment focuses on accessing specialized skills and knowledge abroad, it can lead to greater productivity benefits at home. “This is because skills and knowledge transferred from host countries to the home country are likely to convey productivity benefits to organizations beyond the home-country multinational company responsible for directly or indirectly transferring the skills and knowledge to the home country,” said the report.