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Bilateral investment treaties as deterrents of host-country discretion: the impact of investor-state disputes on foreign direct investment in developing countries

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Abstract

The recent boom of investor-state disputes filed under international investment agreements has fueled a controversial academic and policy debate. We study the impact of these compensation claims on foreign direct investment (FDI) flows to the responding host country. Our econometric analysis focuses on differences in the FDI response from BIT-partner and non-partner countries of developing host countries. This approach allows us not only to distinguish competing hypotheses about BIT function, but also to address endogeneity concerns in earlier studies. We find that BITs stimulate bilateral FDI flows from partner countries—but only so long as the developing host country has not had a claim brought against it to arbitration. Our results provide an additional explanation for the policy-changes observed in many states subsequent to their first experience of an investor-state dispute.

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Fig. 1

Source: http://investmentpolicyhub.unctad.org/isds/filterbyCountry (accessed: September 14, 2016); World Development Indicators

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Notes

  1. See the contributions to the volume edited by Sauvant and Sachs (2009). More recent papers include Busse et al. (2010), Tobin and Rose-Ackerman (2011), Berger et al. (2011, 2013), Egger and Merlo (2012), and Büthe and Milner (2014).

  2. Note that we use the terms ‘disputes’ and ‘claims’ interchangeably in the following to indicate instances in which an investor brings a claim for compensation for alleged violation of a treaty’s provisions to formal ISDS.

  3. Traditionally, relatively few claims were raised against respondent states with high per-capita income. UNCTAD’s database on ISDS lists just 78 claims against high income states up to 2010, accounting for less than 20% of all claims until recently. However, this share increased to about 30% in subsequent years. The most prominent recent example among high income respondent states is Spain which faced 33 claims since 2011.

  4. It remains open to question, however, whether and through which mechanisms FDI in advanced host countries will be affected by the recent increase in the number of disputes with such hosts. This issue is taken up again by performing complementary estimations in Sect. 4.

  5. We were unable to reproduce this aspect of Wellhausen’s findings. While we can only surmise the source of this discrepancy, it is possible that Wellhausen’s results were driven by her choice of transformation of the dependent variable.

  6. For details on this case see: https://icsid.worldbank.org/ICSID/FrontServlet?requestType=CasesRH&actionVal=showDoc&docId=DC2551_En&caseId=C661; bilateral FDI stock data are from UNCTAD.

  7. CAFTA stands for Central American Free Trade Agreement.

  8. See for example Allee and Peinhardt (2011), Jandhyala and Weiner (2014), Wellhausen (2015).

  9. This includes the ability for the investor to extract higher compensation from the host through settlement or negotiation due to the threat of bringing a case to ISDS.

  10. As we explain in more detail below, we also consider high income host countries by performing complementary regressions in Sect. 4.

  11. Indeed, there is also substantial debate about whether BITs attract FDI at all. In addition to the mixed findings in the empirical literature linking BIT participation to increased FDI flows, surveys have shown that many investors were not aware of BITs or their potential (Yackee 2010; Skovgaard Poulsen 2015). Thus the theories about investor response presented here apply to that portion of investors (or their legal counsel) who were informed about BITs.

  12. Proponents of the “BITs as signals” hypothesis argue that studies which examine the impact of BIT participation on the basis of bilateral FDI inflows underestimate the effectiveness of BITs by ignoring the host country’s “willingness to protect all foreign investment” (Neumayer and Spess 2005: 1572). However, assessing the “BITs as signals” hypothesis on the basis of aggregate FDI inflows is likely to overstate the effectiveness of BITs unless the endogeneity of BIT formation is taken into account. As we explain in more detail in Sect. 3 below, the use of bilateral FDI inflows renders it easier to mitigate endogeneity concerns.

  13. If this causal effect is significant relative to other sources of variation in the data, it should be possible to use bilateral FDI data to identify the effect of BIT coming into force even once host-year effects are controlled for. The belief that the case for a causal impact of BITs on FDI flows rests on the identification of greater response from the partner country is one of the reasons that bilateral (c.f. host-level) FDI data dominates the economics literature on the impacts of BITs.

  14. Jandhyala and Weiner (2014) are an important exception. They outline similar mechanisms to those explained here, but are not interested in determining which has the most impact on investor behavior.

  15. The effectiveness of various post-establishment obligations (e.g., lawful expropriation, minimum standard of treatment, transfer of funds) depends to a great extent on strict and binding ISDS provisions.

  16. See for example Miceli (1991) for the classic expropriation of land case and Markusen (2001) and Aisbett et al. (2010) for models specifically designed for the case of international investment agreements.

  17. A review of arbitration decisions by UNCTAD (2008: XXV) revealed that “less than half of the awards rendered favored the claimant, and that damages awarded were considerably smaller than the total claims made by investors.”

  18. The ‘quiet life’ terminology comes from Hicks (1935). See Bertrand and Mullainathan (2003) for a seminal contribution to the recent empirical evidence supporting Hicks’ claim.

  19. Once a developing country improves its investment climate, it will also be more likely to participate in BITs. Consequently, it is hard for the econometrician to distinguish to what extent any resulting increase in FDI flows is due to the improved investment conditions, or due to BIT participation. The lack of adequate and valid instruments renders it still more difficult to establish causal effects of BITs on (aggregate) FDI inflows. See Berger et al. (2013) for a short account of previous attempts to address endogeneity concerns in the literature on BITs and FDI. Kerner (2009) uses BITs signed by the source partner with neighboring hosts as an instrument for BIT formation. This instrument is, however, problematic due to the strong evidence of spatial correlation in FDI flows. Neumayer and Spess (2005) and Allee and Peinhardt (2011) take an even more minimalist approach to the problem by lagging explanatory variables one period.

  20. See middle of page 5 and top of page 7 of Pence (2006). On page 6 Pence (2006) also shows how marginal effects can be calculated based on values of the IHS transformed variable.

  21. Our most conservative specification includes dyad, host-year and source-year fixed effects. Thus any country-pairs that never report non-zero flows, any host-years and any source-years in which there are no reported flows are dropped from the regression. This decreases the proportion of zero or missing flows which are relevant for identification of the variables of interest.

  22. This variable is set equal to 1 if there is a BIT in force and a claim against the host, and the date of first claim against the host is equal to or later than the date of entry of the BIT into force.

  23. This variable is set equal to 1 if there is a BIT in force and a claim against the host, and the date of first claim against the host is earlier than the date of entry of the BIT into force.

  24. Recall that both H2a and H3a predict similarly strong reactions of FDI from partner and non-partner countries to BIT signing.

  25. In contrast, the effects of BIT-related claims on FDI flows are no longer statistically significant when considering high income host countries (see Sect. 4 for details).

  26. See Appendix 2 for exact definitions and data sources for all variables. Descriptive statistics can be found in Appendix 3.

  27. The FDI data for financial offshore centers are highly likely to be biased. We exclude all countries that are on the list of offshore financial centers as reported by Eurostat (2005).

  28. See Appendices 4 and 5 for the source and host country samples.

  29. More precisely, we excluded host countries which were classified as “high-income” according to the World Bank’s World Development Indicators for more than half our sample period.

  30. We are grateful to an anonymous reviewer for having alerted us to sample selection problems. On the other hand, the problem of “inappropriate pooling”, stressed by Blonigen and Wang (2005) with regard to widely varying economic growth effects of FDI in developing versus developed host countries, may be relevant in the present context, too.

  31. Recall the fundamental endogeneity problem is that as a host improves its investment climate we would expect to see increased BIT participation and increased FDI inflows, without the BIT participation necessarily being the cause of the FDI growth.

  32. Specifically, neither the sum of the coefficients for BIT in force and Claim with BIT in force, nor the sum of the coefficients for BIT in force and BIT after claim is positive. A Wald test of the constraint BIT-in force ijt + Claim with BIT ijt  = 0 has a p value of 0.22 and the corresponding value for the constraint BIT in force ijt + BIT after claim ijt  = 0 is 0.36. Thus, if anything, the sums suggest a slight (though statistically insignificant) negative net impact of BITs for hosts which have faced claims.

  33. The magnitude of each of the variables is, however, somewhat diminished. This is consistent with the idea that controlling for host-year effects reduces endogeneity bias. For example Aisbett (2009) has argued that developing host countries which have increasing FDI inflows are more likely to form BITs. Similarly, in the current paper we have argued that claims against developing host countries are likely to be associated with general decreases in FDI flows due to a worsening investment climate.

  34. The coefficient on BIT after claim even proves to be significantly positive in column (3), though just marginally at the 10% level. While not the focus of the current study, the combination of the above results for the high income host sample and the slight negative net impact for non-high income countries of BITs which are signed after there has been a claim may actually point to something systematic. Specifically, one of the functions of BITs is to improve the ease of repatriating assets and profits to the home country. It could be that this effect is showing up in the FDI data.

  35. The coefficients of BIT in force and BIT after claim change together in such a way that the net impact of a BIT coming into force is slightly negative, as it was for the base sample which includes post-socialist countries.

  36. Such models have become popular in the health economics literature (e.g., Buntin and Zaslavsky 2004; Mullahy 1998).

  37. The difference is that instead of showing the impact on FDI flows from protected investors of the first claim against the host, the new interaction term shows the average impact per claim of the cumulative number of claims against the host.

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Acknowledgements

Thanks to Maximillian Mantei for excellent research assistance and to participants at the DIE conference on The Political Economy of International Investment Agreements and anonymous reviewers for helpful comments and feedback. All remaining errors are the authors.

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Correspondence to Emma Aisbett.

Appendices

Appendix 1: Calculation of relative effects

The calculation of marginal effects and marginal elasticities from the coefficients of models linear in the inverse hyperbolic sine (IHS) transformation has been well described in Pence (2006). Since our variables of interest are (0,1) dummies, we are not interested in marginal effects, but rather the relative change in FDI flows associated with a change in a dummy variable(s) from zero to one (Halvorsen and Palmquist, 1980). Denote the FDI flow when the dummy variable(s) take(s) the value zero as y 0 , and the corresponding flow when the dummies are one as y 1 . We wish to calculate the estimated proportional change (also called relative effect), (y 1  − y 0)/y 0.

Consider a general estimating equation linear in the IHS transformation (with the scaling variable ϴ set equal to one as in our case), with dummy variable (D) whose relative effect we wish to calculate.

$${\text{IHS}}\left( y \right) = {\text{X}}\upbeta + {\text{D}}\upalpha$$

It is easy to see that

$${\text{IHS}}\left( {y_{0} } \right) = {\text{X}}\upbeta\;{\text{and}}\;{\text{IHS}}\left( {y_{1} } \right) = {\text{X}}\upbeta + {\text{D}}\upalpha$$

To ease exposition, define w ≡ y + (y 2 + 1)1/2, then, from the definition of the IHS function, IHS(y) = ln(w).

Substituting into the estimating equation and exponentiating we have:

$$\exp \left( {{\upalpha }} \right) - 1 = \frac{{w_{1} - w_{0} }}{{w_{0} }}$$

Substituting for w and rearranging gives

$$\exp \left( {{\upalpha }} \right) - 1 = \frac{{y_{1} - y_{0} }}{{y_{0} }} \cdot \underbrace {{\frac{{y_{0} }}{{y_{0} + \left( {1 + y_{0}^{2} } \right)^{{\frac{1}{2}}} }} \cdot \frac{{\left( {y_{0} - y_{1} + \left( {1 + y_{0}^{2} } \right)^{{\frac{1}{2}}} - \left( {1 + y_{1}^{2} } \right)^{{\frac{1}{2}}} } \right)}}{{y_{0} - y_{1} }}}}_{C}$$
(1)

Thus the relative effect of the dummy variable can be calculated from

$$\frac{{y_{1} - y_{0} }}{{y_{0} }} = \frac{{\exp \left( {{\upalpha }} \right) - 1}}{c}$$
(2)

where c is as defined in Eq. 1 and \({{\upalpha }}\) is the regression coefficient on the dummy variable of interest. Note that c approaches 1 quickly as \(y_{0}\) grows in absolute value. Already with \({y_{0} } = 100\), c equals 1 to 5 decimal places for any \({{\upalpha }}\) between minus one and one. Hence the relative effect can confidently be approximated by \(\exp \left( {{\upalpha }} \right) - 1\) in most economically relevant cases. By symmetry of the IHS function relative effect can be shown to approximate closely exp(-α)-1 for y0 < −100.

The exact solution to Eq. 2 can be found fairly easily by iteration. For illustrative purposes, Tables 7, 8, 9 and 10 show example correspondence values in the range relevant to our study. Note the symmetry of the IHS transformation means that the values in Table 7 are identical to those in Table 10; and those in Table 8 to those in Table 9.

Table 7 Relative effect as a function of \(y_{0}\) and \({{\upalpha }}\)
Table 8 Relative effect as a function of \(y_{0}\) and \({{\upalpha }}\)
Table 9 Relative effect as a function of \(y_{0}\) and \({{\upalpha }}\)
Table 10 Relative effect as a function of \(y_{0}\) and \({{\upalpha }}\)

Appendix 2: Definition of variables and data sources

Variable

Definition

Source

FDI

Bilateral FDI flows from source to host country in current (1000) US$

UNCTAD (2014a)

IHS of FDI

The inverse hyperbolic sine transformation of FDI is given by \({ \log }\left( {FDI + \left( {FDI^{2} + 1} \right)^{1/2} } \right)\)

Own calculation

BIT in force

Dummy variable, set equal to one in the case of a bilateral investment treaty in force between source and host country

UNCTAD (2014b)

Claim against host

Dummy variable, set equal to one in the case a claim has been brought against the host

World Bank (2015)

BIT after claim

Dummy variable, set equal to one if there is a BIT in force and a claim against the host, and the date of first claim against the host is earlier than the date of entry of the BIT into force

Own calculation

Claim with BIT in force

Dummy variable, set equal to one if there is a BIT in force and a claim against the host, and the date of first claim against the host is equal to or later than the date of entry of the BIT into force

Own calculation

PTA

Dummy variable, set equal to one if there is any preferential trade agreement between host and source country

World Trade Organization (2015)

DTT

Dummy variable, set equal to one if there is any double taxation treaty ratified between host and source country

UNCTAD (2015b)

Host total BITs

Total number of bilateral investment treaties the host participates in

Own calculation

Host Log of GDP

Log of host country GDP in current US$

World Bank (2014), data for ARG and TWN from Penn World Table 8.0

Host Exch. Rate

Host country official exchange rate (LCU per US$, period average)

World Bank (2014), data for TWN, TKM and UZB from Penn World Table 8.0

Host Openness

Host country merchandise trade (% of GDP)

World Bank (2014)

Host Inflation

Host country GDP deflator (base year varies by country)

World Bank (2014)

Source Log of GDP

Log of source country GDP in current US$

World Bank (2014), data for ARG from Penn World Table 8.0

Annual claims against host

Number of claims against host country in given year

Own calculation

Cumulative claims against host

Total number of claims that have been brought against host country up to and including the given year

Own calculation

Source annual claims against host

Number of claims against host country in given year brought by investors from the source country

Own calculation

Source cumulative claims against host

Total number of claims that has been brought against host country up to and including the given year by investors from the source country

Own calculation

Appendix 3: Descriptive statistics

Variable

Obs.

Mean

SD

Min

Max

IHS of FDI

60,572

1.39

4.87

−16.88

17.57

BIT in force

60,572

0.25

0.43

0

1

Claim against host

60,572

0.20

0.40

0

1

BIT after claim

60,572

0.02

0.14

0

1

Claim with BIT in force

60,572

0.10

0.30

0

1

PTA

60,572

0.15

0.35

0

1

DTT

60,572

0.26

0.44

0

1

Host total BITs

60,572

17.6

18.1

0

100

Host Log of GDP

60,028

23.74

1.76

18.99

29.74

Host Exch. Rate

59,834

520.83

1939.59

9.33e−12

20,828

Host Openness

58,894

60.28

31.09

5.00

203.04

Host Inflation

59,129

209.53

416.82

1.75e−12

4004.39

Source Log of GDP

60,495

26.64

1.45

22.44

30.42

Annual claims against host

60,572

0.11

0.67

0

21

Cumulative claims against host

60,572

0.76

3.39

0

48

Source annual claims against host

60,572

0.0035

0.08

0

6

Source cumulative claims against host

60,572

0.03

0.34

0

17

Appendix 4: Source country sample

Argentina (19922010), Australia (1992–2010), Austria (1985–2010), Belgium (2002–2010), Brazil (19922010), Canada (1980–2010), Chile (1992–2010), China (20032010), Colombia (19922010), Denmark (1985–2010), Finland (1985–2010), France (1986–2010), Germany (1980–2010), Greece (2003–2010), Iceland (1988–2010), Ireland (2001–2010), Israel (2001–2010), Italy (2001–2010), Japan (1980–2010), Republic of Korea (1990–2010), Luxembourg (2002–2010), Malaysia (19802010), Mexico (19902010), Netherlands (1982–2010), New Zealand (1980–2010), Norway (1986–2010), Poland (1996–2010), Portugal (1990–2010), Russia (2007–2010), South Africa (20012010), Spain (1992–2010), Sweden (1982–2010), Switzerland (1993–2010), Chinese Taipei (1980–2010), Thailand (19802010), Turkey (20002010), United Kingdom (1985–2010), United States (1982–2010), Venezuela (19902010)

  1. Developing source countries in italics (World Bank (2014) classification). In brackets: time span over which FDI data are available for the particular source country

Appendix 5: Host country sample

Albania, Algeria, Angola, Argentina, Armenia, Azerbaijan, Bangladesh, Bolivia, Botswana, Brazil, Bulgaria, Burkina Faso, Burundi, Cameroon, China, Colombia, Democratic Republic of Congo, Republic of Congo, Costa Rica, Côte d’Ivoire, Dominican Republic, Ecuador, Egypt, El Salvador, Ethiopia, Gambia, Georgia, Ghana, Guatemala, Guinea, Guyana, Haiti, Honduras, Hungary, India, Indonesia, Jordan, Kazakhstan, Kenya, Kyrgyzstan, Macedonia, Madagascar, Malaysia, Mali, Mauritius, Mexico, Moldova, Mongolia, Morocco, Mozambique, Namibia, Nicaragua, Niger, Nigeria, Pakistan, Papua New Guinea, Paraguay, Peru, Philippines, Romania, Rwanda, Senegal, Seychelles, South Africa, Sri Lanka, Sudan, Swaziland, Syria, Taiwan, Tanzania, Thailand, Togo, Tunisia, Turkey, Turkmenistan, Uganda, Ukraine, Uruguay, Uzbekistan, Venezuela, Vietnam, Zambia, Zimbabwe

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Aisbett, E., Busse, M. & Nunnenkamp, P. Bilateral investment treaties as deterrents of host-country discretion: the impact of investor-state disputes on foreign direct investment in developing countries. Rev World Econ 154, 119–155 (2018). https://doi.org/10.1007/s10290-017-0285-1

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