North‐South foreign direct investment and bilateral investment treaties

• DOI: http://doi.org/10.1111/twec.12539
• Date: 01 January 2018
• Author: Rod Falvey,Neil Foster‐McGregor
• Published date: 01 January 2018

ORIGINAL ARTICLE

North-South foreign direct investment and bilateral

investment treaties

Rod Falvey

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Neil Foster-McGregor

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Bond University, Gold Coast, Qld, Australia

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United Nations University-Maastricht Economic and social Research institute on Innovation and Technology,

Maastricht, Limburg, The Netherlands

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INTRODUCTION

The last 30 years have seen a proliferation of international bilateral or plurilateral agreements cov-

ering the flows of trade, investment and people. While the scope of Preferential Trade Agreements

(PTAs) tends to be the widest, with currently around 300 PTAs in force and each PTA having an

average of around 12 members (see WTO, 2011), Bilateral investment treaties (BITs) have also

increased in popularity. At the end of the 1960s, there were only 75 BITs in force. Thi s increased

to 167 by the end of the 1970s, and 389 by the end of the 1980s. Today, there are 2,954 BITs in

existence, with 2,319 in force, and 362 other investment agreements (with 293 in force).

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Invest-

ment agreements have become an important policy tool with many proposed deep PTAs including

an investment chapter (e.g., the Trans-Atlantic Trade and Investment Partnership (TTIP), EU-

Canada, EU-India).

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Understanding their impact both on foreign direct investment (FDI) flows and

on economic performance more generally is therefore an important issue.

The aim of BITs is to encourage flows of FDI from generally high-income suppliers to lower-

income recipients. FDI is expected to benefit host countries through a number of channels. In addi-

tion to the inflow of capital, FDI is often accompanied by the movement of firm-specific assets such

as technology, managerial ability, corporate governance and access to networks connecting foreign

markets. FDI is also expected to encourage competition among domestic firms, hopefully increasing

efficiency. Spillovers from FDI may also be expected through the leakage of proprietary knowledge

(see G€

org and Greenaway, 2004 for a review). These potential gains from FDI lie behind the deci-

sion of policymakers in developing countries to sign BITs, despite such agreements impinging on

their national sovereignty (Elkins, Guzman, & Simmons, 2004; Guzman, 1998; Neumayer, 2005).

The benefits from signing BITs for the source countries—and source country firms in particular

—arise because BITs guarantee certain levels of treatment for foreign investors. These include

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http://investmentpolicyhub.unctad.org/IIA, accessed on 12 July 2016.

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Some countries however have recently taken a more negative attitude to BITs and to the dispute mechanism within BITs

more specifically, with Indonesia for example looking to cancel all of its BITs (https://next.ft.com/content/3755c1b2-b4e2-

11e3-af92-00144feabdc0).

DOI: 10.1111/twec.12539

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©2017 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/twec World Econ. 2018;41:2–28.

most-favoured country treatment, fair and equitable treatment for foreign investors, and the free

transfer and repatriation of capital and profits (Dolzer & Stevens, 1995; UNCTAD, 1998). Most

controversially, BIT parties agree to be bound by dispute settlement provisions that are intended to

ensure basic requirements of credible protection of property and contract rights, but which often

result in foreign investors being granted greater security and better treatment than domestic inves-

tors (Vandevelde, 1998).

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The investor settlement procedure potentially involves considerable inter-

ference in domestic policy, with practically any public policy being subject to challenge.

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For

individual hosts, there are likely to be benefits from being able to provide credible commitments

to investors, which can lead to a competitive advantage as long as not all potential hosts have

signed such treaties. The costs of BITs can generally be justified if the outcome of the BIT is to

increase FDI inflows, and if these FDI inflows provide the benefits discussed above.

The extent to which BITs actually encourage inward FDI is an empirical question. Empirical

research addressing the impact of BITs on FDI flows

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generally adopts one of two approaches.

Some studies explain bilateral flows of FDI, usually estimating a gravity-type equation and includ-

ing as one of its arguments a dummy variable for country-pairs that have a BIT. Others move

away from a bilateral focus and examine whether countries that sign BITs see an increase in aggre-

gate FDI inflows. While, in principle, BITs only protect investors from the signatory states to

whom binding commitments have been made, their existence may also signal to potential investors

elsewhere that this host country protects the interests of foreign investors more generally. If this is

the case, then BITs encourage FDI inflows from both BIT partners and non-BIT sources.

An example of the bilateral approach is Hallward-Driemeier (2003), who considers bilateral FDI

flows from 20 OECD countries to 31 developing countries over the period 1980–2000. Controlling

for country size and other country-specific factors, she finds no direct evidence that the existence of

a BIT between a developed and a developing country increases the flow of FDI to the latter. If inter-

actions between the BIT dummy and measures of institutional quality are included, however, the esti-

mated coefficients are positive and often significant, a result implying that BITs are complementary

to institutional quality. Perhaps BITs might seem credible in an environment of good institutional

quality. Alternatively, as noted earlier, BITs might substitute for host institutional quali ty by provid-

ing a certain standard of treatment to foreign investors where domestic institutions fail to do so.

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An example of the aggregate approach is Tobin and Rose-Ackerman (2005) who examine

5 year averages of aggregate FDI inflows for 63 countries over the period 1980–2000. They find

that a higher number of BITs (either in total or signed with a high-income country) lowers the

share of global FDI a high-risk country receives, but raises the FDI share for low-risk countries,

results consistent with a complementary relationship between BITs and institutional quality. Neu-

mayer and Spess (2005) follow a similar approach, using aggregate FDI inflows to individual

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Through this mechanism foreign investors can avoid national legal systems, opting instead for international arbitration,

where they can choose one of the three panellists, and where consensus is required for one of the other two (Elkins et al.,

2004). Recently, there has been a strong increase in the number of arbitration cases (Bellak, 2013) and the presence of inter-

national arbitrage clauses has caused concern amongst citizens in the EU regarding the proposed TTIP agreement.

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Evidence of this is the use of investor-state dispute settlement provisions by tobacco companies in response to cigarette

packaging laws.

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The literature studying the effects of international agreements tends to be skewed towards studies of PTAs. Cipollina and

Salvatici (2010) in their meta-analysis of PTAs include 85 studies, whereas Bellak (2013) in his more recent meta-analysis

of the effects of BITs includes estimates from just 33 studies.

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Related to the notion of heterogeneous effects of BITs, Salacuse and Sullivan (2005) also use bilateral FDI data and find

that signing a BIT with the US is associated with significantly higher FDI inflows, but that signing a BIT with another

OECD country has an insignificant impact on FDI inflows.

FALVEY AND FOSTER-MCGREGOR

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