Jan Wouters, Professor of International Law, Director of the Leuven Centre for Global Governance Studies, University of Leuven
We are living in interesting times for investment treaties, whether bilateral treaties or investment chapters in free trade agreements. Never before have they aroused such an interest from parliaments. People and politicians alike are concerned about their impact on international and domestic affairs. Their scope is expanding dramatically: just think of mega deals like the Trans-Pacific Partnership (TPP) or the Transatlantic Trade and Investment Partnership (TTIP), and the rise of intra-regional investment agreements. Debates on investment agreements have intensified recently within the EU because of the European Commission’s newly-acquired exclusive powers in this arena.
While competition for foreign investment is fierce, current levels of investment, both foreign and domestic, remain (too) low in many jurisdictions. The increased importance of global value chains (GVCs) and ever more integrated trade and investment flows call for (a renewed consideration of) more coherence between trade and investment policies. Today, governments adopting a regulatory measure (e.g. Australia’s plain-packaging legislation for cigarettes) can face both WTO and investment treaty claims, often raising similar issues, but with sharply different adjudication mechanisms – ad hoc arbitration, WTO Dispute Settlement with a permanent Appellate Body – and diametrically opposed remedies – damages vs. non-pecuniary; and very high costs, especially in Investor-State Dispute Settlement
The growing debate requires attention from governments, in particular at the multilateral level. Increased coherence in the system would be beneficial to all countries, including those that have so far navigated it successfully. Governments currently may feel exposed to multiple claims, unlimited damages, and to uncertain or excessively broad interpretations of treaty obligations. If they consider that the treaties they are party to restrain them, rather than help them in attracting investment, they may drop out of the system altogether, instead of seeking reform. This would be unfortunate, because properly-designed treaties can play a constructive role in fostering investment.
Many treaties focus only on investor protection. In addition to being increasingly controversial, those provisions are too narrow for today’s needs, including ensuring sufficient productive investment, providing the infrastructure to support the development of GVCs and removing barriers to cross-border investment that hinder technology spill-overs. Good policies to support the liberalisation of investment are ever more needed. One also needs to consider ISDS carefully in order to respond to public concerns in many jurisdictions. Governments need to modernise, simplify and strive for coherence in investment treaty policy.
For all these reasons, we must revitalise the multilateral debate on investment treaties. A key role should be played in this respect by the G20, the OECD and other international organisations. All G20 governments have been invited to participate in the regular meetings of an OECD-hosted Roundtable that has focused on investment treaties since 2011. At the latest OECD conference on investment treaties in March of this year, major countries, including OECD members, China and India, expressed support for treaties but also for significant reform.
Where to start? We first need to find broad agreement on some core principles and some clearly-defined options for governments with differing interests. That could lead to more ambitious goals like discussions of a multilateral framework or model provisions in key areas. The G20 could give the lead by giving impetus, showing broad government interest, and commissioning work. Turkey has put investment at the centre of its G20 presidency. That is why the G20 and the OECD will be co-hosting a Global Forum on International Investment in connection with the G20 Trade Ministers meeting in Istanbul on 5 October. The trade and investment nexus, and investment treaties, will be key issues there. It is likely that China, in presiding the G20 next year, will similarly place particular emphasis on investment. This should be applauded.
Multilateral attention to improve investment treaties is long overdue. At the adjudicative level, the recent proposal by the European Commission to establish a permanent ‘Investment Court System’ in the context of the TTIP negotiations is an interesting starting point for further discussion. The system, according to the proposal, should be based broadly on the WTO’s Appellate Body, with strict qualifications and ethical requirements and permanent remuneration for its members. It remains to be seen whether the US will go along with the proposal. In any event, it may serve as the starting point for reform of the heavily criticised current system of investor-state arbitration.
Donata Garrasi, ECAS Consulting, and Klaus Hachmeier, Iraq Co-ordinator for the OECD Global Relations Secretariat Middle East and Africa Division (Any views and opinions expressed in this publication are those of the authors and do not necessarily reflect the official view of the OECD or its member governments.)
Massive, popular protests for better public service in Baghdad and across Iraq this summer have prompted the government to announce and execute reforms, which, among other things, reduce the salaries and privileges of government officials and parliamentarians and take steps to fight corruption. Iraqis are sending a clear message: they have had enough, not only of the so called Islamic State and the on-going war against it, but also from years of perceived public mismanagement, corruption, and lacking basic service – for example, the electricity network is not robust enough to provide more than 6 to 8 hours of electricity to the average household. All of this when low oil prices are expected to tear a double-digit deficit into the national budget, forcing Iraq to tap international bond markets for the first time in many years.
But next to these momentous challenges, the Iraqi government continues its agenda for economic reforms. And it is right in doing so as Iraq needs new and greater investment to get on the right track. Economic revitalization, promoting Foreign Direct Investment (FDI), and regional cooperation and trade are key components of any strategy to reduce conflict and build peace, even more so in today’s turbulent Middle East. Creating jobs, raising revenues to pay for quality services, and re-establishing regional economic cooperation are as important as reaching a political settlement and re-establishing security. They all contribute to the same goal, which is to create the conditions for stability and peace.
Governments have no choice but to prioritise action in this area. According to the World Bank, FDI in 25 countries that were classified as conflict affected or fragile grew at a compound annual rate of 12% compared to 4.5% growth in the rest of the world’s FDI in the period of 2005-2012. The figures show that in such high-risk countries untapped resources, reconstruction needs and unmet consumer demand present opportunities for domestic and foreign investors.
Iraq proves the case: the country has witnessed FDI inflows of an impressive $4.8 billion in 2014, according to the 2015 UNCTAD world investment report, an amount similar to countries such as Egypt and Nigeria. While most investments were in the oil and gas sector, the numbers show that a country such as Iraq can attract higher amounts of foreign capital. And while investment volumes will certainly remain somewhat muted and “below potential” until the overall political situation is clearer and security improves, Iraq should use the time to improve investment conditions to better attract private investment and capital now and in the future.
But how is it possible to build investors’ confidence in a country whose territorial integrity and scope for action is under stress from violent extremist groups, separatist movements, factional strife, and foreign interference?
It may indeed sound like an impossible task. But the reality on the ground is also that some businesses are doing well, that the country will continue to receive large inflows of oil revenues, and that the population is young and relatively well-educated. More trust and opportunities can be built as sound reforms are undertaken. The “General Framework of the Government Programme 2014-2018” details the Iraq government’s economic reform agenda. It includes expanding the role of private sector, improving the investment climate, restructuring State Owned Enterprises (SOE), and providing industrial and trade infrastructure through free trade and industrial zones. In line with these commitments, the Government of Iraq has already launched its Private Sector Development Strategy, set up a committee tasked with reforming Iraq’s state-owned enterprises, and seeks to reform its investment law.
So, whilst most of international attention is on the shortcomings of the country and on the related global threats, notably terrorism, organisations like the OECD, working with the Swedish Development Cooperation Agency (SIDA), continue to support programmes aimed at improving the business and investment climate in Iraq. Easy to say, hard to do. What concretely can be done in such challenging contexts as in Iraq today?
The expected outcome of this collaboration is pretty straightforward, albeit ambitious: “ to improve the Government of Iraq’s ability to attract private investment – outside of hydrocarbons – that generate jobs.” How is this going to be done?
First, the Iraqi investment policy framework needs to be strengthened. Here, the OECD is helping to analyse the laws and regulations relevant to investment in Iraq and will formulate recommendations on how to improve the legal framework. This will hopefully contribute to a new investment law, expected to be approved before the end of 2015. The programme, which involves a range of actors, including from the private sector, has a flexible approach, which is key to be able to adjust to the shifting priorities of the Iraqi government.
Second, the government must improve its ability to attract and retain private investment through investment marketing and outreach to investors. Iraq’s National Investment Commission (NIC), the country’s investment promotion agency is the key player here. It needs to be strengthened and to become the central advocator for investment within the Iraqi government. The ambition is two-fold: building an investment proposition with economic indicators, and; better identify and address constraints to investment.
Another key objective to help attract investment is to define and formulate investment opportunities in state-owned enterprises, which investors traditionally find attractive. The development of special economic zones will also help. Iraq has different Economic Zones models, including free zones, which are already active, and has plans to develop industrial zones, investment zones, and economic cities. Such economic zones can be powerful tools to attract investment and create jobs, as they can offer the infrastructure and administrative services investors seek. The OECD and SIDA supported programme is contributing through policy advice on how to design, implement and manage new and existing economic zones – including on a new law on investment zones.
Last, and this absolutely crucial for Iraq and for the region, regional economic integration and trade must be at the forefront of the international response to instability in the region. As the Nobel laureate economist Douglass North has argued, long-term conflict resolution usually requires enduring economic relations, which are best cultivated through specialization and trade, and an open trade system which allows for integration into regional and global value chains. The dynamic is clear: By increasing the cost of violent conflict, dense economic networks and multiple exchange relationships provide powerful incentives for actors to prefer peaceful solutions.
This may sound overly ambitious, but economic cooperation in the Middle East has become a necessity, a key pillar for peace and stability. The well-recognized relationship between economic cooperation and political stability will be crucial for charting a way out of the current quagmire, as experts like Adeel Malik, from Oxford University, and the former finance minister of Jordan, Bassem Awadallah, eloquently explained in a recent commentary on how to escape the Middle East violence trap.
Sufficient attention and funding should be provided to innovative programmes that try to promote key reforms amidst conflict. And in this case, to the Iraq private sector strategy and to initiatives that aim to support such efforts.
Gabriela Ramos, OECD Chief of Staff and Sherpa to the G20
In 2009, Zambian economist Dambisa Moyo published her book, “Dead Aid”which shocked much of the international development community by claiming that ‘traditional’ systems of official development assistance (ODA) to Africa were not delivering, and arguing why we must find alternatives.
These conclusions triggered many stark reactions. That aid may have fallen short of its targets, and in some cases even run counter to them, is certainly a valid point; but to conclude that all forms of aid are therefore “dead”, and of no future use to developing countries, is quite a stretch. First, ODA spending is still alive and well: the OECD estimates that development aid flows hit an all-time high in 2013, at a record $135.1 billion; and while it has remained stable in 2014, overall ODA has increased by 66% in real terms since 2000, when the Millennium Development Goals (MDGs) were agreed to. To the credit of donor countries, these trends occurred when the world economy was being hit by the worst international financial crisis of our time. They were also the source of deep reflections on how to focus on development outcomes and impact, instead of only looking at the level of aid.
In this sense, the mainstream development co-operation debate is putting a lot of effort and innovation into how to use ODA flows more effectively – moving beyond traditional forms of aid and using it in more creative ways, through a wider range of partners and financing mechanisms, and performing more of a catalytic role. Indeed, ODA is increasingly being used as a lever to help countries attract other, complementary forms of financing that will be necessary to meet their development objectives. These other forms of financing include tax revenue and foreign as well as domestic investment. In 2015, the Sustainable Development Goals (SDGs) are being negotiated as successors to the MDGs – and to finance these goals, donors and developing countries alike fully agree on the crucial need for ODA to take on this leveraging role.
Indeed, aid alone (whether in its traditional or its more innovative forms) will not suffice for meeting the SDGs. In just one example, the resources needed every year to achieve the SDGs are estimated to be at least ten times greater than current levels of ODA. This leaves a vast space to be filled. First by donor countries delivering on their commitments to increase their support for financing for development. But also by mobilising private flows and investment that rely on ODA to fill the gap. For the first time in 2012, the share of global foreign direct investment (FDI) inflows going to developing countries exceeded that going to developed countries, making FDI by far the biggest source of capital flows to developing countries.
This said, the overall picture is not rosy: after passing $2 trillion in 2007, global FDI flows fell by 40% during the first two years of the global financial crisis. Six years later, in 2013, they were still down by 30%; in Europe investment outflows are down by as much as 80% since the crisis, with implications that stretch far beyond the Eurozone. The legacies of the crisis are still with us in the form of low investment, low growth and high unemployment. And even when we look beyond this immediate economic context, most developing countries continue to have particularly low levels of investment relative to GDP. In most African countries for instance, investment to GDP ratios struggle to reach 20%, well below the levels of most other developing and emerging regions. This relatively poor investment performance mainly results from a lack of adequate framework conditions through which countries can successfully attract and retain investment.
Developing countries therefore have a challenging task ahead if they hope to stimulate investment flows and make them work for development. To help governments rise to this task and enhance the necessary framework conditions, in June 2015 OECD Ministers plus partner countries that include developing and emerging economies, endorsed a comprehensive policy tool: the Policy Framework for Investment (PFI). Updated by a global taskforce in 2015 led by Myamar and Finland and composed by over 70 countries, the PFI is precisely aimed at addressing the structural conditions for investment in a coherent manner. This includes guidance for attracting investment in specific economic sectors, such as infrastructure, where ODA and private finance can work hand-in-hand particularly well. Based on the PFI, since 2006 the OECD Investment Policy Review process has been used by over 25 developing and emerging economies to assess and reform their investment environment so as to enhance private finance for development.
When they endorsed the updated PFI, Ministers encouraged countries to use the tool as a reference for development co-operation, and particularly as a path towards the SDGs. Exactly how different countries and regions can make the most use of the PFI, so as to attract investment that can complement ODA and tax in financing the SDGs, will be the topic of discussions at the Third International Conference on Financing for Development being held in Addis-Ababa next week. This could be a good opportunity for developing country governments as well as donors to move beyond traditional aid together, and towards more innovative and complementary forms of ODA and investment.
In today’s post, Michael Gestrin of the OECD Directorate for Financial and Enterprise Affairs looks at whether declines in the EU’s flows of foreign direct investment (FDI) simply reflect a particularly severe FDI cycle or whether there might also be structural factors involved.
At the start of the 2007 crisis, global foreign direct investment (FDI) stocks actually declined, and even today, global flows of FDI are still 40% below their pre-crisis peak. Generally, OECD countries were the sources of the biggest declines while many emerging economies experienced increases in FDI flows. Europe has been one of the worst affected regions. EU inflows are down 75% and outflows are down 80% from their pre-crisis levels.
Inflows into the EU are currently around $200 billion, down from $800 billion at the peak of the global FDI cycle in 2007 (see figures). Outflows are also currently around $200 billion, down from $1.2 trillion in 2007. For the rest of the world, a global economy “without” the EU is doing quite well. In this global economy, inflows recovered strongly starting in 2010 and reached new record heights in 2011, at just over $1.2 trillion. With respect to outflows, the FDI crisis was limited to a one-year decline of 20% in 2009. Although world-minus-EU outflows have not grown over the past three years, they have been at record levels.
Part of the strong performance of the world-minus-EU can be explained by the growing importance of the emerging markets, in particular China, as sources and recipients of FDI. In 2012, emerging markets received over 50% of global FDI flows for the first time, and China is now consistently among the world’s top three sources of FDI.
The crisis initially gave rise to a significant gap between the non-EU OECD countries and the rest of world with respect to both inflows and outflows, just as it did for the EU (see figures). A big difference, however, is that for the non-EU OECD countries the gap closed after only two years. While the EU and the world-minus-EU group have been going in different directions ever since the start of the crisis, the non-EU OECD group and its rest-of-world counterpart appear to have returned to a similar cycle after parting ways for a much shorter period during 2008-9.
Comparing the EU and non-EU-OECD shares of world inflows and outflows highlights the extent to which the positions of these two groups have reversed in recent years (see figures). At the turn of this century the EU accounted for over 50% of global inflows and 70% of global outflows. By 2013 both shares were down to 20%. Conversely, the non-EU-OECD countries have seen their shares of global FDI inflows and outflows recover to pre-crisis levels. This group overtook the EU in 2010 in terms of its share of both inflows and outflows, thus reversing the historical relationship.
Why? The greatest declines in inward FDI in the EU have been from within Europe itself (see figures). Before the crisis around 70-80% of the region’s inward FDI consisted of intra-EU investment. Today only 30% of inward FDI is intra-EU. This sharp decline in the share of FDI that EU countries receive from their EU neighbours also helps to explain the decline in outward EU FDI.
The decline in the share of intra-EU in total EU inward FDI would seem to suggest a lack of confidence on the part of EU investors in their own regional market. One tempting explanation for this is that these declines have been concentrated in a sub-set of EU countries that have experienced particularly difficult economic conditions (such as Greece, Ireland, Portugal, and Spain) during the crisis.
This has not been the case. The FDI crisis in Europe has been broad-based, with the bulk of the declines in FDI flows concentrated in the largest economies. France, Germany, and the UK accounted for 50% of the $600 billion decline in FDI inflows between 2007 and 2013. Over the same period, Greece, Ireland, Portugal, and Spain accounted for only $14 billion, or 2%, of the inflow decline. With respect to outflows, France, Germany, and the UK accounted for 59% of the $1 trillion decline between 2007 and 2013. Over the same period, Greece, Ireland, Portugal, and Spain accounted for 12% of this decline.
Part of the explanation for the decline in investment in Europe is linked to an increasing share of international divestment relative to international mergers and acquisitions (M&A, see figures). While pre-crisis levels averaged around 35%, they reached almost 60% in 2010-11 and now stand at around 50%. In other words, for every dollar invested, 50 cents is divested. Consequently, net international M&A investment in Europe is currently at its lowest levels in a decade, at around $100 billion.
The clear “leader” in this regard is the consumer products segment, with a divestment/investment ratio of 148%. This means that for every dollar invested in consumer products over the past six years, around one and a half dollars was divested. This is an example of investment de-globalisation. Domestic and international M&A in Europe have generally followed the same pattern: both are on track to reach their lowest levels in a decade (see figures). Conditions that are holding back international investment in Europe would seem to be discouraging domestic investment as well.
From a policy perspective, the challenges of breaking out of this regional investment slump are daunting but urgent. A useful starting point is the recognition that a supportive environment for productive international investment needs to reflect the evolving needs of international investors. Such a supportive environment has three dimensions.
First, investors generally favour predictable, open, transparent, rules-based regulatory environments, much along the lines put forward by the OECD’s Policy Framework for Investment. Where impediments to investment have not been addressed by governments this often has more to do with implementation challenges rather than disagreement over principles. For example, it is widely accepted that excessive ‘red tape’ is an obstacle to investment but in many countries this is still often cited by business as being one of the most important impediments to doing business. In Europe, many such impediments represent relatively easy opportunities for improving the regional investment climate.
The second dimension concerns important changes in the structures and patterns of global investment flows as well as in the way MNEs are organising their international operations. This is reflected in investment de-globalisation and “vertical disintegration” which has seen MNEs become more focused on their core lines of business over time and more reliant upon international contractual relationships for organizing their global value chains.
Finally, Europe would seem to be confronting a competitiveness puzzle in which declining competitiveness is discouraging investment, and declining investment is in turn undermining competitiveness. A few years ago, OECD Secretary General Angel Gurría outlined six policy recommendations for getting Europe back on a sustainable growth path that also hold for investment:
- Further develop the Single Market.
- Ease excessive product market regulation;
- Invest more in R&D and step up innovation.
- Make sure that education and training institutions deliver highly sought after skills.
- Increase the number of workers participating in labour markets and make markets more inclusive to address social inequalities.
- Reform the tax system, including by reducing the tax wedges on labour.
Today’s post is from OECD Secretary-General Angel Gurría
International investment treaties are in the spotlight as articles in the Financial Times and The Economist last week show. An ad hoc investment arbitration tribunal recently awarded $50 billion to shareholders in Yukos. EU consultations on proposed investment provisions in the Transatlantic Trade and Investment Partnership (TTIP) with the United States generated a record 150,000 comments. There is intense public interest in treaty challenges to the regulation of tobacco marketing, nuclear power and health care.
Some 3000 investment treaties provide special rights for covered foreign investors to bring arbitration claims against governments. Principles of fair and equitable treatment included in many treaties are uncontroversial as general principles of good public governance. But the treaty procedures for interpreting and enforcing them in arbitration claims for damages are increasingly controversial.
A trickle of arbitration claims under these treaties has become a surging stream. Over 500 foreign investors have brought claims, mostly in the last few years. Investor claims regularly seek hundreds of millions or billions of dollars. High damages awards and high costs have attracted institutional investors who finance claims.
Providing investors with recourse against governments is valuable. Governments can and do expropriate investors or discriminate against them. Domestic judicial and administrative systems provide investors with one option for protecting themselves. The threat of international arbitration gives substantial additional leverage to foreign investors in their dealings with host governments, especially when domestic systems are weak.
At the same time, there is mounting criticism. Arbitration cases can involve challenges to the actions of national parliaments and supreme courts. As Chief Justice Roberts of the US Supreme Court wrote earlier this year, “by acquiescing to [investment] arbitration, a state permits private adjudicators to review its public policies and effectively annul the authoritative acts of its legislature, executive, and judiciary”. In a similar vein, Chief Justice French of the High Court of Australia recently noted that the judiciary in his country had not yet made any “collective input” to the design of investment arbitration and that it was time to start “catching up”. This broadening interest in the system will enrich the debate on the future of investment treaties.
Governments and business leaders are also seeking to reform treaties so as to ensure that they help attract investment, not litigation. Some major countries, such as South Africa, Indonesia and India, are terminating, reconsidering or updating what they perceive to be outdated treaties that excessively curtail their “policy space” and entail unacceptable legal risks. Germany opposes the inclusion of investment arbitration in TTIP. The B20 grouping of world business leaders recently called on the G20 to address investment treaties.
International organisations such as the OECD can help governments and others to shape the future of investment treaties. I propose the following agenda for joint action to reform and strengthen the investment treaty system.
Resolve investor claims in public. The frequently secretive nature of investment arbitration under many treaties heightens public concerns. The treaties of NAFTA countries and some other countries have instituted transparent procedures. But nearly 80% of investment treaties create procedures that fall well short of international standards for public sector transparency. This is a major weakness. In July, UNCITRAL (the United Nations Commission on International Trade Law) approved a multilateral convention on transparency. Governments can now easily make all investor claims public. Over a century ago, Lord Atkinson emphasised that a public trial is “the best security for the pure, impartial, and efficient administration of justice, the best means of winning for it public confidence and respect”. Governments – with the support of major investors — should rapidly take action to ensure that investment arbitration adopts high standards of transparency.
Boost public confidence in investment arbitration. Governments have borrowed the ad hoc commercial arbitration system for their investment treaties. But this borrowing is increasingly questioned. Sundaresh Menon, as Attorney-General of Singapore, has observed that “entrepreneurial” arbitrators are subject to troubling economic incentives when making decisions on investor state cases. Advanced domestic systems for settling disputes between investors and governments go to great lengths to avoid the appearance of economic interests influencing decisions. Investment arbitration needs to do the same.
Do not distort competition. The concept of national treatment is a core component of investment and trade agreements. It promotes valuable competition on a level playing field. Investment treaties should not turn this idea on its head, giving privileges to foreign companies that are not available to domestic companies. Governments should protect competition and domestic investment by, for example, ensuring that treaty standards of protection do not exceed those provided to investors under the domestic legal systems of advanced economies. Some case law interpretations of vague investment treaty provisions go beyond these standards, and are unrelated to protectionism, bias against foreign investors or expropriation. Governments that allow for such interpretations should either make public a persuasive policy rationale for these exceptional protections for only certain investors, or take action to preclude such interpretations of their treaties.
Eliminate incentives to create multi-tiered corporate structures. By allowing a wide range of claims by direct and indirect shareholders of a company injured by a government, most investment treaties encourage multi-tiered corporate structures. Each shareholder can be a potential claimant. Indeed, many treaties encourage even a domestic investor to create foreign subsidiaries – it can then claim treaty benefits as a “foreign” investor.
If complex structures were cost-free, perhaps it wouldn’t matter. But they aren’t. Complex structures increase the cost of insolvencies and mergers. They also interfere with the fight against bribery, tax fraud and money laundering because they can obscure the beneficial owner of the investment. Governments should promptly eliminate investment treaty incentives to create multi-tiered corporate structures.
We need international capital flows to support long-term growth through a better international allocation of saving and investment. But the investment treaty system needs to be reformed to ensure that the rights of citizens, governments, enterprises and investors are respected in a mutually beneficial way.
Legal principles applicable to joint government interpretation of investment treaties was one of the issues discussed at the March 2014 OECD Roundtable on Freedom of Investment
In my view: Any developing country can undergo dynamic structural transformation, starting now
Today’s post from Justin Yifu Lin, Honorary Dean at the National School of Development (NSD), Peking University, and former Chief Economist of The World Bank, is one in a series of ‘In my view’ pieces written by prominent authors on issues covered in the Development Co-operation Report 2014: Mobilising resources for sustainable development.
Any developing country – even those with poor infrastructure and a weak business environment – can start on a path to dynamic structural transformation and growth today. How? By facilitating technological innovation and development in industries where it has a comparative advantage.
Take China. At the time of its transition to a market economy in 1979, the business environment was poor, infrastructure was very bad and China lacked the capacity to take advantage of its cheap labour market to produce goods for export. To overcome these obstacles, the Chinese government – at all levels and in all regions – encouraged foreign investment in special economic zones and industrial parks. This enabled China to rapidly develop labour-intensive light manufacturing and become the world’s factory.
The same approach can work in other developing countries. For instance, in August 2011 the late Ethiopian Prime Minister Meles Zenawi visited China. Aware of Ethiopia’s labour cost advantages and China’s plans to relocate its shoe industry because of rising wages, he invited Chinese shoe manufacturers to invest in Ethiopia. Managers of Huajian, a designer shoe manufacturer, visited Addis Ababa in October 2011 and – convinced of the opportunity – opened a shoe factory near Addis in January 2012, employing 550 Ethiopians. Huajian more than doubled Ethiopia’s shoe exports by the end of 2012 and by December 2013, the workforce had expanded to 3 500 (by 2016 it is expected to reach 30 000).
Before this, like almost all other African countries, Ethiopia had found it difficult to attract export-oriented foreign direct investment in light manufacturing. The immediate success of the Huajian shoe factory transformed foreign investors’ impression of Ethiopia, helping them to see it as a potential manufacturing base for exports to global markets. Over just three months in 2013, 22 factory compounds in the new industrial park of Bole Lamin were leased to export-oriented factories.
As long as it is carefully embedded within the broader economy so as to avoid creating isolated ‘enclaves’ of productivity and growth, this type of investment can help to fuel modern economic growth, funding improvements in infrastructure and institutions as well as structural changes in technology and industries to reduce costs of production and increase output values. In any country, these enhancements in labour productivity can fuel a continuing increase in per capita income.
In my view, development finance can have the largest possible impact on accelerating a developing country’s structural transformation, job generation and poverty reduction when the country uses these flows to remove infrastructure bottlenecks and develop industries that draw on the country’s comparative advantages. This pragmatic approach will allow these countries to capture China’s relocation of 85 million labour-intensive manufacturing jobs, allowing them too to grow as dynamically as the East Asian economies.
Getting Globalization Right: China Marches to its Own Beat by Dani Rodrik, Professor of International Political Economy at the John F. Kennedy School of Government, Harvard University, on OECD Insights.
Today’s post is from Adrian Blundell-Wignall, Special Advisor to the OECD Secretary-General on Financial Markets. The view expressed here is his own and does not necessarily reflect that of any OECD government.
A couple of years ago the IMF produced some (cautious) comments and studies arguing that currency management and capital controls were OK in some circumstances. Many emerging market countries took this as an endorsement of their approach to policy which has not been limited to temporary crisis measures. The Figure below shows the national investment-saving correlations for the OECD countries over 1982-2010 and for a group of emerging countries (China, Brazil, India, South Africa, Mexico and South Korea) in the manner of Martin Feldstein and Charles Horioka.
In a 1980 paper, Feldstein and Horioka looked at two views of the relation between domestic saving and the degree of mobility of world capital. If capital is perfectly mobile, you would expect there to be little or no relation between the domestic investment in a country and the amount of savings generated in that country, since capital would flow freely to wherever the returns were highest. On the other hand, if the flow of long-term capital among countries is impeded by regulations or for other reasons, investors will be more likely to keep their money in their own country and increases in domestic saving will be reflected primarily in additional domestic investment. Feldstein and Horioka’s analysis supported the second view more than the first.
Three decades later, the OECD economies have more-or-less achieved an open economy without capital controls (led in large part by Europe). But the emerging markets have a high correlation of national savings to investment (0.7), indicating a prolonged lack of openness.
National Investment-Savings Correlations: OECD versus Emerging Economies
The growing gap between the correlations for the OECD (highly open) and the emerging economies (impeded) is pointing to a fundamental imbalance in the world economy. Does it matter? The IMF study mentioned above showed that countries with stronger capital controls had a lesser fall in GDP in the post-crisis period. While the original authors were cautious in interpreting their results, this was not so for the users of those findings. This is all the more worrying given that the OECD exactly reproduced the IMF study and found that the results were not robust to a simple stability test. In other words, the OECD tests show that these results certainly should not be used as a basis for claiming some form of general support for long-term use of capital controls.
The OECD also ran a simpler study using the IMF’s own measures of capital controls, with both the IMF’s original sample period and updating it. The OECD study found significant and contradictory results, which were much more consistent with an exchange rate targeting and “impossible trinity” interpretation of outcomes:
- In the good years prior to the crisis, capital controls are indeed good supporters of growth. This is likely because combined with exchange rate management there is a foreign trade benefit, companies are not constrained for finance, and containing inflows reduces the build-up of money and credit following from exchange market intervention (and associated asset bubbles).
- However, in the post-crisis period the exact opposite is found and the results are highly significant. Capital controls are negatively correlated with growth. The pressure on the exchange rate is down, not up, as foreign capital retreats, and international reserves are used up defending against a currency crisis (contracting money and credit). Companies are more constrained by cash flow and external finance considerations. Just at the time when foreign capital is needed, countries with the most controls suffer the greatest retreat of foreign funding. Investment and GDP growth suffer.
- The full sample period (data from both before and after the crisis) shows significant negative effects of capital controls. That is, the overall net benefit appears negative compared to less capital controls.
These results have an intuitive appeal, consistent with economic theory. While it is early days, and some caution is required, the findings suggest that in the long-run dealing with the global investment-savings imbalances could be of benefit not only to developed countries, but also to the developing world itself.
Capital Controls on Inflows, the Global Financial Crisis and Economic Growth: Evidence for Emerging Economies by Adrian Blundell-Wignall and Caroline Roulet of the OECD Directorate for Financial and Enterprise Affairs
This paper discusses the issues mentioned above in detail. It investigates whether countries that had controls on inflows in place prior to the crisis were less vulnerable during the global financial crisis. More generally, it examines economic growth effects of such controls over the entire economic cycle, finding that capital restrictions on inflows (particularly debt liabilities) may be useful in good times but may have adverse effects in a crisis.
Macro-prudential Policy, Bank Systemic Risk and Capital Controls by Adrian Blundell-Wignall and Caroline Roulet of the OECD Directorate for Financial and Enterprise Affairs
This paper looks at macro-prudential policies in the light of empirical evidence on the determinants of bank systemic risk, and the effectiveness of capital controls. It concludes that complexity and interdependence is such that care should be taken in implementing macro-prudential policies until much more is understood about these issues.