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.