Why Should I Believe You? The Costs and Consequences of Bilateral Investment Treaties

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1 International Studies Quarterly (2009) 53, Why Should I Believe You? The Costs and Consequences of Bilateral Investment Treaties Andrew Kerner Emory University Bilateral Investment Treaties (BITs) are the primary legal mechanism protecting foreign direct investment (FDI) around the world. BITs are thought to encourage FDI by establishing a broad set of investor s rights and by allowing investors to sue a host state in an international tribunal if these rights are violated. Perhaps surprisingly, the empirical literature connecting BITs to FDI flows has produced conflicting results. Some papers have found that BITs attract FDI, while others have found no relationship or even that BITs repel FDI. I suggest in this paper that these results stem from statistical models that do not fully capture the causal mechanisms that link BITs to FDI. Extant literature has often suggested that BITs may encourage investment from both protected and unprotected investors, yet the literature has not allowed for a full evaluation of this claim. This paper explores the theoretical underpinnings and empirical implications of an institution that works in these direct and indirect ways, and offers a statistical test that is capable of distinguishing between the two. The results indicate that: (1) BITs attract significant amounts of investment; (2) BITs attract this investment from protected and unprotected investors; and (3) these results are obscured by endogeneity unless corrected for in the statistical model. One of the most striking aspects of recent financial globalization has been the proliferation of Bilateral Investment Treaties (BITs). BITs are interstate agreements designed to protect foreign direct investment (FDI) by establishing a broad set of investors rights and, in most cases, by allowing investors to sue host states in an international tribunal if these rights are violated. Over 2,000 BITs have been ratified, including treaties ratified by every OECD country and the vast majority of developing countries (UNCTAD 2005). 1 In recent years BITs have been justified and embraced on the grounds that, by protecting FDI, they encourage capital flows into signatory countries (UNCTAD 1998). But do BITs actually increase FDI inflows? If so, how is this achieved? Author s note: The author can be reached via at The author would like to thank the editors and three anonymous reviewers, as well as Terrence Chapman, Mark Hallerberg, Yoram Hoftel, Jeff Kucik, Lisa Martin, Eric Reinhardt, Scott Wolford, Jason Yackee, seminar participants at Emory University, and participants at the 2007 International Studies Association Conference for their comments and suggestions. A replication data set and is available at and the ISQ Dataverse Network page at 1 The mean number of BITs in force per country was roughly 15 in 2005, which was up from roughly 6.5 in 1995 and 1.5 in Ó 2009 International Studies Association

2 74 Bilateral Investment Treaties Commonly used theories in international relations make different predictions on this matter. Realist arguments, notably those of Downs, Rocke, and Barsoom (1996), contend that international treaties are shallow in the sense that they make formal commitments to actions that would take place regardless of treaty obligations. Alternatively, institutionalist arguments suggest that international agreements can be designed to alter future state behavior (e.g., Abbott and Snidal 2000; Keohane 1984; Simmons 2000). Naturally, and importantly for the purposes of this paper, these two theoretical paradigms make different predictions for the effects of BITs on FDI inflows. The institutionalist paradigm suggests that if BITs are effective, it is because they present significant ex post costs to signatory states that violate the agreement. It follows that we should look for evidence of BITs effectiveness in the behavior of investors from signatory states. For realists, if BITs work at all, they work by identifying cooperative states. In order for BITs to be effective identifiers, there needs to be significant ex ante costs to ratifying a BIT; otherwise states that were not committed to protecting FDI would pool on a strategy of signing and ratifying BITs. Under this view, the effects of BITs should not be limited to investors that are specifically protected by the BIT. Rather, any investor that observes a BIT being ratified will be able to update their beliefs over a state s intentions. Extant empirical work does not clearly indicate whether BITs work according to realist expectations, according to institutionalist expectations, or even whether BITs work at all. Consistent with both realism and institutionalism, several studies have found that signing more BITs correlates with greater aggregate FDI flows (e.g., Büthe and Milner 2008; Neumayer and Spess 2005). On the other hand, studies have generally been unable to show that signing a BIT with a specific country correlates with more FDI from that country (e.g., Hallward-Driemeyer 2003; Tobin and Rose-Ackerman 2005). Taken together, these results present a puzzle. Why do we find evidence that BITs encourage aggregate FDI flows, but fail to find evidence of increased investment by investors who are actually protected? This article is an attempt to address two holes in the literature that may account for these otherwise curious results. One hole is an under-appreciation of the different mechanisms through which BITs might impact FDI flows. While it is generally accepted that BITs might work by tying the hands of ratifying host states or by sending a broadly received signal that a country is trustworthy, the extant literature does not fully consider the theoretical distinctions between these hypotheses. Perhaps for this reason, extant empirical tests do not differentiate between the two mechanisms. The second hole in the literature is that it generally fails to appreciate the endogeneity between BITs and FDI. Developing countries are more likely to pursue BITs with developed countries when they believe doing so will significantly increase FDI inflows. This is tantamount to saying that BITs are more likely to be ratified when a country s FDI inflows are significantly below what they would be were it not for fears of expropriation. This endogeneity can bias results if it is left un-addressed or if it is addressed insufficiently. 2 This paper makes three innovations in its attempt to resolve these issues. First, I explore some of the mechanisms through which BITs may be able to generate ex ante and ex post costs to probe the applicability of institutionalist and realist theories. I argue that there is ample evidence of ex post costs to violating BITs and ex ante political costs that are borne by politicians who pursue them. Second, I employ a statistical model that is able to differentiate between these channels of influence. To do so I use a directed dyad data set to examine the effects 2 Much recent work in IPE has noted similarly endogenous relationships with other agreements. For an example using preferential trade agreements (PTAs) see Baier and Bergstrand (2007) and Magee (2003); for examples using the IMF see Knight and Santaella (1997).

3 Andrew Kerner 75 of BITs, as well as BITs ratified outside of the dyad, on bilateral FDI flows. 3 This allows for an evaluation of whether FDI flows are correlated with being protected by a BIT, observing that a host state has ratified numerous other BITs, or both. Third, I correct for endogeneity by using a two-stage least squares estimator. The results of the statistical models suggest that BITs increase FDI flows from protected and unprotected investors, and that the former relationship is obscured unless endogeneity is corrected. These results have several implications. First, they contribute to a wider debate on the efficacy of international economic institutions, particularly in the context of endogenous institutional choice. Second, the results of this paper comment on the nature of treaty compliance. Downs, Rocke, and Barsoom (1996) have argued that international agreements are entered into by countries that are most likely to observe the terms of the treaty. The results of this paper indicate the opposite. The countries that are most likely to ratify BITs are the ones that, in the eyes of investors, are most in need of the treaty s assurances. Third, the results of this paper point to an under-recognized irony of globalization. By actively opposing international investment agreements, actors opposed to BTIs increase the ex ante costs of ratifying BITs, making BITs more credible and, perhaps, more attractive to governments in need of FDI. Background Information on BITs Foreign direct investment is an investment by foreign nationals that is large enough to grant the investor a significant amount of corporate control (United States Department of Commerce, Bureau of Economic Analysis 1998). Unlike portfolio investment, which can easily be pulled out and reinvested elsewhere, FDI has long time horizons and is generally not done for speculative purposes, but rather to serve domestic markets, exploit natural resources, or provide platforms to serve world markets through exports (Jensen 2003, 588). Countries seek to attract FDI for a variety of reasons. First and foremost, FDI, similar to other forms of investment, is a source of capital and jobs. Second, the typically knowledge-intensive nature of FDI creates knowledge spillovers. These spillovers can arise through firm-to-firm emulation or through the sharing of employees, who bring sophisticated production techniques from foreign-owned firms to domestic firms. Similarly, successful multinationals are often subject to an obsolescing bargain, whereby the skills and resources developed over time in the host state lead to greater negotiating leverage (Vernon 1971). Third, FDI is often concentrated in exporting industries and can generate foreign exchange. Not surprisingly, many developing countries have made the promotion of FDI a key part of their development strategies. 4 Despite the priority that governments place on attracting FDI, these same governments often present political risks that prevent investment from taking place. The need to protect FDI from host governments arises from time inconsistency problems (Simmons 2000). Foreign investors favor host countries that will not expropriate from them in the future (Büthe and Milner 2008; Henisz 2000; Jensen 2003, 2006; Li and Resnick 2003; Neumayer and Spess 2005). Prior to an investment, potential host states have strong incentives to assure investors that they will not expropriate; however, because FDI typically involves high-sunk costs, the state may decide ex post to forgo its earlier commitments, knowing the investor will have little legal or practical recourse (Hallward-Driemeyer 2003). Absent 3 A similar research design can be found in Salacuse and Sullivan (2005). 4 In a 2000 survey of FDI related policies, UNCTAD noted that nearly all surveyed countries reported using various tax incentives to attract investment (UNCTAD 2000).

4 76 Bilateral Investment Treaties some remedy, the investor is left insecure and may be less likely to invest as a result. Bilateral Investment Treaties are designed to reduce the risk of state-led expropriation. 5 BITs define a minimum standard of behavior toward foreign investment. These protections generally include: (1) equal and fair treatment in accordance to that received by any domestic or third-party firm; (2) protection against arbitrary or discriminatory polices; (3) flexibility with respect to staffing; (4) protection against performance requirements of any kind; and, most importantly, (5) that investments shall not be expropriated or nationalized either directly or indirectly through measures tantamount to expropriation or nationalization except for a public purpose; in a non-discriminatory manner; upon payment of prompt, adequate and effective compensation; and in accordance with due process of law (Article 6 of the United States Model BIT). 6 In the event of a perceived violation, an aggrieved investor (or their home state) typically has the right to adjudicate his or her allegation in an international tribunal, most often to the International Centre for Settlement of Investment Disputes (ICSID). 7 The resulting awards are binding and failure to accommodate a ruling can lead to retaliation by the aggrieved party or third-party actors. Why Might BITs Attract Investment? If BITs attract FDI, it is because they generate a credible expectation that a host state will not expropriate. But how is this credibility generated? Fearon (1997) suggests that credible commitments can broadly be seen as serving either hands-tying or cost-sinking functions. A hands-tying mechanism works by creating costs that an actor will suffer ex post if they do not follow through on a commitment. A cost-sinking mechanism attaches irretrievable ex ante costs to an action such that it separates sincere and insincere actors. It is not clear a priori where BITs fit within these distinctions. Extant work suggests protected investors are motivated to invest by BITs capacities to shape future behaviors, but also suggests that unprotected investors are motivated to invest by BITs capacities to signal states intentions. Despite these assertions, the literature has not fully established the plausibility of these mechanisms theoretically or empirically. In the following two sections I argue that either of these possibilities is at least plausible, if not likely. The Direct Effect: BITs as Hands-Tying Devices Institutionalist authors have argued that treaties can be designed to induce compliance. An effective treaty is costly enough to shirk that the commitments made in the treaty are necessarily credible. BITs could function as an effective handstying mechanism if, and only if, the ex post cost of expropriating (and not paying the resulting award) is high enough that countries will refrain from doing so. Elkins, Guzman, and Simmons (2006) suggest several ways that BITs tie the hands of host states through ex post costs. First, BITs dispute settlement procedures make the expectations of the host state explicit: any action deemed expropriation by the adjudicating body must be compensated with the prescribed award. This disallows states from claiming that no expropriation has taken place 5 For a review of FDI related policies before the BIT, see Elkins, Guzman, and Simmons (2006). 6 The US Model BIT is available at: asset_upload_file847_6897.pdf. 7 Of the 219 cases that are reported as of November 2005, 132 of them were arbitrated through ICSID, 65 through UNCITRAL, and the remainder through various standing and ad hoc bodies (UNCTAD 2005).

5 Andrew Kerner 77 when it has, or that proper compensation has been rendered when it has not. Second, by involving the home state of the investor in a dispute, BITs raise the stakes of non-compliance by potentially tying it to diplomatic relations. Home states have an interest in having their treaties honored, and host states have an interest in maintaining good relations with their trade and investment partners. Third, the consequences of not abiding by the decision of a neutral authoritative third party with which it has voluntarily pre-committed to comply (Elkins, Guzman, and Simmons 2006, 15) can be severe. These potential consequences include: (1) reputational costs in the eyes of other countries and investors; (2) the possibility of diminished credit rating 8 ; and (3) the (as yet never exercised) possibility of being referred to the International Court of Justice for non-compliance with an ICSID ruling (International Centre for Settlement of Investment Disputes 2006). If BITs truly serve as a hands-tying mechanism, it should be evident in cases in which compliance can only be explained by a state s treaty obligations. Furthermore, any such evidence would have to show that it was the BIT, and not related or accompanying changes in domestic law, that led a country to protect FDI or to comply with unfavorable rulings stemming from an investment dispute. Unfortunately, we currently lack any comprehensive data on compliance rates. Complicating matters, the decisions rendered in these cases are often kept secret (Peterson 2003). In substitute I rely on anecdotal evidence from Lauder v. The Czech Republic. Except where otherwise cited, the following borrows generously from Desai and Moel (2008). In 1992, the Czech Republic began issuing broadcasting licenses for its newly privatized television airways. One such license was granted to a joint venture between Central European Television for the 21st Century (CET 21) and Central European Media Enterprises (CME). CET 21 was led by a group of prominent Czechs, including businessman Vladimir Železný, and was meant to bring local knowledge and political connectivity to the partnership. CME, which provided much of the capital for the project, was founded by Ronald Lauder in order to acquire and operate a portfolio of broadcast licenses that became available during the privatizations of the 1990s. Having both the capital and the license, this partnership began broadcasting TV Nova in the Czech Republic, with considerable success. The original ownership structure called for the license to be issued to CET 21, in which CME was to acquire a 49 percent share. The notion of such extensive foreign ownership of the broadcasting license created a political backlash, and so the Czech Media Council, along with CET 21 and CME, agreed to issue the license to the Czech-owned CET 21, and allowed CET 21 and CME to create a new company Ceska Nezavisla Televizni Spolecnost (Czech Independent Television Company, or CNTS) that would operate the license. Originally, CME held a 66 percent share in CNTS, with CET 21 holding a 12 percent share and Czech Savings Bank (CSB) holding a 22 percent share. By 1996, however, CME bought out CSB to take an 88 percent stake in CNTS. In May 1997, CNTS altered its agreement with CET 21 so that CET 21 was no longer granted exclusive control of the broadcasting license. In 1997 and 1998, Vladimir Železný bought out the remaining shareholders of CET 21 and then sold most of those shares to CME, under the agreement that Železný would not compete with CNTS, leaving CME with a 99 percent stake in CNTS. CET 21, which at this point was owned entirely by Železný, held the remaining 1 percent. 8 Omar E. García-Bolívar, a member of the panel of arbiters of ICSID, offers that failure to adhere to the awards stipulated by an ICSID ruling may also decrease a country s credit rating especially regarding funds from multilateral organizations such as the World Bank, with which ICSID is affiliated and diminish the value of its commercial instruments such as government bonds (García-Bolívar and Schmid 2004).

6 78 Bilateral Investment Treaties In 1999, CME entered merger negotiations with Scandanavian Broadcasting Services (SBS), a company with holdings in the Scandinavian broadcasting market and elsewhere in Europe. Železný, perhaps sensing an opportunity, demanded a renegotiation of existing agreements between CNTS and CET 21, arguing that CNTS exclusive right to broadcast on CET 21 s license ran counter to the Media Council s intention. Železný, whose control over TV Nova made him a household name and political player in the Czech Republic, refused buyout offers by CME of over $100 million. Instead Železný withdrew CET 21 s broadcasting license from CNTS and began operating the license using programming made available through Železný s other media holdings. Lacking access to a broadcasting license, CNTS went out of business. CME impending merger with SBS was scrapped and CME s stock tumbled. Lauder and CME objected that Železný had broken his contract and appealed their case to the media council and to the Czech courts, neither of which upheld CME s contracts with CET 21 or Železný. They also tried alternative routes to pressure the Czech government. In November 1999 Lauder took out full page ads in The Washington Post and The New York Times that were timed to coincide with a visit by the Czech Prime Minister to Washington, urging investors to think twice before investing in the Czech Republic. Lauder also persuaded Czech-born Secretary of State Madeline Albright to plead his case with the Czech Prime Minister during that visit. Neither bad press nor diplomatic intervention was enough to compel cooperation by the Czechs. Commenting on the situation, the head of the American Chamber of Commerce in Prague noted that No Czech politicians who has any desire to continue being a politician is going to cross swords with Železný (Desai and Moel 2008, 235). Having exhausted the aforementioned remedies, Lauder filed two cases in international tribunals relating to the Czech Republic s BIT obligations. 9 In the first case Lauder sued the Czech Republic personally, claiming that the government s failure to uphold his contracts violated the Czech Republic-United States 1991 BIT. The London-based tribunal hearing the case found that the government of the Czech Republic did not take any measure of, or tantamount to, expropriation of the claimant s property rights (Ronald S. Lauder v. the Czech Republic, UNCITRAL Arbitration Proceedings Final Award 2001, 43). 10 The second case was filed by CME as a corporate entity claiming that CME s treatment violated the 1991 Netherlands-Czech Republic BIT. CME sought damages of $556 million and was awarded $353 million, an amount roughly equal to the annual budget of the Czech Ministry of Health. Outraged at the conflicting decisions and the size of the award, the Czech Government appealed (in vain) and eventually sought a thorough review of its treaty obligations (Bouc 2005). Despite their obvious dismay with the decision, the force of the treaty was enough to compel the Czechs to pay because, as then Foreign Minister Cyril Svoboda said, prompt payment is a must in order to safeguard the nation s reputation abroad (Desai and Moel 2008, 239). The Lauder v. Czech Republic case highlights BITs abilities to protect investors above and beyond what can be achieved with domestic law. The politically influential Železný (who in 2002 was elected to the Czech Senate) was able to use his influence to prevent Lauder and CME from having sufficient recourse to a domestic remedy. Furthermore, this anecdote demonstrates that BITs can influence state behavior beyond what can be achieved through publicity alone. The use of the international tribunal was able to prompt payment from the Czechs even after the facts of the dispute had already become public knowledge. Recall 9 Lauder also filed a case against Železný at the International Chamber of Commerce that was unrelated to any BIT. 10 The final award in Lauder v. Czech Republic is available at:

7 Andrew Kerner 79 that Lauder placed his anti-czech Republic advertisements in The New York Times and The Washington Post in November 1999, almost 4 years before the Czechs paid their fine. Despite the impact that BITs can have (and did have in the preceding case), they do have at least one clear limitation: only protected investors can bring BITrelated suits. Unprotected foreign investors can be expropriated from without triggering any of the ex post costs that are critical to BITs credibility. It should follow that if BITs only work through ex post costs, they should only cause an increase in investment from protected investors. From this we can deduce a first hypothesis. Hypothesis 1: Bilateral Investments Treaties work by amassing ex post costs into an effective hands tying mechanism. They should encourage investment from investors that are protected by BITs. The Indirect Effect: BITs as Sunk Costs Political economists commonly assert that BITs constitute a globally observed signal that a country is serious about protecting foreign investment (Neumayer and Spess 2005, 1571; Tobin and Rose-Ackerman 2005, 14). The rationale typically given is that third parties can observe that a host state has tied its hands with respect to other investors and infer that their investments will be safe as well. But why should BITs have this effect? The logic of hands tying implies that, without the BIT, the host state cannot fully be trusted not to expropriate. Unprotected investors do not have recourse to an international tribunal. The host state does not necessarily have its hands tied in any way with respect to how it treats them. 11 But we need not dismiss this hypothesis. If BITs have a global effect, then the agreements must be credible for reasons beyond the ex post costs of violation. BITs can also present enough ex ante costs, or, to use Fearon s term, sunk costs, that ratifying a BIT credibly signals that a state is predisposed against expropriating from foreign investors. Any investor can observe the signal sent by a ratified BIT, regardless of whether they are protected. To the extent that ex ante costs effectively convey credibility, any investor should be more willing to invest in a state that signs and ratifies BITs. In what follows I will argue that there are, in fact, good reasons to suspect the BITs can create enough ex ante costs to send a credible signal. The main drivers behind these ex ante costs are twofold. First, BITs often limit a host state s regulators and lawmakers. All manner of policy has been challenged by BIT-related suits and these limitations can be politically costly for the politicians that pursue BITs. The South African policy of post-apartheid property reallocation has been challenged by foreign mining companies under the terms of BITs (Peterson 2004). Environmental laws are particularly vulnerable. A Spanish company, Tecnicas Medioambientales Tecmed S.A., successfully challenged the Mexican government after its hazardous waste confinement plant had its permit revoked out of environmental concerns (Peterson 2004). The mere threat of litigation can also be enough to affect national policy. The Canadian government has found that, because of its BIT-related obligations, it may not be able to extend publicly provided health care into services currently provided by foreign-based companies 11 There are, of course, other mechanisms for protecting FDI besides BITs or BIT equivalents embedded in free trade agreements. To the extent that these are located in domestic law, however, they lack the hands tying capacity of a BIT (Fearon 1997).

8 80 Bilateral Investment Treaties (Canadian Centre for Policy Alternatives Consortium on Globalization and Health 2002). Second, BITs put domestic and preexisting foreign investors at a disadvantage. Domestic and unprotected foreign investors must face a legal system that is often slower, more capricious, and less investor-friendly than their protected foreign competition. In the South African mining case mentioned above, Peterson (2004) notes that BIT-protected, foreign-controlled mines could be granted awards by an international tribunal, while domestically controlled mines faced a legal system much more likely to accept the legality of South African policy. Foreign and domestic firms that have invested in knowledge of the local legal system will see that competitive advantage disappear as they compete with firms that can operate outside of it. To the extent that BITs attract new investors, domestic and foreign investors that operated prior to a BIT may find themselves facing greater competition consequences. Despite their potential to generate opposition from public and private interest groups, BITs held a low profile for much of their history. This is not to say that they were costless, but neither did they present serious political obstacles. 12 Today, and increasingly over the past decade, international investment agreements hold a higher profile position in the debate on globalization and politicians must account for this when entering into these treaties. I attribute much of this change in prominence to the dramatic failure of the negotiations over the Multilateral Agreement on Investment (MAI), after which BITs profile and the associated political costs rose dramatically. The MAI was an attempt by developed countries to establish a unified global framework to protect FDI. Following the failure to reach a multilateral agreement during the Uruguay round of the WTO, developed countries felt that a more expeditious strategy would be to limit negotiations to themselves. Major provisions of the MAI called for an expansive definition of investment, strict limitations on performance requirements such as local content requirements or mandated technological transfer, a prohibition on expropriation or any tantamount action without public purpose and prompt compensation, free transfer and repatriation of assets, and an international dispute settlement mechanism to enforce compliance with the MAI, to be conducted in accordance with, if not actually in, the ICSID or UNCITRAL (Kobrin 1998; Walter 2001). In many ways the draft agreement they developed resembled a multilateral BIT. In February of 1997, Public Citizen, an advocacy group founded by Ralph Nader, obtained a draft copy of the MAI and posted it on its Web site. News of the proposed agreement sparked controversy among increasingly internet-savvy political activists. The MAI, if it had succeeded, would have had dramatic consequences for a variety of actors in the developed world and the developing world. In the following months over 600 organizations stretching across 70 countries voiced their opposition to the MAI, including such wide ranging groups as the World Development Movement, the AFL-CIO, the Western Governors Association, and Oxfam (Kobrin 1998). In April 1998 negotiations over the MAI were suspended for 6 months so that negotiators could consult with interested parts of their societies (Kobrin 1998, 98). In November of that year, France, followed soon after by Australia and Canada, pulled out of negotiations altogether, leading to the MAI s collapse. The French government specifically cited political pressure, arguing that...more than any other international agreement of an economic nature, the MAI has raised objections and tensions at the heart of civil 12 Perhaps indicative of these costs, many legislatures in developing countries refused to ratify the BITs that their executives have signed, well before BITs became a popularly recognized political issue. Brazil, for example, signed 14 BITs during the mid-nineties, none of which have been ratified.

9 Andrew Kerner 81 society. The opposition to it was surprising in its scale, strength, and the speed with which it appeared and developed (Lalumière and Landau 1998). 13 Anti-globalization activists drew blood by helping to sink the MAI (de Jonquières 1998). In the period since there has been a greater awareness of investment agreements, including BITs, and more assertive action against them by concerned parts of civil society. Often these groups have forced governments to negotiate less stringent investment protections and occasionally they have been able to scuttle BIT negotiations altogether. The ill-fated BIT between South Korea and the United States stands as a particularly striking example of how effective the opposition to a BIT can be. Negotiations for a U.S.-South Korea BIT began in In many ways, it should have been an easy BIT to pass. In 1998 U.S.-sourced FDI in South Korea totaled $7.3 billion, amounting to 38.7 percent of Korean FDI stock (Choi and Schott 2004). South Korean President Kim Dae-Jung made a BIT with the United States (as well as a BIT with Japan) a cornerstone of his economic policy. The following Korean President, Roh Moo Hyun, appointed Jeffery D. Jones, five-time President of the American Chamber of Commerce in Korea and a vocal supporter of the U.S.-Korean BIT, as a member of the Regulatory Reform Commission. Despite this, the U.S.-Korea BIT proved to be elusive. The root of the difficulty was Korean resistance to the BIT s impact on Korea s screen quota for domestically made films. The Korean screen quota was initially installed in 1967 to help promote the domestic film industry against foreign (principally American) competition. At the time that negotiations began, the screen quota required Korean movie theaters to show domestically produced films for 146 days out of the year. Faced with the prospect of losing this protection, the Korean film industry, in concert with organizations such as the Coalition for Cultural Diversity in Moving Pictures and Korean People s Action against BITs and the WTO (now called Korean People s Action against FTAs and the WTO) organized a campaign against the abandonment of the screen quota and against the U.S.-Korea BIT more generally. 14 The political resistance to the BIT was so great that public officials refrained from even mentioning the screen quota publicly for fear of creating a backlash (Kim 2006). The campaign against the U.S.-Korean BIT hobbled government initiatives to sign a major international treaty with its primary foreign investor. 15 The activation of public resistance is not limited to Korea. In another recent example, public pressure forced the Australian government to dilute the investment chapter of the Australia-U.S. FTA (Capling and Nossal 2004). More dramatically, Evo Morales was able to unseat the ruling party in the 2005 Bolivian presidential election, in large part by harnessing public discontent over the BIT-protected rights of foreign firms operating in Bolivia. The Cochabamba Water Wars of 2000, which helped propel then congressman Morales into the national spotlight is perhaps the most significant expression of these sentiments. 16 Morales, along 13 The reasons for the MAI s failure were not likely due solely to the work of anti-mai activists, though these activists undoubtedly played a significant role. See Graham (2000) for a more complete evaluation of the topic. 14 The Web site for the Coalition for Cultural Diversity in Moving Pictures, includes letters solicited and then sent to President Roh from around the world in support of the screen quota and against the U.S. Korea BIT and liberal economic policy more generally. Interestingly, as of November 19, 2007 you can also download a copy of Hallward-Driemeyer (2003) from their Web site, available at 15 Temporarily, anyway. While the U.S.-Korea BIT was shelved, it would eventually be adopted as part of the U.S.-Korea FTA, including a requirement that screen quotas be reduced to 73 days a year. 16 The Cochabamba water crisis arose after a Bechtel subsidiary, Aguas del Tunari, was granted control over the water distribution network in Cochabamba, Bolivia. Following a rate hike and suspension of service for non-paying customers, large scale protests broke out in Cochabamba and, later, nationally. The Bolivian government was forced to revoke its contract with Aguas del Tunari and handed control of water distribution to a consortium of domestic groups. Aguas del Tunari filed a suit against Bolivia for $40 million under the Netherlands-Bolivia BIT, which it later withdrew.

10 82 Bilateral Investment Treaties with President Correa in Ecuador, have continued to tap into this discontent, most recently by pulling their countries out of ICSID entirely. As the ramifications of BITs continue to become better appreciated by civil society, BITs have been given a more prominent place in the anti-globalization movement. Opposition to BITs has become a cause celebre in and of itself. 17 Investors all over the world can observe host states taking on the costs of this opposition. Of course, BITs are not the only mechanism for protecting the rights of foreign investors. States can and do alter the legal status and obligations of foreign investors through changes in domestic law. However, there are several reasons why BITs are particularly well positioned to generate these ex ante costs. First, the infringement on national sovereignty that is implied by BITs use of international courts has particular resonance with, and draws the ire of, anti-globalization activists. Second, in order to be effective, a signal must be observed. BITs, by taking the form of an international treaty, should be more visible than equivalent changes in domestic law. If these costs are substantial enough and visible enough to make a BIT credible, the effect that it has should not be limited to protected investors. From this we can deduce a second hypothesis: Hypothesis 2: Bilateral Investment Treaties work by marshaling ex ante costs into a widely received, credible signal that a country will not expropriate from foreign investors. They should encourage investment regardless of whether or not the investors are protected by the treaty. Whether BITs sink costs or tie hands, they involve significant costs that imply an endogenous relationship between FDI and BITs. Host states have the greatest incentives to pursue BITs when their expected gain in FDI is highest. Put another way, the more FDI a country receives without the use of a BIT, the less motivation there is for that country to sign and ratify them and vice versa. 18 Because this relationship implies that BITs should be negatively correlated with a shock to FDI, failure to account for this should lead to a systematic underreporting of BITs effectiveness. Moreover, this endogeneity should be particularly troublesome in dyadic research designs. Following similar logic as above, countries should be most likely to enter BITs with a specific country when that BIT s expected impact on FDI flows is highest. Hypothesis 3: Correcting for endogeneity should reveal a stronger relationship between FDI and BITs than would otherwise be evident. Research Design Sample and Dependant Variable To test my hypotheses, I construct a data set with one observation per ordered pair ( directed dyad ) of countries per year. The coverage of countries and years is constrained by the availability of data taken from the OECD s International Direct Investment by Country-Volume 2005-Release This data set measures the size of FDI flows in millions of U.S. dollars (which 17 In 2004 several activist groups including Asia Pacific Research Network, GRAIN, GATT Watchdog, Global Justice Ecology Project, IBON Foundation, XminY Solidariteitsfonds collaboratively launched bilaterals.org, a Web site solely dedicated to opposing BITs and similar agreements. 18 This expectation is consistent with Elkins, Guzman, and Simmon s (2006) observation that less reliable governments sign and ratify BITs more often than more reliable governments. 19 Those familiar with this data set may note that there is a significant amount of missing data. This is dealt with in the robustness checks section.

11 Andrew Kerner 83 I deflate into constant 2000 dollars) from OECD countries into a broad cross section of developing countries. FDI flows often fluctuate greatly, taking on very large values some years, zero other years. In order to account for this distribution I use the natural log of FDI flows as my dependent variable. This is made somewhat problematic by the prevalence of zeros and negative values, neither of which have a log. 20 To get around this, I adopt the technique used by Blonigen and Davies (2004). To accommodate the zeros, this strategy calls for adding one dollar to the value of FDI flows, changing observations that would have called for taking the log of zero (which does not exist) to the log of 1, which is 0. To accommodate negative values, Blonigen and Davies suggest logging the absolute value of FDI flows, and then reintroducing the original sign after the transformation. Thus my dependent variable is given by: DV ¼ ðþ log jðfdi 1; 000; 000Þþ1j There is some controversy in the literature on whether using the logged values is preferable to the unlogged values of FDI flows. Yackee (2007) demonstrates that Neumayer and Spess (2005) results using a logged dependent variable are not robust to using the unlogged form of the dependent variable. The statistical findings I report are robust to either functional form. I report my baseline models (models 1 and 2, in Table 1) with both the logged and unlogged dependent variables. 21 Otherwise, I report results using the logged values of FDI flows. My sample of source countries includes the original OECD countries. 22 plus Japan, Australia, and New Zealand. Late-joiners to the OECD such as Mexico, Korea, and the Central European countries are not included as home countries. I also exclude Turkey from the sample of home countries, despite its being an original member of the OECD. 23 The sample of host countries includes all countries not included as home countries. The 127 developing countries that are included as host countries in the main model are listed in Appendix A. 24 All models cover the years Independent Variables My model has two primary independent variables. The first, BIT ijt, is a dichotomous variable coded 1 if country pair ij is protected by a ratified BIT in year t and 0 if otherwise (taken from UNCTAD s Country-specific Lists of BITs). 25 The second independent variable that I use, Other BITs it is a moving average of the number of new BITs that a host country i has ratified with OECD countries outside of the dyad in years t ) 1, t, and t + 1. I operationalize the variable in this way for a variety of reasons. In its level form, a simple count of extra-dyadic BITs contains a unit root and thus cannot be used for statistical analysis (Enders 2004). Unit roots are typically addressed by first differencing the variable containing the unit root. In this case, however, a first differenced variable would not 20 Each data point represents the balance of capital moving into a country and received earnings or other capital moving back to the home country. The dependent variable takes on negative values in years where more capital was repatriated than sent into a host nation. Thus, the difference between negative and positive values of the dependent variable is one of scale, not of type, and we cannot dismiss these observations in statistical analysis. 21 The unlogged dependent variable is expressed in millions of dollars. 22 The original twenty members of the OECD are Austria, Belgium, Canada, Denmark, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, Turkey, Great Britain, and the United States. 23 The decision to exclude or include these countries as home states turns out to be inconsequential in most models. 24 The 127 figure refers to the sample used in model 1 7. Other models have slightly different samples. 25 Available at

12 84 Bilateral Investment Treaties TABLE 1. Effects of BITs on FBI Variable Model 1a OLS Model 1b OLS Model 2a Model 2b Model 3 Model 4 Model 5 FBI (lag) 0.402*** ) *** )0.032* )0.029 )0.049** )0.034* (0.073) (0.016) (0.411) (0.019) (0.019) (0.024) (0.020) BIT ) ** ** ** * ** (26.992) (0.615) ( ) (6.821) (5.921) (7.889) (7.718) Other BITs (3 year avg of new BITs) ** *** 8.565*** 4.618*** 5.229*** (12.699) (0.200) (0.074) (2.026) (1.590) (1.703) (3.475) Democracy 0.912*** *** 0.027** ** (0.341) (0.010) (0.420) (0.012) (0.016) (0.014) (0.013) Democracy Other BITs 0.049* (0.029) 1997 )18.386*** (6.398) 1997 Other BITs *** (5.964) Savings (lag) )1.433*** 0.052** ) *** 0.105*** 0.163*** )0.069 (0.543) (0.024) (0.891) (0.033) (0.034) (0.048) (0.098) Savings (lag) Other BITs Polcon ) ** ) *** )6.847*** )6.167*** )5.272** )7.600*** (56.638) (1.342) ( ) (2.496) (2.289) (2.549) (2.792) Trade (lag) ) ** 0.031** 0.029** 0.029* 0.054** (0.276) (0.010) (0.440) (0.015) (0.015) (0.017) (0.024) PTA *** ) )8.769*** )7.396*** )17.524*** )8.509*** (66.801) (1.115) ( ) (3.154) (2.674) (6.330) (3.254) Log Source GBP (lag) 0.362* (0.219) *** 9.334* *** *** *** ** ( ) (5.168) ( ) (6.325) (6.244) (7.255) (6.617) log GBP (lag) *** ) )4.268** )4.791*** )7.268*** )4.044** (47.124) (1.203) (60.776) (1.746) (1.815) (2.651) (1.872)

13 Andrew Kerner 85 Table 1. Continued Variable Model 1a OLS Model 1b OLS Model 2a Model 2b Model 3 Model 4 Model 5 World Growth Rate *** *** (4.928) (0.135) (5.627) (0.162) (0.159) (0.201) (0.171) CAOI (lag) )0.117 )15.144** )0.784*** )0.723*** )0.683*** )0.795*** (4.059) (0.108) (7.352) (0.211) (0.192) (0.230) (0.222) N F Statistic first stage F BIT first stage F Other BIT First stage interaction term Hansen J p-value Significance levels : *: 10% **: 5% ***: 1%.

14 86 Bilateral Investment Treaties capture the underlying concept. If a country ratifies several BITs in 1 year, but for some reason fails to ratify any in a given year, it is unlikely that investors would only look at the lack of BITs ratified in that year and not recognize the larger trends. Using a 3-year moving average avoids both pitfalls. Choosing a length of 3 years for the moving average is arbitrary, but the results do not change substantially if I use a 5-year moving average or even a simple differenced variable. I limit this variable to include only extra-dyadic BITs ratified with OECD countries because so called strange BITs BITs signed between poor, often non-contiguous states, neither of which is a significant source of FDI are unlikely to lead to increased FDI and thus should not generate the sorts of costs that motivate the theory of this paper (Elkins, Guzman, and Simmons 2006). If Hypothesis 1 is correct, FDI flows should be responsive to whether a specific pair of countries have ratified a BIT, even when controlling for how many other countries with which the host state has concluded a BIT. If Hypothesis 2 is correct, FDI should be responsive to the amount of BITs ratified with other states, even when controlling for whether or not a specific dyad has ratified a BIT. Control Variables My control variables include several macroeconomic measures taken from the World Bank Development Indicators. 26 I include the log of the source country s GDP, Log Source GDP jt, because I suspect that home countries with higher GDPs send out more FDI and, in anticipation of that, developing countries will be more likely to pursue BITs with these countries. For similar reasons, I include Log GDP it, which measures the log of the host country s GDP. I include a measure of the domestic savings rate, savings it, which is equal to domestic savings as a percentage of GDP. A low domestic savings rate could provide foreign investors with an opportunity for investment, but might also provide politicians with a motivation to take proactive steps to attract FDI, presumably including BITs. All of the aforementioned economic control variables are lagged 1 year to avoid potential reverse causality. I include a measure of the world growth rate t, also taken from WDI, which is meant to capture year to year variation in the world economy that could trigger increases or decreases in FDI. This variable is meant to serve a similar purpose as year-specific dummy variables, which is precluded because of the de-trending process used on the data (see below). I control for the number of veto players in a political system using Witold Henisz s polconiii it variable. As the number of veto players in a political system increases, it becomes harder for a government to make new policy, including signing and ratifying a BIT. As Henisz (2000) has shown, the policy stasis that accompanies a high number of veto players might also affect the investment decisions of foreign investors. As many observers have noted, trade may have a powerful, positive effect on investment flows (Büthe and Milner 2008; Neumayer and Spess 2005). I include (the lag of) Trade as a percentage of GDP it, which is taken from WDI and equal to the sum of exports and imports as a percentage of GDP, because it is also possible that countries with a high volume of trade would be more likely to participate in international trade and investment agreements, including BITs. Similarly, I control for the existence of a trade agreement between host and source countries (PTA ijt ). 27 The predicted sign for the PTA variable is ambiguous, however. On one hand, to the extent that adopting a PTA increases trade it should also lead to an increase in bilateral FDI flows. On the other hand, restrictions on 26 Downloaded March, The preferential trade agreement data was taken from the World Trade Organization s list of regional trade agreements. This list is available at

15 FDI i;j;t ¼ b0 þ b1fdi i;j;t 1 þ b2bit i;j;t þ b3rbit i;t þ d i;t þ U j;t þ W ijt þ l i;j þ e i;j;t ð1þ Andrew Kerner 87 trade may promote FDI if they make producing inside a country a cheaper way to reach a market than importing into it. Under this possibility, ratifying a trade agreement may actually decrease FDI flows by allowing firms to import their goods more cheaply into the host market. This possibility is particularly pronounced in the dyad fixed-effects specification that I use. The variable democracy it measures a country s polity scores from the Polity IV data set (Marshall and Jaggers 2002). I use a standardized version of this measure (ranging from 0 to 100) made available by Pippa Norris. 28 I include this control because it is possible that democratic countries are more likely to receive FDI as well as being more likely to ratify BITs (Jensen 2003; Li and Resnick 2003). Last, I include a measure of (the lag of) capital account openness, CAOI it, using the capital account openness index used by Brune (2004) and coded from the IMF s Annual Report on Exchange Arrangements and Exchange Restrictions. This measure runs from 0 to 11 with higher values signifying a freer capital account. This measure is included to guard against the possibility that BITs are simply proxies for broader efforts that countries take to encourage inward capital flows. 29 Instrumental Variables As alluded to earlier, I suspect that the relationship between FDI and BITs is endogenous. This is to say that the error term from the structural equation is correlated with the independent variables, violating an assumption of ordinary least squares. More formally, Where i refers to the host country, j refers to the home country, d i,t is a vector of control variables specific to the host country, F j,t is a vector of control variables specific to the home country, W ijt is a vector of control variables specific to the country pair and l i,j are dyad fixed effects. e i,j,t is the error term such that: and COVðe i;j;t ; BIT i;j;t Þ 6¼ 0 COVðe i;j;t ; RBIT i;t Þ 6¼ 0 In order to capture the endogenous relationship between BITs and FDI I use a two-stage least squares regression. I use the percentage of a host state s neighbors that have ratified a BIT with the home state in question as an instrument for the existence of a ratified BIT. 30 I use the 3-year moving average of new BITs that a host state s neighbors have ratified as an instrument for the 3-year moving average of the number of BITs that a host country has ratified with countries outside of the dyad. 31 I define neighbor using the Correlates of War data set s coding for type 1 or type 2 contiguity, which includes countries that share a land border or are separated by 12 miles of water or less (Stinnett et al. 2002). I also include a third instrument capturing the 3-year average of the number of BITs ð2þ ð3þ 28 This variable can be downloaded at 29 While controlling for capital account policy reduces the potential for omitted variable bias, it does not erase it entirely. It does not, for example, capture the multitude of tax breaks and other inducements that countries often offer multinational firms to attract their investment. However, such inducements are often firm-specific and belie accurate coding at the country-year unit of observation (Jensen 2007). I leave it to future research to more completely account for these efforts in statistical models of FDI flows. 30 This variable is labeled instrument 1 in the correlation matrix and descriptive statistics that appear in the Appendix Tables A1 and A2. 31 This variable is labeled instrument 2 in the correlation matrix and descriptive statistics that appear in the Appendix Tables A1 and A2.

16 88 Bilateral Investment Treaties ratified by other countries worldwide in a given year. 32 More formally, I estimate the following reduced form equations. BIT i;j;t ¼ b0z i;j;t þ b1p i;t þ b2k i;t þ b3d i;t þ b4u j;t þ b5w ijt þ l i;j þ e i;j;t ð4þ RBIT i;j;t ¼ b0z i;j;t þ b1p i;t þ b2k i;t þ b3d i;t þ b4u j;t þ b5w ijt þ l i;j þ e i;j;t Where F i,j,t is the percentage of a host state s neighbors that have ratified a BIT with the home state in question, P i,t is the 3-year average number of new BITs that a host state s neighbors have ratified and k i,t is the 3-year average of the number of BITs ratified by other countries worldwide. An ideal instrument should be uncorrelated with the error term of the equation but correlated with the endogenous independent variable. As for the latter requirement, there are a variety of reasons why a country might be moved to sign and ratify BITs when its neighbors do. First, I expect that as more and more BITs are signed and ratified, doing so will increasingly become a norm (in the sense of Finnemore and Sikkink 2005) among developing states in need of foreign capital. Norm diffusion would likely accelerate if leaders observed that BITs were successful in neighboring countries or globally. Similarly, as more and more states ratify BITs, states may fear (perhaps unjustifiably, but certainly speculatively, given the paucity of data confirming BITs effectiveness) that they must pursue BITs in order to maintain their competitiveness with other countries in their drive for foreign capital (Elkins, Guzman, and Simmons 2006; Tobin and Rose-Ackerman 2005). This property is easily established statistically as well as theoretically. In my main model, as well as in all of my robustness checks, I report first stage F statistics that indicate my instruments are more than sufficiently correlated with the endogenous variables. The strict exogeneity assumption is more troublesome. One could argue that there is a limited amount of FDI available to the developing world or to certain regions and that FDI flows can therefore be thought of as a zero-sum game. In that situation, BITs ratified by neighbors may deprive a country of FDI through FDI diversion. If FDI diversion were the norm, then BITs in other countries (assuming those BITs are correlated with other countries FDI inflows) would likely be negatively correlated with the error term of my structural equation and therefore would not make an adequate instrument. 33 On the contrary, one could argue that FDI flows to the developing world are better thought of as an expanding pie, rather than a static amount of funds that are diverted from one developing country into another. Under this view, improving legal protections for foreign investors creates new investment opportunities rather than simply spurring the re-allocation of investment from one country to another. If this were the case, then BITs in neighboring countries would not have a negative correlation with FDI inflows, and my instrument set would be justified on theoretical grounds. Recent empirical work on FDI diversion, much of which focuses on the impact of rising FDI flows to China, tends to corroborate the latter view. Chantasasawat et al. (2004) finds that increases in China-bound FDI has not reduced FDI flows to Latin America, even as it has reduced Latin America s share of worldwide FDI flows. Weiss (2004) finds that increasing FDI flows into China does not diminish FDI flows into its South-East Asian neighbors, though he does suggest that increased investment in China may spur FDI in these countries ð5þ 32 This variable is labeled instrument 3 in the correlation matrix and descriptive statistics that appear in the Appendix Tables A1 and A2. 33 An identical concern would arise even if BITs were ineffective, but correlated with other policies that attract FDI inflows. The effect on my instruments set s adequacy would be identical; FDI diversion poses significant problems in either case.

17 Andrew Kerner 89 because of the effects of a global supply chain. Eichengreen and Tong (2007) find no evidence that rises in Chinese-bound FDI is diverting FDI from other countries in the developing world, but does find some evidence of diversion from OECD countries. Outside of China, Kalotay (2004) argues that EU enlargement has not adversely affected FDI flows into the original EU 15. Similarly, Buch, Kokta, and Piazolo (2001) find that the then impending expansion of the EU was not diverting FDI flows away from Southern Europe and into Central and Eastern Europe. Based on these findings I am confident in the adequacy of my instrument set on theoretical grounds, though, for the reasons noted above, some skepticism may be warranted. The exogeneity of my instrument set can also be established statistically using the Hansen J statistic to test the regression equation s over-identifying restrictions. The Hansen J statistic is distributed chi-squared with degrees of freedom equal to the number of over-identifying restrictions and carries the null hypothesis that the instrument set is exogenous. Thus, a rejection of this hypothesis casts doubt on the validity of the statistical model. I report the p-values associated with the Hansen J statistic for each model that uses a two-stage least squares specification. In all but one model (out of 15 models presented in the following sections), these p-values do not indicate that my instrument set is endogenous. Other Econometric Issues As with all time series cross sectional analyses, the stationarity of the data is a major concern. Stationarity, which is a necessary condition to make statistical inferences in a time series context, simply states that the expected values of a series mean and variance are not dependent on time. As mentioned earlier, a Maddala-Wu panel unit root test 34 of the variables indicates that a simple count of BITs ratified with countries outside of the dyad contains a unit roots. The same is true for the number of BITs ratified by other countries worldwide and the average number of BITs ratified by a country s contiguous neighbors, both of which are used as instruments. Using the 3-year moving average of the first difference of each variable, as I do, avoids this problem. The remaining trends in the data, which are substantial, are accounted for by the inclusion of a linear time trend and its square, which was the highest order polynomial that was found to be statistically significant (Enders 2004). I also use dyad fixed effects and include a lagged dependent variable in my analysis. Dyad fixed effects are increasingly viewed as the most appropriate technique in analyzing dyadic trade flows (Subramanian and Wei 2007; Tomz, Goldstein, and Rivers 2007). Dyad fixed effects effectively control for distance, as well as historical or cultural ties, between states. I include the lagged dependent variable for two reasons. First, I expect FDI to be sticky in that investment flows in 1 year should be highly correlated with flows in previous years. Second, including the lagged dependent variable corrects for first order autocorrelation. In all models I estimate my regressions with robust standard errors to correct for unspecified forms of heteroskedasticity. Formally, the model that I estimate is given by FDI i;j;t ¼ b0 þ b1fdi i;j;t 1 þ b2zbit i;j;t þ b3zrbit i;t þb4d i;t þ b5u j;t þ b6w ijt þ l i;j þ e i;j;t ð6þ Where ZBIT i,j,t and ZRBIT i the exogenous products of equations (4) and (5). 34 Implemented using the xtfisher command in Stata 9.

18 90 Bilateral Investment Treaties Results Models 1a and 1b shows the results of my basic model using OLS, and thus not accounting for endogeneity. Model 1a uses the unlogged form of the dependent variable and model 1b uses the logged form, as described above. Neither of the dyadic BIT variables are significant in these models. The dyadic BIT variable in model 1a even carries a negative sign, which is consistent with previous results obtained by Hallward-Driemeyer (2003) and Tobin and Rose-Ackerman The count of extra dyadic BITs is found to be significant in model 1b, using the logged dependent variable, while it is insignificant in model 1a, using the unlogged dependent variable. This finding mirrors those described by Yackee (2007) and Neumayer and Spess (2005). Models 2a and 2b are identical to models 1a and 1b, except that both of the BIT variables have been instrumented using a two stage least squares specification. The first stage F statistics measure the strength of my instruments correlation with the endogenous variables. As a rule-of-thumb, an F statistic at or above 10 is acceptable for an equation with two endogenous variables (Baum, Schaffer, and Stillman 2003). The insignificant p-values for the Hansen J statistic reveal no evidence that the instrument set is endogenous. The contrast between models 1 and 2 is striking. Both of the BIT variables are statistically significant and positively signed in models 2a and 2b. The coefficients on each are considerably larger than in models 1a and 1b. In other words, investors appear to invest more when they are protected by a BIT, but also invest more in countries that have ratified more BITs, even though these BITs do not offer the investor any additional protection from expropriation. Furthermore, correcting for endogeneity reveals a significantly larger effect than is otherwise evident. To get a better sense of what these results mean, Table 2 shows the substantive effect of a 1 standard deviation change in each independent variable on the dependent variable, or in the case of dichotomous independent variables a shift from 0 to 1. The substantive effects in Table 2 are based on model 2a, simply because the unlogged form of the dependent variable makes them easier to interpret. Table 2 shows that, perhaps unsurprisingly, the most important predictor of dyadic FDI flows is the size of the source country s economy. The BIT variable also has a large substantive effects. A 1 standard deviation increase in extradyadic BITs yields an increase of $218,671,000 in annual dyadic flows of FDI, which is equal to an increase of 0.45 standard deviations of the dependent variable. Moving from zero to one in the dyadic BIT variable yields an increase of TABLE 2. Substantive Effects of BITs on FDI Variable Dollar change (millions) Percentage of SD FDI (lag) *** BIT ** Other BITs (3 year avg of new BITs) *** Savings (lag) )0.760 )0.002 Polcon )80.269*** )0.166 Democracy *** Trade (lag) ** PTA ) )0.114 Log Source GDP (lag) *** Log GDP (lag) World Growth Rate *** CAOI (lag) )42.329** )0.088 Significance levels: *: 10% **: 5% ***: 1%.

19 Andrew Kerner 91 $620,114,000 in annual dyadic flows of FDI, which is an increase of 1.23 standard deviations of the dependent variable. The results described in Tables 1 and 2 are at odds with previous findings that have modeled the effect of BITs on FDI using a two-stage least squares model. To recapitulate these results, Tobin and Rose-Ackerman (2005) and Hallward- Driemeyer (2003) found that BITs have insignificant or negative effects on FDI flows between ratifying states. There are several possible reasons why our results differ. First, my model employs a larger cross section of host countries (127) than either Tobin and Rose-Ackerman (54) or Hallward-Driemeyer (31). I also include 22 source countries in my sample, whereas Hallward-Driemeyer uses a comparable 20 source countries but Tobin and Rose-Ackerman use only one, the United States. A more pressing issue is that both Hallward-Driemeyer and, in their bilateral analysis, Tobin and Rose Ackerman, use the number of BITs ratified by the host state with countries outside of the dyad as an instrument for BITs ratified within the dyad. The results of my analysis, as well as those reported by others, indicate that their instrument is likely invalid. Far from being exogenous, it is a statistically significant and theoretically important predictor of FDI flows. If this instrument is correlated with the error term of the structural equation, as it seemingly must be, the resulting estimator is inconsistent and the resulting bias can be large for even modestly correlated instruments (Wooldridge 2003). The control variables yield interesting results as well. Unsurprisingly, the GDP of the source country has a large, positive, and statistically significant impact on FDI flows. The coefficients for democracy are positive and consistently significant, lending support to arguments given by Jensen (2003) and others. Polcon takes on consistently negative values, which ostensibly contradicts the logic that foreign investors are wary of investing where governments can easily change policies (Henisz 2000; Li 2006). Perhaps the most interesting findings among the control variables are the coefficients on PTA and CAOI. As mentioned earlier, the negative coefficient on PTA may suggest that FDI acts as a substitute for trade when such trade is made artificially costly by high tariffs. Under this view, ratifying a PTA could actually cause capital flight by allowing firms to import into a country what had previously been produced there. Similarly, a liberalization of the capital account may trigger capital outflows as foreign firms move to allocate their assets more efficiently. It should be noted, however, that both of these findings are specific to regressions using a dyad fixed effects specification. Unreported analyzes using a pooled model yield different results. In the case of PTA, the coefficient becomes positive and highly significant, while CAOI becomes insignificant at the 0.1 percent level. Last, the coefficient for lngdp is strangely insignificant when the dependent variable is expressed in its unlogged form and, even more strangely, consistently takes on negative values when the dependent variable is expressed in logs. Like PTA and CAOI, however, this appears to be specific to the fixed effects specification. In the unreported pooled models, ln GDP takes on positive and significant values regardless of the functional form taken by the dependent variable. Further Tests of Hypothesis 2 Of the three hypotheses tested in this paper, Hypothesis 2 is potentially the most controversial. Skeptical readers may not accept that BITs are sufficiently costly to the host state or that these costs are translated into a credible signal of intent in the way theorized by this paper. As further evidence in support of Hypothesis 2, models 3, 4, and 5 test some of the less obvious implications of Hypothesis 2. According to the theory presented in this paper, BITs provide unprotected investors with a credible signal due to the ex ante political costs with which it is

20 92 Bilateral Investment Treaties associated. While this suggests Hypothesis 2, it also suggests a conditional relationship. When the political costs are high, BITs should send a strong message to investors. When political costs are low, BITs should send a weaker message, if they send a message at all. To test this conditional relationship, I interact extra-dyadic BITs with three proxies of political costs. First, the political costs of ratifying a BIT should be greater when the political opposition can challenge the incumbent government in free and fair elections, and when political activism on the part of civil society is a protected feature of political discourse. Both of these qualities are among the hallmarks of political democracy. I expect that the signal sent by extra-dyadic BITs should be stronger when they are being sent by relatively more democratic governments that are, by assumption, more sensitive to pressure from civil society. In order to test this hypothesis, I interact the extra-dyadic BITs variable with the democracy measure that already appears in the regression. Similarly, the political costs of ratifying a BIT should be greater when BITs are better known to civil society and affected actors. Earlier I pointed to the breakdown of the MAI as a watershed moment in the political opposition to BITs. It follows that BITs should be costlier after 1997, when a draft form of the MAI was released and widespread public opposition to the agreement began. As above, this increased costliness should therefore send a stronger signal of government intent and attract more investment from unprotected investors. In order to test this hypothesis, I interact the extra-dyadic BITs variable with 1997, which is a dummy variable that is set to zero for the period up to and including 1996, and one for the post-1996 period. The final operationalization of political costs is through the variable Savings. 35 At low levels of domestic savings, a country becomes more reliant on foreign capital, while at higher levels of domestic savings it could more plausibly afford to forgo FDI. Political opposition against BITs should be higher when foreign investment comes at the expense of a real or potential domestic alternative. If there is no plausible domestic alternative to foreign investment, the political costs of ratifying a BIT should be relatively low. As the act of ratification becomes more costly i.e., at high rates of domestic savings the signal being sent to unprotected investors should be stronger and should accordingly lead to more investment. 36 The results from models 3, 4, and 5 provide support (though somewhat limited support) for these conditional hypotheses. In order to fully evaluate these results, it is helpful to examine the conditional coefficients for Other BITs it, which can be found in Tables 3 5. Table 3 contains the conditional coefficients for model 3. The coefficients indicate several things. First, as a country becomes more and more democratic, extra-dyadic BITs have a greater and greater effect on FDI flows, which is what the theory predicts. Second, the change in effect is substantively significant. Moving from the 25th percentile of democracy to the 75th percentile of democracy almost doubles the coefficient for Other BITs it. That said, the interaction term is significant only at the 0.1-level, rather than the more conventional 0.05-level. The conditional coefficients for model 4 are reported in Table 4. These conditional coefficients strongly support the hypothesis that BITs are able to translate increased political costs following the breakdown of the MAI into a stronger signal of state intentions. The coefficient for Other BITs it is almost 3.3 times as large for the period after the MAI increased the political salience of international investment agreements. What is perhaps surprising is that extra-dyadic BITs are effective 35 The author wishes to thank an anonymous reviewer for suggesting this test. 36 I am not suggesting that FDI acts as a substitute for domestic savings in developing countries. Indeed there is good reason to believe, as I have argued earlier, that FDI can be a valuable complement to domestic investment. The regressions reported in this paper suggest that high levels of domestic savings attracts, rather than repels FDI. I am suggesting, however, that the political costs of ratifying a BIT will be less salient when a country has less domestic capital to draw on to finance its economic growth, and is thus more dependent on foreign capital.

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