How Do State Backed Investment Guarantees Shape Foreign Direct Investment

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1 How Do State Backed Investment Guarantees Shape Foreign Direct Investment Abstract Investments in foreign can be exposed to government actions that may restrict investors legal rights and result in seizure of property. One way of mitigating such political risk is to sign bilateral investment treaties (BITs) featuring special protection clauses to prevent discriminating legal actions against foreign investors. Today, investment treaties between represent a major institutional way of supporting Foreign Direct Investment (FDI) flows by reducing investors risk exposure. Besides BITs, many governments offer investment guarantee schemes that insure firms FDI against political risk. If BITs are signed to protect investments in foreign, why do enterprises still rely on state investment guarantees? This study illustrates that investment guarantees can be seen as complements of BITs, particularly in politically risky economies. While BITs offer a legal basis to address common calculable investment risk, state backed guarantees are particularly important for coping with political uncertainty that is not insurable in the private market. Additionally, guarantees appear to resolve time inconsistency problems inherent in BITs. Erdal Yalcin CESifo & Ifo Institute Ifo Center for International Economics yalcin@ifo.de Berne Union Working Paper Series May 2015 The Berne Union is the international organization and community for the global export credit and investment insurance industry. This Working Paper Series aims to share new findings in the field of export credit insurance and international trade. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in these papers are entirely those of the authors and cannot necessarily be attributed to the Berne Union or members of the Berne Union. An electronic version of the papers may be downloaded from the Berne Union website: the berne union/

2 Introduction Although Multinational Enterprises (MNEs) and host effectively stand to mutually profit from cross border investments, the distribution of Foreign Direct Investment (FDI) inflows nevertheless varies substantially across. One fundamental reason for the heterogeneity in how FDI is distributed across the world relates to the risk sensitivity of international investors. Market potentials, relative cheap labour or the availability of scarce resources are often associated with relative higher investment uncertainty in developing and emerging economies. Furthermore, international investors are concerned about political risk and are often sceptical about the quality of respective institutions and the enforceability of laws in the case of legal disputes. In some the likeliness of expropriation or the loss of an investment due to a war still exists. The mitigation of this so called political risk appears to be crucial for a country s general attractiveness as an FDI destination. FDI supplying and politically risky host nations have been trying to improve the environment for international investors in developing and emerging in particular by signing Bilateral Investment Treaties (BITs). With these treaties foreign investors are warranted a minimum standard of treatment that can be enforced in most cases via investor state dispute settlement clauses, which are generally processed in front of independent institutions such as the International Center for the Settlement of Investment Disputes (ICSID). Clearly, BITs are legal commitments that signal an investor friendly environment to MNEs. However, even if a country is bound to laws, in the case of political risk MNEs are still confronted with the likeliness of a sudden investment loss, which may not be recovered over a short period even if a BIT exists. While FDI is risk sensitive, political risk in emerging and developing counties appears to have an increasingly adverse effect on FDI inflows. Many offer state backed investment guarantees to mitigate exclusively political risk and thereby support MNEs in accessing new markets and resources. Do MNEs require investment guarantees even if sign BITs? Are investment guarantees complements or substitutes for BITs? For which are state backed guarantees a reasonable tool to support FDI? This research aims to answer these kinds of questions. A better understanding of how FDI, risk, BITs and state backed investment guarantees are related to each other is crucial to an improvement in global economic integration. We address these questions by analysing how German FDI positions in foreign emerge over time across the world in the light of political risk and the availability of BITs, and statebacked investment guarantees. We conclude that investment guarantees are complements of BITs, particularly in emerging and developing. 1

3 Political risk matters to FDI FDI flows represent an increasingly important pillar of global economic integration. Major drivers of cross border investments are multinational enterprises. Their investment motives can be categorized into three main groups: a) market seeking, b) efficiency seeking, and c) resource seeking. Emerging economies like China or India in particular offer tremendous sales potential for firms. Related FDI flows are referred to as horizontal FDI and are predominantly driven by supply side arguments. Similarly, firms are increasingly investing in foreign to improve their cost efficiency by utilising lower labour costs. Finally, the spatial scarcity of natural resources often requires firms to invest in foreign in order to ensure a stable supply for their domestic plants. These last two motives generally result in vertical FDI and are driven by cost related arguments. An important aspect of FDI is the fact that much of the cross border investments are associated with sunk costs that cannot be recapitalized once investors decide to disinvest. As a result, risk in destination is highly relevant in MNEs final decision to enter a new market. 1 Figure 1: Country Risk Distribution 2011 Source: Ifo Institute based on OECD Risk Measure Based on the OECD s country risk index that ranges between 0 and 7 (low to high risk), Figure 1 illustrates how risk differs across the world. Besides incorporating capital or exchange controls, the index focuses on so called cases of force majeure such as war, 1 The presented results in this paper are based on a larger project using bilateral German FDI data. The analysis covers the period and accounts for 10 different industries. The observed long period and the availability of an industry dimension allows us to identify different economic effects by applying advanced econometric methods. 2

4 expropriation, and natural disasters. It can be considered as an appropriate measure for political risk. 2 The map allows the identification of three groups of. Industrialized regions like the EU or the USA represent with the lowest risk, while central Africa, parts of Asia and South America are the riskiest regions in the world. Interestingly, emerging and developing like the BRIC economies (Brazil, Russia, India, and China) or Turkey and South Africa belong to an intermediate risk class. Figure 2: German FDI Positions in the World (Billion Euros) (24.1,254] (7.5,24.1] (2.5,7.5] (1.07,2.5] (.42,1.07] (.23,.42] (.073,.23] [0,.073] No data Source: German Bundesbank and Ifo Institute Figure 2 summarizes Germany s FDI positions in all across the world for Not surprisingly, regions with a low political risk like Europe or the USA account for the biggest German FDI positions. At the same time, with a highly risky environment like Central Africa or parts of Asia attract the lowest German FDI inflows. Interestingly, those regions with an intermediate risk level such as the BRIC or Turkey and South Africa turn out to be increasingly attractive for German investors. During the last 20 years these developing experienced high growth rates in German FDI inflows (at two digit levels). 2 In the underlying research project further risk measures are accounted for, such as the political risk measure of the PRS Group or the World Bank s expropriation and political risk indicators. Qualitative results across these measures turn out to be similar. 3

5 Bilateral Investment Treaties can be FDI Promoters, but not always If foreign investors are risk sensitive what triggers FDI inflows into risky developing and emerging economies? One supportive international institutional development for crossborder investment can be found in the increasing number of BITs. These bilateral or plurilateral accords have the objective of defining the legal framework for foreign investors, as well as establishing rules for possible dispute resolution, and facilitating cross border investment activities. BITs can be seen as a response to the shortcomings and ambiguities of customary international law in terms of resolving disputes in less developed. Germany is a pioneer country in signing BITs. In 1959, the Federal Republic signed the world s first BIT with Pakistan and established a practice to support national MNEs FDI activities, which has since been adopted by a growing number of other nations. Figure 3: Development of Bilateral Investment Treaties (BITs) Source: UNCTAD Data Figure 3 plots the cumulative number of globally observed BITs over time. By the end of 2011 the total number of signed BITs amounted to 2,833. In recent years attempts to improve investment conditions for foreign enterprises through BITs have been stepped up and the 4

6 depth of covered regulations is increasing. 3 Table 1 illustrates that the number of BITs with BRIC with 301 signed accords represent more than 10% of all BITs. Table 1: Distribution of BITs across country groups as of 2013 Developed economies: 1828 Developing economies: 2011 BRIC economies: 301 Source: UNCTAD Data The impact of BITs on FDI flows has been analysed from different perspectives. According to several recent studies BITs play an important role in stimulating FDI inflows, especially in developing (cf. Busse, Koeniger and Nunnenkamp, 2008; Egger & Merlo, 2012). However, there are also studies that do not identify the robust and significant FDI supporting effect of BITs on FDI if a broader range of is included in the analysis (cf. Gallagher & Birch, 2006). Other studies analyse BITs not only as an isolated contractual phenomenon, but also account for their impact on FDI in terms of additional political and institutional aspects (e.g. Tobin & Rose Ackerman, 2011). Indeed, this latter strand of analysis first confirms an average positive impact of BITs on FDI inflows to developing. Additionally, it is illustrated that the marginal positive effect of a country s signed BITs on its FDI inflows tends to decrease the more BITs are signed. Hence, simply increasing the number of BITs improves on average the likeliness that more FDI is allocated from industrialized economies to emerging or developing country. However, in some the idiosyncratic effect of BITs on FDI inflows turns out not to be the actual cause of higher investments. Figure 3 shows that Germany currently has BITs with 129 partner. However, the size of the FDI positions of German MNEs across the world differs substantially. Given the earlier mentioned results pointing to the different marginal effects of BITs across, we investigate how the impact of BITs varies across different country groups. 3 Within the negotiations of the Transatlantic Trade and Investment Partnership (TTIP) or the Comprehensive Economic and Trade Agreement (CETA) the EU intends to sign new generations of BITs with the USA and Canada. These new BITs are meant to define future standards for succeeding agreements in the world. 5

7 Table 2: Effect of BITs on German FDI Positions across Different Countries FDI Across all Developed Least developed Developing BRIC ST BIT 0.056*** n.e. n.e (0.016) (0.048) (0.13) Political risk 0.016*** 0.039* (0.005) (0.020) (0.009) (0.08) (0.043) Notes: This table summarizes pooled regression results for a panel data set of German FDI positions in all registered destination. Panel dimension is destination country x industry. Further controls which are not listed are: GDP, population, capital formation, exchange rate, free trade agreements and trade. The considered period covers the years between 1990 and Point estimates are listed at 10%, 5% and 1% significance levels. BIT measures the effect of bilateral investment treaties on FDI positions in destination. Political risk represents the OECD risk measure. BRIC ST: Brazil, Russia, India, China, South Africa, Turkey. n.e. stands for no effect. Table 2 summarizes the average effects of Germany s BITs on FDI inflows in respective. The first column measures the additional average FDI creating effect of BITs across all in which German FDI has been invested over the past two decades. Accordingly, the availability of a BIT is accompanied by an increase in FDI inflows on the industry level on average by 5.6% compared to a situation without an investment accord. Additionally, firms invest on average less in with higher political risk, as indicated by the political risk variable. Interestingly, the effect of BITs turns out to be less clear if the analysis is concentrated on specific groups. On average there is no additional significant effect of BITs on FDI if the destination country represents a developed economy or a least developed economy. 4 In the case of developed other factors as economic size or growth are major drivers of FDI (not listed). 5 In developing the direct effect of BITs appears to be higher on average compared to the overall average effect. This last result, however, is based on observations with large variation. Finally, within the group of BRIC ST (BRIC + Turkey and South Africa) a significant additional FDI supporting effect of BITs is not evident. If BITs are not always the primary force that triggers FDI inflows, what is then additionally responsible for an improved investment environment, particularly in developing and emerging economies? 4 The country grouping is based on the World Bank categorization. 5 With most of the developed Germany has no BIT. However, the largest German FDI positions turn out to be in this group of, including e.g. the USA. For a large set of least developed Germany has no signed BIT, and hence the identification of an effect is difficult. 6

8 Investment Guarantees are FDI supportive in developing and emerging economies BITs represent international contracts in which host commit to protect foreign investors, particularly against political risk. While this specific type of commitment enables foreign investors to claim compensations via lawsuits in case of politically induced FDI losses, it doesn t solve the risk faced by MNEs of a sudden loss of invested capital for a certain period until a dispute is settled via a BIT. The time gap between a politically induced loss of investment and the possible recovery of open claims is of particular interest for MNEs if intended foreign direct investments are large. Hence, even if a BIT exists for a politically risky country, the need to bridge a longer period until investment losses are settled potentially explains why BITs may have a less significant positive effect on FDI in developing and emerging economies. Figure 4: German Investment Guarantee Distribution across the World 2011 Source: Data of Federal German Government One tool used by national governments to help mitigate the additional risk for MNEs arising from the described time inconsistency associated with BITs in case of politically induced FDI losses are state backed investment guarantees. The German government offers investment guarantees to cover exclusively political risk if private insurance agencies do not offer appropriate contracts or private insurance premiums turn out to be prohibitive. It is important to mention that state backed guarantees are issued for destination if an 7

9 investment treaty is in force. In this sense guarantees can be considered as complements of BITs. 6 Figure 4 presents the current distribution of German state backed FDI guarantees across the world. Accordingly, major regions in which investment guarantees are employed turn out to be the leading emerging and developing economies. Among them the BRIC ST economies represent those with the largest insurance positions. Table 3: Effects of Investment Guarantees on German FDI Positions FDI Across all Developed Least developed Developing BRIC ST BIT 0.058*** n.e. n.e. n.e. n.e. (0.016) Investment 0.036*** n.e ** 0.049*** 0.069*** guarantees (0.007) (0.009) (0.011) (0.025) Notes: This table summarizes pooled regression results for a panel data set of German FDI positions and guarantees in all registered destination. Panel dimension is destination country x industry. Further controls which are not listed are: GDP, population, capital formation, exchange rate, free trade agreements and trade. The considered period covers the years between 1990 and Point estimates are listed at 10%, 5% and 1% significance levels. BIT measures the effect of bilateral investment treaties on FDI positions in destination. BRIC ST: Brazil, Russia, India, China, South Africa, Turkey. n.e. stands for no effect. Table 3 illustrates how BITs and state backed investment guarantees influence average FDI inflows. While the direct effect of BITs is again significantly positive if all destination are taken into account, for subgroups of there is no significant effect observable. On the other hand, investment guarantees turn out to be highly significant in all politically risky country categories, while there is no effect in developed. 7 German investment guarantees appear to create the largest FDI supporting effect in BRIC ST, followed by a smaller average marginal effect in the remaining developing economies. The smallest effect is observed in least developed. 6 The provision of state backed investment guarantees depends on different requirements and varies across. Importantly, in case of Germany the availability of BITs is a necessary condition. There exist exceptions in which the German government can issue guarantees without a BIT. For several years Brazil represented such a in which guarantees were granted even so no BIT was available. 7 Given that guarantees are primarily granted for investments in risky, there are almost no guarantee positions in developing economies. 8

10 Conclusion Based on a new data set covering German FDI positions across the world and also accounting for state backed investment guarantees, this paper analyses how FDI inflows are shaped by BITs. Its initial results confirm the ambiguous effects of BITs, particularly if effects are analysed based on with different political risk profiles. Results indicate that BITs have a significant and positive effect on German FDI across the world on average. Simultaneously, in emerging and developing FDI inflows observed turn out to be additionally driven by investment guarantees. Herein, the supportive effect of state insurance scheme for investors is particularly large in the BRIC and in Turkey or South Africa. One reason why German MNEs are more or less likely to enter politically risky with high growth potential may be the time inconsistency that can arise in case of FDI losses due to political reasons, even in the presence of BITs. The legal right to settle losses may take too long to enforce and endanger the existence of a whole company. State backed guarantees offer a term transformation and mitigate such frictions. The analysis illustrates that investment guarantees can be seen as complements of BITs, particularly in politically risky economies. The results presented here cover only a small part of possible interactions between FDI, BITs and investment guarantees. Following this new strand of research, we are currently investigating other aspects that are of major interest for both internationally investing MNEs and developing and emerging economies receiving FDI. References Busse, M., Königer, J., Nunnenkamp, P. (2010). FDI Promotion through Bilateral Investment Treaties: More Than a Bit?. Review of World Economics, 146 (1), Egger, P. and Merlo, V. (2012). BITs Bite: An Anatomy of the Impact of Bilateral Investment Treaties on Multinational Firms, The Scandinavian Journal of Economics, 114(4), Gallagher, K.P. and M.B.I. Birch (2006). Do Investment Agreements Attract Investment? Evidence from Latin America, in The Journal of World Investment and Trade, Vol. 7, No. 6, pp Neumayer, E. and L. Spess (2005). Do bilateral investment treaties increase foreign direct investment to developing?, in World Development, Vol. 33, No. 10, pp Tobin, J. and S. Rose Ackerman (2011). When BITs have some bite: The political economic environment for bilateral investment treaties, The Review of International Organizations, Volume 6, pp