trade and development report, 2014

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Chapter VI

INTERNATIONAL FINANCE AND POLICy SPACE

International Finance and Policy Space 121

Tobefullyeffective,policiesaimedatstructuraltransformationrequireafavourablemacroeconomicframework.Thismeanseconomicpolicymustaimtokeepthekeymacroeconomicprices(interestrates,wagesandexchangerates)atlevelsthatfavourrobustcapitalaccumulation,domesticmarketgrowthandtradecompetitiveness.Macroeconomicpolicymustalso avoid excessive instability or unsustainabledomesticandexternalimbalances.inalltheseareas,international finance can play an important, butsometimesdisruptive, role. indeed, foreigncapitalinflows, dependingon their size and composition,mayincreaseorreduceeconomicpolicy’sroomformanoeuvreand,moregenerally,supportorunder-minegrowthanddevelopment.

Regardingsize,neitherextremescarcitynoranoverabundanceofforeigncapitalcontributespositivelytopolicyspace.ontheonehand,scarcitymayrestrictthevolumeofimportsofgoodsthatareessentialforspeeding up the development process, in particularcapitalgoods thatcannotbeproduceddomestically,to the extent that such imports cannot befinancedby current export earnings.A shortage of externalfinancingmay therefore hamper policies aimed atsupportingGDPgrowth,investmentanddiversifica-tion.ontheotherhand,anoverabundanceofforeigncapital inflows usually generates financial bubbles,

currency appreciation, current account deficits andrisingindebtednessofdomesticagents.Thesedevel-opmentsalsoaffectpolicyspace,astheyweakenthelikely impact ofmonetary and credit policies andtheregulationofkeymacroeconomicprices.intheabsenceofcapitalaccountmanagement,thesituationin developing and transition economies that haveaccesstointernationalfinancialmarkets(andarethusalsoexposedtothevagariesofthosemarkets)tendstooscillatefromoneextremetotheother:overabun-danceleadstotheaccumulationofexternalliabilities,followedbysuddenstopsorevenreversalsofcapitalinflows,possiblyprecipitatingafinancialcrisis,whichinturnisfollowedbyaperiodofcapitalscarcity.

economiesareparticularlyvulnerabletofinan-cialinstabilitywheninternationalcapitalflowsaremainly of a short-termnature.Unlike the foreigncapitalthatisusedinfixedcapitalformation,1short-termflowsarenormallyusedfortheacquisitionoffinancialassets,realestateinvestmentsorconsump-tion credit, directly or through the intermediationofdomesticfinancialsystems.Suchflowsarepar-ticularlypronetoboom-and-bustcycles,dependingmainlyoneventsinthemoredevelopedeconomies.They exacerbate the fragility and vulnerability ofdomesticfinancialsystemsandleadtounsustainablecurrentaccountdeficits.

Chapter VI

INTERNATIONAL FINANCE AND POLICy SPACE

A. Introduction

Trade and Development Report, 2014122

indeed,excessiveexposuretoexternalcapitalflowsand the fact that in largepart theywerenotoriented to productive usesweremajor factors inthebuild-upofeconomiccrisesindevelopingandemergingeconomiesinthepastfewdecades,begin-ningwith the latinAmerican debt crises in the1980s.Thesewere not only balance-of-paymentsandbankingcrises;theywerealsofiscalcrises,asgovernmentsthemselvesresortedtoexternalborrow-ingand,inaddition,feltcompelledtobailoutprivatedebtorsandsocializetheir losses(Díaz-Alejandro,1985).Asaresult, theirfiscalpolicyspaceshrankdramatically as governments had to service theirexternal debtwhile economic recessiondepressedfiscal revenues and access to private credit driedout.insuchasituation,theonlyremainingsourcesofcreditsupplywereofficialinstitutions(mainlythebrettonWoodsinstitutions),whichimposedpolicyconditionalitiesontheirlendingthatplacedthewholeburdenofadjustmentonwhatthenbecamedebtorcountries,andfurtheralteredthesecountries’policyspace.Thisexperiencehasbeenrecentlyreplicatedbysomedevelopedcountriesthatwereseverelyhitbytheglobalfinancialcrisisthatstartedin2007-2008.

Partly as a reaction to thesenegative experi-ences,authoritiesinanumberofdevelopingcountrieshave tried to reduce their dependence on foreigncapital.Theyhavesoughttoavoidcurrentaccountdeficitsandreducetheirexternaldebts,andmanyofthemhavesignificantlyincreasedtheirinternationalreservesinordertolessentheirexternalvulnerability.Someof themhave been particularly reluctant toreturntoiMF-ledadjustmentprogrammes.

Therefore, there is a strong case for govern-mentstomanagecapitalflowsbyseekingtoinfluencenotonlytheamountofforeigncapitalmovements,butalsotheircompositionanduse.Suchapragmaticandselectiveapproachtocapitalflows,ratherthanunrestrictedopennessoracompleteban,couldhelpmaximizepolicyspacewithinagivendevelopmentstrategyandgivenexistinginternationalinstitutionalarrangements.Thischapterexaminespossiblewaysforapplyingneededpoliciesinthecontextoffinan-cialglobalization,aswellasvariousobstaclestosuchpolicies(seealsochapterV).2

Constraints on the ability of governments tointroduceproactivepoliciescanbeeitherdefactoordejure.Defactorestrictionsoncapitalmanagementrefertopressuresfromexistingandpotentiallenders

and investors.Theymaydeemacountry’s capitalcontrolmeasures as detrimental to the “businessclimate”, andmay therefore reduceor threaten towithdrawcapitalflowstothatdestination.Theriskofthishappeningmaydetergovernmentsfromapplyingcapitalmanagementmeasures,butthiscouldincreasethe symmetric riskofexcessive short-termcapitalinflowsaswellassuddenoutflows.

De jure obstaclesstemfrommultilaterallyorbilaterallyagreedrulesthatforbidorlimitaresorttocapitalmanagementmeasures.Forinstance,countriesjoiningtheoeCDortheeUcommittomaintainingopencapitalaccountstoothermembers,andwithinvarious regional trade agreements countries oftenpledgetoliberalizetradeinfinancialservices.

overthepast25years,alargenumberofcoun-trieshavesignedinternationalinvestmentagreements(iiAs), either in the formof bilateral investmenttreaties(biTs)orasan“investmentchapter”ofanRTA. Such agreements provide for special treat-mentofforeigninvestors,whichtendstoreducethepolicyspaceoftheparticipatinggovernments.Akeycomponentofthoseagreementsisthe“investor-Statedispute settlement” (iSDS)mechanism,wherebynational governments accept the jurisdiction offoreign arbitration centres on issues thatmightdirectlyor indirectlyaffect theprofitabilityoffor-eigninvestmentsandtherightsofforeigninvestorsunderprovisionsoftheiiAs.Suchmechanismshaveallowedinternationalinvestorstosuegovernmentsandobtainmonetarycompensationforpolicymeas-uresthat,inonewayoranother,allegedlyaffectedtheprofitabilityofthosefirms.Someofthesemeasuresconsistofregulationsdirectlyrelatedtothepublicinterestor todevelopmentchoices, suchaspublichealth, environmental protection and the kinds ofenergysourcesacountryoptstoexploit.othersarerelated tomacroeconomicmanagement, includingexchangeratemanagementandrestructuringofthebankingsystemintimesofcrisis.

Thischapterisorganizedasfollows.Sectionbdiscusses the need for capitalmanagement andotherprudentialmeasurestoenablegovernmentstopreserve their policy space for conductingmacro-economic policies and pursuing their nationaldevelopmentstrategies. it reviews theexperiencesofdevelopingcountriesthatwereaffectedbyvolatilecapitalflowsbeforeandaftertheglobalfinancialcrisis.itthenanalysestheobstaclestocapitalmanagement


policiesandexamineswhichpoliciescountriescanstillapply–andinsomecasesareimplementing–inordertoavoidthepotentiallydisruptivemacroeco-nomic impact of capital flows and better channelthemtofinanceinvestmentanddevelopmentgoals.SectionC addresses the challenges iiAs pose togovernments,whichfaceatrade-offbetweenwhattheybelieveisawayofencouraginginwardforeigninvestmentwhilepreservingtheirsovereignty ina

numberofstrategicareas.itexaminesinwhatwaysandtowhatextenttheseagreementshavereducedthepolicyspaceofgovernmentsseekingtoimple-mentproactiveindustrialpolicies,andthuspossiblyunderminingthedevelopmentcontributionofforeigninvestmentflows.Finally,itconsiderssomeofthealternativeapproachescurrentlybeingdiscussedbypolicymakersindevelopingcountriestoaddresstheseriousshortcomingsofiiAs.

1. Capital flows and their impact on macroeconomic policy space

Thetraditionalviewonhowopennesstocapitalflowsaffectsmacroeconomicmanagementhasbeentermedthe“impossibletrinity”or“trilemma”,fol-lowingRobertMundell,accordingtowhichacountrycannothaveanopencapitalaccount,afixedexchangerateandmonetarysovereigntyatthesametime.Forinstance,withcapitalaccountopennessandafixedexchangerate,thecentralbankwouldloseitsabilitytodeterminethemoneysupply,becauseanexpan-sionarymonetarypolicywouldtendtolowerinterestrates.Thiswouldcausecapitaloutflows,andthere-forereduceinternationalreservesandthemonetarybase,hencecancellingtheinitialmonetaryexpansion.Thesamemechanismswouldworktheotherwaytocompensateforacontractionarymonetarypolicy.

However, the reality is oftenmore shaded,ascountriesdonotopt foreithercompletecapitalopenness or a totallyfixed exchange rate, nor docentralbanksaimatfullautonomy,andtherecannotbecompletelyclosedcapitalaccountsintheeraofglobalization.Hence,therealchallengeseemstobehowtoflexiblymanagethecapitalaccountandotherpolicy variables in order to generate a favourablemacroeconomicframeworkforgrowthandstructuralchange at a timewhen the volume andpattern of

internationalcapitalflowsexceeds thecapacityofmostcountriestoabsorbthemproductively.

Thissectionexamineshowtherapidopeningupofdevelopingcountries to internationalcapitalflowssincethelate1970shasaffectedtheirabilitytoconducttheirmacroeconomicpoliciesintwomajorways.onechannelconsistsofthedirectimpactthatcapitalmovementshaveonkeymacroeconomicvari-ables,suchasexchangerates,monetaryaggregatesandinterestrates,whichinturnaffecttheavailabilityandcostofdomesticcredit,assetprices,andcon-sumptionandinvestmentdecisions.Theotherhastodowiththegreaterleverageofthemaininternationalfinancialagentsoneconomicpolicydecisions.Thisisbecausepolicymakersfrequentlyhavetotakeintoconsiderationtheagenda,perceptionsandinterestsofforeigninvestorsintheformulationoftheirmacro-economic policies, since the portfolio decisionsof those investorsmay have a significant impactoneconomicgrowthand the stabilityofdomesticfinancialsystems.

(a) Impactofcapitalflowsonmacroeconomicvariables

Giventhesizeofaccumulatedglobalfinancialassets, the impact on a country’smacroeconomicstabilityofevenmarginalchangesinitsinternational

B. capital management in an era of globalized finance


capitalflows canbehuge (Haldane, 2011).Theseflows tend to follow a global financial cycle, inwhich “push factors” in thedeveloped economieswherethemainsuppliersofinternationalcreditarebased havemore influence than country-specific“pull factors” (i.e. countries’ demand for credit)(Rey,2013).3indeed,almostallthemajor“waves”ofcapitalinflowsreceivedbydevelopingcountriessincethelate1970sweretriggeredbyexpansionarymonetarypolicies in developed countries (Akyüz,2012),andwereamplifiedbytheleveragecyclesofglobalbanks(brunoandShin,2013).buttheywerealsoinfluencedbyriskperceptionsinthedevelopedcountries’financialmarkets.Thosewaves usuallycame to an endwithmonetary tightening in thereservecurrencycountries.Thispatternwasrepeatedfollowingtheglobalfinancialcrisis.Moreover,thecapitalinflowsreceivedbydevelopingandemergingeconomieshave remained synchronized since thatcrisis(chart6.1).Afterthesharpflight-to-safetyofcapitalinlate2008,resultinginasignificantwith-drawalofforeignportfolioand“other”investmentsfromdeveloping countries, capital flows to thesecountriesrecovered−orevensurpassed−pre-crisislevels.Thiswasatatimewhendevelopedcountriesfollowedveryexpansionarymonetarypoliciesanddeveloping countries seemed to have successfullyrecoveredfromtheglobalcrisis.Alternatingepisodesoffinancialstrainandrestoredconfidenceindevel-opedcountries,despitecontinuedmonetaryeasing,mayexplainthefallincapitalflowstodevelopingcountries inmid-2011andtheirsubsequentrecov-ery one year later.Risk perceptions also changedsignificantly,due toanticipatedchanges inUnitedStatesmonetarypolicy,asreflectedinnewvolatilityofcapitalflowstodevelopingcountries.

Sincetheglobalfinancialcycleisdrivenmainlyby developed countries’ economic conditions anddecisions,thereisnoreasonforittobealignedwithdevelopingortransitioneconomies’macroeconomicconditions and financial needs. even though themajor developed countries that issue reserve cur-rencies have committed themselves to taking intoaccountanypossible repercussionsof theirpolicyactionsforothercountries,theirmonetaryauthori-tiesareessentiallyguidedbytheneedsoftheirowndomesticeconomies.Thiscanleadtoinconsistenciesbetween their goals and those of other countries.For instance, since the 2008 financial crisis, theUnitedStatesFederalReservehasbeenpursuinganextremelyexpansionarymonetarypolicytosupport

Chart 6.1

CAPITAL INFLOwS, 2007 Q1–2013 Q3(Billions of current dollars)

Source: UNCTAD secretariat calculations, based on IMF, Balance of Payments Statistics database.

Note: Capital inflows refer to portfolio and "other investment" flows (3-quarter moving average).

-3

-2

-1

0

1

2

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4

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Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

2007 2008 2009 2010 2011 2012 2013

South AfricaIndonesia

-15

-10

-5

0

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Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

2007 2008 2009 2010 2011 2012 2013

Brazil India

Mexico

Turkey


domesticactivity.Thispolicyhaseffectivelyledtolargecapitalflowstoanumberofemergingecono-mies,asaresultofwhichtheyhaveexperiencedadomestic credit boom and an unwanted currencyappreciation.Conversely,theprogressivereductionofmonetarysupportintheUnitedStatesmayleadtoafinancialshockinemergingeconomies resulting from areversalofcapitalflows,higherinterestratesandcreditattrition.

internationalcapitalflowsgenerally generate a financialcycleinthereceivingcountries.Capitalinflowstendtoresultinanincreaseindomesticbanks’creditsupply,afall in interest ratespreadsandanappreciationofdomesticassetsandtheexchangerate.Thisprovidesanewstimulusforincreasingdomes-ticcredit,astheeconomytendstogrowfasterandhigherassetpricesimprovethe(apparent)solvencyofborrowers.ontheotherhand,italsostimulatesnewcapitalinflows,includingintheformofcarrytrade.4but these effects of capital inflowsgreatlyincreasefinancialfragility,asgrowingindebtednessanddeterioratingcurrentaccountseventuallyleadtoareversalofthoseflowsand,possibly,afinancialcrisis.

in order to be able to create andmaintaindomesticmacroeconomic andfinancial conditionsthat are supportive togrowthand structural trans-formation,governmentsmusthaveattheirdisposalsuitablepolicyinstrumentstopreventorcopewiththeserecurrentshocks.Theymustbeabletofollowcountercyclicalfiscalandfinancialpolicies,includingthroughdiscretionaryfiscalspendingandadaptingbankleveragetomoderatecreditduringeconomicboomswhilepreventingdeleveragingduringdepres-sions.Theymustalsobeabletomaintain keyfinancial prices,such as interest rates and therealexchangerate,atlevelsthatpromoteproductiveinvestment,expanddomestic incomes anddemand, and increase exter-nal competitiveness.Thismayrequire active intervention bycentralbanksaswellascomplementarymacroeco-nomicmeasures,suchasanincomespolicy.

A combinationofmacroeconomic andfinan-cialpoliciescan formacoherent framework fora

catch-upgrowthstrategyandstructuraltransforma-tion.Suchpolicieswouldincludelowinterestrates,exchange ratemanagement aimed at fostering acompetitive economy, investment-oriented fiscalandfinancialpolicies,andanincomespolicyaimedatboostingdomesticdemand.Thesewouldneedto

be accompaniedbyprudentialpoliciesthatcanregulatecapi-talmovementsinordertolimitanyundesiredimpactstheymayhave onmacroeconomic vari-ables, such as those discussedabove.but such policies faceresistanceby thosewho arguethat financial liberalizationcontributestotheoptimization

of factor allocation.They stress that, in order topreventnegativefinancialshocksandmakefinanceworkfordevelopment,thekeyistogainandretaintheconfidenceoffinancialmarkets.

(b) Theconfidencegame

Followingcapitalaccountliberalizationandasuccessionofinternationalfinancialshockssincethe1980s,developingcountrieswereunderstrongpres-surefrominternationalfinancialinstitutionstoadoptconfidence-buildingpoliciesandstructuralreforms.Theybelievedthatsuchmeasureswouldcontributeto economic stability and help reduce the likeli-hoodofeconomiccrisescausedbyvolatileflows.Recommendedpoliciesincludedfiscalausterityandtheadoptionofcornersolutionsfortheirexchangerateregimes(i.e.eitherfullyfixedorfullyflexibleexchangerates),which,supposedly,couldwithstandspeculative attacks against a country’s currency.Accompanyingeconomicreformswereexpectedto

includeliberalizationofmarketsandprivatizationofbothStateassetsanddeliveryofessentialservices.

These recommendations,particularly influential duringthe1990s,werecloselylinkedto a broader set of adjustment

measuresthatinternationalfinancialinstitutionshadbeen recommending since the external debt crisisof the 1980s (TDR 2006, chap. ii).Theproposedpoliciesandreformswerebasedonanunderstand-ingthatfreemarketsensureanefficientallocation

The global financial cycle is driven mainly by developed countries’ policy decisions guided by the needs of their own domestic economies …

… thus, such a cycle is not necessarily aligned with developing or transition economies’ financial needs.


of resources, thereby leading toboth stability andgrowth.Therefore, itwassuggested thatcountriesshould implementmeasureswhichwoulddemon-strate to financialmarkets that theywere optingfor “credible” policies. Such confidence-buildingwiththosemarketswouldattractcontinuouscapitalinflows and help prevent a full-blown economiccrisis. Playing this “confidencegame” (Krugman,1998)forcedpolicymakersintoguessingwhichpoli-ciesfinancialmarketagentswouldjudgetobegoodfor addressing specific economic conditions, evenifthesemaynotbeconsideredthemostsuitablebythepolicymakersthemselvesandbyanon-negligiblenumberofeconomists.

Amajorprobleminplayingthisgameisthatmarketactors’perceptionsofadevelopingcountry’spoliciesandeconomicconditions,andassessmentsoftheirsustainability,arefrequentlyinfluencedbytheir ideologicalbelief inself-correctingfinancialmarketsandtheirdisapprovalofpublicinter-vention, such as regulation ofthefinancialsystemandcoun-tercyclicalpolicymeasures.inaddition, their perceptions canchangeveryrapidly,evenifnochangeinsuchpoliciesandcon-ditionshasactuallytakenplace.5Theresultofthesechangingper-ceptionshasbeenthat,intimesof economic turbulence in international financialmarkets,countriesfaceagreatdealofuncertaintyastowhetheradoptionof“credible”policychoiceswouldbeeffectiveornotinmitigatingmajorturbu-lenceeffectsontheireconomiesand,ultimately,inavoidinganeconomiccrisis.Atthesametime,giventheclosealignmentbetweenthemarkets’understand-ingofconfidence-buildingpoliciesandmainstreameconomicreasoning,governmentshavefewpossi-bilitiestoadoptalternativemacroeconomicpolicies,eveniftheyconsiderthesetobemoreappropriatefortacklingtheireconomicdifficulties.6

inparticular,fiscalresponsibilityhasbeenanimportant element in arguments for a confidence-buildingstrategyonthegroundsthatmarketoperatorsandratingagenciesusuallyattachgreatimportancetofiscalbalanceswhentheyassesscreditrisk,notonlytheriskonsovereignbondsbutalsoondebtissuedbythedomesticprivatesector.indeed,thisdrivestheviewthatintegrationintoglobalcapitalmarketshas

apositiveimpactonfiscaldiscipline,andthereforeonmacroeconomicstability.7

However, this view overlooks the fact that,inmany cases, economic imbalances and relatedinstabilityarecausedbyprivateexcessiveborrowingandspending,encouragedbyeasyaccesstoexternalfinancing.Thiswasamplydemonstratedduringperi-odsofabundantcapitalinflows,whichcorrespondedtoperiodsofexpansionarymonetarystancesindevel-opedcountries(suchas1976−1981,1991−1997and2001−2007),whenfiscalpolicyplayedaminorroleintherapidincreaseofdomesticdemand,risingprivatedebtanddeterioratingexternalbalances.Conversely,whencapitalflowsdecreasedorreversed,inmanycasestriggeringafinancialcrisis,fiscalausterity–whenapplied–wasunabletorestoretheconfidenceof financialmarkets and cause a resumption ofprivatecapitalinflows.onthecontrary,byfurther

cutting domestic demand, fis-cal retrenchment accentuatedeconomicdepression,andconse-quently,increasedtheperceivedcreditrisk.

Totheextentthattheygiverisetoboom-and-bustepisodes,largeandunstablecapitalmove-ments affect fiscal policy andfiscalspace.Thisisnotbecausethey favour balanced fiscal

accountsandlowdebtratios,butratherbecausethefinancialcrises theycauseentail largefiscalcosts,due to both costly bailouts of private banks andnon-financialdebtorsand topublic revenue lossesresultingfromshrinkingtaxableincomes.Thus,fis-calexpendituredoesnotalwaysdecreaseaftercrises,butitscompositionchanges,withhigherpaymentsondebtservicingandlowerexpendituresoninvest-ment,socialtransfersandpublicservices.

inthecontextofstrongcapitalflows,countrieshavebeenadvisedtoadopteitheratotallyfixedorafullyflexibleexchangerateregime–theso-called“cornersolutions”(eichengreen,1994;obstfeldandRogoff,1995).Theyhavebeentoldthat,bymovingtooneortheotherofthecorners,theywouldbebet-terabletowithstandanexternalshock,andtherebyavoidacurrencycrisis,whichcouldrapidlydevelopintoageneralizedeconomiccrisis.outcomesinthe1990s,however,haveprovidedlittlesupportforthisadvice.Neither full exchange rate flexibility nor

International capital flows generally generate a financial cycle in the receiving countries and increase their financial fragility, which can eventually lead to a financial crisis.


“hardpegs”brought about economic stability.onthecontrary,theytendedtoexacerbatetheimpactofvolatilecapitalflows.intimesofmonetaryexpansionindevelopedeconomiesandgrowingriskappetitebyinternationalinvestors,developingcountrieslackedthemacroeconomicpolicytoolstobeabletoabsorbtheresultingcapitalinflowsproductivelyandavoidmajor internalmacroeconomic imbalances.Underafree-floatingexchangerateregime,inflowsledtostrongnominalexchangerateappreciation,therebyweakening the international competitiveness ofimport-competingindustriesandexports.ontheoth-erhand,undera“super-fixed”exchangerateregime,inflowsledtodomesticcreditexpansion,assetpricebubbles and an appreciation of the real exchangerate.inbothcases,theresultwasalmostinvariablytheemergenceordeepeningofcurrentaccountdefi-cits,makingthoseeconomiesoverlydependentoncontinuouscapitalinflows.Whentheseflowstaperedofforreversedintocapitaloutflows,policymakerstypicallyrespondedbysharplyincreasingshort-terminterestratesandusingacontractionaryfiscalpolicytomaintaintheconfidenceofinternationalinvestors,thereby reinforcing the recessionary effects of theoutflows.8Theycouldnotgenerallypreventasteepcurrencydepreciation, itspass-throughtoinflationand a rapid deterioration of the balance sheets ofthoseagents−includingthepublicsector−thathadnetdebtsinforeigncurrency.

Followingthecrisesofthelate1990sandearly2000s,mostdevelopingandemergingmarketecono-mies had less confidence in the ability ofmarketmechanisms to handle large and volatile capitalmovements.Whenanewwaveofcapitalinflowstookplacebetween2003and2008,mostofthesecountriesadoptedamorehands-onapproachtotheirexchangerate systems, generally implementing a “managedfloating”regimeinordertopreventexcessivevola-tilityandmispricing.Theypreferredtoaccumulateinternational reserves rather thanpassively acceptstrongcurrencyappreciation.9inaddition,adoptionofcapitalcontrolsinsomecountriesandmorepru-dentbankingpoliciespreventedthegenerationofnewcreditbubbles.Asaconsequence,mostdevelopingandemergingcountrieswereabletoapplycounter-cyclicalpoliciesandavoidfinancialdistressduringthe2008-2009globalfinancialshock.However,thisdidnotmarktheendofthe“confidencegame”.intheyearsfollowingtheeruptionofthecrisis,pressurebyfinancialmarketagentsinfavouroffiscalausterityandagainstpublicinterventioninfinancialmarkets

resumed. Fiscal austerity policies – particularlyin developed economies –were deemed essentialfor“ensuring thatdoubtsaboutfiscal solvencydonotbecomethecauseofanewlossofconfidence”in financialmarkets,which could trigger a newcrisis(iMF,2010:28).indevelopingcountries,asexplained in chapter ii, renewed instability in thefinancialaccountof thebalanceofpaymentsrein-forcedtheinfluenceofactorsthataskedforamore“market-based”approachinexchangerateandcapitalmanagementpolicies.

2. The need for policy space for capital controls

Theglobalfinancialcrisisshowed,onceagain,thatfinance shouldbe regulated.Atpresent, thereisbroadconsensusontheneedforbetterregulationof domestic financial systems.efforts to containbank leverage, shadow banking and toxic assetshaveadvancedattheinternationallevel(e.g.inthebaselCommitteeonbankingSupervisionand theFinancial Stabilityboard) and the national level(e.g.theDodd-Frankbill intheUnitedStatesandtheproposedring-fencingofdeposit-takinginstitu-tionsfrominvestmentbankactivitiesintheUnitedKingdom).10Moreover,macroprudentialregulationsthat aim to avoid endogenous risk and contagionwithinthefinancialsector,aswellasnegativespill-overs from thefinancial sphere to the rest of theeconomy,areunderdiscussion(GalatiandMoessner,2011;Moreno,2011;iMF,2013;Tarullo,2013;esenandbinatli, 2013).However, these efforts remaintentativeandfacestrongobstaclesonseveralfronts.

First,sincedomesticandinternationalfinancialmarketsarecloselyintertwined,itseemsimpossibletoregulatethefirstifthelatteraretotallyliberalized.indeed,foreigncapitalflowstocountrieshavecausedfinancialfragilitywhentheyhavebeentooabundantandvolatile,notonlybecausetheyhaveaffordedeasyaccesstocreditthatencouragesexcessiverisk-takingat themicro level, but alsobecause theygeneratemacroeconomicdistortionsleadingtosystemicrisks.Amoreselectiveapproachtocapitalinflowsisthere-foreindispensableifthoseflowsaretobemaintainedatmanageablelevelsanddirectedtowardsproductiveuses.Atthesametime,supervisoryauthoritiesinthecountriesfromwhere thoseflowsoriginatecannot


disregard thepotentiallynegative impact resultingfromthepossibleaccumulationofnon-performingcreditsinthebalancesheetsoftheirfinancialinsti-tutions,whichwouldeventuallyweakentheirownfinancialsystems.

Second,largeprivatefinancialactorscontinueto resort to de facto pressures and persuasion todiscouragepolicymakersfromapplyingregulatorymeasures,particularlycapitalcontrols.butwhileitisunderstandablethatmajorbanksandotherfinancialinstitutionswithdirectinterestininternationaltrans-actionswouldargueagainstregulatoryrestraintsbyclaimingthattheirprofit-makingactivitiesareinthegeneralinterest,thisisdeeplymisleading.Similarlymisleadingisequatingtradinginfinancialassetsandliabilitieswith trading in anyothergoodsorservices,imply-ing that no special regulationis therefore justified (see, forexample,Fama,1980).

Third, policymakers andinternational institutions havebeenreluctanttoregulatecapitalflows. indeed, there iswide-spread belief that,with sounddomestic regulation, financialdeepeningandstrongmacroeconomicfundamentals,any economycanbenefit from free capitalmove-ments, as such a frameworkwouldminimize theeconomicinstabilitytheymightgenerateandmaxi-mizetheirpositiveimpactongrowth.Accordingtothisview,evenifsomekindofcapitalmanagementmay be necessary in exceptional circumstances,such as abalance-of-payments crisis, it shouldbetheexception,nottherule.itfurtherpositsthatinnormal times countries should refrain fromusingcapitalcontrolsasaneasybutprecarioussolution,andinsteadaddressthestructuralormacroeconomicshortcomingsthatarethetruereasonsforfinancialfragility.Withsomenuances,thishasbeentheposi-tionoftheiMFandtheoeCDand,tosomeextent,ithasbeentranslatedintotheformalrulessetbytheseinstitutionsasdejureobstaclestocapitalcontrols.This last constraint on policy spacemerits closerattention.

eventhoughtheiMF’sArticlesofAgreementexplicitlyauthorizetheuseofcapitalcontrols, theiMFdiscouragedthemformanyyears.in1997,attheMinisterialMeetinginHongKong(SARChina),

itsManagingDirectorevenproposedincorporatingfreecapitalmovementintheiMFmembers’commit-ments.However, thesuccessionoffinancialcrisesthateruptedimmediatelyafterthemeeting,andthefactthatcapitalmovementswereidentifiedasamajorcauseofsuchcrises,underminedsupportforfullyopencapitalaccounts.

itwasonlyin2012thattheiMFprovidedan“institutional view” on this issue (iMF, 2012). itproposedaplannedandsequencedprocessof lib-eralization thatwouldmaximize the benefits thatcountries could obtain from foreign capital andminimize the costs of “large and volatile capitalflows”. Proposed policieswould include a rangeof progressively deeper and broader supporting

reforms, including reform ofthelegalframework,prudentialregulationandsupervision,anddevelopment of capitalmar-kets (includingadeepeningofdomesticbondandequitymar-kets and pension funds).TheiMFconcededthat“temporaryre-imposition of capital flowmanagementundercertaincir-cumstancesisconsistentwithanoverallstrategyofcapitalflow

liberalization” (iMF, 2012: 15), and can thereforebeused toprevent risks to stability, togetherwithmacroeconomic adjustment andmacroprudentialmeasures.However,notallthetoolswereaccordedthesamestatus.itsuggestedthatcapitalflowmanage-ment(CFM)measuresmaybeusefulundercertaincircumstancesforsupporting(neverforsubstituting)macroeconomic adjustment, butmacroeconomic,structuralandfinancialpoliciesremainedtheprimarytoolsforhandlingdestabilizingcapitalflows.inaddi-tion,asCFMsinvolvesomecostsanddistortions,they“shouldbetargeted,transparentandgenerallytemporary”andthereforeliftedoncethedisruptivecapitalinflowsoroutflowshadabated(iMF,2012:36).FortheiMF,liberalizationremainstherule,andcapital controls a temporary exception subject toobligationssetinitsArticlesofAgreement.inpar-ticular,thelegalityofcapitalcontrolswoulddependontheirobjective:acountrywouldnotbeallowedtorestraincapitalinflowsinordertoartificiallykeepitscurrencyundervalued,butwouldbeentitledtodosoformacroprudentialreasons,orforavoidingexces-sivecurrencydepreciationorappreciationcausedbyfinancialspeculation(iMF,2012).

A selective approach to capital inflows is indispensable if those flows are to be maintained at manageable levels and directed towards productive uses.


Some countries havemade specific commit-ments to opening their capital account.AccessiontotheeU,inparticular,isconditionalonfullcapi-talaccountliberalization.11Similarly,the34oeCDmembers adopted the Code of liberalisationofCapitalMovements,whichobligesthemto“progressivelyabolish, between one anoth-er…restrictionsonmovementsin capital to the extent nec-essary for effective econom-ic co-operation”. in addition,“members shall endeavour toextend themeasures of liber-alisationtoallmembersoftheinternationalMonetary Fund”(oeCD,2013:9).eachcountrymaymakereserva-tionstofreecapitalflows,12andtheCodestatesthatitcannotpreventamemberfromtakingactionforthemaintenanceofpublicorderandessentialsecurityinterests.Furthermore,somemeasuresofliberaliza-tioncanbewithdrawnbyacountryiftheyresultinseriouseconomicandfinancialdisturbance,ortem-porarilysuspendedincaseofseriousdifficultieswithitsbalanceofpayments.butagain,suchactionsaresupposedtobeexceptional.

Theratherstringentcapitalliberalizationrulesof theeUandoeCDapplymainly to developedcountries, although theyalso involveanumberofdeveloping countries, such asChile,Mexico andTurkey,aswellasseveralformertransitionecono-mies thathave joined theeU.However, themainde jure restrictions on developing and emergingeconomies inmanaging their capital accounts areimposedby international tradeagreements.indeed,asalreadydiscussed in chapterVof thisReport,thoseagreementsdonotdealonly(ormainly)withmer-chandisetradeissues;theyalsoincorporate a large number ofprovisionsrelatedtootherareas,including capitalmovements.Themostrelevantofsuchagree-mentsatthemultilaterallevelistheGATS.13

Sincethe1990s,overahundredcountrieshavecommittedtoobligationstoapplyawholeseriesofmeasuresforfinancialsectorliberalizationascoveredbytheGATSanditsAnnexonFinancialServices.

Thoseobligationsrespondednotonlytosomeprivatesectorinterests,butalsotothegeneralconvictionofthattime,thatmarkets–includingfinancialmarkets–couldtakecareofthemselveswithoutjeopardizingthefunctioningoftherestoftheeconomy.eventsof

thepastfewyearshaveshownthedangersof such logic, andhave spawned efforts to re-regulatefinance.

butsucheffortsatfinancialregulation–eventhoseagreedatinternationalinstitutionssuchas the basel Committee andthe Financial Stabilityboard–maynotbefullycompatible

with commitmentsonfinancial servicesunder theGATS (seeTDR 2011).Consequently, they couldleadtolitigationundertheproceduresestablishedbytheGATSwhichcouldaffectaccesstomarketsforothergoodsandservices.Moreover,becauseoftheimpreciselanguageoftheGATS–anditsAnnexonFinancialServices−theareasofpotentialconflictarevaguelydefined(foradetailedanalysis,seeTuckerandGhosh,2011).AsinothermattersrelatedtotheWTo,whensomeregulationischallengedbyathirdparty,WTodisputepanelsandtheAppellatebodyshouldclarifythemeaningofsuchtermsas“restric-tions”,“regulations”and“prudential”.

it is precisely because of the potential forconflict, that some contracting parties have triedto take preventive action by reaching agreementon the interpretation of some terms.14on the onehand, under articleXi (Payments andTransfers)

norestrictionsoninternationaltransfers andpayments on thecurrentaccount(section1)oronthe capital account (section2)maybeappliedif“inconsistent”with specific commitments.Thismeansthatcapitalcontrolscouldbechallengedunderthisarticle.15 Furthermore, underparagraph 2 of article XVi(MarketAccess), once com-mitments aboutmarket accesshavebeenentered,itisnolonger

possibletosetlimitsonsuchaspectsasthesizeoftheservice,numberofbranches,typesofproductsoffered, legal character, and foreign capital par-ticipation.Mostoftheseconsiderationscouldclash

In the increasingly globalized economy, it is impossible to regulate domestic finance when international financial markets are totally liberalized.

Capital management measures should be applied in a preventive way as a normal instrument in the policymakers’ toolkit, and not as an exceptional and temporary device for use in critical times.


withattempts, for instance, topreventbanksfrombecoming“too-big-to-fail”,toimpose“ring-fencing”between deposit-taking and investment bankingactivities, or to function as alocallyincorporatedfirm–withitsowncapital–ratherthanasabranchofaforeigninstitution.These are all areas of finan-cial regulation currently beingdebated,andinsomecountriesalreadybeingimplemented.

on the other hand, theGATSdoescontainprovisionsthatreaffirmtherightofcoun-tries to apply regulations.ThefourthparagraphofthePreambletotheGATSreads:“Recognizing the right ofmembers to regulate,and to introduce new regulations, on the supplyofserviceswithintheirterritoriesinordertomeetnational policyobjectives and, given asymmetriesexistingwithrespecttothedegreeofdevelopmentof services regulations in different countries, theparticularneedofdevelopingcountriestoexercisethis right…”.More specifically, in theAnnex onFinancialServices, art. 2onDomesticRegulationcontainsageneralreservationthatallowscountriesnottocomply,forsomespecificreasons,withtheircommitmentsonservicesliberalization,particularlythatoffinancialservices:“(a)NotwithstandinganyotherprovisionsoftheAgreement,aMembershallnotbepreventedfromtakingmeasuresforprudentialreasons,includingtheprotectionofinvestors,deposi-tors,policyholdersorpersonstowhomafiduciaryduty isowedbyafinancial service supplier,or toensuretheintegrityofthefinancialsystem.WheresuchmeasuresdonotconformwiththeprovisionsoftheAgreement,theyshallnotbeusedasameansofavoidingtheMember’scommitmentsorobligationsundertheAgreement”.16

Despitetheambiguityofthelastsentence,this“prudential carve-out” clause gives a legal basisforgovernments toundertakecapitalmanagementmeasuresinapreventiveway;inotherwords,beforeundesired capital flows generatemacroeconomicdisturbances.Capitalcontrolswouldthereforebeanormalinstrumentinthepolicymakers’toolkit,notanexceptionalandtemporarydeviceforcriticaltimes.

Moregenerally,beyondGATSinterpretations,governmentswilling to re-regulatefinance should

abideby that goalwhen theynegotiate new tradeand investment agreements. inmany cases, theyintroduce clauses calling for full liberalization of

capital flows andderegulationof financial services, in directcontradictiontothepoliciestheyapplyorintendtoapplyintheirownfinancialsystems.inaddi-tion,ashintedabove,theterm“international investment” issometimesbroadenedtoincludeallsortsofcapitalflows,sothatcommitments not to restrictsuchflowswouldbemuchmorestringent thanwhatmay havebeeninitiallyintended.insuch

cases,legitimateeffortsatcapitalmanagementriskaccusationsof“murkyinvestmentprotectionism”.

3. Macroprudential regulation and capital management

(a) The need for capital management

inconditionsofgrowingmacroeconomicvola-tilitycausedbyinternationalcapitalmovements,andgiventherelativeinabilityofso-called“marketcon-fidence-enhancingpolicies”tobringaboutstabilityand long-termgrowth,developing-countrypolicy-makersresortedtomanagedexchangerates,lowerinterestratesandcountercyclicalfiscalpolicy.Sincetheglobalfinancialcrisis,thesegrowth-supportingmeasures started to find increasing acceptance ininternational policy circles, including among theinternationalfinancialinstitutions.17

Anumberofcountriesmanagedtogainsomeroomformanoeuvreinpolicymakingasaresultoftheiraccumulationofinternationalreserves,reduc-tion of external public debt and creation offiscalbuffers,made possible by a benign internationaleconomicenvironmentinthe2000s.Theyrespondedtotheglobalfinancialcrisisbyadoptingacounter-cyclicalfiscalpolicyandliquidityexpansion,whichhelpedstimulatetheireconomiesandsupportsectorsthatweremoreexposedtotheexternalshock.Theywereabletousetheirinternationalreservestopre-ventexcessivecurrencydepreciation,thushelpingtoreduceinflationarypressuresandprotectsectorsfrom

When negotiating trade and investment agreements, governments wishing to re-regulate their financial systems should reject clauses requiring full capital flow liberalization and deregulation of financial services.


currencymismatchesintheirbalancesheets.Theycouldalsouse those reserves tofinance the largercurrentaccountdeficitsarising fromexpansionarypolicies and to counter any sudden contractionofexternaldemand.

However, even these developing countries,alongwith their less fortunate counterpartswhodidnothavethebuffersdescribedabove,stillfaceserious obstacles tomore activemacroeconomicpoliciesinsupportofcatch-upgrowthandstructuraltransformation.Anopencapitalaccountcanpresentasevereconstraintonautonomousmonetarypolicy,which,forinstance,couldbeusedcountercyclicallywhentheeconomyisboomingasaresultofcapitalinflows,evenwhenafloatingexchangerateregimeisinplace.18Undertheseboomingconditions,thealter-native,asrecommendedbyinstitutionssuchastheiMF,andsupposedlyfavouredbyfinancialmarkets,istoadoptatightfiscalpolicytomanageaggregatedemand.However,thispolicychoicecanbeprob-lematic,sinceitimpliesspendingcuts,generallyinpublicinvestment.Yet,suchspendingisnecessarytosupportsectorsoftheeconomythatareimportantforcatch-upgrowth, structural transformationandsocialinclusion.

Thepursuitofthepolicygoalofacompetitiveexchangerateisequallydifficult.Whenalargevol-umeofcapitalisflowingin,thecentralbankmighthave to intervene in the foreign exchangemarketto prevent currency appreciationby accumulatinginternationalreservesandundertakingsterilizationoperationstoavoidanexcessiveincreaseinliquidity.However,theseoperationsmaybefiscallycostlyifdomesticinterestratespaidonissuedbondsaremuchhigherthanthoseobtainedonreserves.

Thesemacroeconomicmanagement difficul-ties suggest that amore effective approach to themanagementofcapitalflowswouldbetotargetthemdirectlyandupfront,ratherthanjusttryingtomiti-gatetheireffects.Forsure,itwouldbeunrealistictoseekacompletedelinkingfromtheglobalfinancialcycle, and anticyclical andpro-growthpolicies inboththefiscalandcreditsphereswillremainoftheutmostimportance.However,reducingthevolumeandnegativeimpactofunwantedcapitalflowswouldimprovemacroeconomicmanagementandcreatetherequisitespaceforpro-growthpolicies.Therefore,properconsiderationshouldbegiventoestablishingaframeworkforeffectivecapitalaccountmanagement.

(b) Recent experiences with capital account management

Developingcountries’experiencewithcapitalaccountmanagementisnothingnew,datingasitdoesbacktothenineteenthcentury.onlyafewmonthsaftermanycountriesinlatinAmericahadaccumu-latedmassivearrearsontheirdebtservice,andwithsomeofthemnotbeingpartytothebradyPlan–andrunningseriousmacroeconomicimbalances−anewcycleofmassiveprivatecapitalflowsstarted.ThiswasaresultoftheUnitedStatesFederalReserve’spolicyofnear-zerointerestratesasasolutiontothefragile situation in this country’s banking system.Manydevelopingcountries,notlearningfromtheirpreviousexperience,againreactedtotheeasysup-plyoffundsbyintroducingfinancialliberalizationmeasuresinthelate1980sandearly1990s.Afewcountries,however,createdaspecificmechanismofcapitalmanagementtoregulatethevolumeofcapitalinflowsandtheirmaturity.Theultimategoalofthesecontrolswastomitigatethenegativemacroeconomiceffectsofinflows,suchasexchangerateappreciationandtheneedforsterilizationtoaddressexcessliquid-ity,whichcarriedfiscalcosts(Massad,1998).Chile’sexperiencewithunremuneratedreserverequirements(URR)iswellknownandhasbeenwidelydiscussedintheliteratureandinpolicycircles,butothercoun-triesalsoexperimentedwithdifferentsortsofcontrolsduringthe1990s.Forinstance,Colombiaemployedsimilar tools asChile, and inbrazil controls tooktheformofanentrancetaxoncertaincapitaltrans-actions,togetherwithotherrestrictions,mainlyonshort-termfixed-income securities (Prates, 1998;epsteinetal.,2004).

overall, controls on capital inflows provedsuccessful in helping countries regain a certainlevelofmonetaryandfiscalpolicyautonomy,reduceexchangeratepressuresandlengthenthematurityofflows.However,mostofthesecontrolswereremovedinthelate1990s,whencapitalbecamescarcewiththeonsetoftheeastAsiancrisisinthesecondhalfof1997.19

Whenanewcycleofcapitalinflowsstartedin2002-2003,developingcountriesagainhadtofindwaystomanagethem.Manycountriesrespondedbyinterveningheavilyintheirforeignexchangemar-ketstoavoidexcessivecurrencyappreciationandbybuildingforeignreservesasaself-insurancemecha-nism.othercountries,suchasindia,neverentirely


removedtheircontrols,maintainingrestrictionssuchasceilingsonexternalborrowingabroad.The2008globalfinancial crisis causeda sudden reversalofcapitaloutofthesedevelopingcountries,butitwasshort-livedas itwassucceededbyanewcycleoflargecapitalinflows,evenexceedingpre-crisislevelsincountriessuchasbrazil,indonesia,theRepublicofKoreaandThailand(iMF,2011).Astheseflowsagainstartedtoexertupwardpressureontheircur-rencies,inadditiontocreatingexcessliquidity,rapidcreditgrowthandassetbubbles,severaldevelopingcountries imposed newcapital controls.Althoughvaryinginformandintensityacrosscountries,thesecontrols had the common purpose of taming theinflows in order tomitigate their negativemacro-economiceffects.20

Themeasuresadoptedwererelatedbothtopricesandquantities, including taxes on certain formsofcapitalflows,unremuneratedreserverequirements,ceilings on different types of capital flows andderivativeoperations,andmini-mum stay periods (ocampo,2012).brazil introduced taxeson portfolio inflows and lateron derivatives; Peru increaseditsfeeonthepurchaseofcentralbankpaperbynon-residents;theRepublicofKoreareintroducedawithholding tax on foreignpurchasesoftreasuryandcen-tral bank bonds; indonesiaadopted aminimum holdingperiod for central bank paperand a limit on short-termbor-rowingbybanks;ThailandadoptedawithholdingtaxonforeigninvestorsinStatebonds;andTurkeychangeditswithholdingtaxrateonbondsissuedbyTurkish corporations abroad,with lower rates forlongermaturities.Thesecountriesalsousedmacro-prudentialdomesticfinancialregulationstoinfluencecapital flows, including reserve requirements onbanks’ short foreign exchange positions (brazil),additionalcapitalrequirementsforforeignexchangecreditexposure(Peru),higherreserverequirementsonforeigncurrencydeposits(indonesia),andceil-ingsontheirbanks’foreignexchangepositions(theRepublicofKorea).21

Duringtheperiod2009−2010,thesemeasureshelpedcountriesmoderatecapital inflows,at leastforsometime.inaddition,continuedinterventions

in the foreign exchangemarkets reduced upwardpressuresontheirexchangerates.Morebroadly,themeasuresprovidedgreaterpossibilities formacro-economicpolicymanagementinlinewithcountries’policy objectives ofmacroeconomic stability andsustained growth. For instance, a few countries,suchasindonesia,kepttheirinterestratesunchangeddespitestrongcapitalinflowsandpossibleoverheat-ing,andSouthAfricaandTurkeyevenloweredtheirrates,althoughthiswasintendedtodeterevenmoreflows rather than tomaintain a pro-growthpolicystance.inthefiscalarea,brazilandTurkeycontinuedtheir expansionaryfiscal policy,while indonesia,theRepublicofKoreaandThailandabstainedfrompursuingamoreproactivefiscalpolicytocurbtheinflationaryeffectsoftheinflows(iMF,2011).

However,thisnewcycleofcapitalflowsisprov-ingshorterthanpreviousones.betweenMay2013andFebruary2014, turbulenceintheinternationalfinancialmarketshitdevelopingcountriestwiceas

a result of announcements of(andlaterinitialstepstowards)changesinUnitedStatesmone-tarypolicy.Theserecentshockshave shown that developingcountries remain vulnerableto sudden reversals of capitalflows.This is despite capitalaccountmanagementandotherprecautionarymeasures thatmanyofthemundertookduringthe 2000s to restrain specula-tivecapitalinflowsandreducepossible fallouts from their

subsequentreversal.Thoseprecautionarymeasuresincludedtheaccumulationofinternationalreserves,areductionoftheexternalpublicdebtasaproportionofGDP,a lengtheningofdebtmaturityand largerlocal-currency-denominated debt, aswell asmorestringentmacroprudential regulation targetingcur-rencymismatchesinthedomesticfinancialsystem(UNCTAD,2014).

During these latest financial shocks, somedevelopingcountrieshavebeenusingtheirreservestotrytoneutralizetheirimpactontheexchangerates,butothers,lackingornotwillingtousetheirreserves,havebeenadoptingstandardpolicyresponsessuchassharpincreasesininterestratesinordertohaltcurren-cydepreciationandcontaininflationarypressures,aswellasfiscaltighteningtorestoreormaintainmarket

Capital management measures recently applied by developing countries provided greater scope for countercyclical policies in line with macroeconomic stability and sustained growth objectives.


confidence.These policy responses demonstrate,onceagain,thatimplementationandmaintenanceofpro-growthpoliciesareextremelychallenginginthecurrentinternationalenvironment.Thisdifficultyisaggravatedbythefrequencyoffinancialshocks,whichhaslimitedtheabilityofaffectedcountries to fully recover frompreviousshocksandrebuildtheirforeigncurrencybuffers.22

Thislatestcycleofcapitalflowsindicatesthatdevelopingcountriesstillhaveawaytogobeforetheyhavefullyeffectivecapital accountmanagement.indonesia’sminimumholdingperiod for central bank paperled non-resident investors to increase their hold-ingsofgovernmentbonds,sincethelatterwerenotsubjecttothesameholdingrequirementrestriction.brazil increasedits taxonportfolioinflowstwice,andextendeditscoveragetoderivativetransactions;italsointroducedreserverequirementsonresidentbanks’foreignexchangeshortpositionstoincreasetheeffectivenessofcontrols(iMF,2011).indonesia’sexperience shows the difficulties that arisewhencontrolsarenotextensiveenoughtocontaininflows.Similarly,brazilwasinitiallytimidandslowinintro-ducingcontrols,anditwasonlyafteritspolicymakersadoptedawiderrangeofcontrolsthattheysucceededincurbinginflows.However,thedelayinstrengthen-ingcontrolsmeantthat,bythetimetheygainedteeth,substantialcapitalhadalreadyenteredthecountry,sothatitremainedvulnerabletosuddenoutflows.

Thelessonstobelearnedfromthesecountryexperiences are that capital accountmanagementshould be strong, comprehensive and dynamicenough to cover possible loopholes that investorsquicklyexploittotheiradvantage.Moreover,capitalaccountmanagementmeasuresshouldbesupportedbyanadministrationthathasthepowerandcapac-itytoimplementthemeffectively.indeed,basedonrecent empirical analysis, eichengreen andRose(2014)arguethatadjustingcontrolsinresponsetocyclicalneedsiseasierifthecountriesalreadyhavecontrolsand thenecessaryassociatedbureaucraticapparatus. Furthermore, controls should apply tobothinflowsandoutflows,anddiscriminatebetweendifferentgroupsoffinancialactors,sothattheytargetspecificinvestorsaswellasspecifictypesofflowsinordertobeeffective(Gallagheretal.,2012).

These recommendations for capitalmanage-ment go beyond thosemade by the iMF (2012).Thisisbecausecapitalaccountmanagementisnotjustameansofcrisismanagement;italsohasafun-damentalmacroprudential,andthuspreventive,role

toplay.Thisisparticularlytrueinviewofthelimitedeffective-nessofmoreconventionalpolicytools,suchasflexibleexchangeratesandausterefiscalpolicy,topreventgrowingmacroeconomicimbalancesresultingfromcapi-talflows.

Thus,inthecurrentinter-nationaleconomicenvironment,the short-term challenge for

countries is todevelopamacroeconomicmanage-ment framework that is sufficiently strong andeffectivetodealwithvolatileprivatecapitalflows.Thelong-termchallengeisforthemtodevelopthecapacitytodeployawiderrangeofinstrumentstoensurenotjustreducedvolatility,butalsosustainedcatch-upgrowth. inaddition toacoherentmacro-economic framework, development and industrialpoliciesneedtouseother instrumentsandmecha-nismsofcapitalmanagementpolicies.

(c) Channelling capital to productive uses

Reducinginstabilityarisingfromvolatilecapitalflowsmay improve thecapacity tousemacroeco-nomictoolsforgrowth-orientedpoliciesandsocialinclusion;however,itdoesnotguaranteethatinflowswillbeusedproductively.Toensuretheirproductivedeployment,thishastobemadeanexplicitpolicyobjective.Capital accountmanagement should beusedtotrytoinfluencethecompositionandmaturityofflows.Thuslong-termflowsshouldbesought,andthoseofaspeculativenaturediscouraged.Similarly,effortsshouldbemadetoattractflowsthataremorelikelytofinanceinvestmentratherthanconsumption.Several instruments are available to policymakersformanaging thecapitalaccount for thispurpose,includingunremuneratedreserverequirementsandminimumstayperiodsaimedatlengtheningthematu-rityofflows,or forbiddingcertain typesofflows,suchasinvestmentsinderivativesmarkets.Domesticbankingregulationscanalsobeusedforencouragingordiscouragingdifferentkindsofforeignborrowing.

Capital account management should be strong, comprehensive and dynamic enough to plug possible loopholes that investors could exploit to their advantage.


Still, althoughsuchcapital accountmeasuresmay indeed yield positive results, their power toinfluencetheenduseofexternalcapitalprobablyissomewhatlimited.Duetothegrowingcomplexityoffinancialmarkets,ithasbecomedifficulttoestab-lish,ex ante,whichflowsare short-or long-term,andwhichwillbeusedproductively.Thisdifficultyappliestoallsortsofcapital,includingFDi,whichiscommonlyviewedasmore long termandoftenperceived exclusively as greenfield investment.However, FDimay also involve short-termbankloans aswell as potentially destabilizing hedgingoperations,and itmaybeassociatedwithmergersandacquisitionsratherthanwithgreenfieldprojects.

Apart from uncertainty about the nature ofcapitalflows,capitalaccountmanagementhasonlyalimitedcapacitytodirectcapitaltowardsproduc-tiveendsbecause,aboveall,thewayscapitalfeedsintoaneconomyandhowitisultimatelyemployedlargelydependonhowacountry’sfinancialsystemisstructuredandregulated.Afterall,mostofthecapitalthat enters a country ismediated by the domesticfinancialsystematsomepointoranother.

economicliberalizationandreforms,whichthemajority of developing countries haveundertakenduringthepast35years,haveconsistedmainlyofderegulation ofmarkets and privatization.These,havedeprivedtheirgovernmentsnotonlyofmacro-economicpolicytools,butalsooffinancialresourcesandotherpolicy instruments and leversnecessaryfor growth anddevelopment. in thefinancial sec-tor,deregulationoffinancialmarketsand,inmanycountries,privatizationofState-ownedbankshavesubstantiallyreducedthenumberofinstrumentsofindustrial,financialandsocialpolicies.Productiveinvestmenthasbeenparticularlyaffectedby thesechanges.

The hopewas that privatization of financialactivitywouldspurproductiveinvestment,structuralchangeandgrowththroughamoreefficientallocationofcapital,thatis,bychannellingcapitaltothemostproductiveuses.butthishasnothappened:thepri-vatefinancialsectoremergingfromthesereformshasnot,byandlarge,filledthegapleftbythewithdrawalofthepublicsectorfromthisarea.indeed,generally,theoutcomehasbeenjusttheopposite.banksandotherfinancialinstitutionshaveincreasinglyfocusedtheiractivitiesontheprovisionofmainlyshort-termfinance–largelyconsumptionlending–insteadof

thelong-termfinanceneededforinfrastructuralandindustrialprojects.

Thus, given howfinancial systemsdistributedomesticcredititcannotbeexpectedthatexternalcapital channelled through themwill be deployedfor productive purposes either. itwould thereforebe necessary to reformnational financial systemsandpoliciesinordertorestoreacountry’scapacityto providefinance for productive activities (TDR 2013,chap.iii).Theseshouldincludethefollowing:measuresbycentralbanksandgovernmentsaimedatencouragingmaturitytransformationoperationsbycommercialbankssothattheyprovidemorelong-termcredit;creditallocationpoliciesinthebankingsystem to support specific productive sectors orareas thatarevital fordevelopment,suchasbasicinfrastructureandresearch;andestablishinginstitu-tions, particularly development banks, specializedintheprovisionoflong-termfinance.Developmentbanksarecriticalinstitutionsfordevelopingcountriesbecausetheyprovidelong-termfinancingnotofferedbyprivatebanks,mainlyforprojectsthataredevel-opmentorientedandgeneratepositiveeconomicandsocialexternalities.Sincetheyhaveclearmandatestofulfilthisrole,theircapitalandfundingstructureisdesignedtoenablethemtomeettheseexpectationseffectively.

brazilisamongthefewdevelopingcountrieswith a strong network of development banks.AtthecentreofthisnetworkisthebancoNacionaldeDesenvolvimentoeconômico e Social (bNDeS),whichprovides loans and invests infirms’ equity,aswellasengaginginon-lendingtootherdevelop-mentbanks.Fundingfortheseloansandinvestmentscomes in different forms, including compulsorysavingsfrombrazilianworkers,23transfersfromthetreasury, government deposits derived from fundsfromprivatization,bondissuesandresourcesfrommultilateralorganizations.loansandinvestmentsaremadeinsupportofawiderangeofindustrialsectors(Chandrasekhar,2014).

likebrazil,theRepublicofKoreacountsona number of development-orientedfinancial insti-tutions, including theKoreanDevelopmentbank,whichprovideslong-termcreditforindustrialactivi-tiesdrawingonfundsderivedfromborrowingfromthegovernment, internationalfinancial institutionsandforeignbanks,aswellasbyissuingbonds.inTurkey, theTurkish industrialDevelopmentbank


(TSKb)isamongthecountry’smaindevelopmentfinanceinstitutions.itisprivatelyowned,asitsequitycapitalbasecomesfromthecountry’sprivatefinan-cialinstitutions,butothersourcesofitsfundingalsoinclude thegovernmentand internationalfinancialinstitutions,suchastheWorldbank,theeuropeaninvestment bank and the international FinanceCorporation.TheTSKbisthusabletomakeloansandequityinvestmentsacrossawiderangeofsectorsoftheTurkisheconomy.italsosupportsaccessbyTurkishcompaniestocreditfrombothdomesticandforeignbanks(Chandrasekhar,2014).24

examplesofnationaldevelopmentbankscanalsobefoundinsomelDCs.ethiopia,forinstance,has three State-owned banks.one of them, theDevelopmentbank of ethiopia (Dbe), provideslong-termfinance to priority sectors, as identifiedbytheGovernment,suchascommercialagriculture,agro-processing activities andmanufacturing. itsfundingbase includes loans from theCommercialbank of ethiopia (another State-owned bank),

concessionalloansfromdonorsandfundsfromthecentralbank,theNationalbankofethiopia(Nbe),whichareraisedthroughbondissues.TheNbe,inturn,derivesitsresourcesfrombillsissuedbyitforpurchasebytheprivatebankingsystemonacom-pulsorybasis(Alemu,2014).

These are examples of national developmentbanks that have a funding base that carries long-termliabilities,orthataresupportedbygovernmentguarantees,whichthenpermitthesebankstofinancelong-termprojects.AWorldbanksurveycovering90developmentbanksfromaroundtheworldfoundthat64percentofthosebanksbenefitfromgovern-mentguaranteesfortheirdebtsandotherliabilities,allowingthemtoborrowatlowercostsandtransferthislowercosttotheirownborrowers(luna-MartínezandVicente, 2012).Moreover, these institutionshavetheabilitytoborrowabroadandthenchannelthe resources to productive activities, or, like theTurkishdevelopmentbank,theycanhelpfirmsobtainresourcesabroadtofinancerealsectoractivities.

C. Policy space with regard to foreign investment

Attractingforeigncapitalisnotagoalinitself.Asdiscussedabove,itmayhavepositiveornegativeeffects on bothmacroeconomic stability and eco-nomicdevelopmentdependingonitsvolume,itsnatureanditsuse. it is not surprising, then,thatdifferent authorshavenotfoundanypositiverelationshipbetween capital inflows andgrowth(bhagwati,1998;Prasadet al., 2003; Stigltiz, 2004;Prasadetal.,2007),or,forthatmatter, a negative relationship(Aizenman, 2005). it is there-fore clearly essential to havenationalpolicies formanagingtheseflows,notonlyportfolioandshort-termflows,but also longer term capital, includingFDi.How

much(orhowlittle)TNCscontributetoeconomicdynamismanddiversification, environmental con-servation, technology transfer, tax revenues and a

healthy trade balance dependscriticallyonthemacroeconomicand regulatory framework inthedifferentlocationsinwhichtheyoperate. influencing theirperformance in someof thoseaspects has been a key ingre-dient of industrial policies, asobservedinchapterVandprevi-ousUNCTADresearch(see,forinstance,UNCTAD,2003 and2012).25However, these toolshavebeenprogressivelylimited

bytheURAs,aswellasbyalargenumberofbilateraland plurilateral trade and investment agreements.

The contribution of TNCs to economic dynamism and diversification depends criti-cally on the macroeconomic and regulatory framework in the different locations in which they operate.


This section examines howpolicy space is beingrestrictedbythoseagreements,andexploressomepossiblewaystohelpovercomesuchrestrictions.

1. Investment protection rules

(a) Rules governing investor-State relations

Traditionally,themainlegalframeworkforfor-eigninvestmentineverycountryhasbeenprovidedbydomesticlaw,whichspecifiesthepermissibleinvest-mentsbyforeigncompanies,theproceduresfortheiradmissionandimplementation,andtheobligationsofinvestors.Domesticlawalsogovernscontractualrelationsbetweenforeigninvestorsandhostcoun-tries. it normally guarantees to foreign investorssettledinthecountrythesametreatmentbypublicauthoritiesand legal guarantees as thoseaccordedtodomesticinvestors.inaddition,severaldevelopingcountries that give highprior-ity to increasing inward FDihavepassedspecificinvestmentpromotionlawswhichprovidevarious incentives to foreigninvestors,particularlytaxincen-tives.insodoing,Statesareabletodeterminethecontentoftheirdomesticlawsgoverninginvestor-Staterelationsandtoresist,toalargeextent,thejurisdictionofforeigncourts(accordingtotheprincipleofStateimmunity).incaseofalegaldispute,foreignfirmscanresorttodomesticcourts,justlikedomesticfirms(principleofnationaltreatment).

Thislegalframeworkhasseemedinsufficienttopotentialforeigninvestors.Consequently,theyhavepushedforinvestmentliberalizationandsupplemen-taryguaranteesfortheirpropertyrightsandexpectedprofits.WiththeincreaseinFDiflowstodevelopingcountries and to several newly independent coun-tries in the 1960s, international investors (almostexclusivelyfromdevelopedeconomies)soughtthecreationofajudicialbodythatwouldsupplementorreplacedomesticlawsandnationalcourtsindevel-opingcountries,which,intheirview,didnotmeethigh standards of independence and impartiality.The resultingNorth-Southdebate sawdeveloping

countries subscribing to theCalvoDoctrine thatadvocated the principle of national treatment, andtheUnitedStatesandeuropeancountriessupportingthedoctrineofan“internationalminimumstandard”thatrequiredtheprotectionofforeigninvestorsunderinternationallaw(independentfromnationallaws).26

While theoeCDconductedlongdiscussionswhich eventually failed to create a judicial bodythatwould supplement or replace domestic lawsand national courts in developing countries,27 theConventionontheSettlementofinvestmentDisputesbetweenStatesandNationalsofotherStates,nego-tiated inparallelunderWorldbankauspices,wasadoptedin1965.ThisConventionstillgovernsinvest-mentprotectiontoday.itdoesnotcontainsubstantiveprovisions in this regard, but provides proceduralrulesforthesettlementofdisputesthrougharbitra-tion.Tothatend,itcreatedtheinternationalCentre

for Settlement of investmentDisputes(iCSiD),whichisoneofthefiveinstitutionsconstitut-ingtheWorldbankGroup.

Thelackofagreementona common international legalframework for foreign invest-ment despite several attemptssincethe1960shasmeantthatthereisnouniformregimegov-erning investor-State relations.Different legal rulesare found

inavarietyofbilateralandmultilateralagreementsconcerninginvestmentliberalizationandinvestmentprotection(Schill,2014).

Some rules on investment liberalization (e.g.rulesreducingbarrierstomarketaccessforforeigninvestors)canbefoundininternationaltradelaw.TheTRiMsAgreementandtheGATScontaininvestment-relatedregulations,asdiscussedinchapterVofthisReportandinsectionbofthischapter.Provisionson investment liberalization, namely the right ofestablishmentandfreemovementofcapital,canalsobefoundineUlaw.likewise,theoeCDCodesofliberalisation ofCapitalMovements andCurrentinvisibleoperations contain non-discriminationcommitmentsbyoeCDmemberStates,andtherebyaimatinvestmentliberalizationinspecificsectors.

However,mostofthenewinternationalrulesareembeddedinbilateralagreementsamongStates,

A key ingredient of industrial policy has been to influence TNCs performance, but it has been progressively limited by the URAs and many other trade and investment agreements.


whichincorporatemechanismsforinvestmentpro-tection.bytheendof2012therewere2,857biTsandmore than 339 investment chapters in freetradeagreements(FTAs)(UNCTAD,2013a).Theseagreements are based on similar general substan-tive principles, such as property protection andthe rule of law, and generallyinclude investor-State disputesettlementmechanisms(iSDS),which enable investors of sig-natorycountriestodemandtheenforcementoftherightsgrant-edundertheagreementsbyhostcountries.Theabove-mentionediCSiDand theUnitedNationsCommission on internationalTradelaw (UNCiTRAl) arethetwomostactivearbitrationcentres.(Whenmorethanonepossibilityisallowedinthebilateraltreaty,thechoiceisgenerallymadebytheinvestor.)

(b) Growing restrictions on policy space

bycreatingadisputesettlementmechanismintheabsenceofacomprehensivebodyoflaw,invest-ment tribunalshavegained a singularly importantrole: instead of applying pre-existing rules to thefactsofindividualcasestheyhavegeneratedtherulesthemselves.28Thisstrategyhasgivenanextraordinarypower to arbitrators, especially because the termsof bilateral agreements protecting investments aregenerallyvagueandthelegalframeworkinwhichtheyoperateareextremelyloose.

indeed, few standards of protection in inter-national investment treaties are crafted as specificrulesthathaveaclearscopeofapplicationandtargetspecificbehaviour.instead,theyarecraftedaslooseandopen-endedstandards.Theconceptof“indirectexpropriation”,andthestandardsoffairandequitabletreatment,nationaltreatment,most-favoured-nationtreatment, full protection and security, and freecapitaltransferareallformulatedinamannerthatleavesconsiderablescopefordiscretionbyarbitraltribunals.Caselawhasshownthattheycanalsobeapplied tomeasures taken by a host government,evenwhenthosemeasuresareinthepublicinterest,includingimplementationofanationaldevelopmentstrategy.infact,Statesmayfindthattheyaresubject

tocommitmentstheyneverthoughttheyweremakingwhensigningthosetreaties.

Tobeginwith, theverydefinitionof“invest-ment” isnotunequivocallymadeexplicit inmanytreaties.Whatexactlyisprotectedisthereforeleftto

thejudgementofarbitrators.Agovernmentmaythinkitisgiv-ing special guarantees only toFDi,onlytofindoutthatotherkindsofcapitalmovements,inparticularportfolioinvestmentsand sovereign debt, are alsocovered by abiT.Therefore,in case it needs to restructureaforeigndebt,holdersofdebtinstruments (includingvulturefunds)may resort to iSDS to

request the entire face value of the original debtinsteadofparticipatingintherestructuringprocess(UNCTAD,2011).29

Furthermore,thevaguenessofinvestmenttreatystandardscanundulyrestrictthefreedomofhostgov-ernmentstoregulateinthepublicinterest,andgivesconsiderablepowertotribunals.Forexampleitisuptotribunalstodeterminewhatconstitutescompensableindirectexpropriationandnon-compensablegeneralregulation,thescopeofnationaltreatment,thecontentoffairandequitabletreatment(FeT),andtheamountofflexibilityitgrantstogovernmentdecision-making.inthelattercase,theacceptedinterpretationofFeTunder customary international law (Cil) providesforcompensationfordenialsofjustice,understoodas“denialofdueprocessincourtoradministrativeproceedingsordenialofpoliceprotection”.However,arbitratorshavefrequentlyadoptedabroaderinter-pretationofFeTtoincludetherighttoa“stableandpredictableregulatoryenvironment”,andthereforeconsideranychangesinregulatoryortaxpoliciesasviolatingiiAprovisions.30Asaresult,governmentsmightfindtheirnormalfunctionscircumscribedbythethreatofhavingtocompensateforeigninvestorsiftheyintroducepolicymeasuresdesignedtorespondtochangingcircumstances(suchasfinancialcrises31ornewscientificfindings)ortopublicdemandwithlawsofgeneralapplication(Wallach,2012).ThesolepossibilityofbreachinganinvestmenttreatycanbesufficienttodeteraStatefromtakinganymeasurethatmightalterthebusinessenvironment,evenifthisisnecessaryforeconomic,socialorenvironmentalreasons(so-called“regulatorychill”).

Since the 1960s, international investors have sought the creation of a judicial body to replace domestic laws and national courts in developing countries and obtain supple-mentary legal guarantees.


Anumberofcasescanbecitedinthiscontext,suchasarbitrationsinconnectionwithArgentina’seconomic crisis in 2001-2002,water concessionsinbolivia,Argentina and theUnitedRepublic ofTanzania,anaffirmativeactionprogrammeaimedatremedyinginjusticesremainingfromtheapartheidsysteminSouthAfrica,banningofharmfulchemi-calsinCanadaandtheUnitedStates,protectionoftheenvironmentinCanada,GermanyandMexico,anti-tobacco legislation inUruguay andAustralia,andGermany’snuclearenergyphase-out.32inthesecases,themanyvaguelegaltermsusedinbiTsraiseconcern thatarbitration tribunalsmayuse themtocurtailgovernmentmeasuresaimedatprotectionoftheenvironment,humanrightsandlabourandsocialstandards,orwhendealingwithfinancialcrises, for thesakeof investorprotection,withoutconsideringthepublicinterestsinvolved.

The general idea behindtheestablishmentofiSDSwasto put “procedure before sub-stance”withtheexpectationthatthisprocesswouldgenerateanaccepted legal framework forinternationalinvestment.However,this“procedure”hasnotbeen transparent andbalancedenough forgeneratinganacceptedbodyoflaw.Tobeginwith,thisprincipleinitselftransfersenormouspowertoa body of non-democratically elected arbitratorswhose ruling often has been criticized (eberhardtandbuxton,2012).

investor rights, such as receiving fair andequitabletreatment,fullprotectionandsecurityoftheir investment, national treatment or protectionfromindirectexpropriation,leaveawidemarginofdiscretiontotribunalsindeterminingthenormativecontentofthoseprinciplesandinapplyingthemtothe specific facts of a case. in fact, the principlesof international investmentprotectionareoftensobroad that it is appropriate to compare themwith“generalclauses” incivilcodes thatdelegate sub-stantial rule-making powers to dispute settlementbodies.Consequently, arbitral tribunals emerge asimportantlawmakersininternationalinvestmentlawwhentransformingthebroadprinciplesofinvestmentprotectionintomorepreciseruleswhichgovernthewaytheexecutive,legislatureandjudiciaryofahost

Statemustconductactivitiesaffectingforeigninves-tors (Sornarajah,2008).Theyareoftenable todoso,notprimarilybyapplyingtheprinciplesoftreatyinterpretationasenshrinedintheViennaConventiononthelawofTreaties(VClT)orbyhavingrecoursetocustomaryinternationallaw,butratherbyturningtoandrelyingonarbitralprecedent.

Suchlaw-makingthroughprecedentraisescon-cernbecauseitenablesinvestmenttreatytribunalstotakeoverafunctionthat,ininternationallaw,isusu-allyallocatedtoStates,andthatnormallytakesplacethroughtheconclusionofinternationaltreatiesorthedecision-makingprocessesof internationalorgani-

zations. it is also problematicbecausethereareusuallyonlyafewcontrolmechanismsStatescanusetoundothedecisionsofthetribunalswithwhichtheydonotagreeandrestricttheeffectofthosedecisionsasprecedentsforfuturecases.Sometimes,invest-ment treaties provide for insti-tutionalmechanisms throughwhichcontractingpartiestoiiAscan issue joint interpretationsof the underlying agreements

thathavebindingeffectonfuturearbitrations,butsuchmechanisms are still the exception.What ismore, there is an imbalancebetween thepotentialsystem-wideeffectofarbitraldecisionsasprecedentandthebilateralstructureofinvestmenttreatiesinwhichStatescannotgenerallybeexpectedtomoni-torarbitrationstowhichtheyarenotparties,orthattakeplaceundertreatiestowhichtheyareequallynotparties.Thisstructurefavourstheinterpretativepower of arbitral tribunals to the detriment of theinterpretativepowersofStatesunder internationallaw.Asthesetribunalstendtotreatthecasesfromthepointofviewofcommercialarbitration,theycan-notbeexpectedtotakeintoaccountthepubliclawaspectsofthosedisputesrelatedtothescopeofthehostState’sregulatorypowers,including,forexam-ple,disputesconcerninglimitsofemergencypowers,regulatoryoversightoverpublicutility companiesand the tariffs they charge, control or banning ofharmfulsubstances,theprotectionofculturalprop-erty or the implementation of non-discriminationpolicies.Therefore,theycanhardlybeexpectedtoconsidertheinterestsofaneconomyasawholeandaspectsofanoveralldevelopmentstrategy.

Critiques of the investor-State arbitration mechanism focus on its consistency, transparency and pro-investor bias, and on its adequacy to address matters of public policy.


(c) Increasing criticism of current arbitration procedures

Problems relating to arbitration procedurebecamemorevisibleasmorecountriesadheredtothesystemandmorecaseswerebroughtbyinves-tors(Schill,2011).between1965and2000,iSDSarbitragecentresregisteredonly50cases(lessthan1.5casesperyearonaverage),whereasbytheendof2013,thecumulativenumberofknowncaseshadclimbedto568(almost40casesperyearonaveragesince2000) (UNCTAD,2014).Themost frequentcritiquesofiSDSprocedurefocusonitsconsistency,transparency and pro-investor bias;more gener-ally,itslegitimacyandadequacytoaddressmattersinvolvingpublicpoliciesareincreasinglychallenged(seeforinstanceFranck,2005;VanHarten,2007;andVanHartenetal.,2010).

Thecoreofthecriticismisthat,whileinvest-menttreatydisputesofteninvolvemattersofpublicpolicyandpubliclaw,thedisputesettlementmecha-nism, namely investor-Statearbitration, follows amodelthathasbeendevelopedfortheresolutionofdisputesbetweenprivatecommercialactors.33

Suchrulesdonottakeintoconsideration the public inter-ests that may be affected ininvestment treaty arbitration(Kingsbury andSchill, 2009).one proceduralmaxim is theconfidentiality in investmenttreaty arbitration.34 Confidentiality is a problembecausethoseaffectedbyarbitrations,inparticularthepopulationofthehostState–includingcitizensandcompetitorsofTNCs–cannotreceiveinforma-tionaboutproceedingsthatimpacttheirinterestsandtheirgovernment’sconduct.35Moreover,confidential-ityrestrictsthepossibilityfordomesticdemocraticprocessestomonitorarbitrationproceedingsandtoassesswhethertheydeliverabalancedandfairdeci-sioninforeigninvestmentdisputes.Confidentialityisalsocontrarytohowdisputesinvolvingthegovern-mentareusuallysettledindomesticcourts,namelythroughopenandaccessibleproceedings.

Closelyrelatedtothelackoftransparency,istheissueofaccessofnon-partiestoarbitration, inparticularthosethatintendtovoiceaspecificinterest

relevant to thedispute.While suchamicus curiaesubmissions are occasionally accepted by arbitraltribunals,theideathatarbitrationisaparty-ownedprocessisatoddswithopeninguptheproceedingstooutsiders.Thisissueisincreasinglyoftenaddressedin newer investment treaties and also in the 2014UNCiTRAlRulesonTransparencyinTreaty-basedinvestor-StateArbitration,butitremainsproblematicinagreatnumberofcases.

Anothermajorareaofcriticismbyseveralgov-ernments,academicsandcivilsocietyorganizationsconcernsthestandardsofindependenceandimpar-tialityofinvestmentarbitratorsandtheirprofessionalethics. in this context, a problem is that there arenorulesthatstrictlyseparatetherolesofarbitratorand counselwithin investment dispute settlementsystem.Thus, except in cases of so-called issueconflicts,servingasarbitratorsinonecase,andascounsel inanother is largelyaccepted in theprac-ticeofinvestmentarbitration.Similarly,theethicalstandardsapplicable toarbitratorsandcounselare

often rather open-ended andvague, leading to standards ofindependence and impartialitythatarewellbelowthoseappli-cableindomesticcourtproceed-ings.Arecentstudyshowedthatthemostprominent arbitratorshadaccumulatedseveralroles,simultaneouslyorsuccessively,includingthoseofcounsel,aca-demic,governmentrepresenta-tive,expertwitnessandseniorcorporatepositions.Fromtheir

differentpositions,theyhavebeenabletopromotea system fromwhich they benefit (eberhardt andbuxton,2012).Moreover,arbitratorshavepecuniaryandcareerinterestsinacceptingcasesonbehalfofinvestors,andthereforeinmakinganexpansiveinter-pretationofinvestmentrules,whichleadstomorecases.AnempiricalstudybyVanHarten(2012)ana-lysedhowinvestmentarbitratorsresolvedtheadmis-sibilityofclaimsincasesonwhichaninvestmenttreatyisambiguousorsilent.Hefoundthat,intheresolutionofcontestedissues,theytendedtofavourclaimantsbyabroadinterpretationoftheinvestmenttreatyandbyallowingmoreclaimstoproceed.36

TheeaseofsuingaStatebeforetheiSDSgivestheinvestorstrongleverageagainstthehostState.evenifitdoesnotresultinafinalresolution,themere

Arbitration tribunals follow a model developed for resolving disputes between private commercial actors, and thus have no reason to consider the broader interests of a host country and its development strategy.


possibilityofacasebeingtakentotheiSDSaltersthe termsof anynegotiated settlement. in severalinstances,settlementshaveincludedsomepaymentsor commercial advantages given to investors inexchangefortheirwithdrawaloftheclaimwhichthehostgovernmentwouldprobablynothavegrantedwithoutthethreatofanonerousfine.

Thepro-investorbiasofiSDSschemescanbepartlyexplainedbytheincentivesstructureforarbi-trators,but,moregenerally,itmayalsoresultfromtheverynatureof the iSDS: ithasbeendesignedfor providing supplementary guarantees to inves-tors; not formaking them respect host-countrylawsandregulations.investors,notStates,aretheonesthatcanthereforeinitiateacase,andcanevenchoosethearbitrationcentre.Therefore,TNCswithapresenceinseveralcountriescanalsochoosethetreatytheywillinvokebyestablishingtheirresidenceaccordingly.

Hence, international investment lawdoesnotincludeanyenforceableobligationson thepartofthe investorwith respect to, for instance labourstandards, human rights or environmental protec-tion.Rather, obligations that directly bind foreigninvestorsaremainlycontainedinthedomesticlawofthehostState.However,itisnotalwayseasyforaStatetoobtainreparationfromaforeigninvestordue, for instance, to tax avoidance (case ofMaliagainstRandgold; see chapterVii, sectionD) ortoenvironmentaldamage(e.g.thecaseofecuadoragainstChevron).indeed,sometimesiSDSmecha-nismshavebeenusedbyTNCstoretaliateagainstprosecutionfortheirallegedwrongdoing.

This shows an asymmetry of governance ininternationalrelations:whileinvestmentprotectionisdeeplyenshrinedinthecurrentinvestmentframe-workbasedoniiAs,competinginterests,bothpublicandprivate,rightsofStatesandobligationsofforeigninvestorsarenotenforcedattheinternationallevelthrough comparable institutions.Moreover,whilehumanrightsareprotectedunderhumanrightstrea-tiesandenvironmentalconcernsareprotectedunderinternationalenvironmentallaw,theseinternationalregimeshavemuchweakerdisputesettlementandimplementationmechanisms than the investmenttreatyframework.37Thisalsohasadirect implica-tionforpolicyspace:governments thatattempt to

introducepoliciesinthedirectionofaprogressiverealizationofthevarioushumanrightsoftheirciti-zens,includingtherighttodevelopment,ortopreventtheir rights frombeing violated by the actions ofinternational investors,may faceproblems relatedtothestipulationsofinvestorprotectioninvarioustradeandinvestmenttreaties.

onlyafewyearsafterthefirstinvestmenttreatyarbitrationsstarted,theproblemofinconsistentdeci-sionsandparallelproceedingsbecameapparent.itaroseafter twoarbitral tribunalsconstitutedundertwoseparatebiTshearddifferentdisputesrelatedtothesamefacts,andarrivedatoppositejudgements.38Similar inconsistencies in arbitral jurisprudencealsoariseinrelationtointerpretationsofidentical,oressentiallycomparable,clausesindifferentbiTsortothesameruleofcustomaryinternationallawbydifferent tribunals.Notorious examples are theinconsistentinterpretationsofmost-favoured-nationclauses− inparticulararisingfromarbitralproce-dure and arbitral jurisdiction− the interpretationofumbrellaclauses,theapplicationofthedefenceofnecessityandnon-precluded-measureclausesiniiAs,aswellasthetreatmentofproceduralaccesstoarbitrationrequirements.

Thelackofconsistencyisanobviousobstacletothestrategyofgeneratingthe“substance”ofinter-nationalinvestmentlawthroughconvergenceinthejurisprudenceofarbitral tribunals.Nevertheless, itseems thatprecedent is increasinglyusedbyarbi-tral tribunals in differentways, such as adoptingrelatively cautious approaches,where precedentservesasanindicationoftheordinarymeaningofatreatyprovision39orasa“sourceofinspiration”40forinterpretation;orformoreimposinguses,wherebyprecedent becomes a standard-setting device oreven an instrument of system-wide law-making.41Nonetheless, the danger of inconsistent decisionspersistsbecauseoftheapplicablelawenshrinedinbilateraltreatiesbeingcouchedinvagueterms,whoseinterpretationislefttoone-offarbitraltribunalsratherthantoapermanentandcentralizedjudicialsystem.42Morefundamentally,followingprecedentsdoesnotmeanimprovingthefairnessandrationalityofthesystemifsomepastrulingswerethemselvesflawed,andwereneitherannullednorcorrectedbytheiCSiDannulment committee even after having identified“manifesterrorsoflaw”(UNCTAD,2014:3).43


2. The current debate on investment protection rules and policy proposals

(a) The need for change

Asalreadymentioned,duringthe1990s,therewasaproliferationofinvestmenttreaties,includingtheiSDS,atatimewhenFDiwasseenasthekeyto unlocking a country’s development potential,andindeedwasviewedalmostasagoalinitself.Atthattime,thedominanteconomicthinkingopposedactiveinterventionbytheStateintheeconomy.inthatcontext,itwasbelievedthatlosingpolicyspacewasnotahighpricetopayforanexpectedincreaseindirectinvestmentinflows.

Thisperceptionbegantochangeinthe2000s.inparticular, the impactofFDioneconomicper-formance–includingfixedinvestment,technologytransfer,provisionofpublicutilities,fiscalrevenues,employment, exports and balance of payments –proved to be less significant andmore contingentthanexpectedincountrieswhereitwasnotaccom-paniedbystrongindustrialpolicies.However,italsobecameapparentthatinvestment-relatedrulescouldobstructthepoliciesaimedatimprovingtheimpactofFDiontheeconomy.Thiswasreflectedinthesharprise in the number of cases brought to arbitrationmechanismsasaresponsetogovernmentpoliciesinanumberofcountries.Atthesametime,econometricstudiesontheimpactofbiTsonFDiflowsreachedambiguous results,44with several studies findingthat the existence ofbiTs or other arrangementsthatincorporatedinvestmentprotectionhadaminorinfluence–ifanyatall–onbilateralFDiinflowsfromdevelopedtodevelopingcountries(seeannextothischapter).

While benefits frombiTs became less evi-dent,thefinancialcoststheycouldinvolveclearlyappeared,andtheyweresometimesexorbitantanddifficult to justify.45 Fromgovernments’ point ofview, the perceived cost-benefit equation of iiAs,involvingthelossofpolicyspaceontheonehandandencouragingFDiflowson theother,began tochange,promptingageneralre-examinationofsuchagreements – particularly of theirmain juridicalinstrument,iSDSmechanisms.

Somewhat paradoxically, new negotiationsof investment treatieswhichmostly replicate the

featuresoftheoldonesareunderwayatthesametimeasvigorousdiscussionsaretakingplaceaboutthenetusefulnessofsuchtreaties,theseriousprob-lemstheypresentforcontractinggovernments,andthefactthattheymaynotcomplywithsomebasicprinciplesofinternationallaw.ThoseprinciplescanbefoundinUnitedNationsconstitutional lawandin comparable domestic constitutional laws.onebasicprincipleistheprotectionofself-determinationwhichreflectstherightofhostgovernmentstosettheir development strategies independently andimplementthemaccordingly.46Theprincipleofself-determinationthereforeprovidesthebasisforaclaimforsufficientpolicyspaceandforallowinghostgov-ernmentstocontrolandregulateforeigninvestorsinthepublicinterestandinlinewithoveralleconomicpolicyandlongertermdevelopmentstrategies.

The principle of sovereign equality requiresthatinvestmentrulesshouldnotbeasymmetricalorone-sidedtothedetrimentofcertainStates.47Thisnotonlyexcludestreatiesthatimposeobligationsonjustoneclassofcontractingparties(i.e.capital-importingdevelopingcountries);italsoexcludestreatiesthatone-sidedlybenefitoneclassofcontractingpartiesandtheirinvestors,namelycapital-exportingcoun-tries,withoutrecognizingatthesametimethedutiesofinvestorsandtheirhomeStatestoensurethatbothcapital-importing and capital-exporting countriesshouldbeabletobenefitfromtheirsovereigntybybeingallowedtointroduceregulationsinthepublicinterest.

The protection ofhuman rights is a furtherprincipleofUnitedNationsconstitutionallawthatshould inform international investment relations.48Togetherwith theprotectionofproperty,duepro-cessandaccesstojusticetoallinvestors,nationalorforeign,thisprinciplestressestheresponsibilityofhostStatestoregulateforeigninvestorseffectivelyinordertoprotectthehumanrightsoftheirpopulations,includingforinstance,therighttoasafeenvironment,drinkingwaterandpublichealth.Thisresponsibilityshouldalsobeextendedtothemacroeconomicandindustrialpoliciesneededfordevelopment,whichisanotheressentialobjectiveofUnitedNationscon-stitutionallaw.49

Whileproblemsarisingfromthecurrentinter-national investment frameworkbasedon iiAs areincreasinglyrecognized(evenbyactorsthatprevi-ouslychampioned thoseagreements), there is less


consensus onhow to resolve them.Someobserv-erswhobelievethesystemshouldbesubstantiallyreformedproposeavarietyofchanges,andmethodsto implement them; others believe that countriesshould avoid evenentering into such treaties, andindeedshouldconsiderexitingfromthosetheymayhavealreadysigned,asdiscussedbelow.

(b) Reforming international investment rules, an arduous task

An essential characteristic of a good legalsystemisthatitcanbeamendedtocorrectitsshort-comingsortobeadaptedtothechangingpreferencesinthecommunityitappliesto.Thispointstoanotherproblemofthepresentinvestmentlawsystem:itisdifficulttoreform.

inthelastfewyears,therehavebeenanumberofinitiativesandproposalsforreformingthecurrent rules on internationalinvestment to better safeguardpolicy space for host States(see in particular UNCTAD,2013b).Proposedreformssug-gest that substantive standardsin future treaties be clarifiedand improved, and the proce-duresrelatingtoinvestor-Statearbitrationchangedtoensurethatinvestmenttrea-tiesareinterpretedinawaythatisacceptabletoallstakeholdersinvolved.

Regardingthefirstissue,clarificationsofinvest-mentprotectionrulescouldincludeconsideringthebreadthofwhatkindsof investmentareprotectedunderthetreatiesandwhoisprotectedasaninves-tor.50Changescouldspecifywhethersovereigndebtshouldbeprotectedasdirectinvestment,orwhetherthereshouldbespecialruleswithregardtodebt,asisthecaseinsomemorerecentinvestmenttreaties.51TreatiescouldalsoreaffirmStates’righttoregulatein order to protect the environment, public healthand safety, social concerns and cultural diversity,andclarificationstothiseffectcouldbeintroducedinthekeyprovisionsonindirectexpropriation,andFeT.These considerationswere incorporated, forinstance,intheinvestmentchapteroftheCanada-eUComprehensiveeconomic andTradeAgreement,which stressed the intention of both contracting

partiestoconcludeatreatythatrespectstheparties’righttoregulate.

Regardingdisputesettlement,theCanada-eUtreaty,aswellastheeU’sinvestmentpolicymoregenerally,includesinvestmenttreatyprovisionsthatpreventinvestorsfromfilingmultipleclaimsattheinternationalandnationallevels,andrulesthatallowarbitral tribunals tofilteroutspuriousor frivolousclaimsatanearlystageofarbitralproceedings,thusavoidinghighcostsofafullhearing.Furthermore,transparencyofarbitrationproceedingsisstrength-enedthroughreferencetothenewUNCiTRAlRulesonTransparency inTreaty-based investor-StateArbitrationthatbecameeffectiveon1April2014.Additionally,stricterrulesonprofessionalethicsforinvestmentarbitratorsaretobeincludedinfutureeUinvestmentagreements.intheCanada-eUtreaty,thecontractingpartieshavealsoagreedtoarosterofarbi-

trators,therebyrestrictingwhocanactasarbitratorinthedis-putesundertheagreement.Thisisakeyissue,asoneofthebasicprinciplesininternationallawisthatarbitratorsmustbeexplic-itly approved by all litigatingparties, a principle that proce-duresiniCSiDdonotrespect.52The treaty also states that thecontractingpartieshaveagreedtoconsidercreatinganappellate

mechanismforarbitralawardsinthefutureinordertoensureconsistencyandincreasethelegitimacyofthesystem.Finally,mechanismsforjointinterpre-tationofthegoverningagreementareincluded,asaremechanismsforthecontractingpartiestojointlyfilteroutarbitralproceedingsinthefinancialsector.

Thisapproachfacesseverallimitations.First,evenifdefinitionsinnewtreatiesaredraftedmoreclearlyandprecisely,thereisnoguaranteethatthiswill translate into actual rulings, as shown in thecaseofRailroadDevelopmentCorporation(RDC)againstGuatemala. in that iSDS case involvingtheDominicanRepublic-CentralAmerica-UnitedStates FreeTradeAgreement (CAFTA-DR), theGovernmentoftheUnitedStatesattemptedtorestrictthe possibility of interpretationof “fair and equaltreatment”bymeansofacustomaryinternationallawannex,butthetribunalignoredtheannex,stillinter-pretedtheFeTbroadlyandfoundtheGuatemalanGovernmentguilty.53

Recognizing the problems arising from the current international investment framework based on IIAs, some observers believe the system should be substantially reformed…


Second, changeswould only apply to newagreements, leaving all the previously agreedunchanged – unless they are renegotiated,whichwouldrequiretheagreementofallthegovernmentsinvolved.As the treatieswill remain bilateral inform,anyimprovementwillonlyhaveeffectforthebilateralagreementinquestion.inthisframework,restrictionsofthescopeofinvestmentprotectedinsometreatiesmaybecircumventedbyforeigninves-torsbyinvokingmost-favoured-nationclausesorbystructuringtheirinvestmentstocomeunderadiffer-enttreatythatprovidesmorefavourableprovisionsoninvestmentprotection.

To face the problems ofsuch “piecemeal approach”,otherproposalsaimatreform-ing the arbitration system alliiAswouldreferto.Functioningof arbitration centres can bemodified.Forinstance,areformto iCSiD Convention couldask contracting States to pre-approveanumberofpotentialarbitratorsfromthePanelofArbitratorsestablishedinsection4oftheConvention, limiting the discretionary power thePresidentof theWorldbankcurrentlyexercises.54More ambitious proposals suggest creating anappealsfacility,orreplacingadhocarbitrationtri-bunalswithaninternationalinvestmentcourt,withjudgesappointedbyStatesonapermanentbasis(VanHarten,2008).Suchinstitutions,itisargued,wouldgivemore coherence to international investmentlaw:althoughtheyshouldstillinterprethundredsofpotentiallydissimilartreaties,atleasttheinterpreta-tionswouldbemorecoherentthanthatprovidedbynumerousadhoctribunals(UNCTAD,2013b).buttheseinstitutions,whilepotentiallyleadingtomoreconvergenceininternationalinvestmentlaw,couldalsodevelopthelawindirectionsthatstatesdidnotforeseeandmaynotcontrol.Centralisationmayleadtomorecoherence,notnecessarilytomorefairness.

Changestothecurrentsystemcannotbelimitedtoprocesses.Asdiscussedearlier,oneoftherootsofthepresentflawsofiSDSwasprocedurecomingbeforesubstance.Thisputinthehandsofareducednumber of non-democratically elected arbitrators,workingwithoutcontrol,coherenceortransparency,theroleofgeneratingacorpsoflawoninternational

investment.itisnotonlytheprocedurefordisputesettlement thatmust be improved, it is thewholelogicthatmustbechanged:substancemustberede-fined,inawaythatrespectstheconstitutionalbasisand principles presented in subsection (a) above.itmust also recognise that the issues involvinggovernmentsandacountry’spolicyspacearecon-substantialtopublic,nottoprivatelaw.Publicandprivatelawsdonotonlydifferbecausetheyapplytodifferentsubjectsoflaw,butalsobecauseofdeepdifferences in their respectivecontentand inspira-tion.Privatelawappliestoprivateindividualsthat

areconsideredequalbeforethelaw,while inpublic law,whatisrelevantisthegeneralinter-estwhichispursuedbypublicpersons.This iswhydifferentsolutionsaregiventoproblemsthatinthemselvesmightappearcomparableorevenidentical(delaubadèreandDevolvé,1986).in a nutshell, general interestprevailsinpubliclawinterpre-

tations,andprivateinterestsinthoseofprivatelaw.Re-examinationofthelegalprinciplesshouldleadtoaradicalreorientationofhowthesedisputesarehandled:inparticular,“aprivatemodelofadjudica-tion(i.e.arbitration)isinappropriateformattersthatdealwithpubliclaw”(UNCTAD,2013a:116;seealsoVanHarten,2008).

Canamultilateralinstitutionprovideanalter-nativeframeworkbasedonpubliclaw?Ananswerto this question should examine several unsolvedissues,addressinginparticularthatoftheone-sidedlogic inwhich investors are always the claimantsandgovernmentstherespondents.Moregenerally,itshoulddiscusswhetheritwillremainamechanismforsolvingdisputesbetweenstatesandprivateinves-tors,orwillneedtoprovideastate-to-statedisputesolvingmechanismasdoes,forinstance,theWTo.Furthermore,countriesmaywant topreservetheirowninterpretationofpubliclaw,reflectingnationalvaluesandchoices,ratherthanacceptingauniformcorpsoflawinwhichdefinitiontheymayhavelittlesay.This has been a key concern,which explainsthe reluctance ofmost developing and also somedeveloped countries to accept initiatives like theMultilateralAgreementoninvestment(MAi),negoti-atedintheoeCDbetween1995and1998.

… while others believe that countries should avoid even entering into such treaties, and indeed should consider exiting from those they may have already signed.


(c) Terminating treaties and reverting to national law

Strictly speaking, iSDSmechanisms do notaddresstheproblemthatjustifiedtheirestablishment.ifthejudicialsystemofacountrydoesnotprovideindependentjusticeorenforcetheruleoflaw(includ-ingtheprotectionofprivateproperty),theappropriateresponseshouldbetofixthoseshortcomings,ratherthanallowaselectgroupofagents(i.e.foreigninves-tors)toseekjusticeelsewhere.Thiswouldtackletherootof theproblemwithout renouncing importantaspectsofnationalsovereignty,andwithoutbreach-ingtheprincipleofequalitybeforethelawbygivingforeignfirmsanadvantageoverdomesticfirms.

Forsure,improvingthedomesticjudicialsys-temmaybedifficultandmaytaketime,butrelyingonasystembasedonbiTsandotheriiAscannotbeconsideredanalternativetosuchreforms,becausesuch a system has serious legal flaws, sacrificesnationallegalsovereigntyandcanobstructthepursuitofnationalpolicyobjectives.Wherenecessary,fillinggapsinthedomesticlegalsystemshouldbegivenpriorityoverallocatingscarcejuridicalandadminis-trativeresourcestonegotiationofsuchinternationaltreaties and defending theState from subsequentcasespresentedtoiSDStribunals.inaddition,evenifpolicymakersgivehighprioritytoattractingFDi,thereisnosolidevidencethatthesetreatiesincreasesuchinvestmentsignificantly(seetheannextothischapter).AndevenifenteringiniiAsmayincreasetheattractivenessofdevelopingcountriesforTNCs,itwouldonlycomplementothermorefundamentalmotivations forFDi, inparticular thegeneralper-formanceof thehost economy (UNCTAD,2009).Hence,ifthelossofpolicyspaceandthefinancialchargethoseagreementsmayinvolvetogovernmentsaffect negatively the economic growth, itwouldnotonlylessenFDiinflows,butalsoweakentheirpotentialcontributiontofastergrowthandstructuraltransformation.Fromthehostgovernments’pointofview,theywouldpayahighpriceintermsoflostpolicyspaceandpotentialfinesinreturnforfew,ifany,gains.

onthesegrounds, itmightbesensiblenottosignsuchtreaties,adecisionalreadytakenbyanum-berofdevelopingcountries.butwhatifacountryhasalreadysigned?Renegotiatingexistingagreementsmaybeanalternative,butitpresentsmanydifficul-ties, as alreadydiscussed.Mostof all, it doesnot

addressthe“originalsin”ofiiAs,whichisreducinggovernmentspolicyspacebyapplyingprivatecom-merciallawtopublicmatters(and,inaddition,inanunbalancedway,sincetheclaimantcanonlybetheinvestor).Thequestionwouldnotbe, then, just toobtainmore“balanced”iiAs,buttorevolvetopubliclaw,whichprivilegesgeneralinterestsoverprivateones.Anotherstrategypursuedbysomecountriesistoterminatetheirinvestmenttreatiesand/orwithdrawfromtheiCSiDConvention.Forexample,bolivia,ecuador,andthebolivarianRepublicofVenezuelahavewithdrawnfromtheiCSiDConvention;somecountries, including theCzechRepublic,ecuador,indonesia,SouthAfricaandthebolivarianRepublicofVenezuela, have already terminated investmenttreatiesorhaveannouncedthewidespreadtermina-tionoftheirtreatyprogrammes.

The rationale behind such action is to onceagain have investor-State relations governed bydomesticlawanddomesticcourtsonly.Forexample,inSouthAfrica protection under investment trea-tiesisintendedtobereplacedbyaPromotionandProtection of investmentbill. in some countriesthis does not necessarily eliminate arbitration inforumsotherthaniCSiDandtheproblemoffollow-ingdifferentlegalstandards.ecuadorhasproposedthe creation of amechanismwithin theUnionof SouthAmericanNations (Union deNacionesSuramericanas−UNASUR)thatwouldapplydif-ferent legal standards.55other countries, such astheCzechRepublicandindonesia,havechosentoretainsomeinvestmentprotectionunderotherinter-nationallegalagreements(e.g.ASeANandtheeU,respectively).

Terminating investment treaties and/orwith-drawingfromtheiCSiDConventioninvolvevariouspreconditionsandlimitations(UNCTAD,2010and2013a).First, inordertobeeffective,ahostStatehastowithdrawfromallofitsinvestmenttreaties;otherwise, investorswill be able to structure orrestructuretheirinvestmentssothattheycomeunderthescopeofprotectionofoneoftheremaininginvest-menttreaties.Second,theterminationofinvestmenttreatiesaffectsnewinvestmentsbutdoesnotusuallyimmediatelyend theprotectionofexisting invest-ments,sincemostinvestmenttreatieshavesurvivalorsunsetclausesthatextendsuchprotectiontobetween10and15years.inordertocircumventthesurvivalclausesininvestmenttreaties,theCzechRepublichaschosenasomewhatdifferentapproachtoterminating


investmenttreatieswiththeconsentofsomeofitsinvestmenttreatypartners.inafirststep,itstreatypartnershaveagreedtoamendthesurvivalclausestostatethattheynolongerapply;inasecondstep,thetreatypartnershaveagreedtojointlyterminatetheinvestmenttreatywithimmediateeffect.Finally,concerningwithdrawalfromtheiCSiDConvention,mostinvestmenttreatiescontainthehostState’scon-senttovariousarbitralforums,includingarbitrationundertheUNCiTRAlrules,oradhocarbitration.WithdrawingfromtheiCSiDConventiononlywillthereforenotsignifyacompleteexitfromtheinvest-menttreatyandfromtheinvestor-Statearbitration

system,althoughitmayreduceaninvestor’schoicebyeliminatingtheinstitutionthathasbeencriticizedthemostwithregardtotransparencyandfairness.56

in any event, retreating from an investmenttreaty remains an option that a sovereign countrymaytakewithoutdependingontheapprovalofotheractors,andithasan immediate impactonallnewforeigninvestments.inaddition,terminatingatreatycouldalsobeanegotiating strategy for reformingexistingones,pushingforacompleterevisionofthepresentsystemandrecoveringsomepolicyspaceintheprocess.

Foreigncapitalflowstodevelopingandtransi-tioneconomiesmaysupportinvestment,economicdiversification andgrowth, or generatemacroeco-nomicinstability,externalimbalancesandboom-and-bustcreditepisodes.Theeffectsarehighlydependentontheiramount,compositionanduse.Governmentsneedtoapplycapitalmanagementpoliciesinorderto establish a suitablemacroeconomic frameworkforinvestmentandgrowth,influencetheamountandtypeofcapitalinflowsandchannelthemtoproduc-tiveuses.ThisisalsotrueforFDi,asitscontributiontostructuralchange,technologicalupgrading,accesstoworldmarkets,employmentgenerationandout-putgrowthdependscriticallyontheregulatoryandpolicyframeworkinthehostcountry.However,dif-ferenttradeandinvestmentagreementsmayreducethescopeforhost-countrygovernmentstoregulatecapitalmovementsandcurtailtheirabilitytoinflu-encethebehaviourofinvestorstoensurethatFDisupportstheirdevelopmentstrategy.

Thischapterhaslookedatthewaysinwhichdevelopingandtransitioneconomiesareaffectedbyaglobalfinancialcyclethatismainlydrivenbydevel-opedcountries’economicconditionsandmonetary

policydecisions.Theresultingcapitalmovementsdonotnecessarilycoincidewiththeneedsofdevelop-ing countries.besides, given theirmagnitude andvolatility, they tend to generate disruptivemacro-economicandfinancialeffects.indeed,internationalcapitalflowsgenerallycreateafinancialcycleinthereceivingcountries.Capitalinflowstendtoresultinanincreaseindomesticbanks’creditsupply,andanappreciation of domestic assets and the exchangerate.Theseeffects,inturn,tendtoincreasefinancialfragility,asgrowingindebtednessanddeterioratingcurrentaccountseventuallyleadtoareversalofthoseflowsand,possibly,afinancialcrisis.

Formacroprudential and developmental rea-sons, governments need sufficient policy space tobeable tomanage foreigncapitalflows, influencetheir amount and composition, and channel themtoproductiveuses.inordertocreateandmaintaindomesticmacroeconomic andfinancial conditionsthat support growth and structural transformation,governmentsshouldhaveattheirdisposalsuitablepolicyinstrumentsformanagingcapitalflowsandforpreventingorcopingwiththerecurrentshockstheycouldprovoke.Thisrequiresthepreventiveuseof

D. Summary and conclusions


capitalmanagementmeasuresasanormalinstrumentinpolicymakers’toolkit,ratherthanasanexceptionalandtemporarydevicetobeemployedonlyincriticaltimes. Several developing countries have recentlyappliedcapitalaccountmanagementmeasuresthat,despite some shortcomings, can be creditedwithreducingtheirfinancialvulnerabilityandincreasingtheirresiliencewhentheglobalfinancialcrisisstarted.

Theremaybedefactoanddejureobstaclestotheimplementationofcapitalmanagementpolicies.Thefirstisrelatedtotheactionoffinancialagentsandthesecondtoformalcommitmentstakeninfavourofcapitalliberalization.onthelatter,despitesomedivergingviews, itseemsthatmultilateralrules intheiMF’sArticlesofAgreementandintheWTo’sGATSenablegovernmentstomanagetheircapitalaccounts forprudential reasons, including throughcapitalcontrols.However,somenewbilateraland/orplurilateralagreementsthathavebeensignedorarebeingnegotiatedintroducemorestringentcom-mitmentswithrespecttofinancialliberalizationthatmight greatly reducepolicy space in this context.Therefore,governmentsthataimtomaintainmacro-economic stability andwish to re-regulate theirfinancialsystemsshouldcarefullyconsidertherisksoftakingsuchcommitments.

Thischapteralsoanalyseshowtherulesembed-dediniiAscouldrestrictgovernments’policyspaceand how these restrictionsmay impact on theirdevelopmentpossibilities.SuchagreementscanhelppolicymakerstofocusonhowbesttoattractFDi.buttakingahistoricalperspective,itshowsthechangingperceptionoftheseagreements.WhenmostoftheiiAsweresignedinthe1990s,itwasbelievedthatanylikelylossofpolicyspaceresultingfromthoseagreementswasasmallpricetopayforanexpectedincrease inFDi inflows.This perceptionbegan tochange in the early 2000swith growing concernsthatinvestmentrulescouldobstructpoliciesaimedat improving the impact of FDi on the economy.Thisisreflectedinthesharpriseinthenumberofcasesthatinvestorshavebroughttoarbitrationasaresponsetogovernmentpolicies,sometimesentailinghighfinancialcoststoStates.Moreover,afterseveral

decadesofoperatingiiAs,thereisnostrongempiricalevidencethattheysignificantlyincreaseFDiinflows,whichhasbeentheirmainraison d’être.

ThemostcontroversialaspectrelatingtoiiAs’impactsongovernments’policyspaceistheiSDS,whichtakestheformofarbitrationtribunalsaimedatenforcingthegeneralrulesstatedinthoseagree-ments.Asthoserulesarefrequentlycraftedaslooseandopen-endedstandards,thetribunalshaveawidemargin of discretion in determining their norma-tive content. Consequently, arbitration tribunalshavebecomeimportantlawmakersininternationalinvestmentlaw,assumingafunctionthatisusuallyallocatedtoStates.inaddition,thelackoftranspar-encyandcoherenceoftenobservedintheoperationsof those ad hoc tribunals, and their apparent pro-investorbias,havegivenrisetoconcernsabouttheentiredisputesettlementmechanism.ThishasledtodifferentinitiativesrelatedtoiSDSwiththeaimofrecoveringthespacefornationaldevelopmentpoli-cies.Theseinclude:(i)progressiveand“piecemeal”reforms,includingaddingnewprinciplesfordraft-ing sustainable development-friendly agreementsand renegotiating bilateral treaties one at a time(UNCTAD,2013b);(ii)thecreationofacentralized,permanent international investment tribunal; and(iii)retreatingfrominvestmenttreatiesandrevertingtonationallaw.

ifthereasonforestablishingiSDSistorespondto failures innational judicial systems thatdonotprovideindependentjusticeorenforcetheprotectionofprivateproperty,theappropriateresponseshouldbe tofix those shortcomings, rather thanallowingforeigninvestorstoseekjusticeelsewhere.Thelegalframework for international investment based oniiAsandonadhocarbitrationtribunalshasfailedsofartoprovidealegitimatealternativetonationalcourts.Asinvestmentdisputesofteninvolvemattersofpublicpolicyandpubliclaw,thedisputesettle-mentmechanismcannolongerfollowamodelthatwasdevelopedfortheresolutionofdisputesbetweenprivatecommercialactors.instead,itshouldtakeintoconsiderationthepublicintereststhatmaybeaffectedininvestmenttreatyarbitration.


1 long-termcapitalflowsthatfinancecapitalformationmayincludegreenfieldinvestmentsandsomelong-term credit or portfolio investments.However notallFDiflows(e.g.mergersandacquisitions)expandproductivecapacity,andneitheraretheyalllong-termcapitalflows(e.g.intra-TNCshort-termcredits).

2 Foranearlierdiscussionofrelatedissues,seeTDR 2006,chaps.iVandV.

3 Rey(2013)highlightstheinterdependencebetweenriskperceptions,leverageandglobalcapitalflows,evidencedbythefactthatreceivingcountriesandregionsborrowthematthesametime.AsnotedbyRey, “There is a globalfinancial cycle in capitalflows,assetpricesandcreditgrowth.Thiscycleco-moveswiththeViX,ameasureofuncertaintyandriskaversionofthemarkets.”Shefurtherobserves,“…oneimportantdeterminantoftheglobalfinancialcycleismonetarypolicyinthecentrecountry,whichaffects leverageofglobalbanks, creditflowsandcreditgrowthintheinternationalfinancialsystem”(Rey, 2013: 17).Therefore, the volumeof cross-borderlending/borrowingisdeterminedbyeventsin countrieswhere the big financial institutionschannellingthelendingarebased.

4 Carrytradereferstocapitalflowsmotivatedbytheopportunityforarbitrageprofitsthatcanbehadfromdifferentials in nominal interest rates in differentcountries,andbytheexpectationofexchangerateappreciation in the destination country (seeTDR 2011,chap.Vi).

5 indiscussingtheinteractionsbetweenpolitics,cred-ibilityandconfidence,MartínezandSantiso(2003)show,forexample,howperceptionsofWallStreetinvestorsaboutthesustainabilityofbrazil’snationaldebtsuddenlychangedinamatterofdaysduringthatcountry’spresidentialelectionsof2002.

6 SeeGrabel (2000) for an extensive discussionofthe relationship between policy credibility andconfidence-buildinginemergingmarkets.

7 Agood exampleof this view is that ofDomingoCavallo,Minister of economy inArgentina inApril1995,atthetimeofthe“tequila”crisis:“Fewwoulddisputethatcapitalinflowsoftheearly1990shelpedtheArgentineeconomy.butiwouldargue,

morecontroversially,thatthecapitaloutflowsthatArgentina has experiencedmore recently havehelped, too.Theyhelpedbecause, in spite of theArgentine economy’s impressive progress towardtransparencyduringthelastfewyears,somepoliti-ciansstilldidnotgetthemessage(i.e.thatfiscaldis-ciplinewasnecessary).(…)Thankstothepressuresexertedby the recent outflows, several importantreformsthattheexecutivebranchhadproposedtotheCongressyearafteryearwithoutsuccesshaveatlastbeenapproved”(Cavallo,1996:47).

8 For an early accountof country experienceswithcapitalinflowsandoutflowssincetheearly1990s,seeGavinetal.,1995;foramorerecentanalysis,seeAkyüz,2013.ontheroleofconfidence-buildingpoliciesinexplainingmacroeconomicoutcomes,seebresser-Pereira,2001.

9 internationalreservesheldbydevelopingcountriesincreased from $1,350 billion to $4,257 billionbetweentheendof2002andtheendof2007(iMF,International Financial Statisticsdatabase).

10 Developingcountrieshavealsoadoptednewregu-latorymeasures in their banking systems, includ-ing supervisory rules and credit orientation. inArgentina, for example, the reformof itsCentralbankCharterin2012gavethatbanktheauthoritytodirectbankcreditonvariousgrounds.

11 Directive88/361/eeC,June24,1988,art.63oftheConsolidatedVersionoftheTreatyontheFunctioningoftheeuropeanUnion.

12 Themost frequent reservations apply to FDi inbanking, broadcasting, energy, primary sectors,telecommunicationsandtransportation.ReservationsareregularlyexaminedbytheoeCDwiththeaimofassistingmemberstoeventuallywithdrawtheirreservations.

13 TheGATS isapositive-list agreement (i.e. coun-trieslist theircommitmentsintermsofmodeandthespecificservicestheywillliberalize,butretainautonomyoverallothersectors(seealsochapterV,sectionb.1)). it defines four differentmodes ofsupply for deliveryof services:Mode1 refers tocross-border trade,Mode2 refers toconsumptionabroad,Mode3referstothecommercialpresencein

Notes


theterritoryofanothermember(FDi),andMode4referstothepresenceoftheservicesupplierintheterritoryofanothermember.

14 in particular, in 2009 and 2011, theRepublic ofecuador, at theCommittee ofTrade inFinancialServicesofWTo,arguedfortheneedtoclarifythewordingofsomearticlesofGATSandtheAnnexonFinancialServices relating tomacroprudentialmeasuresand,mostspecifically,capitalflowsman-agement.TheissuewasfarfromsettledbutremainedontheagendaoftheCommittee.Subsequently,atitsmeetinginMarch2013,variouscountriesmadepresentationsontheirmacroprudentialframework,butnoconsensuswasreachedas towhether theirframeworkwascompatiblewiththerelevantGATSprovisions.

15 Also,underart.XVi(MarketAccess),partiii,ifaMemberhasgrantedaccess toa serviceprovidedfromtheterritoryofanotherMember,itmustallowthecapitalmovementswhichare“essentiallypart”or“related”totheprovisionofsuchaservice.

16 Atfirstglance,thesecondsentenceseemstocancelthefirstone,thatis,therewouldbenoroomtoregu-lateanythinggoingagainstacommitmentpreviouslyenteredinto.butithasbeenarguedthat,first,thestatement,“notwithstandinganyotherprovisionsoftheAgreement…”,providesanexceptionformeas-urestakenforprudentialreasons,whichcouldmeanthateven if inconsistentwithamember’sgeneralobligationsandspecificcommitments,theywouldstillbelegallyallowed.Second,thelistofprudentialmeasures ismerely indicative, as revealedby theword, “including”.Therefore, any othermeasuretakenfor“prudentialreasons”couldbeacceptable.Moreoverthemeasuremaynotevenhavetobe“pru-dential”,butsimplytakenfor“prudentialreasons”.Third,astothesecondsentence,ithasbeenarguedthatitonlyimposesanobligationofgoodfaithinadoptingthose“measuresforprudentialreasons”,implying that they cannot be ad hoc in order toavoidobligations entered into (seeleroux,2002;VonbogdandyandWindsor,2008).

17 However, thisacceptanceisnotuniform,asmen-tionedabovewhendiscussingtheiMF’sambiguouspositionvis-à-vissuchpolicies.

18 See,forexample,Rey(2013),whoarguesthat,ininternationalmacroeconomics,countriesdonotfacea“trilemma”buta“dilemma”; that is tosay, that“independentmonetarypoliciesarepossibleif,andonlyif,thecapitalaccountismanaged”.

19 inChile,capitalcontrolsimplementedintheearly1990senlargednotonlymonetarypolicyspace,butfiscalspaceaswell.Asthenewelectedgovernmentintended to expandpublic expenditure and socialtransfers,itsoughttocontrolaggregatedemandandinflationbyraisinginterestrates,andtheonlywaytopreventthisfromleadingtoexcessivecapitalinflows

thatwouldhaveaffectedmonetarypolicywasbymeansofcapitalcontrolsoninwardFDi.in1998,Malaysia responded to the crisis in the regionbyadoptingcontrolsoncapitaloutflows−ratherthanoninflowsasothercountrieshaddoneintheearly1990s−inordertostemtheseoutflowsandregaincontrolovermacroeconomicpolicy(Ariyoshietal.,2000).

20 See, for example,eichengreen andRose (2014),whodiscusstherationaleunderlyingtheadoptionofthesecontrolsbycountrieslikebrazil,indonesia,ThailandandtheRepublicofKorea.

21 Althoughthefocuswasonrestraininginflows,somecountries,suchasPeru,theRepublicofKoreaandSouthAfrica,alsochangedtheirregulationsaimedatencouragingmorecapitaloutflows(iMF,2011:30–34).

22 See,forexample,iADb(2014),whichnotesthatinlatinAmerica,forinstance,bothactualandstruc-turalfiscalbalanceshavedeterioratedalongsidetheincreaseinpublicdebtratiossincethe2008globalcrisis.Thisemphasizestheneedtorebuildbuffersintheregiontogivecountriessufficientfiscalcapacitytorespondtofutureshocks.

23 inbrazil,theFundodeGarantiadeTempodeServiço(FGTS)isaseveranceindemnityfundforworkers,generatedbymandatorycontributionsbyemployersofupto8percentofwages,whicharedepositedinapublicdevelopmentbank, theCaixaeconômicaFederal.

24 See also: iDFC, 2014, at: http://www.idfc.org/Members/tskb.aspx(accessed21March2014).

25 AccordingtoUNCTAD(2003:87),“AttractingFDimaynot be enough to ensure that a host countryderives its full economic benefits. Freemarketsmaynot leadforeign investors to transferenoughnewtechnologyortotransferiteffectivelyandatthe depth desired by a host country.but policiescan induce investors to act inways that enhancethedevelopment impact—bybuilding local capa-bilities, using local suppliers andupgrading localskills,technologicalcapabilitiesandinfrastructure.”More recently,UNCTAD (2012: 102) includedamongthe“keyinvestmentpolicychallenges”theneedto“connecttheinvestmentpolicyframeworkto an overall development strategy or industrialdevelopment policy thatworks in the context ofnationaleconomies,andtoensurecoherencewithotherpolicyareas,includingoverallprivatesectororenterprisedevelopment,andpoliciesinsupportof technological advancement, international tradeandjobcreation.‘Newgeneration’investmentpoli-ciesincreasinglyincorporatetargetedobjectivestochannel investment to areas key for economic orindustrialdevelopmentandforthebuild-up,main-tenanceandimprovementofproductivecapacityandinternationalcompetitiveness.”


26 TheUNResolution1803oftheGeneralAssemblyof 1962 onPermanent Sovereignty overNaturalResources,UNDocA/ReS/1803(XVii), 2 i.l.M.223(1963)representsacompromiseonthisissue,althoughitclearlyrecognizestheownershipofnatu-ralresourcesbythepeopleoftheproducingcountries.

27 Draft Convention on the Protection of ForeignPropertyandResolutionoftheCounciloftheoeCDontheDraftConvention,7i.l.M.117(1968).

28 Whencreating theiCSiDin themid-1960s,Aronbroches,thenGeneralCounseloftheWorldbank,championed the formula, “putting the procedurebeforesubstance”.inordertoovercometheimpasseinfindingaglobalconsensusonrulesofpropertyprotectionduring the timesofdecolonizationandtheColdWar,headvocatedsettingupaframeworkforresolvinginvestor-Statedisputesthatcouldworkoutsubstantiverulesonthego.

29 ThreecasesagainstArgentinahavebeenacceptedbyiCSiD,undertheArgentina-italybiT.

30 Some treaties includepartial exceptions for taxa-tionmeasures, stating that if bothhomeandhostgovernmentsagreewithinthespecifiedperiodthatataxmeasureisnotexpropriation,thentheinvestorcannotchallengethattaxmeasureundertheiSDS.

31 Forinstance,Argentinawasforcedtosharplydevalueitscurrencyinearly2002,whichresultedinalargenumberofclaimsagainstthecountry.Similarly,aclaimwasopenedagainstCyprusfortakingoverabankin2012toavoidtheimplosionofitsbankingsystem,andanotheragainstGreeceduetoitsrene-gotiationofsovereignbonds.

32 Seerespectively:1)CMSGasTransmissionCov.ArgentineRepublic, iCSiDCaseNo.ARb/01/8,Award,12May2005;lG&eenergyCorp,lG&eCapitalCorp,lG&einternationalincv.ArgentineRepublic, iCSiDCaseNo.ARb/02/1,Decisionon liability, 3october 2006;bGGroup plc v.RepublicofArgentina,UNCiTRAl,FinalAward,24December 2007;ContinentalCasualtyCo v.ArgentineRepublic, iCSiDCaseNo.ARb/03/9,Award, 5 September 2008; National Grid plcv.Argentine Republic, UNCiTRAl,Award,3November 2008; 2)Aguas del Tunari SA v.Republic ofbolivia iCSiDCaseNo.ARb/02/3,DecisiononRespondent’sobjectionstoJurisdiction,21october2005;Suez,SociedadGeneraldeAguasdebarcelona SA, andVivendiUniversal SA v.ArgentineRepublic, iCSiDCaseNoARb/03/19andAWGGroupv.ArgentineRepublic,Decisiononliability,30July2010;biwaterGauff(Tanzania)ltdv.UnitedRepublicofTanzania,iCSiDCaseNo.ARb/05/22,Award,24July2008;3)PieroForesti,idalauradeCarliandorsv.RepublicofSouthAfrica,iCSiDCaseNo.ARb(AF)/07/1,Award,4August2010; 4)Methanex Corp v. US, UNCiTRAl/NAFTA,FinalAwardoftheTribunalonJurisdiction

andMerits,3August2005;ChemturaCorp(formelyCromptonCorp)v.Canada,UNCiTRAl/NAFTA,Award,2August2010;5)VattenfallAb,VattenfalleuropeAG,VattenfalleuropeGenerationAG&CoKGv.FederalRepublicofGermany,iCSiDCaseNo.ARb/09/6,RequestforArbitration,30March2009;MetalcladCorporationv.TheUnitedMexicanStates,iCSiDCaseNo.ARb(AF)/97/1(NAFTA),Award,30August2000;SDMyers,incv.Canada,UNCiTRAl(NAFTA),PartialAward,13November2000;6)FTRHoldingSA,PhilipMorrisProductsS.A.andAbalHermanosSAv.orientalRepublicofUruguay,iCSiDCaseNo.ARb/10/7,NoticeofArbitration, 19 February 2010 (pending); PhilipMorrisAsia limited v.Australia, UNCiTRAl,NoticeofArbitration,21November2011(pending);and7)VattenfallAbandothersv.FederalRepublicofGermany,iCSiDCaseNo.ARb/12/12,registered31May2012(pending).

33 infact,manyinvestmentdisputesrelyonthesamedisputesettlementrulesasthoseapplicableinprivate-privatearbitration,suchastherulesoftheArbitrationinstituteoftheStockholmChamberofCommerce,orinsomecasesthoseoftheinternationalChamberofCommerce,oraremodelledonsuchrules,suchastheUNCiTRAlArbitrationRules.

34 Recently, somepositivedevelopmentshave takenplace towardsmore transparency, inter alia inNAFTAandinothermorerecentinvestmenttreaties,in the revisions in2006of the iCSiDArbitrationRulesandunderthenew2014UNCiTRAlRulesonTransparency inTreaty-based investor-StateArbitration.

35 ThearbitrationconcerningGermany’snuclearpowerphase-out,forinstance,remainsconfidential;onlythe registration of the case and some proceduraldetailsaboutitareknownandavailableontheiCSiDwebsite.

36 VanHarten (2012) examined the frequency ofexpansiveandrestrictiveinterpretationofrulesonissuesonwhichthetextofaninvestmenttreatyisambiguousorsilent.Resolutionsofanissuefroman expansive interpretation tend to favour claim-antsandallowmoreclaimstoproceed.Thestudyfound“tentativeevidenceofsystemicbias”resultingfromexpansiveinterpretationsofthetreaties,basedontheresolutionoffourissues:theconcept(largeorstrict)ofinvestment,theacceptabilityofclaimspresentedbyminorityshareholders,theacceptabilityofclaimsbycorporationswhentheownershipoftheinvestmentextends throughachainofcompaniesrunningfromthehosttothehomeStateviaathirdState;andtheacceptabilityofparallelclaims.ThatbiaswasevengreaterwhentheclaimantwasfromaWesterncapital-exportingState.

37 For instance, human rights complaints,whetherbeforeoneof theregionalhumanrightscourtsor


beforethecommitteesintheuniversalregime,areonly accessible regularly after the exhaustion oflocalremedies;ininternationalenvironmentallaw,individualaccessisevenmorelimited.Thisleadstoanasymmetricenforcementofinternationalnormsoninvestmentprotectiontothedetrimentofotherinternationallegalregimes.

38 Thecasereferredtoaninvestmentinthetelecom-municationssectorintheCzechRepublic.onepro-ceedingwasbroughtbytheinvestoritself,andtheotherbyitsshareholders.eventhoughtheapplicablebiTswerevirtuallyidentical,onetribunalheldtherespondentStateliableforapproximately$270mil-lionindamages,whiletheotherfoundnocompen-sablewrongdoing.CompareCMeCzechRepublicb.V.v.TheCzechRepublic,UNCiTRAl,PartialAward,13.13Sept.2001,FinalAward,14March2003,withRonaldS.lauderv.TheCzechRepublic,UNCiTRAl,FinalAward,3Sept.2001.

39 See, for example,Azurix Corp. V.ArgentineRepublic, iCSiDCaseNo.ARb/01/12,Award,14July2006,para.391.

40 AeSCorp.V.Argentina,iCSiDCaseNo.Arb/02/17,DecisiononJurisdiction,26April2005,para.31.AsimilarapproachmaybefoundinGasNaturalv.Argentina, iCSiDCaseNo.ARb/03/10,DecisiononJurisdiction,17July2005,para.36.Similarly,RomakS.A.v.RepublicofUzbekistan,UNCiTRAl,PCACaseNo.AA280,Award,26November2009,para.170;ChevronCorp.andTexacoPetroleumCo.V.Republicofecuador,UNCiTRAl,PCACaseNo.34877,PartialAwardontheMerits,30March2010,para.164.

41 onthedifferentusesofprecedentininternationallaw,see Jacob,2011.

42 UNCTAD (2014) presents a number of deci-sions taken in 2013 as examples of contradictoryinterpretations.

43 See CMS Gas Transmission Company v. theRepublicofArgentina,iCSiDCaseNoARb/01/8,DecisionoftheadhocCommitteeontheapplicationoftheannulment,25September2007.

44 SeeUNCTAD(2009),Annex:Asummaryofecono-metricstudiesontheimpactofbiTsonFDi.

45 Up to now, the highest awardwas ruled againstecuador,whichwas sentenced to pay $1.8 bil-lionbecauseitterminatedthecontractwithanoilcompanythathadfailedtocomplywithitscondi-tions.SeeOccidental Petroleum Corporation and Occidental Exploration and Production Company v. The Republic of Ecuador (iCSiD Case No.ARb/06/11),Award5october2012.

46 SeeUnitedNationsCharterArt.1(2),andArt.2(7)(regardingnon-interferenceinmattersofdomesticjurisdiction).

47 UNCharter,Art.2(1).48 UNCharter,Preamble,Recital2,Art.55(c).

49 UNCharter,Preamble,Recital3(“socialprogress”),Art.55ff.

50 Tohelpdesign investment treaties thatstrengthenthe development dimension, rebalance rights andobligationsofStatesandinvestors,andthatmanagethesystemiccomplexityoftheiiAregime,UNCTAD(2012)presentsadetailedlistofalternativemodelclausesoneveryissueusuallyincludedinaninvest-menttreaty,startingwithdefinitionsofinvestmentand investor,and includingsubstantivestandards,suchasindirectexpropriationandfairandequitabletreatment,andprovisionsrelatingtoinvestor-Statedisputesettlement.

51 Forexample,thePeru-RepublicofKoreaFreeTradeAgreementwhich entered into force on1August2011,states(inannex9d):“ThePartiesrecognizethatthepurchaseofdebtissuedbyaPartyentailscommercial risk. For greater certainty, no awardmaybemade in favorof adisputing investor foraclaimwithrespecttodefaultornon-paymentofdebtissuedbyaPartyunlessthedisputinginvestormeetsitsburdenofprovingthatsuchdefaultornon-paymentconstitutesanuncompensatedexpropriation[...]orabreachofanyotherobligationunderthisChapter.”And:“NoclaimthatarestructuringofdebtissuedbyaPartybreachesanobligationunderthisChaptermaybesubmittedto,orifalreadysubmit-tedcontinuein,arbitrationunderthisChapteriftherestructuringisanegotiatedrestructuringatthetimeofsubmission,orbecomesanegotiatedrestructuringaspersuchsubmission,exceptforaclaimthattherestructuringviolatesArticle9.3or9.4[i.e.nationaltreatmentorMFNtreatment].”

52 Article37.2 (b) states: “Where thepartiesdonotagreeuponthenumberarbitratorsandthemethodof theirappointment, theTribunalshallconsistofthreearbitrators,onearbitratorappointedbyeachpartyand the third,whoshallbe thepresidentoftheTribunal, appointed by agreement of the par-ties.”Article 38 states: “if theTribunal shall nothavebeenconstitutedwithin90days afternoticeof registrationof the requesthasbeendispatchedbytheSecretary-Generalinaccordancewithpara-graph(3)ofArticle36,orsuchotherperiodasthepartiesmayagree,theChairmanshall,attherequestofeitherpartyandafterconsultingbothpartiesasfaraspossible,appointthearbitratororarbitratorsnot yet appointed.”Article 5 specifies that “ThePresidentofthebankshallbeexofficioChairmanoftheAdministrativeCouncil(hereinaftercalledtheChairman).”AreformtoiCSiDConventioncouldaskcontractingStatestopre-approveanumberofpotential arbitrators from thePanel ofArbitratorsestablishedinsection4oftheConvention.

53 See: http://www.citizen.org/documents/RDCvs-Guatemala-Memo.pdf.VariousattemptstonarrowFeThaveallbeenignoredbyiSDStribunals,such


thatsomeinvestmentlawexpertsarebeginningtothinkthatnoprecisewordingofFeTispossible.

54 SeeArticles5,13.2,14.2and38oftheConventionontheSettlementofinvestmentDisputesbetweenStates andNationalsof otherStates, available at:https://icsid.worldbank.org/iCSiD/StaticFiles/basic-doc/CRR_english-final.pdf.

55 ThemaindifferencebetweeniCSiDarbitrationandalternativeoptions is thegreatercontroldomesticcourtscanexerciseinoverseeingnon-iCSiDarbi-trationsandinenforcingnon-iCSiDawardsundertheNewYorkConventionfortheRecognitionandenforcement of ForeignArbitralAwards,whichcontains, inter alia, a public policy exception forrecognitionandenforcement.

56 inaddition,art.72oftheConventionprovidesthatwithdrawal from theConvention“shall not affecttherightsorobligationsunder thisConventionofthatStateorofanyofitsconstituentsubdivisionsoragenciesorofanynationalofthatStatearisingoutofconsenttothejurisdictionoftheCentregivenbyoneofthembeforesuchnoticewasreceivedbythedepositary.”Howthisprovisionistobeinterpreted,andwhetheritonlycoverstheeffectofarbitralpro-ceedingsthathavebeeninitiatedbyforeigninvestorsbeforetheeffectsofdenunciationoftheConventiontakeplaceorwhetheritensuresthesurvivalofallconsentstoiCSiDarbitrationcontainedinanypriorinvestmenttreatyisaheavilycontestedand,sofar,unresolvedissue.

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Do Bilateral Investment Treaties Attract FDI Flows to Developing Economies? 155

Thisannexpresentsaneconometricexerciseaimedattestingwhetherbilateralinvestmenttreaties(biTs)fosteredbilateralforeigndirectinvestment(FDi)flowsfromdevelopedtodevelopingeconomiesbetween1985and2012.

Annex to chapter VI

DO BILATERAL INVESTMENT TREATIES ATTRACT FDI FLOwS TO DEVELOPING ECONOMIES?

This exercise relies on the standard gravitypaneldatamodel,whichpredictsthatFDibetweenhomeandhostcountriesisproportionaltotheirmar-ketsizeandinverselyproportionaltothegeographicdistancebetweenthem:

• TheexplainedvariableisFDiasmeasuredbythenetbilateralFDioutflowsfromdeveloped(home)todevelopingcountries(host),inmillionsofdol-lars.ThemainsourceforbilateralFDioutflowswastheoeCDInternational Direct Investment Database. Serieswere completedwith datafrom theUnitedStatesbureau ofeconomicAnalysisandfromUNCTADdatabases.

• MarketsizewasmeasuredbyrealGDPofthehomeandhostcountriesinconstant2005dol-lars,usingUnitedNationsNational Accounts Main Aggregatesdatabaseandnationalsources.ApositivesignwasexpectedforthecoefficientsofbothGDPs.Thelargerthesizeofthehome

Model and data sources

country, themoreFDi shouldflowfrom thatcountry;andthelargerthesizeofthehostcoun-trythegreatershouldbethepotentialdemandfortheoutputofforeigninvestors.

• Geographicaldistancebetweenthecapitalcitiesof thehomeandhostcountrieswasobtainedfromtheCEPII GeoDist database(MayerandZignago,2011).itisusedasaproxyfortransac-tionandtransportationcostsaswellasfortheinstitutionalandculturaldistancesbetweentwocountries.Thesignofthecoefficientisindica-tiveoftheprevailingkindofFDi.ApositivesignwouldsuggestexportsandFDiaresubsti-tutes,becauseenterpriseswillservecustomersbyinvestinginthehostcountryratherthanbyexportingfromthehomecountry.AnegativesignwouldindicatecomplementaritybetweenFDiandbilateraltrade,typicallyininvestmentsrelatedtoaninternationalproductionnetworkinvolvingthehomeandhostcountries.


Asetofdummiesrepresentingtime-invariantvariables taken fromCEPII GeoDist datawereincluded. They capture geographical, culturaland historical similarities of country pairs,whichincreaseeconomictiesorreducetransactioncosts.Correspondingdummiesareequaltoonewhenbothcountriesshareacommonlandborder,languageorcolonialhistory.Apositivesignwasexpectedforthecoefficientsofthesevariables.

The standard gravitymodelwasmodified tointroducethevariablesrelatedtobiTsandotherdeter-minantsofFDitocompletetheestimableequation:

• AdummyvariableequalsoneafterthecountrypairhassignedabiT,asreportedbyUNCTAD.GiventhanbiTsaresupposedtoreduceinvest-mentrisks,theycanbeviewedasprovidinganincentive to investors, therefore the expectedsign is positive.Three alternative variablesrepresentingbiTswere used in the estima-tions:twodummyvariables(asignedbiTandtheentryintoforceofabiT)andonevariablewhichmeasuredthenumberofyearsthathadpassedsincethesigningofthebiT.

• labourskillwasmeasuredbytheaverageyearsofsecondaryschoolingintheadultpopulation(over25yearsofage)ofhostcountries.Dataweretakenfrombarroandlee(2010),whichprovide the educational attainment data atfive-yearintervalsfrom1950to2010.Alinearinterpolationwasusedtoobtaindatabyyear.Apositivesignwasexpectedforthiscoefficient.

• Thedifference in averageyears of schoolingwasusedasaproxyfortheabsoluteskilldif-ferencebetweenthehomeandhostcountry.1ifFDiismotivatedbymarketaccess,anegativesignshouldbeexpected,as“absoluteskilldif-ferences reduceaffiliate sales” (seeblonigenetal.,2002);however,ifFDiismotivatedbylowerwagecostsinthehostcountry,apositivesignwasexpected.

• opennesswasmeasuredbytheratioofimportstoGDP.DatawereextractedfromUNCTADdatabasesandnationalsources.Apositiverela-tionshipwasexpected,asitcouldbeinterpretedasameasureofoverallopenness.

• Regionaltradeagreements(RTA)wasadummyvariableequaltooneafterbothcountrieshadsigned a bilateral free trade agreement or aregional trade agreement.Datawere derivedfromadatabaseindeSousa(2012).Apositiverelationshipwas expected, given thatRTAslowertradebarriersandfacilitatethemovementofintermediateandfinalgoodsbetweenfirmsinhomecountriesandforeignaffiliatesinhostcountries.MoreoversomeRTAsincludeotherconditionssuchasinvestmentregulationsthatfacilitatethemobilityoffundsandcapitalflows.SincesomeRTAsincludeFDi-relatedclauses,RTAswereexcludedfromtheestimableequa-tionstoisolatetheimpactofbiTs.inthatcase,thecoefficientofthebiTvariableswasexpectedtobebiasedupwards.

Estimation methods and results

AlargepaneldataofbilateralFDioutflowsto119developingeconomiesfrom27developedecono-miesovertheperiod1985−2012wasusedtoexaminetheeffectofbiTsonFDitodevelopingeconomies.Themodifiedgravityequationwasestimatedbased

ontwoestimationmethods:ordinary leastsquares(olS) and Poisson pseudo-maximum likelihood(PPMl).All time-variant explanatory variableswere laggedbyoneperiod to reduce endogeneityproblems.


Ordinary least squares (OLS)

• Given themultiplicative formof the gravityequation,theusualmethodistotakethenaturallogarithms of the explained and explanatoryvariables(excludingdummies)andapplyordi-nary least squares to the resulting log-linearequation.2

• Tocontrolforomittedvariablebias,homeandhostfixedeffectswereincludedthroughdummyvariableswhichcontrol for all time-invarianthome or host country characteristics.3Alsoincludedweretimefixedeffectstoaccountforanyshocksthataffectallcountries.

• Columns1to5ofthetable6.A.1presenttheresults of the estimations obtained byolS,alongwith robust standard errors and threetypesoffixedeffects (year,host countryandhome country). overall, this specificationexplainsabout50percentofthevariationofbilateralFDioutflows.Resultsshowthatexceptforopennessandcommonborder,coefficientsare all statistically significant. in particular,“geographicaldistance”hasastrongeffect:itsnegativesignindicateseitherthatFDiisrelatedtobilateraltradeorhighoperatingcostsduetogeographical distance, and cultural and insti-tutionaldifferences.Thecoefficientof“labourskill” in host countries has a positive sign,suggestingamoreimportantroleofdomesticmarkets.Allothervariableshavetheexpectedsign.inthisspecificationbiTscoefficientsaresignificantandpositive.However,thepropor-tion ofFDi that can be attributed tobiTs isvery low,asreflected innegligiblechange inR-squaredwhenincludingabiTvariable.

Poisson pseudo-maximum likelihood (PPML)

• Santos Silva andTenreyro (2006) showedthatduetoJensen’sinequality4theuseoflog-linearizedgravitymodelsbyolScangeneratebiased5estimationsandproducemisleadingcon-clusions.Theysuggestedthatthecoefficientsinthegravityequationshouldbeestimatedinits

multiplicative form, and proposed using thePoissonpseudo-maximum-likelihood(PPMl)estimationmethod.PPMlisconsistentinthepresenceofheteroskedasticity,andprovidesawaytodealwithzerovalues(unlikelogarithmspecifications).

• Columns 6 to 10 show results obtained byPPMl,alongwithrobuststandarderrorsandthreefixedeffects.Thecoefficientofskilldiffer-enceisstatisticallysignificant,anditspositivesignprovidessupportforFDithatismotivatedbylowerwagecostsinthehostcountry.Marketsize, labour skill, openness andRTA are allstatisticallysignificantandhave theexpectedsign,whereas coefficients ofbiT variablesarenotsignificant.Thecoefficientsofthefourtime-invariantvariables–geographicdistance,commonborder,commonlanguageandcolony–areallstatisticallysignificant.

• RuizandVilarrubia(2007)arguethatbecausecultural and historical factors are difficult tomeasure,gravitymodels shouldbeestimatedbyusingtimeandcountry-pair6fixedeffects.Columns11to15showtheresultsoftheesti-mationsbyPPMl,withyearandcountry-pairtreatedasfixedeffects.exceptforbiTvaria-bles,alltime-variantcoefficientsarestatisticallysignificant.Sizesofcoefficientsare,ingeneral,higherthanthoseobtainedbyPPMlwithyear,homeandhostcountryfixedeffects.

• When comparing resultswith thoseobtainedusing theolS specification,olS estimatestendtobemuchlargerthanthoseestimatedbyPPMl.Thisshowsthatresultsarequitesensi-tive to the specification. For this reason, theresultsofprevious studiesusingolSshouldbeinterpretedwithcaution.

• Tocheckforrobustness,thegravityequationswerealsoestimatedby includingalternativesdefinitionsofvariablessuchasopenness(i.e.totaltradeoverGDP),skilldifference(i.e.abso-lutevalue,positiveandnegativevalues),andbiT(i.e.numberofyearssinceratificationofabiT).Moreover,varioustransformationsoftheFDivariablesweretried.7inallthesespecifica-tionsthePPMlestimatesofthecoefficientsofbiTremainedstatisticallyinsignificant.

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Thiseconometricanalysisshowsthatstandardgravitymodels permit ameaningful explanationofFDibilateralflowsfromdevelopedtodevelop-ingcountries.However,whenthebiTsvariableisincluded,theresultsareambivalent.Usingonemeth-odology(olSestimationoflog-linearregression),resultsindicatethatbiTshaveapositiveimpactonbilateralFDi,althoughtheestimatedmagnitudeofthisimpactissmall.Since,accordingtorecentlit-erature,thismethodologyproducesbiasedestimates,analternativemethod(PPMl)wasalsoused.ThismethodshowedthatbiTsappeartohavenoeffectonbilateralNorth-SouthFDiflows:themagnitudeof

theestimatedcoefficientsisclosetozero.Moreover,thebiTcoefficientsarenotstatisticallysignificant;inotherwords,resultsdonotsupportthehypothesisthatbiTsfosterbilateralFDi.

These resultsareconsistentwith theexistingliterature,whichobservesthatthecurrentstateoftheresearchisunabletofullyexplainthedeterminantsof FDi, and, in particular, the effects ofbiTs onFDi.Thusdeveloping-countrypolicymakersshouldnotassumethatsigninguptobiTswillboostFDi.indeed,theyshouldremaincautiousaboutanykindofrecommendationtoactivelypursuebiTs.

Concluding remarks

Notes

1 Skilldifferenceismeasuredasthelogarithmoftheratioofthehighesttothelowestaverageyearsofschoolinginthetwocountries.

2 TheFDidatausedherecontain15,983observationsofwhich2,844arezeroand3,410arenegative.Asitisusualintheliteraturetoavoiddeletingobserva-tionswhenapplyinglogarithms,thevalueofFDiwasincreasedin1dollarandnegativevaluesweredeleted.

3 inpaneldataestimations,coefficientsmaybesub-ject toomittedvariablebias; that is, the estimatedcoefficientofanexplanatoryvariableisbiasedwhenimportantvariablesthatareunknownordifficulttomeasure are not included in the equation and arecorrelatedwiththeaboveexplanatoryvariable.SeeAndersonandvanWincoop(2003)foradiscussionofomittedvariablesbiasinthetradegravityliterature.

4 AccordingtoJensen’sinequality,themeanvalueofalogarithmisdifferentfromthelogarithmofameanvalue.

5 Theyshowedthatinagravitymodel,evencontrol-lingforfixedeffects,thepresenceofheteroskedas-ticitycanaffecttheconsistencyofestimators.Thisisbecause,duetoJensen’sinequality,thelogoftheexplainedvariablechangesthepropertiesoftheerrorterminawaythatrendersthecoefficientsbiased.

6 Country-pairdummiesabsorbtheeffectsofallomit-tedvariablesthatarespecifictothecountrypairsbutremainconstantover time, including thestandardgravityvariables (geographicaldistance,commonborder,commonlanguageandcolony).

7 Thefirstrobustnesscheckconsideredonlyastrictlypositive value for FDi.The second included thenegativevaluebyapplying thelevy-Yeyatietal.(2007)transformation,i.e.replacingtheoriginalFDivariable by sign (FDi)*log(abs(FDi)+1). Finally,nominalFDivaluesweredeflatedbytheGDPUnitedStatesdeflator.


Anderson JeandvanWincoope (2003).Gravitywithgravitas:Asolutiontotheborderpuzzle.American Economic Review,93(1):170−192.

barroRJandleeJW(2010).Anewdatasetofeduca-tionalattainmentintheworld,1950–2010.NbeRWorkingPaper15902,NationalbureauofeconomicResearch,Cambridge,MA.

blonigenbA,DaviesRbandHeadK(2002).estimatingtheKnowledge-CapitalModeloftheMultinationalenterprise:Comment.NbeRWorkingPaperNo.8929,NbeR,Cambridge,MA.

deSousaJ(2012).Thecurrencyunioneffectontradeisdecreasingover time.Economics Letters, 117(3):917−920.

References

levy-Yeyatie,PanizzaUandSteine(2007).Thecycli-cal nature ofNorth-South FDiflows. Journal of International Money and Finance,26(1):104−130.

MayerTandZignagoS (2011).NotesonCePii’sdis-tancesmeasures(GeoDist).CePiiWorkingPaperNo.2011-25,Paris.

RuizJMandVilarrubiaJM(2007).Thewiseuseofdum-mies in gravitymodels: export potentials in theeuroMed region.Research PaperNo.WP-0720,bankofSpain,Madrid.

Santos Silva JMC andTenreyroS (2006).The log ofgravity.The Review of Economics and Statistics,88(4):641–658.

trade and development report, 2014

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