| Cuban Reforms and Foreign Investment Legislation - Knowing your neighbor and future partner
March 5th, 2010
Your neighbor, Cuba, is in a critical situation. Cuba’s industrial and commercial infrastructure is obsolete, and quite simply, the situation is unsustainable. Historically, Cuba’s response to economic crisis has been temporary and aimed to restore the status quo at a subsequent date. Cuba is in an urgent need to decentralize its economy, open the country to foreign investments, change the dual currency system and approve new legislation to accommodate new forms of ownership.
Cuba also faces an uncertain political future. Fidel Castro’s health is failing, and a successor may be unlikely to generate the support the Cuban population as the revolutionary leader once did. 1 Raul Castro, Fidel’s brother, is currently running the government, and while many Cubans assume the political status-quo will continue, the political repercussions of Fidel’s passing are unknown2. The only definite is that Fidel Castro will soon be gone, and what happens subsequently to Cuba’s government and economy is open to debate3. A greater demand for changes in the Cuban economic and social system will eventually bring about changes in the political system.
The main objective of this paper is to explore some of the economic, political and legal reforms carried out by Cuban government after the collapse of the socialist bloc and to analyze the possibilities and conditions of foreign investments in Cuba, its risks and problems under the current legal framework. The paper is not intended to predict what or when any political or economic change may occur in Cuba. It is enough to recognize that Cuba is currently facing severe economic times.
1. Thompson, Ginger. Surprising Events, Cuba Stays Calm with Castro on the Sidelines. The New York Times. August 14, 2006. 2. Robles, Frances. A Party Without Fidel Castro. The Miami Herald. December 3, 2006. 3. Pauker, Edward. Privatization in Cuba. Kent Law Seminars, September 6, 2006.
Summary of Cuba’s reforms in some sectors in the last two decades:
Cuba started a decentralization process with market-oriented agricultural reforms when a Farmers' Free Market (FFM) was established in the 1980s. The FFM was the first manifestation of free enterprise where production responded to the forces of supply and demand and was the only source which provided certain degree of relief in the short term for the food shortages affecting Cuba during the period of 1980 to 1986. In this market, small landholders or cooperatives made up of private farmers were allowed to sell their surplus produce directly to the public. This measure led to increased agricultural production, but concerns about profiteering led to new regulations in 1982, and the markets were closed in 1986.
In September 1993 the Cuban Council of Ministers approved the breaking up of large state farms into cooperatives. It was estimated that approximately two- thirds of state-owned agricultural land was redistributed to newly created cooperatives, the so-called Unidades Básicas de Producción Cooperativa (UBPC, or basic units of cooperative production). This measure, together with others, led to a remarkable reduction in the amount of land directly controlled by the Cuban Government.4
The opening of the Mercado Agropecuario was announced by Raul Castro. He declared, “the country’s main political, military and ideological problem today is to feed itself . . . in order to alleviate the situation, [we] expect to open farmers markets soon”5 For instance, producers were permitted, after delivering their contracted amounts to the state, to sell their surplus production on the free markets. In 1999 new agricultural markets were created that reportedly allow even greater use of market-determined pricing.
Raul Castro has also signaled his intention to reconsider the country's economic system. Several changes related to agriculture, including a decision in 2008 to give individuals land for farming, were meant to spur food production on the island. Most experts agree, however, that Raul Castro will not introduce significant economic reforms in the near term. Still, the farmers markets handle less than 40% percent of the farm products available to Cuban customers. Castro’s government says that it has lent 1.7 million acres of unused state land in an effort to cut imports, which currently make up 60% of the country’s food supply. Around 50% of the Cuba’s food imports came from US in 2009 even though US imports to Cuba declined 32% in 2009 from a record $700 million achieved in 2008.6
4 Some Cuban economists refer to the UBPCs as “the third agrarian reform” (e.g. lecture by Pedro Pablo Cuscó at the University of Miami, July 26, 1994). 5 In an interview with Raúl Castro published in the Cuban newspaper, Granma, September 17, 1994 6 An interview with Igor Montero, President of Alimport, Miami Herald, November 3, 2009
2) Monetary – Dollarization
In the early 1990s black-market activity expanded significantly in Cuba. Cubans who received hard currency (mostly U.S. dollars) from relatives abroad converted dollars for pesos in the black market. In order to control the growth of the black market, the authority declared in 1993 that possession and use of foreign currency within Cuba would be decriminalized and shortly afterward the dollar stores were opened to all Cubans7. This helped to create an escape valve for inflationary pressure, while facilitating the flow of foreign remittances to support domestic demand.
In 1994, the Cuban Convertible Peso (CUC) was introduced, with a value set at par with the U.S. dollar and with full hard-currency backing. In 1995, two more policies were implemented. On the one hand, the exchange of formerly non- convertible pesos for foreign currency at a market rate was legalized through official foreign-exchange bureaus. On the other, Cubans were authorized to open bank accounts denominated in foreign currencies.
The use of US dollars in Cuba was later on restricted in 2004 when the Cuban Central Bank (BCC) approved Resolution 80/2004 which indicated that Cuban nationals may have in their possession US dollars - in any quantity and without any restriction -, but only Cuban Convertible Pesos (CUC) should be accepted in cash transactions in Cuba. The Resolution 80/2004 also prescribed a 10% penalty (tax) to the conversion of US dollars to CUC. The same legal document affirms that the rest of the foreign currencies will not be subject to that penalty. In a previous Resolution (Resolution 65/2003), the BCC established the use of the Cuban Convertible Peso (CUC) as the only mean of payment for the transactions accepted in Cuba.
It is worth noting that Cuba has a dual monetary and exchange rate system, the Cuban Peso (CUP) and the Cuban Convertible Peso (CUC). The CUP is the national currency as established in article 9 of Decree-Law 172/97.
Cuba has developed a rather confusing monetary and exchange rate system: there are two parallel currencies, each of which is appropriate in different circumstances.8 The CUP is used mainly for paying essential goods and services (subsidized food, housing, and transportation), and it is the main currency for local citizens. The CUP, however, has not any value in international markets. The CUC is the Cuban “freely convertible currency” which is used by Cuban enterprises as well as foreign and joint ventures.9
7 The Government legalized dollar-denominated remittances under its 1994 monetary reform program. 8 What is the Cuban peso (CUP)? GoCurrency.com, 2005 9 Cuban Central Bank, www.bc.gov.cu
The current use of a dual currency and exchange system creates confusion, distortion of prices, complicates allocation of resources and creates arbitrage. Even though the Cuban government is looking for a unified currency, a decision has not been taken yet. Such decision has been delayed more than expected.
Changes in the Cuban banking system and its regulations have gradually transformed this vital sector of the economy and have opened the door for further transformations once a comprehensive process of economic transition gets underway.10 While it is true that the institutional landscape in which Cuban depository and non-depository financial institutions, as well as their foreign counterparts doing business in Cuba, has been changed by the banking reforms, several unresolved issues and problems remain as obstacles to a truly revolutionary transformation of this key sector of the Cuban economy.
Some of the unresolved issues are the role of the State in the central bank decisions. The Cuban Central Bank (BCC) proposes and the State approves the central bank policies. Another issue is the use of artificial (i.e., nonmarket derived) interest rates and exchange rates that further limits the ability of the central bank to act independently, since it must adhere by the policies set by the State, rather than those formulated by the market, when conducting monetary policy and standing ready to maintain an artificial exchange rate. In addition, the role of the State as the only stakeholder in the central bank means that the central bank is obliged to extend loans, and honor the debts of the State, without having the flexibility to conduct adequate assessments of the risks associated with these practices. In essence, the Cuban Central Bank follows the political directives of the government to an absolute extent and based on political expediency and not economic factors.
In the early 1990s, because of the loss of Soviet economic assistance, the economy sank into hardship and unemployment rose greatly. Self-employment in Cuba was legalized in September 199311. Self-employment was just one of several reforms that Cuba embarked upon in the post-Soviet “Special Period in Time of Peace”. The initial reaction was impressive: by December 1993, just a few months after legalization, 70,000 Cubans obtained licenses for self- employment. The sector continued to rapidly expand for a short time; by May of 1994, the number of self-employed had reached 150,000.12 This measure, as the
10 Gonzalez-Corso, Mario. Cuba's Banking Sector Transformations. The Journal of Latino-Latin American Studies. August 12, 2008. 11 Shixue, Jiang. Cuba’s Economic Reforms in a Chinese Perspective. July 20, 2009 12 Smith, Benjamin. The Self-Employed in Cuba. Cuba in Transition. ASCE 1999
Government hoped, would reduce the size of the public sector, cut government spending, and reduce the Government’s role in meeting domestic demand for certain goods and services. The government issued over 100 self-employment licenses. Examples of licensed activities include: food carts; artisans; mechanic repairs; taxis; home restaurants; shoe repairs; and produce vendors.
By December of 1995, the number of self-employed had climbed to over 200,000. In the same year, the Tax System law (Law Number 73) also came into force. Beginning in 1996, self-employed individuals were required to pay income tax. Annual taxes rates range from 5% to 50% and daily and monthly charges (licenses fees) were established as well. Real estate rental property was legalized in 1997, creating a new source of tax revenue (currently $400/room/month, whether rented or not).
Despite the economic hardships, the government has never reduced the high priority assigned to basic social spending. Health spending remained almost constant in peso terms, education spending declined marginally, and some social security payments have increased lately.
Limitations on the types of property that can be legally owned, transferred, and sold in the open market by ordinary Cubans, place constraints on their ability to use personal property and assets to conduct other business transactions and to secure personal financing.
Existing restrictions on self-employment activities furthermore limit the credit and financing demands of potential micro-entrepreneurs and privately-operated small and medium enterprises that would otherwise rely on credit financing, micro- financing, and collateralized loans to meet their businesses’ capital and funding needs, further reducing the potential profitability of the banking and financial sector. To address this major limitation, future reforms of the banking and financial sector should be complemented with a comprehensive program of reforms to address the need to establish property rights, grant ordinary Cubans with the opportunity to operate private business enterprises, and use their assets as collateral to secure various types of loans and financing.
5) Foreign Direct Investment (FDI)
The Cuban government moved to open its doors to foreign investment long before the downfall of the socialist bloc. In 1982, the Decree-Law 50 became the first Cuban law since the revolution to welcome foreign economic interests. Even in the height of socialism, Cuba saw foreign investment as indispensable for certain sectors13.
13 Johns, Melissa. Foreign Investments in Cuba. Boletín Mexicano de Derecho Comparado. UNAM, 2003
In 1992, the Cuban government took another positive step toward opening the country to external capital through amendments to its 1976 Constitution14. These amendments allowed for important changes to the property regime which herein recognized forms of ownership other than the State’s. The Cuban Constitution also acknowledged that foreign investment could not be expropriated, except for reason of the public benefit or social interest. In the case of expropriation, compensation was to be made in freely convertible currency.
In order to draw external capital, the Government liberalized certain restraints on its investment practices. For instance, amendments to the Cuban Constitution in 1992 eliminated important restrictions on foreign investment, permitting property ownership by mixed enterprises and the transfer of state property to joint ventures with foreign capital. The most significant step to attract foreign investment was taken in September 1995 when new foreign investment regulations, through Law 77, were passed by the Cuban National Assembly.
Foreign investment is not associated to a privatization process in Cuba; it is rather focused on specific objectives that complement Cuba’s development efforts. The objective of the Law 77 of 1995 is to promote and motivate foreign investment; and to this end, it establishes the guarantees for investors, the sectors of the Cuban economy which may receive investments, the form of these investments, the types of investment contributions, the negotiation process and authorization, the import-export mechanics, the banking, taxing, special labor systems for investments, the protection of the environment and the rational use of natural resources15. A very important point of Law 77 is that it does not limit the participation of foreign capital in joint ventures, as was the case of the Decree-Law No. 50 of 1982, which established a ceiling of 49%.
Law 77 recognizes three forms of foreign investment in Cuba:
Joint ventures: Law 77 allows the creation of a domestic entity different from that of the parties and which takes the form of a company with nominative shares. Both parties agree on the percentage of capital to be contributed by both foreign and national investors as established in the company’s incorporation documents.
Contract of International Economic Association: This does not involve the creation of a new domestic entity different from that of the contracting parties. Each contracting party may contribute different funds of properties or services thus creating a common fund, provided the property belonging to each one of them is established.
14 Travieso-Diaz, Matias F. The Laws and Legal System of Free-Market Cuba, 1997 15 Preamble to Law Number 77, Cuban Foreign Investment Act, 1995
100% foreign capital companies: This is a commercial entity with foreign capital, without the involvement of any Cuban partner. In this situation, the foreign investor may be present as an individual or a corporation within Cuba. The foreigner is permitted to manage the company, enjoy all rights pertinent to it and is responsible for all the obligations described in the authorization of doing business in Cuba.
Guarantees to Foreign Investors
Law No. 77 contains guarantees to investors on the basis that they enjoy full protection and security with the foreign investment without being subjected to expropriation except for reasons of public utility or “social interest”. Expropriations of this nature rarely occur. The law provides that those whose investment is expropriated will receive monetary compensation equivalent to the value of the expropriated goods.
Article 25 of the “amended” Cuban Constitution of 1976 authorizes "the expropriation of property for reasons of public benefit or social interest and with due compensation”. Cuban law establishes the procedure for expropriation and the basis to establish its significance and need, and the form of the indemnification taking into account the economic and social needs of the party whose property has been expropriated”.
Finally, article 60 of the Cuban Constitution establishes that “the confiscation of property only applies as a sanction by the authorities and in the cases contemplated by the law”.
Another provision of Law 77 allows the foreign investor in an international economic association to sell or transfer his total or partial participation to the State or a third party (following governmental authorization) at any time and following agreement of the parties, to receive the agreed upon price in freely convertible currency. Similarly, the foreign investor of a 100% foreign enterprise may at any time sell or transfer to the State or third party (following governmental authorization) his total or partial participation in it. Upon expiration of the term established for the operations of a foreign investment vehicle (Joint Venture Company or international economic association) such term may be extended upon agreement between the parties and with government approval.
Disputes that may arise between parties of a foreign investment in Cuba may be resolved according to three methods: 1) the Cuban judicial system; 2) International commercial arbitration in accordance with an arbitration clause, which international arbitration may take place in Cuba, in a third country or in an international arbitration court and 3) the Judicial courts of a third (neutral) country.
As the result of the dynamic process in Cuba in the last few years new forms of foreign investment have been approved involving different sectors and branches of the economy. They are, indeed, more expedite and flexible contractual forms that bring about favorable economic results for each contracting party.
Now, one can speak of a codified legal system which is governed by the principles of law and in theory functioning apparently similarly to other economies and societies, not hiding the fact that they are subject to administrative internal decisions which govern the destinies of the country and the economic activities of the Cuban companies
Areas of potential interest for a foreign investor
There is a growing interest in all the Cuban economic sectors (agriculture, mining, energy, infrastructure, communications, hospitality and banking) in a short to medium term period.
However, the short-term interest in each sector depends on the Cuba’s immediate needs. The Cuban Ministry of each sector is responsible for the success of the foreign investment in his sector.
Sectors closed to foreign investment by Cuban law are health, education and security or national defense. Other sectors excluded from foreign investment are trade (domestically and internationally) and legal consultancy, which in practice have not been approved to date and any operation, if it occurs, will rather be selective.
For now, the main investment focus are in tourism, energy (oil and electricity), mining (nickel), cement, iron/steel industry, food, agriculture and telecommunications.
In agriculture, livestock and fishing many opportunities arise in the long term to meet the needs of local consumption and tourism, replacing imports. Cuba’s agriculture needs equipment, fertilizers and insecticides.
In the food industry there are several joint ventures and cooperative production with foreign firms, especially Spanish.
In the mining and metallurgy sectors the best opportunities are in the nickel industry with strong presence of Canadian and Chinese investments. In energy, and what may result from the oil exploration, there are opportunities in generation of electricity from oil, gas and biomass.
In services, there are attractive long term opportunities given the limited development of most sectors. Communications is a priority due to the lack of
know-how and technology. Foreign presence in the financial services is visible after the implementation of the new banking system. Foreign investment has begun in some areas but depends on a number of regulations that impede their development. In tourism there are short-term opportunities to build hotels on a joint venture and manage state-owned Cuban hotels.
The end of travel restrictions to Americans to visit Cuba will be a trigger to the boom in the tourist sector. Additional tourist services (theme parks, golf courses, and private clubs) can be also developed in collaboration with foreign firms, although the conditions that have been offered so far have not facilitated the development of the sector which has great interest in the long term.
Some of the problems associated with the Cuban Foreign Investment Law:
· Case-by-case approach for the approval of the investment
It is the exclusive faculty of the Council of Minister’s Executive Committee to authorize foreign investments when any of the following sectors are involved and the investment has the following characteristics: those in which the total amount of the contributions by foreign and national investors is over $10 million dollars; companies with 100% foreign capital, those that involve the exploitation of public services such as transportation, communications, waterworks, electricity or the building and exploitation of some public works; where the foreign company is involved with capital participation of a foreign state; when the investment is related to the exploitation of natural resources; those that include the transference of state property or real estate, property of the State and those pertaining to the system of enterprises of the armed institutions.
As such the approval process is complex and places the applicants at the mercy of government officials who can interpret laws and regulations without explanations; in other words, it does not require transparency and fair and equal rules for all16.
· Restricted liquidity of investments:
The sale or transfer of investors’ capital to third parties is subject to the approval of the government. Article 13.5 reads:
“Once the joint venture is created, the partners cannot change except with the consent of the parties and the approval of the authority that granted the authorization.”
16 Johns, Melissa. Foreign Investments in Cuba. Boletín Mexicano de Derecho Comparado. UNAM, 2003
This is a critical restriction on investors’ “exit strategy,” which is a fundamental consideration in evaluating investments 17.
· High risk of foreign exchange losses:
The law stipulates that the transfer abroad of net profits, dividends, proceeds from sale of capital, and the value of expropriated property are to be calculated in “freely convertible currency,” a term or formula which is not defined and, thus, remains uncertain.
Due to the volatility of the market conversion, rate of the peso to hard currencies and because the Cuban peso is officially set at the artificial rate, valuations are unpredictable and could be subject to political manipulations. Furthermore, since the foreign investor is not allowed to have peso deposits in foreign banks outside of Cuba, it is impossible to hedge the risk of devaluation18.
· Risk of reversibility of investment agreements; unreliability of the government’s commitment to capitalism:
Although Law 77 offers investors more guarantees than the previous Law 50, it does not settle fears that joint venture agreements may be reversible.
Article 3.3 of the Law 77 reads: “The foreign investors within Cuban national territory enjoy full protection and security and their assets cannot be expropriated, except for reasons of the public utility or social interest...”
Depending on how the clause is applied, it has been noted that joint venture investment agreements could be terminated by the Cuban government essentially at will, without due process.
There is no mention of recourse to the courts to impugn the validity of the clause and the law stipulates that jurisdiction for any litigation belongs to Cuban courts, which are not independent of the State19.
It has, however, been reported that certain investments have been or could be negotiated to override this disposition. Cuba has signed investment protection agreements with 19 countries which diminish fears of expropriations, but troubling precedents already exist20.
17 Werlau, Maria C. Foreign Investment in Cuba: the limits of commercial engagement. Cuba in Transition. ASCE, 1996
18 Lago, Armando M. An Economic Evaluation of the Foreign Investment Law of Cuba, Cuba in Transition. ASCE, 1995 19 Luzarraga, Alberto, Castro’s self-imposed embargo. New York Law Journal, 1995 20 See # 18
Cuba’s foreign investment system forces investors to accept riskier business regimes than those common to most markets by precluding the formation of corporate structures such as limited liability companies and general partnerships. These business associations could be readily disallowed by a future government of Cuba, which could declare their expropriation. Furthermore, the government’s erratic commitment to capitalism and foreign investment is cause for concern.
While the text of the foreign investment law is free of the typical ideological language of most Cuban laws and regulations, the Cuban National Assembly passed an accompanying statement stressing that Cuba’s economic opening “is not inspired by neo-liberalism nor does it aim for a transition to capitalism”. It is also possible that the Cuban government could grow comfortable with the economic improvements achieved by foreign investment21.
Analysts have pointed to previous successful reforms which were subsequently reversed, demonstrating what appears to be a pattern of implementing reforms until the results deemed intolerable by the leadership.
It seems that Cuba’s reforms are not based on any clear and well-defined theory, although Cuban leaders and other senior Cuban officials have repeatedly said that Cuba’s reforms should be carried out within the principles of socialism. They have expressed their wishes to utilize some forms of the market mechanism, but insist that Cuba will not advance towards market economy. From their perspectives, socialism and market economy are not compatible22.
· Inability to hire workers directly:
The Cuban government insists that those who work for foreign capitalists must continue to feel that they owe loyalty and gratitude to the state23. Thus, Law 77 preserves the Cuban state’s identity as sole employer by keeping in place the former law which prevents Cuban workers from being hired directly by foreign companies, except in exceptional cases.
Under the foreign joint venture arrangements, the Cuban government provides the workforce through a special employment agency of the government. It receives payment in hard currency from the joint enterprise, but remunerates the workers in salaries denominated in Cuban pesos at a minimal fraction of the amount received.
21 Babun, Teo A. Cuba's investment boom. The Wall Street Journal, 1996 22 See # 21 23 The Economist. Cuba Survey, 1996
Allegedly, wages are fixed at equivalent amounts to what workers in state enterprises are earning for the same or similar jobs. In the tourist sector, a portion of the tips must also be turned over to the Cuban management. Aside from the negative effects this has on the investors’ international image, other practical disadvantages arise from this arrangement.
Another problem for foreign investors is related with hiring practices in joint ventures. The government employment agency selects employees. Ideas and behavior deemed contrary to official ideology limit access to academic and work centers.
Because hiring is also subject to cronyism, the foreign capital enterprise’s access to workers on the basis of merit may be restricted, as the most capable and experienced workers may be banned for political reasons or patronage may be dictating who gets hired.
On the other hand, foreign investors may regard with convenience certain aspects of the State’s “control” over the workers. The Economist has noted that because Cuba’s foreign investment regime is based on establishing joint ventures with the Cuban state, the partnership makes it “easy to hire, fire, and control workers” and “comes in handy”24.
The Cuban Foreign Investment Law (Law 77) redefined the legal framework of the foreign investment in Cuba. Despite the initial success of the Law and the publicity obtained in late 1990s, Cuba has not been able to secure foreign investment to the degree that the country needs and is capable of attracting.
The Cuban government needs foreign investment to continue its economic growth and the foreign investors needs the Cuban government to honor its pro- investment policies and promises. It is possible, therefore, to balance the rewards for both sides to ensure profitable ventures for all the players involved. However, there are still challenges such as uncertainty about the Cuban government’s commitment to foreign investment, state control on the economic activities and on the operation of the enterprises and finally the inability of foreign investors to hire directly and to pay workers in convertible currency.
24 See # 23
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