An Economic Analysis of Bilateral Investment Treaties

Jan Peter Sasse An Economic Analysis of Bilateral Investment Treaties

GABLER RESEARCH Ökonomische Analyse des Rechts Herausgegeben von Professor Dr. Peter Behrens Professor Dr. Thomas Eger Professor Dr. Manfred Holler Professor Dr. Claus Ott Professor Dr. Hans-Bernd Schäfer Professor Dr. Stefan Voigt (schriftführend) Universität Hamburg, Fakultät für Rechtswissenschaft und Fakultät für Wirtschafts- und Sozialwissenschaft

Die ökonomische Analyse des Rechts untersucht Rechtsnormen auf ihre gesellschaftlichen Folgewirkungen und bedient sich dabei des methodischen Instrumentariums der Wirtschaftswissenschaften, insbesondere der Mikroökonomie, der Neuen Institutionen- und Konstitutionenökonomie. Sie ist ein interdisziplinäres Forschungsgebiet, in dem sowohl Rechtswissenschaftler als auch Wirtschaftswissenschaftler tätig sind und das zu wesentlichen neuen Erkenntnissen über Funktion und Wirkungen von Rechtsnormen geführt hat. Die Schriftenreihe enthält Monographien zu verschiedenen Rechtsgebieten und Rechtsentwicklungen. Sie behandelt Fragestellungen aus den Bereichen Wirtschaftsrecht, Vertragsrecht, Haftungsrecht, Sachenrecht und verwaltungsrechtliche Regulierung.

Jan Peter Sasse

An Economic Analysis of Bilateral Investment Treaties With a foreword by Prof. Dr. Thomas Eger

RESEARCH

Bibliographic information published by the Deutsche Nationalbibliothek The Deutsche Nationalbibliothek lists this publication in the Deutsche Nationalbibliografie; detailed bibliographic data are available in the Internet at http://dnb.d-nb.de.

Dissertation Universität Hamburg, 2010

1st Edition 2011 All rights reserved © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011 Editorial Office: Stefanie Brich | Sabine Schöller Gabler Verlag is a brand of Springer Fachmedien. Springer Fachmedien is part of Springer Science+Business Media. www.gabler.de No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the copyright holder. Registered and/or industrial names, trade names, trade descriptions etc. cited in this publication are part of the law for trade-mark protection and may not be used free in any form or by any means even if this is not specifically marked. Cover design: KünkelLopka Medienentwicklung, Heidelberg Printed on acid-free paper Printed in the Netherlands ISBN 978-3-8349-2756-9

Foreword The global economy is characterized not only by a steady increase of international trade, but also by growing flows and stocks of foreign direct investment (FDI). This development has manifested itself especially since the mid-1980s. The importance of FDI in providing foreign markets with goods and services has become comparable to trade. FDI also constitutes a crucial source of external finance for developing countries. An important prerequisite for a high level of FDI is that investors view the political risk of the host country as manageable. Political risk may, for example, comprise the danger of expropriation of the investment without adequate compensation, or more subtle regulatory measures with comparable effects, which are often referred to as indirect expropriation. The most important legal instruments in international investment law that may mitigate this kind of risk are bilateral investment treaties (BITs). Since the first BIT, concluded between Germany and Pakistan in 1959, the number of such treaties has risen to the impressive number of more than 2700 in 2010. Despite the undeniable importance of FDI for the global economy and the growing prominence of BITs, the economic analysis has mainly focussed on international trade law and has thus far neglected the analysis of international investment law. This contribution by Jan Peter Sasse seeks, and succeeds, to fill that gap in the existing literature. Jan Peter Sasse begins his research by providing a comprehensive analysis of the economic and legal tools available to international investors who wish to safeguard their assets abroad. In contrast to the domestic context, international law is generally characterized by the absence of a supranational authority that may enforce legal obligations through coercion. Consequently, investors have to rely on economic devices (the exchange of hostages, for example) or on legal protection through international law and the possibly unfavourable domestic legislation and judiciary of host-states. Especially in the light of the lack of a truly multinational treaty on the protection of FDI, bilateral investment treaties can be considered a cornerstone of international investment law. Consequently, a number of recent empirical studies find a positive relationship between the conclusion of BITs and the amount of FDI flows. The economic analysis of the functioning of BITs must first of all illuminate the relationship between the investor and the host-state. This relationship may be characterized by problems of hold-up and asymmetric information. Based on the rational choice principle as advanced recently by scholars of international law and economics, Jan Peter Sasse shows to what extent the host-state can overcome the hold-

VI

Foreword

up problem through self-commitment. Furthermore, the author convincingly argues that signaling is only of limited value in counteracting the asymmetry of information between investors and host-states. Apart from the relationship between investors and host-states, a thorough analysis of bilateral investment treaties has to take into account the strategic interaction among host-states that may consider BITs as an instrument in the competition for FDI. Jan Peter Sasse analyses this competition in great institutional detail with special attention devoted to the environmental conflicts that have emerged in the context of international arbitration. His results show that BITs, if drafted and interpreted with care, may help capture the beneficial effects of institutional competition and mitigate the potentially detrimental effects. The author then contributes to two ongoing discussions in the area of international investment law. Firstly, Jan Peter Sasse provides an empirical analysis of the impact of BITs on the institutional quality of developing countries. He finds that external effects of BITs on institutional quality cannot be verified. The study thus lends empirical support neither to the optimistic calls for BITs as serving as a positive example for developing countries, nor to the pessimistic accounts that regard BITs as detrimental to domestic institutional quality. Secondly, the author provides a systematic analysis of the issue of transparency vs. confidentiality in international arbitration. Jan Peter Sasse explains why more transparency may be harmful for the parties involved and that, as a consequence, a movement towards more transparency in international investment arbitration will be hard to achieve. This publication in the field of international law and economics makes a valuable contribution to our understanding of the functioning of bilateral investment treaties. Jan Peter Sasse also provides an insightful and well-researched analysis of different aspects of the protection of FDI through BITs, including institutional competition, institutional quality, and transparency.

Prof. Dr. Thomas Eger

Acknowledgements This thesis was written while I was a student at the Doctoral College for Law and Economics (Graduiertenkolleg für Recht und Ökonomik) and, subsequently, a research assistant at the Institute of Law and Economics, both at the University of Hamburg. It would not have been successfully finished without the help and support of a number of people. I am especially grateful to Thomas Eger, who supervised the thesis and allowed me to benefit from his helpful comments and advice. Hans-Bernd Schäfer agreed to act as the second reviewer and was of great support to me (and my fellow colleagues) as the Speaker of the Graduiertenkolleg. I am grateful to him, other professors and fellow colleagues, in and around the Graduiertenkolleg, for many inspiring interactions und discussions during my time in Hamburg. Also, I want to thank the chairman of the disputation committee, Manfred Holler, who not only handled the formal dissertation process very efficiently, but also provided helpful comments during the research process. My thanks go to the editors of the scientific series “Ökonomische Analyse des Rechts” for giving me the opportunity to publish my thesis in the series: Peter Behrens, Thomas Eger, Manfred Holler, Claus Ott, HansBernd Schäfer and Stefan Voigt. I had the pleasure of conducting research as a visiting scholar at Columbia University (New York) and my gratitude goes to Avery W. Katz for making this possible. The German Research Foundation (DFG) financially supported my research both in Germany and the United States with generous research grants and I am thankful for that. Additionally, I am indebted to Anne van Aaken, Peter Behrens, Stephania Bonilla, Eberhard Feess, Henning Fräßdorf, Andrew Guzman, Jonathan Klick, Frank MüllerLanger, Jan Matauschek, Susan Russell, Stephan Wittig, Katherine Walker and Tammy de Wright for helpful advice, comments and inspiration during my research process. Focusing on interdisciplinary research may not be the obvious choice for a young student of economics. I owe my passion for the economic analysis of law to two professors who exposed me to this field of research while I was still a graduate student at the Humboldt University in Berlin: Charles B. Blankart and Christian Kirchner. I want to thank them for putting me on the right track. Most importantly, I would like to take this opportunity to thank my father, my sister and Katrin Stägert for their loving support, kind words, patience and encouragement. This book is dedicated to the memory of my mother, Hanne Sasse.

Jan Peter Sasse

Summary Contents FOREWORD...................................................................................................................V ACKNOWLEDGEMENTS ........................................................................................... VII SUMMARY CONTENTS ............................................................................................... IX DETAILED CONTENTS............................................................................................... XI LIST OF FIGURES ..................................................................................................... XIX LIST OF ABBREVIATIONS........................................................................................ XXI LIST OF VARIABLES ..................................................................................................... 1

1

INTRODUCTION ................................................................................................. 1

2

FOREIGN DIRECT INVESTMENT .................................................................... 6

3

ECONOMIC AND LEGAL PROTECTION OF FDI......................................... 17

4

THE ECONOMICS OF BITS ............................................................................. 67

5

BITS AND INSTITUTIONAL COMPETITION ............................................. 124

6

BITS AND INSTITUTIONAL QUALITY....................................................... 155

7

BITS AND TRANSPARENCY ........................................................................ 177

8

SUMMARY AND OUTLOOK......................................................................... 199

APPENDICES............................................................................................................. 205 BIBLIOGRAPHY......................................................................................................... 221

Detailed Contents FOREWORD...................................................................................................................V ACKNOWLEDGEMENTS ........................................................................................... VII SUMMARY CONTENTS ............................................................................................... IX DETAILED CONTENTS............................................................................................... XI LIST OF FIGURES ..................................................................................................... XIX LIST OF ABBREVIATIONS........................................................................................ XXI LIST OF VARIABLES ..................................................................................................... 1

1

INTRODUCTION ............................................................................................... 1 1.1 INTERNATIONAL LAW AND ECONOMICS ............................................................ 2 1.2 STRUCTURE ........................................................................................................ 4

2

FOREIGN DIRECT INVESTMENT ................................................................ 6 2.1 TRENDS AND FIGURES ........................................................................................ 6 2.2 MULTINATIONAL ENTERPRISES AND FDI........................................................... 8 2.3 FDI AND DEVELOPMENT .................................................................................. 12

3

ECONOMIC AND LEGAL PROTECTION OF FDI ................................... 17 3.1 TIME INCONSISTENCY AND EXPROPRIATION RISK ........................................... 17 3.1.1

Time Inconsistency................................................................................... 17

3.1.2

On the Relevance of Expropriation Risk ................................................. 22

3.2 THE ECONOMICS OF FDI PROTECTION ............................................................. 22 3.2.1

Static Devices........................................................................................... 23

3.2.1.1 Hostages................................................................................................ 24 3.2.1.2 Collateral............................................................................................... 27 3.2.1.3 Hands-Tying ......................................................................................... 29 3.2.1.4 Union..................................................................................................... 30

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Detailed Contents

3.2.1.5 Insurance ............................................................................................... 31 3.2.1.6 Devaluation of Assets ........................................................................... 32 3.2.1.7 Lobbying ............................................................................................... 32 3.2.2

Dynamic Devices ..................................................................................... 33

3.2.2.1 Expertise and Time ............................................................................... 33 3.2.2.2 Repetition and Reputation .................................................................... 33 3.2.2.2.1 Repetition...................................................................................... 33 3.2.2.2.2 Reputation..................................................................................... 35 3.2.3

Discussion ................................................................................................ 40

3.3 LEGAL FDI PROTECTION .................................................................................. 40 3.3.1

Domestic Regulation................................................................................ 41

3.3.2

Customary International Law.................................................................. 41

3.3.3

Multilateral Treaties ................................................................................ 43

3.3.3.1 WTO ..................................................................................................... 44 3.3.3.2 Energy Charter Treaty .......................................................................... 44 3.3.3.3 NAFTA ................................................................................................. 45 3.3.4

Investor-State Contracts .......................................................................... 45

3.3.5

Bilateral Investment Treaties................................................................... 45

3.3.5.1 Overview and History........................................................................... 46 3.3.5.2 Treaty Practice and Treaty Interpretation ............................................. 47 3.3.5.3 Preamble and Definitions...................................................................... 48 3.3.5.3.1 Investor ......................................................................................... 48 3.3.5.3.2 Investment..................................................................................... 49 3.3.5.4 Admission ............................................................................................. 50 3.3.5.5 Standards of Treatment......................................................................... 50 3.3.5.5.1 Fair and Equitable Treatment ....................................................... 50 3.3.5.5.2 Most-Favoured-Nation Treatment ................................................ 52 3.3.5.5.3 Additional Standards..................................................................... 53 3.3.5.6 Expropriation and Compensation ......................................................... 54

Detailed Contents

XIII

3.3.5.6.1 Indirect Expropriation................................................................... 55 3.3.5.6.2 Compensation ............................................................................... 56 3.3.5.7 Public Concerns .................................................................................... 57 3.3.5.8 The Settlement of Disputes................................................................... 58 3.3.5.8.1 ICSID ............................................................................................ 59 3.3.5.8.2 Remedies....................................................................................... 61 3.3.5.8.3 Enforcement and Execution of Arbitral Awards .......................... 62 3.3.5.8.4 Costs.............................................................................................. 63 3.3.5.8.5 Empirical Aspects of Arbitration.................................................. 63 3.3.5.9 BITs and Customary International Law ............................................... 64 3.3.5.10 Summary ........................................................................................... 65

4

THE ECONOMICS OF BITS .......................................................................... 67 4.1 THE (PERCEIVED) WEAKNESS OF INTERNATIONAL LAW ................................. 67 4.2 THE EFFECT OF BITS ON FDI ........................................................................... 69 4.2.1

Empirical Studies on the Effect of BITs on FDI ...................................... 69

4.2.2

Discussion ................................................................................................ 72

4.3 LAW AND ECONOMICS OF INTERNATIONAL LAW ............................................. 73 4.3.1

Theories of International Law ................................................................. 74

4.3.2

Rational Choice Approach....................................................................... 74

4.3.3

Methodological Individualism ................................................................. 75

4.3.4

The Three R's: Reputation, Reciprocity and Retaliation ......................... 76

4.4 THE FUNCTIONING OF BITS.............................................................................. 78 4.4.1

The Costs of BITs..................................................................................... 78

4.4.1.1 Concluding BITs................................................................................... 79 4.4.1.2 Breaching BITs: The Three R's Revisited ............................................ 79 4.4.1.2.1 Reciprocity and Retaliation .......................................................... 79 4.4.1.2.2 Reputation vis-à-vis Other States ................................................. 80 4.1.1.2.3 Reputation vis-à-vis Investors ...................................................... 81

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4.4.1.3 Breaching BITs: Non-Reputational Costs ............................................ 83 4.4.1.4 Summary ............................................................................................... 84 4.4.2

Commitment and Signalling..................................................................... 84

4.4.3

Commitment ............................................................................................. 85

4.4.3.1 Repetition Revisited.............................................................................. 86 4.4.3.2 The Commitment Game........................................................................ 86 4.4.3.2.1 The Tribunal's Decision................................................................ 89 4.4.3.2.2 The Arbitration Decision .............................................................. 89 4.4.3.2.3 The Expropriation Decision.......................................................... 90 4.4.3.2.4 The Investment Decision .............................................................. 91 4.4.3.3 Equilibria............................................................................................... 92 4.4.3.4 Hostages and Collateral ........................................................................ 93 4.4.3.5 Extensions............................................................................................. 94 4.4.3.5.1 Compliance and Enforcement in Third Countries ........................ 94 4.4.3.5.2 Settlement vs. Trial ....................................................................... 95 4.4.3.5.3 The Perils of Success .................................................................. 100 4.4.3.6 Summary ............................................................................................. 101 4.4.4

Signalling ............................................................................................... 102

4.4.4.1 Reputation Revisited........................................................................... 102 4.4.4.2 Signalling Theory ............................................................................... 104 4.4.4.3 Rights and Treaties as Signals ............................................................ 105 4.4.4.4 The Signalling Game .......................................................................... 107 4.4.4.5 Equilibria............................................................................................. 110 4.4.4.6 Hidden Characteristics and Hidden Intentions ................................... 114 4.4.4.7 Summary ............................................................................................. 116 4.4.5

Beyond Commitment and Signalling ..................................................... 117

4.4.5.1 Flexibility vs. Commitment ................................................................ 117 4.4.5.2 BITs as Development Aid................................................................... 118 4.4.5.3 Risk Aversion ..................................................................................... 119

Detailed Contents

XV

4.5 EMPIRICAL STUDIES AND THE FUNCTIONING OF BITS ................................... 120 4.6 DISCUSSION AND CONCLUSIONS .................................................................... 121

5

BITS AND INSTITUTIONAL COMPETITION ......................................... 124 5.1 EFFICIENCY AND BITS .................................................................................... 124 5.2 INSTITUTIONAL COMPETITION........................................................................ 127 5.2.1

BITs and the Prisoner’s Dilemma ......................................................... 127

5.2.2

The Economics of Institutional Competition ......................................... 129

5.2.2.1 Tax Competition ................................................................................. 131 5.2.2.2 Environmental Competition................................................................ 133 5.2.3

Discussion .............................................................................................. 135

5.3 BITS IN THE CONTEXT OF INSTITUTIONAL COMPETITION .............................. 136 5.3.1

BITs and Self-Interested Governments .................................................. 137

5.3.1.1 Political Economy and International (Trade) Law ............................. 137 5.3.1.2 Political Economy and International Investment Law........................ 139 5.3.2

BITs and the Prisoner's Dilemma Revisited .......................................... 142

5.3.2.1 BITs and the Underprovision Hypothesis........................................... 142 5.3.2.2 Distribution of the Benefits of FDI..................................................... 144 5.4 PROVISIONS AND EVIDENCE ........................................................................... 145 5.4.1

Non-Discrimination ............................................................................... 145

5.4.2

Fair and Equitable Treatment (FET)..................................................... 146

5.4.3

Indirect Expropriation ........................................................................... 147

5.4.4

Evidence................................................................................................. 148

5.4.4.1 Case Law............................................................................................. 148 5.4.4.2 Analysis............................................................................................... 151 5.5 DISCUSSION AND CONCLUSIONS .................................................................... 152

6

BITS AND INSTITUTIONAL QUALITY.................................................... 155 6.1 THE EFFECT OF BITS ON INSTITUTIONAL QUALITY ....................................... 155

XVI

Detailed Contents

6.1.1

Some Theory........................................................................................... 155

6.1.2 Empirical Literature ............................................................................... 158 6.2 MODEL AND DATA ......................................................................................... 160 6.2.1

Fixed-Effects Model............................................................................... 160

6.2.2

Variables ................................................................................................ 162

6.2.2.1 Dependent Variables........................................................................... 162 6.2.2.2 Independent Variables ........................................................................ 163 6.2.2.3 Overview............................................................................................. 165 6.2.3

Summary Statistics................................................................................. 166

6.2.4

Regulatory Quality and the Rule of Law ............................................... 166

6.2.5

Corruption.............................................................................................. 172

6.2.6

Outliers, Economic Freedom and OECD BITs ..................................... 173

6.3 CAVEATS ........................................................................................................ 173 6.3.1

Selection and Composition of Variables................................................ 174

6.3.2

Perception Based Indicators.................................................................. 174

6.4 DISCUSSION AND CONCLUSIONS .................................................................... 175

7

BITS AND TRANSPARENCY....................................................................... 177 7.1 LEGAL BACKGROUND .................................................................................... 177 7.2 THE CASE FOR TRANSPARENCY ..................................................................... 181 7.2.1

International Law .................................................................................. 181

7.2.2

International Investment Law ................................................................ 183

7.3 THE CASE FOR CONFIDENTIALITY .................................................................. 184 7.3.1

Conventional Arguments for Confidentiality......................................... 185

7.3.2

Structural Arguments for Confidentiality .............................................. 186

7.3.2.1 Informational Ambiguities and the Incentive to Comply ................... 186 7.3.2.2 Efficient Breach and Settlement Problems ......................................... 190 7.3.2.3 The Incentive to Conclude an Agreement .......................................... 194 7.3.3

More Transparency?.............................................................................. 196

Detailed Contents

XVII

7.4 DISCUSSION AND CONCLUSIONS .................................................................... 196

8

SUMMARY AND OUTLOOK....................................................................... 199 8.1 SUMMARY....................................................................................................... 199 8.2 OUTLOOK........................................................................................................ 203

APPENDICES............................................................................................................. 205 APPENDIX A ............................................................................................................. 205 APPENDIX B ............................................................................................................. 207 APPENDIX C ............................................................................................................. 211 APPENDIX D ............................................................................................................. 216 BIBLIOGRAPHY......................................................................................................... 221

List of Figures Figure 2.1: FDI Flows (Inward) 1970-2009 ................................................................... 7 Figure 2.2: FDI Flows (Inward) – Selected Countries and Regions............................... 8 Figure 3.1: Time Inconsistency .................................................................................... 19 Figure 3.2: Hostage-Mechanism................................................................................... 26 Figure 3.3: Collateral .................................................................................................... 28 Figure 3.4: Hands-Tying............................................................................................... 29 Figure 3.5: Time Inconsistency and the Good Host Country (HCgood)......................... 37 Figure 4.1: The Commitment Game ............................................................................. 88 Figure 4.2: The Signalling Game................................................................................ 109

List of Abbreviations BIT

Bilateral Investment Treaty

CIEL

The Center for International Environmental Law

CIL

Customary International Law

DCF

Discounted Cash Flows

DSB

Dispute Settlement Body (World Trade Organization)

EBIT

Earnings Before Interest and Taxes

ECT

Energy Charter Treaty

EU

European Union

FCN

Treaty of Friendship, Commerce and Navigation

FDI

Foreign Direct Investment

FET

Fair and Equitable Treatment

FMV

Fair Market Value

FPI

Foreign Portfolio Investment

FTC

Free Trade Commission

GATS

General Agreement on Trade in Services

GATT

General Agreement on Tariffs and Trade

GDP

Gross Domestic Product

GNI

Gross National Income

HC

Host Country

ICC

International Chamber of Commerce

ICJ

International Court of Justice

ICSID

International Centre for the Settlement of Investment Disputes

IISD

International Institute for Sustainable Development

IMF

International Monetary Fund

LDC

Least Developed Countries

M&A

Mergers and Acquisitions

MAI

Multilateral Agreement on Investment

XXII

List of Abbrevations

MIGA

Multilateral Investment Guarantee Agency

MFN

Most Favoured Nation

MNE

Multinational Enterprise

NAFTA

North American Free Trade Agreement

NE

Nash Equilibrium

NGO

Non-Governmental Organisation

OAS

Organization of American States

OECD

Organisation for Economic Cooperation and Development

OPIC

Overseas Private Investment Corporation

PBE

Perfect Bayesian Equilibrium

PCA

Permanent Court of Arbitration

PD

Prisoner's Dilemma

SCC

Stockholm Chamber of Commerce

TRIMS

Trade-Related Investment Measures

TRIPS

Agreement on Trade-Related Aspects of Intellectual Property Rights

UN

United Nations

UNCITRAL

United Nations Commission on International Trade Law

UNCTAD

United Nations Conference on Trade and Development

USD

US-Dollar

VCLT

Vienna Convention on the Law of Treaties

WGI

World Governance Indicators

WTO

World Trade Organization

List of Variables CM

=

Cooperation gain for the MNE (profit)

CH

=

Cooperation gain for the host country (taxes, spillover etc.)

LM

=

Loss for the MNE in case of expropriation (Loser's payoff)

WH

=

Value of the assets to the host country if expropriated (Winner's payoff)



=

Discount rate of the host country

X

=

Collateral/Hostage

D

=

Damages/Compensation



=

Probability that the host country is reliable

q2

=

Probability that the host country is reliable as assessed by the MNE in period two

z

=

Probability that the bad type will play accommodation in the first period

v

=

Probability that MNE plays invest

y

=

Probability of error

T

=

Litigation costs

R

=

Reputational loss

S

=

Settlement costs

A

=

Costs of concluding the BIT

BR

=

Compliance costs of the BIT for the reliable type (arbitration risk)

BU

=

Compliance costs of the BIT for the unreliable type (arbitration risk)

1

Introduction

Foreign direct investment (FDI) flows amounted to 1,697 billion USD in 2008, while global FDI stocks reached a level of more than 16,205 billion USD.1 These figures underline the fact that FDI has gained an importance that is comparable to trade in providing foreign markets with goods and services.2 In addition, FDI constitutes the largest source of external finance for developing countries.3 Nevertheless, the global financial crisis had a significant impact on FDI at the end of 2008, reducing flows by approximately 14.2% compared to the all-time high of 1,978 billion USD in 2007. The downward trend continued in 2009. Flows declined to 1,114 billion USD, but are expected to rise in the next 3 years to about 1,600 - 2,000 billion USD in 2012.4 In any case, the relative importance of FDI flows in the global economy remains unchanged. However, FDI is prone to risk. In addition to the operational risk inherent in any business activity, FDI suffers from political risk. Investors need to be concerned with the protection of their investment from expropriation, be it direct or indirect, and any other derogation of their assets by governmental actions. Several institutions on both the domestic and international level have developed to mitigate this kind of risk. The most important development in international law in this regard is the emergence of Bilateral Investment Treaties (BITs). While the number of these treaties has been steadily growing since the first treaty in 1959, the number of arbitrations based on BITs and the controversies surrounding the content and impact of BITs has been notably increasing in the last decade. Unlike international trade law, the functioning and consequences of international investment law in general and BITs in particular have not yet been analysed thoroughly from an economic point of view. Indeed, there is a gap in the literature regarding the economic analysis of Bilateral Investment Treaties that is worth addressing. Developing a better understanding of the legal structure surrounding the protection of FDI is an important enterprise, especially because FDI can substantially contribute to the economic development of poor countries. The legal protection of FDI does not only have important implications regarding the integration of the global economy, but also with regard to issues of domestic public policy as BITs limit the sovereignty of governments. The approach of law and economics is well-suited to

1 2

3 4

UNCTAD (2009a), p.xix and p. 251. Comparing FDI stocks and trade flows for the year 2006, Sauvant (2008) argues that FDI "has become the most important vehicle to bring goods and services to foreign markets." See Sauvant (2008), p.1. World Bank (2007), p.314. See UNCTAD (2010), p. xvii.

J. P. Sasse, An Economic Analysis of Bilateral Investment Treaties, DOI 10.1007/ 978-3-8349-6185-3_1, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011

2

Introduction

unite the legal and economic aspects of FDI protection and to advance our understanding of these important issues. 1.1

International Law and Economics

The economic analysis of law is by now an integral part of many if not most areas of law. It is virtually undisputed that – in addition to classical fields like antitrust law economic theories and methods have also improved the understanding of contract law, property law and tort law. The application of economic models has also been expanded to criminal law and family law. Yet, while the field of international law has always received considerable attention by legal scholars, it has traditionally been ignored by scholars with a law and economics background.5 Leading law and economics textbooks do not or only very shortly deal with issues of international law.6 Further, international legal scholars have mainly abstained from the use of economic methods.7 Nevertheless, for about the last decade, there has been a small but growing literature on international legal issues. In 1997, Ronald A. Cass denoted international law and economics scholarship as the "new kid on the block."8 Dunoff and Trachtman (1999) provide one of the first systematic overviews on the economic analyses of international law. The authors identify a number of issue areas where the insights of law and economics can be fruitfully applied. The recent overview article by Sykes (2007) illustrates that, while the bulk of work still analyses international trade law, a number of contributions have now been made in various areas of international law, such as security issues and international investment law. Nevertheless, most fields of international law remain underdeveloped in this respect. But what are the defining characteristics of the law and economics of international law? Three aspects appear especially noteworthy when answering this question. First, the core principle of economics is the rational choice principle. Consequently, rational choice theory is a cornerstone of law and economics. Its application to international law has been the subject of controversial discussion.9 The differences of the rational choice approach as compared to other common approaches to the analysis of international law and international relations can be found in Guzman (2002) and Guzman (2008a). Similar to Guzman (2008a), this book takes a rationalistinstitutionalist approach. In particular, it is not assumed - unlike the "managerial model" laid out by Chayes and Chayes (1995) - that states have a propensity to comply 5 6

7 8 9

A notable exception is international trade law. See e.g., Cooter and Ulen (2004), Shavell (2004) or, for a short comparison of contracts and treaties, Posner (2003), p.136ff. Dunoff and Trachtman (1999), p.2. Cass (1997), p.2. See e.g., Snidal (2002) or Keohane (2002) for the main points of the discussion.

Introduction

3

with international obligations.10 The standard rationalist assumptions encompass that states "are assumed to be rational, self-interested, and able to identify and pursue their interests. Those interests are a function of state preferences, which are assumed to be exogenous and fixed. States do not concern themselves with the welfare of other states, but instead seek to maximise their own gains or payoffs."11 An implicit part of these assumptions about the state is that it acts as a unitary actor. This assumption of the unitary state is very useful for the analysis of many aspects of international law, such as questions of compliance. This approach, although a deviation from the methodological individualism paradigm of economic theory, has also been applied in other areas of economics. With regard to corporate behaviour, Posner (2007) argues: "Economics made much progress in modelling the interactions of business forms without peeking inside them but instead treating them as if they were individuals."12 Therefore and in line with the relevant literature, the arguments in this book will in large part be based on this assumption. Nevertheless, at some points, it will be necessary to deviate from this assumption as some aspects of bilateral investment treaties may be better understood when assuming - in the public choice tradition - that the interests of political leaders and citizens do not align.13 Please note this is not a repudiation of the rational choice principle. Relevant actors are still assumed to be rational. The public choice approach in the context of international relations simply opens the "black box" of the state and allows different actors within the state to have diverging, yet rational interests that influence international lawmaking. However, in analyzing many aspects of international law, it is simply not necessary to open this black box. A second feature of law and economics as compared to other branches of legal theory is its emphasis on the use of certain, often rather formal methodologies, most prominently econometrics and game theory.14 Nevertheless, it should be noted that, while these methods are characteristic to international law and economics, they are not essential to the rational choice approach. For example, quantitative and statistical methods can obviously also be employed to test hypotheses derived from theories not applying the rational choice approach, while a verbal analysis may very well be based on the rational choice approach. A third important aspect is the distinction between the positive analysis and the normative analysis usually employed in economics. While the positive analysis 10 11 12 13 14

Chayes and Chayes (1995), p.3. Guzman (2008a), p.17. Posner (2007), p.136. Namely, in chapter 5 of this book. See e.g. Elkins, Guzman et al. (2006) and Goldsmith and Posner (2005). For a literature overview on economics applied to international law, see Sykes (2007).

4

Introduction

attempts to explain legal rules and outcomes as they are (given the rationality assumption), the normative analysis rather asks how the law should be. The normative criterion employed in law and economics is the efficiency criterion. Economists differentiate between Pareto efficiency and Kaldor-Hicks efficiency.15 A situation where it is impossible to make changes that make at least one person better off without making another person worse off is called Pareto efficient. Put differently, a change that makes one person better off without making anybody worse off is called a Pareto improvement. A less restricted notion of efficiency is the Kaldor-Hicks efficiency. Here, a change is already considered efficient when the winners gain more than the losers lose. In theory, the winners could compensate the losers for the loss and still be better off. This compensation, though, does not actually have to take place. Therefore, Kaldor-Hicks efficient changes are often also referred to as potential Pareto improvements. While the positive analysis of international law based on the rational choice principle is now widely used16, the application of the efficiency principle to international (public) law is rare and not unproblematic. As Van Aaken (2008b) points out, the problems with the use of the efficiency criterion in international law bears a resemblance to problems with its use in constitutional law.17 Here, one of the fundamental problems is that certain constitutional principles may be equally or even more important than efficiency. Another problem related to efficiency and social welfare concerns the level of analysis. From a normative perspective, it makes a huge difference if only the contracting parties are taken into account or if global welfare is taken as the benchmark. Given these considerations, the book at hand is mainly of a positive nature with the notable exception of chapter 5. Where normative conclusions are put forward, the difficulties with the efficiency criterion in international law will be made explicit. 1.2

Structure

The book will proceed as follows: chapter 2 will provide an overview on the underlying causes, effects and trends concerning foreign direct investment. By using a simple game theoretic example, chapter 3 explains why FDI suffers from expropriation risk and discusses the economic strategies and mechanisms that may help to diminish this risk. In addition, this chapter outlines the legal landscape regarding the protection of international investment, with a special focus on the nature and contents of BITs. Chapters 4 and 5 are both devoted to the understanding of the functioning of Bilateral Investment Treaties from different perspectives. Chapter 4 focuses on the relationship

15 16 17

See e.g. Cooter and Ulen (2004), p.16f and p.48. Although the rational choice principle is - as mentioned before - not undisputed. Van Aaken (2008b), p.659.

Introduction

5

between the countries trying to attract FDI and the multinational enterprises (MNEs) providing FDI. At the core of the chapter lies the question of why BITs function despite the (perceived) weakness of international law. The potential commitment and signalling properties of BITs will be analysed and discussed. It will be argued that the scope for a signalling function is rather limited. In addition, the commitment function is structurally similar to the exchange of hostages or collateral and therefore suffers from the same incentive problems. In turn, chapter 5 examines the competition dynamic between developing countries trying to attract FDI. While BITs are certainly part of the institutional competition for FDI, a controversy exists regarding the (welfare) implications of this institutional competition. BITs will be discussed in the context of this controversy. The relevant question is whether BITs are either a manifestation of the detrimental or of the beneficial aspects of this competition. The analysis shows that BITs contain elements of both aspects. Furthermore, the findings of this chapter underline the importance of the consideration of public policy concerns in investment arbitrations. The following two chapters focus on specific issues relating to bilateral investment treaties. More precisely, chapter 6 analyses the impact that BITs may have on domestic institutional quality using panel data in a fixed-effects model. A positive effect can be excluded while rather weak evidence points in the direction of a negative effect. Moreover, the results emphasize the importance of domestic reform for institutional quality. Chapter 7 is concerned with the issue of transparency in international investment arbitration. A lack of transparency has been criticised by a number of observers. Without contradicting the arguments for transparency, this chapter will discuss some structural implications of increased transparency compared to confidentiality and aims to add new arguments to the discussion. Special attention will be paid to the question of who would actually profit from increased transparency, arguing that the benefits of transparency are widespread, while the benefits of confidentiality directly accrue to the parties of a dispute. This explains the persistence of confidentiality in international investment law. Chapter 8 summarises the main results and identifies areas for further research.

2

Foreign Direct Investment

2.1

Trends and Figures

According to the OECD, foreign direct investment "reflects the objective of obtaining a lasting interest by a resident entity in one economy (‘‘direct investor’’) in an entity resident in an economy other than that of the investor (‘‘direct investment enterprise’’). The lasting interest implies the existence of a long-term relationship between the direct investor and the enterprise and a significant degree of influence on the management of the enterprise. Direct investment involves both the initial transaction between the two entities and all subsequent capital transactions between them and among affiliated enterprises, both incorporated and unincorporated."18 As a practical matter, an equity share of more than 10% is usually considered the threshold for the control of an asset.19 In contrast to FDI, investment that does not aim at the exercise of control is usually referred to as Foreign Portfolio Investment (FPI). To be classified as FDI, it does not matter if the direct investment enterprise is incorporated in the foreign country, and is thus a subsidiary or associate company, or not incorporated and is thus a branch.20 A frequent distinction with regard to FDI is between flows and stocks. Obviously, FDI stocks denote the value of FDI in a given country at a given point of time, while FDI flows denote the amount of FDI flowing to a given country in given period of time. Another important differentiation regarding the nature of FDI is between Mergers and Acquisitions (M&As) and Greenfield investment. While the notion of M&A is self-explanatory, Greenfield investment refers to investment that includes the establishment of new production facilities such as offices, buildings and factories.21 The last few years have seen a considerable growth of FDI. In 2006, FDI flows reached $1,306 billion USD while total FDI stocks amounted to roughly $12,000 billion USD.22 Compared to 2005, this constitutes a growth in FDI flows of about 38%. As Figure 2.1 indicates, FDI has been on a growth path since the mid-1980s, reaching a peak in the year 2000 and an all-time high in 2007. However, recent figures for 2008 and 2009 evidence the negative consequences of the financial crisis and have caused FDI to fall to 1,114 billion USD in 2009.23

18 19 20 21 22 23

OECD (1996), 7f. UNCTAD (2007a), p.245. OECD (1996), p.9. UNCTAD (2006), p.15. UNCTAD (2007a), p.9. UNCTAD (2010), p.xix.

J. P. Sasse, An Economic Analysis of Bilateral Investment Treaties, DOI 10.1007/ 978-3-8349-6185-3_2, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011

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7

Figure 2.1: FDI Flows (Inward) 1970-2009

Source: Own diagram based on UNCTAD Data (http://stats.unctad.org/FDI/)

Foreign Direct Investment now constitutes the largest source of external finance for developing countries.24 Nevertheless, the bulk of FDI in 2006, namely more than 60%, went to developed countries.25 As figure 2.2 indicates, the countries of Western Europe experienced the highest FDI inflows. Among the emerging and developing regions, Asia appears to be the most attractive FDI location.

24 25

World Bank (2007), p.314. Kekic and Sauvant (2007), p.6.

8

Foreign Direct Investment

Figure 2.2: FDI Flows (Inward) – Selected Countries and Regions

Source: Own diagram based on UNCTAD Data (http://stats.unctad.org/FDI/)

It is remarkable that, as Sauvant (2008) notes, FDI "has become the most important vehicle to bring goods and services to foreign markets and to integrate national production systems".26 More specifically, in 2006 there were more than 78,000 parent companies with more than 780,000 foreign affiliates.27 Another noteworthy trend is the growing importance of south-south flows (meaning flows between developing countries) since the mid-1980s. Starting from about 4 billion USD in 1985, southsouth flows rose to almost 60 billion USD in 2004.28 Regarding the sectoral distribution of FDI, a relative shift from manufacturing to services can be observed. Of the global FDI stocks in 2005, 61% were in the service sector, compared to 49% in 1990.29 Manufacturing accounted for 30%, leaving the remaining 9% to the primary sector. 2.2

Multinational Enterprises and FDI

Why do enterprises find it worthwhile to invest in foreign countries at all? Goods and, to a growing degree, services could be produced in the home country of the investor and simply be exported to the foreign markets. A number of theories of foreign direct 26 27 28 29

Sauvant (2008), p.3. UNCTAD (2007a), p.12. UNCTAD (2006), p.117. UNCTAD (2007a), p.22.

Foreign Direct Investment

9

investment have been developed. This section will focus on transaction cost/internalisation theories of FDI as developed by scholars like Buckley, Casson, Hennart and Rugman.30 The following summary is based on Hennart (2001). The transaction cost theory of FDI has its foundations in the writings of Coase (1937), Alchian and Demsetz (1972) and Williamson (1985).31 As Hennart (2001) points out, classical trade theorists explained FDI mainly as a result of differences in real interest rates. However, this theory proved to be unable to explain the major flow and growth patterns of FDI. Theories based on transaction cost economics revealed more explanatory power in the context of FDI. In general, transaction cost economics focuses on the costs of cooperation between economic agents as a result of cognitive limitations and opportunism, namely information, enforcement, and bargaining costs.32 The specific question transaction cost theories of FDI seek to answer is why interdependencies across national boundaries are organised through multinational enterprises (and thus through FDI) that could also be organised through markets. Interdependencies, in this context, arise when a "firm located in country X has some assets which have potential value in country Y if successfully combined with some country Y factors."33 The obvious answer is that multinational enterprises (MNEs) will arise when they can organise these interdependencies more efficiently than markets. As Hennart (2001) notes, this implies three conditions for the existence of MNEs: "(1) interdependent agents must be located in different countries (otherwise we would have a domestic firm), (2) the MNE must be the most efficient way to organize these interdependencies (otherwise we would have international market transactions), and (3) given condition (2) the costs incurred by MNEs to organize these interdependencies are lower than the benefits of doing so."34 These conditions are likely to be met where know-how, reputation, raw materials and components, distributions and marketing and, finally, financial capital is involved. Why should MNEs in these areas work more efficiently than markets? It is, for example, well-known, that the market for know-how suffers from information asymmetries. The dynamic is similar to the market for lemons as described by Akerlof (1970). Potential buyers of know-how cannot assess the quality of the product. Obviously, the seller cannot reveal the know-how (if he did, he would give away his

30

31

32 33 34

Hennart (2001), p.131. A competing theory of FDI that nevertheless shares many features with transaction cost theories is the eclectic paradigm. See Dunning and Lundan (2008). Dunning and Lundan (2008), chapter 4. Hennart (2001), on the other hand, emphasises that the transaction cost theories of FDI was developed independently of the writings of Williamson. See Hennart (2001), p.132. Hennart (2001), p.133. Hennart (2001), p.145. Hennart (2001), p.136.

10

Foreign Direct Investment

product for free). If patent systems cannot guarantee the property rights of the knowhow, the optimal way to organise the interdependency might be through an MNE. In the case of reputation, an alternative way for a company from one country to exploit its reputation in another country would be through franchise contracts. However, as Hennart (2001) emphasises, free-riding poses a huge problem to franchising. A single franchisee has the incentive to lower his quality. The reputational costs will be borne by the whole franchise chain and only to a very small degree by the single franchisee – especially when customers are mainly non-repeat customers. When it is very costly or impossible to contractually define quality, ownership (via an MNE) may be a more efficient way to exploit reputation across borders than franchising contracts. The motivation for vertical integration across borders in the case of raw materials and components is different. Here, the problem with market transactions is often the absence of a large number of buyers and sellers. According to Hennart (2001), a small number of market participants in raw materials markets is often the result of economies of scale, high transportation costs, government barriers, and asset specificity.35 Asset specificity means that the value of an asset is (mainly) specific to a certain transaction and thus loses value if used otherwise. As described prominently by Williamson (1985), the party undertaking investment in specific assets may be subject to the hold-up problem, which is opportunistic renegotiation by the other party to the point where the investment would not have been profitable in the first place. Consequently, a value-creating cooperation might not be pursued when the hold-up risk is high. Long-term contracts are a potential solution for this dilemma. However, when long-term contracts are not feasible and transaction-specific investments are considerable, ownership might be a sensible strategy to overcome the hold-up problem. Comparable to the example of raw materials, markets for distribution can be inefficient and subject to hold-up problems as well. Distributors may be reluctant to invest in manufacturer-specific distribution systems. As Hennart (2001) states: "When the physical or intellectual investments necessary to effectively sell a product are large and manufacturer-specific, and the environment is hard to predict, the integration of manufacturing and distribution within an MNE will often be the best solution."36 The last example illustrating the purpose of MNEs concerns financial capital. As mentioned before, classical trade theorists considered FDI as a result of differences in the real interest rate. The preceding paragraphs demonstrated that a number of reasons for the existence of MNEs do not require the existence of interest rate differences.

35 36

Hennart (2001), p.139. Hennart (2001), p.140f.

Foreign Direct Investment

11

Nevertheless, financial capital from country A might often be invested more profitably in country B. The question here is why this should not always simply be done through lending. The problem is that lending money creates problems of moral hazard on the side of the borrower who may take too much risk or not exert enough effort. The cross-national nature of the transaction may make the lender’s control of the funds even more problematic. One solution to this problem could be the use of collaterals. However, when collaterals are not available and the project is nevertheless profitable, a sensible strategy could be the integration of lenders and borrowers into an MNE. As these examples illustrate, the key question for the existence of MNEs and thus FDI is why the organisational form of an MNE for the cross-national transaction is more efficient as compared to the use of the market or contracts. The prerequisite is, of course, that the cross-national transaction is profitable. This prerequisite is evidently not sufficient for the occurrence of FDI. Indeed, in many cases, the cross-national transaction will simply be executed through markets or certain types of contracts. However, if the existence of hold-up risks or information asymmetries means that the transaction is more efficiently structured along the hierarchical lines of a multinational enterprise, FDI will occur. Therefore, the motives for FDI naturally bear a lot of resemblance to the classical reasons for vertical integration as identified by the transaction cost economics literature, adding the cross-national nature of the economic transaction at hand. A different theory of FDI that is often considered the predominant paradigm for direct investment is called the OLI or eclectic paradigm.37 The OLI theory is for the most part not incompatible with the transaction cost/internalisation theory of FDI. As a matter of fact, internalisation is an integral part of the OLI framework. The main difference is that the OLI framework emphasises, apart from internalisation (I), the importance of ownership-specific advantages (O) and location-specific advantages (L). Ownership-specific advantages are the advantages the potential MNE has that it wishes to exploit across borders, while location-specific advantages are the advantages of a potential host country of FDI compared to its competitors.38 As a practical matter, FDI is often classified into three categories: market seeking FDI, resource/asset-seeking FDI and efficiency-seeking FDI. This classification is used by the United Nations Conference on Trade and Development (UNCTAD).39 As the transaction cost theory of FDI has illustrated, the existence of attractive markets or the demand for natural resources is not sufficient for FDI to emerge. In addition,

37 38 39

Ethier and Markusen (1996), p.2. See Dunning and Lundan (2008) for the description of the OLI paradigm. See e.g. UNCTAD (2003), p.85.

12

Foreign Direct Investment

ownership must be a more efficient organisational structure than, for example, market transactions. Nevertheless, the classification used by UNCTAD (2003) can be useful in some respects. 2.3

FDI and Development

Before proceeding, it appears worthwhile to take a closer look at the impact of FDI on the host country's economy. The term host country (HC) is used to denote the country that receives the investment (as opposed to the home country of the investor). With special regard to developing countries, Jain and Vachani (2006) provide an overview on the potential effects of multinational enterprises (MNEs).40 These effects include technology spillover, export spillover and productivity spillover, as well as effects on wages, competition and consumer preferences. The empirical evidence on some of these effects appears to be mixed. One reason is that spillover is hard to measure. As Saggi (2002) notes, spillovers "do not leave a paper trail."41 The question of the effect of FDI on the host country can be approached on two different levels. First, one could look at the effect of FDI on micro-level data like wages, productivity, exports etc. Alternatively, one could look at the growth rate of countries and directly analyse its connection to direct investment. Lipsey (2002) takes the first approach and summarises the main empirical findings of the impact of FDI on wages, productivity, exports, and the introduction of new industries. He observes that the impact of FDI on local wages is positive. Virtually all studies on this matter show that foreign-owned companies pay higher wages than local firms.42 The question is whether these findings reflect that MNEs might mainly operate in high-wage sectors and/or that MNEs might have a higher propensity to hire more highly qualified personnel than domestic firms for reasons unrelated to their foreignness. The numerous studies on this question are very diverse in the sense that they focus on many different countries and regions (including developing as well as developed countries) and employ a diverse set of control variables (firm size, education level, industry sector, etc.). As the overview in Lipsey (2002) illustrates, foreign firms clearly tend to pay higher wages, independent of the region in which they operate (and independent of a wide set of other controlled variables). Another important question concerns the wage effect of MNEs on the labour market (that is, on the wages paid by local firms) in general. Here, the evidence is more ambiguous. Some studies find positive, while others find no or negative spillover of MNEs on

40 41 42

Jain and Vachani (2006), p.8ff. Saggi (2002), p.208. Lipsey (2002), p.20.

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13

wages in domestic owned firms.43 In sum, the effect of the presence of MNEs on the average wage appears to be mainly positive, which indicates that even if there are negative spillovers, these are offset by the higher wages paid by the MNEs themselves.44 Concerning productivity spillover, a logical prerequisite is that foreign-owned firms are on average more productive than domestic firms. Virtually all empirical studies on this matter confirm that foreign firms indeed are more productive, in developing as well as in developed countries.45 The spillover of productivity (or knowledge and technology) to domestic firms is obviously much harder to measure. The main transmission channel for the spillover of productivity to domestic firms is likely backward linkages. These backward linkages describe the connection of MNEs to suppliers. MNEs usually have an interest in establishing or sharing production technology and quality-control techniques in a vertical direction in order to build reliable production networks.46 On the other hand, MNEs have an interest to avoid knowledge spillover in a horizontal direction. These spillovers may nevertheless take place due to imitation, competitive pressures or the movement of employees.47 The empirical evidence on the effect of FDI on productivity is mixed. Some studies even seem to indicate negative spillover effects.48 As Lipsey (2002) points out, the measuring of productivity spillover poses a number of econometric problems, including the validity and availability of productivity indicators as well as problems with model specifications.49 As a logical matter, it is hard to hypothesise that MNE activity should not have any (positive) effect on domestic firms at all. As Moran (2006) provocatively phrases, it "is possible to imagine in the abstract that foreign investors enter a host economy and train local managers and workers who never leave the foreign-owned firms, set up operations without any local firms copying their use of machinery or their management techniques, and create supply chains with indigenous companies that learn nothing new from the relationship, enjoy no scale effects, or, if they do, use the novel skills to sell exclusively to the foreign subsidiaries who capture all the benefits that result."50 Obviously, this scenario appears to be rather unlikely. Nevertheless, given the mixed empirical findings on this issue, it is hard to make any firm assertions. Lipsey (2002) concludes that "the mixed story for spillover, combined

43 44 45 46 47 48 49 50

Lipsey (2002), p.32. Lipsey (2002), p.34. Lipsey (2002), p.40. Moran (2006), p.21. Moran (2006), p.24. Lipsey (2002), p.46. Lipsey (2002), p.49ff. Moran (2006), p.23.

14

Foreign Direct Investment

with the strong evidence for superior productivity of foreign-owned firms, suggests that overall productivity is improved by the presence of foreign-owned operations, although that question is rarely, if ever, examined."51 The evidence of the effect of FDI on exports and the introduction of new industries is, however, well-established and positive.52 The affiliates of MNEs are usually not only more export-oriented than their domestic counterparts; there is also evidence that the presence of an MNE also raises the export propensity of the domestic firms in that industry.53 Consequently, the host country establishes a tighter linkage in the world trading system through FDI. This assertion also partly holds true for imports. The question here is whether trade and FDI are substitutes or complements. At first glance, the answer given by the internalisation theory appears simple: FDI is described as an alternative to trade and consequently, FDI and trade should be viewed as substitutes. However, this simplistic view ignores a number of more complicated processes related to MNE activity. Most importantly, the MNE may import intermediate goods necessary for the production of the final good. Also, the presence of a firm's production facilities for one product in a country may increase the demand of other products of the same company in that country, even when the other products are produced somewhere else. Potential channels might be, among others, increases in demand due to the publicity related to the presence of the firm54 or more efficient deliveries and distribution.55 While there are theoretical arguments both for substitutability and complementarity, the majority of empirical studies finds strong evidence for net complementarity.56 However, depending on the data aggregation level (product specific data as compared to firm or industry specific data), substitution effects can also be shown.57 In sum, while FDI substitutes for imports to some extent, on the aggregate level, FDI leads to even more imports. Examining the possible spillover effects of FDI on certain economic variables leads to the more general question regarding the impact of FDI on economic growth. The importance of the dissemination of ideas for economic development, also through FDI, has been noted by Romer (1993)58, one of the co-founders of the endogenous growth theory. However, the empirical studies on this issue show mixed results. While some studies find no systematic effect of FDI on growth, other studies find that, for certain

51 52 53 54 55 56 57 58

Lipsey (2002), p.59. Lipsey (2002), p.54. Lipsey (2002), p.53. Lipsey and Weiss (1984), p.305. Blonigen (2001), p.84. Blonigen (2001). See Swenson (2004) and Blonigen (2001). Romer (1993).

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15

subsets of countries, there is a robust positive relationship.59 Two recent studies should be mentioned here as illustrative examples. Li and Liu (2005) investigate the relationship between FDI and growth in a panel data study for 84 countries for the period between 1970 and 1999. From the mid-1980s onwards, the authors identify a significant relationship between FDI and economic growth. On the other hand, Carkovic and Levine (2005), using a panel data study for 72 countries from 1960 to 1995, do not find a robust, positive influence of FDI and economic growth. A number of authors have tried to detect the reasons for the inconclusive results of the impact of FDI on growth. Borensztein, De Gregorio et al. (1998) show that FDI can have an important positive impact on growth, but only when the host country already has a certain stock of human capital. In other words, a lack of human capital limits the absorptive capability of the host country. Busse and Groizard (2008) explore the importance of regulatory quality for the impact of FDI on growth. The authors find that excessive business and labour regulations frustrate a positive growth effect of FDI. Alfaro, Areendam et al. (2003) stress the importance of the stage of development of the local financial markets for a positive impact of FDI. Balasubramanyam, Salisu et al. (1996) emphasise the importance of trade policy, or, more specifically, trade openness, for FDI to exert a positive effect on growth. A similar point is made by Moran (2006), who uses a number of examples to illustrate that FDI has detrimental effects where it is understood as part of an import substitution policy, while positive effects accrue in the absence of trade protection. This discussion illustrates that it would be inaccurate to simply imply that more FDI will lead to higher economic growth rates. However, FDI can indeed work as a vehicle for higher growth when certain host country characteristics and policies are met. Nevertheless, as a number of authors emphasise, FDI and MNE activity can also have a negative effect on certain host country variables. Some of these effects have already been mentioned, like the possible negative effect on host countries’ productivity. Also, as Moran (2006) has pointed out, where MNEs operate in protected markets as part of an import substitution strategy, they may use inefficient technology and may also not be able to exploit economies of scale, thus doing more harm than good to the host country's economy.60 Other authors have raised concerns of the impact of MNE activity on environmental and social standards61, on the competition in domestic markets and the loss of market share of domestic firms62, the crowding out of domestic

59 60 61 62

Lipsey (2002), p.55. Moran (2006), p.7ff. For a short overview, see Meyer (2004), p.269ff. See, e.g., Aitken and Harrison (1999).

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Foreign Direct Investment

investment63 and the possible negative balance of payments effects.64 Evidently, the economic literature on these issues can be characterised as controversial. Nevertheless, the majority of economists seem to emphasise the positive effects of FDI on the respective host country. It also seems clear that some of the potential negative effects of FDI can be addressed through adequate domestic policies and thus might, if at all, only pose minor or temporary problems. While the academic debate on the effects of FDI on host countries is far from being over, as a practical matter, the issue seems to have been decided. Governments all over the world seemingly consider the contribution of FDI to domestic welfare as positive and adapt their regulatory systems to attract FDI. From the 184 regulatory changes in 2006 with regard to FDI as monitored by UNCTAD, 147, representing a share of almost 80%, were favourable to FDI.65 For the time span of 1992 to 2001, Kobrin (2005) finds that even 95% of the changes were liberalizing rather than restrictive. Using cross-sectional regressions, Kobrin (2005) shows that external factors do not play a significant role in the liberalisation decision – indicating that favourable FDI policies were not imposed through external pressures. In addition, international development organisations such as UNCTAD emphasise the importance of FDI for development.66 Not surprisingly, developed countries represented by the OECD also see MNE activity as mainly beneficial.67 Lastly, the predominant perception of the beneficial nature of FDI with policy-makers is also reflected by the lasting trend to protect international investment by means of international law, namely through bilateral investment treaties (BITs).

63 64 65 66

67

See, e.g., De Backer and Sleuwaegen (2003). UNCTAD (1997), p.88. UNCTAD (2007a), p.14. See, for example, the foreword by Ban Ki-moon to the World Investment Report 2007, UNCTAD (2007c), p.iii. See e.g. OECD (2002).

3

Economic and Legal Protection of FDI

The preceding section has shown that most countries perceive FDI as predominantly beneficial. Obviously, the companies that engage in FDI prefer this form of transaction to other forms like trade or licensing. If FDI is beneficial to both parties of the transaction, why would FDI need any protection at all? The following section will explain the inherent risk to FDI as the consequence of a time inconsistency problem (section 3.1). MNEs, international organisations and policymakers have implemented economic and legal measures to protect FDI. The former will be introduced in section 3.2. and the latter in section 3.3. 3.1

Time Inconsistency and Expropriation Risk

Investors operating in a risky international environment are naturally concerned with the protection of their assets. Apart from the regular economic risks associated with the operation of a business, a major concern for MNEs is political risk.68 A useful definition of political risk goes back to Weston and Sorge (1972), taken up by Kobrin (1979): political risks "arise from the actions of national governments which interfere with or prevent business transactions, or change the terms of agreements, or cause the confiscation of wholly or partially foreign owned business property."69 The main problem here is the problem of the taking of property owned by foreigners through expropriation or through regulatory measures (indirect expropriation). At the core of this issue is usually the redistribution of assets from foreign businesses to the government or third parties. 3.1.1

Time Inconsistency

The economic problem related to expropriation, be it direct or indirect, is a problem of time inconsistency70 or hold-up.71 Once the investment is sunk, the host state has an incentive to expropriate (or exploit, redistribute etc.) the assets in one way or another. This could be considered a form of opportunism that is present in many if not most sequential transactions. A useful definition of time inconsistency can be found in

68 69 70

71

See, e.g., Busse and Hefeker (2007). Kobrin (1979), p.67. See Guzman (1998). The idea of time inconsistency in government action goes back to Kydland and Prescott (1977). Guzman (1998) uses the expression dynamic inconsistency instead of time inconsistency. See, e.g., Williamson (1983).

J. P. Sasse, An Economic Analysis of Bilateral Investment Treaties, DOI 10.1007/ 978-3-8349-6185-3_3, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011

18

Economic and Legal Protection of FDI

Drazen (2002).72 In his example, a government has to choose a tax rate for a certain time period in the future. It can either decide on this tax rate immediately or it can wait until the relevant period arrives. "Time inconsistency is said to arise if, though nothing has changed (at least ostensibly), these choices are not equal (…)".73 From a gametheoretic point of view, the interaction with respect to international investment resembles a trust game.74 The problem of time inconsistency can in this way be presented as a game-theoretic problem of subgame-(im)perfection.75 The underlying logic can be illustrated in a simple sequential two-player game of complete information involving a representative multi-national enterprise (MNE) and a host country (HC). First, the MNE decides whether to invest or not. If no investment takes place, the payoff for both players is zero. If the investment takes place, the host country has two options: it can either accommodate or expropriate the investment.76 If the host country accommodates, both player receive their share of the cooperation gain: the MNE receives CM and the host state gains CH, where CH is a measure indicating how much a country can gain through FDI, be it through taxes or spillover effects, with CH ! 0 . Further, it is assumed that WH (with WH t 0 ) describes how much the investment is worth to the host state if expropriated.77 In that case, the remaining value of the investment to the investor (which is often negative and therefore rather a loss or damage) is defined as LM. Consequently, the extensive form of the game looks as follows:

72

73 74 75

76

77

See Drazen (2002), p.101f. The focus of Drazen (2002) is, however, on time inconsistency problems where governments use that phenomenon to increase social welfare by misleading their constituents. The focus of this book is, on the other hand, how time inconsistency can be avoided when it is anticipated by the economic agents. Drazen (2002), p.102. For an illustration of the trust game, see, e.g., Kirstein (1999), p.20 ff or Schmidtchen (1994). Time Consistency and Subgame Perfection are not identical concepts. First of all, the notion of time consistency is usually related to macro-economic issues, while subgame perfectness (or perfection) is a game theoretic expression. More importantly, subgame perfectness is a useful solution concept in numerous dynamic games that have no reference to time consistency. Nevertheless, for the exposition of time consistency in a game theoretic context, subgameperfectness seems to be the most practical way. The similarity between time consistency and subgame perfectness is also illuminated in McTaggart and Salant (1989) and explained in Rasmusen (2001), p.105. For a more game-theoretic reflection on Kydland and Prescott (1977), see Fudenberg and Tirole (1991), p.74ff. Please note that by expropriate, the judicial term implying the payment of compensation is not meant, but simply the appropriation of the assets of the investor/MNE. Yet, the use of the word appropriate or, alternatively, confiscate, could be equally misleading. Or how much the host country can win (thus WH) by taking the opportunistic action. The notation used here is in line with Dixit (2004), p.15.

Economic and Legal Protection of FDI

19

(0,0) Don't Invest

(CM,CH)

M Accommodate Invest H

Expropriate

(LM,WH)

Figure 3.1: Time Inconsistency

Notation CM

=

Cooperation gain for the MNE (profit)

CH

=

Cooperation gain for the host country (taxes, spillover, etc.)

LM

=

Loss for the MNE in case of expropriation (Loser's payoff)

WH

=

Value of the assets to the host country if expropriated (Winner's payoff)

Player There are two players: the host country (HC) and a representative investor or multinational enterprise (MNE) Strategies The game has two stages. In the first stage, the MNE decides whether to invest. When there is no investment, the game is over. In the case of investment, there is a second stage. The host country now must decide whether to accommodate or expropriate the investment. Payoffs In the case where no investment takes place, the payoff to both players is normalised to zero (second best opportunity). When the MNE invests and the host country accommodates, the MNE generates a profit of CM and the HC gains spillover and taxes of CH. In the case where the MNE invests and the HC expropriates, the MNE will incur damages LM and the HC an expropriation gain WH. In the baseline (no cooperation) case, we assume CM >0, LM CH.

20

Economic and Legal Protection of FDI

This kind of game is also known as the trust game, which is a one-sided version of a prisoner’s dilemma.78 Assuming rationality, the solution of this game can be derived straightforwardly using backwards induction. This solution concept requires starting the analysis at the final decision node or final stage of the game. At the second (and final) stage of the game, the host country must decide whether to accommodate or to expropriate. If WH < CH, that is, if the investment yields more payoff to the host state when it is in the hands of the MNE, the outcome is the cooperative outcome (Invest/Accommodate). However, in many cases, the assumption WH > CH appears to be more realistic. If that is the case, the host state will expropriate in the second stage. As rationality and complete information are assumed, the MNE will anticipate this and, if LM WH - XH, the hostage will induce cooperation between the players. Nevertheless, the main problem with hostages can also be demonstrated with a small modification of the game above. Remember that often, the hostage taker has no incentive to destroy the hostage because that may incur an additional cost or there may even be costs associated with keeping the hostage (these costs will be denoted as T as they can be understood as a form of transaction costs). In addition, the hostage has no or little value to the hostage taker. We can easily extend the game tree to include a third stage with the choice of the MNE between destroying or keeping the hostage and returning it:

95 96

Monaldi (2002), p.4. See also Monaldi (2001). The importance of hostages for economic transactions in general in the absence of legal remedies has especially been emphasised by Williamson (1983).

26

Economic and Legal Protection of FDI

(LM+ XM - T, WH-XH) Don't Invest

Keep

(0,0) M

M

Return

Accommodate

(CM, CH)

Invest H

(LM+ XM - T, WH-XH) Keep

Expropriate M

Return

(LM, WH)

Figure 3.2: Hostage-Mechanism

The game presented in figure 3.2 has an implicit assumption, namely that the hostage will be transferred at the time of investment. Further, we assume that the host country will expropriate retroactively if the MNE keeps or destroys the hostage despite prior accommodation of the HC.97 If keeping or destroying the hostage is indeed costly to the MNE while the value of the hostage itself is low, that is if XM - T 1-y, which is true for any value of y that is above 0.5, indicating that the tribunal has some ability to differentiate between the defective and the cooperative behaviour. The ruling of the tribunal will not only define the amount of compensation D, but also impose the reputational sanction R on the host country, as it is then verified by a third, expert party that the country has violated the terms of the BIT.301 This reputational sanction relates not only to investors, but also to other states who might refrain from cooperation (also in other areas of international law) in the future. 4.4.3.2.2

The Arbitration Decision

At the final stage of the game, the MNE will have to decide between initiating arbitration or keeping still. This stage of the game will only be reached if the MNE has invested in the first round. The decision of the MNE to file for arbitration depends on the behaviour of the host state in the preceding round. Therefore, we have to differentiate between two cases:

300 301

Guzman (2008b), p.185. Unless the proceedings were not held in private. See chapter 7 on this issue.

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The Economics of BITs

Case 1: HC accommodated in Case 2: HC expropriated in the prior round the prior round The MNE will C + (1-y)D-T > C M M initiate rearranges to arbitration if: T < (1-y)D

LM + yD-T > LM rearranges to T < yD

The MNE will initiate arbitration if the cost of arbitration is smaller than the expected compensation payment of the arbitration award. The two conditions are straightforward. The decision to initiate arbitration depends on the possibility to prove the wrongdoing to the tribunal and the expected damage payments. The MNE does not care about the reputational losses of the HC. Equally, the payoff from the investment (LM or CM)is sunk at that point. It is simple to see that a low value of y may give room for opportunistic behaviour on the part of the MNE who might be tempted to initiate arbitration even if there was no defective HC-behaviour in the first place. If, however, the ability of the tribunal to differentiate between defective and cooperative behaviour is reasonably high, this case is rather unlikely. Depending on the payoffs of the MNE, we can identify three cases: (1) the MNE will always initiate arbitration: (1-y)D > T, (2) the MNE will only initiate arbitration if the HC expropriates (but not otherwise): yD > T > (1-y)D (3) the MNE will never initiate arbitration: T > yD. A theoretical fourth case is that the MNE would only initiate arbitration when the HC accommodates but not otherwise. This can be ruled out as y > (1-y) which implies that T < (1-y)D and T > yD cannot both be true. 4.4.3.2.3

The Expropriation Decision

Again, reaching this stage of the game presupposes that the MNE has invested in the first round. The decision of the host country then depends on the subsequent choice of the MNE. The HC will anticipate the behaviour of the MNE in the subsequent stage and adapt his strategy accordingly. The three possible cases are summarised in the following table (the assumption y>(1-y) holds):

The Economics of BITs

91

Case 2: MNE will Case 1: MNE will Case 3: MNE will only initiate always initiate never initiate arbitration if the HC arbitration arbitration expropriates CH -(1-y)(R+D)-T < CH < WH -y(R+D)-T HC will WH -y(R+D)-T expropriate rearranges to rearranges to if WH - CH > (2y- WH - CH > y(R+D)+T 1)(R+D)

CH < WH

Starting with case 3: obviously, if the MNE will never initiate arbitrations, the game is practically similar to the basic trust game and the HC will, in a one-shot setting, expropriate as long as CH < WH. With regard to case 1, we can see that the HC will expropriate if the expropriation value is high compared to the cooperation payoff. The assumption y > (1-y) ensures that the higher the sanction (R+D), the smaller the incentive to expropriate. Equally, with growing ability of the tribunal to detect the uncooperative behaviour, the incentive to expropriate naturally declines. However, it has been mentioned in the previous section that the prerequisite for this case, namely (1-y)D > T, is unlikely to be true. Clearly, the interesting case for our purpose is case 2 where T takes an intermediate value. Only if the cost of the BIT can counterbalance the difference in payoffs between defection and cooperation (WH - CH ) will the BIT be able to serve as a commitment device. This will be true for high values of y, high reputational costs (R) or damages (D) and also high litigation costs (T). Noteworthy, at the same time, high litigation costs will diminish the incentive of the MNE to seek arbitration in the first place. 4.4.3.2.4

The Investment Decision

The investment decision marks the first stage of the discussed model and relates to the crucial question: when can the BIT induce the MNE to invest? As before, the subsequent choices of the players shape the strategy of the MNE in the first round (including the choices of the MNE itself). Remember that the payoff in the case where no investment takes place is normalised to zero. The choice to invest may be followed by the HC to expropriate or to accommodate, which may, in turn, be followed by the binary choice to seek arbitration or not. This leaves four cases to look at:

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The Economics of BITs

MNE keeps still and

MNE seeks arbitration and

Case 1: HC Case 2: HC Case 3: HC Case 4: HC accommodates expropriates accommodates expropriates MNE invests if

CM>0

LM>0

CM+(1-y)D-T>0

LM+yD-T>0

By assumption, we have LM < 0, which rules out case 2. Consequently, the MNE will either invest if the host country does not expropriate or if the remedy D compensates for the losses despite litigation costs. 4.4.3.3

Equilibria

First, one point must be remembered that has been neglected in the preceding sections: the fact that concluding the BIT itself is associated with costs. These costs consist mainly of negotiations and the ratification process. Only if the existence of the BIT has a positive impact on the investment decision of the MNE will a host country ever bother to incur these costs. Therefore, we are interested in the equilibria where the MNE actually invests. Four of these investment equilibria (also exemplified by the final nods in figure 4.1) exist and without making any assumptions on the values of the variables, each of these final nodes is a possible equilibrium of the game. Yet, if the assumptions of the baseline game are used, the equilibrium relating to the strategy set (invest, expropriate, keep still) can be eliminated. If the remedies of the BIT are not used, the HC will not have to adapt its behaviour. Therefore, the situation is identical to the baseline game – consequently, this cannot be an equilibrium of the game as long as LM < 0. Put differently, if the MNE would prefer keeping still despite expropriation, the HC would anticipate this and expropriate. This, in turn, would be anticipated by the MNE leading to no investment in the first place. If this is the case and the conclusion of a BIT is associated with costs, the HC never has an incentive to conclude a BIT. The remaining three equilibria cannot be ruled out in a similar fashion. However, two of these equilibria include the use of arbitration and require strong assumptions. First, the equilibrium relating to (invest, accommodate, arbitrate) presupposes that the MNE has a high chance of success even if there was no uncooperative behaviour by the HC in the first place (T< (1-y)D). This is certainly possible and may sometimes be the case in reality, but certainly does not reflect the intentions when concluding a BIT. Second, the equilibrium based on (invest, expropriate, arbitrate) presumes that the MNE would invest knowing that there will be expropriation, which will be the case if LM+yD-T>0. Especially as LM0). On the other hand,

330 331

Sauvé and Zampetti (2007), p.215. One might think of the sovereignty costs as discussed in section 4.4.1. Nevertheless, the MNE does not care about the costs to the host country, but about the arbitration (expropriation risk). This will of course be lower when the sovereignty costs are low – in that sense, the two aspects are closely related.

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The Economics of BITs

the unreliable type will expropriate and thereby expose itself to high arbitration risk. It will have to face reputational costs, pay legal fees and may be forced to pay compensation. The assumption is therefore BR < BU.332 Obviously, the arbitration risk will also depend on the amount of investment covered by the BIT in question, meaning that, for example, a BIT with a major capital-exporting country like Germany may have a bigger effect on BU than a BIT with a small, non capital-exporting country. If there is no investment and no BIT is in force, payoffs for all parties are zero. If there is no investment and a BIT is in force, the MNE has a payoff of zero, while both the reliable and the unreliable type must carry the cost of concluding the BIT. If there is investment and no BIT in force, payoffs correspond to the baseline game (see section 3.1.1) with CH for the reliable type and WH for the unreliable type. In that case, the MNE receives CM if he is facing a reliable type and LM if he is facing the unreliable type (as before LM BR

110

4.4.4.5

The Economics of BITs

Equilibria

As the MNE cannot observe the type of the host country, but can observe the action the host country takes, the reliable type might use BITs as a signal. Three types of equilibria are possible: separating, semi-separating and pooling equilibria. In the separating equilibria, the optimal strategies of the reliable and the unreliable type differ. Typically, the reliable type will sign a BIT and the unreliable type will not sign a BIT. In a semi-separating equilibrium, at least one type uses mixed strategies. In pooling equilibria, both types will take the same action, that is, both will either sign a BIT or refrain from doing so. Depending on the parameter specifications, all of these equilibria are possible. Therefore, it appears reasonable to make further assumptions on the feasible and realistic parameter space. First, the existence of many BITs can be observed in reality. If the signalling model has any explanatory power, a pooling equilibrium where nobody signs BITs can be ruled out. Such an equilibrium exists, inter alia, when the expected payoff of the MNE is positive despite the absence of a BIT – the MNE would invest in any case. Consequently, and considering that a BIT creates costs for both types of HC, no HC would ever bother to sign a BIT. This is exactly the case when T CM  (1  T ) LM ! 0 . This equation will be especially true when the probability of facing an unreliable type is very low. In the following, it is assumed therefore that T CM  (1  T ) LM  0 . Put differently, in the absence of a BIT, the MNE will not invest. Yet, as CM>0 and LM