Trade Note May 29, 2003 From Singapore to Cancun: Investment Among the many questions that WTO management expertise, and/or a ministers will take up in their differentiated product ­ distinguishing them September meeting in Cancun, from other financial flows. Mexico, is the issue of an international The investment agreement. This is one of This picture changed abruptly in 1998. World Bank the four issues under discussion since Since then, FDI flows have leveled off Group the Singapore Ministerial of 1996. (figure 1) though they have not fallen as WTO Ministers in November 2001 precipitously as debt flows (figure 2). FDI www.worldbank.org chose to launch negotiations on a trends were a reflection of several factors: multilateral framework covering the bursting of the stock market bubble in investment, "subject to a decision to 2000, which lowered market value of all be taken by explicit consensus on corporations, and made it less attractive to modalities at the Cancun Ministerial undertake acquisitions via exchanges of in 2003". Its purpose was "to secure stock, a main driver of intra-OECD transparent, stable and predictable investment; the subsequent downturn in the conditions for long-term cross border global economy which lowered profitability investment" that will expand trade. in markets, and with it the incentive to International Two questions therefore face the undertake investment anywhere, particularly international community, and in higher risk foreign markets; and the Trade developing countries in particular: reversal of current account balances in East Department Can new multilateral initiatives on Asia and Latin America after 1998 that investment policy promote more ­ and reduced the demand for financing from all more productive ­ investment and foreign sources. Investment in hence more rapid development? And, infrastructure--notably power and can a negotiation that includes this telecommunications--contracted area lead to reciprocity that will disproportionately, reflecting overbuilding expand developing countries' ahead of growth in demand, so the cessation opportunities? of growth (particularly in East Asia and By Richard Latin America, favored destinations in the Newfarmer The drive to include an international early 1990s) left these industries with global investment agreement in the WTO excess capacity. By 2001, FDI in accords comes against a backdrop of infrastructure was down more than 20% one of the most impressive waves of relative to 1998 peaks. Finally, the wave of These notes summarize foreign direct investment in history. privatizations on attractive terms, crested in recent research on global Indeed, a hallmark of globalization the 1990s, dissipated by the turn of the trade issues. They reflect solely the views of the has been the expansion of foreign millennium. author, and do not direct investment (FDI). Developing necessarily reflect the views of the World Bank countries have been major Against this backdrop of stagnant FDI flows Group or its Executive beneficiaries, with FDI flows to developing countries, the aspiration of Directors, or the countries comprising almost three-quarters of the Doha declaration to increase stable they represent. net financial flows in 2002. flows seems noteworthy. An international Moreover, FDI flows tend to be more agreement might contribute to increasing Trade Note 2 stable and less volatile than portfolio stable flows of investment through two or debt flows. They are bundled with main channels: increasing market access for cross-border flows of technology, investors to permit enhanced competition; TRADE NOTE May 29, 2003 and augmenting protection of investors' foreign investment. Countries as diverse as rights to reduce risk and thereby raise China, Mexico, and most recently, Korea relative risk -adjusted returns. have progressively lowered policy barriers to entry in sector after sector to bring in new sources of capital, increase competition to Fi gur e 1 FDI gr ew r api dl y unt I l l at e 1990s, a spur productivity growth, and accelerate the nd t hen l eveled of f ....... pace of technological progress. Consider the Inward FDI t o devel opi ng countri es US$ bi l l i on changes in investment regulations. 250 UNCTAD research has shown that between 200 Net I nwar d FDI 1991 and 2001, a total of 1393 regulatory 150 changes were introduced in national FDI Por t f ol I o equI t y 100 regimes, of which 1315 (or 95 percent) were in the direction of creating a more favorable 50 environment for FDI (Figure 3). During 0 1989 1991 1993 1995 1997 1999 2001 2001 alone, a total of 208 regulatory Sour ce: W or l d Bank Gl obal Devel opment FI nance 2003 changes were made by 71 countries, only 14 of which (or 6 percent) were less favorable for foreign investors (UNCTAD, 2002). Fi gur e 2 .... and hel d up af t er 1999 i n spI t e of The vast majority of these changes were f al l i ng debt f l ows introduced autonomously rather than in the FDI and debt fl ows t o devel oping count ri es context of international negotiations. US$ bi l l i on 200 I nwar d FDI Today, nearly all countries have removed 150 entry restrictions and limitations on foreign 100 equity shares in manufacturing. Some 50 restrictions remain in mining, natural De b t 0 resources and agriculture, though these 1995 1996 1997 1998 1999 2000 2001 2002 mainly take the form of regulations on land -50 use and concessions. The main restrictions Sour ce: Worl d Bank Gl obal Devel opment FI nance 2003 on FDI are centered in services ­ that is, in finance, telecommunications, power, transport, ports, wholesale and retail trade, Fi gur e 3 I n par t because r egul at or y changes real estate, and business and legal services become mor e f avor abl e (Hoekman and Saggi, 2000; Sauvé and Number of regulat or y changes Wilkie, 2000). In finance, 250 communications, and power, many 200 Mor e f avor abl e countries restrict entry to protect state Less f avor abl e 150 monopolies; in other sectors, powerful 100 unions, professional associations, or business lobbies may prevent entry; and in 50 others, entry is restricted merely as an 0 1991 1993 1995 1997 1999 2001 anachronistic carry-over from a less Sour ce: UNCTAD, 2002 globalized era. Increasing market access for investors The payoff to unilateral reductions in these policy barriers to entry is high. Foreign As with trade barriers, countries around the investment in telecommunications, for world have progressively dismantled example, has revolutionized telephony restrictions on incoming foreign investment, service in developing countries. One study as nationalist fears of many governments found that reducing protection in services have given way to aggressive pursuit of by half would have a benefit to incomes 2 TRADE NOTE May 29, 2003 four times larger than liberalization of One pre-requisite for moving forward with a merchandise trade (Robinson, et al, 1999). multilateral investment agreement is that The World Bank (2001), using conservative participating countries must believe the assumptions to illustrate the effects of policy commitment make sense through the reforms in trade and transportation, lens of promoting national development. communications, financial services, and While the upside benefit to autonomous other private services, showed that broad liberalization in services (among other and simultaneous services reforms could areas) is usually high, it may not be for a produce income gains for developing particular country. Fortunately, the countries of more than 9 percent (World modality under discussion is a GATS-like Bank, 2001: 171-172) . Realizing this high positive list that would let policymakers set potential requires more than liberalization - their own pace for liberalization and avoid it requires a regulatory framework that, commitments in any sector where it felt where possible, permits competition and uncomfortable. This provides an unusual disciplines natural monopolies in network degree of flexibility to all governments-- industries; and it requires pro-poor even if it slows the pace of multilaterally regulation that ensures where appropriate agreed liberalization. universal access and cross-subsidies to the poor or disadvantaged regions (see World From the narrow perspective of market Bank, 2001: pp 77 ff). access for investors, an international agreement is less urgent. Since most Including these potential reforms to national restrictions that limit FDI entry are in investment regimes in a new international services, a multilateral vehicle for realizing investment agreement has two potential the twin benefits from an international benefits that may lead to greater investment. agreement already exists for services, First, much as with the logic of a trade namely the General Agreement on Trade in negotiation, the negotiation process may Services (GATS). The agreement allows lead to greater liberalization of investment countries to designate those sectors it regimes than can be accomplished wishes to liberalize and maintain entry unilaterally. Second, if investment is not restrictions in other sectors a government negotiated in isolation, but as part of a feels are important. In any case, the fact broader set of trade negotiations, then the that market access could be widened under traditional mechanism of reciprocal access the GATS in precisely the area where most concessions can help generate support for restrictions exist limits the additive value of greater openness at home and abroad. For any new investment agreement--save for example, exporters in developing countries the reciprocal access it leverages in other who obtain improved access to foreign sectors. agricultural markets can be a countervailing force against those who resist the A key issue ­ which can only be determined elimination of investment barriers in during the negotiation process ­ is the value telecommunications. At the same time, the of an investment agreement in leveraging need to fight these domestic political reciprocal commitments among trading economy battles makes a country a credible partners. If an investment agreement is negotiator for improved access. The reciprocated with new market access in process, if it works, can produce a double markets of importance to developing benefit: liberalizing countries would benefit countries ­ in agriculture, labor-intensive from increased competition associated with manufacturers and even services ­ it may foreign direct investment, and their firms produce the much sought-after double would have improved access to foreign benefit (World Bank 2002).. From a strictly markets. market access perspective, this underscores the importance of judging the upside 3 TRADE NOTE May 29, 2003 potential of a new agreement against the provide a definition of investment coverage, reciprocal access it leverages in other provide investor protections such as against sectors.1 expropriation, require national treatment for post-entry establishments, stipulate Increasing Investor Protections compensation for the expropriation of their investments, and provide for a dispute A second possible channel to increase resolution mechanism. The latter usually investment flows ­ distinct from wider permit the investor to sue the state for market access ­ is through increasing breach of treaty under binding arbitration. investor protections. A foundation of any In some cases, treaties proscribe any country's investment climate is the government action that would reduce the protection of property rights for investors. value of the private investment, even if Since investors put money at risk against the based on environmental or other promise of returns in subsequent periods, regulations, and establish grounds for predictable regulation and protection of compensation. Such compensation could property rights are integral to the investment either entail extensive liabilities for the host decision. Stein and Daud (2002) have government or compel them to refrain from shown that institutional variables associated making certain policy choices. with investor protections ­ including political stability, government effectiveness, Does the signing of bilateral investment rule of law and lower risks of expropriation treaties increase the flow of FDI? Few ­ are all significantly associated with studies address this question.3 In the most increases in investment flows, controlling exhaustive study to date, Hallward- for other determinants of FDI. Said Dreimeier (2002) analyzed bilateral flows differently, the policies and institutions that of OECD members to 31 developing frame the domestic investment climate are a countries over two decades. Her analysis powerful determinant of inward investment found that, controlling for a time trend, flows. BITs had virtually no independent effect in increasing FDI to a signatory country from Would protections in an international a home country. Said differently, countries investment agreement (IIA) lead to increases signing a BIT were no more likely to in foreign direct investment into developing receive additional FDI than countries countries? One benefit2 might conceivably without such a pact. Even comparing flows arise from multilateral investment in the 3 years after a BIT was signed to the protections. A multilateral set of disciplines 3 years prior, there was no significant on investment protection would arguably increase in FDI. help participating developing countries send a positive signal to potential foreign Fi gur e 4 However, BI TS do not add much investors regarding the permanence of policy changes, the expected standard of FDI Infl ows before and aft er sIgnIng BI Ts treatment afforded to foreign investors, and Shar e of annual FDI f low 0.3 recourse to a dispute settlement procedure. Surprisingly few empirical studies examine 0.2 whether in fact an IIA will increase investment. 0.1 One way to test this proposition is to look at 0 -3 -2 -1 Year 1 2 3 the consequences of enhancing investor Year s bef or e si gni ng Signed Year s af t er sI gni ng protections through bilateral investment Not e: Shar e of home count r y FDI f l owI ng t o host count r y wI t h BI T Sour ce: Wor l d Bank Gl obal EconomI cs Pr ospect s 2003 treaties (BITs) for flows of FDI among signatory countries. BITs customarily 4 TRADE NOTE May 29, 2003 This evidence suggests that protections Stein (2001) find that FTAs generally tend resulting from a multilateral investment to increase FDI.4 Lederman, Maloney and agreement will, by itself, have little impact Serven (2003) corroborate this when FTAs in achieving the objective of increasing combine to form the largest markets. investment flows. Another line of reasoning However, investor protections in Chapter 11 supports this conclusion. BITs cover about may have played an important independent half of investment to developing countries role. This is because Mexico's legal and already, and any new multilateral investment judicial framework is well below competing protections are unlikely to be superior ­ and destinations (such as East Asia, the US and therefore additive ­ to these bilateral UK, and even the average for Latin investment treaties. America). In an analysis of shareholder rights, creditor rights, efficiency of It is worth asking whether enhanced investor judiciary, rule of law and absence of protections, in combination with reductions corruption, Mexico scores below the Latin in trade protection that permit liberalized American average in 4 of 5 measures investment access and more open flows of (Lopez de Silanes, 2002, as cited in goods, would lead to increases in foreign Lederman, Maloney and Serven 2003:24). direct investment. The experience of To the extent that Chapter 11 provided regional agreements is arguably relevant. investors with additional comfort over and One example is NAFTA. NAFTA is a above the existing investment climate, its comprehensive arrangement that includes protections would have offset these significant investor protections in disadvantages. combination with broad-based tariff reductions and border liberalizations. In a multilateral context, the aspiration of Chapter 11 of the NAFTA agreement allows the Doha round is precisely to combine investors to sue the government in event of global reductions in border barriers for regulatory or other actions that might goods and services with increases in diminish the value of a foreign investment. investor protections. To be sure, the In their study, Lederman, Maloney and experience of regional arrangements is less Serven (2003) find that, in addition to relevant to the extent that the preferential positive forces in the global economy that trade access diverts investment into the propelled investment into Mexico and other preferential market and/or that trade emerging markets after 1994, "the trade openness dominate the effects of additional opening and NAFTA accession also played investor protections. Nonetheless, the a role in Mexico's FDI rise..." (2003: potential for some, as yet unquantified chapter 4: 23). Firms, especially export synergy between more open markets and oriented firms, appeared to take advantage agreed investment protections exists. Much of liberalized financial flows inherent in as with our conclusions above on the NAFTA to begin to use foreign equity and anticipated benefits for liberalizing market debt financing. access, this section leads us to conclude that the benefits to developing countries of a Neither this study nor others attempt to multilateral set of disciplines for investment distinguish the role of enhanced investor rest largely on whether the process of protections from access to the Mexican negotiations secures commitments for new market and its other resources in increasing market access in agriculture and other goods the flow of FDI. It may be that simply of interest to developing countries. liberalizing the investment law in 1993 and making it easier to take advantage of Dispute resolution merits careful scrutiny productivity-adjusted wage differentials in the NAFTA countries was sufficient to Benefits flowing from a multilateral explain the difference. Indeed, Daude and investment agreement also can entail costs 5 TRADE NOTE May 29, 2003 if a contractual agreement is broken ­ as it importance of the ultimate rights of should. It is important that parties to an aggrieved parties that win cases under WTO agreement understand the contractual panels. The WTO could "instruct the liabilities they assume when the sign onto offending member to bring the inconsistent commitments. The Working Group on measure into conformity with its WTO Trade and Investment has reached consensus obligations"; and, failing that, "prevailing that, in contrast to the provisions in bilateral states are free to resort to ...unilateral investment treaties, individual foreign counter-measures ...suspension of the investors will not be allowed to sue foreign treaty...and temporary compensation or governments for abrogation of protections; suspension of concessions" (WTO 2002: rather the home government of the investor 20). What would be the appropriate remedy would file an appeal under normal WTO for a government that imposed a regulation dispute resolution procedures. that effectively diminished the future earnings of an enterprise? While these have This distinction is important. The number of an established history in the case of trade cases being filed under the BITs and disputes, there is no comfortable parallel in Chapter 11 of NAFTA is rising rapidly. investment. These issues have received Forty-eight alleged BIT violations are under insufficient attention to date. review arbitration at the International Center for Dispute Resolution. Cases have arisen Conclusion out of the Argentine devaluation, changes in tax policy perceived as adverse by investors, The benefits of a multilateral investment expropriations following conflict or coups, agreement for developing countries hinge irregularities in bidding processes and others critically on the increased market access (see Peterson, 2003a). Perhaps the most such an agreement would leverage for their significant case to date is of a tribunal in exporters and on the additional domestic Stockholm that required the government of reforms that it leverages at home. If the Czech Republic to pay one company, negotiating partners, particularly in OECD Central European Media (CME), $350 countries and in middle income countries million for violation of a bilateral that are investors themselves, see a investment treaty that deprived CME from a multilateral investment agreement as worthy stake in an English language TV station in of concessions that reduce their barriers to Prague. This amount was ten times higher trade in agriculture, textiles, and other areas than previously known awards under of importance to developing countries, an arbitration cases, and about equal to the agreement in this area would be a classic entire public sector deficit of the Czech "win-win" for all parties. Evidence Republic (see Peterson 2003b). Several suggests that trade liberalization combined separate cases under NAFTA similarly have with clear investment rules holds the largest prompted successful investor suits against potential for increasing investment ­ and the all three governments--Canada, US, and highest productivity investment ­ in Mexico ­ by investors. Unrelated cases in developing countries. However, an each of the three countries, for example, investment agreement without substantial contended environmental regulations new market access is unlikely to accomplish reduced the value of their companies; its objectives of increasing stable arbitration panels awarded hefty damages investment flows. And there is an important and raised new complex legal issues. coda: to avoid problems that are now surfacing with the resolution of disputes Since the WTO discussions have adopted a with bilateral investment treaties and different approach than investor-state suits, NAFTA's Chapter 11, it is important that all their corresponding damages are largely countries understand the fine print irrelevant. However, they do underscore the associated with dispute resolution. 6 TRADE NOTE May 29, 2003 1Relying on the GATS framework has two drawbacks. First, it would not cover investment outside of services, and, while this is the sector with greatest restrictions, some potential would be foregone. Second and more generally, the GATS has fallen short of its potential. The coverage of commitments for a large number of countries is limited. About two-thirds of the WTO membership has scheduled less than 60 or fewer sectors (of the 160 or so specified in the GATS list) (see Stern, 2002). In many cases, commitments do not reflect the actual degree of openness (Mattoo, 2000). In other cases, countries have not moved actively to register sectors ­ even where domestic policies are open to foreign investment. Finally, sometimes countries' commitments serve to protect the position of privileged incumbents, domestic and foreign, rather than to enhance contestability of markets. The primary reason is the incentives to participate in the form of reciprocal benefits within the narrow area of services itself are rather low; Doha may offer an opportunity to redress this problem if rich countries are willing to table significant liberalization in agriculture and textiles in exchange for access to services markets in developing countries. 2 Another less important argument is that a multilateral regime for investment protection could help to counter-balance the bargaining asymmetries built into BITs and regional agreements conducted along North-South lines. The negotiating asymmetries that are common to bilateral agreements have in some cases led to treaties in which developing countries have taken on substantive obligations with reciprocity effectively limited to the promise of increases in future private investment (see below). Moreover, to the extent the power imbalance is actually redressed in a multilateral agreement in favor of weaker states, constituencies within the global business community may well, as was the case in the MAI negotiations, prefer the stronger level of investment protection embedded in BITs and lose interest in a multilateral agreement. 3UNCTAD in a recent study found little evidence that BITs increased FDI (UNCTAD, 1998). That work looked at a single year of investments and tested if the number of BITs signed by the host was correlated with the amount of FDI it received. 4 They find that : "FTA provisions tend to a host country that is an FTA partner with a source country will receive 70- percent more FDI that a non-partner, other things being equal" (2001: 114), though it should be noted their regression coefficients are significant only at the 15% level. References Gestrin, Michael, and Alan M. Rugman.1993. "The NAFTA's Impact on the North American Investment Regime." C.D. Howe Commentary No. 42, Toronto: C.D. Howe Institute. March. Hallward-Driemeier, M. 2002. "Bilateral Investment Treaties: Do They Increase FDI Flows?" Background Paper for Global Economic Prospects 2003: Investing to Unlock Global Opportunities. The World Bank. Washington D.C. Hoekman, Bernard M., and K. Saggi. 1999. "Multilateral Disciplines for Investment-Related Policies." Policy Research Working Paper No. 2138. World Bank, Development Research Group. Washington, D.C. Lederman, D.l, Maloney, W. and L. Serven. 2003. Lessons from NAFTA for Latin America and Caribbean. The World Bank. Washington D.C. April (draft). 7 TRADE NOTE May 29, 2003 Mattoo, Aaditya. "Developing Countries in the New Round of GATS Negotiations: Towards a Pro-Active Role." World Economy, Vol. 23, No. 4, 471-489. Peterson, Luke 2003a. "Emerging Bilateral Investment Treaty Arbitration and Sustainable Development" Research Note, Invest-SD News Bulletin, International Institute for Sustainable Development (IISD). April. (Available at: http://www.iisd.org/pdf/2003/trade_bits_disputes.pdf) __________. 2003 b "Czech Republic Hit With Massive Compensation Bill in Investment Treaty Dispute" Invest-SD News Bulletin, International Institute for Sustainable Development (IISD). March 21 Robinson, S., Z. Wang and W. Martin. 1999. "Capturing the Implications of Services Trade Liberalization." Paper presented at the Second Annual Conference on Global Eeconomic Analysis, GL Avernaes Conference Center, Ebberup, Denmark. June 20- 22. Rugman, Alan M., and Michael Gestrin. 1994. "NAFTA's Treatment of Foreign Investment." In Alan M. Rugman, ed., Foreign Investment and NAFTA, pp. 47-79. Columbia: University of South Carolina Press. Sauvé, Pierre, and Christopher Wilkie. 2000. "Investment Liberalization in GATS." in Sauvé, Pierre and Robert M. Stern, eds., GATS 2000: New Directions in Services Trade Liberalization. pp. 331-363. Washington, D.C.: Center for Business and Government, Harvard University and the Brookings Institution Press. Stein, Ernesto and Christian Daude. 2001. "Institutions, Integration and Location of Foreign Direct Investment." in New Horizons for Foreign Direct Investment. pp101 ­ 128. Paris : OECD. Stern, Robert M. 2002. "Quantifying Barriers to Trade in Services." In Bernard M. Hoekman, Philip English, and Aaditya Mattoo, eds., Development, Trade and the WTO: A Handbook. Washington, D.C : The World Bank. World Bank, 2001. Global Economic Prospects 2002 Investing to Unlock Global Opportunities. Washington: World Bank ___________. 2002. Global Development Finance. Washington, D.C. World Trade Organization 2002. Report (2002) of the World Group on the Relation ship Between Trade and Investment to the General Council 9 December 2002 Geneva: WTO. UNCTAD. 1998. Bilateral Investment Treaties in the mid-1990s. New York : United Nations. ____________. 2002. World Investment Report. New York : United Nations. 8 TRADE NOTE May 29, 2003 This Trade Note was written by Richard Newfarmer, Economic Adviser in the Development Research Group. It draws from the World Bank's Global Economic Prospects 2003, Chapter 4, written by Richard Newfarmer and Pierre Sauve. This Trade Note can be downloaded at http://www.worldbank.org/trade/tradenotes. 9