Ibrahim F. I. Shihata
An examination of the proposed multilateral investment guarantee agency
The share of developing countries in foreign direct investment is small, perhaps less than 30 percent of the total. The volume of this small share has also declined in recent years from more than $17 billion in 1981, according to the highest estimates, to some $10 billion in 1983. The higher financial returns that an investor often receives from investing in developing rather than developed countries have not changed this picture, due in part to the prevailing perceptions that investing in developing countries usually entails greater noncommercial risks. So important are these perceptions that quite often even investors from developing countries, when given the choice, tend to invest in developed countries despite awareness of the smaller profits and more complex regulatory requirements often encountered there.
The effects of this decline in the volume of foreign investment and the continued problem of capital flight have been aggravated by the serious fall in commercial bank lending to developing countries as a group (net transfers—a concept used by the World Bank to denote net flows less interest payments—dropped from $16 billion in 1981 to –$21 billion in 1983) and by a decline in official development assistance. More than at any previous time, there seems to be a need to improve the investment climate in developing countries and stimulate greater commercial flows to them. In addition, there has been a growing realization among developing countries that foreign private investment, under appropriate conditions and safeguards, can produce net gains. The complex relationship between investors and their hosts has become more balanced with the growing importance of developing countries in the world economy and the evolution of substantive and procedural rules for the treatment of foreign investment. It is in this context that the Bank has revived its proposal to establish a multilateral investment guarantee agency.
This article is based on a more detailed paper by the author that will appear in Political Risks in International Business, edited by Thomas L. Brewer (New York, Praeger, forthcoming).
Governmental guarantees against noncommercial risks in foreign countries are not new; their origins lie in the export credit schemes that European countries adopted in the 1920s. The United States established a national program in 1948, guaranteeing U.S. investments in Western Europe against restrictions on the conversion of currencies (transfer risk), and gradually expanded it to cover investments in developing countries against all political risks. Similar programs have now been adopted by other industrial countries and some semi-industrial countries, with many of them combining these programs with their previously established systems of export credit insurance.
In the late 1950s a proposal was made to establish an international agency that would insure foreign investors against noncommercial risks. Although the Bank, at the request of the OECD’s Development Assistance Committee, assumed responsibility for the matter in 1961 and produced a number of elaborate studies and draft conventions in the late 1960s and early 1970s, the establishment of such a multilateral agency did not materialize.
Citing the need “to improve the investment climate—for potential investors and potential recipents alike,” A. W. Clausen, the President of the Bank, took the initiative to revive the proposal in his first address to the Fund-Bank Annual Meetings in 1981. As a result of detailed studies undertaken by the Bank and informal discussions by its Executive Directors, the management of the Bank formulated a new plan. This version differs in many respects from previous proposals in which the agency would have no share capital and would have conducted operations exclusively on behalf of sponsoring member countries. The new features—which include a primary reliance upon share capital, a willingness to leverage this capital, and a greater role for the host countries—should give the agency broader scope in which to operate and greater flexibility, thus making it of particular interest to developing countries. The Bank is currently in consultation with members prior to a formal presentation of this proposal to its Executive Board.
Nature and scope
The basic objective of the proposed new multilateral agency is to encourage greater flows of resources to productive enterprises in developing member countries by guaranteeing foreign investments against noncommercial risks. The agency would, in addition, furnish information on investment opportunities, prepare studies, give advice to its members on formulating and implementing policies toward foreign investment, and cooperate with other international organizations engaged in related areas. The agency’s operations would be broadly delineated in its convention, elaborated in its policy rules, and more precisely defined in its contracts of guarantee. This would permit it sufficient flexibility to adjust coverage to changes in investment arrangements and gradually expand operations as it built up financial reserves and gained experience.
Covered risks would encompass noncommercial events that affect an investor’s rights, including the three traditionally recognized political risks: (1) the transfer risk resulting from host government restrictions and delays in converting and transferring local currency; (2) the risk of loss resulting from host government action or omission depriving investors of control over or substantial benefits from investments; and (3) the risk of loss resulting from armed conflict or civil unrest. (Other specific noncommercial risks may also be covered under the joint request of the investor and the host country.) General nondiscriminatory measures, such as those normally taken by states to regulate economic activity, are, however, not included unless they result in breach of legal commitments. In all cases, guarantees would be confined to measures introduced or events occurring after a contract had been concluded. Transfer risk seems the obvious candidate for wide coverage; under present circumstances it is the most relevant from the viewpoint of investors, and probably least likely to evoke political objections from the host countries.
Although the agency would focus primarily on direct investment, eligible investments could include any other transfer of assets, in monetary or nonmonetary form, for productive purposes. The scope of eligible investments could be expanded as the agency’s resources increase and it becomes better able to develop its risk-measurement rules. At the outset the investment covered might include equity participation and equity-type loans; eventually, it could also encompass profit-sharing, service, management and turnkey contracts, arrangements concerning industrial property rights, international leasing arrangements, and arrangements for the transfer of know-how and technology. It might even cover straight project loans, portfolio investments, and some forms of export credits. Coverage would be limited to long- and medium-term arrangements that involve productive new investments, including new transfers of foreign exchange to modernize, expand, or develop existing enterprises. Reinvested earnings, which could otherwise be transferred abroad, could also be deemed new investments.
The agency would charge premiums and fees for its services, the structure and level of premiums to be determined by its board. Revenues would be allocated, in order of priority, to (1) cover administrative expenses; (2) pay claims of insured investors; and (3) a reserve fund. Initially, however, the agency would have to rely on its members in meeting its administrative expenditures and paying whatever claims might arise under contracts of guarantee.
There would eventually be separate windows for two types of operations: guarantees issued on the basis of the agency’s own capital and reserves, and guarantees issued for investments sponsored by members. The latter would be issued by the agency on behalf of the sponsoring members who would carry the ultimate financial burden of the sponsored guarantees on a pro rata basis. The proposed $1 billion initial capital would be subscribed by all members, with only a small portion (10 percent) paid in and the remainder kept under call to meet obligations that could not otherwise be met through paid-in capital and retained earnings. The agency’s operations would be financed through its capital and reserves until it reaches the ceilings designated by its board. Such ceilings would include a general limitation of up to five times capital and reserves, as well as country ceilings related to the volume of investments originated from or carried out in one member country. Once a ceiling is reached, the agency could start the second window operations based on sponsorship; here the agency basically would act as the agent of the sponsoring countries and hold a separate sponsorship fund. This would receive the premiums of sponsored guarantees and pay for administrative costs and claims resulting from them, complemented in this respect by calls on sponsoring members.
One basic concern raised about the proposed agency is whether it would, in fact, increase investment flows. Additional flows would result when guarantees attract investments that would not have taken place otherwise. Although it is impossible to quantify potential additional investments, there are strong indications that multilateral guarantees would encourage otherwise hesitant investors by providing a better investment climate.
Investors’ calculations to maximize profitability usually involve two components, risk and return. Any perceived improvement in the risk profile could lower the rate of return required by the investor to undertake the investment (“hurdle rate”). If noncommercial risk is associated with an investment, an investor can expect to reduce this hurdle rate in return for a guarantee that diminishes risk. As the premium that the investor would pay for such a guarantee would reduce the return from the investment, additionality could ensue whenever the reduction in the hurdle rate exceeded the premium.
Concern over noncommercial risks has been reflected in the creation of national investment guarantee schemes and underscored by the rapid growth of the private political risk insurance market and the political risk analysis profession over the last decade. A study for the U.S. Overseas Private Investment Corporation concluded that in about 25 percent of the cases it examined, investments would not have taken place without a guarantee; in 18 percent, investments would have proceeded without a guarantee; and in the remaining 57 percent, although there was no decisive evidence, a guarantee did appear essential in many instances.
Salient features of the proposed multilateral investment guarantee agency
Membership: open to all Bank members and Switzerland.
Entry into force: when 15 (10 developing) countries join and furnish part of initial capital subscriptions.
Organization: council of governors, board of directors, and president and staff. Council delegates general authority to board, but retains vote on admission, changes in capitalization, amendments, and suspension or liquidation of operations. President has responsibility for ordinary business.
Subscribed capital: share capital, initially $1 billion, is open-ended and increased with new membership. Individual subscriptions negotiated on the basis of ability to pay.
Sponsorship: in addition to operations based on share capital and reserves, members may sponsor investments for guarantee, incurring loss-sharing liability for them on pro rata basis with other sponsoring members.
Relationship with national agencies: cooperative arrangements using their administrative support, facilitating communication between them.
Relationship with private risk insurers: cooperative arrangement to leverage underwriting capacity, diversify risks, maximize administrative efficiency. Reinsures some of its portfolio with private insurers and co-insures large investments.
Payment of claims: investor first required to seek administrative remedies in host country. Agency assesses claims, provides for prompt payment. Disputes submitted to arbitration, unless the parties agree on other methods.
Voting: Members classified for voting purposes only as home or host countries; each group allotted the same number of votes. Important decisions require approval by a special majority.
“Qualitative additionality” can also occur when a guarantee offered by an international agency, even if not essential for the investment to be undertaken, has an impact on the structure of the investment. This would be the case when, as a result of the agency’s evaluation, investments are made for longer periods of time or with greater benefits to the host country. It may also ensue from changes in the mix of foreign investors: if a guarantee plays a larger role for small- and medium-sized investors than for large transnational corporations, host countries might be able to gain more technology adapted to their needs and more labor-intensive investments.
Some developing countries could also benefit as home countries of investments, since an agency would accord their nationals investing abroad protection that is lacking at present. This aspect is gaining importance with increased investment flows among developing countries.
Links to national programs
With all DAC member countries operating their own national investment guarantee programs, is an international agency necessary and would it increase effectiveness? It is estimated that less than 20 percent of net investment flows from DAC member countries to developing countries was guaranteed under national programs during 1977-1981. According to OECD sources, only an estimated 9 percent of the existing stock of investments was covered at the end of 1981. The various national programs are utilized in different degrees, varying from more than 50 percent (Japan, Austria and, possibly, Korea) to less than 5 percent (most European programs). The small percentage of coverage by national agencies cannot be taken as evidence of the lack of need for guarantees. Recent contacts with investors prove the contrary; there is a potential demand for investment guarantees that is not met by the national programs, due mainly to constraints inherent in the national approach to investment insurance (lack of risk diversification, emphasis on nationality and national interests, and limited financial and appraisal capacities).
The proposed agency would complement national programs rather than compete with them. It would be designed to enhance risk diversification, contribute additional appraisal capacity, and overcome gaps resulting from different terms, conditions, and administrative practices of the various national agencies. To achieve this complementary role, it would focus on the following operations:
• Guarantee, or co-guarantee with national agencies, investments in countries where the national agency is already heavily exposed.
• Guarantee investments from member countries that do not have a national investment guarantee program.
• Guarantee investments that, though sound, are not eligible for a national guarantee.
• Guarantee types of investments (e.g., service contracts) or risks (e.g., breach of host government undertakings) not covered under the respective national programs.
• Co-guarantee large investments with national agencies, thus mitigating risk concentrations for both the national and the multilateral agency.
• Guarantee, or co-guarantee with national agencies, multinationally financed investments, permitting uniform protection to all co-investors.
• Guarantee low-risk projects in high-risk countries (most national investment guarantee administrations are not fully equipped to assess risks on the basis of project-related criteria).
• Provide reinsurance of national investment guarantee agencies, in particular of tranches of large investments and part of large host country exposures. In this way the agency could enhance its own risk diversification and that of the reinsured national agencies.
The agency must become self-sustaining over the medium term. Administrative expenses and claims would have to be met through premium revenues and returns on invested reserves. The experience of national investment guarantee programs of OECD countries sustains this expectation: as of December 1983, their aggregate net payments on claims (claims not recovered from host countries) amounted to just 16.4 percent of their aggregate premium revenues. The dramatic expansion of private political risk underwriting over the last decade also indicates that it has been a profitable business.
Nonetheless, the agency might not quickly become self-sufficient, as the term is understood in insurance economics, because political risks cannot be readily calculated by conventional actuarial criteria. The proposed financial structure would ensure that claims would be paid even if losses exceeded premium revenues. These would be met through calls on shareholders or sponsors, as the case may be.
Obviously, the agency’s ability to pay claims without recourse to such calls would largely depend on its premium structure. While a variation of premiums according to actual loss potential would serve the financial interests of the agency, differentiation by host countries might give rise to political difficulties. To reconcile these two aspects, the agency could differentiate by project rather than by host country. This would follow the practice of all major private U.S. political risk insurers and the Overseas Private Investment Corporation. Private insurers in the United States, for example, have quoted premiums ranging from 0.75 to 7 percent per annum for investments in the same host country. OPIC considers 12 different factors to rate expropriation risks and another 11 factors to rate armed conflict risks. Aspects such as the host government’s attitude toward the guaranteed investment are also considered. While the transfer risk is normally associated with the foreign exchange liquidity of the host country, investments generating export revenues might not be affected by the general balance of payments problems of a host country. Premiums would reflect a variety of considerations and most differences would relate to economic rather than political factors.
Most international financial institutions, such as the World Bank, are donor agencies that transfer funds on their own account to developing countries. The proposed agency would, by contrast, only guarantee investments made by third parties in developing member countries. It would emphasize the importance of stable investment conditions rather than provide financial intermediation. As a consequence, its proposed voting structure differs from that of a typical financial institution where voting is primarily linked to capital contributions. Voting in this context would reflect an emphasis on building mutual confidence and policy cooperation within the agency.
The proposed allocation of equal voting power to home and host countries as groups is intended to reflect the focus on policy cooperation between host and home countries. A requirement of special majorities for decisions of particular financial significance would provide an advantage to larger contributors, reflecting the financial nature of the agency.
A distinction between home and host countries as groups would be confined to the allotment of voting rights. Votes would not be cast in groups but by individual governors or directors according to the merits of each case; in effect, it is expected that decisions would be taken by consensus in most cases. Home and host countries have a common interest in a well-balanced voting structure, since such a structure would ensure the agency’s credibility and success.
Relations with host countries
Since the agency would underwrite only investments specifically approved by the host country for that purpose, any involvement or potential for a dispute with a host country would be confined to investments guaranteed by the agency with the full consent of the host country. Where the agency compensated an investor under the contract of guarantee, it would assume only the substantive rights that the investor had acquired. Subrogation, assumption of the legal rights of the compensated investor to collect damages, could thus achieve nothing more than the assignment of an existing claim from the investor to the agency.
Host country approval could eventually result in international arbitration of a dispute between the agency and a member country. The jurisdiction would be limited to disputes between the agency and a member state related to a guaranteed investment. It would not endow a private investor with procedural rights under international law.
The convention establishing the agency would not include substantive rules with respect to the treatment of guaranteed investments. Any bilateral agreement between a member and the agency would be concluded by mutual consent and no member would be under obligation to enter into such an agreement. The convention could not conflict with the Code of Conduct of Transnational Corporations currently under negotiation within the framework of the United Nations, nor could it conflict with bilateral investment protection treaties whereby the contracting parties give reciprocal assurances on the treatment of the investments of the nationals of a party in the territory of the other. In particular, a multilateral guarantee would not affect the validity of an investment protection treaty; it would add to it.
Multilateral guarantees, though normally available for foreign investment only, would not in themselves discriminate against domestic investment, since they would protect only existing rights rather than create new rights for the investor vis-à-vis the host country. A transfer risk occurs because a foreign investor must rely on the ability to repatriate invested capital. In an expropriation, the guarantee would assure the investor only adequate compensation in a foreign currency; it would not protect against host governmental actions as such. Foreign investment would remain subject to host governmental regulation, as would domestic investment.
The agency and the Bank
As proposed, the Bank would not have an institutional stake in the agency or assume responsibility for its operations. Although the agency would presumably enter into a cooperative agreement with the Bank to benefit from its services and cut down its own costs, the only direct role envisaged for the Bank is that its President would act as chairman of the agency’s board of directors. The interests of Bank members that do not wish to join the agency would not be affected. The initiative to create a multilateral agency has, nonetheless, been taken by the Bank’s management; it is being discussed by the Bank’s Board, and its various aspects are being studied by Bank staff. This is consistent with the Bank’s role as a catalyst in the promotion of foreign investment.
The experience of several national investment guarantee schemes in developed countries should point to the need for a multilateral agency to support and supplement their work through reinsurance and co-insurance activities and the provision of insurance where protection by national schemes is unavailable or inefficient. It is hoped that the mutual interests involved would enable the Bank to bring the proposed agency to fruition in the near future. Although not a substitute for concessional flows or for new lending by commercial banks, foreign direct investment from developed as well as from capital-exporting developing countries should be encouraged to promote development efforts. An adequate financial protection provided through a multilateral agency may well prove to be the most timely step required in this direction.
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