DAVA Mercantile Digest no. 2 by Horia Ciurtin, Senior Expert & Founder
(also see in .pdf format)
When thinking where to invest next, Uzbekistan would not necessarily rank first among your options. Nonetheless, a constant high cotton production, low-wage workforce, a relative proximity to the largest markets, combined with a (seemingly) supportive state agricultural policy and incentives for investors made Uzbekistan’s textile industry an attractive business venue. However, as always, there is another side of the coin. This Mercantile Digest analyzes the challenges (legal and political) of Uzbekistan’s textile industry, while also offering advice for investors in order to prepare themselves in such a delicate economic environment.
Introduction: ‘White Gold’ in Central Asia
For Uzbekistan’s unbalanced economy (like most in the region), production and exports have been restricted to a limited range of goods. First comes the exploitation and sale of mineral resources abroad. Gold rises to 32% of Uzbekistan’s export figures, being sent almost entirely to Switzerland. This is a one-way, one-partner trade relationship. The second most exported resource is copper, closely followed by zinc, uranium and – then – by petroleum gas. While the metals are largely sold to Turkey, the energy products are sent via the Bukhara–Tashkent–Bishkek–Almaty pipeline to Kazakhstan or – even further on – to China.
Figure 1 – The Exports of Uzbekistan  [Source: The Observatory of Economic Complexity]
However, despite its fair resources of gold (fourth-largest in the world), copper and gas, Uzbekistan has rather made a worldwide reputation from the intense cultivation of cotton, its (once) economic crown-jewel. Dubbed as ‘white gold’, the state-supported cotton growth had been a strategic policy even during the Soviet period, leading to a (limited) industrialization in the textile industry. Despite a relative decline from the results it had when part of the USSR, it still maintains the upper-hand in the region, having a production nearly double than all the other Central Asian countries combined.
Figure 2 – Top Cotton Producers [2016-2017] [Source: USDA – FAS Cotton Report – July 2017]
In this sense, according to the United States Department of Agriculture (Foreign Agricultural Service), Uzbekistan still ranks 7th among global producers of cotton and 5th among exporters. Its economy depends on these crops, as revenues from cotton and the (subsequent) textile industry account for a consistent part of its GDP, although – for strategic considerations – the total cultivated area has decreased, in order to allow more wheat cultivation and ensure the security of the food sector (see Figure 3 below), thus decreasing the external dependence in this sector.
Transforming the Cotton Industry: State Policy and FDI
Being Uzbekistan’s main cash crop, there have been concerns for establishing a more sustainable approach regarding cotton production. The mere export of non-retail pure cotton yarn and of raw cotton is not sufficient on the long term for obtaining a viable economic model. On the background of an ever more restricted area for cultivating cotton (due to wheat production and frequent irrigation problems), there arose the need for obtaining a higher added-value from this economic sector, if the overall production cannot be further stimulated. Thus, the Uzbek authorities realized that a stable cotton output (even though smaller than before) could generate further revenues if integrated into a network of processing plants that operate ‘on the ground’ and not outside the country.
Figure 3 – Share of sown area under main agricultural crops [Source: State Committee on Statistics]
As local capital and know-how for establishing and running modern textile factories was insufficient in Uzbekistan, the government did what all developing economies did at the time: offered incentives for the attraction of FDI (foreign direct investment). Islam Karimov’s – the previous leader (until 2016) – plan was publicly acknowledged and promoted, showing that “we are creating a powerful textile and light industry sector. Moreover, we should integrate in the world market as other developed countries with the finished products excluding raw cotton”.
Therefore, Uzbekistan aimed for a transformation of the economy: from exporter of raw materials to a producer of finished (textile) goods. Not only the workforce needed to be partially retrained, but also the existing supply chains had to be altered. Whereas the previous model was based on exports of cotton towards countries with strong manufacturing industries, the Uzbek authorities now needed to attract investors whose production would be more profitable – from a tax, wage and energy cost perspective – than in their own countries. And – then – after processing the cotton within Uzbekistan, they would export finished products toward other markets.
For such an ambitious goal – and, perhaps, overreaching – the authorities offered various sets of incentives: in matters of taxation, custom duties and preferential financing. Among others, the most important stimuli offered for investors in the textile industry have been the following: (a) a 7 year holiday tax for foreign investors, (b) an exemption of property tax for those who export textile goods, (c) an exemption from all taxes (but not VAT) for the producers of (semi)finished textile goods, (d) a complete customs duty exemption for acquiring the necessary technology in processing textiles.
And this state-driven development has borne fruit. Thus, in 2012, there were almost 50 foreign companies (or joint ventures) active in Uzbekistan’s textile industry, while other sources talked of almost 150 companies with foreign participation. Most of them – predictably – coming from Turkey, Russia, China, but also from the United States, the United Kingdom or South Korea. Exports were diversified, not simply relying anymore on the sending of raw materials to other countries where they would be further processed. In addition, in 2015, the textile industry accounted for almost 1/5 of the GDP and almost 1/3 of all the workers activating in Uzbekistan’s industrial sector. It seemed to be a (moderate) success story, very uncommon among former USSR countries and even among ex-Communist states in Eastern Europe.
A Deteriorating Business (and Legal) Environment?
Nonetheless, even in (economic) success stories there is a (legal) downside when a state-centric paradigm of development is involved. Central-planned monetary policy, corruption and cronyism undoubtedly affected the confidence of foreign investors looking at Uzbekistan for profitable business. After a series of international investment cases litigated under the aegis of the International Center for the Settlement of Investment Disputes (a World Bank affiliated institution) in the mining, telecom and retail sectors, it finally came down to the textile industry.
Thus, in 2013, the first investment claim relating to this economic sector was registered at ICSID (Spentex Netherlands, B.V. v. Republic of Uzbekistan, ICSID Case No. ARB/13/26), on the basis of the 1996 Netherlands-Uzbekistan Bilateral Investment Treaty (hereafter, BIT). A Dutch subsidiary – Spentex Netherlands B.V. –of an Indian textile company claimed that the legal standards of protection offered by the BIT (and the national investment legislation) have not been respected, resulting – finally – in the bankruptcy of the company. More precisely, the alleged arbitrary removal of secured subsidies put the investor in the position to suffer losses and be unable to further operate the three acquired cotton-processing plants. In the end, the local companies were placed in liquidation proceedings under the supervision of the National Bank of Uzbekistan.
With the award still confidential (since its issuing in December 2017), some details of the case have emerged. As in two previous cases against Uzbekistan – Metal-Tech v. Uzbekistan and Kim v. Uzbekistan – there have been serious issues of corruption argued during the arbitration. And they have been invoked by the respondent state, Uzbekistan. More precisely, its defense strategy – successful in the end – was to argue that the investors obtained the industrial platforms due to their corruption-by-proxy practices, distorting the public bid through local consultants who were awarded large amounts of money for providing no actual expertise. They were rather involved by the investors due to alleged connections and influence upon political factors of decision.
Thus, even though Uzbekistan emerged victorious in this legal conflict (as an investment established through corruption does not benefit from the protection of international law), itself was ‘challenged’ by the tribunal. The arbitrators prompted to the fact that Uzbekistan was uncooperative in showing the actual officials that finally took the bribes, defending itself by unveiling the wrongful behavior of some of its own organs.
In this context, the majority of the Spentex v. Uzbekistan arbitral tribunal indirectly – and discreetly – ‘sanctioned’ Uzbekistan’s own involvement in corruption practices, recommending (or ‘urging’) the state to make a donation to the United Nations’ anti-corruption fund. The payment seems to have been made (according to IAReporter) by the respondent state to the United Nations Development Program, in order not to risk an adverse ruling on the costs of arbitration, although successful in its main defense against the investor.
Later on, in 2017, a couple of Turkish investors in the textile industry also registered a case at ICSID against Uzbekistan (Bursel Tekstil Sanayi Ve Diş Ticaret AŞ, Burhan Enuştekin and Selim Kaptanoğlu v Republic of Uzbekistan, ICSID Case No ARB/17/24), focusing on the state’s failure to permit them to benefit from the promised incentives. Based on the 1992 Turkey-Uzbekistan BIT and the domestic investment legislation, their claim revolves around the fact they established a state-of-the-art processing plant, designed to produce goods for exports towards the United States and the European Union, relying on the tax exemptions and subsidies offered by Uzbekistan.
Funded through the EBRD, it reflected Uzbekistan’s public policy to enhance its production of finished textile goods, the plant being conceived “to transform […] intermediate products […] into finished garments thus enabling the […] move downstream into garment production (forward vertical integration) where operating margins are considerably higher than in yarn and fabric production.” However, despite their initial agreement, the investors claim that the Uzbek authorities did not – eventually – maintain their initial commitment and drove them into bankruptcy.
As the case is still pending – with an outcome expected no sooner than 2020 – it is hard to predict what the actual allegations and defenses will be. Nonetheless, investment cases usually build upon previous ones, being structured roughly along the same lines, if the investment conditions and acts of the respondent state are similar. What is known, though, it that this litigation also involves foreign investors in the textile industry – down along the processing chain – meant to benefit from Uzbekistan’s ‘opening up’ to the global markets and the corresponding incentives.
Together with the earlier Spentex case, they represent two instances of success story gone wrong. And nowhere else than in the textile industry, a desired ‘crown jewel’ of Uzbekistan’s economic development. While the first case has been won due to partial self-incrimination – a very dangerous tactic on the long-term – the second one is still open to debate. And – more than sure – the Turkish claimants have learnt their lesson from Spentex.
Outside the narrow legal box, these two cases are indicative – a tip of the iceberg – of the endemic problems that underpin Uzbekistan’s business environment. In macroeconomic terms, it has registered a mild economic success, unlike most of its Central Asian peers. Not based solely on hydrocarbon exploitation and export, Uzbekistan’s industry has increased the level of vertical integration, obtaining more processing capacities on its territory.
However, as shown by the two ICSID litigations, there are problems in regard to the state’s capacity – or willingness – to maintain its commitments toward foreign investors. And the manner in which such investors operate – often through corruption and bid-rigging – is a sign of what type of actions a business needs to take before being granted the ‘blessing’ of the domestic authorities. Such operations did not occur in a vacuum or outside the state’s vigilant glance. They were rather tolerated – or tacitly encouraged – for the benefit of a restricted political elite.
What to Do: Three Steps for an Integrated Legal Defense
Therefore, it remains to be seen whether the new leadership of Shavkat Mirziyoyev maintains its advertised stance against corruption. If so, the business environment within Uzbekistan might just be the success story everyone was expecting for a long time in Central Asia: a profitable and safe venue for developing in the textile industry. Until then – however – there are a few steps that diligent investors need to take before engaging head-on in Uzbekistan’s challenging economy.
First of all, they need make sure that their company operates under the protection of a Bilateral Investment Treaty that allows for international arbitration (preferably under the aegis of ICSID, due to enforceability issues). If this is not the case – or the treaty in question is limited in its scope – restructuring through a friendlier jurisdiction is needed.
Second, investors should not wait for the state to take actual (decisive) measures against the company. International law is not simply about defensive moves. It can also be used pre-emptively in order to counteract a mounting ‘attack’ that stems from state authorities. The ‘creeping’ expropriation should not be allowed to build-up little by little, until the company finds itself between a rock and a hard place. And – in no event – should a mounting pressure try to be ‘defused’ through the (seemingly) convenient offering of bribes. That shall only preclude any valid legal claim in front of an international tribunal, while also attracting criminal liability at domestic authorities’ discretion.
Third, diligent investors really need to retain international lawyers that are specialized in investment law. They should not fall for the usual ‘trap’ of simply relying on local lawyers that ‘know’ the inner workings of the Uzbek system and promise an easy way out of the legal conundrum. While the latter can – and should – be used on a regular basis, they must be supplemented by investment lawyers that prepare for the worst case scenario: an international arbitration. If successful, it can either result in a consistent damages award or in a settlement with the authorities. But it is the only ‘exit’ out of Uzbekistan without losing the entire investment.
Therefore, any investor has to carefully assess the economic prospects and ensure for the legal risks it might face in the future. Uzbekistan’s textile industry is – indeed – attractive and it offers mercantile opportunities hard to match elsewhere. But the government’s track-record in delivering on its commitments needs to be put into perspective. While not a reason for hesitating to invest in Uzbekistan, it is a reason for caution and due diligence. A specialized one. An integrated (and pre-emptive) investment law strategy.
Horia Ciurtin, Founder and Senior Expert of DAVA | Strategic Analysis; Associate Expert for New Strategy Center, a reputed strategy think-tank with offices in Bucharest, the Managing Editor of the online platform for the European Federation for Investment Law and Arbitration (Brussels), the EFILA Blog, as well as Legal Adviser in the field of International Investment Law. He can be contacted at firstname.lastname@example.org