Competitive Neutrality and the TPP

August 11, 2015International Tradeby East Asia Forum

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Hopes are that competitive neutrality will prevent SOEs from dominating the TPP.

As the Trans-Pacific Partnership (TPP) goes through another round, some details have started trickling out from the secretive negotiations. A concerning detail for Australia is the provision that applies penalties to foreign state-owned enterprises (SOEs) if they receive discounted loans when investing in TPP member economies.

The idea of ‘competitive neutrality’ is the basis for these provisions. This clause aims to stop SOEs from receiving an advantage over their private competitors by virtue of their connection to their home state.

But why not welcome subsidised foreign capital?

There are two important reasons that competitive neutrality is on the radar for TPP negotiators: first, cheap state capital can theoretically reduce the ability of other competitors to compete for investment opportunities on commercial terms. Second, SOEs can appear more likely to indulge in irrational strategic investment behaviour such as tying-up the supply of strategic resources on behalf of the state.

Competitive neutrality is one consideration when managing investment from SOEs. But so is understanding that the 12 TPP signatory nations are competing for investors with the rest of the world. Blindly increasing the barriers to entry for foreign SOE capital by applying penalties if they receive discounted loans would be a free kick for countries that are not signatories to the TPP.

The issues inherent in welcoming international capital flows from SOEs laid bare during the dark days of the Chinalco-Rio Tinto debacle in Australia in 2009. Australian politicians — influenced by public apprehension, cultivated by a well-placed competitor public relations campaign — appeared to be jumping at Chinese shadows, hastening to roll up the red carpet and slam the proverbial door on SOE investors.

A leaked US embassy cable about the new foreign investment guidelines quoted an official from Australia’s Foreign Investment Review Board (FIRB) as saying: ‘The new guidelines reduce uncertainty for potential investors, but pose new disincentives for larger-scale Chinese investments. … The new guidelines are mainly due to growing concerns about Chinese investments in the strategic resources sector’.

These ‘new disincentives’ discussed by FIRB management appeared rather strong. From 2002 to 2009, only one of the nine major Chinese investments in iron ore was outside of Australia. From 2009 to 2012, 10 of 21 deals were with countries other than Australia. While other factors played a role in China’s retreat from Australia’s red dirt, such as the Sino Iron-CITIC Pacific comedy hour and the increased cost of doing business in the Pilbara, where most of Australia’s iron ore mining takes place, Australia’s ad hoc reforms certainly improved the prospects for Australia’s iron ore competitors in Canada, Peru, Brazil, Russia and Guinea.

More broadly, an examination of China’s investment in iron ore, still the commodity of greatest interest to Australia, provides valuable information about how competitive neutrality works in practice.

First, Chinese SOEs do distort competitive neutrality. Loans from Chinese state banking institutions that provide preferential access for SOEs and international benchmarks plus a margin are the basis, which is generally lower than that available from commercial institutions.

But the question is whether this distortion of competitive neutrality actually harms the market. Evidence from the iron ore industry shows that it does not. In addition, preferential loans have been a feature of developments by other investors who have received state-related loans, for example from Japan and South Korea, as well as from China.

From 2002 to 2012, SOEs made 25 of 30 Chinese iron ore investments around the world. Of these 30 investments, firms with an operating competency in mining made 21. Only one of the investments was by a specialised iron ore miner.

But these Chinese iron ore investors increased rather than decreased partnership opportunities for non-Chinese iron ore investment. Chinese SOEs most often took minority equity positions in partnership with specialised non-Chinese iron ore firms. Joint ventures and minority acquisitions dominated Chinese iron ore investments (22 out of 30 investments).

Therefore, while Chinese SOE investment may distort our ideas of competitive neutrality, in the case of iron ore it did not appear to reduce the ability of competitors to compete for investment opportunities on commercial terms. In fact, Chinese SOE investment increased access to partnership opportunities for non-Chinese iron ore investors.

Similarly, critics have also expressed concern about the potential for Chinese iron ore procurers to tie-up supply. By ‘locking up’ strategic resources, state-backed firms would thus be able to withhold resources strategically from foreign steel producers, such as in Japan, Taiwan and South Korea.

But new research of a sample of 50 Chinese iron ore procurement arrangements shows that instead of tying-up resources, China’s iron ore procurement arrangements broadened the competitive global supply base. Long-term contracts by Chinese buyers reserved only 63.8 percent of projected iron ore output from Chinese projects. This increased access to iron ore for other buyers in the Asian market.

While the experience of Chinese SOE investment in iron ore may not be wholly transferrable to agriculture or other strategic industries, it shows that blanket slogans such as ‘competitive neutrality’ does not make Australia more competitive. As the TPP negotiations begin the sprint to the finish line, Australia needs to come to terms with the complex realities of dealing with SOEs or risk sitting on the sidelines as its competitors prosper.

TPP may deny Australia its piece of the China pie is republished with permission from East Asia Forum

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