Foreign Direct Investment

1
Foreign Direct Investment in Gold Mining in the
Developing Countries An Analysis of Award and
Implementation of the Contract of Works System
in Indonesia By Balbir Bhasin
2
Purpose Scope of Study
Key Question What changes does a developing
country need to make to its foreign investment
policy, law and the implementation process with
respect to mining, so as to make it more
conducive for foreign investment and achieve a
long term balance between the needs of the
investor and those of the country?
3
Research Questions

• What are the real and perceived problems faced by
  foreign investors when negotiating and bidding
  for contracts?
• What changes need to be made in the structure of
  CoWs, and the awarding process that results in
  greater transparency and benefits both the
  foreign investor and the host government?
• What are the political limitations to
  implementing these changes?

4
Research Design

• Main research paradigm is hermeneutics using two
  instrumental case studies for evaluation and
  interpretation.
• Documentary analysis and unstructured interviews
  will be the main instruments for data collection.

5
Fundamental Structure of CoW

• Conjunctive Title This grants the right to the
  contractor to proceed to mining exploitation as
  and when a commercial discovery is made without
  further approvals the rights and obligations of
  the contractor covering all stages of the
  undertaking from general survey and exploration
  all the way to production and marketing of the
  product are stipulated in the contract.
• 2. Lex Specialis Treatment The CoW guarantees
  that, once approved by the government, the terms
  and conditions of the contract will not be
  subject to any subsequent changes to the general
  laws and regulations of Indonesia.

6
1st Generation of COW

• Negotiated in toto with Freeport. Only one
  contract signed in 1967.
• Covered an area in Irian Jaya centered on the
  Ertsberg gold deposit discovered by the Dutch in
  1936.
• Exploration period 2 years Feasibility Study
  period of 6 months Construction period of 3
  years and Operating period of 30 years following
  commencement of commercial production.
• Company given the right to keep its books in US
  dollars and to retain offshore the proceedings of
  sales in foreign currencies.
• Most generous contract in favor of the foreign
  investor and Freeport has been carrying out a
  successful mining operation since.
• Tax holiday of first 3 years after commencement
  of production.
• Exemption on most other taxes and from royalties
  on copper and gold.
• Company given full management and control on all
  matters related to exploration and mining
  operations.

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2nd to 6th Generation1967 to 1997

• Introduction of export and property taxes.
  Restriction on exemption from import duties.
• Processing (including smelting and manufacturing)
  of material to be within the country.
• Increased indirect taxation through Withholding
  Tax and Value Added Tax.
• Required to have an Indonesian partner at the
  outset.
• Imposition of import duties on spare parts
• Freeport agreement generated tremendous interest
  in the international mining community.
• Large scale general mining began.

8
2nd to 6th Generation1967 to 1997

• Contracts changed abolition of tax holiday,
  increase in corporate tax rates, payment of
  royalties, land rent and other taxes added.
• Specifications of number of Indonesians to be
  employed.
• Equity shares to be offered to Indonesians (rose
  from 20 to 51)
• Imposition of new royalty scheme based on fixed
  US dollar amounts per units of contained metal.
• Increase in land and building taxes.
• Increase in amount of security deposit and
  minimum expenditure levels.
• Imposition of royalties by the province concerned
  for industrial minerals used to construct the
  mine.
• No guarantee of purchase of product by the
  government in case of an export ban.

9
The Busang Scam and Aftermath (1996-7)

• Bre-X, a small Canadian company purchased Busang
  site in East Kalimantan in March 1993 from an
  Australian company.
• The players were de Guzman, a Filipino geologist,
  John Felderhof, a Dutch born Canadian citizen,
  and David Walsh, a Canadian businessman.
• They bought the claim for 86,000 and proceeded
  to claim the biggest gold find of all time.
• In 1996, company made public announcements
  raising estimate of lode size from 2.5 million
  oz., to 30 to 70 million oz. To eventually 200
  million, which would be worth 70 billion at
  current prices.
• Claims were backed with salted ore samples a
  technique of sprinkling gold dust on the core
  samples to fool assayers.
• Bre-X stock prices skyrocketed from a penny
  stock to 200 in September 1996.

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The Busang Scam and Aftermath (1996-7)

• Walsh Felderhof sold around 83.5 million of
  Bre-X stock and moved to the Cayman islands.
• Big players became involved Investment bank
  J.P. Morgan was a Bre-X advisor.
  Freeport-McMoran came in as a partner in February
  1997 and promised to spend 1.2 billion to
  excavate the mine. Bostons giant fund, Fidelity
  Investments was Bre-Xs largest investor.
• In Indonesia, there was a mad scramble to get a
  piece of the action Barrick Gold of Canada
  joined forces with Suhartos eldest daughter.
  Bre-X hired as consultant a company linked to the
  Presidents eldest son. The Presidents close
  confidante, Bob Hasan intervened to force a final
  deal that included a 30 stake in the mine for
  himself, 15 for Freeport (who was to kick in
  400 million to take operational control of the
  project) 45 for Bre-X, and 10 for the
  Indonesian government.

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The Busang Scam and Aftermath (1996-7)

• Fraud was discovered when Freeport hired
  Strathcona Mineral Services of Toronto to make an
  independent assessment.
• The bubble burst and de Guzman was found dead,
  apparently suicide by jumping out of helicopter.
• Bre-X stock plummeted from C26.80 to C3.30 to
  about Canadian 8 cents.
• Big and small investors lost 2 billion.
• Result
• Indonesian and Canadian authorities were
  embarrassed!
• All contracts would give the government a free,
  open-ended, 10 stake.
• Government would get a share of capital gains on
  overseas stock markets.
• New contracts would require full Indonesian
  management within 6 years of operation.

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7th GenerationResponse to Busang

• Only 38 of 6th generation applications were
  approved, mostly with major companies.
• 260 applications were pending, most were Canadian
  juniors.
• Cash security deposits were now required.
• Final area to be no more than 62,500 hectares.
• Refunding of security deposit was made more
  difficult and lengthy.

13
The Collapse of the Indonesian Economy

• Asian Financial Crisis - mid 1997
• Decline of Indonesian Rupiah from Rp2,400 (to 1)
  to 4,000 to 6,000 to 10,000 to 16,500 on January
  22, 1998
• Riots and student protests
• Suharto resignation on May 21, 1998
• Vice President Habibie - No progress
• New Elections 1999 - Democracy Fragmentation -
  Timor, Irian, Aceh, (Racial)

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Proposed 8th Generationfor applications after
1st November 1997

• Security of Tenure provisions eroded.
• Severe increase in payment of royalties.
• Local governments allowed to tax and charge.
• Bank-ability of CoW reduced the ability to raise
  finance.
• Absolute power to government in granting approval
  of plans and designs relating to construction,
  operation, expansion, modification and
  replacement of facilities within the contract
  area.
• Severe changes made to Contract Area, Feasibility
  Study Period, Construction period, and Operating
  Period.
• Release of Security deposit further delayed.
• Company no longer has the right to all the
  necessary licenses and permits.
• Limits rights of companies to bring in expatriate
  employees.
• Force Majeure now completely in favor of the
  government.
• Companies now required to contribute to community
  development.

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Case Study OneP.T. Danau Toba Mining, North
Sumatra

• Project is called Sibolga and covers 659,738
  hectares.
• Foreign entity is Normandy Anglo Asia Mining. a
  JV of the Normandy Group of Adelaide, Australia
  and Anglo American PLC of Great Britain (Anglo)
  which is a consolidation of Anglo American
  Corporation of South Africa and Minorco SA of
  Luxembourg. It is associated with De Beers
  Consolidated Mines Limited.
• Normandy Group is capitalized at 3.5 billion and
  Anglo and its associates in excess of 20
  billion,
• Indonesian partner is PT Austindo Nusantara Jaya
  (Austindo) and is controlled by Julius Tahija, an
  80 year old Ambonese Christian and his two sons.
• The shareholding is 90 Normandy and 10
  Austindo.
• Authorized capital is 200,000, with paid up
  capital being 50,000. The Indonesian
  contribution of 5,000 was contributed to
  Normandy as a loan.
• The joint venture agreement between the two
  parties explicitly states that Normandy would
  control and manage the project.
• The site was selected based on recommendation of
  one of the companys contract geologists who had
  explored the area earlier.

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Case Study TwoP.T. Tambang Tondano Nusajaya
North Sulawesi

• Project is called Tondano and covers an area of
  297,200 hectares.
• Foreign entity is Aurora Gold Limited of Perth,
  Western Australia and has a market capitalization
  of 210 million.
• The local partner is again P.T. Austindo
  Nusantara Jaya, the same partner with Normandy.
• Aurora has an equity stake of 85 and Austindo
  15.
• Aurora has a facility of 10,000,000 available to
  the venture. An equity loan of 60,000 was made
  available, out of which 15,000 was advanced.
• For security, Aurora is pledged all shares of
  Austindo in the JV.
• The site is an extension of an already existing
  mine that Aurora holds under a separate and
  earlier CoW. (PT Meares Soputang Mining, 4th
  generation, 1986).

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Case Studies Conclusions

• Dealing with Govt. officials and bureaucracy
  remains a slow and inefficient process,
• Security clearance process is tedious and costly,
• Most serious problem is one of illegal miners,
  and damage to environment by them
• Local government officials are demanding payments
  and hampering work,
• Problems in obtaining clearance from Forestry
  Department for exploration due to conflict of
  interest

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Research Findings

• Investment in mining in Indonesia has come to a
  halt due to the prevailing situation.
• First time ever, independent survey done by
  PriceWaterhouseCoopers in Dec. 1999 and 2000
  confirmed this.
• Major issue is the breakdown in law and order.
• Foreign investors risk has been increased
  considerably.
• Risks are
• Rising country risk
• Rising security risk
• Rising legislative risk
• Rising inconsistency in policy
• Rising costs of doing business
• Others bureaucratic inefficiency and poor
  infrastructure development

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Recommendation for Reform

• Proposed 8th Generation CoW needs to be
  re-evaluated
• Mineral royalty rates need to be adjusted to
  world standards
• Regional autonomy legislation needs to be
  implemented intelligently
• Local government taxes and charges need to be
  more balanced
• Ring Fencing Concept needs to be replaced with
  One Company - Multiple CoWs
• Regional participation in sharing of benefits
  needs implementation
• Long term stability and application of the
  contract needs to be ensured.

20
Lessons for Developing Countries

• Contract of Work system works!
• Need to understand the long term and special
  nature of the mining industry
• Political stability - mandatory for resource
  development
• Good governance can only come through
  transparency
• Risks must be managed for mutual benefit
• Need to understand the benefits and intricacies
  of foreign investment in resource development
• The rule of law is an absolute must
• Minimize political and regulatory risk for the
  foreign investor in mining
• Transparency and good governance is a
  pre-requisite to encouraging DFI
• Need to restructuring regulatory bodies and
  procedures thus creating the environment for
  sustainable DFI

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In Conclusion

• Will the CoW system survive?
• Inter-regional competition may create a
  competitive market oriented climate where regions
  will compete on such factors as transparent
  government with less corruption and giving the
  locals direct benefits.