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Protecting foreign investment: implications of a WTO regime and policy options

Zed Books Ltd

Introduction

The context and objectives

Foreign direct investment (FDI) emerged as one of the most important aspects of cross-border economic activity over the 1990s. Compared to the total exports of goods and services of the order of US$7.4 trillion in 2001, the sales of affiliates of multinational enterprises (MNEs) totalled $18.5 trillion in 2002, while in 1990 sales of foreign affiliates were only marginally higher than those of global exports.

The expansion of FDI inflows generated the belief that the expanded inflows would help in filling up the resource, technology and foreign exchange gaps that constrain the process of development of poorer countries. Governments of developed and developing countries alike competed among themselves to attract more FDI inflows through policy liberalizations and incentives. However, FDI has been concentrated in developed countries and in a few developing countries. In addition, there has been increasing awareness of a wide variation in the quality of FDI. While some investments may bring to host countries valuable developmental gains and other favourable externalities (such as employment generation, diffusion of technology and expansion of exports), others may actually crowd out domestic investments and may be immiserizing. Hence governments have employed various policy measures such as screening mechanisms, performance requirements, incentives for diffusion of knowledge, and so on, to make the operations of foreign investors conform to the development policy goals of the host countries.

Recognizing the limitations of national policies and laws in regulating the operations of MNEs, the international community also launched several initiatives aimed at the regulation of different activities and practices of these enterprises. These include the United Nations Code of Conduct on Transnational Corporations, the UNCTAD International Code of Conduct on Transfer of Technology, the Multilaterally Agreed Set of Principles for Control of Restrictive Business Practices, the ILO's Declaration on Multinational Enterprises and Social Policy and the OECD's Code on Multinational Enterprises, among others.

Given that the bulk of the FDI flows originate in developed countries and developing countries are mostly at the receiving end, there has been a North–South divide on the investment issue. Developed countries have striven to secure favourable conditions for investment by their enterprises worldwide, by seeking the liberalization of investment regimes through bilateral and multilateral negotiations. They have resisted the attempts of developing countries to evolve binding codes of conduct of MNEs within the UNCTC and UNCTAD framework. Furthermore, they have strategically used the multilateral trade negotiations to create a more favourable framework for FDI worldwide even though investment is more a development issue than a trade issue. Thus, despite the resistance of developing countries, the Final Act of the Uruguay Round of the GATT included an Agreement on Trade-Related Investment Measures (TRIMs). The Agreement requires member countries to phase out performance requirements relating to trade, such as local content requirements and foreign exchange neutrality. The General Agreement on Trade in Services (GATS) provided a framework for liberalization of trade in services including through cross-border commercial presence, which is akin to FDI. The TRIMs Agreement also provided for a review within five years of the operation of the Agreement and to 'consider whether the Agreement should be complemented with provisions on investment policy and competition policy'.

The industrialized countries have made a number of attempts to widen the scope of the multilateral regime on investment beyond what is covered in the Agreements on TRIMs and GATS (viz. commercial presence as a mode of delivery of services). These attempts include an initiative to negotiate a Multilateral Agreement on Investment (MAI) launched in 1995 under the aegis of the OECD, an attempt that failed. Since the First Ministerial Conference of the WTO at Singapore in 1996, the industrialized countries have pushed to bring a more comprehensive agreement on investment than TRIMs on to the WTO agenda. The Singapore Ministerial Conference decided to establish a WTO Working Group on Trade and Investment (WGTI). The Fourth Ministerial Conference of the WTO, held in November 2001 in Doha, resolved to launch negotiations on trade and investment after the Fifth Ministerial Conference, subject to an explicit consensus at that conference.

As a result, investment has emerged as one of the most contentious issues in the WTO negotiations. Developing countries fear that a multilateral framework on investment negotiated within the single undertaking of WTO will curtail their ability to regulate the operations of foreign enterprises in tune with their development policy objectives, and hence that it will not serve their interests. They would also like to understand the implications of such a framework for their development more fully before deciding to undertake negotiations in such a critical area. The developed countries, on the other hand, are persisting in their demand for a multilateral framework, which they see as important for securing 'transparent, stable and predictable conditions for cross-border investments'.

In this context, the Fifth Ministerial Conference of the WTO, scheduled to be held in September 2003 in Cancun, Mexico, is going to be of critical importance. The developing countries will have to debate the various pros and cons of a possible multilateral framework so as to evolve their position for a ministerial conference. They will also have to examine their position on different elements of a multilateral framework, should a negotiating mandate be granted by the Cancun Conference.

Against this backdrop, this book discusses various issues concerning the involvement of the WTO in the area of investment, overviews the literature on the developmental implications of a possible multilateral framework and discusses various options open to developing countries in this area. It also provides reflections on different elements of a possible multilateral framework on investment, should the negotiating mandate be given by the ministerial conference.

The chapter layout

The subject matter of the book is divided into four parts. Part I deals with FDI and its impact on development, Chapter 2 examines host country policies and Chapter 3 the international framework dealing with FDI. Part II deals with the WTO's TRIMs Agreement. Chapter 4 introduces the TRIMs Agreement, the negotiating history, its scope and coverage and its main provisions. Chapter 5 discusses the implications of the TRIMs Agreement for developing countries. It also presents a way forward for developing countries for the review of the Agreement in the light of the evidence on its impact.

Part III deals with a possible multilateral framework on investment. Chapter 6 discusses the OECD's attempt to evolve a Multilateral Agreement on Investment (MAI). Chapter 7 examines the case for a multilateral framework on investment in the WTO from a development perspective. It finds that developing countries are not likely to benefit significantly from such a framework, and that building a consensus would also be difficult, in view of the OECD's experience with MAI negotiations.

Finally, Chapter 8 in Part IV discusses various options for developing countries. It discusses four alternative positions that developing countries could adopt depending upon the circumstances of the negotiating process.

Foreign direct investment, host government policy and development

§ Foreign direct investment (FDI) inflows have increasingly engaged the attention of national policy-makers as well as the international negotiators over the past decade. The rapid growth of the magnitudes of FDI over the past decade has generated optimism among the developing countries about not only solving their resource scarcities with greater inflows but also getting along with them other critical resources for development such as entrepreneurship, technology, organizational capability and, sometimes, even market access. Therefore, most developing countries have liberalized their policy regimes governing FDI and have attracted them with incentives and other preferences. However, FDI inflows have been highly concentrated in the high- and middle-income countries. Furthermore, there is a great variation in their quality. Hence their developmental impact has varied across countries quite widely. This chapter summarizes some broad trends and patterns in FDI flows and reviews the literature on their developmental impact, to serve as a background to the analysis of other chapters of the book. The structure of the chapter is as follows: the first section summarizes the trends and patterns in FDI inflows and highlights the North–South dimension. The second section presents a selective review of literature on the developmental impact of FDI. The fourth section overviews the various aspects of policy that the governments of developed and developing countries have employed to improve the developmental impact of FDI inflows. The final section outlines some implications for policy.

Trends and patterns in FDI inflows and the North–South divide

FDI flows expanded at an unprecedented rate during the 1990s to become the most visible and prominent manifestation of the increasing global integration of economic activity. Compared to the average annual growth of trade in goods and services of about 6–7 per cent over the 1990s, FDI inflows grew at an average annual rate of 20 per cent over 1991–95 and at 32 per cent during 1996–2000 despite the economic crisis in some important regions of the world. As a result, the magnitude of global FDI inflows increased from US$159 billion in 1991 to $1.27 trillion in 2000 (Table 1.1).

To a large extent, the recent growth of FDI flows has been fuelled by cross-border mergers and acquisitions (M&As) in North America and Europe as a part of an ongoing wave of industrial restructuring and consolidation. However, FDI has become an increasingly important channel of market servicing as a part of the trend of globalization. Table 2.2 shows that sales of foreign affiliates of corporations were roughly of the same order ($2 trillion) as world exports in 1982. By 2000, the affiliate sales had grown to more than double the world exports at $15.7 trillion compared to world exports of $7 trillion.

The bulk of FDI flows originate in developed countries and developing countries are on the receiving end most of the time. Table 2.3 shows that the top ten industrially and technologically most advanced countries account for as much as 74 per cent of FDI outflows. Therefore, the North–South divide is quite prominent in the case of investment.

The North–South divide becomes apparent from the positions adopted by developed countries at the international negotiations concerning investment. Keeping in mind the increasing importance of FDI as a channel of servicing the markets, a favourable international framework for FDI is seen by developed countries as furthering their commercial interests and national competitiveness. Therefore, developed country governments identify themselves with the investors and have tended to protect their interests at these negotiations, as is observed in Chapter 3. It will be seen that developed countries have resisted initiatives of the UN system evolving binding Codes of Conduct on corporations in the 1980s and have, on the other hand, been seeking to evolve an international regime guaranteeing an unfettered movement for their corporations through multilateral trade negotiations.

FDI Inflows to developing countries

FDI inflows are expected to be less volatile and non-debt-creating. They are also expected to be accompanied by a number of other assets that are valuable for development, such as technology, organizational skills, and sometimes even market access, among others. Hence, most countries – developed as well as developing – compete among themselves in attracting FDI inflows with increasingly liberal policy regimes and incentive packages. However, the expansion of the magnitude of FDI over the 1990s has benefited only a handful of developing countries, as is clear from the following summary of emerging trends and patterns.

FDI inflows received by developing countries expanded from under US$42 billion in 1991 to $240 billion in 2000. The growth of FDI inflows in developing countries seem to have been slower than that of global inflows, especially in the late 1990s (see Figure 2.1).

The share of developing countries in FDI inflows rose sharply during the early 1990s from 26 per cent in 1991 to over 40 per cent in 1994. Since then it has steadily declined to below 24 per cent in 2000 (see Figure 2.2). The sharp rise in the share of developing countries in the early 1990s was largely owing to the emergence of China as the most important host of FDI in the developing world.

1. Growing marginalization of poorer countries

The shares of different regions also tend to mask the inter-country variations in the relative importance as hosts of FDI. FDI inflows are highly concentrated in a handful of high- and middle-income countries. Low-income and least developed countries remain marginalized in the distribution of FDI inflows. The share of 45 least developed countries as a group in global FDI inflows is negligible at half a per cent and it shows a declining trend over the 1991–2000 period (see Figure 2.3). Just ten most important hosts of FDI among developing countries account for over 80 per cent of all inflows received by developing countries in 2000. The concentration in the top ten recipients increased from 66 per cent in the mid-1980s to over 80 per cent in the late 1990s.

2. Prospects for expansion of FDI inflows to low-income and least developed countries

The expanding magnitudes of FDI inflows tend to create optimism among poorer countries regarding the potential of these inflows for expediting the process of their development. However, the 1990s saw an even greater concentration of these flows among a handful of high- and middle-income countries.

A recent study of the determinants of inter-country variation in the FDI penetration in the host countries, made in the framework of an extended model of the location of foreign production in a three-dimensional setting, found that factors such as country size, level of income or development, and extent of urbanization affect a country's ability to attract globalized production from MNEs (Kumar 2000). The elasticities of these factors' effect on FDI inflows are greater than one, suggesting that size and income levels impact on FDI inflows more than proportionately. The availability of better infrastructure adds to the attractiveness of a country to MNEs. A competitive advantage of developing countries based on availability of low-cost labour is inadequate to prompt MNEs to locate there. The study also finds the role of geographical and cultural proximity between home and the host countries to be important in encouraging intensive investment links. Hence relatively smaller, poorer and agrarian countries have their limitations in tapping the resources of MNEs for their industrialization. Therefore, policy liberalization alone is not adequate for attracting MNEs to invest in poorer countries (Kumar 2002).

Developmental impact of FDI on the host economies: a selective review of the literature

FDI usually flows as a bundle of resources including, besides capital, production technology, organizational and managerial skills, marketing know-how, and even market access through the marketing networks of multinational enterprises (MNEs) that undertake FDI. These skills tend to spill over to domestic enterprises in the host country. Therefore, FDI can be expected to contribute to growth more than proportionately compared to domestic investments in the host country. There is now a body of literature that has analysed the effect of FDI on growth in inter-country framework and another analysing knowledge spillovers to domestic enterprises from MNEs (see e.g. De Melo 1997; Kumar and Siddharthan 1997; and Saggi 2000 for recent reviews of the literature). However, the mixed findings reached by these studies on the role of FDI inflows in host country growth and on knowledge spillovers from MNEs suggest that these relationships are not unequivocal. The primary consideration for expecting a more favourable effect of FDI on growth is the externalities of MNE entry for domestic firms. Externalities such as knowledge spillovers may not take place in some cases because of poor linkages with the domestic enterprises or poor absorptive capacity, for instance. FDI projects vary in terms of generation of linkages for domestic enterprises. There is also a possibility of MNE entry affecting domestic enterprises adversely given the market power of their proprietary assets such as superior technology, appeal of brand names and aggressive marketing techniques. Therefore, FDI may crowd out domestic investment and may thus be immiserizing (Fry 1992; Agosin and Mayer 2000). The crowding out effect may be sharper when the technology gap to be bridged between foreign and domestic firms is very wide. Furthermore, because FDI may be attracted to a country by high growth rates, among other factors, the observed relationships between FDI and growth rate may suffer from causality problems.

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Excerpted from Protecting foreign investment: implications of a WTO regime and policy options by Carlos Correa, Nagesh Kumar. Copyright © 2003 Carlos Correa and Nagesh Kumar. Excerpted by permission of Zed Books Ltd.
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