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  1. 1. Yale Law School Center for Law, Economics and Public Policy Research Paper No. 293 Foreign Direct Investment and the Business Environment inDeveloping Countries: The Impact of Bilateral Investment Treaties Jennifer Tobin Susan Rose-Ackerman This paper can be downloaded without charge from: Social Science Research Network Electronic Paper Collection at: http://ssrn.com/abstract=557121
  2. 2. Foreign Direct Investment and the Business Environment in Developing Countries: the Impact of Bilateral Investment Treaties May 2, 2005 Jennifer Tobin Yale University Department of Political Science PO Box 208301 New Haven, Connecticut 06520 Jennifer.Tobin@yale.edu Susan Rose-Ackerman1 Yale University Law School P.O. Box 208215 New Haven, CT 06520 susan.rose-ackerman@yale.edu1 Jennifer Tobin is a graduate student in the Department of Political Science, Yale University. Susan Rose-Ackerman is the Henry R. Luce Professor of Law and Political Science, Yale University. Email addresses:jennifer.tobin@yale.edu; susan.rose-ackerman@yale.edu. The comments of Daniel Tarullo, Thomas Waelde,Bertrand Marchais and participants in workshops at the Aspen Institute, New York University Business School,New York University Law School, Georgetown Law School, and the University of California at Davis School ofLaw are gratefully acknowledged. 72
  3. 3. Foreign Direct Investment and the Business Environment in Developing Countries: the Impact of Bilateral Investment Treaties May 2, 2005 Abstract:The effects of Bilateral Investment Treaties on FDI and the domestic business environmentremain unexplored despite the proliferation of treaties over the past several years. This paperexplores the objectives and possible consequences of BITs. Specifically, it asks whether BITsstimulate FDI flows to host countries, and if this relationship is conditional on the level ofpolitical risk in a country. We find a very weak relationship between BITs and FDI. Further, wefind that rather than encouraging greater FDI in riskier environments, BITs only have a positiveeffect on FDI flows in countries with an already stable business environment. Overall, BITsseem to have little positive effect either on foreign investment or on outside investors’ perceptionof the investment environment in low- and middle-income countries. 2
  4. 4. I. IntroductionThe impact of multinational firms on developing countries is one of the most hotly contestedissues in the current debate over globalization. Much has been written about the macro-economic impact of foreign investment. Our interest goes beyond these macroeconomicimplications to focus on the political and social effects of foreign direct investment (FDI). Ourgeneral interest is in the decision-making processes of both foreign investors and hostgovernments. Although these processes are complex and multi-faceted, our focus in this paper ison the role of Bilateral Investment Treaties (BITs), an instrument of growing importance asemerging economies seek to attract foreign investment. This study of BITs is part of our ongoingattempt to understand how foreign investors’ and host countries’ efforts to limit risk affect thedomestic business environment.Investors always face risks because changes in market prices and opportunities cannot beperfectly predicted ex ante. However, in many developing countries the risk goes beyondordinary market risk. Investors may have little trust in the reliability and fairness of propertyrights and government enforcement, and conversely, local businesses, citizens, and politiciansmay have little confidence in the motives and staying power of international business. Investorscomplain that the rules are unclear and variable over time. Critics in the host country worry thatinternational investors will reap most of the gains and will flee at the first sign of trouble. In theextreme, the distrust on both sides can be so large that little or no investment takes place, evenwhen this investment would be beneficial to both parties.In recent years international investors in low- and middle-income countries have been aided bythe growth of bilateral investment treaties (BITs). These are treaties signed between the homecountries of investors and potential host countries that set a general framework for thenegotiation of FDI deals. They bind the host country to treat all foreign investors from the homecountry in ways that will protect their investments and that give them either parity with oradvantages over domestic investors.The popularity of BITs suggests that many investors are not confident about the legal andpolitical environment in low- and middle-income countries. Given this fact, host countriesbelieve they will benefit from signing a treaty that may seem on its face quite one-sided in favorof foreign investors. The policy questions are then two-fold. First, do BITs stimulate FDI flowsto the host country? If the answer to this question is positive, do the treaties encourage certaintypes of FDI more than others? Second, how do the treaties interact with the level of politicalrisk in the host country? Are the treaties working in their intended manner by compensating fora risky domestic investment environment?If countries concentrate on making special deals with foreign direct investors, we speculate thatthey might neglect measures that improve the investment climate overall. One could study thisproblem at the level of individual deals to see if their terms permit multinationals to opt out ofrestrictive local rules or to get better protections from costly government policies. This is animportant research priority, but it is beyond the scope of this paper. Instead, we focus on BITS,the one generic policy that clearly singles out foreign investors and consider their effects. We 3
  5. 5. realize that our results will not be definitive. BITs are a relatively new phenomenon ininternational business, and their impact is only beginning to be felt.We proceed as follows. Section II provides a brief overview of the growth and impact of FDI onlow- and middle- income countries and discusses its relationship to domestic property rights.Section III is an introduction to BITs. Section IV discusses our empirical results. Section Vconcludes. II. Foreign Direct Investment, and Domestic Property RightsBoth theory and empirical evidence provide mixed results on the benefits versus the costs ofFDI. On one side of the debate, scholars suggest that FDI brings new technology and productiontechniques, raises wages, improves management skills and quality control, and enhances accessto export markets.2 Some of the costs include stifling of domestic competition and indigenousentrepreneurship, increased income inequality, lower public revenues, an appreciation of theexchange rate, and a continuing reliance on local resource endowments, rather thanmodernization of the productive sector of the economy. Characteristics of the host country—such as human capital, labor and wage standards, and the distribution of existing technologyacross countries, will affect how much countries benefit (or lose) from foreign investmentopportunities (Lall and Streeten 1977; Kofele-Kale 1992; Blomstrom, Lipsey et al. 1996; Lankesand Venables 1996)Both the type of FDI and the mode of entry affect FDI’s impact on host countries. The existingempirical work has only begun to sort out these complexities. In our view, the inconclusiveresults arise because the precise impact of FDI varies between industries and countriesdepending on the characteristics of countries and their policies.3 Its impact also depends upon theprecise nature of the deal that is struck between the investor, the host country, and any jointventure partners.In poor, high-risk environments FDI is likely to be the major source of investment funds.Regardless of the inconclusive results concerning the pros and cons of FDI, low- and middle-income countries view it as a primary means for increased economic growth. Thus, host countrygovernments work to attract FDI. They offer incentives to multinational corporations (MNCs)designed to attract FDI from competing countries and to offset potential risk factors that mightdeter investment. Likewise, MNCs employ strategies to reduce the potential risk of investing inunstable environments.4Over the period 1995-2000, FDI inflows grew at an annual average rate of 17 per cent for low-and middle-income countries.5 Following a short period of decline in inflows both absolutely2 For overviews of work discussing the influence of FDI on technology transfer see (Caves 1974; Findlay 1978;Koizumi and Kopecky 1980; Mansfield and Romeo 1980; Cooper 2001; Hanson 2001; Klein, Aaron et al. 2001)3 (Kofele-Kale 1992; Blomstrom, Lipsey et al. 1996; Lankes and Venables 1996).4 See Rose-Ackerman (2004).5 FDI inflows are defined as the gross level of FDI flowing into a region over a period of time (usually one year).FDI stock is defined as the total accumulated value of foreign owned assets at a given point in time. Developingcountries are defined according to the World Bank’s income classifications, based on gross national income (GNI) 4
  6. 6. and as a share of world flows in 2000-2001, inflows to developing countries have continued torise both absolutely and as a share of global inflows. FDI inflows to developing countries grewfrom US$158 billion in 2002 to $172 billion in 2003; their share of world FDI increased by 8percentage points to 31 per cent in 2003 (Figure 1 and Figure 2).6 FDI continues to be the largestsource of external finance for developing countries, exceeding the sum of commercial bank loansand portfolio flows in most years (Figure 3). It is also more stable than financing from otherexternal sources. Between 1997 and 2001, FDI was relatively flat as a share of the GDP ofdeveloping countries, but the ratio between FDI and non-FDI flows varied from 4.6 to 1.8. [Insert Figure 1 about here] [Insert Figure 2 about here] [Insert Figure 3 about here]There are two principal ways to attract FDI, which may be complements or substitutes. The firstis to establish special, favorable conditions for FDI that do not apply to all investment; thesecond is to improve the overall politicaleconomic environment to reduce risk. One way toreduce risk is to have clearly defined and enforced property rights. Well-enforced property rightsnot only lead to greater amounts of current domestic investment but also create a stable marketenvironment that can promote FDI. Confidence in the enforcement of property rights reducesthe incentive to insure against political risk and reduces the cost of doing business (Abbott 2000).Studies on corruption and political risk show that foreign investors prefer to do business inenvironments with well-enforced property rights.7If strong property rights are desirable for both domestic and foreign investors, why don’tcountries simply replicate the property rights systems of western capitalist societies? One reasonis that most developing country governments do not have the legal systems and institutionalstructures in place to adequately enforce laws. In other cases, it is simply not in the best interestsof governments to create or enforce strong property rights. Such governments cannot makecredible commitments not to violate their own country’s rules. It is only when the benefits ofproperty rights enforcement outweigh the benefits of low levels of enforcement that governmentswill strengthen enforcement.8 Governments in countries with weak property rights may seek toattract FDI by making special deals with investors that do not have to be extended to thedomestic economy as a whole, or that, in the extreme, even undermine domestic protections.9per capita. The category “developing countries” includes low-income, lower-middle income, and upper-middleincome countries. See: http://www.worldbank.org/data/countryclass/classgroups.htm for exact classifications.6 All dollar figures are in constant 2000 US dollars.7 Although a number of authors have hypothesized this link, Anderson’s studies of corruption in Eastern Europeconfirm the relationship. See for example, Anderson et al. (2003), Anderson (1998; Anderson 2000). See alsoLeBlang (1996), Goldsmith(1995) and Grabowski and Shields (1989).8 See Barzel (1989) and Firmin-Sellers (1995). Borner et al (1995) confirms Firmin-Sellers finding in their study ofproperty rights and investment in Ghana.9 For example, Hernando De Soto (2000) argues that without clear ownership, land can be stripped from the poor tomake way for government and foreign-led industrialization projects. 5
  7. 7. III. Bilateral Investment TreatiesGiven the weakness of the domestic politicallegal environment in many low- and middle-income countries, investors seek alternatives tailored to their needs. This can be done on a case-by-case basis, but transaction costs can be reduced if the host country commits itself to a basicframework. Along with other international institutions, this is what BITs do.10 They provideenforceable rules to protect foreign investment and reduce the risk faced by investors. Accordingto the United Nations Conference on Trade and Development’s (UNCTAD) comprehensiveoverview of BITs, the treaties promote foreign investment through a series of strategies,including guarantees of a high standard of treatment, legal protection of investment underinternational law, and access to international dispute resolution (UNCTAD 1998). BITs arebecoming a more and more popular tool for developing countries to promote and protect foreigninvestment.The first BIT was signed in 1959 between Germany and Pakistan and entered into force in 1962.The number of new BITs concluded rose rapidly in the 1990s. According to UNCTAD, theoverall number of BITs rose from 385 in 1990 to 2,265 at the end of 2003. As of the end of2004, 176 countries were involved in bilateral investment treaties (Figure 4)11. Most earlytreaties were signed between a developed and a developing country, generally at the urging ofthe developed country governments. Typically, before the 1990s, developing countries did notsign BITs with each other, but throughout the 1990s and into the present day more and moredeveloping countries have been signing the treaties with each other (Figure 5). [Insert Figure 4 about here] [Insert Figure 5 about here]The proliferation of BITs has followed a general geographic pattern. Most early BITs weresigned between African and Western European Countries. Asian nations slowly began to enterthe arena in the 1970s, followed in the late 1980’s and early 1990’s by central and easternEuropean countries. It was not until the 1990s that Latin American nations began to enter intothese agreements.12 A. BITs: HistoryInternational law on commerce and investment originally developed out of a series of Friendship,Commerce, and Navigation treaties (FCNs) and their European equivalents. FCNs providedforeign investors with most favored nation treatment in host countries but were mainly signedbetween developed countries. The United States also attempted to protect foreign investors10 Other parts of a foreign-investor-friendly package usually include membership in the World Bank’s InternationalCenter for the Settlement of International Disputes (ICSID) and its Multilateral Insurance Guarantee Agency, a taxtreaty limiting double taxation, and membership in the 1958 New York Convention on the Recognition andEnforcement of Foreign Arbitral Awards.11 Figures 3 and 4 only have data through 2000. Although most countries maintain public lists of the treaties thatthey have signed and ratified, publicly available data that aggregates all treaties are only available beyond 2000 forall ratified treaties. In these figures we include both signed and ratified treaties.12 Although Latin American countries were not signatories to BITs until the 1990s, their largest trading partner, theUnited States, provided political risk insurance and guarantee agreements to most Latin American Nations. 6
  8. 8. through investment guarantees and legal provisions. It established the precursor to the OverseasPrivate Investment Corporation (OPIC) in 1959 to protect investment in postwar Europe andexpanded its coverage to developing countries in 1971.In 1967, the OECD attempted to establish a multilateral agreement on foreign investmentprotection—the OECD Draft Convention on the Protection of Foreign Property. The conventionproposed an international minimum standard of protection for foreign investment but wasopposed by developing countries, mainly in Latin America, that insisted on subjecting foreigninvestment to domestic controls with disputes being settled in domestic courts.13 Following thefailure of the OECD convention, European countries and later the United States began toestablish more and more bilateral investment agreements with developing countries.14 B. BITs: Basic ProvisionsOverall, the provisions of BITs are meant to secure the legal environment for foreign investors,establish mechanisms for dispute resolution, and facilitate the entry and exit of funds. BITscover expropriation of property as well as indirect takings that are tantamount to expropriation.BITs are currently the dominant means through which investment in low- and middle-incomecountries is regulated under international law (Walker 1956; Schwarzenberger 1969; Kishoiyian1994). The treaties are a response to the weaknesses and ambiguities of customary internationallaw as applied to investments by international firms in countries at low levels of development.Customary law mainly developed in response to trade and investment between developedcountries and was not adequate to conditions in these more risky and institutionally weakenvironments (UNCTAD 1998).The majority of existing BITs15 have very similar provisions based as they are on the modeltreaties developed by the home countries of the major MNCs. The major differences lie in theprotection or non-protection of certain types of investment and in whether or not the treaties’apply as soon as a contract has been signed or whether funds must actually have been invested.As with their predecessors, the FCNs, BITs usually provide national and most-favored-nationtreatment to foreign investors in the host country. However, most BITs contain clauses thatexclude investments in particular areas such as national security, telecommunications, andfinance. National treatment ensures foreign investors the right to establish any business that thehost government allows domestic investors to establish. National treatment is not followed in allBITs. Some limit treatment to that considered “fair and equitable;” in contrast, some require thatall foreign investments gain approval regardless of the domestic situation (Mckinstry Robin1984). Further, the US model treaty as well as many European BITs establish the right of theinvestor to transfer all earnings to the investing country.13 In 1974, a number of developing countries supported a United Nations resolution to protect the nationalsovereignty of the economic activities and resources of host countries (Charter of Economic Rights and Duties ofStates, G.A. Res. 3281, 29 U.N. GAOR Supp. (No.31) at 50, 51-55, U.N. Doc. A/9631 (1974)).14 European treaties are generally known as Bilateral Investment Protection Agreements (BIPAs); the U.S. treatiesare known as BITs. The United States signed twenty-three FCNs between 1946 and 1966, but did not enter into anyother bilateral agreements on investment until the 1982 BIT with Panama. Shenkin (1994) attributes this to areluctance on the part of developing countries to enter into FCNs with the United States as well as the attractivenessof the European BIPA program.15 We will use BIT to refer to both BITs and BIPAs. 7
  9. 9. Over time BITs have evolved. The most important change was treaty provisions that transferredsome investor-host country disputes from local courts to international arbitration. According toone knowledgeable observer, such disputes only began to be covered in the late eighties, and thischange was essential in giving the treaties real bite.16 BITs generally provide for resolution ofboth country-country and investor-host country disputes by an international body such as theWorld Bank Groups International Center for the Settlement of International Disputes (ICSID)17or other arbitration systems, such as those operated by the International Chamber of Commerce(ICC). The United Nations Commission on International Trade Law (UNCITRAL) has aframework document that can govern arbitrations but does not operate an arbitration institution(UNCTAD 1998). Enforcement of such arbitral decisions is provided by the 1958 New YorkConvention on the Recognition and Enforcement of Foreign Arbitral Awards. The possibility ofenforcing arbitral awards directly without going through diplomatic channels benefits investorswho win judgments against states.Typically, developed countries prepare a model treaty based on the 1967 Draft Convention onthe Protection of Foreign Property and on already existing BITs (UNCTAD 1996). These modeltreaties are then modified for use in a variety of situations. Thus, treaties emanating from adeveloped country are likely to be similar or even identical, but differences exist between thoseproposed by different developed countries. An important recent development, not reflected inour data set, is the United States’ new model BIT issued in late 2004. It represents a significantnew departure because it strengthens property rights protections and includes requirements forsignatories to make rules and regulations transparent, to introduce domestic administrativeprocedures, and to consider the impact of investments on environmental and labor conditions.Only the first two elements in this list, however, can be enforced through arbitration. Discussionof this new model is beyond the scope of this paper, but it appears to reflect the United States’belief that BITs are truly bilateral and that greater specificity will be in the interest of USinvestors, consumers, and workers.18 C. The Impact of BITs on Developing Countries 1. Costs and Benefits of BITsDeveloping countries employ BITs as a means to attract inward investment. The protections toforeign investment are presumed to attract investment flows to developing countries that willlead to economic development. Developing countries hope that the treaties signal to foreigninvestors either a strong protective investment environment or a commitment that foreigninvestments will be protected through international enforcement of the treaty.16 Email correspondence from Thomas Wälde with Susan Rose-Ackerman, August 5, 2004.17 ICSID lists 86 decided cases on its website www.worldbank.org/icsid (visited September 20, 2004). Another 14cases have produced some kind of holding although some panel rulings face annulment proceedings with the losingparty demanding a follow-up procedure with a new panel. Of these 100 cases, only 37% were filed during the first25 years of ICSID’s existence. The rest were filed between 1997 and 2003 as BITs begin to play a major role ininternational investment. Furthermore, NAFTA arbitrations are also filtered throughICSID’s Alternative Facility. Another indication of caseload is the number of pending cases. In September 2004there were 64 cases pending that date from 2002-2004. The Argentine peso crisis produced an unusually largenumber of challenges. Twenty-seven of the pending cases filed in that period list Argentina as the respondent orover forty per cent of the total.18 The 2004 Model BIT is available at http://www.state.gov/e/eb/rls/othr/38602.htm. 8
  10. 10. Beyond attracting investment, developing countries hope that BITs will have peripheral benefits.For example, binding foreign investment disputes to international arbitration may serve not onlyas a signal that the current government is friendly towards FDI, but it may also lock futuregovernments into the same policy stance. Further, BITs may provide symbolic benefits to thecurrent government. For example, signing a BIT may signal a willingness to sign internationaltreaties in other areas. For countries in transition, BITs may provide a shortcut to policycredibility in the international arena (Martin and Simmons 2002).These benefits must be balanced against the costs. Although developing countries may enter intothe treaties in the hopes of obtaining peripheral benefits, some countries may be forced to signthe treaties to compete with similar countries. For example, if two countries offer relativelysimilar investment environments and one signs a BIT with a major foreign investor, the othercountry may agree to sign a similar treaty—regardless of the potentially negative impacts of thattreaty—simply to remain on par with the competing country.BITs may lead to a division of profits that favors developed countries. They increase thebargaining power of MNCs relative to a non-BIT regime and may disfavor domestic investors.MNCs argue that BITs only level the playing field for them relative to domestic investors, but itis at least possible that the scales may end up tilted toward foreign investors. For example,foreign investors have recourse to international arbitration tribunals to settle any claims resultingfrom what they believe to be unfair treatment of their property. Domestic investors are left to thelocal property rights enforcement systems. If domestic investors try to define themselves asforeign to get access to their preferred forum, that may be evidence that the local courts are seenas less effective than international arbitration.19Furthermore, developing countries fear a loss of control over their internal economic activitythrough restrictions on their employment and development policies as well as through challengesto national industries. This loss of sovereignty may be too high a burden for some developingcountries and lead them to refuse to sign BITs (Kahler 2000).Nearly all BITs contain clauses that some firms have used to petition governments for damagesstemming from government actions such as tax law changes and environmental or healthregulations enacted after investment has taken place. Firms have tried to sue for damages underan equivalent clause in NAFTA. Specifically, firms have claimed that the state’s actions amountto the expropriation of profits or that they do not give the investor equal treatment. Investorshave lost many of these cases especially when the government law or regulation has a publicpolicy justification and is applied uniformly. Nevertheless, this remains an area of concern tocountries contemplating signing new BITs and to developing countries with many outstandingBITs that are seeking to reform their tax and regulatory systems.2019 See, for example, a recent case involving the Ukraine and the status of a Lithuanian company organized byUkrainian investors who then claimed that the Lithuanian/Ukrainian BIT applied to their business dealings inUkraine. Tokios Tokelės v. Ukraine, ICSID Case No. ARB/02/18.20 This is not the place for a detailed analysis of this important issue. However, to give a flavor of the issuesinvolved consider Occidental Exploration and Production Company (OEPC) v. the Republic of Ecuador, LondonCourt of International Arbitration, Administered Case No. UN 3467 (July 1, 2004). OEPC won refund of a portionof value added tax paid. The arbitrators dismissed OEPC’s claims for expropriation and impairment of investment 9
  11. 11. Repatriation of profits is another area that may have negative consequences for developingcountries. The majority of treaties grant the investor the ability to repatriate profits “withoutundue delay” although there is an exception for times of economic emergency.21 If the treatiesare interpreted to give a narrow reading to the term “economic emergency,” the ability torepatriate profits could intensify liquidity problems faced by host countries (Mckinstry Robin1984; Kishoiyian 1994). This seems to be an issue in the cases currently pending in ICSIDagainst the government of Argentina. As an example, Suez, a French water and energy firm thathas invested in Argentina, is suing the government of Argentina under the expropriationprovisions of the French-Argentinean BIT for compensatory damages following the devaluationof the peso. This is only one of 30 cases currently pending against Argentina, all stemming fromthe financial crisis of 2002. Although the Suez case is still pending, the validity of the claimunder the BIT is worrisome for the economic situation in Argentina.22The potential benefits of BITs have recently become the focus of some scholarly attention. Onescholar, Hallward-Driemeier (2003), analyzes bilateral FDI flows from OECD countries todeveloping nations and finds little evidence of a connection between BITs and FDI flows. Shefurther finds that countries with weak domestic institutions do not get significant additionalbenefits from signing BITs with OECD nations. On the other hand, Salacuse and Sullivan(2004)find a strong correlation between signing a US BIT and FDI flows both overall and from theUnited States. Similarly, Neumayer and Spess (2004) find that the more BITs a country signs,the greater the FDI flows to that country. They also suggest that BITs serve as a substitute fordomestic institutions. We discus the results of each of these papers in more depth in our resultssection. 2. Risk and BITsWho is signing BITs and whyGiven the mixed impact of BITs, we would expect that low- and middle-income countries willvary in their enthusiasm and in their insistence on the inclusion of exceptions. For example,resource rich countries have an advantage in bargaining with foreign investors. Therefore, wewould expect resource rich states to try to avoid signing such treaties or to sign treaties withfavorable clauses; in contrast, states with few distinctive benefits to offer investors are morelikely to need to sign BITs (Abbott 2000; Kahler 2000). Countries competing for the same typesof investment need to mimic the policies of competing countries, or they risk placing themselvesat a disadvantage. Thus, we would expect that if one country signs a BIT as a signal to foreignthrough arbitrary and discriminatory measures. Instead, the panel held that Ecuador had not given OEPC fair andequitable treatment because it did not treat it as well as other exporters. These other exporters included not just oiland gas exporters but exporters of any other product from flowers to bananas. This decision suggests the level ofintervention with domestic policymaking by arbitral tribunals even if panels seldom find that tax and regulatoryrules amount to “expropriation.”21 Kishoiyian(1994) points to an ICSID study of 335 BITs. All provided for the immediate repatriation of profits, but60 enabled the host country to take into account its balance of payments situation in the country, and many providedfor interest or set the precise rate of exchange in the event of a delay.22 EFE News Service, June 28, 2002, “France-Argentina French Firm to Press Argentina for Indemnification onLosses.” 10
  12. 12. investors that their investments will be protected, this will encourage similar countries to actlikewise.Weak countries may sign BITs to constrain stronger states, but in the process they must accept adeal that is favorable to the stronger state. Only risk-takers will invest in countries such asSomalia and the Congo. These investors are likely to care mainly about natural resources; theyare not much concerned with the overall domestic investment environment. Even if thesecountries signed BITs, it is unlikely that investors would rely on the treaties to assure investmentprotections. In contrast, a few middle-income countries, such as Korea, Chile, and Singapore,have broken the risk barrier and are considered to be low investment risks. Firms haveconfidence that those countries will enforce the property rights of all investors. In thesecountries, BITs vary more from the model treaties than in other developing countries. Theirstable investment environment enables them to negotiate over the terms or even to refuse to signtreaties without risking a loss of foreign investment. For example, Singapore refused to enterinto a BIT with the United States based on its model treaty because of its limits on performancerequirements. Further, Singapore’s treaties with France, Great Britain, and the Netherlands limitthe protection offered to investors to specifically approved investment projects (Kishoiyian1994). Singapore only agreed to a treaty that covered investment as part of a broader free tradeagreement that contained other provisions of importance to its import and export business.23The middle cases of risk are the most interesting to us. These cases lie at mid-point of propertyrights evolution and could either stagnate or move forward. On the one hand, without BITs,competition for foreign investors could encourage property rights reform—perhaps aided bydomestic investors who realize the potential benefits of establishing a rule of law. On the otherhand, domestic elites and corrupt bureaucrats might attempt to maintain the status quo. Agovernmental decision to reform property rights is unlikely if the rents derived from the non-enforcement of property rights are high, if incumbents do not expect to gain many benefits fromreform (perhaps because they risk losing political power) and, most importantly, if the power ofthe opposing interest groups is high.Property rights reformWithout BITs, improvements in property rights enforcement come from government decisions tofoster economic growth through increased foreign and domestic investment. But, this will onlyoccur when the benefits of increased investment along with any political capital gained fromthose changes outweigh the costs of enforcement and the political losses from those harmed bythe new system. The trade literature has demonstrated that foreign investors have a great deal ofpower in host country political decisions. Thus, in the absence of BITs, these investors might beadvocates of broader reforms that could benefit all investors. In contrast, a world with BITsmight reduce the interest of MNCs in property rights reform and enforcement in developingcountries. Domestic reform may be less likely and the country may even regress toward policiesthat harm domestic investors. Attempts at reform may fail, or no attempts at reform may be madeat all. In such cases, the BIT, although benefiting foreign investors, could have a negative effecton the trustworthiness of the business environment for domestic investors. Of course, even witha BIT foreign investors can benefit from some improvements in the domestic property rights23 The text of the agreement, signed on May 6, 2003 is at:http://www.ustr.gov/Trade_Agreements/Bilateral/Singapore_FTA/Section_Index.html 11
  13. 13. regime and may even use the provisions of international treaties as a template for domesticlegislation.24 Thus a key empirical issue is whether MNCs seek both BITs and overall domesticreform that has spillovers for local firms or whether they concentrate on internationalinstruments such as BITs and ignore or even oppose domestic legal reform.25 D. ConclusionsMany observers of the global business environment view the growing internationalization ofcommercial law, through BITs and international arbitration, as a desirable trend. They urge itsexpansion to cover a broader range of contract disputes. However, although internationalcommercial law norms and BITs reduce risk and solve collective action problems, their impacton social welfare is ambiguous. They may impose discipline on governments that wouldotherwise favor narrow interests or demand corrupt payoffs. They bind a country to upholdcontracts with international direct investors (Waelde 1999). Thus, BITs may bring greater FDIflows, especially to riskier countries. Alternatively, developing countries may be faced withstandard form treaties drafted by wealthy countries that limit a nation’s domestic policyflexibility and lead it to favor outside investors or narrow local interests over the generalpopulation. Because BITs are based on models drafted by capital exporting states and expresslittle concern with improving the overall legal structures of developing countries, they mayreduce the available benefits to the host country from FDI (Guzmán 1997). Of course, suchcountries are in a weak bargaining position in all international fora unless they have valuablenatural resources deposits. Thus, there may be nothing special about BITs. Perhaps on themargin they are better than a non-BIT regime based on individual contracts enforced ininternational arbitration outside of the BIT framework. Nevertheless, one can also ask if analternative regime, say a more truly multilateral one, might not provide greater benefits toemerging and developing countries that compete for FDI. The next step in our analysis,therefore, is to test empirically some of the claims made for BITs.24 For an example see Konoplyanik (1996) on a Russian case where the Energy Charter Treaty was used as atemplate for a domestic statute.25 Consider a few cases that indicate the possible disjunction between property rights and BITs. Botswana andNamibia have the highest property rights rankings of all countries in sub-Saharan Africa in both the InternationalCountry Risk Guide (ICRG) and Freedom House, two generally accepted ratings of property rights. (Seehttp://www.icrgonline.com; http://www.freedomhouse.org/ratings/index.htm). Yet, as of 2000, Botswana was asignatory to two BITs, only one of which is with a developed country (Switzerland) and Namibia has signed onlyfive. Zimbabwe and South Africa, neighboring countries with significantly lower rankings on the property rightsscale, have signed 24 and 18 BITs, respectively. In Latin America, Peru and Venezuela, two countries that bothembarked on programs of property rights reform and failed, are well above the mean for BITs in the remainder ofLatin America. Peru and Venezuela have signed 26 and 22 BITs respectively, with the mean for Latin Americabelow 14. 12
  14. 14. IV. Quantitative Analysis A. HypothesesOur analysis of BITs leads to two main suppositions regarding their implications for low- andmiddle-income countries: 1. Low- and middle-income countries sign BITs in an effort to attract greater amounts of FDI, and 2. BITs serve as a substitute for a stable investment environment.Therefore, if BITs actually have these effects, we would expect the following to be trueempirically: Hypothesis 1: Foreign investment inflows will be positively associated with Bilateral Investment Treaties Hypothesis 2: The riskier the investment environment in a country, the more BITs will contribute positively to FDI flowsIn the following analysis, we find little support for either of these hypotheses. That is, we findlittle empirical support to substantiate the main motivations for developing countries to signBITs.An empirical analysis of these hypotheses requires a two-pronged approach. First, we look athow BITs, in general, interact with other determinants of foreign investment to affect FDIinflows. Second, we analyze how BITs with one specific home country, the United States, affectbilateral FDI inflows to the host country.The data for our study are based on various indicators of government performance, investmentrates, social indicators, and investment treaties in up to 176 countries. The datasets werecompiled from a variety of sources and therefore contain a different number of observations foreach variable. The data sets use panel data from 198426 through 2000 for low- and middle-income countries27 to take into account the dynamic nature of some of the data, and to control forsome of the statistical problems inherent in cross sectional analyses of this type.We recognize that our findings are preliminary. Without the ability to differentiate betweentreaties, it is not possible to ascertain if certain elements within the treaties, rather than theoverall number of treaties signed, or even the identity of the home country act as the causalmechanisms in the study. However, this analysis takes a first step towards understanding some26 While data on BITs goes back to 1959 when the first BIT was signed, and US FDI data goes back to the 1960s,our data on political risk only goes back as far as 1984, so that all of our analyses are limited to 1984 and beyond.27 Appendix B contains a list of countries used in each analysis. Appendix E contains correlations between variablesin each of the analyses. 13
  15. 15. of the important relationships between BITs and the investment environment in low- and middle-income countries.There is a broad empirical literature on the determinants of FDI.28 A review of the literatureshows that there is no clear agreement on the factors that determine FDI inflows to developingcountries. The studies use diverse variables and often come to opposing findings on therelationship between certain variables and investment. Nevertheless, we can use past work tospecify a reasonable model for the determinants of investment as a basis for understanding theimpact of BITs. We break our analysis into two parts, a general analysis to determine the impactof signing treaties on overall FDI inflows and a bilateral analysis between the United States andlow- and middle-income countries. B. General AnalysisOur first analysis addresses the hypothesis that total number of BITs signed by a low or middleincome country acts as a signal for foreign investors. If this is the case, we would expect FDIflows to increase with the number of BITs signed. However, the strength of the signal could berelated to the economic strength of the home country. Thus we separate BITs into two categoriesdepending upon whether the home country is classified as developed or developing, and analyzethe impact both of the total number signed and of the number signed between a developing hostcountry and a developed home country. Of course, it is also possible that rather than sending asignal to all investors, a BIT with a particular country merely reassures home country investors,thus encouraging investment only if an investor’s home country has signed a BIT with the hostcountry29. We study this possibility in our second analysis discussed in the following section.a. SpecificationOur general specification for foreign direct investment to low- and middle- income countriestakes the following form: yit = β 0 + β1b i ,t + β 3ri ,t + β 2i i ,t + β 4s i ,t + β 5p i ,t + β 6g i ,t + β 7ni ,t + ηi + vit (1)FDI inflows to low-income country i in time t as a percentage of world FDI flows (y) dependupon the logged number of BITs signed by the host country (b), the level of political risk (r), thelog of the average level of income (i), the inflation rate (s), the natural log of the population ofthe host country (p), economic growth (g), natural resources (n), some random error (v), andfixed country effects (η). Each of the variables is indexed by country (i) and time period (t). Thevariables are described in detail below in the data section.28 Chakrabarti (2001) offers a good overview of the literature on the determinants of FDI. For more specificanalyses, see for example: Schneider, F. and B. Frey (1985), Root and Alimed (1979), Sader (1993), Billington(1999), Markusen (1990), Gastanaga et al (1998), Ozler and Rodrik (1992), and Henisz (2000).29 Our second analysis addresses this point by examining how BITs signed with the United States affect US FDIflows to host countries. 14
  16. 16. Our general specification is useful for examining the independent effects of BITs on FDI indeveloping countries. However, we wish to test whether this effect changes depending on thelevel of institutional risk present in the host country. To examine this effect, we use a series ofinteractions:yit = β 0 + β1b i ,t + β 2 i i ,t + β 3ri ,t + β 4 s i ,t + β 5p i ,t + β 6 g i ,t + β 7 n i ,t + β 8 (b * r)i ,t + η i + vit (2) where each variable is identical to the general specification but includes an additionalinteraction between BITs (b) and political risk (r).We initially estimated equations (1) and (2) by ordinary least squares (OLS). However, it ispossible, that FDI is endogenously determined. We have reason to believe that host countriessign BITs in order to attract FDI. At the same time, it may be the case that firms withsubstantial investments in host countries may advocate for BITs between their home country andthat host country. If we believe that firms with investment in place encourage BITs, then BITscould also be an effect of FDI. Thus, we need to investigate the effect of BITs on FDI whiledealing with this possibility of endogeneity. We address this possibility by estimating our modelby instrumental variables. We instrument for (b), the number of BITs signed by the host countrywith two distinct variables. First, a time variable and second, a variable that proxies for the levelof democracy in the host country. The literature on BITs is limited, making it difficult to trulyunderstand the determinants for signing. Theoretically, however, we know that BITs should becorrelated with time. There are a number of reasons for this correlation. For example, theincentive to sign BITs escalates over time as more and more countries sign BITs and countriescompete to sign similar treaties to avoid being left out (Elkins, Guzman et al. 2004). Further, ascountries learn about BITs and come to believe in their potential benefits, they are more likely tosign greater numbers of treaties. Finally, as we know from our review of BITs, donors andinternational financial institutions have been urging countries to sign ever greater numbers oftreaties. Ideally, we would want a variable that captures each of these variables independently sothat we could ascertain the true determinant of BITs and use this as our instrument. However,statistically, time—which captures all of these effects—is just as valid an instrument. Oursecond instrument proxies for the level of democracy in the host country. The developedcountries in our study who account for the vast majority of FDI flows tend to be democracies,and tend to sign treaties (especially trade and investment treaties) with other democracies(Elkins, Guzman et al. 2004). At the same time, although investors are concerned with thepolitical stability of a country, they are unlikely to be directly concerned with its level ofdemocracy.Beyond the theoretical reasoning for our instruments, they must fulfill two basic requirements:they should be correlated with BITs and they should be orthogonal to the error process. Weperform some basic statistical operations to understand the correlations: we examine the fit of thefirst stage regressions and we run the Hansen (or Sargan/Hansen) test of over-identifyingrestrictions, which tests the overall validity of our instruments (Sargan 1958).First, we test that (b) BITs are in fact correlated with time and not with (y) FDI inflows as apercentage of world inflows. The correlations between time and the log of total BITs and high-income BITs are 0.55 and 0.36, each significant at the 99 percent confidence level. Thecorrelation between time and FDI as a percentage of world FDI is -0.0001 and is not significant 15
  17. 17. at any confidence level. Similarly, the correlations between the level of democracy and the logof total BITs and high-income BITs are 0.21 and 0.19 while the correlation with FDI is 0.01.More important, the F-statistic of all of the first stage regressions suggested by Bound et al(1995) to test the validity of the instrument is well above the 99-percent confidence level.30Finally, in all the regressions that follow, we present the results of the Hansen test alongside theresults. The null hypothesis of the Hansen test is that the instruments are not correlated with theresiduals, or in other words that the instrumental variables are not correlated with the error term.If the test rejects the additional moment restrictions, it indicates that the specification of themodel may be incorrect—that is, the instrument set is invalid. In no regression do we fail toreject the null hypotheses of the test so that they support the validity of our instrument set in allof our regressions.Each model is run using fixed effects. A Hausman specification test rejected the assumption thatthe error component from a random effects model was uncorrelated with the error in that model.Thus, our random effects model will be less efficient then our fixed effects model, and we feelconfident with the results of the fixed effects model.31 Finally we include the wald chi-squaregoodness of fit test to show the overall fit of the model. The test statistic is an assessment of theimprovement of fit between the predicted and observed values by adding independent variablesand is measured as chi-squared. Specifically, it tests the hypothesis that each of the parameterestimates in that set equals zero. A p-value for the test-statistic of less then 0.05 indicates thestatistical significance of the parameter estimates 32b. Variables and Data i. Dependent VariableAs the dependent variable for our general analysis we use the broadest measure of FDI inflowsavailable on a yearly basis from UNCTAD.33 We measure annual FDI inflows to a particularcountry as their share of total FDI inflows to developing countries in that year. Thus, weexamine how each country’s fraction of developing country FDI inflows increases (or decreases)based on the number of treaties signed.34 FDI inflows are provided on a net basis, and includecapital provided (either directly or through other related enterprises) by a foreign direct investorto an FDI enterprise or capital received from an FDI enterprise by a foreign direct investor.There are three components in FDI: equity capital, reinvested earnings, and intra-company loans.If one of these three components is negative and is not offset by positive amounts in theremaining components, the resulting measure of FDI inflows can be negative, indicating30 We include the first-stage regressions in Appendix G31 We ran each model using random effects, controlling for geography and distance from the equator. The resultswere not significantly different from the fixed effects model, so we do not include them here. The maindisadvantage of the fixed effects form, of course, is that we cannot capture the effect of any variation acrosscountries that is not also reflected in the panel data for individual countries.32 We include the Wald Chi-Square statistic rather than R-squared because of its lack of statistical meaning in thecontext of instrumental variables estimation. For a more detailed explanation see (Stata).33 See Appendix C for sources and definitions of variables and Appendix D for summary statistics.34 We re-ran the models using FDI as a percentage of GDP, and the results did not change significantly. This ratio,however, measures changes in the importance of FDI to the overall economy, rather than changes in inflows, themeasure we are interested in, so we retained our ratio of FDI inflows to overall FDI flows in the reported results.We also re-ran the models using FDI as a percentage of world FDI inflows. 16
  18. 18. disinvestment.35 For ease of interpretation, we multiplied the dependent variable by 100 so thatall results can be read as percentages. ii. BITsData on BITs are available from a listing published by UNCTAD that documents the parties toevery bilateral investment treaty, the date of signature, and the date of entry into force. Thesedata are available for every BIT of public record from the first treaty signed in 1959 betweenGermany and Pakistan through December 2000 (UNCTAD 2001). Because of the long-termnature of BITs, we measure our BIT variable as the natural log of the cumulative number of BITssigned by a particular country at the beginning of the time period.36 We take the natural log ofthe total number of BITs signed under the assumption that if BITS are serving as a signal toforeign investors, they are likely to have decreasing returns to scale for attracting investment.We measure the cumulative total at the beginning of the time period rather than the average overthe period, assuming that BITs signed at the beginning of a five-year period will affectsubsequent, but not immediate FDI flows. Finally, we separate out those BITs signed withdeveloped countries from those signed with developing countries and ask if the results differwhen when BITs between two developing countries are excluded. iii. Political RiskWe include political risk as a potential determinant of FDI inflows, theorizing that countries withhigh levels of political risk will attract less investment then those with low levels of risk. Thismeasure serves as our proxy for the domestic investment environment. There are several readilyavailable measures of political risk. For the purpose of cross-sectional comparison across time,we use a measure produced by the International Country Risk Guide (ICRG). Their variable isbased on institutional indicators complied by private international investment risk services. TheICRG political risk index utilizes measures of the risk of expropriation, established mechanismsfor dispute resolution, contract enforcement, government credibility, corruption in government,and quality of bureaucracy. It is measured on a scale from one to 100 (the individualcomponents are available in Appendix A) with higher numbers equating to lower (better) levelsof risk in a country. iv. Market sizeMarket size is universally accepted as the leading determinant of FDI inflows. We use twoproxies that, taken together, indicate the value of investing to serve a country’s market. The firstis the log of GDP per capita (income), and the second is population. Beyond market size, there isgeneral disagreement on the determinants of FDI. Theoretically, the rate of growth of acountry’s economy would seem to be important for attracting FDI, as a fast growing economy inthe present would indicate future development potential (Schneider and Frey 1985). v. Natural resourcesAccording to UNCTAD (2001), the majority of FDI to the least developed countries is throughnatural resource investment. The presence of natural resources in a country is expected to attract35 For more information see the World Investment Directory Website:http://r0.unctad.org/en/subsites/dite/fdistats_files/WID.htm36 Although the results of the analysis do not change substantially if we use ratified BITs rather than signed BITs, webelieve that signed BITs are a more appropriate measure as the time between signature and ratification should, ingeneral, reflect the anticipation of ratification, especially as treaties are retroactively applied to existing investments. 17
  19. 19. foreign investment regardless of other factors that would usually attract or discourage investors.Natural resource endowments are measured through a composite of natural fuels and oresexported from individual countries that is available from the IMF’s International FinancialStatistics Database. However, because we are using a fixed effects formulation we will not beable to capture much of the effect of this variable because it does not change much over time forany individual country.37 vi. InflationWe include the inflation rate as a proxy for macroeconomic stability in a country. We expect theimpact of inflation to be ambiguous. On the one hand, if lending is done in the local currency,unanticipated inflation benefits debtors. On the other hand, high inflation rates may indicatedomestic policy failures that discourage both savings and investment. Regardless of thedirection of causation, macroeconomic stability ought to be an important determinant of foreigninvestment. vii. Other variablesSocial factors such as literacy or health are highly collinear with our measures of market size andgrowth and were therefore excluded from the model. viii. Instruments • Time: Time is included as the square of a time index that is equal to 1 for period 1, 2 for period 2, etc… Periods are measured in five year intervals so the index goes from one to four and is then squared. • Level of democracy: As a measure of democracy we use the ratings from the Polity IV project (Marshall and Jaggers 2000). This measure is the difference between two indices—a negative one for autocratic characteristics, and a positive one for democratic characteristics—each of which is measured on a scale of 0 to 10. Thus the index goes from -10 to 10 .We hypothesize that a host country is more likely to sign BITs the more democratic it is. Because of the fixed effects format, however, we actually measure changes in democratization in countries over time and hypothesize that if a country becomes more democratic, it will be likely to have more BITs in place.Depending on the type of FDI, the level of openness (measured as exports plus imports to GDP)could have a positive or negative impact on a country’s ability to attract FDI. FDI focused onexploiting the local market would be attracted to a country with a less open economy, and FDIfocused on the tradeables sector would be positively related to openness. The opposing nature ofthe theory as well as gaps in the data for our sub-sample of countries led us to exclude opennessfrom our estimation. Furthermore, for some countries the level of openness is not independent ofthe level of FDI, especially if the FDI is directed toward the export market. We also excludeblack market premia from our analysis. Black market premia are a symptom of overvaluation ofnational currencies and thus are likely to relate to lower levels of investment. They are oftenused in empirical evaluations as a proxy for distortions in the financial system. However, in ourcase, the paucity of data reduced our sample size from 65 to 48 countries, necessitating itsexclusion from the analysis. Further variables that could act as determinants of FDI that we37 In the random effects estimates we found that natural resources have a positive but insignificant effect on FDIflows. 18
  20. 20. excluded because of opposing theory or lack of data include the host country’s wage,government consumption, and tax rates. The host country wage has been shown in variousstudies to be both an inducement and a deterrent to FDI based on the type of investment. Forexample, Schneider and Frey (1985) and Pistoresi (2000) found that higher wages tended, onaverage, to discourage FDI, although Caves (1974) and Wheeler and Mody (1992) found apositive association between FDI inflows and the real wage. Tax rates do not let us separate outtax incentives to attract investment from high tax rates that deter FDI.38 Likewise, overallmeasures of government consumption do not permit one to separate out that which types ofspending attract investment and that which are deterrents. DataTo avoid the impact of year-to-year variation caused by the pattern of individual deals, we usefive-year averages for the period 1985 to 2000 for all variables other than BITs, which aremeasured at the beginning of each five-year time period.39 The five-year period was chosenbecause it is unlikely that signing a BIT would cause FDI in a country to immediately increase.Instead, there is likely to be some window on both sides of the signing of the BIT when FDIcould increase as a result of the BIT. Investors may observe negotiations between the host andthe home country and increase FDI under the assumption that the BIT will be signed, in whichcase we might see increased FDI before the BIT is even signed. The more likely case, is thatinvestors observe the signing of the BIT and subsequently decide to invest. In this case, wemight not see investment for some period of time after the signing of the BIT. By looking at 5-year averages, we are able to incorporate both anticipatory investment as well as subsequentinvestment into our analysis. <<Insert Table 1 about here>> <<Insert Table 2 about here>>38 We included measures of taxes on goods and taxes on income available from the IMF’s International FinancialStatistics in both sets of regressions on FDI and private investment. The coefficients were equal to zero and notstatistically significant in any regression. This, in addition to the problems discussed in the text, led us to excludethem from the analyses.39 Although some of our data goes back to 1959, the bulk of the data covers 1975 to 2000. 19
  21. 21. Table 1 FDI and Bilateral Investment Treaties: General Analysis (1985-2000)Dependent Variable: FDI inflows to country/ FDI inflows to all developing countries Base Case 2 3 4 5Log of BITs signed -0.50 -9.20*High Income (0.34) (5.02)Log of BITs signed -0.32 -6.96**All (0.24) (3.43)Natural Log GDP per capita 0.14 0.39 0.23 -2.87 -2.54 (0.81) (0.88) (0.87) (1.80) (1.85)Economic Growth 0.05* 0.05* 0.05** 0.12** 0.12** (0.02) (0.03) (0.03) (0.05) (0.06)Political Risk -0.01 0.01 0.01 -0.13** -0.14* (0.01) (0.02) (0.02) (0.06) (0.07)Risk* 0.11**Log of Total BITs (0.06)Risk* 0.15*Log of High income BITs (0.08)Inflation -0.001** -0.002** -0.002** 0.001 -0.001 (0.0005) (0.0001) (0.001) (0.001) (0.0001)Natural Resources 0.01 0.01 0.01 0.01 0.01 (0.01) (0.01) (0.01) (0.01) (0.01) ** ** ** ** **Natural log Population 0.00002 0.00003 0.00003 0.00003 0.00002 (0.000006) (0.000002) (0.00001) (.00001) (.00001) **Intercept -0.18 -3.93 -2.52 29.92 27.76 (6.26) (7.06) (6.85) (16.94) (17.76)Country N 63 63 63 63 63Wald Chi2 28.32 256.71 245.18 133.72 114.59Prob > Chi2 0.00 0.00 0.00 0.00 0.00Hansen test(P-value) † 0.11 0.12 0.54 0.74**indicates significant at .05 level, *indicates significant at .10 levelHeteroskedasticity consistent standard errors given in parentheses† The null hypothesis is that the instruments are not correlated with the residuals. 20
  22. 22. Table 2 Conditional Effects of BITs on FDI inflows Total High Income Countries in BITs BITs Range (a) (b)Range of Political Risk 0 (high risk) -6.96*** -9.20* (3.43) (5.02) 5 -6.39*** -8.44* (3.15) (4.61) 10 -5.82*** -7.68* (2.88) (4.21) 15 -5.24*** -6.92* (2.60) (3.80) 20 -4.67** -6.17* (2.32) (3.39) 25 -4.10** -5.41* 1 (2.05) (2.98) 30 -3.53** -4.65* 2 (1.77) (2.58) 35 -2.96** -3.89* 7 (1.50) (2.17) 40 -2.39** -3.13* 18 (1.22) (1.76) 45 -1.82* -2.37* 22 (0.95) (1.36) 50 -1.25* -1.61* 30 (0.68) (0.96) 55 -0.68 -0.85 31 (0.42) (0.57) 60 -0.11 -0.09 44 (0.22) (0.26) 65 0.46* 0.67* 23 (0.26) (0.38) 70 1.03** 1.43* 23 (0.49) (0.74) 75 1.60** 2.19* 7 (0.76) (1.14) 80 2.17** 2.95* 3 (1.03) (1.54) 85 2.74** 3.71* (1.30) (1.95) 90 3.31** 4.47* (1.57) (2.35) 95 3.88** 5.23* (1.85) (2.76) 100 (low risk) 4.45** 5.99* (2.12) (3.17)Notes: The dependent variable FDI inflows is equal to FDI inflows to country/FDIinflows to all developing countries over the five years of each period;(Heteroskedasticity-consistent standard errors are in parentheses.)* Significant at 90-percent level.** Significant at 95-percent level.*** Significant at 99-percent level. 21
  23. 23. c. ResultsAll of our models clearly demonstrate the importance of economic growth and population ormarket size for determining FDI. The results are in Table 1. In our base specification, we find apositive and significant relationship between economic growth and FDI inflows, controlling forthe remaining determinants of FDI. Specifically, a one-percent increase in economic growthleads to a 0.03 percent increase in a country’s share of FDI to all developing countries. Thispositive association grows stronger when we include BITs into the specification. Populationalso has a positive and significant effect that holds throughout all of the specifications, though itsimpact is small. Inflation has a negative and significant effect in our base model as well as ourmodels that control for BITs, but the relationship loses significance in the models that accountfor the contingent relationship between political risk and BITs. Natural resources and GDP arenot significant in any of our specifications. Most importantly, political risk and BITs (modeledas either the total number of treaties signed or only looking at those treaties signed with high-income countries) are not significant when included without the contingent relationship.Although it seems counter-intuitive that political risk does not seem to be a determining factorfor investment flows, it is also interesting that BITs by themselves do not determine the flows.One reason for the result might be the lack of variation in this variable within countries overtime. However, the more likely rationale is that as a tool for attracting FDI, BITs do not work inisolation.When we control for the fact that BITs’ effect on FDI inflows may be conditional on the level ofpolitical risk in the country, both variables gain significance. Our discussion of BITs posits thatthe relationship between BITs and FDI should be contingent on the level of political risk in thehost country, so this result is important for our analysis.The coefficient estimates in Table 1 are approximate at best. Table 2 helps one to betterunderstand the interactive effect of BITs and political risk on FDI. It shows the conditionaleffect of both the total number of BITs and the number of high-income BITs signed by the hostcountry at all levels of political risk, with separate coefficient estimates and standard errors foreach level of political risk. These estimates are generated from the coefficient estimates and thevariance-covariance matrices from the regressions in columns (4) and (5) of Table 1. Columns(a) and (b) distinguish between the effects of total BITs and high income BITs alone with thelatter having a slightly stronger effect on FDI inflows. In both cases, BITs have a negative effecton FDI inflows at high levels of political risk and this negative effect grows smaller as a countrybecomes less risky. Column (a), shows that for a country with a very high level of risk, signing aBIT actually decreases their FDI inflows as a percentage of FDI flows to all developingcountries. For example Haiti in the period 1990-1995 had a political risk level of 25, so thataccording to our estimation, for each additional BIT, Haiti’s portion of all developing countryFDI would decrease by 4.1 percent. This negative result remains true through levels of politicalrisk up to 50. After this point, at middle levels of risk, BITs seem to have no effect FDI inflowsuntil risk levels of 65 where the effect turns positive. Thus, a country like Brazil, with a risklevel of 65 in the period 1990-1995, could expect to see each additional BIT increase its portionof developing country FDI by 0.46 percent. At levels of political risk above 65 this positiveassociation continues to increase, but as our data set is focused on developing countries, we havefew observations at such low levels of political risk (and no observations above 81). 22
  24. 24. It does seem questionable that BITs might actually discourage FDI flows. It is more likely thecase that at these high levels of political risk BITs simply have no effect on a country’s ability toattract FDI. It is only once a country achieves some minimally low level of political risk thatBITs may become important for host countries to attract FDI. Nevertheless, this negative sign issignificant, and should be taken into account when encouraging risky countries to sign BITs.Overall, the insignificant effect of BITs on FDI without the interaction with political riskindicates that the effect of BITs on FDI is highly dependent on the level of political risk presentin the host country. Interestingly, this relationship runs counter to the hypothesis that arises fromour discussion of BITs. As a country becomes riskier, BITs do less to encourage FDI inflows. Infact, BITs do not seem to encourage FDI except at low levels of political risk.It is important to contrast these results with the results obtained in other studies of the effect ofBITs on FDI mentioned above. Neumayer and Spess (2004) find that the more BITs a countrysigns, the greater the FDI flows to that country. Their contrasting result could, as the authorspoint out, be a result of the difference in our sample size as well as the extended time period oftheir study. Their study includes 119 countries and goes back as far as 1970; we have only 63countries in our study, and our time period is limited to after 1984 because of the limitedavailability of political risk data. Furthermore, a number of countries (such as Korea, China, andcountries in Central and Eastern Europe) were omitted from our study because of datalimitations, but may be important to a full understanding of the role of BITs. In contrast,however, Neumayer and Spess include a number of very small island countries and that may alsobe skewing their results. It is also unclear how they have dealt with the transition from socialismthat occurred in Europe during the period. This regime change was surely a more importantstructural shift than the signing of BITs and their BITs data may be picking up that phenomenon.More importantly, their use of year-to-year data across such a long time period is likely to skewtheir results. Year-to-year variation in FDI inflows to developing countries, especially smalldeveloping countries, tends to be large, so that averaging over the period appears to a moreappropriate technique.Salacuse and Sullivan (2004) find a strong correlation between US BITs and overall FDI inflowsto a country, but they find that BITs with OECD members have no impact. We have a number ofquestions about their methodology. First, like our criticism of Neumeyer and Spess, the one-yearlag they employ seems too short. Second, by using overall flows instead of shares, they may becompounding time trends with the impact of BITs. Third, fixed country effects may beimportant. We experimented with both a random effects model and a fixed effects model. Thedummy for Latin America had explanatory power in the random effects regression, a region witha number of US BITs. Overall, it is likely that there is omitted variable bias in the Salacuse andSullivan estimates. In this portion of their study the authors do not estimate a fixed effects modeland do not compensate by including country-specific factors that may not change substantiallyfrom year to year. Finally, the different sample composition may have an effect here as well.Our analysis includes 63 countries while they include only 30.To conclude, although we can point to some possible reasons for our differing results comparedto these two studies, clearly, more work is needed to sort out the underlying factors at work.However, according to our results, BITs do not seem to be a strong determinant of FDI, and mayin some cases have a negative effect. Additionally, it could be that in order for BITs to be 23
  25. 25. credible to investors, some minimum level of property rights protection needs to be in place.This suggests that, contrary to the studies summarized above, the total number of BITs signed bya host country does not signal an improved climate for investment, except in cases where theinvestment climate may already be stable. Rather, BITs may only benefit investors fromsignatory countries. Our next step, therefore, is to look at this possibility. C. Bilateral AnalysisOur general analysis investigates how signing BITs affects overall FDI flows into a country. If,as our results indicate above, the total number of BITs signed has little impact on a country’sability to attract overall FDI, it may, nevertheless, be the case that BITs have a more directimpact, that is, they serve to attract FDI from the home country. To explore this directrelationship, we turn to an analysis of US BITs and related outflows of US FDI.a. SpecificationOur bilateral specification for FDI from the United States to host developing countries takes thefollowing form: yit = β 0 + β1b i ,t + β 2 i i ,t + β 3ri ,t + β 4 s i ,t + β 5p i ,t + β 6 g i ,t + β 7 n i ,t + τ t + ηi + vit (3)In this case, we examine the dependent variable (y) in two different ways, first, as total inflowsfrom the US to a given country in a period, and second, as inflows to a country as a percentage ofall US inflows to developing countries. We report the results of both models below. Eachmeasure of (y) , depends upon US BIT, a dummy variable, (b), the log of the average level ofincome of the host country(i), the level of political risk in the host country (r), the degree ofopenness of the host country economy (s), the natural log of the population of the host country(p), economic growth (g), natural resources (n), exchange rate stability (x), the difference in thelevel of education between the host country and the United States (e), time effects (τ), somerandom error (v), and fixed country effects (η). Each of the variables is indexed by country (i)and time period (t). Those variables that differ from the general analysis are described in furtherdetail below.We again wish to test whether the effect of signing a BIT on FDI inflows is dependent on thelevel of institutional risk present in the host country. As in our general analysis, we include anadditional specification that contains a series of interactions between whether a host country hassigned a BIT with the US (b) and political risk (r). Again, as in our general analysis we initiallyestimate equation (3) by OLS. It is possible that the endogeneity problem in our general modelis not a concern in the case of US FDI flows. Blonigen and Davies(2001), in their work onbilateral tax treaties with the US, point out that the U.S. does not limit tax treaties only tocountries that have high FDI activity. Similarly, Appendix F demonstrates that there is littlecorrelation between the levels of inflows of US FDI and the date that BITs are signed. In fact, inmany cases, the US has signed treaties with host countries with very low FDI inflows.Nevertheless, we may still believe that US investors with significant FDI flows in developingcountries may advocate for the US to sign a BIT with that host country. Following Hallward-Driemeier (2003), we instrument for a country having signed a US BIT with the number of BITssigned with other high-income countries in the same time period. As with our general model, we 24
  26. 26. need again to test that the instrument is correlated with the endogenous variable and orthogonalto the error process. The correlation between other high-income BITs and our US BIT variableis 0.31 while its correlation with FDI is 0.08. The F-statistic of all first stage regressions is wellabove the 99-percent confidence level and in no regression do we fail to reject the nullhypothesis or the Hansen test, suggesting the validity of the instrument.Finally, as in our general analysis, each model is run using fixed effects. A Hausmanspecification test again rejected the assumption that the error component from a random effectsmodel was uncorrelated with the error in that model. Thus, our random effects model will beless efficient then our fixed effects model and we feel confident with the results of the fixedeffects model.40b. Variables and Data i. variablesThe most comprehensive source for FDI data is the “U.S. International Transactions AccountsData,” produced yearly by the United States Bureau of Economic Analysis (BEA).41 The datacomprise two broad areas covering all US FDI operations from 1950 through the present. TheBEA reports balance of payments and direct investment data on transactions between US parentsand their foreign affiliates abroad, and financial and operating data covering the foreignoperations of US-based multinational corporations. The BEA’s data generally conform tointernational reporting standards and are available with substantial country and industry detail.Thus, for understanding the bilateral relationship between FDI inflows and BITs, the BEA datawould seem ideal. According to the UNCTAD database on FDI, US-based MNCs accounted fortwelve percent of outward world FDI flows in 2000 and 21 per cent of FDI outward stock.Further, more than half of U.S. FDI is directed towards the European Union. Nevertheless, thebreadth and quality of the BEA data give a strong indication of the relationship between US BITsand US FDI flows (Quijano 1990; Mataloni 1995; Lipsey 2001; UNCTAD 2001).We measure FDI flows in two ways. First, as net capital outflows from the United States inmillions of US dollars. In this case, we are interested in changes in overall US capital stock as aresult of signing a BIT with the US. In other words, we care only about how signing a BIT withthe US affects US FDI flows to that specific country. FDI flows are the best indicator of yearlychanges in US capital stock in our countries of interest. Second, we measure FDI flows asoutflows from the United States as a percentage of all US outflows to developing countries. Inthis case, we are able to control for the possibility that signing a BIT may divert flows away fromother developing countries. This way we are able to observe how a country’s fraction of US-developing country FDI changes based on the signing of a BIT with the US.40 We ran each model using random effects, controlling for distance of the capital of each host country fromWashington, DC, as well as continent dummies.41 The BEA’s U.S. International Transactions Accounts Data are available on line for interactive analysis at:http://www.bea.doc.gov/bea/di/di1fdibal.htm 25
  27. 27. Our BIT variable is a dummy equal to 1 in the year that a BIT was signed between the hostcountry and the US and each year thereafter and a 0 in each year that there is no BIT with theUS.42In addition to the variables used in the general analysis, we include a measure of exchange ratestability of the host country, as well a variable to measure the difference in average years ofschooling between the US and the host country to proxy for skill differences between the hostand investing country. Theoretical analysis posits that the greater the difference in skill levelbetween countries, the lower the level of investment (Carr, Markusen et al. 2002). Specifically,we use the difference in total mean years of education between the United States and the hostcountry as our measure of skill difference. Of course, because of our fixed effects formulationthis variable wil only matter if some there have been changes over time in this variable.Theoretically, exchange rate levels and stability have an important influence on FDI flows, buttheir impact is ambiguous. Exchange rate stability could increase investment in low productivityinvestment or investment for production in the local market while decreasing investment inindustries with high entry costs or investment tended for re-export (Bénassy-Quéré, Fontagné etal. 1999).43 ii. DataAgain, as in our general analysis, we would like to avoid the impact of year-to year variation inFDI flows as well as to create a window around the signing of the treaty to include anticipatoryand subsequent investment inflows. Data limitations necessitated three-year averages rather thanthe five-year averages that we used in our general analysis44. To account for FDI reflecting pastlevels of income and economic growth, our models lag all of our economic variables to accountfor greater changes over time.45 <<Insert Table 3 about here>> <<Insert Table 4 about here>> <<Insert Table 5 about here>>42 Of course this is only true of the BIT variable in the OLS regressions. In our 2SLS regressions, the BIT variableis equal to the fitted values obtained from the first-stage regression.43 In our pooled analysis, we include a measure of distance between the US and the host country government.Distance serves as a proxy for the transport and trade costs that affect the firm’s decision to invest, and thus weassume that the greater the distance between a host country and the US, the lower the probability of US investment.44 Differences between 3-year averages and 5-year averages were insignificant for the results of the analyses.45 Differences between lagged and non-lagged models were insignificant in all analyses. 26
  28. 28. Table 3 FDI and Bilateral Investment Treaties: Bilateral Relationship with the United States (1980-2000)Dependent Variable: US FDI outflows to host country in thousands ofconstant US dollars OLS 2SLS Base Case Equation 3 Equation 4 Equation 3 Equation 4BIT signed withUS -122.20 241.84 -117.07 2089.07 (147.43) (376.39) (496.84) (14980.14)Ln GDP per capita 315.78* 322.07* 322.76* 321.79* 320.74* (174.33) (177.63) (177.33) (178.76) (179.85)Political Risk 1.72 0.74 2.08 0.77 9.34 (4.83) (4.51) (5.55) (4.85) (59.64)Risk* -6.90 -39.93US BIT (8.94) (267.83)Growth -247.47 -217.81 -251.76 -219.06 -439.50 (533.78) (507.86) (543.52) (465.81) (1520.89)Population 0.0007** 0.0007** 0.0007** 0.0007** 0.0007** (0.0003) (0.0003) (0.0003) (0.0003) (0.0003)Natural Resources -0.66 -0.83 -0.79 -0.82 -0.47 (2.31) (2.45) (2.42) (2.64) (2.11)Openness -2.74 -2.86 -2.85 -2.86 -2.74 (1.85) (1.92) (1.92) (2.05) (0.46)Exchange Rate -0.46* -0.45* -0.46* -0.45* -0.50Stability (0.26) (0.27) (0.26) (0.28) (0.46)Skill Difference 30.40 31.33 31.54 31.26 31.76 (67.99) (68.41) (68.20) (67.64) (66.37)Time Counter 33.38*** 37.11*** 36.96*** 36.98** 33.06 (9.34) (11.86) (11.79) (19.01) (34.81)Intercept -68704.85*** -76110.23*** -75882.82*** -75853.71** -68526.69 (19762.88) (24863.12) (24746.73) (38450.62) (67254.15)Country N 54 54 54 54 54Wald Chi2 79.20 76.50 84.26 76.60 92.07Prob > Chi2 0.00 0.00 0.00 0.00 0.00Hansen test (P-value) 0.91 0.99†**indicates significant at .05 level, *indicates significant at .10 levelHeteroskedasticity consistent standard errors given in parentheses† The null hypothesis is that the instruments are not correlated with the residuals. 27
  29. 29. Table 4 FDI and Bilateral Investment Treaties: Bilateral Relationship with the United States (1980-2000)Dependent Variable: US FDI outflows to host country/ Total US FDI outflows to developing countries OLS 2SLS Base Case Equation 3 Equation 4 Equation 3 Equation 4BIT signed with US -0.36 2.05 -1.24 -5.54 0.62 1.77 2.26 64.87Ln GDP per capita 1.20* 1.22* 1.23* 1.27* 1.24* 0.68 0.70 0.69 0.70 0.73Political Risk 0.02 0.02 0.02 0.01 0.00 0.03 0.03 0.03 0.02 0.26Risk* -0.05 0.09US BIT 0.04 1.16Growth -1.46 -1.37 -1.60 -1.16 -0.82 2.47 2.38 2.53 2.09 6.81Population 0.000003** 0.000003** 0.000003** 0.000003** 0.000003** 0.000001 0.000001 0.000001 0.000001 0.000001Natural Resources -0.002 -0.002 -0.002 -0.004 -0.003 0.009 0.010 0.010 0.011 0.015Openness -0.01 -0.01 -0.01 -0.01 -0.01 0.01 0.01 0.01 0.01 0.01Exchange RateStability -0.01*** -0.01*** -0.01*** -0.01*** -0.01*** 0.00 0.00 0.00 0.00 0.00Skill Difference 0.10 0.10 0.10 0.11 0.10 0.28 0.28 0.28 0.28 0.28Time Counter 0.09** 0.10** 0.10** 0.13* 0.11 0.04 0.04 0.04 0.07 0.15Intercept -188.17** -210.27** -208.76** -260.67* -236.62 77.70 91.96 91.45 137.75 289.80Country N 54 54 54 54 54Wald Chi2 97.65 107.50 111.54 87.4 81.18Prob > Chi2 0.00 0.00 0.00 0.00 0.00Hansen test(P-value) † 0.89 0.75**indicates significant at .05 level, *indicates significant at .10 levelHeteroskedasticity consistent standard errors given in parentheses† The null hypothesis is that the instruments are not correlated with the residuals. 28