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Political Risk

Expropriation: Pakistan's Message to Foreign Investors

Daniel Wagner | February 1, 2010

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Pakistan's recent de facto expropriation of one of the country's largest ever foreign investments—the Reko Diq mine in Baluchistan—has sent a shudder through the foreign investment community. The government has said that the deal originally agreed with the provincial government is unfair and not in the country's long-term interests.

This seems an odd time for Pakistan to be sending foreign investors a mixed message with respect to the sanctity of contracts and unpredictability of government actions. At the same time, there is an important lesson to be learned for foreign investors everywhere: cutting a deal that is perceived as fair by all parties will enhance the chance that a project will proceed, and be successful in the long-term.

Rising Economic Nationalism

In January 2010 the government of Pakistan threatened to cancel the $3 billion Reko Diq copper and gold project led by Canadian investor Barrick Gold and Chilean mining company Antofagasta in the country's resource rich Baluchistan province, citing the need to protect is strategic national interests. With an economic life of 25–30 years, the project is expected to earn $40 to $50 billion from the extraction of raw copper and gold, making it one of the largest mines of its kind in the world. It is therefore not a surprise that the government is interested in maximizing its potential long-term monetary benefits from the project.

Given that the mine is located near the Afghan border, in a province that has been at odds with the central government over revenue sharing from natural resource projects, and the base of a nationalist insurgency for decades, the original investors were given some incentives to proceed with exploration and feasibility studies, and were in return given a lucrative deal. The government now appears to think the deal is too lucrative, and that some of the terms agreed upon are unfavorable to Baluchistan and the central government. Baluchistan was required to provide 25 percent of the project funding in order to get a 25 percent return—a tall order for a province with limited financial resources. Baluchistan now wants 80 percent of the proceeds.

The project is controversial. Proponents claim it will generate much needed jobs and, if successful, act as a magnet for future investment in the province and mining sector. Proceeds from the project should help fund infrastructure development in the area. Opponents cite concerns about by-product pollution from mining, security issues, whether revenues will actually lead to infrastructural development, and whether corruption among local government officials would actually be exacerbated as a result of the project.

These are all legitimate issues, but the bottom line is that Baluchistan stands to gain from Reko Diq, as does the central government. Without the seed capital to fund exploration and produce a feasibility study from private investors, the project would never have gotten off the ground. Having accomplished that, Pakistan now jeopardizes the 15 years it has spent to get to this stage by playing the nationalism card, at a time when Foreign Direct Investment has fallen 57 percent in Pakistan since July 2009.

The message in the Reko Diq case is that a cash-strapped government with limited sources of revenue will seek to protect its long-term interests by either seizing high profile foreign exchange generating projects or renegotiating them.

Extractive Enterprises are Particularly Vulnerable

Extractive industries are generally more vulnerable to adverse action on the part of host governments for several reasons:

  • They tend to be large and high profile.
  • They employ thousands of people and have significant impact on local communities.
  • They are strategically important to host countries.
  • They are subject to a wide range of legal regimes and laws, which frequently change.
  • They involve the production of waste products, which makes them more highly scrutinized for environmental compliance than other forms of investment.

Mining projects, in particular, have been the object of numerous instances of expropriatory-type actions on the part of host governments since the 1970s. Interference by local or national authorities and revocation of mining or export licenses are the most common ways in which governments indirectly expropriate mining investments. Although rare, outright acts of expropriation on the part of host governments do still happen, as has been demonstrated in recent years in Bolivia, Ecuador, and Venezuela.

In addition, mining projects are prone to sustainable development-related operational complications, largely due to the impact they have on local environments and populations. Many mining companies have made great progress in taking the initiative to avoid conflict with non-governmental organizations (NGOs) and indigenous peoples by taking care to be inclusive in the planning, construction, and operation of mines. Many recent investors in the sector have taken care to establish strong relationships with tribal leaders and negotiate agreements that give all participants a sense of fair play.

Among the most famous cases involving local population backlash for agreements that were not perceived to be fair is Bougainville in Papua New Guinea, beginning in 1989. Disputes over environmental impact, financial benefits, and social change brought by the mine renewed a secessionist movement that had been dormant since the 1970s and forced the mine to close permanently. The conflict led to a war that lasted 8 years, claimed an estimated 20,000 lives, and resulted in the island becoming politically independent. While an extreme example, Bougainville serves as a reminder of how quickly events can spin out of control, and the lasting impact of failing to take indigenous interests seriously.

Lessons Learned

That Pakistan has made such a bold move with Reko Diq, when it is facing one of the worst political and economic crises in its history, implies that governments can take action that is contrary to investors' interest at any time. Pakistan has demonstrated that it will not hesitate to look after its own interests, for its own benefit. International investment law states that governments have a right seize foreign investments in the national interest, to the extent that investors are given fair, equitable, and timely reimbursement. Even if a government does not have the financial means to provide such reimbursement, it can still take unilateral action, leaving investors to seek legal recourse through arbitration or other means. This is indeed one of the risks of engaging in cross-border investment.

One of the biggest mistakes international investors make is to focus on their own future net income generation rather than on what makes sense from all parties' perspective. Experienced investors in natural resource projects know that when they agree to tariff, tax, or revenue sharing arrangements that give local participants and host governments a real sense of fairness, their projects generally proceed with minimal conflict. This minimizes operational complications and usually ends up contributing handsomely to the bottom line. Yet, in the negotiation process, too many companies make the mistake of being too focused on their own well being, and not enough on what benefits local communities and the long-term health of provincial and host governments.

The message in the Reko Diq case is that a cash-strapped government with limited sources of revenue will naturally seek to protect its long-term interests by either seizing high profile foreign exchange generating projects or renegotiating them. Barrick and Antofagasta would have been wise to consider the possibility of a change in Baluchistan's posture over the long term and negotiate a deal that gave the province a better sense of genuine benefit and fair play. Many other mining companies have learned the same lesson.

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