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The Effect of Treaties on Foreign Direct InvestmentBilateral Investment Treaties, Double Taxation Treaties, and Investment Flows$

Karl P. Sauvant and Lisa E. Sachs

Print publication date: 2009

Print ISBN-13: 9780195388534

Published to Oxford Scholarship Online: May 2009

DOI: 10.1093/acprof:oso/9780195388534.001.0001

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Explaining the Popularity of Bilateral Investment Treaties *

Explaining the Popularity of Bilateral Investment Treaties *

Chapter:
(p.73) 3. EXPLAINING THE POPULARITY OF BILATERAL INVESTMENT TREATIES *
Source:
The Effect of Treaties on Foreign Direct Investment
Author(s):

Andrew T. Guzman (Contributor Webpage)

Publisher:
Oxford University Press
DOI:10.1093/acprof:oso/9780195388534.003.0003

Abstract and Keywords

This chapter looks at why BITs have become the preferred method for governing the relationship between foreign investors and host governments in developing countries. It offers a novel explanation of why developing states fought aggressively against the former rule of “prompt, adequate, and effective” compensation for expropriation and in favor of a more lenient standard, and yet contemporaneously flocked to sign treaties that offer investors much greater protection than did the old rule of customary international law. It shows that although an individual country has a strong incentive to negotiate with and offer concessions to potential investors—thereby making itself a more attractive location relative to other potential hosts—developing countries as a group are likely to benefit from forcing investors to enter contracts with host countries that cannot be enforced in an international forum, thereby giving the host a much greater ability to extract value from the investment. The chapter offers a comprehensive explanation for the behavior of developing countries and assesses the desirability of BITs. It discusses the welfare implications of BITs as compared to the “appropriate compensation” standard that developing countries have advocated at the UN. It demonstrates that although BITs increase global efficiency, they likely reduce the overall welfare of developing countries. Finally, the chapter discusses the impact of BITs on customary international law.

Keywords:   bilateral investment treaties, Hull Rule, international law, appropriate compensation, developing countries

INTRODUCTION

A serious analysis of bilateral investment treaties (BITs) and their implications both for investment levels and for the distribution of the gains from investment is timely. BITs have become the dominant international vehicle through which investment is regulated. As of 1996, there were 1,010 BITs in existence around the globe,1 more than half of which have been signed or brought into force since the start of 1990.2 The number of countries that have signed at least one BIT has reached 149 (including some countries that have ceased to exist, such as the USSR), leaving very few countries without such treaties. Although a substantial academic literature related to these treaties exists, there has been surprisingly little analysis of the impact of BITs on the welfare of the countries that have signed them. This chapter seeks to address this large gap in the literature and contribute to a more coherent understanding of BITs, their impact on foreign investment, and their effect on the welfare of nations.

In recent years foreign direct investment (FDI) has grown at an unprecedented rate.3 Between 1986 and 1990, global FDI flows increased from $88 billion dollars to $234 billion, representing an average rate of increase of 26% in nominal terms and 18% in real terms. From 1980 to 1993 the stock of foreign investment increased at an average annual rate of 11% in real terms, reaching a total of $2.1 trillion in 1993.4 A significant proportion of FDI flows has been (p.74) directed at developing countries: FDI flows to these countries grew from $13 billion in 1987 to $22.5 billion in 1989 to $90.3 billion in 1995.5

BITs rose to prominence during a period in which the international regulation of foreign investment was the subject of great change, uncertainty, and controversy. Not long ago, when a host country expropriated a foreign investor’s property, the relevant rule of customary international law, known as the Hull Rule, required “prompt, adequate, and effective” compensation. In the years that followed World War II, however, developing countries questioned the Hull Rule, claiming the right to determine how they would treat investors and the standard of compensation that should apply if that treatment was sufficiently harmful. This challenge to the Hull Rule proved successful and, by the mid-1970s, the Hull Rule had ceased to be a rule of customary international law.

Countries began to establish BITs even before the demise of the Hull Rule. These treaties, typically signed between developed and developing nations, are binding international agreements that govern the treatment of foreign investment. Even though developing countries as a group objected vociferously and repeatedly to the Hull Rule, these same countries have signed more than a thousand BITs that incorporate obligations similar to the Hull Rule. Indeed, most BITs offer investors even greater protection, at the expense of host countries, than the Hull Rule ever did. Most important, BITs typically include terms that protect the foreign investor against a “contractual breach” by the host. Thus, when a BIT is in force between a host and a home country, an agreement made between the home country investor and the host is binding for both. A breach of the agreement by the host is a violation of the BIT and, therefore, a violation of international law. BITs also give the aggrieved investor access to binding arbitration, thereby creating an enforcement mechanism that is much more effective, and thus better able to ensure compliance by the host, than was the Hull Rule.

This chapter looks at why BITs have become the preferred method of governing the relationship between foreign investors and host governments in developing countries. Because BITs impose obligations that are similar—and, indeed, that exceed—those imposed by the Hull Rule, and because the legal position advocated by developing countries has always been for fewer such legal requirements, the simultaneous opposition to the Hull Rule and embracing of BITs is a paradox.6 This chapter offers a novel explanation of why developing states (p.75) fought aggressively against the former rule of “prompt, adequate, and effective” compensation for expropriation and in favor of a more lenient standard, and yet contemporaneously flocked to sign treaties that offer investors much greater protection than did the old rule of customary international law. It is demonstrated that although an individual country has a strong incentive to negotiate with and offer concessions to potential investors—thereby making itself a more attractive location relative to other potential hosts—developing countries as a group are likely to benefit from forcing investors to enter contracts with host countries that cannot be enforced in an international forum, thereby giving the host a much greater ability to extract value from the investment. Put another way, developing countries as a group have sufficient market power in the “sale” of their resources that they stand to gain more when they act collectively than when they compete against one another. This chapter offers a comprehensive explanation for the behavior of developing countries and assesses the desirability of BITs.

In addition, this chapter discusses the welfare implications of BITs as compared to the “appropriate compensation” standard that developing countries have advocated at the UN. The chapter demonstrates that although BITs increase global efficiency, they likely reduce the overall welfare of developing countries.

Finally, the chapter discusses the impact of BITs on customary international law. The chapter argues that because BITs are signed by developing countries in pursuit of their economic self-interest rather than out of a sense of legal obligation, these treaties do not support a rule of customary international law that incorporates the Hull Rule.

Before proceeding, a note of clarification is in order. The bulk of the literature on BITs and foreign investment protection has focused on expropriation, devoting much less attention to other types of disputes between investors and hosts. The analysis here, however, encompasses all potential disputes between investors and hosts. Indeed, disputes that do not involve a direct taking are more interesting and relevant today because outright takings are now quite rare. The most common source of tension between an investor and a host country is not expropriation but rather conflicts that fall short of a taking. Customary international law—even under the Hull Rule—provides little protection for the investor against these less extreme actions by the host. BITs, on the other hand, allow potential investors to negotiate for whatever protections and safeguards they feel are needed. In other words, BITs provide the investor with protections that are superior, in all forms of investor-host conflicts, to those of customary international law.

(p.76) A. The fall of the Hull Rule and the Rise of the BIT

Early in this century, the world’s principal nations shared the view that investors were entitled to have their property protected by international law and that the taking of an alien’s property by a host nation required compensation that was “prompt and adequate.”7 Consensus surrounding the Hull Rule was possible during the first half of this century because many of the countries that later opposed the rule were then colonies rather than sovereign countries. Before decolonization, the official views of these countries were controlled by their colonial masters, who supported a regime of full compensation. Furthermore, colonies were not recognized as independent nations, suggesting that even if they had an independent, publicly stated view of how international law should protect investors, that view would not have affected customary international law.

As former colonies became sovereign countries, however, these newly minted countries were able to voice their own views, and those views became relevant to the formulation of customary international law. As their numbers grew, these countries carried greater weight in the international arena, and as they questioned existing international norms, including the Hull Rule, the status of those norms was threatened.8

In the battle for international legitimacy, both sides of the debate claimed that customary international law was on their side. The developed world pointed to the history of the Hull Rule and to the support it had received both in practice and in writings by commentators. In response, least developed countries (LDCs) pointed out that practice had not always accorded with the Hull Rule and that, in any event, the rule simply lacked the broad international support that customary international law requires.9 Although the developed world denied the point, (p.77) it seemed that the debate itself was undermining the claim that the rule retained its status as customary international law.

Beginning in the early 1960s, LDCs found a forum in the United Nations from which to announce their views and, in doing so, further undermined the position of developed countries. From 1962 through the mid 1970s, the United Nations General Assembly—dominated by LDCs—passed a series of resolutions intended to emphasize the sovereignty of nations with respect to foreign investment. The relevance of these resolutions is not that they themselves announced or created a rule of customary international law. Rather, because a large majority of countries made it clear that they felt no legal obligation to follow the Hull Rule, the resolutions demonstrated that “prompt, adequate, and effective” was no longer a rule of customary international law.10 Moreover, the UN resolutions demonstrate that developing countries, acting as a group, prefer a regime under which they are able to expropriate property when they feel it is justified and under which they need only pay what they determine to be appropriate compensation.

Once it became clear that the Hull Rule was no longer recognized, which certainly occurred in the wake of Resolution 3171 and may have occurred much sooner, neither the traditional “prompt, adequate, and effective” standard nor the “appropriate compensation” standard had enough international support to be considered a rule of customary international law. In the absence of BITs, therefore, developing countries had won a clear victory. The international rules governing North-South investment were entirely uncertain, and individual countries were in a position to determine what constituted appropriate compensation.11

In light of the considerable and long-term efforts by LDCs to defeat the Hull Rule, one might conclude that developing countries oppose any form of investment protection at the international level. That conclusion, however, is contradicted by widespread and enthusiastic LDC support for BITs. In a remarkably short period of time, BITs have become an important part of the foreign investment landscape. Between 1959, the year the first BIT was signed, and 1991, (p.78) over 400 BITs were signed worldwide. More than ninety developing countries and most developed countries were parties to at least one such treaty during this period. In the 1990s the pace of BIT signings increased dramatically and by mid-1996, over one thousand BITs had been signed, with almost every country on the globe party to at least one such treaty. Whatever impact these treaties may have on customary international law, they represent an important part of the international investment landscape in their own right.

Furthermore, BITs offer foreign investors greater protection than the Hull Rule ever did. They do so primarily by providing a mechanism through which a potential investor and a potential host can establish a contract that is binding under international law. In addition, the provision of dispute settlement procedures offers investors a neutral forum in which disputes can be heard and a means to enforce settlement decisions. The other provisions of BITs offer substantive protections such as national treatment, most favored nation treatment, free transfer of assets, and a prohibition on performance requirements. Finally, BITs reproduce the Hull Rule’s requirement of prompt, adequate, and effective compensation for expropriation, including “expropriations” that fall short of a direct taking.

B. The Dynamic Inconsistency Problem

1. Dynamic inconsistency and FDI

Before turning to an explanation of the behavior of developing countries, it is helpful to introduce a phenomenon know as the “dynamic inconsistency problem.” Dynamic inconsistency exists when a preferred course of action, once undertaken, cannot be adhered to without the establishment of some commitment mechanism. The problem is akin to wanting to “tie oneself to the mast” but being unable to do so. More formally, dynamic inconsistency describes situations in which a “future policy decision that forms part of an optimal plan formulated at an initial date is no longer optimal from the viewpoint of a later date, even though no new information has appeared in the meantime.”12

In the domestic setting, the dynamic inconsistency problem is avoided in most private transactions through contract. Parties are able to commit to a certain behavior because private contracts are enforceable under domestic law. This ability to contract, in turn, allows parties to negotiate, subject to transaction costs, the most efficient possible agreement. In the international setting, however, the dynamic inconsistency problem is a significant barrier to efficient foreign direct investment. The central problem is that a sovereign country is not able, absent a BIT, to credibly bind itself to a particular set of legal rules when it negotiates with a potential investor. Regardless of the assurances given by the host before the investment and regardless of the intentions of the host at the time, the host (p.79) can later change those rules if it feels that the existing rules are less favorable to its interests than they could be. Domestic legal structures, critical to the credibility of contractual promises among private parties under domestic law, are no longer adequate to ensure compliance with the initial agreement. These risks are particular to the foreign direct investment setting because the host government is a direct participant and has interests and objectives of its own that may conflict with those of the investor.

As a result of the dynamic inconsistency problem, when an investor enters into an agreement with a host nation, the two typically will not be able reach an optimal agreement. Notice that there need not be an intent to deceive on the part of the host. Even if the host wants to reach an efficient agreement and is willing to commit itself to a certain treatment of the foreign investment, it is unable to do so credibly because the host has the ability to later change its domestic laws to suit its own purposes.

Because the foreign investor cannot rely on domestic laws to protect its interests, the only alternative legal structure is international law. International law, however, does not provide a way for a host country to make credible and binding commitments to an investor. The mechanisms for the enforcement of a contract between a country and a private firm is at best extremely weak and at worst completely non-existent. The precise status of such contracts is the subject of ongoing debate in the field of public international law and is far from being settled. For the present purposes, it is sufficient to note that there is no consensus that a contract with a host, by itself, offers a firm any additional protections under international law. Furthermore, even if protections exist in theory, the investor cannot be sure that they will be enforced by an arbitral tribunal or that the host will accept the decision of a tribunal if the firm obtains a favorable ruling. The fact that such agreements cannot be relied upon with any confidence implies that it is not possible for a country to make its commitment fully credible even if it enters into an agreement.

The protections afforded to contract rights are so uncertain under international law that it is reasonable to model investor behavior on the assumption that these rights are of little or no value to the investor. More importantly, because these protections are unreliable, international law does not allow the host to make credible contractual commitments. This uncertainty explains why the debate over the protections afforded by customary international law was so important. Until the rise of BITs, there were few legal constraints, beyond those provided by customary law, on the behavior of host countries toward foreign investors. Thus, if the international community concluded that customary law did not require prompt, adequate, and effective compensation upon the taking of property, there would be no way for investors to achieve these protections. On the other hand, if the international community accepted the Hull Rule as international law, there would be no way for developing countries to except their own behavior from the rule.

(p.80) 2. The behavior of host countries and investors

To understand foreign investment in developing countries, one must consider how the lack of a credible contracting mechanism affects the incentives of a government in its dealings with a particular foreign investor. During negotiations, the government of a potential host country wishes to encourage the investor to invest. The firm, on the other hand, wants to achieve the greatest possible return and will invest in the host country only if that country offers conditions that will produce the greatest anticipated profit.

If investor and host had the ability to credibly bind themselves to a particular set of conditions governing the investment, we would expect, subject only to transaction costs, the investor to select the most efficient location for its investment and to write a binding contract with that country. The agreement would spell out the conditions on which the investment would take place and would provide for some division of the “surplus” (i.e., profit) from the investment between the investor and the host. This division of surplus need not be stated explicitly, but it could take the form of concessions and commitments on the part of each party. For example, the host might agree to offer certain tax advantages to the investor, agree to allow the repatriation of profits, and waive certain import restrictions. The firm, on the other hand, might bind itself to providing a certain level of employment, certain transfers of technology, and so on.

The absence of a credible contractual mechanism, however, makes the investment problem much more difficult. Even if an investment is valuable enough to make it worthwhile for the country to commit to certain concessions that benefit the investor—favorable tax treatment, for example—it cannot do so in a credible fashion. Once the investment is made, the host country no longer needs to offer benefits sufficient to attract the investment; it only has to treat the investor well enough to keep the investment. The difference between the two time periods (before and after investment) comes about because both the host and the investor know that once the firm has made its investment, it typically cannot disinvest fully.13 In other words, once it has invested, withdrawal would impose a cost on the firm. The host country can take advantage of this situation, and extract additional value from the firm by, for example, increasing the tax rate beyond the level that was agreed upon when the investment took place. Had the firm known that the tax rate would be higher than the agreed upon level, it may have chosen to invest elsewhere, or not to invest at all. Once the investment is made, however, (p.81) it may be cheaper for the firm simply to pay the higher tax rather than to disinvest and reinvest elsewhere.

The problem may even be worse because the host can impose any level of tax (or other policy to take value from the firm) it chooses, as long as the tax is less than the amount that it would cost the firm to disinvest. Most importantly, the host can assess the firm’s situation and select the maximum possible transfer of value that the government can demand without driving the firm out of the country altogether.

Extracting value from the firm by increasing the tax rate or otherwise changing the conditions under which the firm will operate represents only one of the options available to the host once the investment is made. The other two options are to abide by its original promises to the investor or to expropriate the investor’s property.

There are two categories of costs facing a country that chooses to expropriate outright. The first is that the government (or the private parties to whom the government gives or sells the enterprise) may be far less competent to run the facility than the original firm. After expropriation, the firm’s managers are likely to leave the country, taking a substantial amount of human capital with them and making it difficult for the host government to run the business as well as the investors who built the facility. This will impact both the profits that the enterprise will generate (if any) and the level of spillover benefits provided (employment, technology transfer, etc.). A second cost is to the country’s reputation. The firm whose assets have been taken will undoubtedly complain to its home country, and that country may take action. Indeed, if the expropriation is severe enough, even countries whose nationals have not been affected may sanction the host country. In addition, the expropriation will be noticed by other firms which, as a result, may be hesitant to invest in that country in the future.

Because the costs of outright expropriation are likely to be high, the more moderate course of extracting value from the firm without forcing divestment, as discussed above, may be attractive. This can be done in a variety of ways, including changing the tax rate, restricting the repatriation of profits, imposing new labor or local content requirements, and so on. This approach allows the country to take advantage of the existing management and their skills, thus avoiding the major costs of an outright expropriation, while still extracting value from the enterprise. This more moderate approach may also be preferred because it is less likely to provoke significant sanctions by the home country of the investor. After all, the firm’s assets have not been seized and it is often difficult to identify where the right of a government to set policy crosses over into unreasonable conduct.

For any irreversible investment,14 then, the host country will be able to demand a higher payment after the investment takes place than it could have demanded before investment of the capital. This is so because the investor will invest only (p.82) if it expects to receive revenues that are greater in present value than its total costs. Before the investment, total costs include all expected costs of the investment, including irretrievable capital costs. Once the original investment has been made, however, the investor will not include the sunk (irretrievable) costs in its calculation because those funds are lost regardless of its actions. Once the investment is made, therefore, hosts may extract at least up to the value of the sunk costs without making it profitable for the firm to withdraw.

Of course, the firm understands the impact of the dynamic inconsistency problem before it invests. It may, as a result, choose not to invest. The potential host, on the other hand, wants the investment to take place, and to get the investment it would be willing to bind itself to a set of conditions on which the investment would take place. Because there is no binding commitment mechanism available, however, the host cannot make a credible commitment and the investment—desired by both parties—may not take place.

In light of the above discussion, one might ask why there is any direct foreign investment at all and why the investment that does takes place is often treated well. The reason is that the above description is based on a single investment decision. In actual fact, countries want to maximize their returns over longer horizons. Thus, they may resist the temptation to seize assets today in order to create or maintain a reputation that will attract future investment. Countries may also resist the temptation to extract value from foreign firms if they fear that sanctions will be imposed by the home country of the investor. The long-term effects of individual investment decisions, in other words, change the incentives of the host country.

These effects, however, do not completely remove the dynamic inconsistency problem. When the host country considers the reputational effect of its actions, it will weigh the gains from breaching its agreement with the firm against any lost benefits caused by reduced efficiency within the firm, sanctions imposed by other countries, and the effect of the action on its reputation. A priori, there is no reason to think that this balancing establishes an efficient set of incentives for the host. Indeed, the fact that host countries sign agreements with investors, even when those agreements are not enforceable, indicates that the parties do not believe that reputation, by itself, is sufficient to give the host the proper incentives. The contracts represent an attempt to increase the cost to the host of violating the terms under which investment takes place.

The foregoing discussion has considered the impact of the dynamic inconsistency problem on the host country. The effect of the dynamic inconsistency problem must also be considered from a global perspective. In global terms, the most efficient outcome is achieved if investment takes place where it will earn the greatest total return. Absent transaction costs, this outcome is achieved when the parties are able to contract with one another and when a breach of contract is accompanied by expectation damages. The dynamic inconsistency problem, however, undermines efficiency because it discourages investment that would (p.83) be desirable. Firms realize that host countries have incentives to squeeze additional value from their operations after the investment is made, and this causes firms to avoid some investments altogether. Rather than facing expectation damages if it breaches, the host faces a penalty in the form of lost future investment and sanctions from foreign countries. It would be mere coincidence if these sanctions were equivalent to expectation damages, implying that the decision to breach the contract with the investor will not be based on appropriate incentives.

C. Explaining the Paradoxical Behavior of LDCs

As discussed above, the behavior of developing countries presents an apparent inconsistency. On the one hand, they have repeatedly sought to establish a norm that leaves significant power in the hands of the sovereign country in its relations with investors, makes it difficult for countries to enter into binding contracts with foreign investors and, therefore, leaves the dynamic inconsistency problem unresolved. On the other hand, developing countries have willingly and, indeed, enthusiastically, signed BITs with developed countries. These bilateral treaties undermine precisely the independence and control that the countries have fought so hard to protect.

This part of the chapter considers and rejects the possibility that developing countries have simply changed their views on the subject or that, in exchange for signing BITs, LDCs have received concessions that they did not receive under the traditional standard of full compensation. Another explanation is then advanced, namely, that LDCs face a prisoner’s dilemma in which it is optimal for them, as a group, to reject the Hull Rule, but in which each individual LDC is better off “defecting” from the group by signing a BIT that gives it an advantage over other LDCs in the competition to attract foreign investors.

1. Existing explanations of LDC behavior

One possible explanation of the behavior of LDCs is that the developing countries themselves have come to conclude that they are better off if they allow themselves to be bound through a contractual mechanism with investors. This might be termed the “LDC enlightenment theory.” For a period of time after World War II developing countries fought to defeat the Hull Rule and reduce the protections provided to international investment. More recently, however, these same countries have come to realize that it is in their interest to encourage foreign investment in their country and that one way to do this is to provide strong protections for foreign investment. Developing countries may also have developed a better understanding of the dynamic inconsistency problem and its importance in the foreign investment realm. As a result, they are now prepared to accept BITs because they appreciate the need to overcome this problem.

This theory is unsatisfactory for at least two reasons. First, the period in which BITs have been signed has overlapped considerably with the period in which LDCs sought to discredit the Hull Rule. The first BIT was signed in 1959, when West Germany established a treaty with Pakistan, and by the mid-1970s, West Germany (p.84) had concluded more than forty BITs with other countries. The major efforts to undermine the Hull Rule at the multilateral level took place during the 1960s and 1970s. In other words, during the very period when the General Assembly was denouncing the Hull Rule, large numbers of developing countries were signing bilateral treaties. If developing countries truly had changed their views on the value of commitment mechanisms and binding agreements, we would not expect to see a significant number of BITs in force and more being negotiated at the same time that the General Assembly voted 108 to 1 in favor of the 1973 Resolution on Permanent Sovereignty over Natural Resources and adopted the New International Economic Order. Nor can it be argued that the countries signing BITs and those fighting against the Hull Rule are different subsets of countries because both the BIT movement and the movement against the Hull Rule have included a majority of developing countries.

Furthermore, had developing countries decided, as a group, that providing greater protections for foreign investors served their interest, one would expect them to express that view at the General Assembly. The choice of the General Assembly as the forum for previous resolutions concerning investment demonstrates that developing countries have found it to be a useful and accessible forum. Moreover, if LDCs had truly changed their minds, the best way to demonstrate that they no longer held the views on investment expressed in the General Assembly resolutions would be to announce their new views in the same forum. One would also expect developing countries to have signed multilateral investment treaties rather than bilateral treaties.

An alternative theory is presented by M. Sornarajah, who argues that developing countries, after successfully tearing down the Hull Rule, adopted BITs in reaction to the confused status of foreign investment and the uncertain protections afforded to it by international law: “knowing the confused state of the law, [countries] entered into such treaties so that they could clarify the rules that they would apply in case of any disputes which may arise between them.”15 If the goal of BITs was to clarify existing rules, however, there is no reason for them to provide so much protection to investors. If LDCs believed that international law offered relatively weak protections for foreign investment—as they indicated in the General Assembly resolutions—they could “clarify” such a rule. BITs, however, offer much more protection for investment than any rule to which developing countries have publicly subscribed. Furthermore, it is difficult to understand why LDCs would undermine the Hull Rule—which provided a clear rule regarding the protection of foreign investment—only to adopt BITs to avoid the legal ambiguity generated by the demise of the Hull Rule.

Rudolf Dolzer advances a different explanation. He claims that developing countries are prepared to accept the Hull Rule in the context of BITs because of (p.85) the “special benefits that developing countries enjoy under such treaties.”16 Sornarajah appears to hold this view as well, arguing that although a developing “state subscribes to a particular norm of international law, it is prepared to treat the nationals of a state with which it has entered into a bilateral treaty in accordance with the norm which has been agreed to in the treaty.”17 This view is difficult to reconcile with the content of most bilateral treaties. There is little in such treaties that inures to the benefit of the host countries apart from the benefits that those countries enjoy from a regime of investor protection. If the benefits of investor protection are sufficient to make these treaties desirable to LDCs, of course, it becomes impossible to explain why the countries sought to undermine investor protection when they dismantled the Hull Rule.

2. A strategic analysis of LDC behavior

To understand the apparent paradox of the LDC struggle against the Hull Rule as customary international law and the simultaneous embracing of BITs that mandate even stricter investment protections, one must realize that developing countries have different interests when they behave as a group than they do when they behave individually. In other words, the decision of individual countries to sign bilateral agreements is not a sign that these agreements are in the interest of LDCs as a group, and the efforts of LDCs as a group to defeat the Hull Rule do not imply that an individual country would not want to embrace the rule for its own purposes.

a. The interests of an individual LDC.

Consider first the incentives facing an individual developing country. In its negotiations with investors, the country would like to have the ability to make binding commitments to potential investors. If it is able to make credible commitments, it will be able to attract more investors. Specifically, the country may be able to attract investors who, absent a commitment to lower taxes, for example, would choose a different country for their investment. Furthermore, for those investors who would invest in the country even in the absence of a commitment mechanism, the country can simply decline to offer more favorable conditions, thus getting those investors to invest on the same terms as would exist without the ability to commit.

The developing country, therefore, has a strong incentive to enter into BITs to increase the investment it receives and, thereby, increase the benefits enjoyed by the country. Put simply, by entering into a BIT, a country is better able to compete for investment. In practical terms, this implies that if a single LDC is offered the opportunity to enter into a treaty that will allow it to make binding commitments to investors without affecting the ability of other LDCs to do so, it will have a strong incentive to sign such a treaty.

The amount of extra investment that can be attracted to a country that is able to enter binding contracts depends on the sensitivity of the demand for the (p.86) resources of that country (raw material, labor, government regulations, location, etc.). If the market for those resources of the country is highly competitive (i.e., characterized by many buyers and many sellers), even a relatively small improvement in the conditions offered to potential investors will lead to a large increase in investment. As in any competitive market, a small change in the price of the goods being sold will lead to a large increase in demand. In the foreign investment context, the goods being sold are the resources of the LDC, and the “price” at which investors can get access to those resources will fall as investors are offered more attractive conditions by the potential host.

If the market is competitive, therefore, the ability to commit to a binding contract allows a country to increase dramatically the amount of investment it receives. It is important to note, however, that much of this increase in investment will come at the expense of other developing countries. If other LDCs have not signed such treaties, a country that does sign one will gain an important advantage, and if other countries have already signed BITs, a country that signs one will eliminate the advantage those other countries had in the competition for foreign investment. Thus, regardless of what other countries are doing, a developing country has a strong incentive to be enthusiastic about signing a BIT.

Based on the above discussion, one might conclude that a regime that allows developing countries to contract with investors is preferred to the system advocated by developing countries in their UN resolutions. A contracting regime is preferred, the argument would go, because it increases the number of efficient investments, which in turn leads to greater global wealth. Furthermore, a contracting regime is in the interest of developing countries because it allows them to offer incentives that will increase investment and well-being in their countries. The contention is that because an individual country is able to attract investment more successfully when it can make binding commitments, the ability to make such commitments must be good for LDCs as a group. As argued below, however, the conclusion that LDCs are better off as a group simply does not follow from the fact that individual LDCs benefit from a contracting regime.

b. The interests of LDCs as a group.

To understand the incentives and interests of LDCs when they act as a group, imagine a scenario in which two countries are competing against each other to attract a potential investor. Assume that both countries have signed a BIT with the home country of the investor. To attract the investment, each country is willing to make concessions to the potential investor. A country whose initial offer is insufficient to attract the investment has an incentive to increase the concessions it offers as long as the benefits of the investment to the country exceed the costs of the concessions. The result, therefore, is a bidding up of the concessions made to the investor. Ultimately, if the market for the resources of the developing countries is competitive, the potential hosts will continue to bid against one another until the benefit enjoyed by the host from the investment is zero. Only then will the country that stands to lose the investment find it impossible to offer the firm a more attractive package. Once the offers to (p.87) the firm have been bid up to the point where the winning country stands to make no net gain from the investment, the firm does not have to share any of the surplus with the host and can, therefore, simply choose the location that offers the highest overall return. This is the efficient result because all investments that offer a positive expected net present value can be made and all investments will be made in the country where they offer the highest return.

The impact of this bidding contest on the distribution of the gains from an investment project is dramatic. The country that receives the investment will have won the competition to attract the capital, but will gain little or nothing from its victory. The benefits to the country generated by the investment (in the form of employment, technology transfers, tax revenues, and so on) will be offset by the incentives and concessions that were needed to attract the firm (tax breaks, reduced pollution controls, relaxed employment regulations, and so on). In other words, as in any competitive market, the seller—here the host country—will receive no economic profit. The entire profit will be enjoyed by the investor.

In the presence of BITs, then, potential host countries will bid down the conditions on which they allow investment in an attempt to attract as much investment as possible. Ultimately, the concessions extended to investors may be so great that countries will be indifferent between having and not having the investment. The competitive nature of the market means that the benefits of investment will all go to the investor, leaving no surplus for the host.

Contrast this result with the result under the Charter of Economic Rights and Duties of States (CERDS) regime. Imagine two countries competing for a potential investor, but without any way for either country to make a binding commitment. In this situation, the investor cannot obtain any credible guarantees regarding the treatment of its investment. The investor may still decide to invest, however, because the countries in question have reputational concerns that encourage them to treat investment well. Moreover, the investor can also take steps to protect itself by, for example, entering into a joint partnership with the host (so that the host has a strong incentive to let the investor maximize profits), placing a few critical operations abroad (so that the host will gain little by expropriation), or demanding a signed agreement which, although not binding under international law, may cause the host international embarrassment if it treats the investment poorly. Most importantly, the investor may choose to invest without any binding commitments from the host country because LDCs offer advantages that are unavailable in the investor’s home country (e.g., low labor costs, favorable environmental or labor laws, locational advantages, natural resources, and so on). Even though the investor lacks the protections of a BIT, it may still be worthwhile to invest.

If the investment takes place in the absence of a BIT, the country that receives the investment will be able to extract value from the investor because the host has the power to unilaterally change the conditions under which the firm operates. The firm’s only defenses are the ability to pull its operations out of the country (p.88) and the reputational concerns of the host. The value extracted will depend on the reputational concerns of the country, the value that is available, and the success of the investor’s efforts to make such value extraction difficult. In any event, the host will gain more from each dollar invested than it would in a world of BITs because once the investment is made, the host can extract value without losing the investment.

Thus, under the CERDS regime, hosts get more value from each investment. The disadvantage of CERDS, however, is that there will be fewer investments because the inefficiencies of the regime make it more costly to invest. Some investments that would be profitable under a BIT regime will no longer be profitable under CERDS. These investments will never be made, and developing countries will lose the benefits associated with them.

Obviously, if the level of investment dropped below a certain point, LDCs would be worse off as a group under the CERDS regime than they would be under a BIT regime. On the other hand, if there is only a small reduction in the overall level of investment, LDCs may be better off under CERDS because they can receive a larger share of the return from investments. In determining which regime benefits LDCs most, it is crucial to determine how much investment will be lost under CERDS. The critical issue is the sensitivity of investment to the cost of investing. If the investment into LDCs taken as a group is sufficiently insensitive to the cost of investment, then LDCs as a group would be better off under the CERDS regime than under a BIT regime.

This analysis explains the efforts of LDCs, acting as a group in the General Assembly and elsewhere, to undermine the Hull Rule. In the debate over the status of the Hull Rule as customary international law, developing countries were working to change a rule that applied to them all. Attempts to undermine the Hull Rule, therefore, were attempts to change the rules that applied to LDCs as a group. Even though individual countries have been eager to sign BITs, LDCs as a group may be better off in a regime that leaves them unable to enter binding contracts with investors. Thus, the incentives for an individual country and for LDCs as a group are different. This difference arises because developing countries compete among themselves for a limited pool of investment. As they compete, they bid away some of the surplus they would otherwise enjoy, and this lost surplus may in fact exceed the gains from new investment (i.e., from investment that would not otherwise have been made in any developing country). The net result is that whereas individual LDCs may be better off vis-à-vis other LDCs in a BIT regime, LDCs as a group may suffer an overall welfare loss.

3. The outstanding empirical question

The above discussion offers a novel explanation of LDC conduct. For the theoretical explanation to be correct, however, an empirical claim about foreign investment must be made. Specifically, the above theoretical claims are true only if the flow of investment into LDCs as a group is relatively insensitive to the terms on which that investment is made as compared to the flow of investment into a single developing country. (p.89) In economic terms, the demand for the resources of LDCs as a group must be relatively inelastic while the demand for the resources of a single country must be relatively elastic. Ultimately, this is an empirical question that cannot be answered without further research. Although it is not possible to demonstrate that the empirical conditions assumed by this theory exist without a formal empirical study, it is possible to show that it is reasonable to assume the existence of these conditions.

For investment flows into developing countries as a group to be less sensitive than flows into a single developing country, it must be that a developing country is more likely than a developed country to be a substitute for another developing country. In other words, at the margin, more investors will switch from one developing country to another in response to a change in costs in one developing country than will switch from developing countries to developed countries in response to a change in cost in all developing countries. Although developing countries and developed countries do share certain characteristics, there are enough distinct traits of developing countries to support this assumption. For example, labor in developing countries is often extremely inexpensive relative to developed countries. Thus, the threat of an increase in the wage rate in an LDC may not deter an investor because even if there were a substantial increase in the cost of labor, it is likely to remain below that of the developed world. Similarly, developing countries have natural resources that do not exist in developed countries, or that are not as abundant and inexpensive. In addition, the legal and regulatory climate of many developing countries may be more advantageous for investors.

For a single country, it is reasonable to assume that the foreign investment decisions regarding investment in that country are relatively sensitive to the cost of investing (i.e., the elasticity of demand for the resources of the LDC is high). This is because developing countries must compete against one another for investment and, as the cost of investing changes, so may the choices of investors. If the cost of investing increases, for example, the potential investor can simply invest in a different developing country. Similarly, if the cost of investing is reduced, investment that would have gone to a different country may be attracted. For a single country, therefore, the increased cost of investing prompted by the dynamic inconsistency problem (as compared to a BIT regime)—holding conditions in other LDCs constant—will cause a relatively large reduction in the total amount of foreign investment. Investment will simply move to a developing country that can make a binding agreement.

For developing countries as a group, however, the sensitivity of investment demand is likely to be much lower. If the cost of investment rises in all developing countries, an investor must either invest despite the increased cost or abandon its intention to invest in a developing country. The advantages offered by one developing country are much more likely to be found in another developing country than in a developed country. Put differently, it is reasonable to assume (p.90) that, in the eyes of investors, developing countries are more like one another than they are like developed countries. Thus, investment will be much less sensitive to the cost of investing (i.e., the elasticity of investment will be lower) when we consider LDCs as a group rather than individually.

In addition to the fact that the empirical assumptions necessary to support the theory advanced in this chapter are plausible, those assumptions are also supported by the observed behavior of developing countries. No other theory has been advanced that is capable of explaining why developing countries simultaneously opposed the Hull Rule and embraced BITs. If the empirical assumptions underlying the theory of this chapter are incorrect, these actions by LDCs are irreconcilable.

4. An economic interpretation. A fundamental insight that drives the results found in this chapter is the recognition that the presence or absence of a credible mechanism for contracting changes the competitiveness of the market for foreign investment. If it is possible to make credible commitments through contracts, every potential host country must compete for the investment, leading to a competitive market for the resources of those countries and, therefore, zero economic profit (or, at least, low profits) for the “seller” (i.e., the host). As in any competitive market, the seller must compete for business, and the buyer—here the investor—receives the entire surplus from the transaction.

If LDCs can act as a group, however, there is less competition. Imagine, for example, explicit collusion among all developing countries that is aimed at increasing the rents earned from the sale of their resources to investors. If that collusion was successful, one would expect LDCs as a group to have some market power and, therefore, to be able to increase the price at which investment takes place and to extract some of the surplus of the transaction. The collusion, of course, will cause a reduction of the overall level of investment, but the gains from colluding would outweigh the losses to LDCs.

The host is able to extract rents because once the investment is made, the host is in the position of a monopolist. It can choose to set the price of its resources at the level that maximizes its own return. The basic theory of monopoly pricing teaches that a monopolist will set a price that is above the competitive price in order to extract monopoly rents. The result, of course, is a reduction in the demand for the resources, a loss to the buyer (here, the investor), and increased profits. Overall, there is a net loss, referred to as a “deadweight loss.” In the context here, the host will demand more value from the investor than it would in a competitive environment. Thus, to the extent potential hosts compete against one another for investment, and to the extent that this leads to a competitive market for the resources offered by potential hosts, it should be expected that hosts will seek to extract value from the firm after the investment takes place. Because the investor has made an irreversible investment, it cannot easily withdraw from the country, making its demand for those resources very inelastic indeed.

Collusion among LDCs would still leave LDCs as a group in competition with developed countries. Developing countries would only be able to extract rents (p.91) from investors if they were able to obtain some market power despite the presence of developed countries. Whether or not they are able to do so is the empirical question discussed in section D.3 above, where it is suggested that such market power is in fact plausible.

All that remains, then, is to explain the relationship between explicit collusion and the demise of the Hull Rule. By ending the Hull Rule, developing countries eliminated the rule of customary international law that required them to pay full compensation for “takings.” In the absence of any other international law or treaty, no mechanism existed for a host to commit to an investor in a credible fashion. Thus, the legal regime ensured that no country could bind itself to a certain standard of treatment before investment; only reputational constraints controlled the behavior of LDCs.

Without the ability to obtain a credible commitment from host countries and without a rule of customary international law protecting investment, investors faced a higher expected cost of investment because of the dynamic inconsistency problem. The effect, therefore, was the same as an explicit agreement among all developing countries that they would not bid against one another for investment. In fact, without BITs, the regime was even better for LDCs than a collusive agreement because it was impossible for any single country to “defect” from the agreement; thus, the “cartel” of LDCs was extremely stable.

The above explains, in economic terms, why developing countries fought to undermine the Hull Rule. Their willingness to sign BITs, as explained above in section C.2, was caused by the fact that BITs introduced a mechanism through which developing countries could compete for investment. Just as members of a cartel may seek to defect from the cartel to increase their sales, individual LDCs embraced BITs as a way to compete for foreign investment.

D. Efficiency, welfare, and international law

1. Efficiency implications

Under most BIT arrangements, contracts between investors and host countries are binding at the international level. This binding contractual mechanism of BITs is made possible by the dispute settlement procedures. Failure to respect the terms of a contract with a foreign investor is a violation of the BIT and gives the investor the right to pursue a remedy through a dispute settlement procedure, which in most circumstances is binding arbitration. To the extent that the damage scheme under a BIT is interpreted as expectation damages (as opposed to, say, restitution damages), the efficient outcome is achieved. Moreover, even if the measure of damages is not expectation damages, the BIT regime is more efficient than either CERDS or the Hull Rule because it governs a wider range of potential host-investor disputes (i.e., it applies to more than direct expropriation).18

(p.92) More important than the measurement of damages, however, is the fact that the BIT framework, by providing a binding and credible contractual mechanism, allows the parties to avoid the dynamic inconsistency problem. The presence of an impartial dispute settlement mechanism that is capable of ensuring compliance by the host helps ensure that host governments will honor their agreements.19 Subject only to transaction costs, a BIT regime will cause capital to be invested where it stands to earn the greatest return. Thus, the cost of investing is reduced, more investment will take place, and the investment that does occur will be allocated in an efficient manner. BITs, therefore, yield an efficient allocation of capital.

In contrast to a BIT regime, the rules of CERDS introduce a significant degree of inefficiency. Under CERDS, the security of an investment is dependent on the goodwill of the host country. Outside the discipline provided by the market for foreign investment, investors enjoy little protection against actions by the host. Although these reputational concerns may provide nontrivial protection, investors still have cause to be concerned about expropriation and other less dramatic actions by the host country because there is no reason to think that reputational concerns are enough to cause hosts to honor all commitments. The lack of a credible commitment mechanism, in turn, drives up the cost of investment and causes profitable investments, which both the host and the investor desire, to be foregone because they are rendered unprofitable by the dynamic inconsistency problem.

In addition to reducing the amount of investment, the CERDS regime may distort decisions regarding where to invest. Imagine, for example, that two countries wish to attract a particular investment. Country A may be the better location for the investment because of, say, its geographic location and the available social infrastructure. Nevertheless, the investor may decide to invest in country B because country B is considered more likely to honor the agreement under which the investment takes place. This is an inefficient result because the investment would be, by assumption, more valuable in country A. If it were possible for country A to write a binding contract with the investor, the distortionary effect of reputation would be eliminated and the investment could be made efficiently. A BIT arrangement, therefore, is better on efficiency grounds than a regime based on CERDS.

(p.93) 2. Welfare implications

The efficiency of BITs, however, is not the whole story. As compared to CERDS, BITs sharpen the competition for investment among potential hosts. This forces LDCs to offer greater and greater concessions to potential investors, bidding away the gains the host would otherwise enjoy. In effect, BITs make the market for foreign investment much more competitive by allowing competition in the price of investment, that is, the terms under which investment takes place.

In the absence of BITs, international law currently yields the same economic result as would an agreement among developing countries to never negotiate with potential investors before the investment. Such collusion would force investors to either invest without knowing the final terms under which they have to operate or to refrain from investing. The practical effect is to increase the price at which the resources of developing countries are sold. This in turn reduces the amount sold and, assuming investment into LDCs as a group is not overly sensitive to changes in the terms of investment, the result is monopolistic gains for developing countries. The CERDS regime, in other words, makes the market for foreign investment and LDC resources imperfectly competitive, allowing developing countries (the sellers) to capture a larger share of the rents. Capital importers, therefore, are better off as a group under the CERDS regime than under the BIT regime. Just as a monopolist (or an oligopolist) enjoys an increase in welfare when it is able to reduce the competitiveness in a market, so LDCs enjoy greater returns under CERDS because this regime makes the market for foreign investment less competitive.

From the point of view of the welfare of developing countries as a group, the best of the three possible regimes is CERDS, followed by the Hull Rule (which only covers direct expropriation), followed by the BIT regime. The BIT regime is the least beneficial to LDCs because it includes the most expansive definition of investment and thereby allows greater competition among developing countries.

The purpose of this chapter is not to advocate one of these systems over another. Rather, it seeks simply to show the relevance of the distributional issues. Without a mechanism to redistribute wealth between countries, the distributional consequences of a particular policy should be considered. The rise of BITs has reduced the market power held by developing countries, which, in turn, has reduced the benefit these countries can capture from any particular investment. For this reason, the BIT regime may actually reduce the overall welfare of developing countries and therefore should not be uncritically embraced by those who seek the interests of LDCs. On the other hand, there can be no serious doubt that, from a global efficiency perspective, a regime that allows for contracting between host governments and investors is more efficient than a regime in which potential hosts cannot effectively commit to any particular behavior or agreement.

3. The impact of BITs on customary international law

This chapter has sought to explain the paradox of LDC objections to the Hull Rule and the widespread (p.94) adoption of BITs. In addition, the chapter has pointed out the ambiguous effect of these treaties on the welfare of LDCs. The explanation of BITs presented here also allows the analysis of another issue that is attracting some attention, namely, the role of BITs in the establishment of customary international law. Do these treaties codify an agreed upon set of principles that applies to all, or do they merely represent lex specialis as between the parties?20 The debate is of some importance because if the BITs establish a rule of customary law, that law will apply to all countries even in situations where the host has not signed a BIT with the home country of the investor.

Those who argue that the BITs represent the codification and entrenchment of customary principles of international law point to the large number of such treaties and the fact that many of the nations that rejected the traditional Hull Rule standard of compensation have signed BITs. The prevalence of BITs, the argument goes, demonstrates that both developed and developing countries now consider the traditional compensation standard to be the relevant standard of international law. As one commentator has put it, “Is it possible for a State to reject the rule according to which alien property may be expropriated only on certain terms long believed to be required by customary international law, yet to accept it for the purpose of these treaties?”21

The analysis presented in this chapter shows that this question can and must be answered in the affirmative. The arguments of those who view BITs as evidence of customary law are flawed for two reasons. First, as the above quote illustrates, these arguments overlook the fact that the Hull Rule ceased to be a rule of customary law sometime before 1975. Second, the arguments fail to take into account that customary law requires not only practice, but also a sense of legal obligation. As the International Court of Justice has made clear,

Not only must the acts concerned amount to a settled practice, but they must also be such, or be carried out in such a way, as to be evidence of a belief that (p.95) this practice is rendered obligatory by the existence of a rule of law requiring it…. The States concerned must therefore feel that they are conforming to what amounts to a legal obligation. The frequency, or even habitual character of the acts is not in itself enough.22

Therefore, in the words of another scholar, “The repetition of common clauses in bilateral treaties does not create or support an inference that those clauses express customary law…. To sustain such a claim of custom one would have to show that apart from the treaty itself, the rules in the clauses are considered obligatory.”23

The relevant inquiry concerning whether BITs establish a rule of customary international law, therefore, is whether the presence of BITs establishes a sense of legal obligation or at least serves as evidence of such an obligation. Clearly, the BITs’ effect on international law would be simplified if these treaties included an explicit acknowledgment that the treaty merely codified rules of customary law; unfortunately, BITs do not contain such language. Similarly, if the treaties explicitly stated that they did not represent a codification of a legal obligation, it would be clear that BITs should not be taken as evidence of customary law. Again, the treaties themselves are silent on this point.

To determine whether BITs evidence a sense of legal obligation on the part of signatories, therefore, requires an inquiry into the reasons countries sign BITs. If BITs are signed out of a sense of obligation or to clarify a legal obligation, they must be considered evidence of customary international law. On the other hand, if BITs are signed for reasons unrelated, or even contrary, to a country’s sense of legal obligation, BITs are not evidence of customary international law.

This chapter has provided an explanation for the popularity of BITs among developing nations that is based on the economic interests of those nations. As discussed earlier, signing a BIT offers an LDC an advantage in the competition for foreign investment. That BITs have been signed in large numbers merely demonstrates the magnitude of the perceived benefits associated with the ability to avoid the dynamic inconsistency problem. Thus, if countries have signed BITs out of economic motives, the treaties should not be interpreted as evidence of customary international law. It is equally plausible that BITs represent a permissible derogation from the existing rules of customary law and that countries have pursued the treaties because it is in their economic interest to do so. This means that BITs offer no evidence concerning the rules of customary international law that govern compensation for appropriations.

The absence of a sense of legal obligation is further demonstrated by the vigorous opposition by developing countries to the Hull Rule. By the mid-1970s, (p.96) the LDCs’ consistent objections to the Hull Rule successfully undermined its status as customary law, and there is no evidence that LDCs have since developed a greater sense of legal obligation toward the protection of foreign investment. It is simply not possible to explain the paradoxical behavior of LDCs toward foreign investment based on a view that BITs reflect opinio juris.

The demise of the Hull Rule and the rise of BITs represent a struggle between developed and developing countries over the international protections to be provided for foreign investment. In the first round of this fight, developing countries successfully dismantled the Hull Rule. In the second round, developed countries responded with treaties that offered each individual LDC an opportunity to improve its position in the competition for investment. Although it appears that the developing world has lost the battle over investment protection, it must be recognized that the international legal structures were changed along the way. Developing countries have demonstrated that they do not feel an international legal obligation to provide full compensation for expropriation or to honor their contractual commitments to investors. On the other hand, they have, in pursuit of their economic self-interest, committed themselves to such behavior through BITs. BITs, therefore, do not reflect a sense of legal obligation but instead are the result of countries using the international tools at their disposal to pursue their economic interests.

CONCLUSION

Bilateral investment treaties have become the dominant international vehicle through which North-South investment is protected from host country behavior. Because these treaties allow investors and hosts to establish binding and enforceable contracts, there is little doubt that BITs increase the efficiency and reduce the cost of foreign investment. In particular, the treaties solve the dynamic inconsistency problem by permitting the host country to bind itself to a particular course of action before the investment takes place.

This chapter has shown, however, that there is more to the story. Although BITs improve the efficiency of foreign investment, they may not increase the welfare of developing countries. BITs give an individual country the ability to make credible promises to potential foreign investors. As a result, the country is more attractive to foreign investors and will receive a larger volume of investment than it would without the ability to make such promises. The increase in investment, however, is likely to come in large part at the expense of other developing countries. Developing countries as a group, therefore, will enjoy relatively modest gains from an increase in total investment. It is probable that these gains will be outweighed by the losses those countries will suffer as they bid against one another to attract investment.

Developing countries would be better off if, rather than competing against one another to attract investment, they could require potential investors to (p.97) commit their investments to a particular country without a binding investor-host agreement. In this situation, which exists if neither the Hull Rule nor a BIT governs the investment, the host country can extract rents from a foreign investor because it can wait until an investment is made before increasing the costs to the investor. Just as a monopolist increases the price and reduces the quantity of goods sold to maximize profits, host countries under CERDS can increase the costs to investors and maximize the gains to the host country.

This strategic analysis of the behavior of developing countries explains why developing countries support CERDS–a collective action that allows LDCs to maximize their profits as a group—and, contemporaneously, sign BITs—an individual action that gives a signatory an advantage relative to other developing countries. It also makes it possible to assess the welfare implications of BITs. There is little doubt that BITs increase the overall efficiency of foreign investment, but they appear to do so at the cost of reducing the gains to developing countries. Whether this is a desirable trade off is, perhaps, a matter of debate. Finally, the analysis herein argues against viewing BITs as evidence of customary law. Developing countries sign these treaties to gain an advantage in the competition for investment rather than from a sense of legal obligation, as is required to establish a rule of customary international law.

Notes

(p.98)

Notes:

(*) “Why LDCs Sign Treaties That Hurt Them: Explaining the Popularity of Bilateral Investment Treaties,” 38 Virgina J. Int’l Law 639 (1998)Virginia Journal of International Law.

(1.) “Recent Actions Regarding Treaties to Which the United States Is Not a Party,” 35 I.L.M. 1130, 1130 (1996)

(2.) id.

(3.) The simultaneous growth in FDI and the popularity of BITs should not be assumed to imply causation. Although BITs and FDI are obviously related, the sensitivity of FDI to the presence of BITs is an empirical question that must be left for future research.

(4.) seeErnest H. Preeg, Traders in a Brave New World: The Uruguay Round and the Future of the International System 13 (1995)

(5.) see Malcolm D. Rowat, “Multilateral Approaches to Improving the Investment Climate of Developing Countries: The Cases of ICSID and MIGA,” 33 Harv. Int’l L.J. 103, 103–04 (1992);Anthony M. Vernava, “Latin American Finance: A Financial, Economic and Legal Synopsis of Debt Swaps, Privatizations, Foreign Direct Investment Law Revisions and International Securities Issues,” 15 Wis. Int’l L.J. 89, 145 n.199 (1996).

(6.) I am not the first to note this paradox. see , e.g.,M. Sornarajah, The International Law of Foreign Investment 259 (1994)(“This duplicity can be explained on the basis that while these states subscribe to a particular norm of international law at the global level, they are yet prepared to accord a higher standard of protection to the nationals of states with which they conclude bilateral investment treaties in the hope of attracting investment.”);Rudolf Dolzer, “New Foundations of the Law of Expropriation of Alien Property,” 75 Am. J. Int’l L. 553, 567 (1981)(“This apparent contradiction can be easily explained in light of the special benefits that developing countries enjoy under such treaties.”).

(7.) seeGer. v. Pol.Henry J. Steiner et al., Transnational Legal Problems 451–54 (1994)Id.Id.seeU.S. v. Nor.U.K. v. Spain

(8.) A rule of customary international law requires two elements: (1) the general practice of states, and (2) state adherence to the rule based on a belief that such adherence is legally required (opinio juris).

(9.) seeThe International Law of Foreign Investment, suprasupraOscar Schachter, “Compensation for Expropriation,” 78 Am. J. Int’l L. 121, 123 (1984)

(10.) Put differently, the UN resolutions provide evidence of the demise of the Hull Rule, not of the rise of an alternative rule of customary international law.

(11.) see Dolzer, supra note 6, at 553 (“[T]he present state of customary international law regarding expropriation of alien property has remained obscure in its basic aspects.”).

(12.) Olivier J. Blanchard & Stanley Fischer, Lectures on Macroeconomics 592 (1989).

(13.) seeAndrew Guzman & Aart Kraay, “Uncertainty, Irreversibility, and Foreign Direct Investment” (1996) (ch. 2 of unpublished Ph.D. dissertation, Harvard University)

(14.) An investment is irreversible for our purposes if withdrawal from the investment yields less than the full value that was invested.

(15.) Sornarajah, The International Law of Foreign Investment, supra note 6, at 233.

(16.) Dolzer, supra note 6, at 567.

(17.) Sornarajah, State Responsibility and Bilateral Investment Treaties, supra note 6, at 90.

(18.) Although rarely clear on the question, most commentators appear to view the “prompt, adequate, and effective” standard—present in both BITs and the Hull Rule—as a form of expectation damages. see , e.g.,Brice M. Clagett, “Protection of Foreign Investment Under the Revised Restatement,” 25 Va. J. Int’l L. 73 n.8 (1984)(“The standard method of establishing [adequate compensation] is called discounted-cash-flow analysis.”); Schachter, supra note 9, at 124–25 (stating that the Hull standard was “full value,” i.e., fair market value); World Bank Guidelines on the Treatment of Foreign Direct Investment, reprinted inIbrahim F.I. Shihata, Legal Treatment of Foreign Investment: The World Bank Guidelines 155, 161, 163 (1993)(defining “adequate” to mean fair market value, and “effective” to mean in a convertible currency).

(19.) More precisely, the agreement will be honored or the investor will be able to recover its losses.

(20.) For a detailed argument that BITs do not contribute to the formation of customary law, see Bernard Kishoiyian, “The Utility of Bilateral Investment Treaties in the Formulation of Customary International Law,” 14 Nw. J. Int’l L. & Bus. 327, 329 (1994)(“[E]ach BIT is nothing but a lex specialis between parties designed to create a mutual regime of investment protection.”). For the opposing view, see Asoka de Z. Gunawardana, “The Inception and Growth of Bilateral Investment Promotion and Protection Treaties,” 86 Am. Soc’y Int’l L. Proc. 544, 550 (1992)(“Although the provisions of the bilateral investment promotion and protection treaties may not have attained the status of customary international law, they have an undoubted part to play in that regard.”);David R. Robinson, “Expropriation in the Restatement (Revised),” 78 Am. J. Int’l L. 176, 177 (1984)(“[M]any of the same developing nations that supported these [United Nations] declarations as political statements have, in their actual practice, signed bilateral investment treaties reaffirming their support for the traditional standard as a legal rule.”).

(21.) F.A. Mann, “British Treaties for the Promotion and Protection of Investments,” 52 Brit. Y.B. Int’l L. 241, 249 (1982)

(22.) North Sea Continental Shelf (F.R.G. v. Den.; F.R.G. v. Neth.), 1969 I.C.J. 3, 44 (Feb. 20).

(23.) Schachter, supra note 9, at 126.