Foreign Investment in Cuba: Will ‘Serious Changes’ Open a Floodgate?

Cuba FDI

Cuba is a country ripe for foreign investments, but U.S. businesses must be patient with what may seem like a slow pace of change in the island nation, experts said at a recent Cuba Opportunity Summit held at the Nasdaq MarketSite in New York. But for companies that take a longer-term view and invest with realistic expectations, Cuba offers a potential windfall as one of the last untapped emerging markets in the world.

For starters, U.S. businesses must discard their old view of Cuba. “Cuba in 2015 is not the Cuba of the 1950s Twitter ,” said Mark Entwistle, former Canadian ambassador to Cuba and now founding partner of Acasta Capital, during a panel at the summit, which was organized by Knowledge@Wharton, Wharton’s Lauder Institute and Momentum Event Group. “It’s a much more mature country, and it’s more independent.”

While the world was taken by surprise last December when President Barack Obama and Cuban President Raul Castro announced that the two nations would work to re-establish relations, sweeping reforms have been occurring in the Communist nation for many years. The ascension of Fidel Castro’s younger brother to the presidency in 2008 was key to ushering in these changes, said Philip Peters, president of the Cuba Research Center.

“The man in charge now, President Raul Castro, is quite different from his brother, and he’s putting the country on a path that his orthodox brother would never have chosen,” Peters said. “He’s a very blunt guy actually, very businesslike in many ways. I think he’s made a diagnosis that what they have is not sustainable and that they need to change — and he said very bluntly that either ‘we fix this or we will go under.’”

“President Raul Castro is quite different from his brother, and he’s putting the country on a path that his orthodox brother would never have chosen.” –Philip Peters

The Cuban economy has been under pressure for years, prompting the government to enact reforms that included the unprecedented mass layoff of more than one million citizens. “They couldn’t afford it anymore,” Entwistle said. These unemployed workers are being encouraged to start their own small businesses. Indeed, entrepreneurs now make up 11% of the labor force compared to 3% in 2010, Peters noted.

“These are serious changes,” Peters added. They’re based on recent realizations that “the government is too big, that the economy overall needs to be more productive, that more government projects are not the way, that they need a bigger private sector [and] they need foreign investment to drive production forward. They need a lot of it.”

This conclusion has led Cuba to initiate plans to make its market more alluring to foreign investors. In early 2014, the Cuban government passed a new foreign investment law that offered deep tax cuts, beefed up investment security and provided other benefits to investors. For instance, the new regulations would halve profit taxes to 15% and shield investors from paying it for eight years. It also axes the 25% labor tax.

The law sets out three main vehicles for investment in Cuba — commercial contracts with Cuban entities, joint ventures with Cuban partners or purely foreign-owned companies, said Gustavo Membiela, partner at the law firm of Hunton & Williams LLP. Most of the financial perks, however, would be set aside for businesses with Cuban participation or ownership. Areas prime for investment include agriculture, infrastructure, sugar, nickel mining, building renovations and real estate development, including an expansion in hotels and resorts to accompany a boom in tourism.

Disputes would be handled mostly by arbitration, bypassing the Cuban legal system, Membiela noted. In addition, businesses can choose a neutral country whose laws they want to use, such as the application of Spanish regulations, as they go into Cuba, he added. Initially, there will be various sorts of internal attempts to resolve a dispute among partners to avoid arbitration. But if that does not work, Entwistle said he knows from personal experience that the dispute would head to arbitration tribunals of the International Chamber of Commerce in Paris.

As for Cuba’s right to expropriate foreign assets, Membiela pointed out that under the new investment law, the government can only seize property under certain conditions, which are not dissimilar to the rules in other countries. Further, he noted that multilateral treaties also may protect one’s investments, depending on the place of incorporation. Cuba has multilateral treaties with 71 countries, according to Membiela. Cuba’s ability to seize assets is a key concern for businesses following its 1960 privatization of U.S. refineries for refusing to process Soviet oil, leading to the U.S. embargo.

Besides the new investment law, Cuba has another carrot for investors. In 2013, the Cuban and Brazilian governments created the Mariel special development zone, which sits in Mariel Bay along the northern coast of Cuba, 28 miles west of Havana. The port and trade zone, which will have vastly more capacity than the port in Havana, is being touted as the Caribbean’s first container terminal facility. It can accommodate large vessels and benefit from the current expansion of the Panama Canal, according to news reports.

Mariel will provide investors with even better tax breaks and other benefits than those under the new investment law, Membiela said. For example, Mariel investors are shielded from the 12% profit tax for a decade, and all equipment and materials brought in will be treated as duty-free, according to news reports. Ana Teresa Igarza, general director of the Zona Especial de Desarrollo Mariel, told the Prensa Latina news agency that the zone has received over 300 formal requests to settle there from businesses worldwide.

Lofty Goal

Cuba is aiming to attract $2 billion to $2.5 billion in foreign direct investments per year, which Peters said is “pretty ambitious” given that in the entire 1990s it managed to get $4 billion to $5 billion. But Cuba’s minister for foreign trade and investment said on state TV last year that the country needs that amount of foreign capital to achieve its economic growth target of 7% a year.

“[The Cubans] have realized they can’t do this themselves. So they are open for business on the foreign investment side.” –Mark Entwistle

While Cuba has made drastic changes, many old ways remain that could trip up foreign investors. For instance, businesses still have to hire employees through the Cuban government, Peters noted. Also, Cuba still operates under two currencies, the Cuban peso and the Cuban convertible peso. Having a dual currency complicates transactions, bifurcates the economy and makes market pricing tougher, he added. “They need to unify the currencies and make it freely convertible.”

U.S. companies also face additional barriers from a trade embargo and other sanctions levied against Cuba since 1960 that have been codified into law. These statutes will not be easy to reverse given the opposition from mostly mainly Republican lawmakers in Congress. For now, Cubans and Americans are in talks to reopen embassies in each other’s countries as the first step in normalizing relations. “The pace of all these things is kind of slow,” Peters said.

A Turbulent History

But these changes must be viewed in light of how far Cuba has come since the middle of the 20th century.

In the early years of the Cuban revolution in the 1960s, after Fidel Castro seized power from the Batista regime, the government got rid of all the foreign investors. “It was part of their achievement, as they saw it, of full … economic sovereignty,” Peters said. The next step was to abolish private enterprise in the late 1960s. “There was a great revolutionary offensive, as they called it, and they wiped out the remaining small businesses because they were viewed as unnecessary to the socialist project — all of them.”

The next “ideological campaign” came in 1986, when Cuba ended free market sales of agricultural produce and re-concentrated it in the hands of the state, Peters noted. The state took over the distribution of produce from farmers so there was no need for any private sector, market-based intermediary.

So what Cuba has done recently reverses its policies of the last 50 years, a drastic step whose full import should not be missed even if circumstances forced its hand. “Now all of those decisions have gone out the window,” Peters said. “These are major points in the economic history of socialist Cuba – those decisions have been reversed, and it’s a really important thing to note.”

“They’re hard, tough negotiators, but they’re very explicit. They’re very clear-minded. They have their own economic development priorities; it won’t be necessarily what we want to do.”  –Mark Entwistle

According to Entwistle, if the Cuban economy could chug along unaided by outside investments, that would be the state’s preference. “If they could do it all themselves, they would.” But Cuba realized that if it wants to thrive, it needed outside help for such things as accessing the global capital markets. “They have realized they can’t do this by themselves,” Entwistle said. “So they are open for business on the foreign investment side.”

Internally, Cuba is also transforming itself with the creation of urban cooperatives. Entwistle pointed out that these are effectively “quasi-privatization of state enterprises.” He described them as being similar to management buyouts of state companies in a variety of sectors. Cuban economists are predicting that there could be a thousand of these cooperatives created this year. “The regulatory framework surrounding cooperatives hasn’t really caught up with where they are in the economy and in society, but it’s something to watch,” he added.

Cubans have seen an influx of foreign investments before, but it did not work out. In the 1990s, the fall the Soviet Union — its main benefactor at the time — led to a collapse of the Cuban economy. To recover, the country opened its doors to outside investors. “There was a Wild West time from roughly 1993 to the end of the 1990s. It was crazy town,” Entwistle said. “All kinds of foreign businesses came in at that time.” While Americans were absent, Europeans, Canadians, Israelis, Mexicans and Chileans “flooded the place. They formed all these joint ventures in every rational field you could count.”

However, many of these foreign ventures failed. Cuba “learned powerful lessons in the 1990s,” Entwistle said. The Cubans realized that it was important to do their due diligence and to get to know their business partners well before entering into ventures. As a reaction to the 1990s, policy changes were made in the 2000s. The Cubans “cleaned out a lot of these joint ventures for non-performance,” he said. They included both foreign businesses as well as “mom and pop shops who couldn’t deliver.”

It is this complicated political and economic history that shapes Cuba today. U.S. companies that wish to be successful must take the time to understand this emerging market, its government and its people. “Really listen to what they tell us,” Entwistle said. “They’re hard, tough negotiators, but they’re very explicit. They’re very clear-minded. They have their own economic development priorities; it won’t be necessarily what we want to do.”

But companies that take careful consideration will find an unexpected stability in which to thrive. “Fundamentally, if you have a medium-term, strategic vision for the country, you’re not in it for a quick buck and … you understand what you are going to do, it is in fact a very stable environment,” Entwistle said.

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