No Two-tier Telecoms

The telecommunications industry is going through a global downturn following the bursting of the “telecom bubble.” While the world is preoccupied with other major issues today, it is useful to remember that this industry will recover and that it is essential to the health of the new economy.

Governments worldwide are looking for ways to help restore the health of this critical sector, but none has found the magic elixir. In Canada, the government is examining possible changes in its rules on foreign ownership in the hope of attracting more investment. There are also debates about changing the domestic regulatory regime. In this regard, there are important lessons to be learned about what to do, and in particular what not to do, by assessing the U.S. experience in regulating telecoms.

The U.S. experience amply demonstrates that it is a mistake to try to create more competition by prescribing regulatory rules that favour certain types of players over others. For example, the United States attempted to give small wireless services companies special advantages like bidding credits and exclusive access to spectrum auctions, with disastrous results. One of the largest of the favoured bidders soon entered bankruptcy, did not pay the billions of dollars it owed the U.S. Treasury, and has failed to put the valuable spectrum to productive use.

In another example, the United States created extremely favourable conditions for new local telecom companies, allowing them to use the established companies’ facilities at rates that were set below cost. The artificial business models based on these advantages led to the construction of weak companies, most of which failed. This created a misallocation of capital away from those companies with strong businesses which otherwise would have expanded and contributed to the overall strengthening of telecom infrastructure in the United States.

Each of these U.S. policies failed because they ignored the economies of scale or scope in telecommunications that push the industry towards a handful of suppliers, including cable companies, telephone companies and wireless providers. These companies compete vigorously with each other and will compete more vigorously in the future. Canada should not try to induce a larger number of suppliers than the demand for telecom services can sustain by itself. Eventually, many of the favoured companies will fail, wasting precious Canadian (and foreign) resources that could be put to productive use. It is better to leave these fundamental choices to the market.

In considering revisions of its foreign ownership rules, Canada should reject a two-tier regime in which the rules are more restrictive for some established firms than for other smaller or newer competitors. Such tiering would relax the investment restrictions only for smaller Canadian players, while leaving more restrictive rules in place for incumbents like Telus, Bell, ManitobaTel and the cable companies. The purported objective of such a strategy is for government to induce artificially greater competition by creating an unbalanced field that favours smaller players, such as Sprint Canada and AT&T Canada — or so the theory goes. Unfortunately, tilting the playing field in this fashion invites investment into companies that would not be able to justify such infusions based upon market fundamentals. The United States tried a similar policy of favouring new, smaller local entrants and has watched as McLeod, Winstar, Rhythms, Covad, GST, IGT and numerous others filed for bankruptcy.

A tiered foreign investment regime in Canada would divert capital from strong companies that have proven their ability to maintain Canada’s leadership in telecommunications. These companies will require billions of dollars to upgrade their networks to provide the growing variety of services demanded by Canadian consumers.

Struggling smaller companies, supported temporarily by advantageous access to foreign capital, are less likely to be able to provide these new services. If, on the other hand, these favoured companies are a likely source of such innovation, they should be able to compete for capital on even terms with the larger, regulated Canadian carriers.

If Canada’s objective is to create additional competition in local markets, implementing an ownership regime based on market distortions is certainly not the way to proceed. Competition in Canada is here to stay and that competition will become more vigorous as cable companies introduce cable telephony and wireless markets continue to take market share from the likes of Bell and Telus.

Another option under consideration that should also be rejected is a licensing regime for foreign investment in telecommunications that would allow the government to decide the admissibility of foreign capital on a case-by-case basis. Under this regime, there would be no prescribed limits on foreign ownership, but any changes in foreign interests in a telecommunications company would spark a review of its licence. Such licensing would extend regulators’ discretionary powers to approve or reject applications outright or grant licences with conditions attached. The assessment process would be subjective, as would any decisions concerning the “appropriate” capital structure of the firm.

American telecom licensing requirements for foreign investors are a major irritant in international trade negotiations because they fly in the face of transparency tests that are hallmarks of liberalized economies. The only benefits from this convoluted licensing process are those accruing to politicians and their constituents who can extract concessions from investors.

The United States can impose foreign investment restrictions and suffer only limited losses from them because its capital market is very large. However, Canada’s market is much smaller, and foreign investors are likely to be repelled by a highly politicized regulatory regime. Licensing would be more likely to frighten investors than to attract new capital.

The 1996-2001 American telecom investment boom, which was exacerbated by the U.S. Federal Communications Commission’s tiering and licensing policies, should serve as a lesson for Canadian policymakers because it resulted in massive investments with little lasting value. The distortions created by the FCC’s attempt to favour new entrants into local telecommunications contributed to the evaporation of about US$80-billion of market capitalization, and nearly US$40-billion of real spending on infrastructure has been wasted.

This flood of excess capital directed to companies that ultimately failed to use it wisely has significantly weakened the U.S. telecom sector. Incumbents have also experienced an erosion in their share prices because of these distortions, leading them to refrain from investing in network upgrades because of the competitive disadvantages created by the preferential regime.

The best way to strengthen any sector is by attracting quality capital through a regime that has no artificial conditions or distortions. The market should be allowed to decide how this capital is allocated. Canada should resist the temptation of emulating policies that were designed to increase investment in the short term, but over the longer term created a painful reversal in the U.S. telecom market.

Canada has one of the most successful telecommunications regimes in the world. It would be very unwise for it to follow its southern neighbour down the road to severe contraction and despair in telecommunications.