A BIT (sorry) More on ISDs

A nice discussion of my article with SBD at The National Interest has taken place in comments at the International Economic Law and Policy Blog, mostly centering on the question of investor-state dispute (ISD) clauses in trade deals. A bit wonkish (okay very wonkish), but potentially very important as well.

Mark Kantor, who is affiliated with Georgetown and Columbia Universities, has disagreed with our take on ISDs, which is that a US-EU trade deal could precipitate a general decline in their usage. He raises some very good points; you should read them. He may very well be correct. (Although he's wrong to say that we don't take into account recent US and EU ISD behaviors, including the inclusion of ISDs in the model BITs of the US and EU; in fact we mention that specifically.)

But I'm not quite ready to give up our claim just yet. Via Nathan Jensen, here's a recent report in Columbia FDI Perspectives by Joachim Karl of UNCTAD demonstrating, among other things, the increased costliness to governments (including those of developed economies) of ISDs. One highlight:

Governments face a dilemma. While many governments consider ISDS a key element of international investment protection, ISDS is becoming increasingly risky. For one, governments’ risk of being sued by foreign investors is growing. Second, when a dispute arises, the defence requires enormous resources; if a case is lost, damages can be very high. Third, governments live with an unpredictable arbitration practice without having the legal safety net of an appellate body like in the WTO. Fourth, complex domestic legal issues reaching beyond international investment law are examined by international arbitrators. Fifth, as more disputes are directed against countries with highly developed domestic judicial systems, governments need to ask themselves how positive discrimination of foreign investors in respect of ISDS can be justified.

Karl notes that many countries are in something of a holding patterns regarding ISDs: not ready to do away with them, but not exactly expressing enthusiasm for them either. He also notes that the US is one of the leaders in restrictions to and regulations of ISDs. As such, if the US decides to de-emphasize ISDs it could provide momentum for a more general movement in that direction. the Here's part of the crux:

Overall, the existing ISDS system is no longer recognized as an indispensable core part of IIAs. Discontent is not limited to a few developing countries, but has spread to G-20 countries, including some of the BRICs. Further momentum could jeopardize the ISDS system as a whole.

We suggest that, for political reasons, a US-EU FTA/BIT could be part of that momentum if it excludes an ISD, and there are good reasons to believe that it might. In fact, that is our argument.

We could be wrong, but it's nice to know that we're not the only ones thinking along these lines.

What Might a US-EU FTA Mean for International Investment Treaties?

In a previous post, Will discussed how a potential US-EU free trade agreement might effect widespread trade liberalization through inclusive institutions such as the UN. Indeed, many commentators are wary of the possible deal, believing it to signal the end of inclusive negotiations that characterize the WTO (though Will provides a nice counter to such alarmist claims).

A ratified US-EU FTA also has the capacity to change international investment law quite fundamentally. At stake is whether an agreement would have an investor-state dispute clause (ISD). Unlike traditional dispute settlement mechanisms, ISDs allow firms to sue states directly, usually within the context of an international arbital board such as the International Centre for the Settlement of Investment Disputes (ICSID). ISDs are controversial primarily because there is a widespread fear that MNC with deep pockets will engage in litigation wars of attrition. Furthermore, when investors can sue states directly, governments no longer have access to diplomatic tools to smooth over disputes. And, to the extent that the long term viability of open goods and capital markets requires some flexibility to deal with domestic push-back, the removal of states as arbiters of which investment disputes are worth pursuing and which are better left ignored could have lasting negative implications for the political viability of economic openness.

Unlike some other aspects of FTAs, ISDs can actually become salient issues. In South Korea there were a series of protests against the ISD provision of the recently ratified US-South Korea FTA. Other countries, including India, South Africa, and Australia, have recently decided to nullify portions of trade and investment treaties that include ISD provisions. Still, ISDs are widespread. The model US Bilateral Investment Treaty includes an ISD provision and ISD clauses are standard in US FTAs. However, the types of treaties that contain ISD clauses tend to be signed between states characterized by economic asymmetries.* BITs are a prime example - while over 2000 such treaties exist, there are no BITs between two advanced industrial economies.

So, the question then is whether a US-EU FTA agreement will include an ISD clause. Generally, advanced industrial countries have shown they are more interested in promoting legal regimes that protect "their" MNEs while less willing to cede jurisdiction over investment disputes in which they might be a defendant. For instance, Australia has decided to drop ISD clauses from its BIT and FTA regime after it was sued by Philip Morris; Philip Morris used Australia's BIT with Hong Kong to establish ICSID jurisdiction. Given growing dissatisfaction with the costs of ISD, it will be interesting to see if such clauses would persist if the US and EU decide to not subject themselves to such extra-territorial juridical measures.

My quick, speculative take is that ISDs will be less widely used in the future. As advanced industrial economies begin to receive more FDI from emerging economies with which they have such dispute clauses, they will seek to extract themselves from such agreements. Moreover, a movement away from ISDs may be a good thing. First, ISDs tend to create duplicated layers of juridical authority that generate confusion. Second, as mentioned above, ISDs make it harder for governments to intercede in investor-state disputes in ways that allow for flexibility necessary to maintain broad coalitions of support for deep economic integration. Finally, there is some evidence that states with ISDs tend not to pursue meaningful domestic legal reforms, and thus ISDs can contribute to the persistence of partial economic reforms that ultimately impede broad-based growth.** Removing ISDs may help overcome some of these problems.

*An important semi-exception is that NAFTA includes ISD provisions. However, this clause remains quite controversial in Canada. Canada has not yet ratified the ICSID convention, reiterating the extent to which countries are quite resistant to ceding final arbital authority to an international tribunal. Additionally, the US-Australia FTA suggests, but does not require, dispute settlements between investors and states.
** A place to start reading about this: Ginsburg, Tom (2005) "International Substitutes for Domestic Institutions: Bilateral Investment Treaties and Governance" International Review of Law and Economics 25:107-123.

FDI Undeterred: Argentina's Messy Investment Climate

Argentina's investment policies certainly have been in the news recently. In this past Monday's (Dec 17) WTO Dispute Settlement Body's meeting, the US, EU, and Japan requested an establishment of a dispute panel against Argentina. Concurrently, Argentina sought to establish dispute panels against the EU (Spain in particular) and the US. Australia and Turkey lodged a formal complaint that Argentina was trying to use the DSB for inappropriate purposes. (See more here)

For more context, the Kirshner government wrested control of YPL from Spanish energy giant Repsol this past May. In the ensuing fall out, Repsol sued the Argentine government in a U.S. court, President Obama revoked Argentina's preferential trade privileges, and Repsol filed arbitration paperwork at ICSID earlier this month. No one is too confident that Repsol is going to recoup any of its $10 billion investment, especially since Argentina probably hasn't paid out a single arbitorial award. Spain is also threatening to sanction Argentina and Repsol has publically stated it will seek damages from any corporation that subsequently enters production and exploration agreements with YPL.

Standard political theories of foreign direct investment rest on a central insight from obsolescing bargaining (OBM) - FDI is limited by the political risk that firms face when they sink investment in a foreign jurisdiction, thus becoming "captive" to a potentially predatory state that faces incentives to promise contract sanctity ex ante and then renege on these promises ex post. From this perspective, no multinational should want to invest in Argentina - the risk of expropriation is just too high. Tools designed to mitigate the problems associated with time inconsistency of preferences just are not working in the Argentinian case (i.e. - Argentina is not compensating firms for contract breach, despite rulings against it). Yet, my weekly update from the Economist Intelligence Unit includes a discussion about how large oil multinationals are rushing to invest in Patagonia's shale deposits. Multiple oil giants are in contract negotiations with the Argentine government to undertake production sharing agreements with the newly nationalized YPL. And, they are doing this despite Repsol's threat to go after these private corporations for damages associated with nationalization.

So, what is the standard OBM missing? Of course, firms have to care about many things besides political risk. Economic factors are the primary drivers of investment decisions; political considerations are largely secondary. In this context, big countries with large domestic markets and with rich endowments of lucrative natural resources typically can get away with a lot of things small countries without energy reserves cannot. This economic/geographic argument underpins Rachel Wellhausen's recent post on the permissive environment for Argentina's nationalistic investment policies. And, understanding the economic factors that provide governments' more bargaining power vis-a-vie investors certainly explains much of the deviation away from what OBM-based theories predict.

But, I think there is something else we need to consider - how firm and investment characteristics modify OBM dynamics. Some of my current research considers how firms are heterogenous in both the amount of political risk they will accept and how they define political risk. What do I mean by this? First, firm characteristics matter for how risk acceptant they will be. Some of the most interesting current work on FDI focuses on explaining these systematic variations. Daniel Blake argues multinationals view their subsidiaries as a portfolio of potential revenue streams, and within this holistic management conception, MNEs might be willing to sustain losses in one location as part of a larger strategy of gaining market share. Ben Graham argues that firms can learn how to manage political risk, and that some firms are uniquely positioned to manage such risks and therefore may specialize in locating in high risk countries. Together, both of these arguments fit nicely with EIU’s assertion that large oil companies are willing to take large bets in Argentina’s shale fields despite threats of nationalization. Indeed, such threats may benefit large energy multinationals because small firms are less able to manage these risks, depressing acquisition prices. This is an important point because it indicates that certain multinational firms will actually benefit from nationalistic policies!

While a bit further afield from the Argentine case, I also argue firms vary in how exposed they are to the threat of government interference. Firms that enter countries through privatization of utilities and infrastructure as well as firms that engage in resource extraction on government land are more vulnerable to government interference than are manufacturing firms. Right now, I'm working on a project that shows that bilateral investment treaties (treaties specifically designed to overcome OBM problems) have differential effects on different modes of entry for FDI. The point here is that BITs may help attract FDI for privatization much more than FDI for private sector M&As or greenfield investment. Since there is some evidence that mode of entry matters for contributions to economic growth, this insight has important investment and development policy implications.

FDI, Regulation, and Shifting Power Centers: China and Rio Tinto

On July 5th, without warning or explanation, Chinese officials arrested four Rio Tinto employees, one of them an executive and Australian citizen.  Later, China's state run media reported the arrests were connected with allegations that Rio Tinto obtained confidential documents revealing China's bargaining strategy for negotiating iron ore prices with the multinational mining firm.  Australian officials are particularly concerned since the detainees were given no access to outside communication and Chinese officials did not divulge any information about their whereabouts or the charges they face to Rio Tinto or the Australian government.

The ensuing diplomatic breakdown between China and Australia illustrates two points about the nature of foreign direct investment (FDI) today.

1) Power asymmetries are shifting.  

Most academic work on FDI treats developed (read OECD) countries as price makers and developing countries as price takers.  In other words, highly developed countries act on behalf of their multinationals by securing legal protection for multinationals' FDI in other countries.  This is mainly done through the use of Bilateral Investment Treaties (BITs).  The literature treats developing countries (China included) as grateful for whatever FDI they can get, and therefore willing to submit to OECD standards of legal protection for businesses.  

The problem with this view is that FDI sourcing patterns are shifting.  As the Chinese economy can support regional trade and FDI growth as well as export FDI to Africa and elsewhere, China doesn't need to cower to western demands for business protection.  Indeed, China never really has.  

Bottom line: predictions of convergence towards one standard of FDI legal protections depends upon the preferred regulatory level of key players.  China's rise underscores the possibility of multiple and competing regulatory regimes.

2)  The link between home country and multinational must be tested:

The focus on regulatory regimes like BITs assumes that home countries act as agents for their multinationals and that home countries discriminate against multinationals based on the multinational's home countries.  Talk that the recent events in China will lead to a backlash against Chinese multinationals looking to directly invest abroad depends upon the idea that countries will retaliate against Chinese-owned firms as well as the Chinese government.  And, the Chinese experience is an easy test of this link because many Chinese firms are in part owned by the Chinese government.  It is not entirely clear that this link holds more generally or consistently.