The Express Tribune - 24 May 2021
Investment treaties and FDI
By Hussain H Zaidi
A recurring question in contemporary economic literature is the relationship between bilateral investment treaties (BITs) and foreign investment.
Is it necessary for a country seeking foreign direct investment (FDI) to conclude BITs with capital exporting economies? What is the role of BITs in attracting FDI? What are their potential costs?
Such questions are exceedingly important for Pakistan as well for at least two reasons.
One, over the years Pakistan has concluded a large number of BITs, but received only meagre FDI inflows. Two, from time to time international tribunals have invoked provisions of some of those BITs to slap the country with hefty penalties.
A case in point is the 2019 $5.9 billion award by a tribunal of the International Centre for Settlement of Investment Disputes (ICSID) against Pakistan in the Reko Diq case.
Like any other treaty between sovereign states, a BIT is aimed at providing a stable and predictable environment for carrying out the activity concerned – in this case cross-border capital inflows – by creating legally binding rights and obligations on a reciprocal basis.
Most of the obligations are undertaken by the government of each party, while the rights are generally assumed by investors from each party. Such an arrangement seems logical, as investors putting their capital into another country need legally binding guarantees from the host government as to the safety and security of their investment, fair treatment, repatriation of profits and principal back to the home country, etc.
Since there must be a credible mechanism to enforce these rights and obligations, provisions for the settlement of investor-state disputes are an integral part of the BITs.
To examine whether a positive relationship exists between the number of BITs signed by a country and the inward FDI it has received, we may look at the economies with the largest number of BITs and those which are the major recipients of FDI.
According to ICSID, in terms of BITs signed Germany is the leader worldwide, with 160 such agreements, followed by Switzerland (134), China (128), the United Kingdom (117), the Czech Republic (113), France (112), the Netherlands (110), Egypt (109), Belgium-Luxembourg (100), Italy (100), Turkey (93), South Korea (87), India (85), Spain (79) and Finland (77).
In 2019, the last year before the Covid-19 pandemic struck the world and disrupted normal economic activity, the largest recipient of FDI was the US with inflows of $246 billion.
The other major FDI recipients were China ($141 billion), Singapore ($92 billion), the Netherlands ($84 billion), Ireland ($78 billion), Brazil ($72 billion), Hong Kong ($68 billion), the United Kingdom ($59 billion), India ($51 billion), Canada ($50 billion), Germany and Australia ($36 billion each), France ($34 billion), Mexico ($33 billion), Russia ($32 billion), Italy ($27 billion), Cyprus ($24 billion), Indonesia ($23 billion), Sweden ($21 billion) and Israel ($18 billion).
It is evident from the above data that some of the major recipients of FDI are also the leaders in signing the BITs. These include China, the Netherlands, the UK, Germany, France, Italy and India.
This suggests a correlation between the number of BITs signed by a country and its ability to attract large FDI inflows. However, from this it is difficult to infer that the BITs by themselves account for the large FDI inflows. It is even more difficult to establish a causal connection between the BITs and FDI inflows. This is for quite a few reasons:
One, several economies which are among the largest recipients of FDI don’t boast of having signed a corresponding number of BITs. Take, for instance, the US and Singapore.
Over the years, both countries have attracted great gobs of FDI. In 2019, the US and Singapore were the top and third largest recipients of FDI respectively. However, the US is party to only 58 BITs and Singapore has signed only 42 BITs.
Likewise, Ireland and Brazil were the fifth and sixth largest recipients of FDI respectively in 2019. However, Ireland has only one BIT to its credit, while Brazil is signatory to 14 such treaties. Secondly, the economies which are engaged in outbound FDI may be more in need of BITs than the FDI recipients. The former are eager to protect the interests of their enterprises which invest overseas.
BITs, since they create legally binding obligations for host states towards foreign investors, are arguably the most credible way to protect these interests. Now, the largest recipients of FDI are in most cases also the largest sources of FDI.
In 2019, for example, the top 20 sources of FDI (outbound FDI) in the descending order were Japan, USA, the Netherlands, China, Germany, Canada, Hong Kong, France, South Korea, Singapore, the UK, Italy, Spain, Sweden, Russia, Belgium, Ireland, Denmark, the UAE and Brazil.
Fourteen of those countries were also among the top 20 recipients of FDI. Out of the remaining six countries, South Korea, Belgium and Spain are among the top 20 signatories of BITs. This suggests that the outward FDI explains, at least in part, a large number of BITs signed by a capital exporting country.
Thirdly, factors other than the BITs can better account for a country’s ability to attract FDI. Market size, especially the presence of a large and growing middle class, as in the case of China, USA and Brazil, is one such factor.
However, the example of a small city-state like Singapore points out that size is not necessary for attracting FDI; skilled labour, top quality physical and commercial infrastructure, ease of doing business and overall investment climate are also important.
Cost of BITs
Not only are the BITs not necessary for attracting FDI, they have potential costs as well. A case in point is Pakistan, which is a signatory to 52 BITs, but has a rather poor record of attracting FDI.
BITs signed by Pakistan provide for international arbitration in case of a dispute between the state and foreign investors. As Pakistan is capital deficient, while its BIT partners are mostly capital abundant, it is the latter’s enterprises that mostly invest in Pakistan.
Therefore, the investor-state dispute provisions are almost always likely to be invoked by businesses from the capital abundant countries.
On the other hand, domestic stakeholders, by and large, lack the capacity to fulfil — and in some cases to even comprehend — the commitments undertaken in such treaties.
In Pakistan’s BITs, international arbitration generally takes the form of a tribunal of ICSID, which is a subsidiary of the World Bank Group. The ICSID system tends to favour foreign investors over host countries, especially when they fall into the category of developing nations.
To conclude, the BITs are neither a necessary nor a sufficient condition for attracting FDI. They can at best complement the FDI-conducive domestic conditions. If at all, such treaties need to be negotiated adroitly so as to minimise their potential costs.
The writer is an Islamabad-based columnist