FDI, Investment Agreements & Development: Myths & Realities

23/05/2016
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This article by the South Centre’s Chief Economist briefly explains the myths and realities of foreign direct investment (FDI). It then analyses how a country’s investment policy is being constrained by rules in the WTO and in the bilateral investment treaties (BITs).

 

Foreign Direct Investment and Development

 

Foreign direct investment (FDI) is perhaps one of the most ambiguous and least understood concepts in international economics. Common debate on FDI is confounded by several myths regarding its nature and impact on capital accumulation, technological progress, industrialization and growth in emerging and developing economies (EDEs). It is often portrayed as a long-term, stable, cross-border flow of capital that adds to productive capacity, helps meet balance-of-payments shortfalls, transfers technology and management skills, and links domestic firms with wider global markets.

 

However, none of these are intrinsic qualities of FDI. First, FDI is more about transfer and exercise of control than movement of capital. Contrary to widespread perception, it does not always involve flows of financial capital (movements of funds through foreign exchange markets) or real capital (imports of machinery and equipment for the installation of productive capacity). A large proportion of FDI does not entail cross-border capital flows but is financed from incomes generated on the existing stock of investment in host countries. Equity and loans from parent companies account for a relatively small part of recorded FDI and an even smaller part of total foreign assets controlled by transnational corporations (TNCs). In 2008, retained earnings constituted 60% of outward FDI stock for non-bank affiliates of US non-bank corporations. In the same year, total assets controlled by US affiliates were 8.6 times the net external finance from US sources. Globally, in 2011, retained earnings accounted for 30% of total FDI flows. In the same year, half of the earnings on FDI stock in EDEs were retained, financing about 40% of total inward FDI in these economies. Thus, the notion that FDI is functionally indistinguishable from fresh capital inflows and represents a flow of foreign resources crossing the borders of two countries has no validity.

 

Second, an important part of FDI involves transfer of ownership of existing firms. Only the so-called greenfield investment makes a direct contribution to productive capacity and involves cross-border movement of capital goods. But it is not easy to identify from reported statistics what proportion of FDI consists of such investment. In particular, statistics provide almost no information on how retained earnings and loans from parent companies, two of the three sources of finance for FDI, are used. Furthermore, even when FDI is in bricks and mortar, it may not add to aggregate investment because it may crowd out domestic investors, as shown by most studies on the effects of FDI on domestic investment.  Evidence also shows widespread association between rising FDI and falling gross fixed capital formation (GFCF) in the developing world. All these suggest that the economic conditions that attract foreign enterprises may not always be conducive to faster capital formation and that the two sets of investment decisions may be driven by different considerations.

 

Third, what is commonly known and reported as FDI contains speculative components and creates destabilizing impulses which need to be controlled and managed as any other form of international capital flows.  Many of the changes in financial markets that have facilitated international capital movements have not only increased the mobility of FDI, but also made it difficult to assess its stability. FDI inflows to EDEs are subject to boom-bust cycles and closely correlated with non-FDI (portfolio) flows as they are also influenced by global liquidity conditions and risk appetite. Surges in FDI inflows could generate unsustainable currency appreciations in much the same way as surges in other forms of capital inflows.  FDI in property is often motivated by speculative capital gains and subject to severe bubble-and-bust cycles.  More importantly, financial transactions can accomplish a reversal of FDI.  What may get recorded as portfolio outflows may well be outflows of FDI in disguise: a foreign affiliate can borrow in the host country in order to export capital. Furthermore, foreign banks established in EDEs can be a major source of financial instability.  They tend to contribute to build-up of fragility in host countries and transmit shocks from home countries, as seen during the eurozone crisis.

 

Fourth, the immediate contribution of FDI to the balance of payments may be positive, since it is only partly absorbed by imports of capital goods required to install production capacity.  But its longer-term impact is often negative because of profit remittances and the high import content of production and exports by foreign firms. Many countries with a long history of involvement with TNCs face negative net transfers on FDI; that is, their new FDI inflows fall short of profit remittances on the stock of inward FDI.  Again, in a large majority of EDEs, export earnings by foreign companies do not cover their import bills and profit remittances.  This is true even in countries highly successful in attracting export-oriented FDI such as China.

 

Finally, superior technology and management skills of TNCs create an opportunity for the diffusion of technology and ideas. However, spillovers are not automatic but need to be extracted through policy guidance and interventions. Foreign firms invest in EDEs in order to exploit their existing competitive advantages such as rich natural resources and cheap labour and infrastructure services rather than to move them up on the technological ladder. TNCs resist passing their technological and managerial know-how to host countries since these give them a competitive edge.  The high productivity and competition they bring could help improve the efficiency of local firms, but these can also block entry of these firms into high-value product lines or drive them out of business. They can prevent rather than promote infant-industry learning unless local firms are supported and protected by deliberate policies. They may help EDEs integrate into global production networks, but participation in such networks also carries the risk of getting locked into low-value-added activities.

 

To sum up, contrary to what is maintained by the dominant corporate ideology, FDI is not a recipe for rapid and sustained growth and industrialization in EDEs. However, this does not mean that FDI does not offer any benefits to EDEs.  Rather, policy in host countries plays a key role in determining the impact of FDI on industrialization and development.  A laissez-faire approach could not yield much benefit. It may in fact do more harm than good.  Successful examples are found not necessarily among EDEs that attracted more FDI, but among those which used it in the context of national industrial policy designed to shape the evolution of specific industries through interventions. In this respect the experience of successful late industrializers, notably in East Asia, yields a number of policy lessons:

 

  • Encourage greenfield investment but be selective in terms of sectors and technology;
  • Encourage joint ventures rather than wholly foreign-owned affiliates in order to accelerate learning and limit foreign control;
  • Allow mergers and acquisitions (M&A) only if there are significant benefits in terms of managerial skills and follow-up investment;
  • Do not use FDI as a way of meeting balance-of-payments shortfalls.  The long-term impact of FDI on external payments is often negative even in EDEs attracting export-oriented firms;
  • Debt financing may be preferable to equity financing when there are no significant positive spillovers from FDI;
  • FDI contains speculative components and generates destabilizing impulses which need to be controlled and managed as any other form of international capital flows;
  • No incentives should be provided to FDI without securing reciprocity in benefits for industrialization and development;
  • Performance requirements may be needed to secure positive spillovers including employment and training of local labour, local procurement, domestic content, export targets and links with local firms;
  • Domestic firms should be nurtured to compete with TNCs;
  • Linking to international production networks organized by TNCs is not a recipe for industrialization.  It could trap the economy in the lower ends of the value-chain.

 

Multilateral and Bilateral Constraints on Investment Policy

 

The experience strongly suggests that policy interventions would be necessary to contain adverse effects of FDI on stability, balance of payments, capital accumulation and industrial development and to activate its potential benefits. Still, the past two decades have seen a rapid liberalization of FDI regimes and erosion of policy space in EDEs vis-à-vis TNCs. This is partly due to the commitments undertaken in the World Trade Organization (WTO) as part of the Agreement on Trade-Related Investment Measures (TRIMs). However, many of the more serious constraints are in practice self-inflicted through unilateral liberalization or bilateral investment treaties (BITs) signed with more advanced economies (AEs) – a process that appears to be going ahead with full force, with the universe of investment agreements reaching 3,262 at the end of 2014 (UNCTAD IPM, 2015). Although there is considerable diversity in the obligations contained in various BITs, the constraints they entail are becoming increasingly tighter than those imposed by the WTO regime.

 

There are two main sources of WTO disciplines on investment-related policies: the Agreement on TRIMs and specific commitments made in the context of the General Agreement on Trade in Services (GATS) negotiations for commercial presence of foreign enterprises (the so-called mode 3) in the services sectors. In addition to these, a number of other agreements provide disciplines, directly or indirectly, on investment-related policies, such as the prohibition of investment subsidies linked to export performance in the Agreement on Subsidies and Countervailing Measures.

 

The TRIMs Agreement does not refer to foreign investment as such but to investment generally. It effectively prohibits attaching conditions to investment in violation of the national treatment principle or quantitative restrictions in the context of investment measures. The most important provisions relate to prohibition of domestic content requirements whereby an investor is compelled or provided an incentive to use domestically produced rather than imported products, and of foreign trade or foreign exchange balancing requirements linking imports by an investor to its export earnings or to foreign exchange inflows attributable to investment. By contrast, in TRIMs or the WTO more broadly, there are no disciplines restricting beggar-my-neighbour investment incentives by recipient countries that are just as trade-distorting.  Such incentives provide an effective subsidy to foreign investors and can influence investment and trade flows as much as domestic content requirements or export subsidies, particularly since a growing proportion of world trade is taking place among firms linked through international production networks controlled by TNCs (Kumar, 2002).

 

The obligations under TRIMs may not affect very much the countries rich in natural resources, notably minerals, in their earlier stages of development.  FDI in mineral resources is generally capital-intensive and countries at such stages depend almost fully on foreign technology and know-how in extractive industries and lack capital good industries.  Linkages with domestic industries are usually weak and output is almost fully exported. Domestic content of production by foreign companies is mainly limited to labour and some intermediate inputs. The main challenge is how to promote local processing to increase domestic value-added. However, over time, restrictions over domestic content requirements can reinforce the “resource curse syndrome” as the country wants to nourish resource-based industries, to transfer technology to local firms and establish backward and forward linkages with them.

 

Domestic content requirements are particularly important for investment in manufacturing in countries at intermediate stages of industrialization, notably in automotive and electronics industries – the two key sectors where they were successfully applied in East Asia.  Most industries of EDEs linked to international production networks have high import content in technology-intensive parts and components while their domestic value-added mainly consists of wages paid to local workers. Raising domestic content would not only improve the balance of payments but also constitute an important step in industrial upgrading. Restrictions over domestic content requirements would thus limit transfer of technology and import-substitution in industries linked to international production networks.

 

However, TRIMs provisions leave certain flexibilities that could allow EDEs to make room to move in order to increase benefits from FDI. First, the domestic content of industrial production by TNCs is not independent of the tariff regime. Other things being equal, low tariffs and high duty drawbacks encourage high import content.  Thus, it should be possible to use tariffs as a substitute for quantity restrictions over imports by TNCs when they are unbound in the WTO or bound at sufficiently high levels. Similarly, in resource-rich countries, export taxes can be used to discourage exports of unprocessed minerals and agricultural commodities as long as they continue to remain unrestricted by the WTO regime.

 

Second, as long as there are no commitments for unrestricted market access to foreign investors, the constraints imposed by the TRIMs Agreement could be overcome by tying the entry of foreign investors to the production of particular goods. For instance, a foreign enterprise may be issued a licence for an automotive assembly plant only if it simultaneously establishes a plant to produce engines, gearboxes or electronic components used in cars. Similarly, licences for a computer assembly plant can be tied to the establishment of a plant for producing integrated circuits and chips. Such measures would raise domestic value-added and net export earnings of TNCs and would not contravene the provisions of the TRIMs Agreement.

 

Third, export performance requirements can be used without linking them to imports by investors as part of entry conditions for foreign enterprises. This would not contravene the TRIMs Agreement since it would not be restricting trade (Bora, 2002, p. 177).  Finally, the TRIMs regime does not restrict governments in demanding joint ventures with local enterprises or local ownership of a certain proportion of the equity of foreign enterprises. In reality, many of these conditions appear to be used widely by industrial countries in one form or another (Weiss, 2005).

 

Since the TRIMs Agreement applies only to trade in goods, local procurement of services such as banking, insurance and transport can also be set as part of entry conditions of foreign firms in order to help develop national capabilities in services sectors. This would be possible as long as EDEs continue to have discretion in regulating access of TNCs to services sectors. The existing GATS regime provides considerable flexibility in this respect, including for performance requirements. However, the kind of changes in the modalities of GATS sought by AEs, including the prohibition of pre-establishment conditions and the application of national treatment, could shrink policy space in EDEs a lot more than the TRIMs Agreement.

 

The constraints exerted by most BITs signed in recent years on policy options in host countries go well beyond the TRIMs Agreement because of wide-ranging provisions in favour of investors. These include broad definitions of investment and investor, free transfer of capital, rights to establishment, the national treatment and the most-favoured-nation (MFN) clauses, fair and equitable treatment, protection from direct and indirect expropriation and prohibition of performance requirements (Bernasconi-Osterwalder et al., 2012). Furthermore, the reach of BITs has extended rapidly thanks to the use of the so-called Special Purpose Entities (SPEs) which allow TNCs from countries without a BIT with the destination country to make the investment through an affiliate incorporated in a third-party state with a BIT with the destination country. Many BITs also provide unrestricted arbitration, freeing foreign investors from the obligation of having to exhaust local legal remedies in disputes with host countries before seeking international arbitration. This, together with lack of clarity in treaty provisions, has resulted in the emergence of arbitral tribunals as lawmakers in international investment. These tend to provide expansive interpretations of investment provisions, thereby constraining policy further and inflicting costs on host countries (Bernasconi-Osterwalder et al., 2012; Eberhardt and Olivet, 2012;  UNCTAD TDR, 2014).

 

Only a few EDEs signing such BITs with AEs have significant outward FDI.  Therefore, in the large majority of cases there is no reciprocity in deriving benefits from the rights and protection granted to foreign investors. Rather, most EDEs sign them on expectations that they would attract more FDI by providing foreign investors guarantees and protection, thereby accelerating growth and development. However, there is no clear evidence that BITs have a strong impact on the direction of FDI inflows. More importantly, these agreements are generally incompatible with the principal objectives of signing them because they constrain the ability of host countries to pursue policies needed to derive their full potential benefits.

 

While in TRIMs investment is a production-based concept, BITs generally incorporate an asset-based concept of investment whether the assets owned by the investor are used for the production of goods and services, or simply held with the prospect of income and/or capital gain. This is largely because BITs are fashioned by corporate perspectives even though they are signed among governments. Typically, agreements are prepared by the home countries of TNCs and offered to EDEs for signature.  The coverage of BITs includes a broad range of tangible and intangible assets such as fixed-income claims, portfolio equities, financial derivatives, intellectual property rights and business concessions as well as FDI as officially defined by the Organisation for Economic Co-operation and Development (OECD) and the International Monetary Fund (IMF). This implies that all kinds of assets owned by foreigners could claim the same protection and guarantees independent of their nature and contribution to stability and growth in host countries.

 

It also opens the door to mission creep. Investment agreements may be granted jurisdiction by tribunals over a variety of areas that have nothing to do with FDI proper, further circumscribing the policy options of host countries. Indeed, the expansive scope of investment protection in the North American Free Trade Agreement (NAFTA) has already given rise to claims that patents are a form of investment and hence should be protected as any other capital asset, thereby threatening the flexibilities left in the Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS) and access to medicines (Correa, 2013). Similarly, there have been claims by Argentinian bond holders that such holdings should be protected as any other investment under the Italy-Argentina BIT, thereby intervening with the restructuring of sovereign debt (Gallagher, 2012).

 

The combination of expansive interpretations of investment and “free transfer of capital” provisions of BITs seriously exposes host EDEs to financial instability by precluding controls over destabilizing capital flows. This is also recognized by the IMF.  In its Institutional View on the Liberalization and Management of Capital Flows, the IMF (2012) notes that “numerous bilateral and regional trade agreements and investment treaties … include provisions that give rise to obligations on capital flows” (para. 8) and “do not take into account macroeconomic and financial stability” (para. 65) and “do not allow for the introduction of restrictions on capital outflows in the event of a balance of payments crisis and also effectively limit the ability of signatories to impose controls on inflows” (Note 1, Annex III).  The Fund points out that these provisions may conflict with its recommendation on the use of capital controls and asks for its Institutional View to be taken into account in the drafting of such agreements.

 

Although the IMF’s Institutional View focuses mainly on regulating capital inflows to prevent build-up of financial fragility, prohibitions in BITs regarding restrictions over outflows can also become a major handicap in crisis management. It is now widely agreed that countries facing an external financial crisis due to an interruption of their access to international capital markets, a sudden stop of capital inflows and rapid depletion of reserves could need temporary debt standstills and exchange controls in order to prevent a financial meltdown (Akyüz, 2014). However, such measures could be illegal under “free transfer of capital” provisions of BITs.

 

Where rights of establishment are granted, the flexibilities in the TRIMs Agreement regarding entry requirements noted above would simply disappear. The national treatment clause in BITs requires host countries to treat foreign investors no less favourably than their own national investors and hence prevents them from protecting and supporting infant industries against mature TNCs and nourishing domestic firms to compete with foreign affiliates. It brings greater restrictions  than  national  treatment  in TRIMs because it would apply not to goods traded by investors but to the investor and the investment.

 

Further, provisions on expropriation and fair and equitable treatment give considerable leverage to foreign affiliates in challenging changes in tax and regulatory standards and demanding compensation. In particular, the concept of indirect expropriation has led states to worry about their ability to regulate. The fair and equitable treatment obligation has also been interpreted expansively by some tribunals to include the right of investors to a stable and predictable business environment.

 

The large majority of outstanding BITs do not make any reference to performance requirements of the kind discussed above, but a growing number of them signed in recent years incorporate explicit prohibitions (Nikièma, 2014). Some BITs go beyond TRIMs and bring additional prohibitions for performance requirements both at pre- and post-establishment phases. Others simply refer to TRIMs without additional restrictions. Still, this narrows the ability of governments to move within the WTO regime because it allows investors to challenge the TRIMs-compatibility of host-country actions outside the WTO system. This multiplies the risk of disputes that host countries can face since corporations are much more inclined to resort to investor-state arbitration than the states do in the WTO system.  The MFN clause could entail even greater loss of policy autonomy in all these areas, including performance requirements, by allowing foreign investors to invoke more favourable rights and protection granted to foreign investors in agreements with third-party countries.

 

While investment agreements entail a considerable loss of policy autonomy, they do not appear to be serving the intended purpose and accelerating the kind of FDI inflows sought by policy makers in host countries. Evidence suggests that BITs are neither necessary nor sufficient to bring significant amounts of FDI. Most EDEs are now wide open to TNCs from AEs through unilateral liberalization or BITs or free trade agreements (FTAs), but only a few are getting FDI with significant developmental benefits and most of these countries have no BITs with major AEs. Econometric studies on the impact of BITs on FDI flows are highly ambivalent. While a few studies contend that BITs affect FDI flows, they do not examine whether BITs have led to the kind of FDI inflows that add to industrial dynamism in host countries. The majority of empirical studies find no link between the two (UNCTAD, 2009, Annex and UNCTAD TDR, 2014, Annex to Chapter VI).  Similarly, survey data show that the providers of political risk or in-house counsel in large US corporations on investment decisions do not pay much attention to BITs (Yackee, 2010).

 

Conclusion

 

Policy space in several key areas affecting the contribution of FDI to the pace and pattern of industrialization might be somewhat constrained by the WTO Agreement on TRIMs, but it is still possible for EDEs to encourage positive spillovers without violating the WTO commitments. However, many of the more serious constraints are in practice self-inflicted through investment and free trade agreements. There are strong reasons for EDEs to avoid negotiating the kind of BITs promoted by AEs. They need to turn attention to improving their underlying economic fundamentals rather than pinning their hopes on BITs in attracting FDI. Where commitments undertaken in existing BITs seriously impair their ability to use FDI for industrialization and development, they can be renegotiated or terminated, as is being done by some EDEs, even if doing so may entail some immediate costs.

 

 

- Yılmaz Akyüz is the chief economist of the South Centre.

 

This article is based on South Centre Research Paper 63 entitled “Foreign Direct Investment, Investment Agreements and Economic Development: Myths and Realities”, available at http://www.southcentre.int/research-paper-63-october-2015/.

 

 

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