Conclusive evidence is still missing that signing bilateral investment treaties and other international investment agreements helps developing host countries attract more FDI – and yet, the number of such agreements has mushroomed. What is more, developing countries have witnessed a wave of litigation – and yet they increasingly agreed to stricter FDI-related provisions in international investment agreements, in particular with regard to investor-state dispute settlement mechanisms and pre-establishment national treatment of foreign investors.

Why is it that developing countries agree to binding investment rules at the bilateral and plurilateral level which do not appear to serve them well, while they have so far resisted the inclusion of such rules at the multilateral level?

Domino theory of international investment agreements

Baldwin’s (1993, 1997) ‘domino theory of regionalism’ provides the most plausible starting point to answer this question. It is critically important to overcome the purely bilateral perspective of analysing the determinants of investment agreements, which characterises the earlier literature. Baldwin develops a political economy model to show that an idiosyncratic event of economic integration among third countries triggers domino effects by changing the cost-benefit calculus of non-members.The triggering event threatens to harm the profits of competing outsiders, thus increasing their inclination to join existing integration schemes or initiate new ones.

This process is driven not least because economic agents tend to “fight harder to avoid losses than they do to secure gains” (Baldwin 1993: 4). Baldwin and Jaimovich (2012), as well as Baccini and Dür (2012), provide empirical analyses of interdependent formation of trade agreements. The authors of both papers propose a ‘contagion index’ to capture the extent to which a trade agreement between countries A and B changes country C’s incentive to conclude a new agreement with either A or B – in a defensive move to mitigate adverse effects from trade diversion.

The logic of why countries concerned about trade diversion do not decide in isolation on trade agreements can easily be transferred to international investment agreements. In the case of such agreements, this would imply that an agreement concluded between a pair of a host country and a source country of FDI increases the incentive of a competing host country to engage in agreement negotiations in order to avoid FDI diversion. The boom would feed itself, even if each host country had a preference not to enter into investment agreements had competitors not done so before.

Indeed, some empirical studies have found that the diffusion of bilateral investment treaties is associated with competitive pressure among developing host countries (Elkins et al. 2006, Neumayer and Plümper 2010). However, these studies have some common shortcomings. Competition among host countries of FDI is typically proxied by spatial lags using trade relations or geographic distance as weights. Given that bilateral treaties and other agreements raise concerns about FDI diversion in the first place, it is more appropriate to use existing FDI relations as weights. More importantly, these studies do not account for the content of the treaties and other investment agreements, essentially treating them as ‘black boxes.’

Important international investment agreement content

In recent research (Neumayer et al. 2014), we reckon that the defensive moves of developing countries concerned about FDI diversion in favour of competing host countries extend beyond the decision to become a party in an investment agreement. Contagion may also help explain the increasing strictness of provisions in bilateral and other investment agreements. Two developments relating to the liberalization and protection of FDI are critically important in this respect (Berger et al. 2013):

  • Guarantees of market access for foreign investors, i.e. the extent to which investment agreements include provisions on national treatment in the pre-establishment phase; and
  • The extent to which the agreements include a strong investor-state dispute settlement mechanism, which is key in ensuring that foreign investments are effectively protected from discriminatory or abusive treatment in the host country.

Developing countries are caught in a race to conclude not only more investment agreements but increasingly more stringent treaties, even though – viewed in isolation – they would prefer not to sign an agreement with investor-state dispute settlement and national treatment provisions that limit their capacity to impose conditions on foreign investors. Specifically, a developing country can be expected to be most concerned about other developing countries concluding agreements with major FDI source countries if these agreements contain strict provisions because these pose the greatest threat in terms of potential FDI diversion away from the country.

As a corollary, spatial dependence in the form of FDI competition-driven pressure on a developing country to sign more stringent investment agreements should therefore stem from the existence and diffusion of such agreements with equally stringent provisions in other developing countries competing for FDI from developed source countries, not from agreements with less stringent provisions.

This logic can explain the stylised facts of the dynamics of rolling-out investment provisions of different strengths over time (see Figure 1 below). Developing countries, which collectively would be better off refusing to take binding international commitments, dislike strong investment provisions even more than weak provisions. Hence, in the early periods agreements with weak provisions will dominate. Yet, the same temptation that induced some developing countries to sign investment agreements with weak provisions in the beginning in order to seize a first-mover advantage, lures them or others into signing agreements with strong provisions, such that at some point these become the dominating type of investment provisions.

This specific target contagion, in the terminology of Neumayer and Plümper (2010), may be exemplified by considering the competition for Japanese FDI among mainly Asian host countries. The incentives of Vietnam to conclude a bilateral treaty with Japan when South Korea had concluded one were shaped by two factors:

  • The relative importance of Japan as one of several foreign investors in Vietnam, reflecting the extent to which Vietnam could potentially suffer from FDI diversion due to the treaty between Japan with South Korea;
  • The relative importance of South Korea in Japan’s total outward FDI stock, reflecting the extent to which South Korea is a relevant competitor for Japanese FDI.

Obviously, Vietnam’s decision to conclude an investment treaty with Japan did not depend only on Japan’s one with South Korea, but in the same way on bilateral treaties that Japan had previously concluded with other host countries, including Russia (1998), Pakistan (1998), Bangladesh (1999), and Mongolia (2001).

Figure 1. Diffusion of international investment agreements over time

nunnenkamp fig1 30 jul 14

New empirical findings

We estimate so-called event history models to assess the empirical relevance of contagion among developing host countries as a determinant of the conclusion of stricter investment agreements. We employ a semi-parametric Cox proportional hazard estimator with standard errors clustered on dyads of host-source countries. We construct dependent dummy variables which differentiate between investment agreements with weak and strong provisions.1

Using the coding from Yackee (2009) and Berger et al. (2013), the empirical analysis covers the period 1978-2004 and pairs among 21 developed source countries and 87 developing host countries. The analysis controls for various factors to isolate the effects of contagion, including other bilateral agreements, such as double taxation treaties, major host country and source country characteristics, including a general propensity to sign relevant treaties, and pair-specific factors such as differences in GDP, diplomatic representation and geographical distance. Bilateral FDI stocks are used as weights in the construction of the spatial lag variables that capture the competitive diffusion dynamics to reflect the competition for FDI among host countries.

For a start, the estimation results reveal that a developing host country is more likely to participate in an investment agreement (with or without provisions) with a specific developed source country if other developing host countries competing for FDI from this source country have done so with the same source country. More interestingly, when differentiating between agreements with weak and strong provisions, the evidence on spatial dependence in the form of target contagion among FDI-competing developing host countries is fully consistent with expectations. In particular, we find that FDI-competition driven spatial dependence in agreements with weak provisions exclusively stems from other dyads that have signed agreements with weak provisions, while the spatial dependence in investment agreements with strong provisions exclusively stems from other dyads that have signed agreements with strong provisions.

In fact, not only do agreements with strong provisions in other FDI-competing developing countries not increase the hazard of signing agreements with weak provisions, they even lower the hazard, instead inducing developing countries to sign agreements with equally strong provisions.

Where will it lead?

The estimation results crucially depend on the major FDI source countries (France, Germany, Japan, the Netherlands, the UK, and the US) included in the sample. From this, one may conclude that the diffusion of investment agreements with investment provisions is driven by competition of developing countries for FDI from the major source countries.

This also implies that the diffusion of agreements with increasingly strict provisions will not necessarily result in an exhaustive web of treaties. Each developing country will have to consider whether the pressure to conclude an agreement with a specific developed country is worth the cost in terms of loss of policy discretion. Despite the failure of the OECD’s MAI negotiations and the lack of agreement to put investment on the WTO’s negotiating agenda, however, the major source countries of FDI will eventually get close to their objective of a comprehensive web of investment agreements with increasingly stricter investment provisions with those developing countries that compete with each other as hosts of their FDI.

Published in collaboration with Vox 

Authors: Peter Nunnenkamp, senior economist, Kiel Institute for the World Economy and Martin Roy, counsellor in the Trade in Services Division, WTO

Images: An investor reacts as he talks on a mobile phone while standing near an electronic board displaying stock prices at Karachi Stock Exchange April 14, 2014. REUTERS/Akhtar Soomro