What Do the Data Say about the Relationship between Investor-State Dispute Settlement Provisions and FDI?

March 11, 2015 1:00 PM

Investor-state dispute settlement (ISDS) provisions are one of the areas being discussed for potential inclusion in the investment chapter of the Trans-Pacific Partnership (TPP). ISDS provisions allow a foreign investor to use dispute settlement proceedings presided over by an impartial panel of arbitrators if a host government expropriates its property or regulates its business in an arbitrary or discriminatory manner. Empirical evidence has shown that treaties including these provisions have a positive effect on foreign direct investment (FDI) flows between signatory countries.

What exactly does existing research say about how effective ISDS provisions are at increasing FDI? Unfortunately, very few rigorous empirical studies have looked specifically at the relationship between ISDS provisions and FDI. But there is a very rich body of research on bilateral investment treaties (BITs), many of which include ISDS provisions as a key component. It is widely accepted by investment experts that ISDS provisions are crucial for increasing the credibility and effectiveness of BITs (Wälde 2005, and Allee and Peinhardt 2010). These provisions are included in almost all of the United States’ existing BITs, and they have become increasingly common in BITs signed by countries other than the United States (Berger et al. 2010). Thus looking at the relationship between BITs and FDI can give insights into the likely effects of ISDS on FDI.

Studies of the impact of BITs on FDI show that these treaties do have a positive effect on increasing investment (Egger and Merlo 2007, Egger and Pfaffermyar 2004, Rose-Ackerman and Tobin 2009 and 2011, Busse et al. 2010, Neumayer and Spess 2005, and Haftel 2010). They also identify factors that may determine when BITs are more or less effective at promoting FDI. In particular, BITs are most useful when they can substitute for weak domestic legal and regulatory institutions in the host country (Busse et al. 2010). This has been found to be the case in a number of studies, including Berger et al. (2010), which isolates transition countries in Central and Eastern Europe and argues that BITs were an effective means to attract FDI to transition countries that lacked any reputation concerning the credibility of unilateral FDI-related measures immediately after the regime change. In addition to their effects on actual FDI flows, BITs have been shown to have a positive effect on foreign investors’ perceptions of the property rights environment in the country in which they are investing (Rose-Ackerman and Tobin 2011, and UNCTAD 2009).

On the other end of the regulatory spectrum, a study of the potential benefits to the United Kingdom of including ISDS provisions in a trade agreement with the United States determines that the benefits would not be that great because “the US government assesses the UK as a very safe place to invest” even without additional ISDS provisions (Skovgaard Poulsen et al. 2013).

Thus these studies show that BITs encourage investment by foreign firms relatively more in countries that need to signal credibility with investors. That being said, BITs cannot completely compensate for an otherwise extremely weak investment environment (Rose-Ackerman and Tobin 2009 and 2011).

The demonstrated importance of country characteristics in determining how effective BITs and ISDS provisions will be in promoting FDI raises an import methodological issue related to studies of BITs and FDI. Most of the existing studies use data at the country level, thus comparing country pairs that do and do not have these treaties and provisions in place between them. However, a much better approach is to instead use firm-level data in order to see how individual firms respond to changes in treaty status between countries. Because many different firms invest in a single country, this approach allows the researcher to look at how signing a new treaty changes the behavior of firms within a country, instead of comparing across countries that differ along many dimensions other than treaty status. One of the studies of BITs and FDI takes this approach. Egger and Merlo (2007) use firm-level data on the foreign activity of all German multinationals and find that BITs increase the number of multinational firms that are active in a particular host country, as well as the level of FDI per firm.

In conclusion, BITs are the best test case we have for the effectiveness of ISDS provisions. The evidence is not perfect, but it does suggest that packages of investment protections, of which ISDS provisions are a key part, encourage FDI. For this reason, ISDS provisions should be included in the investment chapter of TPP.

References

Allee, Todd, and Clint Peinhardt. 2010. Delegating Differences: Bilateral Investment Treaties and Bargaining Over Dispute Resolution Provisions. International Studies Quarterly 54, no. 1: 1–26.

Berger, Axel, Matthias Busse, Peter Nunnenkamp, and Martin Roy. 2010. More Stringent BITs, Less Ambiguous Effects on FDI? Not a Bit! WTO Staff Working Paper ERSD-2010-10. Geneva: World Trade Organization.

Busse, Matthias, Jens Königer, and Peter Nunnenkamp. 2010. FDI promotion through bilateral investment treaties: more than a bit? Review of World Economics 146, no. 1: 147–77.

Egger, Peter H., and Merlo, Valeria. 2007. The Impact of Bilateral Investment Treaties on FDI Dynamics. World Economy 30: 1536–49.

Egger, Peter, and Michael Pfaffermayr. 2004. The impact of bilateral investment treaties on foreign direct investment. Journal of Comparative Economics 32, no. 4: 788–804.

Haftel, Yoram Z. 2010. Ratification counts: US investment treaties and FDI flows into developing countries. Review of International Political Economy 17, no. 2: 348–77.

Neumayer, Eric, and Laura Spess. 2005. Do Bilateral Investment Treaties Increase Foreign Direct Investment to Developing Countries? World Development 33, no. 10: 1567–85.

Rose-Ackerman, Susan, and Jennifer Tobin. 2011. When BITs Have Some Bite: The Political-Economic Environment for Bilateral Investment Treaties. The Review of International Organizations 6, No. 1: 1-32.

Rose-Ackerman, Susan, and Jennifer Tobin. 2009. Do BITs Benefit Developing Countries? In The Future of Investment Arbitration, ed. R.P. Alford & C. A. Rogers. Oxford University Press.

Skovgaard Poulsen, Lauge N., Jonathan Bonnitcha, and Jason Webb Yackee. 2013. Costs and Benefits of an EU-USA Investment Protection Treaty. LSE Enterprise Working Paper.

UNCTAD (United Nations Conference on Trade and Development). 2009. The Role of International Investment Agreements in Attracting Foreign Direct Investment to Developing Countries. New York: United Nations.

Wälde, Thomas W. 2005. The “Umbrella” Clause in Investment Arbitration: A Comment on Original Intentions and Recent Cases. Journal of World Investment and Trade 6, no. 2: 183-236.

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