Do Bilateral Investment Treaties Lead to More Foreign Investment?

By Damon Vis-Dunbar and Henrique Suzy Nikiema
30 April 2009

The global network of over 2600 bilateral investment treaties (BITs) has been built on the basis of promoting foreign direct investment (FDI), and yet, after a decade of research, whether in fact BITs lead to an increase in FDI flows is a matter of debate. There are a number of reasons for the diverse results in the empirical studies that have addressed this question, and they are well explained in a book published last month by Oxford University Press, which brings together an impressive collection of essays and empirical studies on the impact of investment treaties on FDI flows (The Effect of Treaties on Foreign Direct Investment: Bilateral Investment Treaties, Double Taxation Treaties, and Investment Flows). As an introduction to the topic, ITN has posed a few questions to three academics for their views on the relationship between BITs, FDI flows and sustainable development.

Eric Neumayer is a professor in the department of geography and environment at the London School of Economics and Political Science. An economist by training, he is the coeditor of the Handbook of Sustainable Development and author of Greening Trade and Investment: Environmental Protection Without Protectionism.

Kevin P. Gallagher is an economist in the Department of International Relations at Boston University and senior researcher at the Global Development and Environment Institute at Tufts University.  He is the co-editor of a new book titled Rethinking Foreign Investment for Sustainable Development: Lessons from Latin America, and co-author of The Enclave Economy: Foreign Investment and Sustainable Development in Mexico’s Silicon Valley.

Horchani Ferhat is professor of law and political science at the University of Tunis, Tunisia. He is the author of numerous articles and books on international law, including Les Sources Du Droit International Public.

Interview with Eric Neumayer

ITN: What does your research tell us about the relationship between BITs and FDI?

My research, which was published in an article co-authored by Laura Spess in the journal World Development in 2005, was one of the very first studies to demonstrate a positive effect of BITs on FDI to developing countries. In other words, by signing more BITs with developed countries, particularly those that are major FDI exporters, developing countries give up some of their domestic policy autonomy by binding themselves to foreign investment protection, but could expect to receive more FDI in exchange. The research also showed that the effect was possibly more pronounced in countries with weak domestic institutions, i.e. in countries for which the confidence and credibility-inspiring signal to foreign investors following the signing of BITs was most important.

ITN: Different analyses produce different results on the question of BITs and their impact on FDI flows.  What are the key methodological differences, and differences in assumptions, that drive the different results?  Are there any clear “best practices” in estimating these impacts?

The majority of studies confirm a positive effect of BITs on FDI. Some of the earlier studies had key methodological deficiencies, such as employing a small and non-representative sample. Best practice studies now should employ a large, representative sample, should use so-called bilateral or dyadic FDI data (i.e. data that tells us from where the FDI comes from and where it is flowing to) and not just aggregate FDI data (i.e. total FDI flows to countries without information on where it comes from), should estimate both static and dynamic models (i.e. models that exclude and include the temporally lagged dependent variable, respectively), should deal with possible non-stationarity (in simple words: should deal with trends in the data) and should deal with errors in the data generating process. My own research on BITs is now more than five years old, which is a long time in academia. Naturally, in retrospect it should have done all of the things I would now regard as “best practice”. It did some of it, but not others. However, other more recent studies have improved on our initial study and most of them come to the same overall conclusion. This makes me confident that our initial result is in fact robust.

ITN: What steps should governments take to ensure that BITs make a positive contribution to their economic development?

Governments can promote sustainable development with appropriate policies. There is nothing in BITs that would prevent them from adopting these policies, as long as they affect all economic actors evenly, and do not discriminate against foreign investors merely because they are foreign. There is a widespread misunderstanding that BITs, or BIT-like provisions in regional trade agreements such as the North American Free Trade Agreement (NAFTA), have been abused by foreign investors to knock down environmental and other sustainable development related policies. However, as I have tried to show in my book Greening Trade and Investment: Environmental Protection without Protectionism (London: Earthscan 2001), in practically all cases where foreign investors have sued governments and were awarded damages by an arbitration panel they have done so because the policies in question were formulated in a way that clearly discriminated against foreign investors. If governments wish to pursue policies that promote sustainable development without discriminating against foreign investors, BITs and the investor-to-state dispute resolution mechanisms contained therein will not stand in their way.

Moreover, by promoting FDI, BITs are likely to make an indirect contribution to sustainable development. There is some evidence that, on average, foreign investors pay higher wages and are environmentally more friendly than their domestic counterparts. Naturally, this depends on which country the foreign investment comes from and to which sector it goes to. Chinese foreign investment is likely to contribute less than FDI from Scandinavian countries to sustainable development. FDI into natural resource sectors has often created large-scale environmental damage in the past, but this may be changing for the better as multinational corporations take corporate social responsibility more seriously.

Interview with Kevin P. Gallagher

ITN:  What do empirical studies tell us about the relationship between BITs and FDI?

There is widespread agreement in the peer reviewed literature that the major determinants of FDI are macro economic and political stability, having a large and growing GDP, or being in proximity to a country with a large and growing GDP that can be exported to.  A BIT or an FTA may help but without a stable and growing economy (or the ability to serve as an export platform to a stable and growing economy) a BIT is of little help.

An illustrative example is comparing Brazil and Haiti.  Brazil, year after year, is the leading recipient of FDI in Latin America.  Indeed, it is always in the top three among developing nations.  Firms move there to serve its large domestic market, access natural resources, and serve as an export platform to other hubs (that are less stable) in South America.  Brazil has no BITS and is very concerned about some of the measures that are found in US style BITS.  Haiti receives little to no FDI and if they signed a BIT they would not become the new fad for foreign investors.

Thus, given that the benefits in terms of increased market access to FDI are in question, countries should think twice about surrendering the costs in terms of the lost policy space for sustainable development policies.

ITN: Is there any evidence that BITs in combination with other reforms can drive sustainable development?

Investment forms the core of growth and sustainable development.  Thus, agreements that can attract and steer investment into productive and sustainable economic activity should be a top priority.  Unfortunately we are not there yet.  Indeed, most US BITS make it more difficult to put together a sustainable development path by giving countries little wiggle room in terms of having the necessary tools to do so.  A country needs a very well developed set of institutions to counteract some of the components of the treaties.

Of course, nations “trade away” such instruments for the hope that a BIT will bring more investment.  As the World Bank implicitly said in the Global Economic Prospects of 2005, nations need to be careful about this trade off.

That being said, Chile is a nation that has been able to have FDI enable broader based development.  Although BITS and the US-Chile FTA outlaw the ability of the nation to have pre-establishment screening of firms, selective performance requirements, and environmental impact statements, Chile pursues many of these instruments at the deal level, rather than requiring them.  They bargain hard to ensure that the environmental practices of firms are reviewed, that linkages to the local economy will be created and so forth.  They also have policies at the national level for research and development and supplying credit to local firms to make sure their domestic economy has the absorptive capacity to make FDI work for development.

In the case of Mexico however, FDI has been of only limited success. Mexico’s policy focuses on increasing the quantity of FDI with hopes that other benefits will come automatically.  Foreign firms ended up wiping out a lot of local capacity, creating “enclave economies” cut off from the rest of the economy.  This process partly explains Mexico’s slow growth despite massive surges in FDI and exports.

The US is now in the process of reforming its model BIT.  Given the heightened awareness regarding some of the impacts BITS have had, the process will include many more inputs from stakeholders than in the past.  I’m confident and hopeful that the new US BIT will look different than recent ones.

ITN: What steps should governments take to ensure that BITs make a positive contribution sustainable development?

The best way for smaller developing countries to ensure that investment agreements are more conducive to sustainable development is to lean toward multilateral and larger regional FTAs.  In those settings they have more bargaining power by working in coalition with the larger developing nations like Brazil, India, and China that are able to attract FDI for development.

ITN: Different analyses produce different results on the question of BITs and their impact on FDI flows.  What are the key methodological differences, and differences in assumptions, that drive the different results?  Are there any clear “best practices”in estimating these impacts?

Most of the studies done are econometric analyses that model the extent to which a BIT has a statistically significant and independent effect on investment flows.  The results vary depending on the sample size, number of countries and years analyzed, and the types of control variables.  A best practice would be to systematically combine  a large N panel econometric analysis (having lots of countries and lots of data for those countries)with a series of corresponding qualitative on the ground case studies where researchers put together surveys on firm behavior. The big econometric analysis would help deal with some of the statistical issues that are beyond the scope of this interview to go into.  The case studies would help capture things that are tough to quantify.

Interview with Horchani Ferhat

ITN: In your opinion, have international investment agreements concluded between developed and developing countries had a positive impact on economic development?

It is difficult to answer this question precisely, in part because the extent to which IIAs effect the flow of FDI is unclear. The presence of IIAs is certainly less important to foreign investors than factors like market size, quality of infrastructure and the availability of a skilled workforce. That said, not concluding IIAs may have a negative effect on economic attractiveness of the country, as it may raise concerns regarding the security of investments, particularly if other factors that are important to investors are not present to a significant degree.

Overall, I believe that IIAs are an important factor in promoting economic development, as they can influence not only the flow of FDI, but also whether FDI serves a public good. However, whether IIAs promote FDI in a positive way very much depends on how well they are negotiated. Unfortunately, many countries still lack the necessary expertise in this area, particularly in understanding the relationship between investment and sustainable development.

ITN: Are there certain clauses or provisions on which developing countries should be particularly careful when negotiating bilateral investment treaties?

Many terms must be given special attention by developing countries. First the preambles of the agreements are particularly useful in interpreting agreements in the case of disputes. Preambles should include development issues in addition to other issues such as economic cooperation. One must be aware that IIAs between African and European countries, for example, are not reciprocal agreements: the rationale for such agreements for each country is different (development for the former and market penetration for the latter). So, this should be written in the preambles to protect the interests of both parties. Notably, the first generation of IIAs tended more balanced. Often other agreements were concluded in parallel, such as agreements on technical assistance, cooperation in education, financial assistance, etc. Unfortunately, this is not the case with most modern IIAs, in which the sole purpose is to protect the interests of investors and not those of the host countries.

Secondly, clauses that permit exceptions or derogations from the rules of treatment and protection are of crucial importance, particularly in the case of a dispute between the host country and foreign investor. Indeed, some BITs contain exceptions related to health, safety, public morals or the protection of the environment. This is the case of the 2004 U.S. model BIT, for example, which allows the parties to take necessary measures if such measures do not constitute “arbitrary or unjustifiable discrimination or a disguised restriction on trade or investment.” In all cases, the more clearly the exception is explained, the better. Exceptions that are broadly worded provide a lot of discretion to tribunals.

In addition, Most-Favoured Nation provisions should be negotiated with caution, especially regarding the question of its extension to the settlement of disputes. Regarding the application of fair and equitable standard of treatment, it is now generally recognized that tribunals need to take into account of the investor’s conduct. The investor cannot claim unfair and inequitable treatment, if he commits a fraud or is liable for illegal conduct, for example. But this should still be emphasized treaties.

I could go on; this list is certainly not comprehensive.

ITN: What additional steps should governments take to ensure that BITs make a positive contribution sustainable development?

We should keep in mind that BITs have as their primary purpose the protection of foreign investments against discriminatory measures by the host state. This explains the range of provisions relating to non-discrimination, fair and equitable treatment, prohibition of arbitrary measures, full protection and security, prohibition of measures equivalent to expropriation, and the arbitration of disputes. Foreign investors should be able to use these standards of treatment and protection, including access to arbitration.

Clearly, however, there is an imbalance. The concerns of the host state, including sustainable development, are not covered in a significant way by these agreements. The question, therefore, is how to restore the balance? One solution is for clauses in IIAs that place obligations on foreign investors, such as refraining from activities that amount to an infringement of sustainable development, including human rights, labour law and environmental protection. This proposal could be combined with a consultation mechanism between the host state and national state of the investor, as a prerequisite to any investor-state judicial remedies under the treaty. Another option is a mechanism similar to “Disputes Boards” used by the International Chamber of Commerce, which accompany the implementation of major construction contracts to facilitate the execution of these contracts and prevent possible disputes.