Globalization and International Investment

Fiona Beveridge

• Publisher: Routledge
• Year: 2017
• Print ISBN:
  9780754624158
• eBook ISBN:
  9781351933049
• Topic: Law
• Subtopic: International Law
• Index: Law

This volume brings together a broad range of articles on international law and foreign investment which together provide a contemporary overview of the diverse range of issues and perspectives which continue to exercise policy-makers and scholars alike. Central to this collection is the tension between market-oriented reforms on the one hand, raising issues of market access and protection of investors, and corporate social responsibility discourses on the other, raising concerns about environmental protection and respect for human and labour rights. Regional perspectives on these issues reveal differing priorities and approaches.

Part I

Law and Foreign Investment: Concepts and Issues

[1]

EFFECTIVE LEGAL SYSTEMS AND FOREIGN DIRECT INVESTMENT: IN SEARCH OF THE EVIDENCE

AMANDA PERRY^*

WHAT do we know about the role of legal systems as determinants of the location of foreign direct investment (FDI)? The short answer to this question is: not enough.¹ In recent decades, most governments have come to believe that FDI is an important source of the capital and technology necessary for economic development, and to seek new ways to induce foreign investors to locate within their jurisdiction.² Commentators and development agencies regularly argue or imply that FDI flows are to some extent determined by the effectiveness of the host State’s legal system.³ That is, it is suggested that the manner in which laws are implemented in a State can act as a deterrent or an attraction to potential foreign investors.⁴

There are well developed theoretical arguments why the effectiveness of legal systems should be a determinant of FDI (Part I). However, there is little empirical evidence to suggest that such a relationship actually exists; and there are existing theoretical arguments, including the concept of bounded rationality and the importance of informal business relationships, why any such relationship will be limited (Part II). In addition, there is good reason to expect that investors with different characteristics, such as size of nationality, will have varying degrees of sensitivity to the effectiveness of legal systems—a possibility which has generally been ignored by commentators (Part III). This article concludes that if legal reform aimed at attracting FDI is to be efficient and effective, then further research must be conducted into the existence and nature of any relationship between the effectiveness of legal systems and FDI flows (Part IV).

Throughout the article, reference is made to a study of the role of the Sri Lankan legal system as a determinant of FDI, conducted by the author (“the Sri Lanka study”). The Sri Lanka study was undertaken in 1997–1998 using 67 responses to a postal survey of foreign investors in commercial operation in Sri Lanka (Sri Lanka study survey),⁵ and 35 semi-structured interviews with the wider Sri Lankan community (Sri Lanka study interviews).⁶ Given its limited size and geographical scope, this study is used primarily to demonstrate the need to question the dominant theory relating to the role of legal systems as a determinant of FDI, and to suggest the routes which further research in this area could take.

I. LEGAL REFORM AND FDI

IN recent decades, the World Bank has led a resurgence of interest in the relationship between law and development. Regional development banks, such as the Asian Development Bank, and bilateral and multilateral aid organisations such as the Organisation for Economic Cooperation and Development (OECD) and the U.K. Department for International Development (DFID) are firmly committed, at least at a policy level, to the provision of funding and technical assistance for legal reform programmes.⁷ Like this article, development agencies understand the legal system to include all institutions and officials who are involved in creation and implementation of law, including courts and judges; bureaucrats; and politicians, in their capacity as makers and implementers of law.

With regard to the promotion of FDI in particular, commentators and development agencies argue that “as important as what rules say … is what they mean in practice. A pristine statute on investment that is unknown, unadministered and unenforced is ineffective.”⁸ For example, DfID proposed in 1997 that it should help developing countries to implement the “right domestic policies and conditions” such as “political stability, transparent and accountable government and the prevention of corruption,” which “are crucial in order to attract and retain both foreign and domestic investment”.⁹ One commentator argued that Sri Lanka’s failure to attract FDI “can only be explained” by the “relative conduciveness (sic) of the investment climate,” which is made unattractive by a lack of certainty, transparency and stability.¹⁰ Similarly, the former general counsel of the World Bank argued in 1995 that “a legal and regulatory framework … is a fundamental element in the stability and flexibility needed for the investment environment;”¹¹ the 1997 World Development Report concludes that perhaps the worst damage that a State can do to its prospects of investment is to cultivate an air of uncertainty;¹² and the Foreign Investment Advisory Service (FIAS) of the World Bank Group argues that ineffective legal systems “increase the withdrawal of investors who may have made a preliminary decision to commit to a country”.¹³

Many States now seek assistance from development agencies to reform their legal systems with a view to attracting FDI.¹⁴ This assistance is based upon the argument that investors are attracted to States which have effective legal systems; that an effective legal system is one which implements laws efficiently and predictably; and that reform of an inefficient and unpredictable (i.e. ineffective) legal system can help a State to attract FDI. At the root of this argument is the micro-level transaction costs analysis favoured by neo-institutional economics.

The argument that the effectiveness of a legal system can affect FDI flows appears to be based on the assumption that economic actors both should and do structure their activities in order to reduce transaction costs.¹⁵ In theory, the role of laws and legal systems is to reduce those search and information, bargaining and enforcement costs associated with undertaking any transaction. However, legal systems are often unsuccessful in this regard.¹⁶ Not only do legal systems fail to reduce transaction costs which exist in the market, but they themselves tend to impose additional transactions costs on economic actors.

First, transaction costs are said to arise through the inefficient enforcement of laws—for example, if court procedures are subject to delays, or bribes are required to lubricate bureaucratic decision-making. Followers of neo-institutional economics (including development agencies), argue that efficiency is best achieved where a State’s laws are of good quality—that is modern;¹⁷ and its courts and bureaucracies are provided with adequate infrastructure, and trained and properly compensated staff.¹⁸

Second, transaction costs are said to arise through the unpredictable enforcement of laws—for example, if bureaucrats exercise discretionary powers in an arbitrary fashion, or judicial interpretations of laws are inconsistent. Followers of neo-institutional economics (including development agencies) argue that predictability is best ensured where laws are stable,¹⁹ accessible²⁰ and clear;²¹ the discretionary powers of the State (including its bureaucrats) are limited;²² corruption is low²³ and powers are separated among branches of government,²⁴ in particular through the creation of an independent judiciary.²⁵

In the context of international economic activity such as FDI, neo-institutional economic theory would predict that foreign investors will be attracted to States with “effective” (i.e. relatively low transaction costs), and avoid States with “ineffective” legal systems (i.e. relatively high transaction costs).²⁶ However, even if the effect of transaction costs is such that foreign investors should be attracted to states with legal systems which are “effective”, there is little empirical evidence to suggest that they are so attracted. This lack of evidence, and some theoretical explanations for it, are explained in Part II.

II. EVIDENCE OF THE RELATIONSHIP BETWEEN LEGAL SYSTEMS AND FDI

A World Bank representative working on legal reform in Sri Lanka readily admitted in an interview that “one can never be sure” whether improvements in levels of FDI “can be attributed to legal reform or not. It is very difficult to know if law reform will have an impact, but to some extent, that thought is intuitive”.²⁷ A review of existing literature reveals that, intuition aside, there is little empirical evidence to confirm that international economic actors do in fact pay significant attention to reducing their exposure to transaction costs endogenous to legal systems (Section A). Furthermore, there are good theoretical and empirical grounds to suppose that the impact of legal systems upon the location of FDI is likely to be limited by the capacity of foreign investors (Section B).

A. Empirical Studies

The scope and number of empirical studies which have touched upon the link between legal systems and the location of FDI are so great that no attempt will be made to summarise them all in this article. However, it is possible to note first, that such studies rarely make a direct attempt to address the role of legal systems as a determinant of FDI; and second, that the conclusions of such studies are inconsistent. These points can be illustrated by briefly examining a selection of existing work.

A substantial amount of research has addressed the growing importance of perceptions of political risk in the FDI decision making process.²⁸ Political risk is the “risk inherent in doing business in the … political environment of another country”.²⁹ More specifically, it has been defined as the risk that a host state will “confiscate all or a portion of the investor’s property rights located in the host country”. These studies are of limited use in assessing the role of legal systems as a determinant of FDI, since “confiscation of property” is generally narrowly interpreted to occur only by the introduction of a new law, rather than by the failure to enforce an exist...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Table of Contents
• Acknowledgements
• Series Preface
• Introduction
• PART I LAW AND FORIGN INVESTMENT: CONCEPTS AND ISSUES
• PART II DISPUTE SETTLEMENT
• PART III REGULATING THE MULTINATIONALS
• PART IV THE REGULATION OF FOREIGN INVESTMENT AND THE PUBLIC INTEREST: STRIKING A BALANCE?
• PART V AN INTERNATIONAL AGREEMENT FOR INVESTMENT?
• PART VI THE REGULATION OF FOREIGN INVESTMENT AND THE PUBLIC INTEREST: STRIKING A BALANCE?
• PART VII REGIONAL PERSPECTIVES
• Name Index