Foreign investment and shared sovereignty

Taking back control of our laws and courts is at the heart of the case for Brexit. However, the government acknowledges that once we leave the EU, our new trade and investment agreements will require legal mechanisms to resolve cross-border disputes (see White Paper).

The most common mechanism in international agreements is an investor-state dispute settlement (ISDS) system whereby foreign investors have the right to claim against a domestic government at an independent supranational tribunal. The rising number and nature of claims under ISDS is fuelling perceptions of unfairness and political opposition. Resistance to ISDS led to the blocking of the EU-US Transatlantic Trade and Investment Partnership (TTIP) and almost stopped the EU Canada Comprehensive Trade Agreement (CETA).

ISDS are usually included in Bilateral Investment Treaties (BITs) or investment chapters of Free Trade Agreements to give legal protection to overseas investors. They include legal clauses that define the rights of foreign investors to challenge domestic governments and refer disputes to a supranational court (for example, the International Centre for Settlement of Investment Disputes). The idea is that ISDS provide some legal comfort to foreign investors that their investments will not be expropriated or discriminated against.

Existing research on ISDS in BITs relates to developing countries and so the findings are not necessarily relevant to the UK. New research by Armstrong and Winkler (2017) looks at the effectiveness of the legal provisions of ISDS mechanisms in BITs in supporting foreign direct investment flows between Organisation for Economic Co-operation and Development (OECD) countries. We argue that while developed countries may not expropriate assets, they are adept at using non-tariff barriers to protect domestic concerns. Therefore, it is not just the existence of ISDS in a BIT that matters for investment, but rather the legal provisions supporting the ISDS mechanism.

We argue that the “restrictiveness” of legal provisions has a larger and statistically significant impact on investment flows.We look at the legal provisions supporting ISDS mechanisms in 398 BITs between 34 OECD countries (excluding Latvia) between 1985 and 2015. Only eight BITs do not have an ISDS mechanism. We consider three legal provisions as characterising the ‘restrictiveness’ of the ISDS mechanism in BITs.

  • Do foreign investors have pre-consent to refer to a supranational ISDS tribunal or is domestic court approval required first?
  • Can investors claim on a broad scope of investment disputes or only to the terms of the BIT?
  • Is the tribunal’s interpretation binding or can either party make their own interpretation of the BIT to the tribunal?

We define a BIT that only has pre-consent to an ISDS mechanism as ‘weak’ and a BIT that has pre-consent, broad scope and a binding interpretation as ‘Strong’. We estimate various specifications of a standard cross-border statistical model (a gravity equation model) and compare the estimated impact of ‘weak’ and ‘strong’ BITs on the size of foreign direct investment flows. Our results are summarised in chart 1. There is little evidence that ‘weak’ BITs influence investment flows. By contrast there is evidence that ‘strong’ BITs are associated with on average 70% greater foreign direct investment flows.

It is worth noting that only when all three of the legal provisions that define a ‘strong’ BIT are present, including interaction terms, the result holds. Having one or two provisions is not enough: all three are required to provide legal protection and support the greater direct investment flows. This supports our idea that it is not the existence of ISDS per se, but the legal provisions around the ISDS that matter.

As with almost any policy, analysis it is difficult to prove that a policy really causes the economic effect. In our estimation we take account of the institutional quality in each country, the amount of trade and whether there is a Preferential Trade Agreement between the countries and the long-term specific characteristics of each country. However, because legal provisions in BITs are ultimately a policy choice (as are all economic agreements) causality cannot be proven.

Why might this finding be particularly important for the UK? First, the UK is primarily a services based economy – eight out of ten jobs are in services. Most of our international trade in services is not by road, sky or sea but through the sales of overseas affiliates. Services trade is less about sourcing from the cheapest labour markets, and more about access to local markets and complying with local rules. Foreign affiliates that supply local services are less geographically mobile and so arguably more exposed to protectionism.

Second, the UK is the third largest recipient of foreign direct investment in the world (behind the US and China). According to the Office of National Statistics (ONS) around 60 per cent of inward and 50 per cent of outward direct investment is in the services sector. Lidl and Santander are household names, while Tesco and WPP have multiple stores and offices overseas. Sales of foreign affiliates are not included in the antiquated official trade

data, but they are important for UK jobs. ONS experimental data shows that 4 million jobs in the UK are in firms that have benefited from foreign investment.

At present the European Court of Justice rules on EU Law for cases brought by citizens, firms and governments. It can be considered a ‘supreme from of ISDS’ enforcing the rules of the Single Market but where member states are ultimately in charge of the rules and its governance. Once the UK has left the EU, the government will need to negotiate new legal procedures to resolve cross-border investment disputes.

The evidence in Armstrong and Winkler (2017) suggests that restrictive legal provisions provide greater support for investment and jobs. By design, these provisions imply limits on national sovereignty. It remains to be seen whether the public will be prepared to accept new limits on sovereignty to support foreign direct investment.  Around the world ISDS are seen as part of the problem of global economic governance rather than the solution.

By Dr Angus Armstrong, Associate Fellow of the ‘UK in a Changing Europe’. Julian Winkler is Researcher at the Oxford Martin School. You can read the full report here.

Disclaimer:
The views expressed in this analysis post are those of the authors and not necessarily those of the UK in a Changing Europe initiative.

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