When BITs Have Some Bite: The Political-Economic Environment for Bilateral Investment Treaties

November 14, 2006

Jennifer Tobin University of Oxford Nuffield College New Road Oxford, OX1 1NF Jennifer.Tobin@nuffield.ox.ac.uk Susan Rose-Ackerman1 Yale University Law School P.O. Box 208215 New Haven, CT 06520 susan.rose-ackerman@yale.edu

Jennifer Tobin is a graduate student in the Department of Political Science, Yale University, and research fellow at Nuffield College, Oxford University. Susan Rose-Ackerman is the Henry R. Luce Professor of Law and Political Science, Yale University. Email addresses: jennifer.tobin@nuffield.ox.ac.uk; susan.rose-ackerman@yale.edu. We are grateful to Ryan Bubb for his mathematical development of the theory relating world BITs and individual country BITs and to Santiago Montt for his research on the characteristics of BITs.

Abstract Past empirical work on the growing number of BITs in force around the world has produced conflicting findings concerning their impact on FDI. This study takes an important step towards resolving some of these conflicting results. We show both theoretically and empirically that BITs cannot be judged in isolation. Their impact on host country FDI flows must be studied within the context of the political, economic and institutional features of the host country that is signing the BIT and in the light of the worldwide BITs regime. We find that BITs do indeed have a positive impact on FDI flows to developing countries. Importantly, however, we show that this general positive impact is highly dependent on the political and economic environment surrounding both FDI and BITs. Our statistical results demonstrate that, as the coverage of BITs increases, overall FDI flows to developing countries may increase, but the marginal effect of a countrys own BITs on its FDI will fall. Additionally, a stronger political environment for investment and a better local economic environment are complements to BITs. Our results demonstrate that we can only understand the impact of BIT programs on FDI with a broader understanding of the political-economic environment surrounding investment.

The benefits and costs of foreign direct investment (FDI) for poor and middle-income countries are the subject of a lively scholarly debate. Although the debate continues, most countries actively seek to attract FDI; it is a major source of investment funds, and governments view it as a stimulant to overall economic growth.2 Countries frequently offer investment guarantees and incentives to multinational corporations (MNCs) hoping to attract greater flows of FDI. One prominent example of these incentives is the Bilateral Investment Treaty (BIT). At present, over 2000 BITs have been signed throughout the world.3 We seek to understand their impact on host countries in the developing world.4 BITs are touted as a potent tool for attracting FDI and recent empirical work suggests that potential host countries do indeed sign BITs in an effort to improve their attractiveness as sites for FDI (Elkins, Guzman, and Simmons 2006). Yet the empirical basis for the claim that BITs stimulate FDI is weak. Recent studies have come to conflicting conclusions. Salacuse and Sullivan (2004) and Neumayer and Spess (2004) find strong correlations between BITs and FDI flows on both a bilateral and a general basis. At the same time, using a different set of models and assumptions, both Hallward-Driemeier (2003) and an earlier paper by the present authors find little evidence of this connection. Each of these papers assumes that the effect of BITs on FDI flows is independent of the broader political and economic environment. This is an unwarranted assumption that this paper attempts to correct. When we take the interaction with the broader political-economic environment into account, we find, in contrast to our previous
2

FDI accounted for more than half of net resource flows to developing countries in most recent years, and is more stable than non-FDI flows. For example, over the period 1996-2004, FDI flows to developing countries averaged 163 billion dollars, while private equity flows averaged only 7 billion and total foreign aid (grants) averaged only 32 billion (IMF International Financial Statistics). 3 The exact number of BITs in-force at the end of 2004 was 1,674. An additional 718 have been signed but not ratified (UNCTAD 2005). 4 As in most work on investment, the host country refers to the country where the investment is taking place, while the home country refers to the country of residence of the foreign investor.

work, that there is a positive relationship between BITs and FDI, but only under certain conditions. Furthermore, the strength of the interaction is a function not only of the FDI environment in the host country, but in the world as well. We take account both of a countrys own treaties and of the dramatic growth in the number of BITs throughout the world. The model also accounts for interactions between the general economic and political environment of the host country and BITs, and it does a better job of dealing with statistical difficulties than existing studies. Our innovations are two-fold. First, we draw on and develop a more sophisticated theoretical framework that we believe captures reality better than past efforts. Second, our econometric tests are more appropriate to the nature of the data than past efforts, including our own earlier paper. Our statistical work provides evidence for three claims. First, the number of BITs signed by a developing host country with a wealthy home country generally has a positive impact on FDI in subsequent periods. Second, the marginal impact of a countrys own BITs on its ability to attract FDI falls as the global coverage of BITs grows. Although the growing world total of BITs may stimulate FDI, the pool of funds remains limited. Hence, the use of BITs as a signal of a strong investment environment in a particular country is muted by the greater availability of BITs, and as the worldwide coverage of BITs increases, the benefit from ones own BITs falls. Third, the political-economic environment in a country matters for how BITs affect FDI flows. Specifically, we hypothesize both that BITs serve as a complement rather than a substitute for the host country political environment for investment, and that the general economic environment in a host country interacts with the number of BITs to enhance or dampen BITs impact on FDI. Overall, we find that the relationship between BITs and FDI is powerfully influenced by both the global and local environment for FDI. Simple linear models that do not

account for these interactions can be misleading. As we illustrate at the end of the paper, the impact of BITs on FDI seems to vary a good deal across time for countries at different levels of development. Countries with very poor investment environments need to improve domestic conditions before BITs can have an impact on flows of FDI. The paper is organized as follows. First, we present summary data on FDI and BITs; next we introduce the theoretical perspective that underlies our paper; we then introduce our data set and estimation techniques, and, finally, discuss our empirical findings.

I. Foreign Direct Investment and BITs Given the weakness of the domestic political\legal environment in many low- and middleincome countries, investors seek alternatives tailored to their needs. This can be done on a caseby-case basis with customary international law as a backup, but transaction costs can be reduced if the host country commits itself to a basic framework by treaty. Along with other international institutions, this is what BITs do.5 They provide enforceable rules to protect foreign investment and reduce the risk faced by investors. The treaties seek to promote foreign investment through a series of strategies, including guarantees of a high standard of treatment, legal protection of investment under international law, and access to international dispute resolution for both states and private investors (UNCTAD 2005). BITs are becoming a popular tool for developing countries seeking to promote and protect foreign investment. UNCTAD and some wealthy countries actively promote BITs as tools to stimulate FDI.

Other parts of a foreign-investor-friendly package usually include membership in the World Banks International Center for the Settlement of International Disputes (ICSID) and its Multilateral Insurance Guarantee Agency, a tax treaty limiting double taxation, and membership in the 1958 New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards.

A. BITs: Proliferation and History International law on commerce and investment developed out of a series of Friendship, Commerce, and Navigation Treaties (FCNs). FCNs provided foreign investors with most favored nation treatment in host countries but were mainly signed between developed countries. The extension of treaty obligations to developing countries began in 1959 when the first BIT was signed between Germany and Pakistan; it entered into force in 1962. The number of BITs rose slowly during the sixties, seventies and eighties. Most were signed between a developed and a developing country, generally at the urging of the developed country governments. Typically, before the 1990s, developing countries did not sign BITs with each other. The number of new BITs concluded rose rapidly in the 1990s. According to UNCTAD, the overall number in-force rose from 385 in 1990 to 2,392 at the end of 2004 (Figure 1, (UNCTAD 2005). As of the end of 2005, 177 countries were involved in bilateral investment treaties {UNCTAD, 2006}. Beginning in the 1990s more and more developing countries signed BITs with each other, in part because of the efforts of UNCTAD to promote their spread. In that decade, 42% were concluded between developed and developing countries, 38% were between developing countries, and the remainder included countries within southeastern Europe and the Commonwealth of Independent States (UNCTAD 2005) (Figure 2). The proliferation of BITs has followed a general geographic pattern. Most early BITs were signed between Germany and Switzerland, on the one side, and a range of low income countries, mostly in Africa, on the other. Other wealthy European countries began to sign treaties in the 1960s and 1970s; the United States did not sign its first BIT until 1982. Asian nations slowly began to enter the arena in the 1970s, followed in the late 1980s and early 1990s by

central and eastern European countries. In the 1990s Latin American nations began to enter into these agreements.6 Given the proliferation of bilateral treaties, one might wonder why a multi-lateral agreement was not forthcoming. Indeed, as early as 1967, the OECD attempted to establish a multilateral agreement on foreign investment protectionthe OECD Draft Convention on the Protection of Foreign Property. The convention proposed an international minimum standard of protection for foreign investment but was opposed by developing countries, mainly in Latin America, that insisted on subjecting foreign investment to domestic controls with disputes being settled in domestic courts.7 Following the failure of the OECD convention, European countries and later the United States began to establish more and more bilateral investment agreements with developing countries.8 B. BITs: Basic Provisions Overall, the provisions of BITs are meant to secure the legal environment for foreign investors, to establish mechanisms for dispute resolution, and to facilitate the entry and exit of funds. BITs and related instruments covering both trade and investment, such as the North American Free Trade Agreement (NAFTA), are currently the dominant means through which investment in lowand middle-income countries is regulated under international law. The treaties are a response to the weaknesses and ambiguities of customary international law as applied to investments by international firms in countries at low levels of development.

Although Latin American countries were not signatories to BITs until the 1990s, their largest trading partner, the United States, provided political risk insurance and guarantee agreements to most Latin American Nations. 7 In 1974, a number of developing countries supported a United Nations resolution to protect the national sovereignty of the economic activities and resources of host countries (Charter of Economic Rights and Duties of States, G.A. Res. 3281, 29 U.N. GAOR Supp. (No.31) at 50, 51-55, U.N. Doc. A/9631 (1974)). 8 European treaties are generally known as Bilateral Investment Protection Agreements (BIPAs); the U.S. treaties are known as BITs. The United States signed twenty-three FCNs between 1946 and 1966, but did not enter into any other bilateral agreements on investment until the 1982 BIT with Panama. Our data sets combine BITs and BIPAs.

The majority of existing BITs have very similar provisions based as they are on the model treaties developed by the home countries of the major MNCs. They require that foreign investors from the signatory countries be treated at least as well as domestic investors and as investors from other countries. The major differences lie in the protection or non-protection of certain types of investment and in whether or not the treaties apply as soon as a contract has been signed or whether funds must actually have been invested. Over time, the most important development has been the inclusion of investor-state arbitration for most issues that might arise under the treaty. Most early treaties omit this provision, and others limit its application. By 1990, according to data compiled by Santiago Montt (2006) from UNCTAD, almost all new treaties included general provisions for investor/state arbitration. This made BITs more useful to investors who no longer needed to obtain the support of their home governments when a dispute arose. BITs generally provide for resolution of both country-country and investor-host country disputes by an international arbitral body. The World Bank Group's International Center for the Settlement of International Disputes (ICSID) was created especially to handle investor-state disputes.9 Typically, developed countries prepare a model treaty based on the 1967 Draft Convention on the Protection of Foreign Property and on already existing BITs. These model treaties are then modified for use in a variety of situations. Thus, treaties emanating from a developed country are likely to be similar or even identical, but differences exist between those proposed by different developed countries. An important recent development, not reflected in our data set, is the United States revised model BIT issued in late 2004. It represents a significant new departure because it strengthens property rights protections and includes
9

ICSID lists 112 decided cases and 104 pending cases on its website www.worldbank.org/icsid (visited November 12, 2006). Most were filed between 1997 and 2006 as BITs begin to play a major role in international investment.

requirements for signatories to make rules and regulations transparent, to introduce domestic administrative procedures, and to consider the impact of investments on environmental and labor conditions. Only the first two elements in this list, however, can be enforced through arbitration.10 II. Theory Developing countries sign BITs with the aim of attracting inward investment to promote economic development.11 There are two competing hypotheses about the relationship between a countrys BITs and FDI. First, a BIT signed with a particular home country sends a signal to investors in that country that prospective investments in the host country will be well protected. Second, BITs send a signal to all investors, whether or not their own home country has signed a BIT with a particular host country. Investors consider the BITs regime in a developing country as an overall indication of its willingness to protect the interests of foreign investors. The number of BITs with investor countries could then indicate that the country is protecting investors either through the enactment of general laws favoring all investment or through a business environment that is particularly favorable to external investors. Firms see a willingness to sign BITs with investor countries as a credible signal from the host country to investors throughout the world. However, not all BITs are equal. Some BITs are signed with countries that are likely sources of FDI; others are signed between developing countries, neither of which is likely to invest much in the other. We assume that BITs of the latter sort do not send a signal to investors as a group. A country that signs a BIT with an important source of FDI, such as the United States or Germany, is sending a stronger signal than one that signs a treaty with Bulgaria or Sierra Leone.
10 11

The 2004 Model BIT is available at http://www.state.gov/e/eb/rls/othr/38602.htm. Although little academic work has been done on the proliferation of BITs, interviews by one of the authors, (Tobin) with government officials yielded a desire to attract FDI as the main purpose for low- and middle income countries to sign BITs. Further, empirical work on the diffusion of BITs by Elkins, Guzman, and Simmons (2006)} finds that the proliferation of BITs is a result of competitive economic pressures among developing countries to capture a share of foreign investment.

This paper examines variants of the second hypothesis concerning the signaling value of BITs. In subsequent work we will examine data on country pairs, although the data are less complete than those on global flows. Published sources eliminate data that might reveal information on individual deals. Thus, the more the data are disaggregated, the greater the problem of missing observations. We seek to understand the strength of the signal sent by developing countries when they sign BITs with the industrialized countries (measured for us by membership in the OECD before its recent expansion to include some countries in Eastern Europe). Our measure of impact is the effect on FDI. Previous research on BITs, although distinguishing between developing and industrialized countries as treaty partners, has ignored the way BITs might interact both with the global coverage of BITs and with the host countrys environment. In contrast, we take into account four complications. They are, first, the interaction between a countrys own BITs and the global BITs regime; second, the way the political environment may interact with BITs to influence FDI levels; third, the interaction between the number of BITs and economic conditions inside the country that influence FDI, and, fourth the vast differences in the size and resource endowment of the countries trying to obtain a slice of the FDI pie. Note that we are not trying to explain overall levels of FDI into low and middle income countries. If that were our aim, we would need to focus almost exclusively on a few large, middle income, and/or resource rich countries such as China, Brazil, and Mexico. Rather, we ask both whether countries benefit from BITs and if the importance of BITs is strengthened or moderated by the political-economic environment of the host country and by the global BIT regime.

i) The Global BIT regime

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Consider, first, the impact of the global level of BITs on FDI flows into a particular country. Previous work has assumed that an individual countrys ability to attract FDI is unaffected by the investment climate elsewhere. This seems unrealistic. MNCs can locate throughout the world and will select the location that promises the best opportunities for profit. If very few countries have BITs, those that do may be especially attractive locations for investment. However, as more and more countries sign more and more BITs, the relative benefit of an extra BIT can be expected to fall. One of the present authors, Rose-Ackerman, and Ryan Bubb (2006) developed a formal model of this possibility based on earlier work by Guzman (1998). Figure 3 illustrates their basic result. The model assumes that wealthy countries are the source of most FDI and always benefit from BITs.12 The figure shows the situation in developing countries. The x-axis is the number of BITs in force between developed and developing countries as a share of all possible BITs that could be signed between these groups of countries. The y-axis records both the benefit to developing countries from entering the BITs regime and the benefits of staying out and being covered only by customary international law. The curve labeled t is the benefit to a developing country from signing BITs as a function of the global coverage of BITs. The curve labeled c is the benefit of staying with customary international law. As more countries sign BITs, the benefit of BITs to any one country falls, but because the benefit of staying out also falls, more and more countries sign up. In the model, the equilibrium occurs either with 100 percent BITs coverage (figure 3a) or at an intermediate level such as n (figure 3b). Thus we predict that although the marginal value to a country of signing an extra BIT will be positive, the size of that marginal effect falls as the global coverage of BITs increases.13
12

As MNCs in emerging countries begin to invest abroad including in wealthy countries, this model will lose its descriptive force. Under NAFTA and a few BITs, disputes are arising where an MNC located in a developing country brings a case against a wealthy country, for example, Mexican companies versus the United States, or Argentina investor versus Spain. 13 We take no position on Guzmans suggestion that developing countries could be better off in a regime governed by customary international law with no BITs compared with a global BITs regime. As Bubb and Rose-Ackerman

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ii) The political environment for FDI The second complication is the possible interaction between BITs and the political environment for investment. If the environment is risky because of a dysfunctional or kleptocratic government, BITs might permit foreign investors to opt out of domestic institutions. However, weak or venal governments are unlikely to be credible treaty partners. Thus, rather than being substitutes, improvements in the political environment for investment are likely to complement BITs and further enhance their impact. We interact the number of BITs in force in individual host countries with a measure of the political environment for investment. We hypothesize that, on balance, BITs will have a positive interaction with the underlying political determinants of investment. iii) The economic determinants of FDI BITs may also mitigate or enhance the economic factors that drive investment to a particular host country. FDI can flow into a country for a number of different reasons. Some FDI leads to the production of products for the domestic market; other FDI is designed to produce goods for export. Countries may attract FDI if they have numerous consumers with some discretionary income, if they have plentiful and valuable natural resources, and\or if they have an inexpensive work force with skills needed by investors. Standard attempts to study the determinants of FDI recognize the importance of all of these factors but obtain somewhat conflicting results as to their importance. We believe that the impact of the economic determinants of FDI should be contingent on BITs through two channels: 1) economic factors that attract investors but do not depend upon the size of the country or its resource base, and 2) factors that measure the ability of a country to absorb profitable FDI projects. Our innovation is to interact indices of economic factors and of absorptive capacity with the number of BITs in
(2006) show and figure 3 illustrates, either outcome is possible.

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force in individual host countries to determine whether the impact of BITs is enhanced or reduced when countries are attractive destinations for FDI. The first channel could work in either of two conflicting ways. On the one hand, if the impacts of BITs and economic variables are positive taken alone, their interaction should be positive as well. Then, BITs increase the profitability of any type of FDI. On the other hand, BITs may serve as useful tools for overcoming economic shortfalls so that they have a bigger impact in countries with weak fundamentals. We hypothesize that the first impact is dominant; on balance, BITs enhance the value of underlying economic determinants of investment. A country with many BITs but low income, slow growth, and a closed economy will be unlikely to attract much FDI. BITs, if they do indeed send a signal to investors, complement other reasons for investing. Second, the host countrys endowments may be a proxy for a countrys capacity to absorb profitable FDI projects. A country with a small market or resource base may obtain just as much benefit from BITs in percentage terms as a large one, but the extra FDI it receives will generally be smaller in dollar terms than the FDI received by a large country. If so, this suggests that one should interact the number of BITs with an index of the capacity of the country to absorb FDI measured by the size of the market and by the resource base. One would expect a positive sign on this interaction that reflects the differences in country scale. ***** Overall, previous analyses of BITs have ignored the issue of what BITs are meant to do and how they are meant to do it. BITs cannot attract FDI by themselves; they must work within the existing political-economic environment to strengthen the opportunities for developing countries to attract FDI. The effect of BITs is likely to depend on the broader political and

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economic environment. Franzese (1999) and Brambor, Clark et al. (2006) show that when a variable is theoretically expected to depend on the values of other variables in the model, not including those interactions leads to mis-specified equations and potentially misleading results. The following analysis, therefore, allows more precise and theoretically plausible estimates by allowing the effect of BITs to vary along with the broader political-economic environment.

Quantitative Analysis Our empirical analysis explores the following related questions. First, does the number of BITs signed by a country with OECD members encourage FDI by sending a signal to investors that overall investor protections are strong? Second, even if the signal is strong and reliable, is its impact on FDI muted as more and more BITs are signed by other countries competing for investment from abroad? Third, do indices of the political environment for investment, the host country economic environment, and the capacity of the host country to absorb FDI interact with the number of BITs to enhance their impact? Thus we have: Hypothesis: Foreign investment inflows to developing countries will be positively associated with the number of active BITS between a host and an OECD country. Corollary 1: This positive association will decrease as the overall number of BITs signed by OCED countries increases throughout the world. Corollary 2: This positive association will be greater the better the political environment for investment. Corollary 3: This positive association will be greater the better the domestic economic environment Corollary 4: This positive association will be greater the greater the capacity of a country to absorb FDI

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A. Specification Our dependent variable (described in more detail in the data section) is measured as net FDI flows to a host country between 1980 and 2003 in constant 2000 dollars as reported by the World Bank in the World Development Indicators (WDI). Our host countries include only middle and low income countries. This constitutes between 20 and 40 percent of total FDI depending upon the year. We are not concerned with FDI between wealthy countries most of which have strong domestic legal environments. The independent variable of most interest is a count of BITs a country has in force with OECD countries. We only consider BITs with high income (OECD) countries on the ground that they are the ones with the potential to have an impact on FDI flows during the time period of our study. To test our hypotheses we need to estimate a model of the determinants of foreign direct investment into developing economies. The theoretical and empirical work in this field is vast, with much disagreement regarding which factors should be included as determinants. Models differ depending on whether data is firm-level, country-pair level, or deals with developed versus developing countries. We present a reduced form FDI specification based on our theoretical model of the determinants of FDI and those variables most strongly supported by the existing FDI literature. 14 Our proxy for the political environment for investment is an index that covers factors such as rule of law, political risk, and governanceall factors hypothesized to determine foreign investors investment decisions (Jun and Singh 1996; Gastanaga, Nugent et al. 1998; Wei 2000; Blonigen 2005). The next group of variables seek to capture the economic determinants in the first channel outlined above. These are first, as basic measures of economic health, the log of GDP
14

For a complete overview of the determinants of FDI see Blonigen (2005).

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per capita (income), and the rate of growth of a countrys economy (Schneider and Frey 1985), Second, openness to trade is likely to have an impact on FDI, with high trade barriers attracting horizontal FDI (tariff-jumping), while vertical FDI is likely to be attracted to more open economies (Blonigen 2005). Finally, we seek to capture the absorptive capacity of the country in two ways. First, we include population as a measure of market size, given the level of per capita income. Second, according to UNCTAD (2001), the majority of FDI to the least developed countries is natural resource investment. The presence of natural resources in a country is expected to attract foreign investment regardless of other factors that would usually attract or discourage investors. Social factors such as literacy or health are highly collinear with our other measures and were therefore excluded from the model. To avoid the impact of year-to-year variation caused by the pattern of individual deals, we average all data over five years over the time period 1980 to 2003 (four years for the last period). The five-year period was chosen because it is unlikely that signing a BIT would cause FDI in a country to immediately increase. Instead, we assume that investors observe the signing of the BIT and subsequently decide to invest. These decisions would then show up in the data several years later. Thus, there might not be an effect on investment for some period of time after the signing of the BIT. Because we expect the BIT signal to operate with a lag, we use BIT data from the previous five year period to estimate FDI in any particular period. We are not, however, able to fully account for the possibility that some FDI might flow before a BIT is signed in anticipation of its benefits. Given the lags between investment plans and the actual flow of funds, however, we do not believe this is a serious weakness. In addition, firms with substantial investments in host countries may advocate for BITs between their home country and

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that host country that will have retrospective impact. If firms with investment in place encourage BITs, then BITs could also be an effect of FDI. To account for the possible endogeneity of the BIT variables as well as of income and growth, we lag those variables by one period. Data on many variables were unavailable for some country-years. If we had deleted all countries with missing data, this would have reduced our sample by up to 40 countries. To deal with the possibility of selection bias that could arise from dropping such a large number of (nonrandom) observations, we use the Amelia (Honaker, Joseph et al. 2003) program for multiple imputation to replace missing data with the best predictions of the data.15 Amelia uses the known values of certain variables and correlation across independent variables to generate five datasets with unique values for missing observations (King, Honaker et al. 2001). To reflect the level of uncertainty of the estimated values, we then use the program Clarify (Tomz, Wittenberg et al. 2003) to combine the estimated results from each of the five estimations. Additionally, we performed a number of tests to be sure that our results were not unduly affected by any outlying observations.16 Following these procedures for imputing missing data, and checking for outliers, our data cover a total of 135 countries over the period 1980-2003. A complete list of countries included in our study is in the appendix.

To test our hypotheses we estimate four specifications. Our base model for foreign direct investment to low- and middle- income countries mirrors that of past studies, and takes the following form: Real FDI flows to low-income country i in time t (y) depend upon the number of OECD BITs in force with the host country (b), the total number of BITs in the world with OECD
15

Listwise deletion estimates are available from the authors. Results did not change substantially, but are not included because of potential bias. 16 Information on outliers is available in appendix A.

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countries (B), an index of the political environment for investment (r), the natural log of the average level of per capita income (i), the natural log of the population of the host country (p), economic growth (g), natural resource trade levels (n), openness (o), a random error (v), and fixed country and time effects (). Each of the variables is indexed by country (i) and time period (t). The variables are described in detail below in the data section.

yit = 0 + 1bi , t 1 + 2 Bt 1 + 3ri ,t 1 + 4i i ,t + 5pi , t + 6g i ,t 1 + 7 n i ,t + 8oi , t +i + vit

(1)

We estimate the model using Ordinary Least Squares (OLS), including country level fixed effects to control for factors unique to each country and time dummies to control for changes to FDI that are simply an effect of the period of time we are dealing with. Because of the possibility of auto-correlation and heteroskedasticity,17 we report Newey-West autocorrelation and heteroskedasticity consistent standard errors.18 Although model (1) is useful for understanding the independent effect of BITs on FDI inflows, our theory leads us to believe that this effect is conditional. Specifications 2-4 test the contingent relationship of BITs with world BITs and the countrys political-economic environment. The second specification interacts the level of world BITs that involve OECD countries with the number of such BITs in force in each country in each time period.
17

We do not include a lag of our dependent variable, as there is little theoretical justification for it. While past years FDI may influence current years, it is unlikely that FDI measured with over the previous 5-year period influences current FDI. Although the inclusion of a lagged dependent variable was statistically significant when included in our model, Achen (2000) argues that lagged dependent variables are likely to be statistically significant, but including them in models without theoretical justification can explain away variation in the dependent variables that should be explained through theoretically justified independent variables. 18 Standard diagnostic tests showed that our errors exhibit first-order, but not second-order serial correlation. Controlling for two lags of inflation, residual-correlation tests found no significant serial correlation remaining. We estimate and show standard errors using two lags in order to be cautious, but differences in the size of standard errors between one and two lags are minimal.

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yit = 0 + 1b i , t 1 + 2 Bt 1 + 3 (b * B ) + 4 ri , t 1 + 5i i , t + 6 p i , t + 7 g i , t 1 + 8 n i , t + 9o i , t + i + vit

( 2)

With the assumption that each of our general determinants of FDI may vary as the number of BITs that an individual country has increases, model (3) reflects the interaction of the determinants of FDI with the number of BITs in force with the host country.

yit = 0 + 1b i , t 1 + 2 Bt 1 + 3 ( B * b) + 4 ri , t 1 + 5i i , t + 6 pi , t + 7 g i , t 1 + 8 n i , t + 9o i , t +

(3)

10 (r * b) + 11 (i * b) + 12 (p * b) + 13 (g * b) + 14 (n * b) + 15 (o * b) +i + vit

Although this model enables us to see the individual interactive effects of BITs with each aspect of the greater political-economic environment, the high correlations between each of the interactions result in naturally high standard errors (correlations are above.8 in most cases). Thus, the results of this model, while interesting, are difficult to interpret. Our theory hypothesizes that our variables measuring economic conditions and those measuring a countrys capacity to absorb FDI should interact with the level of BITs in a country to affect FDI in similar ways. Therefore, we group both sets of variables into two indicators to determine the interactive effect of both the economic environment and the capacity of a country to absorb FDI. We continue to include a separate measure of the political environment for investment because it seeks to capture a distinct aspect of the conditions under which FDI is made. Model (4) allows us to test each our hypothesis and each of our corollaries in a more efficient manner:

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yit = 0 + 1bi , t 1 + 2 Bt 1 + 3 ( B * b) + 4 ri , t 1 + 5i i , t + 6 p i , t + 7 g i , t 1 + 8 n i , t + 9 oi , t +

10 ( r * b) + 11 (pe * b) + 12 (ac * b) +i + vit

Where pe denotes an indicator representing the individual economic variables (per capita income, economic growth, and openness to trade) and ac demotes an indicator representing a countrys capacity to absorb FDI using measures that capture the absolute levels of these variables(natural resource flows and population).

B. Data Dependent variables: As the dependent variable in the first set of estimates we use the broadest measure of FDI inflows between 1970 and 2003 available on a yearly basis from UNCTAD/World Bank.19 FDI inflows are provided on a net basis, and include capital provided (either directly or through other related enterprises) by a foreign direct investor to an FDI enterprise or capital received from an FDI enterprise by a foreign direct investor. There are three components in FDI: equity capital, reinvested earnings, and intra-company loans. If one of these three components is negative and is not offset by positive amounts in the remaining components, the resulting measure of FDI inflows can be negative, indicating disinvestment.20 We convert the data to constant 2000 US dollars. Independent Variables: BITs in country and total: Data on BITs are available from a listing published by UNCTAD that documents the parties to every bilateral investment treaty, the date of signature,
19 20

See the appendix B for the description of the variables. For more information see the World Investment Directory Website: http://r0.unctad.org/en/subsites/dite/fdistats_files/WID.htm

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and the date of entry into force. These data are available for every BIT of public record from the first treaty signed in 1959 between Germany and Pakistan through December 2004{UNCTAD, 2001 #121}. We measure the cumulative total of BITs in force as the average over the previous time period, rather than the current period, assuming that BITs in force in the previous five-year period will affect subsequent, but not immediate FDI flows. We only include BITs that have at least one OECD member as a signatory. Political Environment for Investment: For the purpose of cross-sectional comparison across time, we use an index produced by the International Country Risk Guide (ICRG). Their variable is based on institutional indicators complied by private international investment risk services. The ICRG index includes measures of the risk of expropriation, established mechanisms for dispute resolution, contract enforcement, government credibility, corruption in government, and quality of bureaucracy. It is measured on a scale from one to 100 with higher numbers equating to better levels of the political environment in a country (that is, lower levels of political risk). Per Capita Income and Growth: Income is measured by the log of GDP per capita (income), and growth is the annual growth rate of per capita GDP. Openness: We include the sum of exports plus imports divided by GDP as a measure of openness. Of course, both FDI and openness may be determined by some third set of unmeasured factors that determine the strength of the market and its openness to both trade and investment, but our interest here is not in unpacking those factors but in concentrating on the impact of BITs. Natural Resources: Natural resource endowments are measured through a composite of natural fuels and ores exported from individual countries that is available from the IMFs

21

International Financial Statistics Database. The data is measured in constant 2000 dollars US. Notice that this variable is the absolute level of exports. Thus it is a proxy for the overall importance of the countrys natural resource exports in the world market. Population: Population is the log of total population Indicators: We used two different techniques to create and test indicators that would measure the general economic environment and the capacity of a country to absorb FDI. The former includes per capita income, growth and openness. The latter includes population and natural resource exports. First, we created two additive measures of each of the individual variables weighted by their coefficient estimates from model (1). We then standardized the variables to have a mean of 0 and standard deviation of 1 for ease of interpretation. According to our theory, the coefficient estimates of model (1) are incorrect as they do not account for the very interactive effects that we are testing for. Therefore, we created a second set of indicators using principle component analysis (PCA) which combines the individual components into an index of weighted linear combinations of those variables, and again standardized the resulting indicators for ease of interpretation. In both cases, each of the included factors was highly correlated with the resulting index. The resulting estimates of model (4) did not change substantially based on which set of indicators was used. We present estimates using the indictors created through principal component analysis to minimize the measurement error of using estimates from model 1, but these results are available from the authors.21

C. Results
21

Noting that neither openness nor population are statistically significant across our models, we also created both sets of indicators omitting both of these variables. None of the results changed significantly and thus we do not report them here.

22

Table 1 reports the results of our four models. The results are consistent with our hypothesis. The number of BITs a country has in force with a high income country has a significant, positive effect on FDI inflows, regardless of the specification. Column (1) reports the results of model (1), the linear specification. As with past research that has studied the effects of counts of BITs on FDI flows, there is a significant, positive impact of an additional BIT on FDI. Further, each of the independent variables has the expected sign except for population, which along with openness are not statistically significant in the model. In past research, the investigations have stopped at this point. Our theory leads us to believe that this positive impact is not linear. Column (2) of Table (1) interacts the number of BITs in the world with the number of BITs in an individual country. This interaction is negative and significant. An additional BIT signed by a country does have a positive impact on FDI flows, but this positive impact is lessened as other countries in the world sign more BITs. Moving to include interactions with domestic conditions, column (3) reports the results of model (3), the fully interactive model. If model (1)which finds a linear relationship between BITs and FDIwere correct, the coefficients on each of the interactive terms in column (3) should be insignificant (Franzese 1999). Column (3) clearly shows that this is not the case. In fact, each of the individual interactive effects is significantly different from zero at least at the 90 per cent confidence level. Further, the R-squared, adjusted for a greater number of independent variablesone measure of goodness of fitincreases substantially from models 1 and 2 to model 3 for both of our dependent variables. Specifically, it increases from 0.25 in the linear model to 0.59 in the fully interactive model. Thus, we are confident in our claim that the relationship between BITs and FDI is not linear.

23

Unfortunately, once we include multiple interactions in the model we can no longer safely interpret the coefficient estimates. Although most of our interactive terms are significant either alone or in conjunction with their component variables, this level of significance only holds true if all other variables are equal to zero. Once we adjust the other variables in the model to their means (or within one standard deviation of their means) most statistical significance falls away. Further, many of the interaction terms are highly correlated with each other and with their underlying components. This high level of correlation naturally results in large standard errors making it difficult to understand the specific relationships between the independent variables and FDI. Once we account for varying levels of BITs in the interaction terms, the interactive effects are significant in very few cases. Nevertheless, Franzese (1999) and Franzese and Kam(2005) show that we must allow our theory and the power of the interactive model to drive our specification.22 Despite the low significance levels, however, we can conclude that the simple linear model in (1) is incorrectly specified--model (3) explains much more of the variance. Furthermore, we see that the results of model (2), our first corollary, continue to hold, that is as the number of BITs in the world increases, signing an additional BIT has a decreasing marginal return in terms of FDI to low- and middle-income countries. GDP, openness and population also exhibit a negative relationshipas a country gets richer, more open and larger, the marginal impact of BITs falls. Again, while we cannot be certain of these results, it could be that, contrary to our hypothesis, BITs sometimes serve as a substitute for low values of these variables. The political environment for investment, growth, and natural resources each has a

22

The adjusted R-square in all four of our models increases from the non-interactive to interactive models. Further, tests of joint significance of the entire model surpass p=.001 in each of our specifications.

24

positive contingent relationship with FDI. That is, it seems that each of these factors complement BITs in their positive relationship with FDI. Having demonstrated that the linear specification is incorrect, we now seek a more parsimonious specification that limits the problem of collinearity that arose in model (3). To do this we estimate model (4), which includes our two indicators as well as interactions with world BITs and the political environment for investment. Recall that the first indicator groups together the economic variables that have been normalized for the size of the country while the second includes the measures of absorptive capacity. Again, it is easy to see the strength of this model compared with that of the linear model (1). The interaction between the political environment for investment and BITs is significant at the 99 percent confidence level, and the interaction between the economic indicator and BITs is significant at 90 percent. The interaction between BITs and World BITs is jointly significant with the individual BITs variable at the 95 percent level. Although the absorptive capacity indicator is not significant, all the interactive terms and the individual BITs variable are jointly significant above the 99 percent confidence level. Further, the R-squared has increased from 0.25 to 0.30 between models (1) and (4). With this more parsimonious model we can be more confident of the relationship between BITs and FDI then the simple linear model, we can test our hypotheses, and we can be confident in interpreting the estimates of the interactive effects. Again we see that BITs have a positive affect on FDI flows. Although interpretation of the coefficient estimates is difficult because of the multiple interactions, we can still see that the positive effect of BITs on FDI is lessened as more countries in the world sign BITs, but strengthened as a countrys political environment for investment, economic environment, or absorptive capacity improves. Figures 4 and 5 show graphically the effect of signing an

25

additional BIT on FDI as the number of BITs in the world increases and as the political environment for investment improves, holding all other variables at their means. These estimates are generated from the coefficient estimates and the variance-covariance matrices from the regressions in Table 1 column (1) and column (4). In figure 4, we see that in the linear model, regardless of the number of BITs signed by other countries, the effect of a country signing an additional BIT increases FDI by, on average, 23 billion dollars. The effect of an additional BIT on FDI in model (4) remains positive, but it decreases as more countries in the world enter into BITs and becomes insignificantly different from 0 at around 665 BITs, well below the current number of BITs existing in the world that involve OECD countries. Although it is risky to put too much trust in the exact coefficient estimates, we have found strong support for corollary 1. That is, we can infer that when BITs were a relatively novel feature of the global economy they had a significant, positive impact on FDI flows to developing countries. However, now that they have become quite common place, their positive impact has declined. Figure 5 examines the interactive estimates of an individual countrys BITs on FDI as the political environment for investment in a country improves, holding all other variables at their means. In the linear model as a countrys political environment improves, an additional BIT provides a constant additional flow of FDI of, on average, 23 billion dollars. The upward sloping line reflects our estimates of the political environment from model (4). Here we see that as a countrys political environment for investment improves, the impact of signing an additional BIT increases. For example, for a country with a poor political environment rating of about 45 (about one standard deviation below the mean), an additional BIT would increase expected FDI by 24 billion dollars, while for a country with an investment environment at the level of 75 (close to the top of data sets range) an additional BIT would increase expected FDI by nearly 40

26

billion dollars. Therefore, we have also found support for corollary 2. Foreign investment flows are positively associated with BITs, and this effect is strengthened the stronger the host countrys political environment for investment. Additionally, we find support for corollary 3, but not for corollary 4. That is, once we employ a single indicator for the economic environment, we avoid the problem of multicollinearity, and BITs seem to complement the general investment environment in their positive impact on FDI. However, the capacity of a country to absorb FDI, although positive, can not be differentiated from zero in our model. Figure 6 helps us to understand the importance of these estimates a bit more clearly and allows us to examine the importance of the political environment for investment, the economic indicator, and the absorptive capacity indicator. We ranked countries according to the indicator that measures the economic environment, and randomly selected two countries from each quartile. We then estimated their expected FDI flows based on their actual number of BITs, their index of the political environment for investment, the economic indicator, and the absorptive capacity indicator at the point in time matching the number of world BITs. For countries with good investment environments and strong political-economic environments (Malaysia and Chile for example), an additional BIT always has a positive impact on estimated FDI flows (although the effect decreases along with the number of BITs in the world). However, for countries with weaker political-economic and investment environments, this positive impact is increasingly smaller, with those in the lowest quartile (Sudan and Afghanistan for example) reaching a point of zero impact well before the current number of existing BITs in the world. That is, when there were relatively few BITs in the world, regardless of a countrys political environment for investment, level of economic development, or capacity to absorb FDI, signing an additional BIT significantly and positively affected FDI flowsand this impact was not relatively different

27

depending on quartile. For most countries, this positive impact increased for at least one to two periods before beginning a decline. In other words, when there were few BITs in the world, not only did signing a BIT send a positive signal to foreign investors, but the signal became more pronounced as investors took BITs into account. However, as BITs became more and more popular, their ability to serve as a signal of a relatively safe investment environment faltered. In the current climate with over 1,000 BITs in force with OECD countries, only the least risky and most developed of the developing countries gain any positive impact from signing additional BITs according to our findings. Thus we conclude that countries outside the top quartile should not rush to sign BITs, rather they need to concentrate on improving their domestic investment environment through efforts to limit political risk and assure all investors secure environment.

D. Robustness checks In our first test of the robustness of our results, we use the same specification, but change the source of our dependent variable to OECD data on FDI outflows from member countries. The advantage of using the OECD data as the dependent variable is that it matches our measure of BITsboth cover only OECD member states.23 Unfortunately, in the OECD data the number of country-period data points falls from over 1000 for the WDI to 675. The direction of causation between all of our main independent variables of interest, interactions, and indicators remained the same, however the magnitude and statistical significance of many of our indicators was lower. Nevertheless, using OECD flows as a dependent variable strongly supported our hypotheses that the relationship between BITs and FDI flows, while positive, is not linear. Aside from changing the dependent variable, we experimented with different ways of measuring the original dependent variable, BITs, and our indicators. First, we ran the analysis
23

The correlation between the two dependent variables for the data points that they have in common is .76.

28

for three-year periods and year-to-year differences. The 3-year period results were not significantly different from those we present here. Year-to-year results were naturally quite different because of the nature of the FDI data. The huge year to year swings in FDI flows pointed to the 5-year average as the best means for analysis. Our independent variable of interestthe number of BITs in force in a country in a given time periodcan be measured in a number of ways. First, it could be that simply signing a BIT is as good a signal as the actual entrance into force of the treaty. This may indeed be true. The results from using a count of BITs signed rather than just those in force did not significantly change the results of the analysis. Further, it could be that signing only one BIT sends a signal, and all subsequent BITs simply support that signal, or that the country with which you sign the BIT is important. We tested these possibilities in two ways. First, we re-ran our analysis using a dummy variable for whether a country had any BITs or not. While our interactions and independent variables retained the same direction of causation from our original analysis, the BIT variable (in the interactive model) became negative. Next, we experimented with a measure under which we weighted each BIT by an index representing the total GDP of the OECD signatory member. Our reasoning was that signing a BIT with an economically powerful country should have a greater impact than signing with a smaller country. The results using this measure were not an improvement over the raw count, and they were more difficult to interpret. Thus, we only report the results using the raw counts. Finally, we evaluated the sensitivity of our results to an alternative approach to endogeneity. We employed the Arellano-Bond generalized method of moments estimator which uses instrumental variables to address the possibility of endogeneity between several of our independent variables and FDI flows {Scheve, 2004 #154}{Kosack, 2006 #155}. We tested this

29

method both with and without the use of a lagged dependent variable. In both cases, the magnitude and direction of our results is not significantly affected by the method. Although the significance levels of our BIT variables and BITs interaction with world BITs and risk is not significantly different, neither indicator is individually significantly different from zero (though they are both jointly significant). Two tests of validity, the Sargan-Hansen test of overidentifying restrictions and the Arellano-Bond test for autocorrelation in first-differences supported these results. In the end we report the results of our original model rather than the

Arellano-Bond estimator because of the increased efficiency of OLS and the familiarity of most readers with that estimation technique.

E. Conclusion Past empirical work on the growing number of BITs in force around the world has produced conflicting findings concerning their impact on FDI. This study takes an important step towards resolving some of these conflicting results. We find that BITs do indeed have a positive impact on FDI flows to developing countries. Signing treaties generally appears to send a signal to foreign investors of a welcome investment environment. Importantly, however, we show that this general positive impact is highly dependent on the political and economic environment surrounding both FDI and BITs. Poor countries cannot bootstrap an aggressive program of signing BITs into a major increase in FDI. They cannot avoid the hard work of improving their own domestic environment as it affects the political risks of investment. Our statistical results demonstrate that, as the coverage of BITs increases, overall FDI flows to developing countries may increase, but the marginal effect of a countrys own BITs on its FDI will fall. Thus, if there are other costs associated with BITs, countries may be less eager

30

to sign the treaties over time. If BITs both limit the countrys profit per dollar of FDI and increase the volume of investment, a fall in the marginal impact of BITs on the volume of FDI will reduce the net benefits of BITs. A stronger political environment for investment and a better local economic environment are complements to BITs. Our most important conclusion is that BITs cannot be judged in isolation. Their impacts on host country FDI flows must be studied within the context of the political, economic and institutional features of the host country that is signing the BIT and in the light of the worldwide BITs regime. Only with a broader understanding of the political-economic environment can we fully understand the impact of BIT programs on FDI flows.

31

References Blonigen, B. (2005). "A Review of the Empirical Literature on FDI Determinants." Atlantic Economic Journal 33(4): 383-403.

Brambor, T., W. Clark, et al. (2006). "Understanding Interaction Models: Improving Empirical Analyses." Political Analysis 14: 63-82.

Bubb, R. and S. Rose-Ackerman (2006). BITs and Bargains. Draft. Cambridge and New Haven.

Franzese, R. (1999). "Partially Independent Central Banks, Politically Responsive Governments, and Inflation." American Journal of Political Science 43(3): 681-706.

Franzese, R. and C. Kam (2005). Modeling and Interpreting Interactive Hypotheses in Regression Analysis: A Brief Refresher and Some Practical Advice. Ann Arbor.

Gastanaga, V., J. Nugent, and B. Simmons (1998). "Host Country Reforms and FDI Inflows: How Much Difference Do They Make?" World Development 26: 1299-1313.

Hallward-Driemeier, M. (2003). Do Bilateral Investment Treaties Attract FDI? Only a bitand they could bite. World Bank Policy Research Working Paper. Washington.

Honaker, J., A. Joseph, et al. (2003). AMELIA: A Program For Missing Data, Harvard University.

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Jun, K. and H. Singh (1996). "The Determinants of Foreign Direct Investment in Developing Countries." Transnational Corporations 5(2): 67-105.

King, G., J. Honaker, et al. (2001). "Analyzing Incomplete Political Science Data: An Alternative Algorithm for Multiple Imputation." American Political Science Review 95(1): 49 69.

Kosack, S. and J. Tobin (2006). "Funding Self-Sustaining Development: The Role of Aid, FDI and Government in Economic Success." International Organization 60(1): 205-243.

Montt, S. (2006). A Network Theory of BITs Generation. Draft. New Haven.

Neumayer, E. and L. Spess (2004). Do bilateral investment treaties increase foreign direct investment to developing countries? Working paper, London School of Economics. London.

Salacuse, J. and N. Sullivan (2004). "Do BITs Really Work? An Evaluation of Bilateral Investment Treaties and Their Grand Bargain." Harvard International Law Journal 46(1).

Scheve, K. and M. Slaughter (2004). "Economic Insecurity and the Globalization of Production." American Journal of Political Science 48(4): 662-674.

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Schneider, F. and B. Frey (1985). "Economic And Political Determinants Of Foreign Direct Investment." World Development 13: 161-75.

Tomz, M., J. Wittenberg, et al. (2003). Clarify: Software for Interpreting and Presenting Statistical Results, Harvard.

UNCTAD (2001). Bilateral Investment Treaties 1959-1999. Geneva, United Nations.

UNCTAD (2005). World Investment Report 2005: Transnational Corporations and the Internationalization of R&D. Geneva, United Nations.

Wei, S.-J. (2000). "How Taxing is Corruption on International Investors?" Review of Economics and Statistics 82(1): 1-11.

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Figure 1

Running Total of all BITs in Force

2500

2000 Total Number of BITs

1500

1000

500

0
19 64 19 66 19 68 19 70 19 72 19 74 19 76 19 78 19 80 19 82 19 84 19 86 19 88 19 90 19 92 19 94 19 96 19 98 20 00 20 02 19 60 19 62

BITS in force between an OECD country and a low-income country Total BITs Signed BITs in force between low-income countries

Source: UNCTAD FDI database

35

Figure 2

Number of New BITs Signed by Developing Countries, by decade

600 500 400 300 200 100 0
65 3 0 69 6 4 125 3119 230 477 436 With Developed Countries With Developing Countries With Central and Eastern European Countries

1960s

1970s

1980s 1990s

Source: UNCTAD BITS database

36

Figure 3a

Figure 3b

t c

t c

n Fraction of BITS Fraction of BITs,

Source: Derived from Figure 2 in (Bubb and Rose-Ackerman 2006)

37

Figure 4: Linear vs. Interactive Effect of a BIT on FDI Flows For Various Levels of World BITs
70000

60000

50000
Interactive Effect (Model 4)

40000 FDI 30000

Linear Effect (Model 1)

20000

10000
Dotted lines represent confidence intervals

0 0 35 (1959) 70 105 140 175 210 245 280 315 350 385 420 455 490 525 560 595 630 665 700 (1998) World BITs

38

Figure 5: Linear vs. Interactive Effect of a BIT on FDI Flows for Various Levels of The Political Environment for Investment
80000 70000 60000 50000 40000 FDI 30000 20000 10000 0
0 5

Dotted lines represent confidence intervals

Interactive Effect

Linear Effect

-10000 -20000 Weak Investment Climate Political Environment for Investment Strong Investment Climate

39

10 0

10

15

20

25

30

35

40

45

50

55

60

65

70

75

80

85

90

95

Figure 6: Conditional Impact of an Additional BIT on FDI at various levels of World BITs for 8 Country Estimates
60000

50000 Malaysia Chile 40000 Georgia FDI 30000 Senegal 20000 Malawi Afghanistan Malaysia Chile Sudan Paraguay Malawi Senegal Georgia

Paraguay

10000 Sudan Afghanista n 38.8 63.6 93.4 133.2 192.6 347 654 905

0 World BITs

40

Table 1 FDI and Bilateral Investment Treaties

Dependent Variable: FDI flows from OECD
Model 1 (1) 23156** (10153) -28.49 (70.33) Model 2 (2) 38816* (22225) 0.42 (63.68) -29.37*** (11.06) 1240* (760) 1284* (763) Model 3 (3) 30155** (15064) 72.77** (35.93) -38.14*** (15.4) -5212*** (1383) 6365*** (1262) 81950** (41623) 79048* (41586) 50419** (18476) -21216*** (4723) 2955* (1777) 2737* (1671) -5521** (1966) 4460*** (1199) 34.13 (270) 7.89 (276) 404* (219) -366*** (107) 5761** (2455) 0.13*** (0.05) 0.13*** (0.05) 0.09 (0.05) 0.02* (0.01) -5715 (7365) -6714 (7339) 5391 (7790) -14078*** (3716) 5324 (4242) 17083 (12013) -0.03 (0.09) -119 (271) 2998* (1616) Model 4 (5) 11050^ (18961) 56.81^ (45.96) -44.98^ (30.25) -508 (644) 494*** (160) 87483** (43133)

BIT BITs (total) BITs (interaction) Political Environment for Investment Political Environment (Interaction) GDP GDP (Interaction) Growth Growth (Interaction) Openness Openness (Interaction) Economic Indicator Natural Resources Natural Resources (Interaction) Population Population (Interaction) Capacity Indicator

Country N 135 135 135 135 R^2 0.25 0.26 0.59 0.30 The dependent variable FDI Flows are average FDI inflows to developing countries from all countries in constant US dollars over the five years of each period; Fixed time effects for countries and periods are not shown. Newey-West autocorrelation and heteroskedasticity-consistent standard errors in parentheses. * Significant at 10-percent level. * *Significant at 5-percent level. * Significant at 1percent level. ^ Jointly significant at 10-percent level.

41

Appendix A: Included and Excluded Countries As with any large-N analysis, we were concerned that our results in this paper were unduly affected by a few outliers. For example, China, a country with few BITs is, nonetheless, a major location for FDI and, increasingly, a source for FDI. Though it is difficult to check for outliers in time-series, cross-sectional data using traditional techniques, we did search for them in a number of ways. We first examined the means and standard deviations of the variables themselves to check for anything unusual. A few country time periods did stand out in terms of low numbers of BITs with extremely high FDI inflows. These countries included Brazil, China and Mexico over the last three time periods. Their inclusion in the data set did not seriously affect our results, and we felt that their exclusion would be non-random. Results with their exclusion are available from the authors. Finally, we used a number of standard regression diagnostics, including cooks distances, dfbetas, and added-variable plots. Though these tools are not perfectly suited to our purposethey do not account for the time-series nature of our data or for heteroskedasticitythey might still have pointed to potential outliers. The tests revealed very few disproportionately influential observations: only Argentina and Poland stood out. Removing these had no effect on the results, and thus we retained them in our estimation. We eliminated a number of small island nations whose FDI data was not generally available and who tend not to sign BITs. These countries were eliminated if two or more of the following were true: 1) their population was more than two standard deviations below the mean population of the overall sample, 2) they had no BITs, and 3) more than 50 percent of FDI data-years were missing. Therefore, the following countries were excluded from the analysis: American Samoa, Kiribati, Marshall Islands, Northern Mariana Islands, Palau, Samoa, Seychelles, Solomon Islands, St. Kitts and Nevis, St Lucia, St Vincent and Grenadines, Vanuatu. Finally, we removed countries that tended to be positive outliers in terms of FDI flows from the UNCTAD dataset, but tend to be financial paradises or serve as havens for round-trip FDI, these countries included the Cayman Islands, Bermuda, and Hong Kong.

42

Appendix A. Contd. Countries included in Analyses

Afghanistan Albania Algeria Angola Argentina Armenia Azerbaijan Bangladesh Belarus Belize Benin Bhutan Bolivia Bosnia and Herzegovina Botswana Brazil Bulgaria Burkina Faso Burundi Cambodia Cameroon Cape Verde Central African Republic Chad Chile China Colombia Comoros Congo, Dem. Rep. Congo, Rep. Costa Rica Cote d'Ivoire Croatia Cuba Czech Republic Djibouti Dominica Dominican Republic Ecuador Egypt, Arab Rep. El Salvador Equatorial Guinea Eritrea Estonia Ethiopia Fiji Gabon Gambia, The Georgia Ghana Grenada Guatemala Guinea Guinea-Bissau Guyana Haiti Honduras Hungary India Indonesia Iran, Islamic Rep. Iraq Jamaica Jordan Kazakhstan Kenya Korea, Dem. Rep. Kyrgyz Republic Lao PDR Latvia Lebanon Lesotho Liberia Libya Lithuania Macedonia, FYR Madagascar Malawi Malaysia Maldives Mali Mauritania Mauritius Mayotte Mexico Micronesia, Fed. Sts. Moldova Mongolia Morocco Mozambique Myanmar Namibia Nepal Nicaragua Niger Nigeria Pakistan Panama Papua New Guinea Paraguay Peru Philippines

Poland Romania Russian Federation Rwanda Sao Tome and Principe Senegal Serbia and Montenegro Sierra Leone Slovak Republic Somalia South Africa Sri Lanka Sudan Suriname Swaziland Syrian Arab Republic Tajikistan Tanzania Thailand Togo Tunisia Turkey Turkmenistan Uganda Ukraine Uruguay Uzbekistan Venezuela, RB Vietnam West Bank and Gaza Yemen, Rep. Zambia Zimbabwe

43

Appendix B: Description of Variables

Description of variables
Variable Name Dependent Variables Foreign Direct Investment (World Bank) Description and Source

Net foreign direct investment flowing into a country each year. Measured in millions of constant 2000 US dollars. Source: World Development Indicators

Independent Variables Bilateral Investment Treaties, with high-income countries

Equal to the number of treaties signed with high-income countries up to that time period Source: UNCTAD database on bilateral investment treaties.

Bilateral Investment Treaty, sum Equal to the sum of all BITs in force between OECD and non-OECD countries up to that particular time period. Source: UNCTAD database on bilateral investment treaties and World Development Indicators Log GDP Per Capita Logarithm of GDP per capita expressed in constant (2000) U.S. dollars. Source: World Development Indicators Growth Growth rate of per capita GDP, measured as the percent change per year in GDP Source: World Development Indicators. Investment Environment Assessment of the political stability of the countries covered by ICRG on a comparable basis, by assigning risk points to a pre- set group of risk components. The minimum number of points assigned to each component is zero, while the maximum number of points is a function of the components weight in the overall political risk assessment. The risk components (and maximum points) are: Government stability (e. g., popular support) (12), Socioeconomic conditions (e. g., poverty) (12), Investment profile (e. g., expropriation) (12), Internal conflict (e. g., terrorism or civil war) (12), External conflict (e. g., war) (12), Corruption (6), Military in politics (6), Religion in politics (6), Law and order (6), Ethnic tensions (6), Democratic accountability (6) and Bureaucracy Quality (4). Scale from zero to 100; low scores indicate high political risk. Source: International Country Risk Guide. Measures total US dollar amounts of natural fuels and ores exported from the host country. Measured in millions of current (2000) U.S. dollars. Source: IMFs International Financial Statistics Database. Log of total population in a country each year in millions. Source: World Development Indicators. Openness Exports of goods, services, and income plus Imports divided by real gross domestic product. Measured in current (2000) U.S. dollars. Source : World Development Indicators

Natural Resources

Population

44

Appendix C: Summary Statistics

Summary Statistics: General Regressions

Variable Obs Mean Std. Dev. Min Max

Foreign Direct Investment Flows (World Bank)

810

51253

246359

-148588

4028299

BITs in force (all OECD countries)

810

1.79

3.16

21.6

Sum of BITs in force (all OECD countries) Log of GDP per capita GDP growth (annual) Political Risk

810 810 810 675

247 6.71 3.29 55.43

204 1.02 4.44 10.48

64 4.42 -31.02 15.4

654 8.98 35.59 82.6

Natural log of total Population Natural Resources Openness

810

15.70

1.69 354196 34.75

11.17 0 0

20.97 4847621 226.87

810 127133 810 69.46

45

Appendix D: Correlations
FDI (World) FDI (World) FDI (OECD) BITs in force Sum of BITs in force BITs/BITs in force Log of GDP per capita GDP growth (annual) Political Risk Population Natural Resources Openness 1 0.76 0.37 0.16 0.33 0.14 0.09 0.23 0.34 0.36 -0.07 FDI (OECD) BITs in force Sum of BITs in force Log of BITs/BITs GDP per in force capita GDP growth (annual) Political Natural Risk Population Resources

1 0.37 0.23 0.36 0.26 0.04 0.29 0.34 0.43 -0.06

1 0.44 0.92 0.10 0.02 0.27 0.30 0.32 0.09

1 0.57 0.01 0.01 0.30 0.06 0.18 0.22

1 0.13 0.01 0.31 0.23 0.32 0.13

1 0.01 0.51 -0.17 0.22 0.27

1 0.12 0.02 -0.01 0.01

1 -0.08 0.12 0.36

1 0.47 -0.55

1 -0.12

46