Foreign Investment, Investment Treaties and Development: Myths & Realities
The growing debate on investment agreements has underscored the importance of understanding the nature and effects of foreign investment. The issues of FDI, investment treaties and development are examined in this South Bulletin.
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FDI, Investment Agreements & Development: Myths & Realities
This article by the South Centre’s Chief Economist briefly explains the myths and realities of foreign direct investment (FDI). It then analyses how a country’s investment policy is being constrained by rules in the WTO and in the bilateral investment treaties (BITs).
By Yılmaz Akyüz
Foreign Direct Investment and Development
Foreign direct investment (FDI) is perhaps one of the most ambiguous and least understood concepts in international economics. Common debate on FDI is confounded by several myths regarding its nature and impact on capital accumulation, technological progress, industrialization and growth in emerging and developing economies (EDEs). It is often portrayed as a long-term, stable, cross-border flow of capital that adds to productive capacity, helps meet balance-of-payments shortfalls, transfers technology and management skills, and links domestic firms with wider global markets.
However, none of these are intrinsic qualities of FDI. First, FDI is more about transfer and exercise of control than movement of capital. Contrary to widespread perception, it does not always involve flows of financial capital (movements of funds through foreign exchange markets) or real capital (imports of machinery and equipment for the installation of productive capacity). A large proportion of FDI does not entail cross-border capital flows but is financed from incomes generated on the existing stock of investment in host countries. Equity and loans from parent companies account for a relatively small part of recorded FDI and an even smaller part of total foreign assets controlled by transnational corporations (TNCs). In 2008, retained earnings constituted 60% of outward FDI stock for non-bank affiliates of US non-bank corporations. In the same year, total assets controlled by US affiliates were 8.6 times the net external finance from US sources. Globally, in 2011, retained earnings accounted for 30% of total FDI flows. In the same year, half of the earnings on FDI stock in EDEs were retained, financing about 40% of total inward FDI in these economies. Thus, the notion that FDI is functionally indistinguishable from fresh capital inflows and represents a flow of foreign resources crossing the borders of two countries has no validity.
Second, an important part of FDI involves transfer of ownership of existing firms. Only the so-called greenfield investment makes a direct contribution to productive capacity and involves cross-border movement of capital goods. But it is not easy to identify from reported statistics what proportion of FDI consists of such investment. In particular, statistics provide almost no information on how retained earnings and loans from parent companies, two of the three sources of finance for FDI, are used. Furthermore, even when FDI is in bricks and mortar, it may not add to aggregate investment because it may crowd out domestic investors, as shown by most studies on the effects of FDI on domestic investment. Evidence also shows widespread association between rising FDI and falling gross fixed capital formation (GFCF) in the developing world. All these suggest that the economic conditions that attract foreign enterprises may not always be conducive to faster capital formation and that the two sets of investment decisions may be driven by different considerations.
Third, what is commonly known and reported as FDI contains speculative components and creates destabilizing impulses which need to be controlled and managed as any other form of international capital flows. Many of the changes in financial markets that have facilitated international capital movements have not only increased the mobility of FDI, but also made it difficult to assess its stability. FDI inflows to EDEs are subject to boom-bust cycles and closely correlated with non-FDI (portfolio) flows as they are also influenced by global liquidity conditions and risk appetite. Surges in FDI inflows could generate unsustainable currency appreciations in much the same way as surges in other forms of capital inflows. FDI in property is often motivated by speculative capital gains and subject to severe bubble-and-bust cycles. More importantly, financial transactions can accomplish a reversal of FDI. What may get recorded as portfolio outflows may well be outflows of FDI in disguise: a foreign affiliate can borrow in the host country in order to export capital. Furthermore, foreign banks established in EDEs can be a major source of financial instability. They tend to contribute to build-up of fragility in host countries and transmit shocks from home countries, as seen during the eurozone crisis.
Fourth, the immediate contribution of FDI to the balance of payments may be positive, since it is only partly absorbed by imports of capital goods required to install production capacity. But its longer-term impact is often negative because of profit remittances and the high import content of production and exports by foreign firms. Many countries with a long history of involvement with TNCs face negative net transfers on FDI; that is, their new FDI inflows fall short of profit remittances on the stock of inward FDI. Again, in a large majority of EDEs, export earnings by foreign companies do not cover their import bills and profit remittances. This is true even in countries highly successful in attracting export-oriented FDI such as China.
Finally, superior technology and management skills of TNCs create an opportunity for the diffusion of technology and ideas. However, spillovers are not automatic but need to be extracted through policy guidance and interventions. Foreign firms invest in EDEs in order to exploit their existing competitive advantages such as rich natural resources and cheap labour and infrastructure services rather than to move them up on the technological ladder. TNCs resist passing their technological and managerial know-how to host countries since these give them a competitive edge. The high productivity and competition they bring could help improve the efficiency of local firms, but these can also block entry of these firms into high-value product lines or drive them out of business. They can prevent rather than promote infant-industry learning unless local firms are supported and protected by deliberate policies. They may help EDEs integrate into global production networks, but participation in such networks also carries the risk of getting locked into low-value-added activities.
To sum up, contrary to what is maintained by the dominant corporate ideology, FDI is not a recipe for rapid and sustained growth and industrialization in EDEs. However, this does not mean that FDI does not offer any benefits to EDEs. Rather, policy in host countries plays a key role in determining the impact of FDI on industrialization and development. A laissez-faire approach could not yield much benefit. It may in fact do more harm than good. Successful examples are found not necessarily among EDEs that attracted more FDI, but among those which used it in the context of national industrial policy designed to shape the evolution of specific industries through interventions. In this respect the experience of successful late industrializers, notably in East Asia, yields a number of policy lessons:
Encourage greenfield investment but be selective in terms of sectors and technology;
Encourage joint ventures rather than wholly foreign-owned affiliates in order to accelerate learning and limit foreign control;
Allow mergers and acquisitions (M&A) only if there are significant benefits in terms of managerial skills and follow-up investment;
Do not use FDI as a way of meeting balance-of-payments shortfalls. The long-term impact of FDI on external payments is often negative even in EDEs attracting export-oriented firms;
Debt financing may be preferable to equity financing when there are no significant positive spillovers from FDI;
FDI contains speculative components and generates destabilizing impulses which need to be controlled and managed as any other form of international capital flows;
No incentives should be provided to FDI without securing reciprocity in benefits for industrialization and development;
Performance requirements may be needed to secure positive spillovers including employment and training of local labour, local procurement, domestic content, export targets and links with local firms;
Domestic firms should be nurtured to compete with TNCs;
Linking to international production networks organized by TNCs is not a recipe for industrialization. It could trap the economy in the lower ends of the value-chain.
Multilateral and Bilateral Constraints on Investment Policy
The experience strongly suggests that policy interventions would be necessary to contain adverse effects of FDI on stability, balance of payments, capital accumulation and industrial development and to activate its potential benefits. Still, the past two decades have seen a rapid liberalization of FDI regimes and erosion of policy space in EDEs vis-à-vis TNCs. This is partly due to the commitments undertaken in the World Trade Organization (WTO) as part of the Agreement on Trade-Related Investment Measures (TRIMs). However, many of the more serious constraints are in practice self-inflicted through unilateral liberalization or bilateral investment treaties (BITs) signed with more advanced economies (AEs) – a process that appears to be going ahead with full force, with the universe of investment agreements reaching 3,262 at the end of 2014 (UNCTAD IPM, 2015). Although there is considerable diversity in the obligations contained in various BITs, the constraints they entail are becoming increasingly tighter than those imposed by the WTO regime.
There are two main sources of WTO disciplines on investment-related policies: the Agreement on TRIMs and specific commitments made in the context of the General Agreement on Trade in Services (GATS) negotiations for commercial presence of foreign enterprises (the so-called mode 3) in the services sectors. In addition to these, a number of other agreements provide disciplines, directly or indirectly, on investment-related policies, such as the prohibition of investment subsidies linked to export performance in the Agreement on Subsidies and Countervailing Measures.
The TRIMs Agreement does not refer to foreign investment as such but to investment generally. It effectively prohibits attaching conditions to investment in violation of the national treatment principle or quantitative restrictions in the context of investment measures. The most important provisions relate to prohibition of domestic content requirements whereby an investor is compelled or provided an incentive to use domestically produced rather than imported products, and of foreign trade or foreign exchange balancing requirements linking imports by an investor to its export earnings or to foreign exchange inflows attributable to investment. By contrast, in TRIMs or the WTO more broadly, there are no disciplines restricting beggar-my-neighbour investment incentives by recipient countries that are just as trade-distorting. Such incentives provide an effective subsidy to foreign investors and can influence investment and trade flows as much as domestic content requirements or export subsidies, particularly since a growing proportion of world trade is taking place among firms linked through international production networks controlled by TNCs (Kumar, 2002).
The obligations under TRIMs may not affect very much the countries rich in natural resources, notably minerals, in their earlier stages of development. FDI in mineral resources is generally capital-intensive and countries at such stages depend almost fully on foreign technology and know-how in extractive industries and lack capital good industries. Linkages with domestic industries are usually weak and output is almost fully exported. Domestic content of production by foreign companies is mainly limited to labour and some intermediate inputs. The main challenge is how to promote local processing to increase domestic value-added. However, over time, restrictions over domestic content requirements can reinforce the “resource curse syndrome” as the country wants to nourish resource-based industries, to transfer technology to local firms and establish backward and forward linkages with them.
Domestic content requirements are particularly important for investment in manufacturing in countries at intermediate stages of industrialization, notably in automotive and electronics industries – the two key sectors where they were successfully applied in East Asia. Most industries of EDEs linked to international production networks have high import content in technology-intensive parts and components while their domestic value-added mainly consists of wages paid to local workers. Raising domestic content would not only improve the balance of payments but also constitute an important step in industrial upgrading. Restrictions over domestic content requirements would thus limit transfer of technology and import-substitution in industries linked to international production networks.
However, TRIMs provisions leave certain flexibilities that could allow EDEs to make room to move in order to increase benefits from FDI. First, the domestic content of industrial production by TNCs is not independent of the tariff regime. Other things being equal, low tariffs and high duty drawbacks encourage high import content. Thus, it should be possible to use tariffs as a substitute for quantity restrictions over imports by TNCs when they are unbound in the WTO or bound at sufficiently high levels. Similarly, in resource-rich countries, export taxes can be used to discourage exports of unprocessed minerals and agricultural commodities as long as they continue to remain unrestricted by the WTO regime.
Second, as long as there are no commitments for unrestricted market access to foreign investors, the constraints imposed by the TRIMs Agreement could be overcome by tying the entry of foreign investors to the production of particular goods. For instance, a foreign enterprise may be issued a licence for an automotive assembly plant only if it simultaneously establishes a plant to produce engines, gearboxes or electronic components used in cars. Similarly, licences for a computer assembly plant can be tied to the establishment of a plant for producing integrated circuits and chips. Such measures would raise domestic value-added and net export earnings of TNCs and would not contravene the provisions of the TRIMs Agreement.
Third, export performance requirements can be used without linking them to imports by investors as part of entry conditions for foreign enterprises. This would not contravene the TRIMs Agreement since it would not be restricting trade (Bora, 2002, p. 177). Finally, the TRIMs regime does not restrict governments in demanding joint ventures with local enterprises or local ownership of a certain proportion of the equity of foreign enterprises. In reality, many of these conditions appear to be used widely by industrial countries in one form or another (Weiss, 2005).
Since the TRIMs Agreement applies only to trade in goods, local procurement of services such as banking, insurance and transport can also be set as part of entry conditions of foreign firms in order to help develop national capabilities in services sectors. This would be possible as long as EDEs continue to have discretion in regulating access of TNCs to services sectors. The existing GATS regime provides considerable flexibility in this respect, including for performance requirements. However, the kind of changes in the modalities of GATS sought by AEs, including the prohibition of pre-establishment conditions and the application of national treatment, could shrink policy space in EDEs a lot more than the TRIMs Agreement.
The constraints exerted by most BITs signed in recent years on policy options in host countries go well beyond the TRIMs Agreement because of wide-ranging provisions in favour of investors. These include broad definitions of investment and investor, free transfer of capital, rights to establishment, the national treatment and the most-favoured-nation (MFN) clauses, fair and equitable treatment, protection from direct and indirect expropriation and prohibition of performance requirements (Bernasconi-Osterwalder et al., 2012). Furthermore, the reach of BITs has extended rapidly thanks to the use of the so-called Special Purpose Entities (SPEs) which allow TNCs from countries without a BIT with the destination country to make the investment through an affiliate incorporated in a third-party state with a BIT with the destination country. Many BITs also provide unrestricted arbitration, freeing foreign investors from the obligation of having to exhaust local legal remedies in disputes with host countries before seeking international arbitration. This, together with lack of clarity in treaty provisions, has resulted in the emergence of arbitral tribunals as lawmakers in international investment. These tend to provide expansive interpretations of investment provisions, thereby constraining policy further and inflicting costs on host countries (Bernasconi-Osterwalder et al., 2012; Eberhardt and Olivet, 2012; UNCTAD TDR, 2014).
Only a few EDEs signing such BITs with AEs have significant outward FDI. Therefore, in the large majority of cases there is no reciprocity in deriving benefits from the rights and protection granted to foreign investors. Rather, most EDEs sign them on expectations that they would attract more FDI by providing foreign investors guarantees and protection, thereby accelerating growth and development. However, there is no clear evidence that BITs have a strong impact on the direction of FDI inflows. More importantly, these agreements are generally incompatible with the principal objectives of signing them because they constrain the ability of host countries to pursue policies needed to derive their full potential benefits.
While in TRIMs investment is a production-based concept, BITs generally incorporate an asset-based concept of investment whether the assets owned by the investor are used for the production of goods and services, or simply held with the prospect of income and/or capital gain. This is largely because BITs are fashioned by corporate perspectives even though they are signed among governments. Typically, agreements are prepared by the home countries of TNCs and offered to EDEs for signature. The coverage of BITs includes a broad range of tangible and intangible assets such as fixed-income claims, portfolio equities, financial derivatives, intellectual property rights and business concessions as well as FDI as officially defined by the Organisation for Economic Co-operation and Development (OECD) and the International Monetary Fund (IMF). This implies that all kinds of assets owned by foreigners could claim the same protection and guarantees independent of their nature and contribution to stability and growth in host countries.
It also opens the door to mission creep. Investment agreements may be granted jurisdiction by tribunals over a variety of areas that have nothing to do with FDI proper, further circumscribing the policy options of host countries. Indeed, the expansive scope of investment protection in the North American Free Trade Agreement (NAFTA) has already given rise to claims that patents are a form of investment and hence should be protected as any other capital asset, thereby threatening the flexibilities left in the Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS) and access to medicines (Correa, 2013). Similarly, there have been claims by Argentinian bond holders that such holdings should be protected as any other investment under the Italy-Argentina BIT, thereby intervening with the restructuring of sovereign debt (Gallagher, 2012).
The combination of expansive interpretations of investment and “free transfer of capital” provisions of BITs seriously exposes host EDEs to financial instability by precluding controls over destabilizing capital flows. This is also recognized by the IMF. In its Institutional View on the Liberalization and Management of Capital Flows, the IMF (2012) notes that “numerous bilateral and regional trade agreements and investment treaties … include provisions that give rise to obligations on capital flows” (para. 8) and “do not take into account macroeconomic and financial stability” (para. 65) and “do not allow for the introduction of restrictions on capital outflows in the event of a balance of payments crisis and also effectively limit the ability of signatories to impose controls on inflows” (Note 1, Annex III). The Fund points out that these provisions may conflict with its recommendation on the use of capital controls and asks for its Institutional View to be taken into account in the drafting of such agreements.
Although the IMF’s Institutional View focuses mainly on regulating capital inflows to prevent build-up of financial fragility, prohibitions in BITs regarding restrictions over outflows can also become a major handicap in crisis management. It is now widely agreed that countries facing an external financial crisis due to an interruption of their access to international capital markets, a sudden stop of capital inflows and rapid depletion of reserves could need temporary debt standstills and exchange controls in order to prevent a financial meltdown (Akyüz, 2014). However, such measures could be illegal under “free transfer of capital” provisions of BITs.
Where rights of establishment are granted, the flexibilities in the TRIMs Agreement regarding entry requirements noted above would simply disappear. The national treatment clause in BITs requires host countries to treat foreign investors no less favourably than their own national investors and hence prevents them from protecting and supporting infant industries against mature TNCs and nourishing domestic firms to compete with foreign affiliates. It brings greater restrictions than national treatment in TRIMs because it would apply not to goods traded by investors but to the investor and the investment.
Further, provisions on expropriation and fair and equitable treatment give considerable leverage to foreign affiliates in challenging changes in tax and regulatory standards and demanding compensation. In particular, the concept of indirect expropriation has led states to worry about their ability to regulate. The fair and equitable treatment obligation has also been interpreted expansively by some tribunals to include the right of investors to a stable and predictable business environment.
The large majority of outstanding BITs do not make any reference to performance requirements of the kind discussed above, but a growing number of them signed in recent years incorporate explicit prohibitions (Nikièma, 2014). Some BITs go beyond TRIMs and bring additional prohibitions for performance requirements both at pre- and post-establishment phases. Others simply refer to TRIMs without additional restrictions. Still, this narrows the ability of governments to move within the WTO regime because it allows investors to challenge the TRIMs-compatibility of host-country actions outside the WTO system. This multiplies the risk of disputes that host countries can face since corporations are much more inclined to resort to investor-state arbitration than the states do in the WTO system. The MFN clause could entail even greater loss of policy autonomy in all these areas, including performance requirements, by allowing foreign investors to invoke more favourable rights and protection granted to foreign investors in agreements with third-party countries.
While investment agreements entail a considerable loss of policy autonomy, they do not appear to be serving the intended purpose and accelerating the kind of FDI inflows sought by policy makers in host countries. Evidence suggests that BITs are neither necessary nor sufficient to bring significant amounts of FDI. Most EDEs are now wide open to TNCs from AEs through unilateral liberalization or BITs or free trade agreements (FTAs), but only a few are getting FDI with significant developmental benefits and most of these countries have no BITs with major AEs. Econometric studies on the impact of BITs on FDI flows are highly ambivalent. While a few studies contend that BITs affect FDI flows, they do not examine whether BITs have led to the kind of FDI inflows that add to industrial dynamism in host countries. The majority of empirical studies find no link between the two (UNCTAD, 2009, Annex and UNCTAD TDR, 2014, Annex to Chapter VI). Similarly, survey data show that the providers of political risk or in-house counsel in large US corporations on investment decisions do not pay much attention to BITs (Yackee, 2010).
Conclusion
Policy space in several key areas affecting the contribution of FDI to the pace and pattern of industrialization might be somewhat constrained by the WTO Agreement on TRIMs, but it is still possible for EDEs to encourage positive spillovers without violating the WTO commitments. However, many of the more serious constraints are in practice self-inflicted through investment and free trade agreements. There are strong reasons for EDEs to avoid negotiating the kind of BITs promoted by AEs. They need to turn attention to improving their underlying economic fundamentals rather than pinning their hopes on BITs in attracting FDI. Where commitments undertaken in existing BITs seriously impair their ability to use FDI for industrialization and development, they can be renegotiated or terminated, as is being done by some EDEs, even if doing so may entail some immediate costs.
Yılmaz Akyüz is the chief economist of the South Centre.
This article is based on South Centre Research Paper 63 entitled “Foreign Direct Investment, Investment Agreements and Economic Development: Myths and Realities”, available at http://www.southcentre.int/research-paper-63-october-2015/.
Productive South Centre Board Meeting, held in Beijing
The South Centre held its 35th Board meeting in Beijing. Below is a brief description of the meeting as well as some highlights of events linked to the Board meeting.
By Yuefen Li
On 10-11 November 2015, the South Centre Board held its 35th meeting in Beijing, China, at the invitation of the Government of the People’s Republic of China. The meeting itself was hosted by the Chinese People’s Institute of Foreign Affairs (CPIFA), an institute that was set up by Premier Zhou Enlai in 1949 to foster and promote better people-to-people dialogue and understanding between China and the rest of the world.
The Board at its 35th meeting discussed and made decisions on the activities and financing of the South Centre, and looked at the medium- and long-term prospects and institutional and global contexts for strengthening the work of the South Centre in promoting the interests of the developing countries in the global arena.
The highlight of the Board’s visit was a meeting with Chinese State Councillor Mr. Yang Jiechi, at the Great Hall of the People in Beijing on 10 November 2015.
The South Centre’s Chairman, Mr. Benjamin Mkapa, formerly the President of the United Republic of Tanzania, thanked State Councillor Yang for the warm welcome and the cooperation of China with the Centre.
Both State Councillor Yang and South Centre Board Chairman Benjamin Mkapa recalled the meeting between President Xi Jinping of China and Mr. Mkapa in his capacity as Chairman of the South Centre when President Xi visited Tanzania in March 2013. Mr. Yang said that the meeting “gave a strong impetus to strengthening the cooperation between the South Centre and China.”
During the meeting, Mr. Yang stated that “the South Centre, as an important think-tank of developing countries, plays a significant role in boosting South-South cooperation and South-North cooperation. China values the great support the South Centre provides for the participation of developing nations in international development cooperation, and is ready to advance cooperation with the South Centre to maintain close communication and coordination on major issues concerning international development such as the 2030 Agenda for Sustainable Development and help developing nations realize common development and prosperity.”
South Centre Chairman Mr. Mkapa mentioned how impressed he was with the new Chinese initiatives to promote South-South cooperation and said: “The South Centre is very happy with this because we were set up precisely to promote South-South cooperation. The South Centre is now the only international inter-governmental think tank and research centre set up by the leaders to serve all the developing countries.”
Mr. Mkapa added that “the South Centre is ready to constantly deepen South-South cooperation with China, contributing to the realization of the 2030 Agenda for Sustainable Development.”
Another highlight was the Brainstorming Meeting on South-South Cooperation and China co-organized by the South Centre with the Chinese People’s Institute of Foreign Affairs and the Institute of World Economics and Politics/Chinese Academy of Social Sciences on 12 November 2015. Senior Chinese experts elaborated the new Chinese initiatives on South-South cooperation and in creating new regional and international institutions and their potential impact in assisting developing countries in implementing the post-2015 development agenda.
South Centre Chairman Mr. Mkapa said that with its large and growing economy, China has a crucial role in the present and future development of the developing countries. He also praised the new Chinese South-South funds for climate change and for the development agenda, amounting to US$5.1 billion which President Xi announced at the United Nations’ SDG summit in September 2015.
The Chairman and Board Members also visited Chengdu as part of the Board’s programme in China, upon the invitation of CPIFA, and experienced the cultural and natural diversity of China as examples, in many ways, of the same kind of richness and diversity in terms of culture and nature that may also be found in other developing countries of the South.
Yuefen Li is the Special Advisor on Economics and Development Finance of the South Centre.
China’s boost to South-South cooperation
Two new Chinese funds totalling US$ 5.1 billion to help developing countries tackle climate change and development problems could be a game changer in South-South cooperation and international relations.
By Martin Khor
China gave a big boost to South-South cooperation when its President, Xi Jinping, made two unprecedented mega pledges totalling US$5.1 billion to assist other developing countries, during his visit to the United States in September.
Firstly, he announced that China would set up a China South-South Climate Cooperation Fund to provide RMB 20 billion or US$3.1 billion to help developing countries tackle climate change. This announcement was made at the White House at a media conference with US President Barrack Obama.
Secondly, at the Development Summit at the United Nations, Xi said that China would set up another fund with initial spending of US$2 billion for South-South Cooperation and to aid developing countries to implement the post-2015 Development Agenda.
The sheer size of the pledges gives a big political weight to the Chinese contribution. President Xi’s initiatives have the feel of a “game changer” in international relations.
It is significant that Xi used the framework of South-South cooperation as the basis of the two funds.
In the international system, there have been two types of development cooperation: North-South and South-South cooperation.
North-South cooperation has been based on the obligation of developed countries to assist developing countries because the former have much more resources and have also benefitted from their former colonies as a result of colonialism.
Indeed, developed countries have committed to provide 0.7% of their GNP as development aid, a target that unfortunately is being met by only a handful of countries.
South-South cooperation on the other hand is based on solidarity and mutual benefit between developing countries as equals, and without obligations as there is no colonial history among them.
This is the position of the developing countries and their umbrella grouping, the G77 and China.
Xi himself, at a South-South roundtable he chaired at the UN, described South-South cooperation as “a great pioneering measure uniting the developing nations together for self-improvement, is featured by equality, mutual trust, mutual benefit, win-win result, solidarity and mutual assistance and can help developing nations pave a new path for development and prosperity.
“As the overall strength of developing nations improves, the South-South cooperation is set to play a bigger role in promoting the collective rise of developing countries.”
In recent years, as Western countries reduced their commitment towards aid, they tried to blur the distinction and have been pressing big developing countries like China and India to also commit to provide development aid just like them, within the framework of the OECD, the rich countries’ club.
However, the developing countries have stuck to their political position: The developed countries have the responsibility to give adequate aid to poor countries and should not shift this on to other developing countries. The developing countries however will also help one another, through the arm of South-South cooperation.
This has increasingly led some of the developed countries to vaguely threaten to reduce their aid commitment, unless some of the developing countries also pay their share. For them, South-South cooperation is just too vague and too small.
This perception has been changed by the two Chinese pledges, both interesting in themselves.
It is noted by many that the $3.1 billion Chinese climate aid exceeds the $3 billion that the United States has pledged (but not yet delivered) to the Green Climate Fund (GCF) under the UN Climate Convention.
Major developing countries have been pressed to contribute to the GCF but they have correctly argued that the GCF is a fund meant for developed countries to meet their historical responsibility to assist developing countries. Developing countries can choose to help one another through the avenue of South-South cooperation.
China has now taken that South-South route by announcing it will set up its own South-South climate fund, with the unexpectedly big size of $3.1 billion, an amount larger than any developed country has pledged at the GCF. Last year, when China initially announced a similar fund, the sum mentioned then was only $20 million.
With such a large amount, the Chinese climate fund has the potential to facilitate many significant programmes on climate mitigation, adaptation and institutional building.
As for the other fund announced by President Xi, the initial $2 billion is for South-South cooperation and for implementing the development agenda just adopted by the UN. The agenda’s centrepiece is the sustainable development goals. Xi mentioned poverty reduction, agriculture, health and education as some of the areas the fund may cover.
This new fund has the potential of helping developing countries learn from one another’s development experiences and practices and make leaps in policy and action.
Xi also said an Academy of South-South Cooperation and Development will be established to facilitate studies and exchanges by developing countries on theories and practices of development suited to their respective national conditions.
The next steps to implement these pledges would be to set up the institutional basis for the funds, and design their framework, aims and functions. It is a great opportunity to show whether South-South cooperation can contribute as positively as North-South aid.
After all, South-South cooperation is meant to complement and not to replace North-South cooperation.
Of course, aid is not the only dimension of South-South cooperation, which is especially prominent in the areas of trade, investment, finance and the social sectors.
The regional trade agreements in ASEAN, East Asia, and the sub-regions of Africa and Latin America, as well as the trade and investment links between the three South continents, have shown immense expansion in recent decades.
Recently, the world imagination was also captured by the creation of the BRICS Bank, the Asian Infrastructure Investment Bank and the Chinese One Belt One Road programme, which all contain elements of South-South cooperation.
South-South cooperation in aid, however, is symbolically and practically of great importance, as it tends to assist the more vulnerable— including poor people and countries, and fragile environments including biodiversity and the climate undergoing crisis.
Let’s hope that the two new funds being set up by China will give a much-needed boost to South-South cooperation and solidarity among the people.
Martin Khor is the Executive Director of the South Centre. Contact: director(at)southcentre.int
Implications of Argentina’s Deal with “Super holdouts”: Need for an Urgent Revision to Bond Contracts and for a Debt Workout Mechanism
By Yuefen Li
Argentina signed an agreement in principle on 29 February 2016 with four “super holdout” hedge funds including NML Capital Ltd, Aurelius Capital, Davidson Kempner and Bracebridge Capital. Buenos Aires would pay them a total of about $4.65 billion, amounting to 75 percent of the principal and interest of all their claims of Argentina’s bonds that were defaulted on during the 2001 debt crisis. The payment is to be made in cash before 14 April 2016, provided that Argentina’s Congress approves the repeal of Argentina’s domestic laws, namely the Lock Law and the Sovereign Payment Law, which prohibit the country from proposing terms to the holdouts that are better than those Argentina offered to its creditors in earlier restructurings. This deal would allow the return of Argentina to the international capital market after more than 15 years of exclusion, something that is imperative for the government to try to put the economy on a more sustainable path even though this would mean having to use a substantial part of its foreign currency reserves to pay off the holdout bond holders. Nevertheless, there are systemic implications of this deal to future sovereign debt restructurings which deserve careful examination and remedial actions.
The reason to call the four hedge funds as “super holdouts” is because they are the largest, the most combative and the most tenacious holdout creditors. Argentina floated exchange bonds in 2005 and then again in 2010 after it defaulted during the 2001 debt crisis on its bonds that were valued at nearly $100 billion. Ninety-three percent of the holders of Argentine restructured sovereign bonds accepted the exchange proposals at a considerable “haircut” (i.e. discount rate) of about 65% (that is, they agreed to receive only 35 cents for each dollar of the face value of the restructured bonds). The remaining 7% of the bond holders turned down the offers.
In 2003, NML Capital Ltd which is managed by Elliott first sued Argentina for repayment of 100% of the face value of the bonds they hold. As a result of the suit, U.S. District Judge Griesa issued his pari passu ruling which prohibited Argentina from servicing its bonds before paying the holdouts. This led Argentina to default on its debt again in 2014. With it the thirteen year-long litigation saga – considered to be among the most publicized, the ugliest and the most divisive legal battle in history for sovereign debt restructuring – came to a stalemate with both sides refusing to move.
To end the stalemate, the newly elected President of Argentina, Mauricio Macri, made resolving the holdout dispute a priority and in February 2016 offered to pay $6.5 billion to the group of six hedge fund holdouts. Two of the funds accepted the offer but not NML and three other funds which asked for better terms. Hence, we see different degrees of tenacity among holdouts, resulting essentially in different levels of payment to them and compromising inter-creditor equity. Clearly, the deal is a great victory for the “super holdouts”. In addition to the 75% payment in principal and hefty interest accumulated over the years, thirteen years of hefty legal bills will also be picked up by Argentina. Estimates on the returns that the “super holdouts” will make on their investment in Argentina’s bonds range from three to five times what they paid for the bonds in the first place.
The business model of these hedge funds is well known. They seek and buy sovereign bonds issued by States that are going through economic distress for a fraction of the bonds’ face value and then holding out by refusing discounted repayment of such bonds when offered by the issuing State, seeking instead to getting paid in full or as close to full as possible for the principal plus interest through litigation or other means including seizing assets. Although the precise information on the prices paid by these “super holdouts” for the Argentinian bonds is not easily available, based on data from the Ministry of Finance of Argentina, Bloomberg estimated that payment on principal would equal to about four times the face value of bonds Elliott holds. Elliott will get back, under the terms of the deal struck on 29 February 2016, $2.28 billion on its $617 million investment in principal.
However, the payment from the deal struck with Argentina may not be the only profit the “super holdout” funds get from their Argentina bonds. It is common for these funds to purchase CDSs (Credit Default Swaps) against the distressed bonds they hold. CDS is a credit derivative which ensures creditors get paid of the premium as well as the interest in times of default and other credit events. This creates a win win business situation for the hedge funds and lose lose dilemma for the sovereigns. With CDSs, the hedge funds would get paid if the borrowers default or the bond prices suffer from a deep decline. They would get paid twice if a defaulted borrower loses legal battle and is forced to pay the hedge funds.
In the case of Argentina, further to the pari passu injunction, a “failure to pay” credit event triggered the payment of the CDS on Argentina’s debt. Yet, it is not possible to get the CDS positions of the hedge funds involved in the litigation against Argentina. Some observers have suggested that relevant hedge funds against Argentina may also hold CDS on these bonds and thus profit from a default scenario. When being probed at the court room, Elliott’s lawyer chose to give an evasive answer.
However, purchasing large quantities of CDSs is the business model of such kind of hedge funds. This creates a conflict of interest as the hedge funds holding CDSs on the particular bond they are litigating in court are in a very good position to trigger default or push the prices of the litigated bonds lower through their litigation tactics. In return, these hedge funds can get paid for their CDS holdings because of the default and sharp price decline. Subsequently, because of the desire to return to the international market, the bond issuers would have to resume negotiation with the same hedge fund which would not give up until they squeeze as much as possible from the sovereign bond issuers.
Nevertheless, it is understandable that the new government of Argentina moved fast to tackle the impasse of the bond holdout problem. The country is facing many severe economic challenges at the moment. Inflation is about 25% and the primary fiscal deficit is more than 5.8 percent of GDP.
To make up the fiscal shortfalls, the government has been borrowing from the central bank, leading to a big drop in its foreign reserves. In the current global economic environment of low aggregate demand and declining commodity prices, it is not very realistic to pin hope on increasing trade revenue to replenish its foreign reserves, especially when its two largest export products – soya and petroleum – are subject to worsening terms of trade and drastic price fluctuation. To mitigate the severe liquidity shortage, Argentina has already utilized its currency swap arrangements with China. The government also has the option of cutting expenditure in order to ease the liquidity crunch, but embarking on a Greek-style austerity programme would be highly unpopular. Inflation has already eroded the real take-home pay of the wage earners and demonstrations for wage increase have been going on for years. To regain access to the capital markets to raise new money is important for mitigating the severe shortage of liquidity and smooth out economic bottlenecks.
The last hurdles to Argentina being able to return to the international capital market to obtain financing are these “super holdouts” as well as the injunction from the U.S. District Court. The deal would therefore clear both obstacles as Judge Griesa has granted the lifting of the injunction upon the repeal of the Argentine domestic laws. As the injunction is an important leverage for the “super holdouts” to get paid, they requested the injunction be lifted after they get paid. The country has already settled some major arbitration cases and disputes in previous years.
However, can we collectively utter a sigh of relief and celebrate the coming to an end of the longest and the most high profile holdout case in the history? Before doing so, we need to contemplate the impact and the implications of such a publicised legal battle that would end by the payment of billions of dollars to “super holdouts”.
Firstly, it would not be surprising for creditors involved in future debt restructurings to first look around and find out whether there are big institutional creditors with strong financial and legal positions involved in the same case. If so, the tendency could be to wait for a “me too” chance instead of examining the creditors’ own economic positions and decide whether or not to be cooperative and accept the restructuring proposals. This will then most likely result in a delayed and disorderly debt workout and undermine the objective to quickly rescue the financially distressed governments and restore debt sustainability.
Secondly, huge financial gains for the “super holdouts” could lead to the birth of more “baby NML” making this much specialised profession a more crowded market. With this litigation case being so dramatic and traumatic that even a ship was seized, some creditors could be more combative and more uncompromising in the future. As a result, creditor coordination would turn out to be more difficult than before.
Thirdly, it is highly likely that these hedge funds would look for more weak links in the bond contracts further than pari passu and prepare themselves for the next target. The tremendous influence of these hedge funds, their legal tactics and the demonstrated tenacity have already led to efforts to strengthen the contractual clauses to reduce chances of holdout and rushing to the court. These include the tightening of the language of the collective action clause (CACs) and pari passu clause as well as the strengthening of sovereign immunity. However, there are other boilerplate/general clauses which could be subject to innovative interpretations like what happened to pari passu.
Fourthly, even though the legal battle between NML and Argentina is coming to an end, the impact of the powerful 2012 injunction on pari passu may still linger on. The question on whether the conditional lifting of the injunction granted by Judge Griesa would make the injunction disappear for good remains to be seen. The injunction prevents Buenos Aires from servicing its bonds until it settles with the holdouts. As Professor Anna Gelpern mentioned, this is a powerful financial weapon. It would certainly favour the holdouts if the borrower does not have close to infinite financial resources to fight lengthy legal battles. If holdouts can still use this injunction as recourse, chances of borrowers to win the legal battle would be significantly diminished. Outstanding bonds without improved language of CACs and pari passu is eye boggling. The newly revised CACs and pari passu clauses will take a long time to phase in depending on the maturity of the bonds. With the slow recovery from the global financial crisis and low commodity prices, some developing countries are facing debt sustainability challenges, making them eventual easy targets for litigation-oriented hedge funds.
How can the potential negative systemic impact from this case be mitigated and make future debt workout timely and orderly?
Current efforts have concentrated on making it more difficult for holdouts to rush to the court room through strengthening current contract clauses. This is necessary and welcome. However, this may be far from sufficient. The financial incentives to be “super holdouts” are immense. Additionally, NML and other holdout hedge funds have done everything within the law. The “super holdouts” have every right to purchase bonds at the secondary market as bonds are transferable and the secondary market is needed to make bonds liquid. Herding behaviour can make bonds undervalued. But buying them at a fraction of their face value is not a crime.
While the purchase of sovereign bonds on the secondary market at discount rates may be legal, one can say that the business model of specializing in purchasing hugely undervalued bonds for the purpose of resorting to litigation and other means to force the distressed governments to pay the full face value is not ethical because it is at the expense of the ordinary tax payers and the well being of a sovereign state.
Academia and institutions have used the strategy of “name and shame” hoping the “super holdouts” would give in. Apparently, it has not had much impact. Argentina’s unsuccessful pleadings in the U.S district and supreme courts were supported by the Pope, Nobel Prize winners, countries like France, Mexico and Brazil, international intergovernmental institutions like the IMF, the United Nations and the South Centre, NGOs and ordinary citizens. None managed to persuade the hedge funds to give up.
Three approaches may be of value to consider for the purpose of reducing the recurrences of the NML-style “super holdouts”.
One approach is to reduce incentives for holdouts. It is common business practice for goods and services bought at huge discount in retail stores or via internet to have clear stipulations that they are either not refundable or cannot be changed or returned. People take it for granted that it is a lawful and correct business practice. To buy things at Christmas sales and go back to the stores and request for refund of the full original price of the products would be considered as unethical. Why then is it so unlawful to reject the request of the “super holdout” to get paid 100% when the bonds were bought at a fraction of their face value? Because sovereign bond contracts often do not explicitly mention that bonds bought at a discount will be redeemed by the government at the discounted rate rather than at face value, the issuing State then gets bound to respect the bond contract and pay it at face value.
In the absence of a multilateral legal framework on sovereign debt restructuring mechanism, reducing incentives may be done through revising the contractual terms for the bonds. In the case when the bonds were bought at a steep discount, there could be a contractual clause to limit the margin of returns to minimize the likelihood of litigating for 100% repayment. Consideration could be given to add a clause to bond contracts to the effect that “in case of a debt restructuring, the bondholders would be paid back no higher than X% of the purchase price of the bond.” The percentage could be a range and take into consideration the past holdout cases together with haircut levels of historical debt restructuring incidences. The range or specific percentage should allow sufficient profit margin and avoid the possibility of moral hazard of strategic default. In this way, secondary market operations would not be disrupted and hopefully the incentives for super holdout could be diminished.
Other ways of reducing incentives for super holdout should be examined. For instance, the statutory penalty interest rates of some of the bonds Elliott holds are exorbitantly high. According to the Wall Street Journal, these bonds would bring 10-15 times of return to Elliott. These kinds of arrangements give insane incentives to holdout bond holders.
Another way out is to explore whether it is really beneficial for the stability of the international financial market not to regulate hedge funds specialized in debt holdout. At a time of increased social responsibilities for the institutions of the real economy, more regulations in the banking sector and more specific codes of conduct for various business sectors, should there also be some regulations and codes of conduct with respect to these hedge funds? Apparently, conflict of interests and lack of transparency do exist in their purchases of CDSs, hence, there should be efforts to investigate into this relatively closed and opaque business.
Finally, there have been repeated international efforts to establish an international debt workout regime or legal framework to cope with systemic issues relating to the “too late and too little” phenomenon for debt restructurings as well as the holdout problem. The IMF tried in 2003. The United Nations General Assembly set up an Ad Hoc Committee mandated to create a multilateral legal framework for sovereign debt restructurings in September 2014.
As one outcome, in 2015 the Committee formulated the ‘Basic Principles on Sovereign Debt Restructuring’ based on years of research and consensus building in UNCTAD. However, political resistance from the developed countries has made it difficult for the United Nations to push the work to a more inclusive and substantive phase. The Argentina case has proved once again the need of a debt workout mechanism.
Yuefen Li is the Special Advisor on Economics and Development Finance of the South Centre.
Climate Change Battles in Paris: An analysis of the Paris COP21 and the Paris Agreement
The UN Climate Change Conference (known as COP21) in December 2015 adopted a historic Paris Agreement which attracted a lot of congratulations but also some criticisms. This article describes the battles in Paris, mainly between developed and developing countries, on many of the key issues. It also analyses the outcomes of these issues within the Paris Agreement and how these outcomes emerged from the battles among the Parties.
By Meenakshi Raman
The Paris Agreement adopted by the 21st Conference of Parties (COP21) under the United Nations Framework Convention on Climate Change (UNFCCC) on 12 December, was the outcome of major battles on a multitude of issues, especially between developed and developing countries.
Developing countries by and large had these negotiating objectives. They wanted (a) to defend the Convention and not let it be changed or subverted; (b) to ensure that the Agreement is non-mitigation centric with all issues (including adaptation, loss and damage, finance and technology, besides mitigation) addressed and in a balanced manner; (c) to ensure differentiation in all aspects be reflected, with the principles of equity and common but differentiated responsibilities (CBDR) and respective capabilities; (d) to ensure that developed countries enhance the provision of finance and technology transfer’ (e) to ensure that ‘loss and damage’ is recognised as a separate pillar apart from adaptation and (f) legally binding provisions, especially on the developed countries.
The United States and allies (especially those under the Umbrella Group) wanted the opposite. They mounted an onslaught on the Convention, seeking to weaken the provisions and their obligations; they wanted to redefine differentiation so as to blur the different obligations of developed and developing countries; and they wanted a legal “hybrid” (in terms of what clauses are and are not legally binding), mainly to suit the US administration’s relations with the US Congress which is hostile to the climate change issue.
COP21 was a battleground that involved an onslaught (with both defensive and offensive interests) of the US and its allies versus the resistance and offensive by the Group of 77 and China, and especially the Like-minded Developing Countries (LMDC) (which includes India) that had comprehensive negotiation positions and a well operating machinery.
A major concern was how the French Presidency of COP 21 would behave, in light of the polarised positions.
Towards the end, an important meeting took place between the LMDC and the French Presidency (who were crafting the final compromise), during the night of Friday, 11 December, where the LMDC presented its “super-redlines”. Among them included that the purpose of the Agreement is to enhance the implementation of the Convention in accordance with the principles and provisions of the Convention; reflection and operationalisation of equity and CBDR across all elements; clear differentiation between developed and developing countries on the mitigation efforts; commitment by developed countries on provision of finance, technology transfer and capacity-building with no transfer or extension of obligations to developing countries to provide finance.
The LMDC conveyed the message that with 30 countries in its grouping representing more than 50% of the population of the world and 70% of the poor, it wanted the COP to be a success but that the outcome must be balanced, and not depart from its super-redlines. In the end the French took the LMDC points, and got the US to agree.
The COP 21 Presidency was generally viewed as playing a fair and difficult role in securing a delicate and balanced outcome, except for an incident in the final plenary that somewhat marred the process.
This is the ‘should incident’ where the US wanted the word “shall” to be replaced with the word “should” in Article 4.4 of the Agreement that related to the mitigation efforts of Parties. The US wanted developed and developing countries to be treated in a like manner legally, as the original version referred to “shall” for developed countries and “should” for developing countries.” Instead of raising the issue from the floor of the plenary, the US request was accommodated by the COP Presidency by what was termed a “technical correction” and the word “shall” was then replaced with “should” and was read out by the Secretariat. This was viewed with dismay by some LMDC delegations, but as there was no formal objection, the US-inspired amendment stood.
Another incident was when Nicaragua put up its flag in the final session of the Paris Committee that adopted the Paris agreement but it was ignored by the Chair. After the agreement had passed, the Minister of Nicaragua made a strong statement protesting against his being ignored earlier.
Highlights of the Paris Agreement
To understand the COP21 outcome, a reflection on the key clauses of the Paris Agreement and the decision that adopted it is important. Below is an initial assessment of the issues that form the context of the clauses, and the final outcome, with an assessment as to whether the views of developed or developing countries (or both) prevailed.
Given that the Agreement is a new legal instrument, it will have to be ratified by Parties for it to come into effect. It will enter into force after at least 55 Parties to the Convention, accounting in total for at least an estimated 55 per cent of the total global greenhouse gas emissions have deposited their instruments of ratification or acceptance. (The Agreement is expected to come into effect post-2020.)
The Agreement (12 pages) was adopted as an annex of a decision (19 pages) of COP21.
Purpose of the Agreement (Article 2)
Article 2 of the Agreement states in sub-paragraph 1 that: “This Agreement, in enhancing the implementation of the Convention, including its objective, aims to strengthen the global response to the threat of climate change, in the context of sustainable development and efforts to eradicate poverty, including by:
(a) Holding the increase in the global average temperature to well below 2 °C above pre-industrial levels and to pursue efforts to limit the temperature increase to 1.5 °C above pre-industrial levels, recognizing that this would significantly reduce the risks and impacts of climate change;
(b) Increasing the ability to adapt to the adverse impacts of climate change and foster climate resilience and low greenhouse gas emissions development, in a manner that does not threaten food production;
(c) Making finance flows consistent with a pathway towards low greenhouse gas e