Elsevier

World Development

Volume 36, Issue 11, November 2008, Pages 2456-2469
World Development

International Investment Agreements and Services Markets: Locking in Market Failure?

https://doi.org/10.1016/j.worlddev.2007.10.018Get rights and content

Summary

Bilateral investment treaties (BITs) and investment chapters in preferential trade agreements have become popular measures to guarantee investor-friendly policies. While they reassure multinational firms, they also constrain host country authorities in regulating markets to stimulate competition. These problems are widespread in service industries characterized by significant economies of scale. This paper presents case studies of the difficulties the Chilean regulatory authorities faced in regulating the financial services, telecom, and energy industries. It concludes that able regulators are necessary, but that international agreements need to also leave enough policy space.

Introduction

Services trade and investment have become one of the most important driving forces of economic globalization. During 1974–2004, commerce in services grew from 5% to 20% of global trade and from a quarter to over 60% of the total stock of foreign direct investment (FDI) (UNCTAD, 2004a, World Trade Organization, 2004). A growing share of these transactions is covered by preferential trade agreements (PTAs), accords that reduce barriers to trade and investment between members only. A recent survey by the WTO concludes that PTAs in services are multiplying faster than any other type of trade agreement (Crawford & Fiorentino, 2005). By contrast, the General Agreement on Trade in Services (GATS) plays only a minor role for services FDI in developing countries (Hoekman, 1995, Sauvé, 2000). Remarkably, preferential trade and investment in services remains primarily a North–South affair. Services transactions between the major economic powers EU, USA, and Japan are covered by commitments made in the WTO and the OECD. Developing countries at times include services in South–South PTAs, but with few exceptions like South Korea, Brazil, and Mexico they are still insignificant foreign investors in the sector (Ramamurti, 2001, p. 27).

A second instrument of growing importance is bilateral investment treaties (BITs) (Vandevelde, 1998). BITs are international legal commitments that guarantee the property rights of foreign investors. BITs and PTAs increasingly converge, as preferential agreements include BIT-equivalent chapters, while BITs negotiated by the United States prescribe the granting of pre-establishment rights and concrete steps toward the liberalization of investment rules that also apply to services. All PTAs negotiated by the United States, Canada, and Japan with developing countries include BIT-like chapters with investor-state dispute-settlement procedures, while European countries are in the process of “upgrading” their existing BITs through renegotiations.

Although PTAs and BITs are not the most important measures to reduce trade and investment barriers, since most countries undertake these steps unilaterally, they have become the principal international contracts to maintain open FDI regimes for services in developing countries. Current research suggests that international agreements help countries attract FDI by signaling that they will pursue a liberal economic policy (Neumayer & Spess, 2005). This benefit, however, comes with a price: by promising an investor-friendly policy, developing countries limit their regulatory freedom. This paper argues that because many services industries require regulation to guard against market failure, the trade-off implied by international agreements can prevent host countries from reaping the full benefits of liberalization. Rather than reducing prices for consumers, they can lead to transfers of rents to foreign firms, or the replacement of domestic oligopolists by foreign ones. Intended as a protective measure against expropriation, BITs and investment chapters in preferential trade agreements may have the effect of deterring host countries from regulating effectively to ensure competition.

Many service industries are textbook examples of imperfect competition. If such industries are opened to foreign investment, first-movers can buy up enough assets, achieve a dominant market share, and deter competitors from entry (Tirole, 1988). Even if liberalization is later “multilateralized,” or applied on a non-preferential basis, first-movers may not have to face real competition.

This article presents case studies of services liberalization in Chile to provide evidence of the constraining effect of market structures and international agreements. The Latin American country is a good test case because it is relatively small, with a population of about 16 million and a per-capita income of about US$5000 at market prices,2 and had already undertaken significant steps to liberalize its service markets prior to signing any PTAs or BITs. Moreover, since successive Chilean governments have pursued liberalization more vigorously than most developing countries, many service industries are almost completely foreign-owned. Protection of domestic industries therefore cannot account for the lack of competition.

This paper focuses on three industries in which foreign investment is often a precondition for market entry: energy, telecommunications, and financial services. The analysis first shows how in the first two industries companies used open threats to try to constrain regulators, while in banking government officials worried about international legal constraints despite their conviction that the existing rules were insufficient. It then provides evidence that foreign firms directly sought constraints on host country governments in PTA negotiations when it suited their competitive position (as in the case of the EU–Chile FTA), while firms that were excluded raised market-opening demands that may stimulate competition (as in the US–Chile FTA).

This paper proceeds as follows. The first section briefly surveys the literature on preferential trade agreements, BITs, and the protection of FDI. Section 2 spells out the theoretical case for why market structures in services require strong regulation. Sections 3 to five turn to the case studies. The final section concludes and considers policy implications.

Section snippets

Services FDI, commitments, and signaling

Developing countries have to deal with two fundamental challenges when trying to attract FDI. First, they need to reassure foreign investors that their property rights will be respected by future governments that may have different policy preferences—a time-inconsistency problem that requires a credible commitment. Second, they need to distinguish themselves from other potential FDI hosts by showing their true intentions to investors with a limited capacity to assess risks—a problem of

The structure of service markets

Services can be supplied in four different ways, or “modes” in GATS parlance: cross-border supply (mode 1, e.g., translation), consumption abroad (mode 2, e.g., tourism), commercial presence (mode 3, or direct investment), and presence of natural persons (mode 4, e.g., consultants). Modes 1 and 3 are the primary objectives of services liberalization negotiations.

In the case of cross-border supply, a liberalized market allows firms to reap economies of scale. Given the nature of many services,

Imperfect competition and policy constraints in Chile’s service industries

Among developing countries, Chile stands out as the first to almost completely liberalize its FDI regime, subject to only a limited screening process under decreto ley 600 (DL 600). Investing firms sign a contract with the Chilean government that guarantees access to the necessary foreign exchange and optionally locks in an effective tax rate of 42% (UNCTAD, 2004b). In practice, Chile’s economy has been open to foreign investment since the mid-1970s. Despite a very liberal practice in granting

Constraining rather than liberalizing? The EU–Chile FTA

As European firms established themselves as key players in Chilean markets, the EU Commission considered an FTA to lock in liberalization commitments. The FTA was negotiated during 10 separate rounds during April 2000–June 2002. Building on a 1990 political agreement between Chile and the EU, signed to express support for Chile’s democratic transition, the EU Commission concluded a “Framework Agreement for Cooperation” in 1996. Formal negotiations began in November 1999. Until then, negotiating

Liberalizing with few constraints: The US–Chile FTA

Demonstrating its commitment to hemispheric liberalization, Chile originally planned to join NAFTA under the treaty’s accession clause shortly after the agreement was to come into effect. At the Summit of the Americas in Miami in 1994, the three NAFTA members officially invited Chile to join the North American trade agreement. Negotiating accession, however, proved impossible, since the Clinton administration and Congress failed to come to an agreement over the conditions under which the

Conclusion

This article has analyzed the interaction between investors and the host government in two service industries in Chile. As industries characterized by significant economies of scale barriers to entry, they are subject to regulation by the host government. In addition to threats of withholding investment and seeking recourse in local courts, multinational firms have used threats of international arbitration based on BITs and the investment chapters in PTAs to prevent regulation that would limit

Acknowledgments

The author would like to thank Pablo Heidrich, Tony Heron, Lawrence Saez, Ken Shadlen, Ricardo Raineri, seminar and panel participants at FLACSO Buenos Aires, the International Studies Association 2005 and 2007 meetings and the 2007 conference of the American Political Science Association, and the anonymous reviewers for comments and suggestions. Matthieu Beauchemin provided outstanding research assistance. This research was partially funded by Nouveaux Chercheurs Grant No. 2007-NP-114251 of

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