I am co-authoring a paper with three of my graduate students (Noel Johnston, Chai-yi Lee, and Abudulhadi Sahin) on government decisions to break contracts with foreign investors.  Our main finding in the paper is that governments are actually less likely to break contracts during periods of economic crisis, and that governments that are dependent on other countries for foreign aid for support from the multilaterals (specifically IMF programs) are less likely to expropriate investors assets or income streams.  Our data analysis include a model that predicts expropriation events in a country-year, and a survival analysis of political risk contracts issued by the U.S. government political risk insurance agency (OPIC).  We’re revising our paper for submission over the next week or two.  Drop me an email if you want a copy.

A final part of the project is a series of case studies of “pre-claims” from the World Bank’s political risk insurance arm, the Multilateral Investment Guarantee Agency (MIGA).  The MIGA folks have bee really helpful in providing feedback on our project and providing information on the “pre-claims” of expropriation, where they document government actions taken that threatened investors and how this dispute was eventually settled.

These cases provide a window into both why governments “try” to break contracts and why they eventually back down.  The table at the end of this post provides basic info on the disputes.  I had the opportunity to talk to MIGA about a bunch of these cases.

Table 1 does provide some examples of government incentives to renege on contracts during periods of crisis, although there are two important points.  First, these are cases of pre-claims, where the government either ultimately backed down from the initial policy to a resolution with the investors or in a few cases the negotiation is still under way.  Second, these crisis-triggered expropriations are quite uncommon.  Only seven of the 34 cases are related to economic crisis, and three of these are related to the financial crisis in Argentina.

Other types of disputes are much more common. In some cases political change leads to an investment dispute, for example a new minister of mines in Guatemala denying tariff adjustments or a regime change in Guinea leading to the canceling of a telecommunications contract.  Also common are reviews of privatization programs or the revising of contracts written by previous regimes previous contracts.  Examples include privatized natural resources investment in the Democratic Republic of the Congo and Moldova. Political change in Ecuador let to a review of all water concession contracts.

Other patterns of investment disputes are related to what seem to be legitimate environment regulations.  In Costa Rica the government expropriation an investment with compensation to preserve a rain forest, was a dispute was over the level of compensation, not the legitimacy of the government action.  The government of Guyana’s canceling of a contract due to a mercury contamination from a mining operation is another clear example. A dispute in Benin over potential environmental and safety issues in a hotel investment that was being build over buried oil pipelines is an example of environmental issue leading to a dispute over who pays for unexpected costs to a project.

The most common pattern of these pre-claims is governments attempting to renegotiate terms of contracts, often on the tariffs that power and water providers can charge consumers or payments owed to firms from the government.  Why do governments want to rewrite these contracts?

Interviews with MIGA staff point to unbalanced contracts as one potential trigger for expropriation threats.  In a number of power contracts, investors pushed much of the risk onto the host government that eventually led to major financial losses by the government.  The contract on hydroelectric generation by AES in Uganda is a clear example of this pattern.  AES negotiated favorable terms for a power generation contract, which became obvious during a period of low rainfall.  The government attempted to renegotiate the contract, claiming that they were incurring major financial losses by making minimum payments to AES. Similar examples include the 2003 geothermal dispute in Nicaragua, 2003 and 2004 power disputes in Kenya and Guatemala, and 2007 dispute over the investment in a cotton gin in Afghanistan.

This wide variety of types of pre-claims provides evidence of exogenous shocks (crisis, environmental disasters), political change, and simply disputes between firms and governments.  There are also a number of cases that could be classified as “corruption”, often where government officials either attempted to extract from firm, or that the government was attempting to force our the firm in order to help a competitor. Given this wide range of triggers for the disputes, is there a common pattern to how these were successfully renegotiated?  To answer this question we drawn on a number of interviews with MIGA officials.

One of the major tools that can be used is to articulate how these claims, made public through MIGA, would have negative consequences for the country’s reputation.  Some of the clearest cases were the disputes in China, where in a couple of pre-claims local or provincial government officials took actions against a firm and MIGA contacted the central government to intervene.  The conclusion of the 1998 dispute in China was literally a public ceremony signifying a conclusion of the dispute that included the company and government officials.

While different in nature, the role of reputation in the 1998 dispute in Guatemala was important in resolving the issues at stake.  In essence, the energy minister was pushing for changes in a power contract.  MIGA consulted with the Ministry of Finance, articulating the potential financial consequences of expropriation behavior.  The political fight between these ministries is complicated, but the Minister of Finance eventually prevailed.

In many cases, powerful external actors also intervened.  The clearest example was the heavy involvement of President of the World Bank and the Prime Minister in Spain in the 2003 power dispute in Moldova.  According to MIGA sources, the government was harassing a Spanish power provider to entice the company to sell to a Russian company.  The President of the World Bank and Prime Minister of Spain directly sent letters, including a direct threat of cutting off World Bank, International Finance Corporation, and European Bank for Reconstruction and Development financial support.

The World Bank was also active in adjudicating the 2009 power dispute in Uganda.  But, as noted above, this was a relatively unbalanced contract in favor of the investor.  While the World Bank pushed for the Uganda government to moderate their claims, the World Bank wasn’t completely unsympathetic to the government concerns about the contract.  The contract was eventually rewritten with the firm taking more the risk in the electricity generation part of the contract, although the government took on a number of major risks at the distribution end of the contract.

Similar pressure was put on Benin by the Bank for their discriminatory treatment of a foreign cell phone provider.  This foreign firm was threatened with a major up front fee for future taxes to continue their operations, despite domestic providers not being included in this new fee plan.  The World Bank threatened to cut off future grants to Benin and the pressure on the foreign firm subsided.

The Democratic Republic of the Congo is one of the more complicated cases of foreign involvement, where the International Finance Corporation (IFC) and MIGA had involvement in a mining operation.  DR Congo was in the process of transforming their notoriously secretive mining contracts into a paradigm of transparency, signing onto the high profile Extractive Industries Transparency Initiative (EITI).  But the problem was on how to deal with the previous contracts.  Rather than providing a formal rule on how old mines would be treated, each mining operation engaged in one-on-one negotiations with the government.  This was a process rife with potential corruption, but the World Bank (IFC and MIGA) backed mine opted for the highest EITI standard.  This hardline stance by the World Bank lead to a major disagreement with the government.  The Bank negotiated hard, although the number of important post-conflict World Bank programs in DR Congo actually made threats of cutting them off from funding less credible than in the case of Benin and Uganda.

In some cases, international financial institutions not only provided the sticks, they provided carrots to help negotiate a settlement.  The ill-faded cotton gin dispute in Afghanistan was solved with money from multilaterals, while the Inter-American Development Bank provided funds to help cover power contracts that were costing the Guatemala and Nicaraguan governments scarce foreign currency.

The role of multilaterals isn’t a guarantee of stable relations between investors and governments.  Ecuador’s expelling of the World Bank from the country and Argentina’s tense relations with the IMF and Bank documented above provide evidence that multilateral involvement isn’t a panacea.  But the evidence does suggest that these institutions wield carrots and sticks that can be used to avoid expropriation events, even in cases of contracts that were very unfavorable to host governments.

Our cases study of the 34 “pre-claims” from MIGA compliments our statistical analysis in the paper.  We show that there is no absolute guarantee against the expropriation of investment.  Pressure to expropriate or breach contracts can come from a number of different factors.  Governments that are concerned about their reputation and/or governments dependent on multilaterals for financial support are much less likely to engage in expropriations.  At the other extreme, when a government such as Argentina as already alienated investors and multilaterals, there are few remaining constraints from reneging on contracts.

We’re still writing up these details and interviewing more people at MIGA on these disputes.  But it seems like these “pre-claims” are a window into government incentives to initially break contracts, and how diplomatic or economic pressure leads the governments to eventually back down.

Table 1: MIGA Pre-Claims (1998-2010)