Foreign Direct Investment in Cuba A study on the 2014 reforms

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Foreign Direct Investment in Cuba

A study on the 2014 reforms

William Johansson

Gustaf Swartling

Economics, bachelor's level 2018

Luleå University of Technology

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Abstract

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Acknowledgements

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Abbreviations

CECM Executive Committee of the Council of Ministers

EU European Union

FDI Foreign direct investment

H-O Heckscher-Ohlin Theorem

JV Joint venture

MINCEX Ministry of International Commerce and Foreign Investment

MINVEC Ministry of Foreign Affairs of Cuba

OLI Ownership, location and internalization

RCA Revealed comparative advantage

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Chapter 1 Introduction

Chapter One describes Cuba’s current economic situation and discusses the laws and regulations regarding foreign investments and how important foreign investments can be for Cuba. The chapter ends by stating the purpose of the field study and how the question at issue will be answered.

1.1 Problem discussion

In 2016, the Cuban Government officially announced that the country’s GDP had decreased by 0.9 percent, the first official recession in 23 years. The recession took place due to the economic situation in Venezuela (one of the country’s biggest trade partners) which had been exporting subsidised oil in exchange for Cuban doctors since the beginning of 2000. The decrease in the price of sugar, nickel and oil, which accounted for 50.4 percent of total exports also contributed to the recession. In the same year, 80 percent of consumer goods were imported due to low productivity and efficiency, generating a substantial trade deficit of US$ 7.9 billion. In 2015, Cuba had participated in a foreign debt reduction agreement, leading to a foreign debt of US$ 29.8 billion. Since the agreement, Cuba had started to pay off its national debt, however, at the same time new credit agreements had been signed. (Swedish Embassy, 2017)

Vidal (2014) suggests that Cuba needs to increase their exports to improve the current state of affairs, but there are factors preventing this. Cuba uses a two-currency system with two flexible exchange rates, with the consequence of low competitiveness, segmentation, higher transaction costs and distorted relative prices. According to De la Torre and Ize (2014) and Vidal and Perez (2014), the monetary duality has severely damaged exports in the past two decades. At the same time, the currency has been overvalued in relation to the US dollar and this has particularly affected the export sectors of the economy.

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Caribbean countries. JVs can be successful for Cuba, but the government drives a wedge between Cuba and global/international capital flows by denying business permits or discouraging foreign investment. (De la Torre and Ize, 2014)

1.1.1 Legal framework

Law 890 was enacted one year after the revolution in 1960, leading to significant changes in the Cuban economy. The law nationalized both foreign and privatized enterprises leading to a total socialist regime. New constitutions and amendments in Law 890 proclaimed Cuba as a socialist state striving towards communism. The revolution led to a centralized economy with the Soviet Union as the main trading partner. Cuba exported sugar and nickel above the market price and imported subsidised oil. In other words, the revolution led to a centralized economy heavily dependent on the Soviet Union. In the 80s, world prices of sugar and nickel fell at the same time as the US blockade intensified. Cuba entered a heavy recession and Castro realized that FDI was needed to save the economy. (Gallousis, 2001)

The first major reform, Law 50, was enacted in 1982, and covered general legal, financial, tax, commercial and labor provisions in five Chapters. The objective of Law 50 was to enable economic growth by allocating FDI to sectors favoring Cuban export, mainly tourism and manufacturing plants. The new law enabled the possibility to invest and establish joint ventures (JVs) in Cuba but placed restrictions by changing the definition of a joint venture.

Under the new law, a JV had to consist of both national and international investors; the latter being allowed to own a maximum of only 49 percent of the JV. In other words, national investors needed to own the majority of the venture. The ownership rule created uncertainty, since foreign investors had to relinquish the majority of the venture to the Cuban government. JVs had to use state employment agencies and only Cubans could be employed, except for higher positions. A 25 percent wage tax had to be payed to the agency as well as a 30 percent tax on net profits.

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from acquiring private property according to Chapters 14 and 15 of the Constitution (Gallousis, 2001).

A new law (Law 77) was enacted in 1995 as a direct response to the severe depression that resulted from the collapse of the Soviet Union. The purpose of the law was to protect national sovereignty while promoting economic development (Gallousis, 2001). Law 77 covered the same areas regulating FDI as Law 50 but was far more detailed (containing 17 Chapters).

According to the law, each proposed investment needed to be approved by the government. First, the application was sent to the Ministry of International Commerce and Foreign Investment (MINCEX) which discussed the case with relevant institutions. After the consultation, MINCEX sent a recommendation to the Executive Committee of the Council of Ministers, which decided the outcome of the case. Law 77 required that the whole process from application to final decision be completed within 60 days. (Feinberg, 2012)

Law 77 enabled FDI in the form of 100 percent foreign owned JVs fully protected from expropriation, unless the case had a public interest or was counter revolutionary. JVs were permitted to reinvest profits if authorized by the government, otherwise the taxation rate on profit was 30 percent. JVs had to hire employees from state-owned employment agencies, to which it also paid their salaries, with limited exceptions. Subsequently, the employees received their salaries from the employment agency. The agencies charged high (salary) fees which led to low salaries being allocated to employees. These, in turn, led to decreased motivation, resulting in a low-wage, low-productivity trap. Over 90 percent of the salary did not reach the employee and could be described as the world’s heaviest labour tax (Feinberg. 2012). Industrial parks and duty-free zones were also introduced under Law 77 to promote production and industrialization, since the zones yielded advantages that could not be shared by companies outside the zones.

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Chapters were amended in 1992 to promote FDIs, hence allowing real estate ownership to be enabled in Law 77 (Gallousis, 2001).

However, some policies remained. JVs still had to employ through employment agencies leading to a low-productivity trap and an interesting observation is that the government purposely ignored Law 77 (Chapter 11 Article 10) that allowed FDI in all sectors except health care, education and the military by excluding FDI in the sugar industry This could be explained by the historical fact that in the past, larger countries had exploited the sugar industry for their own interest. From 2002, the number of JVs decreased for several political reasons, such as claims of illegal activity and that joint ventures had not reached the economic goals targeted by the government

In 2014, a new legal framework was approved by the state to attract FDI. This resulted in several structural reforms. The reforms gave autonomy to companies to retain their earnings and to control decision making regarding investments, employment and prices. The reforms also allowed non-state cooperatives in the agricultural sector. Feinberg (2014) mentions that it is important to understand the distribution of income and opportunities when an economic reform is enacted. The potential losers may not see the potential loss, and the potential winners can’t see the potential gains. In this reform, the potential winners were the farmers who would benefit from the new price incentive, entrepreneurs in the private sector, workers hired by JVs and managers in the state-owned enterprises who could gain from decentralization.

The new law covered the same areas as Law 77, but, according to Romero Gomes (2014), significant changes were made:

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- Export of national goods in competitive conditions were prioritized.

- A Chapter was added with the purpose of regulating the state’s involvement in the characteristics of the foreign investment. In addition, environmental protection was strengthened in regard to businesses dealing with technology and innovation.

The Council of Ministers adopted legal provision and a timetable to unify the currency by training personnel and institutions that would be part of this complex process. However, this has not yet been finalised. Despite significant changes in the policies, the reforms are still in their first stage and more needs to be done to ensure that the economic and social transformation is intact and consistent.

The Swedish Embassy (2017) mentions that the bureaucracy, liquidity issues, the two-currency system and other factors still prevent the flow of FDI into Cuba. Cuba has historically had issues with foreign investments when it comes to laws and regulations and this may continue after the reforms in 2014. There is still a large trade deficit and a need for new investors and growth in exports. This leads to the research question which is presented in the next section.

1.3 Research questions

The study investigated whether the reforms made in 2014 have had an impact on FDI and if the issues regarding FDI, which Law 77 addressed, remain. The question of whether FDI can increase exports in stronger industries were also investigated.

The study aimed to answer the following questions:

• How has the new reform affected FDI and do the same issues experienced with Law 77 exist after the reforms in 2014?

• To which industry should FDI be allocated in order to achieve a potential increase in exports?

1.4 Purpose

FDI may result in an increase in exports; which could in turn counter the current recession. Thus, the purpose of the study was to identify one industry with high potential to which FDI should be allocated.

1.5 Method

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industries with relatively high exports. These industries were discussed briefly to determine which ones should be used in the second method.

The second method was a minor field study during which individuals who had experience and knowledge about these industries were interviewed. This also helped answer the research questions by combining them with the theories and the literature review.

1.6 Scope of the study

The study focused on the goods markets and excluded service industries. Cuba has an emerging tourism sector, but it is hard to quantify and even harder to define since it includes multiple industries within it. Cuba also exports medical services and enables Cuban doctors to work in Venezuela in exchange for subsidised oil, which amounts to a considerable share of total exports (Swedish Embassy, 2017).

Macro-economic factors such as the US embargo were not included in this study because of the complexity and the history behind them and the study focused on domestic laws and regulations.

The research study assumed that the RCA model would yield potential industries for FDI, which meant that industries with relatively low exports were excluded even though they may have had great potential for FDI. (The reasons for this approach are discussed later in more detail in this paper.)

The flow of FDI was estimated by gathering data of FDI inflow and the number of joint ventures in Cuba. There are other ways for foreign investors to invest, as presented in the background, but data regarding alternatives to JVs is scarce. Therefore, this study based the inflow FDI on the numbers of joint ventures.

1.7 Structure of the paper

Chapter 2 of this paper presents data regarding FDI inflows and JVs to show the impact of the previous laws, and analyses export industries.

Chapter 3 presents the Heckscher-Ohlin theorem; the foundation of the revealed comparative advantage model and an explanation of a country’s trade pattern. The OLI theory is also presented to explain why FDI exists and why some industries attract more than others.

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Chapter 5 describes the RCA model that was used to determine which industries in Cuba had relatively high exports in comparison to the rest of the world and explains the interview process.

Chapter 6 presents the results from the RCA model and provides a motivation for which industries the study should examine. The results of the interviews are also presented in this chapter.

Chapter 7 discusses the research question, analyses the data gathered and reaches a conclusion as to which industry FDI should be allocated.

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Chapter 2 Background

This chapter presents data showing Cuba’s estimated FDI inflow, which is compared to the total FDI flow for the rest of the world to show a general difference in FDI inflows. The number of JVs in total during 1990–2011, JVs divided by industry in 2003 and JVs existing in certain industries in 2003 are presented to show how policies and regulations affect their numbers. Furthermore, information regarding Cuba’s exports is presented, focusing on the key export industries. These are important because previous research has shown that FDI allocated to strong export industries could lead to an increase in exports. Finally, FDI inflow to Costa Rica is compared to that of Cuba to show how policy-making can yield an increase in FDI.

2.1 FDI and JV data

Table 1. Annual flow of FDI in Cuba

Year Flow per annum,

Million US$ (estimated) Cumulative 1993 54.0 54.0 1994 563.4 617.4 1995 4.7 622.1 1996 82.1 704.2 1997 442.0 1,146.2 1998 206.6 1,352.8 1999 178.2 1,531.0 2000 448.1 1,979.1 2001 38.9 2,018.0 Source: Feinberg (2012)

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Table 2. Annual flow of FDI in the world.

Year Global total FDI flow per annum Billion US$ 1993 211.748 1994 241.856 1995 319.9 1996 363.576 1997 461.268 1998 679.308 1999 961.898 2000 1461 2001 796.274 Source: https://data.worldbank.org

Table 2 contains data of the total FDI flow in the world between 1993–2001. There is a clear overall trend showing an increase of FDI of US$ 584.526 billion between 1993– 2001. However, there was also a sharp decline in 2001 breaking the positive trend, when the total FDI decreased with US$ 664.726 billion, a decrease of about 55 percent from the previous year.

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Figure 1. Number of JVs in Cuba between 1990–2011 Source: Feinberg (2013)

Figure 2. Number of JVs by sector in Cuba in 2003 Source: Spadoni (2004)

In 2003, most of the joint ventures (64) were linked to the basic industry followed by tourism, (56) construction (47) and agriculture (21) (Figure 2 (Spadoni, 2004). Feinberg (2013) states that the government strategically allocated JVs in the most vital export industries such as nickel, tobacco, fruit, beverages, tourism and communications industries. Some of these industries are concentrated in large joint ventures such as Sheritt International (nickel), Habanos (tobacco), Zaza (fruits), BM (fruits) and Sol Melia (tourism). The high concentration of JVs in vital industries can be seen in Figure 2

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The food industry was the most important source of income from exports in 2015. About 49 percent of total exports originated from the food industry, with raw sugar being the main source, (27 percent of total exports) followed by tobacco (15 percent) and liquor (7 percent). The mining industry (nickel) was the second largest exporter, with raw nickel and nickel mattes accounting for 12.4 percent. The third largest export (11 percent), was refined petroleum (OEC, 2018.

Petroleum was imported from Venezuela at a subsidised price in exchange for Cuban doctors. Venezuelan petroleum accounted for almost half of the energy demand and it is estimated that Cuba imported around 50,000 barrels/day in 2016. Some of the oil is re-exported, which explains the fact that petroleum accounted for 11 percent of total exports in 2015 (Swedish Embassy, 2017).

Even though around 49 percent of Cuban exports were from the food industry, about 80 percent of foodstuffs for consumption were imported in 2016. This can be explained by the inefficiency of the agricultural sector and the lack of diversity in crops i.e. raw sugar accounted for 27 percent of Cuban exports in 2015. The government launched agricultural reforms in 2008 with the aim of modernizing the industry and making it more efficient by diversifying crops. The goal was to be self-sufficient in milk, beans, poultry, coffee and corn. So far, the reforms have not had any significant effect due to bureaucracy and decreased investments (Swedish Embassy, 2017).

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The number of JVs during the time period 1990–2011 presented in Figure 1 shows a decline post 200. This could be explained by the government’s decision to terminate many joint ventures for several reasons. These included broken promises, illegal activities, not achieving Cuban economic goals and loss of profits by the company. Another factor was that national companies did not welcome the increase in competition from more efficient JVs. National companies used political influence to inflate various bills such as electricity or real estate rents and created difficulties in practical matters e.g. visas for employees and delayed petrol deliveries. These factors could explain the fact that 68 JVs were dissolved in 2003 at the government’s initiative. (Figure 3) (Spadoni, 2004)

2.2 The case of Costa Rica

Costa Rica, a country similar to Cuba, enacted reforms in the mid-80s to attract FDI, yielding a significant impact on the economy. The influx of FDI led to imports of new technology, generating an increase in productivity and transfer of knowledge. Most importantly, FDI also provided access to international markets (Trejo, 2014).

Table 3. Flow per annum of FDI in Costa Rica

Year Flow per annum, Million US$

1985 69.9 1986 61.0 1987 80.3 1988 122.2 1989 101.3 1990 162.5 1991 178.4 1992 226.0 1993 246.7 1994 297.6 1995 336.9 1996 426.95 1997 408.17 1998 613.08 1999 619.46 2000 723.42 2001 621.84 Source: https://data.worldbank.org

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Both Tables 2 and 3 show a similar pattern in the flow of FDI. They indicate a positive trend, with a peak reached in 2000 followed by a substantial decrease, 55 percent and 16 percent respectively. On the other hand, Table 1 (Cuba) shows no clear trend of an increase in FDI. The flow of FDI fluctuates, with higher peaks and lower troughs. However, there is a similarity in Tables 1 and 2 with the considerable decrease after the peak in 2000. Also, there is a significant difference in the amount of FDI inflow when comparing Cuba to Costa Rica.

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Chapter 3 Theoretical Framework

Chapter 3 presents the Heckscher-Ohlin (H-O) theorem (see Background, Chapter 2, for the connection to the trade pattern) This is the foundation of the revealed comparative advantages model and can give theoretical answers to why some industries are more effective than others. Secondly, the ownership, location and internalisation (OLI) theory is presented to give an understanding of why FDI occurs and why some industries have more FDI inflows than others.

3.1 Heckscher-Ohlin theorem

The H-O theorem can be applied to identify why some industries export relatively more than others. It states that trade depends on those factors of production that a country has a relatively large supply of. If a country is relatively abundant in one specific factor of production in comparison to another country, the country will have a comparative advantage. (Husted and Melvin, 2013). The H-O theorem claims that comparative advantage differs in terms of relative factor abundance and factor intensity. Hence, the theory predicts that countries will produce more goods when they use their relative abundant production factors intensively (Morrow, 2009).

The conclusion of the H-O theorem is that in the absence of trade distortions, countries will produce goods and services that use their most abundant factors. In other words, trade patterns are determined by countries’ access to production factors (Husted and Melvin, 2013). The H-O theorem identifies industries that should have relatively high exports given their production factors, but this does not necessarily mean that FDI will be allocated to these industries. However, the next theory gives an explanation as to why this might happen.

3.2 The OLI paradigm

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Filippaios, 2008). The theory’s hypothesis is that firms will engage in FDI if the following criteria are satisfied:

1. Ownership advantages in the market, in the form of intangible assets which may be either exclusive or specific for the firm

2. If Criteria 1 is satisfied, the firm will acknowledge these benefits by internalizing the advantages in their own activities instead of signing license contracts with independent firms.

3. If Criteria 1 and 2 are satisfied, the firms will make a profit when exploiting these advantages. Otherwise, foreign markets would be characterized by exports and domestic markets by home production.

According to Dunning (1979), companies enhance their incentive to exploit these advantages when their ownership advantages become greater. Firms are more likely to engage in FDI if production increases and if the foreign location becomes more attractive. However, the determination of a country's engagement in international production is dependent on the extent of the firm's inherence these advantages and the locational perks compared with other countries endowment.

Dunning (1979) classifies these advantages (Appendix 2). He suggests that international production can in some way be explained by these criteria. However, the model can't predict which countries, industries or firms will participate in FDI, but suggests that the advantages will not be equal across borders, industries or firms and also that they are not static. Whether or not a country possesses these advantages will be determined by country-specific characteristics, which are discussed in the next section.

3.2.1 Ownership advantages

Dunning (1979) categorizes the ownership advantages of firms with related country-specific characteristics e.g. the size of the firm is positively related to the size and structure of the market, since large markets tend to attract large corporations, thus generating ownership advantages due to the large scale of production. However, if diversification is scarce and/or if no rules are applied regarding industrial concentration, the necessary size of the market to achieve large-scale production will be smaller.

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investment. These investments can particularly be in areas where there is no domestic experience, e.g. mining companies. The important elements are the skills, expertise and technology to acknowledge the location and value of resources (Dunning, 1979).

The last variable is government intervention, which can affect the generation of ownership advantages and the economic relationship between countries. This can be by government ownership or entering industries, such as: accessibility, type, and the human capital available to the firms such as training and education policies; the grade of innovation through patent and trade mark legislation; the extent of diversification of firms given the competition policy and other macro-economic policy factors.

3.2.2 Locational advantages

Locational advantages that are accessible for the investing firm are connected to the host country's endowment. These advantages can be the market size, good infrastructure, cheap wages, and other factors that may contribute to the country's competitive advantages (Dunning and Lundan, 2008). Important to note is that these can change over time. Dunning (1979) mentions that FDI will encounter resistance in the beginning as a result of barriers of physical and psychological distance, but as these start to diminish, it is easier to increase foreign production.

3.2.3 Internalization advantages

The internalization advantages are the decisions taken on how ownership-advantages will be used and are therefore directly connected with multinational enterprises. These advantages help firms to develop from the ownership-advantages in the most efficient way. If there are no internalization advantages, the firms will find it more profitable to hire an independent firm through licensing (Johnson, 2005).

In summary, ownership-advantages are essential for firms to operate in a foreign market. The other two advantages, location and internalization, explain how FDI will take place and where (Dunning and Lundan, 2008).

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Chapter 4 Literature Review

Chapter 4 presents the literature, the historical impact of laws and regulations, previous studies on FDI’s effect on export in developing countries and studies on Cuban laws regarding FDI. It compares and discusses the articles and conclusions that have contributed to this study. Finally, this chapter presents contributions this article might have made in comparison to previous research.

4.1 Studies on FDI’s effect on exports

Whether FDI could have an impact on exports has been examined before, especially in relation to developing countries where export growth has been greater than GDP growth. This is not the case for Cuba, but the countries examined have been through similar processes when attracting FDI to achieve growth.

The first study, conducted by Davaakhuu, Sharma and Oczkowski (2015) examined whether or not foreign investments have played a part in Mongolia's export success. The authors gathered data from the mining and manufacturing sectors between 1995–2015 and used this in an econometric model to investigate the demand and supply of exports. The results show that the increase in export demand was mainly due to the mining and manufacturing sectors. The relative price of exports and the real effective exchange rate was not statistically significant and had no impact on the volume of exports. The result showed that the world income variable was statistically significant, showing that an increase in world income by 10 percent would increase Mongolia's exports by 10 percent.

The results on the supply side showed that the mining industry had an impact on export growth. The variable for export prices was positive and statistically significant, indicating that an increase in export prices compared to domestic prices would result in an expansion in the supply of exports. FDI was positive and statistically significant, showing that foreign companies had a role in the supply of exports. The authors concluded that developing countries like Mongolia provided evidence that FDI was a powerful tool for export expansion.

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run exchange rate, and that world income did not have an impact on the export success. The results on the supply side showed that an increase in export prices relative to domestic prices increased the supply of exports, and that the supply of exports declined as the domestic demand increased, due to a negative elasticity in the supply of exports.

In this research, the FDI coefficient was positive but not statistically significant, which meant that the authors could not conclude that FDI had an impact on India’s export success. However, according to Sharma (2003), this could be explained by the inward-oriented policy that has existed for a long time and may have discouraged foreign investors. Sharma (2003) also mentions that if the purpose of the investments was to by-pass trade barriers in the host country, a growth in exports was highly unlikely, but exports could increase if FDI was allocated to an industry with a comparative advantage.

Trejo (2014) focused on Costa Rica’s export success and how they managed to attract FDI. The author discussed Costa Rica’s laws and regulations regarding FDI since the 80s and applied their strategies to Cuba. Trejo (2014) motivated this study by finding similarities; both countries prioritized health care and education more than similar countries and Costa Rica also had more large state-owned corporations in comparison to other South American countries.

The author discussed different investment strategy factors such as education and human capital, openness to trade, market access and fostering institutions. Finally, he discussed mistakes that Cuba could learn from and finished with some concluding remarks on what was reasonable to expect and what could be achieved with the given investment strategies. He mentioned that Cuba could make similar reforms to attract FDI, but it would depend heavily on Cuban entrepreneurs and the Cuban State.

4.2 Studies on laws and regulations regarding FDI

The following papers analyse how Cuban laws and regulations (Laws 50 and 77) have changed and what their impacts on FDI have been.

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weaknesses, and their impact on the Cuban economy and their efficiency in attracting FDI.

FDI had been illegal for 23 years before Law 50 because of the political climate. Law 50 was enacted in 1982 with the aim of increasing economic development by establishing economic associations between Cuba and foreign investors. The law was divided into five chapters covering: general law, finance, tax, commercial and labour provisions. Law 50 provided the opportunity for JVs in which one part had to be a national investor; a state-owned enterprise. The state-state-owned enterprise had to own at least 51 percent of the joint venture in order to retain control over the venture and only Cubans could be employed except in higher positions. Gallousis (2001) concluded that the main obstacles in Law 50 were the lack of private property ownership and the bureaucracy that hampered streamlining regulations and procedures.

Cuba entered a great depression called ‘el periodo especial’ after the collapse of the Soviet Union. Law 77 was enacted in 1995 to counter ‘el periodo especial’ by further increasing the attraction of FDI. Law 77 was more elaborate containing 17 chapters. For example, in 1996 the annual Havana International Trade Fair attracted over 1,650 firms. This was a significant increase in comparison to the 108 firms in 1985. The author concludes that changes in Law 77 were necessary if Cuba wanted to attract foreign investors. There are still high risks when investing in Cuba due to the political uncertainty in the legal system (Gallousis, 2001)

The second research, conducted by Feinberg (2012), analysed the flow of foreign investments in Cuba between 1990–2011. The author analysed data covering foreign inflows, number of joint ventures, joint ventures sales export and inflows of FDI during this time. Many joint ventures had been strategically allocated to important export sectors such as nickel, fruit, beverages and tourism.

How the articles described above contribute to this paper is discussed in the literature discussion.

4.3 Literature discussion

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purpose of Law 77. These articles contributed to a greater understanding of how the laws and regulations worked and helped us to determine how they affected FDI. The fact that the number of JVs decreased after 2002 indicated that there was something wrong with how Law 77 was implemented. The fact that JVs were excluded from the sugar industry, the highest export industry, proved how political ideology influenced the flow of FDI in a negative way.

Whether FDI could create an expansion in exports was researched by Davaakhuu et al. (2015) and Sharma (2003), who discussed factors that contributed to Mongolia's and India's export successes, focusing on FDI. The authors used similar models but didn’t obtain similar results. Davaakhuu et al. (2015) concluded that FDI and the increase of world income contributed to Mongolia's exports, but these two factors did not contribute to Indian exports. Whether FDI can contribute to Cuba’s exports will be determined by finding similarities in the policy-making that the Indian and Mongolian governments imposed, and how these states started to open their economies and change their investment policies to attract more foreign investors.

Trejo (2014) focused on how to apply a similar country’s investment strategy to Cuba’s situation to see if they could follow the same route, instead of conducting an empirical study like Davaakhu et al (2015) and Sharma (2013).

Trejo (2014) mentioned several factors that would determine Cuba’s investment strategy, however the category that is most relevant to this study is that of education and human capital. This is because the competitive advantages for Costa Rica’s exports and their inflow of FDI can be explained by a productive labour force and high levels of training and education. Well-established human capital existed in Cuba before the economic reforms, but at that time demand was scarce. There was an underdeveloped domestic market in manufacturing and services, with simple agricultural products for export that did not require advanced training or technical sophistication in production or management. The human capital was therefore allocated to the state’s bureaucracy.

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The article written by Baskaran, et al. (2010) legitimizes the assumption that access to factors of production determines trade flows. The empirical support of the importance of factors of production will be an important consideration when determining to which industry more FDI should be allocated.

4.4 Contribution

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Chapter 5 Methodology

Chapter 5 presents the methodology of this study. It starts by explaining the approach of the study and then presents the RCA model and how the interviews were conducted. Finally, it describes how these methods contributed to this study.

5.1 Research approach

This study used quantitative and qualitative approaches to obtain results. The quantitative method consisted of an RCA model to determine Cuba’s comparative advantages. The qualitative approach consisted of interviews.

5.2 Data

The data used in the RCA model was collected from the Observatory of Economic Complexity (OEC), an organisation that gathers data from the World bank and the UN Comtrade Database. The data consist of export values in each industry defined by the OEC and the export value of the world in the same industries. This paper only considers two different instances to see if the new legislation had affected the trade pattern: the first in 2013, a year before the new law was enacted, and the second in 2016.

The qualitative data was collected by interviewing individuals who had experience in the relevant industries. More information about the interviews and how they were conducted can be found in Chapter 6. Most of the data used in the study was approximated or dated, increasing the importance of the theoretical framework and interviews.

5.3 Revealed comparative advantage

The revealed comparative advantage (RCA) measures a country's exports relative to world exports (Balassa & Noland, 1989).

The RCA model states:

𝑅𝐶𝐴 1 = (𝑋𝑖𝑗/𝑋𝑖𝑡) (𝑋_𝑛𝑗/𝑋_𝑛𝑡)

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comparative advantage in that specific export commodity in comparison to the rest of the world. If 𝑅𝐶𝐴 < 1 the country does not have a comparative advantage since its share of the export is less than the world’s share. Measuring exports and excluding imports is a limitation in the model. A country can have a comparative advantage in an industry where re-export is a substantial part of export.

The model identifies industries with relatively large exports, without taking distortions such as trade barriers and tariffs into account. Of course, trade is far from frictionless, but the model is useful as a starting point when analysing bilateral trade flows by identifying weak and strong industries without evaluating why certain industries are weak or strong (French, 2017). Since Cuba was a closed country with highly regulated trade, the results could have been distorted. The results showed whether goods in certain industries were easier to export instead of taking factor proportions into account. This could lead to low values in industries with an actual comparative advantage and vice versa.

Dunning (1979) also used the RCA in exports and in FDI, to determine if a country possessed any of the OLI advantages mentioned in Chapter 3. The results showed that developing countries’ comparative advantages usually lay in labor-intensive and small-scale technology and their supply of cheap standardized products to other developing countries. The author concluded that if a country possessed high RCA values in both exports and FDI it was due to the high correlation between their ownership advantages, resource endowment and market structure.

As firms become more multinational, they become more important in influencing the ownership advantages, which means that the evolution of FDI patterns may to some extent follow the trade pattern, since investments in the beginning focus on differences in factor endowments. This proves that industries with comparative advantages in developing countries are more attractive for foreign investors.

In this study, the RCA model yielded a straightforward mapping of industries with a comparative advantage in export, and combined this with a minor field study that would help to determine to which industries FDI should be allocated. The procedure of the field study is presented in the next section.

5.4 Minor field study

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interviews was to obtain a deeper understanding of how Cuban sectors worked. Qualitative research is flexible, being adaptable to changes in context, depending on how the research takes place. It is also a good complement to quantitative research since qualitative data produces explanations (Mason, 2002). In our case, the explanations produced were built around the revealed comparative advantage model. The interviews added another dimension to the results we obtained from applying RCA on the collected data.

Interviews can be conducted in three forms: structured, semi structured and unstructured. A structured interview uses close-ended questions that are the same for all interviews. The purpose is to gather specific information with high reliability and repetitive answers. This form confirms quantitative data but does not entail elaborative answers (Gill et al., 2008). An unstructured interview gives the researcher a deeper understanding and according to David and Sutton (2016) a qualitative interview tends to be more unstructured.

Researchers can use three types of questions: standardized, semi standardized and unstandardized. A standardized question yields straight answers where the researcher already knows the possible outcomes, for example, yes or no. An unstandardized question produces open answers that the researcher cannot predict.

This study conducted semi-structured interviews with unstandardized questions. This allowed insight into people’s knowledge, interpretation and experience of the subject area and allowed the subject to speak freely, creating a fair representation in the interviews. (Mason, 2002). The questions were open-ended and prepared in advance, depending on the subject, but also allowed for follow-up questions.

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Two sampling strategies were used in the study. The first strategy was to approach interviewees who had been recommended by an individual with knowledge and expertise. The second was the ideal-typical-bellwether-case (Goetz and LeCompte, 1984) where the researcher develops a profile in advance, including qualifications such as knowledge and area of expertise. Interviewees are selected if they match the profile.

Expectations regarding knowledge and current employment of interviewees were determined beforehand and Kristine Erlandsson Juarez of the Swedish embassy in Cuba, who has expertise in the trade areas suggested by the results (food products and mining) recommended several interviewees from her broad network within the trade and economic sectors.

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Chapter 6 Results

This chapter presents the results of the RCA model that motivated which industries would be discussed in the rest of this study. Summarized results from the interviews are also presented.

6.1 RCA

The calculated results from the RCA model are presented below. The RCA model was applied to Cuban export data from 2013 and 2016; before and after the reforms. This would indicate whether the reforms made in 2014 had an impact on FDI and thus on Cuban exports.

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Table 3 Cuba 2013 Industry Export value Cuba (million $) Export value world (million $) RCA Value

Agriculture, forestry and food

1040.407 3,488,000 4.0078

Mining and quarrying 906.966 11,689,000 1.0425

Manufacturing 12.02 2,808,000 0.0575

Chemicals 396 3,250,000 1.6371

Machinery and instruments 71.2 9650000 0.0991

Arts and antiques 1.2 42400 0.3803

Textiles 2.7 1,729,000 0.0210 Total 2430.493 32,656,400 Table 4 Cuba 2016 Industry Export value Cuba (million $) Export value world (million $) RCA Value

Agriculture, forestry and food

856.36 2,940,000 6.926

Mining and quarrying 150.4317 5,505,000 0.5716

Manufacturing 2.545 2,343,000 0.0227

Chemicals 102 2,600,000 0.8206

Machinery and instruments 8.29 8,510,000 0.0204

Arts and antiques 3.16 54800 1.2061

Textiles 0.842 1,550,000 0.0114

Total 1123.6341 23,502,800

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had a greater value than one. The tables indicate that the exports of both Cuba and the rest of the world decreased between 2013 to 2016. This could mean that Cuba followed the world economic trends, or that the reforms had not attracted FDI to increase exports. The minor field study attempted to explain this situation and the results are presented in the next section.

As the study could not include all industries, it considered only two – ‘Agriculture, forestry and food’ and, ‘mining and quarrying’. ‘Manufacturing, machinery and instruments’, ‘arts and antiques’ and ‘textiles’ were discarded from the start. ‘Manufacturing’ consists of wholesale and retail products and was not highlighted in the background. The industry is small in Cuba and had low RCA values in both 2013 and 2016. The same applied to ‘machinery and instruments’.

‘Arts and antiques’ was not relevant, even with a value greater than one in 2016, as the home and global market is small compared to the other industries. It will therefore never contribute to Cuba’s economic growth. This also applies to the textiles industry, which makes the smallest contribution to Cuba’s exports. This leaves the three largest industries: ‘agriculture, forestry and food’, ‘mining and quarrying’ and ‘chemicals’.

‘Agriculture, forestry and food’ is the only industry that had a value greater than one, before and after the reform. It has a history in Cuba and was highlighted in the background. It is also the largest export industry and is an obvious choice for further examination. The other two industries had a value greater than one in 2013 but dropped after the reforms and exports dropped substantially between 2013 and 2016. ‘Mining and quarrying’ is a larger industry with large JVs whereas no statistics were found for JVs in the chemical industry. Therefore, ‘mining and quarrying’ was the second industry to be examined.

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These aspects led to the conclusion that the agriculture and mining industries were the most interesting to examine in the minor field study to see whether the results in the interviews confirmed the current conclusion based on the background, theories and results. The interviews would also contribute to determining whether policies regarding FDI could increase exports or whether there were alternate ways to achieve an increase in exports other than an upswing in the world economy.

6.2 Minor field study

This section examines the agriculture and mining industries. The industries were further narrowed down since Cuba has unilateral trade in both industries. In the food industry, sugar is the main good, accounting for 27 percent of total exports. In the mining industry, nickel is the main export good and is both exploited and manufactured.

The results are presented in the following order: An overview of FDI in Cuba and the opinion on the law that was established in 2014 followed by summaries of the interviews focused on the food and mining industries.

6.2.1 FDI reforms from 2014

Oniel Diaz is an employee at KREAB and works as a strategic communications counsellor. He graduated from Havana University with a master’s degree in

international relations, specializing in trade. He started his career in the biotech industry as an export manager for the western Europe area and has worked with manufacturing and exports for five years. Oniel believes that the reformed law is an improved version and that the government is beginning to understand the importance of FDI, but the reforms have not made enough change and there is still room for improvement in laws and regulations regarding FDI.

There are three limitations in the law according to Oniel. First, the state-run companies are highly centralized and require time-consuming decision making. There is also a lot of bureaucracy in procedures regarding FDIs, leading to even more time-consuming obstacles for JVs. Finally, there is still a broad skepticism of FDIs for political/

ideological reasons, making it even more difficult to apply new laws and regulations to attract FDI.

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for JVs. Finally, JVs still need to employ and pay salaries through national employment agencies who pay low salaries to the employees leading to less motivation and low productivity. The low salaries have also led to a unique situation where highly skilled and educated human resources are attracted to the private sectors (taxi, tourism, restaurants) with substantially higher salaries than the salaries that the state and JVs offer.

Oniel explained that the government has a portfolio of projects in certain industries where FDI is prioritized. Included in this portfolio are agriculture, mining, bio tech, tourism and energy. FDI allocated to these industries will make an impact and develop the economy. The government is aware of the importance of allowing the industries more FDI in order to boost the economy. He concluded that the agriculture industry had the most potential. A lot of food is imported, and the industry is run at a low capacity with low productivity e.g. 60 percent of arable fields are not cultivated. Also, there is a strong connection between agriculture and the growing tourist industry, making it more attractive to invest in, since an increase in tourism could lead to an increase in demand for popular agricultural products such as tobacco and sugar.

The OLI theorem can be applied to Oniel’s reasoning regarding the limitations mentioned in the reforms enacted in 2014. The high level of centralization and bureaucracy are examples of government intervention that prevent ownership advantages according to the OLI theorem. The low salaries are another way government intervention reduces ownership advantages.

6.2.2 Food products

Jenny Loven is a counsellor in Political, Economic and Development affairs from the EU delegation in Cuba. She has a degree in law from the University of Stockholm and has previously worked as a diplomat in Italy and countries in the Balkans. Jenny has also worked with foreign aid in the Swedish Department of Foreign Affairs and for the EU Commission in Brussels. The EU delegation works with aid directed to different departments and industries such as agriculture, energy, economic development and research in Cuba.

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pay directly. The need for high credits lead to new trading partners, leading to a situation of rising debts. For ideological reasons, Cuba chooses debt over foreign investors. Jenny stated that the food industry is monopolized by the communist regime leading to inefficient production by using out of date machines and the lack of crop diversification. Jenny also mentioned the threat of climate change on the agricultural industry and the lack of skills and technology to counter it. To summarize the interview Jenny believed that aid and foreign investors are needed to boost the food industry, but that bureaucracy stands in the way.

There is an abundance of sugar cane leading to large exports in sugar, which coincides with the H-O theorem regarding exports in industries with an abundance of production factors. This is seen in the results when the RCA model is used showing that there are relatively large exports in comparison to the world percentage. There are ownership advantages in the agriculture industry, due to the lack of domestic experience. The government’s protectionist approach to the sugar industry makes it hard to establish FDI in that field.

Lenia Palma is the office manager at Elof Hansson AB Cuban office. Elof Hansson is a Swedish trade consultant company. Lenia graduated with a degree in law and has worked within legal advice for 16 years. She started her career in trade by working for state owned import companies between 2009–14, importing food and chemical goods. In 2014, she started to work at Elof Hansson where she gives legal advice to customers regarding trade, tax and legal documents.

Elof Hansson’s main customers are from the fields of sugar and mining and they import machines and spare parts. According to Lenia there are a lot of barriers to entry for foreign companies. The main barrier is the bureaucracy when applying for a license to establish themselves in Cuba. First you need to apply for a license to import to Cuba. The application requires financial documents and company books that are sent to the foreign trade ministry through the Cuban consulate. This process takes between 2–5 years with no guarantees of approval. If approved, the license must be renewed every third year by updating information such as current employees and key numbers.

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more competitive. Cuba has tried to attract foreign investors by easing regulations, but the lack of legal security presents a risk that investors are not willing to take.

The OLI theorem can also be applied to Lenia’s description of the current bureaucracy facing foreign firms in the process of establishing themselves in Cuba. The government intervenes, leading to a long administrative process, making it difficult for foreign investors to establish and invest. At the same time there is a lack of government intervention in improving legal security, which makes it less attractive to foreign investment. There are also potential ownership advantages in technology since the sugar industry uses old machines.

6.2.3 Mining

Bosse Ekström is employed by Volvo Construction and Equipment AB and has worked as a product support manager in Cuba since 1984. His job is to sell machines to the mining industry, and to build business relations with customers. He started working as a mechanic and went on to sell heavy machines. Bosse mainly works with clients in the mining industry, mostly nickel but in recent years has also worked in the tourist industry. The main barrier to entry Bosse experienced is the license to operate in Cuba that needs to be extended every third year.

Volvo was established in Cuba over 40 years ago, selling machines to the manufacturing industry. In recent years, Volvo have shifted their focus towards the nickel industry. Bosse explained that the reason Volvo’s interest in the nickel market was due to its potential. They saw a large population with an increasing need for new buildings and infrastructure. Since Volvo has existed in Cuba for a long time, the companies in the nickel industry preferred Volvo’s products over those of their competitors.

Cuba has mines, but they need to import the right equipment to extract the minerals, which makes the nickel industry reliant on FDI. It is run by two mines, one of which is state owned and the second is owned by a Canadian joint venture. Volvo receives insurance from EKN (Export Kredit Nämnden), which will finance purchases if the Cuban companies are not able to pay. This is also one of the reasons why they stay.

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company is one of the few that have received this license and Volvo can therefore avoid all the bureaucracy that comes with this issue.

Cuba has the third largest nickel reserve in the world but, at the same time, is the sixth largest exporter of nickel. This is due to a lack of competition and the use of low quality machines imported from China. Bosse stated that there is more room for FDI as a result of the lack of competition in the market, and that other minerals had been discovered such as gold and zinc, increasing the potential in the mining industry. However, it is still difficult to enter the market, since Volvo owns 70–80 percent of the relatively small market, which can make entry unprofitable.

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Chapter 7 Discussion

Chapter 7 discusses the results from Chapter 6 in order to answer the research questions posed. First, how the new reforms affect FDI and second, whether FDI can increase exports in the food and mining industries. Finally, taking into account the research questions, the selected industries are analysed and compared to determine the industry to which FDI should be allocated.

Attracting FDI has been an issue for the past 36 years, and reforms have been made continuously in an attempt to increase this. Gallousis (2001) concluded that positive changes were made in Law 77 but there was still room for improvement. Oniel (interview 11 May 2018) reasoned similarly and stated that the reforms made in 2014 were an improved version of Law 77. The government had started to understand the importance and impact FDI could have on economic development.

Similarities were also found when regarding weaknesses in the laws. Both stated that there were still low legal guarantees when investing in Cuba, leading to higher risks for the investors, since the government (for political reasons) still had not accepted the free market model.

Bureaucracy is often mentioned as a barrier to FDI. Feinberg (2012) states that bureaucracy makes the process of approval for FDI complicated and time-consuming since there are many institutions involved. Lenia (interview 4 April 2018) discussed the bureaucratic process when renewing the license to operate in Cuba. The license must be renewed every third year and all the necessary documents must be updated. Oniel (interview 11 May 2018) concluded that the high level of centralization in state-run companies made decision making and implementations unnecessarily complicated, time- consuming and bureaucratic. Gallousis (2001) concluded that the bureaucracy limit the influx of FDI due to reasons mentioned above. As mentioned, bureaucracy is a factor that both authors and interviewees mentioned in different contexts and with varying opinions as to where the responsibility for the issue lay. This shows the magnitude and complexity of the impact of bureaucracy on FDI.

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Oniel (interview 11 May 2018) also mentioned the issues regarding employment agencies and stated that the bureaucracy and wage policies led to low productivity and a work environment with low morale. These issues have existed since Law 50 and reforms have not changed the situation.

Feinberg (2012) and Oniel (interview 11 May 2018) concluded that the establishment of duty-free and industrial zones have not had a significant impact on FDI. The companies established in these zones still face the issues mentioned above. Oniel (interview 11 May 2018) stated that the only change had been the lower tax rates in the zones.

Reforms have been made since Law 50. The reforms in 2014 improved the law theoretically but not in practice. The same issues regarding legal security, bureaucracy and employment agencies were discussed in all reforms. Thus changes to attract FDI have been made in theory but not in practice. In other words, laws and regulations might well have affected FDI in a negative way.

Attracting FDI is not the only issue Cuba faces. It also has a large trade deficit and its only solution is to boost its exports. FDI may be the solution to this problem. Sharma (2003) concluded that the impact of FDI depends on the policy regime, which could either be inward or outward. An inward regime attracts FDI to the domestic markets and the outward regime attracts FDI to the export sectors. India has had an inward-oriented policy for a long time, which may be the reason why the FDI variable was not statistically significant. On the other hand, Davakhuu et al. (2015) found evidence that FDI had an impact on Mongolia’s exports – Mongolia having a more outward-oriented policy. It is difficult to determine which policy Cuba has implemented.

Oniel (interview 11 May 2018) and Feinberg (2012) stated that the Cuban government tried to attract FDI to the most vital export industries. Romero Gomes (2014) mentioned that they also used their duty-free zones to attract more FDI to the agriculture sector. Since reforms had been made to institute self-reliance in milk, beans, meat, poultry, coffee and corn production (Swedish Embassy, 2017). This is an inward policy, since the FDI will capture the domestic markets. However, at the same time, the agricultural sector is the largest export industry, indicating that the policy might also be outward oriented. Cuba may therefore have a more outward oriented policy.

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approach, since the government wants to attract FDI to the agricultural sector and the mining industry. Oniel (interview 11 May 2018) stated that 60 percent of all agricultural ground was uncultivated and Bosse (interview 3 May 2018) mentioned that Cuba has the third largest nickel reserves. They are large export industries but there are still gaps that need to be filled. Davakhuu et. al (2015) did not mention whether the Mongolian government used the same approach, but he described Mongolian trade liberalization. The results showed that the liberalization had not affected the export performance. It is possible to postulate therefore, that where FDI is allocated is more important than easing the restrictions.

If FDI is allocated to an industry with a comparative advantage, a growth in exports is more likely to occur (Sharma, 2012). Cuba has comparative advantages in both food products and mining, which make these industries more interesting for foreign investors. This doesn’t necessary mean that Cuba has high factor proportions in these industries. It could be explained by other factors. However, Oniel stated that there was a lot of uncultivated land and Bosse mentioned the high nickel reserves. You can therefore assume that the comparative advantages exist due to factor proportions.

Trejo (2014) explained that the reason behind the large inflows of FDI to Costa Rica was the high productivity of the labour force. Most of the FDI had been allocated to industries with a comparative advantage demanding high technical standards and specialized knowledge. There were similarities in the high-level education and skilled labour when comparing Cuba to Costa Rica. However, Oniel (interview 11 May 2018) stated that productivity was low due to the employment agencies’ payment of low wages and low salaries in state-owned enterprises. Consequently, human capital relocated to the private sectors with higher wages. Inefficient use of human capital might affect exports by preventing their increase.

Even though a low-productivity trap exists, Cuba’s outward-oriented policy and the great potential of the vital export industries with high factor proportions, leads to the conclusion that FDI may create a growth in exports.

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international and domestic markets and is also connected to the growing tourist industry. The industry is highly concentrated and is not running at full capacity. There is still room for FDI, especially for new machines and because 60 percent of the land is uncultivated. Also, the low competition and the potential for diversification of crops makes the industry more attractive.

The mining industry is also highly concentrated in larger JVs. The reason behind the concentration is the barrier to entry caused by high costs. Volvo’s historical presence has given them a great advantage and they control about 70 percent of the input market. However, the competition in mines and factories is low and far from full capacity due to lack of investments. The mining industry supplies mostly international markets. The lack of infrastructure could be the reason for its absence in domestic markets. Also, the lack of investments has led to an insecure situation where the state-owned mine, Che Guevara, has shut down.

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Chapter 8 Summary and further research

The final chapter summarizes the study; presenting how the new reforms have affected FDI and how an increase in FDI might increase exports in food and mining. Limitations and propositions for further research are presented.

Cuba entered a recession in 2016 which continued throughout 2017. The low level of exports in combination with high debts to maintain the high level of imports led to a worrying economic situation. One method of boosting the economy was to attract FDI that may increase exports. The purpose of the study was to conclude where FDI should be allocated by analysing laws and regulations and to determine whether an increase in FDI could increase exports.

Laws and regulations regarding FDI have been reformed since the 80´s with the purpose of attracting FDI. Law 50 was enacted in 1982 and the most significant reforms were made in Law 77 and the reforms of 2014. The laws have worked in theory but not in practice, leading to a limited impact in attracting FDI. This was concluded regarding law 77 by Feinberg (2012) and by Oniel analysing the reforms made in 2014 (Interview 11 May 2018). (The data in the background presented declining numbers of JVs and weak numbers in the flow of FDI.)

FDI may have an impact on a country’s exports but there are many other factors affecting the impact. These include to which industries FDI is allocated; whether the government is inward or outward-oriented; and most importantly, whether the industries to which FDI is allocated have a comparative advantage. This last also depends on whether the comparative advantage exists due an abundance of factor proportions or that there are other underlying reasons behind this.

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