How NOT to boost foreign investment

Ana Palacio, former Spanish foreign minister and former Secretary General of the International Centre for Settlement of Investment Disputes (ICSID), recently wrote a Project Syndicate op-ed on “How to Boost Foreign Investment” that inspired, well provoked, me to write this response.

Ms. Palacio argues that we can observe two diverging trends: on the one hand, increasing foreign direct investments (FDI) from emerging countries such as Brazil, India and China are supposed to increase the support for strengthening the global system of investment protection. On the other hand, she laments, a number of states lose interest in the system, especially its dispute-resolution dimension. She especially draws attention to the effect that Argentina’s refusal to adhere to the various ICSID rulings against its handling of the financial crisis in 2001 and 2002 had on ICSID as an institution. Argentina’s example, she argues, inspired a number of other Latin American states to leave the system.

Ms. Palacio is not alone in her demand for institutional reforms of the current investor-state dispute settlement (ISDS) system. She pictures the World Trade Organization’s Dispute Settlement Mechanism – and especially its permanent Appellate Body – as an example of where reforms of the ISDS system should be headed. Interestingly, she does not elaborate on the fact that in the WTO only states are allowed to bring claims against other states.

That is all well and good, and reforms of the ISDS system are indeed needed, but the main problem I have with this op-ed is that Ms. Palacio argues that a more effective ISDS system would be good for developing host countries:

“The unfortunate byproduct of this self-reinforcing cycle of non-compliance [by Argentina and other Latin American states] and delegitimation is damage to the global economy in general, and, in particular, to the developing countries that are most in need of foreign investment. These countries are being denied a useful tool for attracting FDI, with recent evidence suggesting that signing a BIT by itself does not lead to increased inflows.”

She went on arguing that:

“Reinforcing the ICSID is one of the biggest current challenges facing the World Bank and the international community. Without FDI, there cannot be development; and, without legal security, there will be no FDI. If we are to see truly global FDI flows, particularly to those countries that need them the most, we must begin to address the institutional deficiencies of the investment-protection regime.”

Notwithstanding my skepticism that more FDI will always be good for development and developing countries, is Ms. Palacio right in arguing that strong ISDS rules boost FDI flows?

The empirical evidence at hand does not support this strong claim. Early econometric studies, summarized in this UNCTAD report, on the relationship of investment treaties and FDI came up with a slightly positive assessment. These studies, however, treated investment treaties as rather uniform instruments, which they are evidently not. Two important differences relate to the strength of ISDS and market access provisions. More recent econometric analysis (see here and here) found that strong ISDS rules do not have a significant impact on FDI flows. In fact, in terms of FDI promotion it does not make a difference whether an investment treaty allows foreign investors the possibility to independently invoke his rights vis-à-vis the host state or not.

Other empirical studies (see here and here) found that market access provisions, on the hand, have a significant impact on FDI flows. Of course, drawing policy conclusions from econometric studies alone requires some caution. One conclusion, however, that can be drawn is that ever higher levels of procedural and substantive investment protection – the overriding logic that drove the conclusion of investment treaties in the last six decades – is not necessarily a good thing for developing host countries. In light of this evidence it should be welcomed that recently more and more treaties do include more balanced language that increases host countries’ policy space. With regard to the second trend, extending the coverage of investment treaties by including market access provisions, however, more empirical evidence is needed. In particular, in addition to econometric studies we need more fine-grained analysis of past experiences of investment liberalization on developing countries.

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