II. CONSIDERATIONS REGARDING PRIVATIZATION THROUGH FOREIGN DIRECT INVESTMENT

The ultimate aim of Bulgaria's privatization program is to raise the efficiency of the economy in a debt overhang climate. The stability of the economy and long-run efficiency effect are to be achieved if only privatization brings about "responsible" owners. Most of the SOEs perform adversely and their subsidy-seeking behaviour, raising the internal public debt stock is a burden for the budget. Arrangements that involve replacement of state ownership and management by private property are envisaged to enhance the role of the private sector and overcome the constraints on its development. DES mechanisms and the inflow of FDI they are expected to bring about are an important vehicle for privatization by strategic foreign profit-maximizing investors who are the principal buyers in the secondary market.

The inflow of foreign capital in the country through debt-equity swaps will ease debt servicing and its linkage through the fiscal deficit. On the other hand, the mutual interlinkage between privatization and inward FDI contribute to revive economy and building up national competitive position.

Restrictive fiscal policy and sustaining budget deficit within bearable limits are among the main policy concerns during the transition. By the same token, there is little room left for the Government to promote GDP growth by traditional fiscal measures. Thus, DESs present a nonconventional mechanism for financing privatization and growing Bulgaria out of the current crisis. Equity investment is hoped to reduce state borrowing from overseas for investment in the economy thereby reducing external obligations.

2.1. Some Elements of The Profitable Investment Climate

The economic analysis of an attractive investment environment in a indebted country should consider from investor's point of view the existence of sufficiently profitable investment opportunities for DESs to take place. The mechanism of DESs entails equity investment in the debtor country. There are three parties in the debt-equity transaction: the investor (if he buys the obligation from the creditor bank) who has positive time preferences and decides to forgo current consumption and finance an equity investment expecting certain return on it (investors can include the original creditor banks, other financial institutions, industrial firms, private individuals and institutional investors); the debtor government who decides on the portion of debt to be swapped; creditor banks.

Foreign investorвs perspective

Foreign investors' rationally expect higher return on the equity. Thus, they adjust their investment behaviour in response to the effect that debt reduction negotiated will have on competitive returns to investment in the debtor country. Obviously, if these anticipations affect favourably the terms of equity sales of some domestic assets DESs may be in the interest of the debtor country. Since the real costs and benefits for the debtor country depend on the quality of economic policies pursued the efficiency of DES can be improved. From the point of view of the government of the indebted country the choice over the amount of debt to be swapped is a matter of a time-consistent and credible policy (see L. Golberg and Mark Spiegel, 1992). For an attractive investment environment the government has to be credible when deciding on the extent of DESs, buying back the bonds from the investors and requiring from them to invest the cash in local equity. The scope of DESs depends on the remaining nominal debt obligations. In this aspect lack of clarity in the existing legislation and its relevancy to DESs schemes as well as a time-concictent government policy are important deterrents to investment.

The potential plausibility of welfare-enhancing DES is affected if the government lacks enough stock to finance the programme. Investors could be assured in the credibility of the transaction if there are available loans and support provided by international institutions. It is largely held that the initiation of the deal implementation will open access for Bulgaria to many sources of official funding from the World Bank, EU and other G-24 sources. These resources will do away with the default-risk climate for debt servicing and will further attract inward capital towards its free allocation. Within the process of debt-equity auction fees and discount rates for conversion are policy determined. This is very much related to the prevailing economic climate and economic management strategy. The government may successfully use this fee basis as a means of generating revenue and thus influencing the overall impact of debt-equity transactions. While sharing in the yield on debt-equity conversion discounts by the fee setting process government can exercise leverage in directing investment by varying the fees across industries. This works through the different subsidies provided to the foreign investor. To the extent that these incentives influence investment activity they can be an attractive element of the economic environment.

The location advantages for FDI in Bulgaria as an indebted country are these elements that create an attractive climate for debt-equity swaps. The elements of the current legal framework - treatment of foreign capital, sectors open to foreign investment, patterns of FDI in terms of types and capital structure, business registration procedures; the relevant institutional structure; the economic conditions in the country and the future prospect are these location specific conditions that determine investor' choice. Stable and contract-enforcing legislation is necessary to assure foreign investors that once their equity investment became productive they would not be subject to any undesired expropriations and payment difficulties. The few years of the reform have passed without clear privatization strategy which in general have limited the inflow of foreign capital.

Bulgarian privatization and its appeal for foreign investors

With the adoption of the Law on the Transformation and Privatization of State-Owned and Municipal Enterprises in 1992 possibilities for foreign participation in the privatization were open.

In respect to the Law all physical and legal Bulgarian and foreign persons have equal rights to take part in the privatization process. There are three exceptions to this option. Employees are given the preference to buy up to 20 percent of the shares of each company at a 50 percent discount, with the total amount of the allowed discount per employee not exceeding its annual income. These shares are non-voting for a period of three years. Only Bulgarian citizens after a lengthy procedure for obtaining permits from the Privatization Agency and the Ministry of Finance, may buy shares of the companies by an installment payment scheme. In the case of small-scale assets which are sold through tender or auction, the employees are given up to 30 percent discount of the price if they have won the auction or tender. The above preferential status of the Bulgarian employees are minor and will not have a serious effect on the pace of foreign privatization (privatization of state assets by foreign capital).

The shares of the company can be sold by public offering, public auctioning of blocks of shares, by publicly invited tender and through negotiations with potential buyers. Direct negotiations would be the most appealing procedure for foreign investments as some of the recently concluded transactions have indicated. Foreign investors may obtain up to almost 100 percent of each company. Basically, there is no limitation for them to obtain immediately 80 percent of the shares and subsequently buy the remaining shares that have not been sold to the employees within the three month provided by the law.

Recently mass privatization schemes have been adopted which entitle Bulgarian citizens to take part in the privatization of the state enterprises, which will not be included in the list of assets selected for debt-equity conversion. These schemes can not bring "fresh money" into the economy and can hardly contribute to the economic efficiency in their early "distribution" phase. Furthermore, it is argued that mass privatization program will negatively influence capital markets' developments due to the provision that vouchers are non-voting for a period of three years. Stock markets are a necessary environment for privatization since they can provide for the presence of high-class companies and big volume of transactions. Their small volume is a limitation to the supply of viable projects for DESs. The lack of liquid markets and institutional investors (trusts, pension and investment funds) where households, firms and investors can trade assets and swap risks with each other is an obstacle for a speedy privatization and restructuring of the economy.

In general privatization procedures are simple and brief and are coordinated by the Privatization Agency, branch ministries or municipal councils according to the size of the assets and the type of ownership (municipal or state ownership). The transactions concluded by the Privatization Agency indicate that foreign investors remain the only potential buyers of large enterprises. In this sense, DESs will promote large-scale investments and speed up privatization.

The procedures for tenders follow internationally established principles which guarantee the transparency of the transaction. In some cases the tender conditions may include requirements for preservation of the company's profile, number of jobs, investment profile, protection of the environment.

The specific and complicated nature of DES schemes needs a clear regulatory framework which is to be based on the existing relevant legislation. The pricing of equity swapped, the exchange rate and techniques employed for valuating the assets may be a rather controversial issue. The recent devaluation of the BLV and the recession experienced further decline the price of the domestic productive assets. In this respect the presence of consultancy companies with world-known corporate image as KPMG Peat Marwick, Price Waterhouse, Arthur Andersen, Ernest and Young, Deloite and Touch, Coopers and Lybrands guarantee international quality and standard.

Two years after the adoption of the Privatization Law its achievements are evaluated as quite modest. Despite expectations for rapid privatization the process is rather sluggish due to a number of practical problems, the time-consuming establishment of the real estate property rights and defining the shares of privatized companies in another company (see D. Bobeva, Al. Bozkov).

2.2. Foreign Investment Patterns

Legal Advantages

Foreign capital invested in Bulgaria is regulated by the Business of Foreign Persons and Foreign Investment Protection Act 1992. The objective of act is to reduce bureaucracy and provide effective legal guarantees for investors. Its conditions are said to be one of the most liberal in Central and Eastern Europe.

Foreign investors can hold up to 100 percent of the company's capital enjoying rights equal to those of domestic investors. A foreign person may acquire ownership over buildings and limited material rights over real estate. The legal forms of investment are also rather diverse in comparison with the other Central and Eastern European countries - foreign investors can set up branches and commercial agencies. These forms of foreign economic activity give certain advantages to foreign companies in the initial phase of their investment profile when they get knowledge about the local market. Later, this experience turns out to be an advantageous basis for their investment plans.

The liberal legal conditions of the Bulgarian investment legislation also offer variety of forms of investment. There are no regulations prohibiting foreign investment in certain arrears with the exception of only three cases which are subject to authorization - banking and insurance, production and trade in arms and military equipment, development or extraction of natural resources. A special permitment is required in these cases if foreign participation is sufficient to secure a majority in decision making.

Foreign investment are protected against expropriation. The repatriation of income from investment, the liquidation quota in the cases of termination of the investment are not restricted, subject of course to payment of local taxes prior to transfer. Foreign exchange regulations have also been considerably liberalized. Any foreign person may open accounts, deposit foreign currency or BLV with Bulgarian Banks, as well as dispose of shares and securities.

An important factor of the investment environment is the tax treatment of foreign investment. Recently, some fiscal incentives to foreign investment were withdrawn, so that domestic and foreign investors are de facto subject to almost equal tax treatment. There are tax exemptions during the first five years in the free trade zones and thereafter a tax rate of 20 percent (the current profit tax rate is 40 percent).

Despite the political hustle the open investment regime in the country has remained in the course of the past years of the reform and thus providing for a time-consistent Government policy. The transparency of the investment climate is provided by the relevant policy-coordinating governmental bodies - the Commission for Foreign Investment at the Council of Ministers, the Privatization Agency, etc. These institutions aim to sidestep the bureaucratic hurdles facing an acquisition whilst in western management to promote marketing and production efficiencies.

The rationale to throw "good" money after "bad"

The foreign direct investment process typically entails several steps: strategic assessment of alternative investment opportunities; evaluation of the environment, investment climate, choice of financing strategy; estimation of the risks involved and return on risks. The rationale for international investment is very much influenced by the availability of attractive investment climate and well-designed swap programme. Investors who are risk averse attempt to diversify their investment portfolios so that risk can be reduced. New portfolio diversification theories suggest picking investments so that the total return on a portfolio is correlated to the return in the market in general while the return on each investment tend to be unrelated. Of course this "market portfolio" can not do away with risk allocation with the market in general. It is because of this property that Hanke suggests the design of a "multi-market" diversified portfolio. This portfolio will be expanded to include other markets (see St. Hanke). These other markets will generate returns that are unrelated to those in the original market. Thus, there is room for international markets to come into play. A part of the portfolio will be invested in other countries allowing the international investor to gain higher returns per unit of risk than he would with a well-diversified home-country portfolio. Among the financing options for investment, equity is often among the least preferred, since this method involves often difficult management process ( see K. Dezseri and J. Marcelle). The ongoing process of transition is accompanied by unstable foreign exchange and money markets which often have unpredictable effects and thus limit investment initiative.

In general, investors consider local currency debt as the most attractive form of financing because it explicitly matches currency in cash and debt. At present the economic conditions in Bulgaria considerably curb the scope of this channel because of its high cost due to high interest rates and transaction costs. These are DES schemes that will provide access to local funds at a discount in the form of a subsidized price for the countryвs external obligations acquired in the secondary market. This opportunity for the international investor to buy local shares that are good values is in addition to the attractiveness of Bulgariaвs market from an overall diversification point of view.

To-date experience with FDI shows some specific features of the Bulgarian patterns in terms of volume, structure, direction of penetration, sending country and size.

A precise quantification of investment inflows has been bedeviled by the lack of statutory requirements for registration of all foreign investors. Quite often the transfer of know-how in the local affiliate and the capital reinvested are also not registered. Bulgaria suffers from shortage of capital mainly due to lack of clear privatization and restructuring strategies, lack of clarity in much of the existing legislation, the unsettled debt problem and scarce publicity on long-term investment opportunities in the country.

Clear attitude towards foreign privatization and introduction of new mechanisms such as debt-equity-swaps (DES) will catalyze the process. Undoubtedly, public support for foreign investment in equity is a necessary element of an attractive investment climate. In this respect, national sentiments and fear of "sell-out" the country to profit-motivated foreigners can underrate the efficiency of foreign investment in restructuring the acquired local companies.

At present Bulgaria finds itself in the initial stage of foreign investment penetration when economic conditions and policy concerns limit foreign involvement to trade and service investments rather than through the international capital markets. After a slow start, foreign investment is now accelerating with companies such as UK's Rover, considering establishing assembly plants, Heineken, Coca Cola, Jacobs and Nestle S.A. with an arrangement for investment in reconstruction, marketing and distribution network. Firms with foreign capital follow efficient production behaviour since they are concerned about the comparative advantage of their products and liberal trade conditions. Their presence in the national economy could bring about reduction of entry barriers of the country to the markets of developed countries and reshaping of Bulgariaвs export and trade flows.

A case study of fifteen companies with foreign participation in Bulgaria presents evidence for analyzing investors' incentives, entry strategy, aims, expectations and limitations in front of their business. Companies with foreign participation pursue efficiency- and market-seeking strategies. Initially, they exploit country's differences in costs and factor endowment, acquire information about prospects for specialization in local production. Natural supply advantages of Bulgaria, such as climatic conditions and geographic proximity to the enormous East markets are certain incentives for multinational companies to invest. The operations of efficiency-seeking investments can be further facilitated by liberalizing trade restrictions, since they include intrafirm trade. Intergovernmental arrangements on the protection of foreign investment contribute to the presence of many multinational companies in the country. This is an encouraging indicator of a change in the country's investment opportunities. Contrary to the initial wave of small investment at present foreign companies pursue strategies to achieve objectives beyond short-term profit maximization. Bulgaria as an investment site is a new strategic market where new products can be developed and profits proportionate to the risk can be earned. Undoubtedly, the present environment of undeveloped market arrangements and deficient infrastructure limit the operations of foreign companies.

Sectorial analysis of FDI inflows evidence their growing volume in services. This process is triggered not only by supply factors including technological advantages in communications and allowance for informational services but also by the change in the traditional investment patterns. Recently, worldwide an increasing share of capital inflows is attracted in capital- and technology-intensive industries. In Bulgaria this process takes place in sectors which are said to be priority - transport and telecomms, tourism (hotels and new leisure activities), electronics and electrical engineering via introduction of information technology, Western management, pollution controls (see Tables 5 and Table 6).

• • Source: Foreign Investment Commission

• • Source: Foreign Investment Commission

Small-scale investments make up 65,4% of all foreign investment and only 14,6% of registered investments are above $ 20,000. Along with the arguments raised above there are some claims that the insignificant number of foreign investment is primarily due the small number of joint ventures (see D. Bobeva and Al. Bozkov, 1992). Unlike all other countries in the region, where foreign investments participated mainly in setting up joint ventures, these figures are about 1,900 for Bulgaria. Setting up a joint venture with a local partner may be beneficial if the local partner has strong market share and local brand recognition The information about the entire set of firm specific knowledge and advantages are attractive for the foreign investor. Results from several successive surveys carries out with managers of joint-ventures indicate that despite these benefits foreign investors are keen to keep direct control and alleviate efficiency-control problem investing "on green". The problem with green-field investment is that initially its cost is positively correlated with the production factor intensity of the recipient industry. It also takes time before production can begin.

Foreign investors need to distinguish among different groups of companies looking for the most attractive site. At the time of the preliminary talks with the creditors the Government's Foreign Debt Management Committee outlined the criteria for choosing entities to be swapped. These are mainly export oriented, in branches that have gained relative profitability (tourism, food processing, transport), indebted but with good production capacity. Foreign investors may be importantly concerned about potential restructuring costs and the indebtedness they have to bear for the acquired local company. If these costs are higher than the asset cost then the process can stop. Foreign privatization of companies that are technologically or market dependent from foreign companies should be promoted. This way the process will bring about sector and technological restructuring, demand responsive production, new patterns of trade policy. These considerations make direct FDI privatization, i.e. transformation of the existing non-private enterprise into private foreign ownership an attractive method.

Parallel to the institutional set-up a government policy for intensification of foreign investors' participation in privatization through DESs has to stipulate the guidelines for these transactions: DESs conditions, percent discount of face value of debt bonds, dividend remittances and capital repatriation regulations , minimum period of ownership over the equity. The flexibility of these guidelines is crucial for the attractiveness of the debt-equity conversion schemes. The experience of some Latin American countries, like Chile, Argentina, Mexico in terms of the DESs regulatory framework they have applied is useful for drawing lessons for Bulgaria . This framework has to be devised in the context of the broader FDI policy. It needs to approach foreign capital through policy-driven measures built around formal trade and investment preferences through free-trade areas, customs and common markets, and market-driven solution which is given by multinational companies pursuing gains through integration of their foreign affiliates at recipient country's level.

The various path and programmes of other countries that have applied DES are potential testing procedure. Chile's conversion program is said to be very successful, swapping 15% of Chile's total long-term debt by schemes for privatizing SOEs on competitive basis among potential strategic investors. This auction-based system (also the case of Philippines, Argentina, Chile) is useful for Bulgaria for screening the most suitable investor and raising the price of the enterprise.