Tài liệu An Economic Analysis of Bilateral Investment Treaties pdf

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.. The most import

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 schaftlichen Folgewirkungen und bedient sich dabei des methodischen Instru-mentariums der Wirtschaftswissenschaften, insbesondere der Mikroökonomie, der Neuen Institutionen- und Konstitutionenökonomie Sie ist ein interdisziplinäresForschungsgebiet, in dem sowohl Rechtswissenschaftler als auch Wirtschafts-wissenschaftler tätig sind und das zu wesentlichen neuen Erkenntnissen über Funktion und Wirkungen von Rechtsnormen geführt hat

gesell-Die Schriftenreihe enthält Monographien zu verschiedenen Rechtsgebieten und Rechtsentwicklungen Sie behandelt Fragestellungen aus den Bereichen Wirt-schaftsrecht, Vertragsrecht, Haftungsrecht, Sachenrecht und verwaltungsrecht-liche 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 Nationalbibliografi e; detailed bibliographic data are available in the Internet at http://dnb.d-nb.de

Dissertation Universität Hamburg, 2010

1st Edition 2011

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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, Hans-Bernd 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 Müller-Langer, 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 FDIPROTECTION 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

XII 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 FDIPROTECTION 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

XIV Detailed Contents

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

A PPENDIX A 205

A PPENDIX B 207

A PPENDIX C 211

A PPENDIX 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

DSB Dispute Settlement Body (World Trade Organization) EBIT Earnings Before Interest and Taxes

FCN Treaty of Friendship, Commerce and Navigation

FDI Foreign Direct Investment

FET Fair and Equitable Treatment

FPI Foreign Portfolio Investment

GATS General Agreement on Trade in Services

GATT General Agreement on Tariffs and Trade

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

NAFTA North American Free Trade Agreement

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

TRIMS Trade-Related Investment Measures

TRIPS Agreement on Trade-Related Aspects of Intellectual Property

Rights

UNCITRAL United Nations Commission on International Trade Law

UNCTAD United Nations Conference on Trade and Development

VCLT Vienna Convention on the Law of Treaties

WGI World Governance Indicators

List of Variables

C M = Cooperation gain for the MNE (profit)

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

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

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

 = Discount rate of the host country

D = Damages/Compensation

 = Probability that the host country is reliable

q 2 = 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

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

B U = 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 UNCTAD (2009a), p.xix and p 251

2 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

3

World Bank (2007), p.314

4 See UNCTAD (2010), p xvii

J P Sasse, An Economic Analysis of Bilateral Investment Treaties,

DOI 10.1007/ 978-3-8349-6185-3_ ,

© Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011

1

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

rationalist-institutionalist 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 A notable exception is international trade law

6 See e.g., Cooter and Ulen (2004), Shavell (2004) or, for a short comparison of contracts and

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

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

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

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

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

Foreign Direct Investment 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

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, south-south 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

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.32The 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

32 Hennart (2001), p.133

33

Hennart (2001), p.145

34 Hennart (2001), p.136

10 Foreign Direct Investment product for free) If patent systems cannot guarantee the property rights of the know-how, 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

Hennart (2001), p.139

36 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 Ethier and Markusen (1996), p.2

38

See Dunning and Lundan (2008) for the description of the OLI paradigm

39 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

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

Foreign Direct Investment 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

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

Foreign Direct Investment 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

For a short overview, see Meyer (2004), p.269ff

62 See, e.g., Aitken and Harrison (1999)