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Journal of Comparative Economics 32 (2004) 788804

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The impact of bilateral investment treaties


on foreign direct investment
Peter Egger a, , Michael Pfaffermayr b
a Helen Kellogg Institute for International Studies at the University of Notre Dame, 130 Hesburgh Center,

Notre Dame, IN 46556-5677, USA


b University of Innsbruck, Universitaetsstrasse 15, 6020 Innsbruck, Austria

Received 2 June 2003; revised 12 July 2004

Egger, Peter, and Pfaffermayr, MichaelThe impact of bilateral investment treaties on foreign
direct investment
This paper uses a large panel of OECD data on stocks of outward foreign direct investment (FDI)
to evaluate the impact of bilateral investment treaties. For several variants of the knowledge capital
model of multinationals, we demonstrate that investment treaties exert a significant positive effect
on outward FDI, if they actually are implemented. Moreover, even signing a treaty has a positive,
although lower and in most specifications insignificant, effect on FDI. Journal of Comparative Economics 32 (4) (2004) 788804. Helen Kellogg Institute for International Studies at the University
of Notre Dame, 130 Hesburgh Center, Notre Dame, IN 46556-5677, USA; University of Innsbruck,
Universitaetsstrasse 15, 6020 Innsbruck, Austria.
2004 Association for Comparative Economic Studies. Published by Elsevier Inc. All rights reserved.
JEL classification: C23; F12; F23

* Corresponding author.

E-mail address: pegger@nd.edu (P. Egger).


0147-5967/$ see front matter 2004 Association for Comparative Economic Studies. Published by Elsevier
Inc. All rights reserved.
doi:10.1016/j.jce.2004.07.001

P. Egger, M. Pfaffermayr / Journal of Comparative Economics 32 (2004) 788804

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1. Introduction
The first bilateral investment treaty (BIT) was signed between Germany and Pakistan in
1959 and came into force in 1962. Up to 1999, another 1856 BITs have been signed and further BITs are expected in the future (United Nations, 2000). BITs are designed to facilitate
foreign direct investment (FDI) from economies with abundant capital and skilled labor,
i.e., mainly OECD countries, to the less developed economies. Many of the existing BITs
between the current OECD economies involve one old and one new OECD member. For
example, the Czech Republic, Hungary, Poland, and the Slovak Republic concluded BITs
with old OECD members in the early 1990s and then joined the OECD afterwards. The theoretical literature on the expected impact of BITs on FDI is not conclusive. Hoekman and
Saggi (2000) argue that, due to some differences in national rules, BITs may be the source
of higher transaction costs and uncertainty from a firms perspective. Although this point
would support an argument for a harmonized global BIT, i.e., a multilateral investment
treaty, these authors concede that differences in cultural, political, and general business
climate characteristics are more important determinants of the transaction costs associated
with FDI.
Formally, BITs regulate FDI-related issues such as admission, treatment, expropriation,
and the settlement of disputes at the bilateral level. Ex ante, they establish transparency
about risk and, thus, reduce the risk of investing in a country. Ex post, BITs ensure that
firms have certain rights, e.g., property rights, and preserve them from expropriation.1 According to the Fact Sheet on the US bilateral investment treaty program released by the
Office of Investment Affairs of the Bureau of Economic Business Affairs, the programs
basic aims are the following.2 First, BITs should protect US FDI in those countries where
US investors rights are not protected through existing agreements. Second, they should
encourage host countries to adopt market-oriented domestic policies that treat private investment fairly. Third, they should support the development of international law standards
consistent with these objectives.3 In some sense, BITs extend an investors property rights
and regulate how host governments must arbitrate disputes covered by the treaty. Further,
BITs define what is deemed expropriation, formulate how and under which conditions
property may be expropriated, and determine how quickly and comprehensively investors
must be compensated.
The UNCTAD (1998) study summarizes the following features of BITs, which are
designed to attract FDI. First, BITs facilitate and encourage bilateral FDI between the
contracting parties. To achieve this goal, most BITs guarantee foreign investors fair and
equitable, non-discriminatory, most-favored-nation and national treatment in addition to
access to international means of dispute resolution. Moreover, BITs usually provide legal
protection of both physical and intellectual properties under international law and investment guarantees with a special focus on the transfer of funds and expropriation, including
1 Maskus (2000) addresses the issue of protecting intellectual property. Drabek and Payne (2002) considers
the importance of the risk of expropriation.
2 Hallward-Driemeier (2003) provides further details.
3 Hoekman and Saggi (2000) remark that, with the notable exception of those negotiated by the US, BITs do
not usually address the question of market access liberalization.

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P. Egger, M. Pfaffermayr / Journal of Comparative Economics 32 (2004) 788804

the rules of compensation. In this way, they facilitate insurance and reduce insurance premia. Some BITs provide even more reliable and transparent conditions for investors than
do national laws. Hence, they allow transition economies to provide guarantees for foreign investors while undertaking national legislative reforms at the same time.4 From this
perspective, BITs reduce the costs of investing abroad, including risk premia, so that FDI
should increase if new BITs are implemented. In addition, BITs should make new inward
investment attractive and also reduce the likelihood of investment outflows.
The theoretical trade literature incorporates multinational enterprises (MNEs) in trade
models characterized by increasing returns and considers both horizontal MNEs and vertical MNEs. Horizontal MNEs have production facilities in both the parent and host countries (Markusen, 1984, and Markusen and Venables, 1998, 2000) and tend to be found
in the similarly endowed economies, e.g., within the OECD.5 Vertical MNEs unbundle
completely the headquarter services from production to exploit factor cost differentials
(Helpman, 1984; Helpman and Krugman, 1985). Therefore, vertical FDI tends to occur in
dissimilar economies, e.g., between the OECD and the developing countries. Carr et al.
(2001), Markusen (2002), and Markusen and Maskus (2002) develop knowledge capital
models of MNEs in which both horizontal and vertical activities arise endogenously.
In a panel econometric framework, Hallward-Driemeier (2003) finds little evidence of
any positive impact of BITs on FDI. A study based on cross-section analysis by UNCTAD
(1998) supports only a weak nexus between signing BITs and changes in FDI flows and
stocks. By contrast, United Nations (2000) view BITs as the most important instrument
for protecting FDI at the international level. In this paper, we undertake an empirical
assessment of the impact of BITs on FDI stocks. We estimate several variants of the
knowledge capital model of MNEs using the largest available panel of outward FDI stocks
provided by OECD, which contains FDI of OECD countries into both OECD and nonOECD economies. Information on BITs, both signed and ratified, is available from the
World Bank.
We find a significant and positive impact of ratified BITs throughout. The estimated
effect of BITs on real outward FDI stocks amounts to about 30% in the preferred specification. Additionally, we look at whether simply signing a BIT will have a positive
anticipation effect. We find a positive impact from signing a treaty, although its magnitude is smaller than that associated with the ratification of an existing treaty. However, the
estimated anticipation effect is insignificant, in most specifications, leading us to conclude
that the advantages to simply signing a BIT are inconsequential. The next section provides
details on the econometric specification and discusses the construction of the variables.
In Section 3, we present the main estimation results together with extensive sensitivity
analysis. The last section concludes with a summary of the empirical findings.

4 Whereas BITs aim to avoid additional fixed costs by reducing these types of risk, bilateral tax treaties deal
with the repatriation of profits. Davies (2004) and Chisik and Davies (2004) present a thorough theoretical treatment of tax treaties. Blonigen and Davies (2003) provide an empirical assessment of the impact of bilateral tax
treaties on FDI.
5 Deleted in press.

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2. Specification and data base


In the estimated empirical models, we focus on variants of the knowledge capital model
estimated by Carr et al. (2001), Egger and Pfaffermayr (2004b) and Markusen and Maskus
(2002). Carr et al. (2001) and Markusen and Maskus (2002) use foreign affiliate sales as
the dependent variable because their two factor knowledge capital model does not include
physical capital. Egger and Pfaffermayr (2004a, 2004b) present a three factor model and
derive explicitly the hypotheses for a specification having FDI stocks as the dependent
variable. However, Blonigen et al. (2003) illustrate that the key parameters are qualitatively similar if sales instead of FDI are used. This literature supports using four types of
variables to explain the stock of outward FDI at the bilateral level, namely, country size,
factor endowments, trade and FDI frictions, and interaction terms. Table 1 summarizes the
definitions of our explanatory variables and reports their expected signs from the knowledge capital model, the horizontal models, and the vertical models.

Table 1
Variables and theoretical predictions
Abbreviation

Definition

KK

HOR

VER

GDPij t
SIMIij t

ln(GDPit + GDPj t )
ln{1 [GDPit /(GDPit + GDPj t )]2
[GDPj t /(GDPit + GDPj t )]2 }
ln(tert. school enr.it )
ln(tert. school enr.j t )
dummy variable
dummy variable
ln(distanceij ) D+
[ln(tert. school enr.it )
ln(tert. school enr.j t )]
[ln(GDPit ) ln(GDPj t )] D+
[ln(tert. school enr.it )
ln(tert. school enr.j t )]
ln(GDPit + GDPj t ) D+
[ln(tert. school enr.it )
ln(tert. school enr.j t )]
ln(GDPit + GDPj t ) D
[ln(tert. school enr.it )
ln(tert. school enr.j t )]
1 after the BIT has been signed,
0 otherwise
1 after the BIT has come into force,
0 otherwise

+
+

+
+

0
0

+/

+/

+/

+/

SKij t
D+ = 1 if SKij t > 0, 0 otherwise
D = 1 if SKij t < 0, 0 otherwise
DISTij D+ SKij t
GDPij t D+ SKij t
GDPij t D+ SKij t
GDPij t D SKij t

BITSij t (BIT signed)


BITFij t (BIT into force)

Notes. 1. The notation i indicates the parent country, j refers to the host country, and t is the time index. 2. The
labels KK, HOR, and VER denote the predicted signs from the knowledge capital, the horizontal, and the vertical
models of the multinational enterprise, respectively. 3. The model predictions are derived in Carr et al. (2001),
Egger and Pfaffermayr (2004a, 2004b), and Markusen and Maskus (2002).

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P. Egger, M. Pfaffermayr / Journal of Comparative Economics 32 (2004) 788804

Both absolute bilateral country size (GDP) and similarity in bilateral country size
(SIMI) affect horizontal FDI positively.6 In contrast to national exporting firms and vertical MNEs, horizontal MNEs run a production plant in each market and, thus, incur higher
fixed costs. A larger size of both the home and the host market increases the likelihood
that horizontal MNEs cover these fixed costs. The bilateral difference in the endowment
ratio of skilled to unskilled labor (SK) increases vertical FDI, because vertical MNEs
arise only if countries differ in terms of production costs, i.e., if SK > 0. The difference
in the skilled to unskilled labor endowment supports vertical FDI to a lesser extent, if the
bilateral distance is large, the home country is large, or bilateral size is large. Transport
costs impede trade and, thus, sales of vertical MNEs. The positive nexus between distance
and transport costs motivates the interaction term, denoted by DISTSK, which is nonzero if SK > 0. The home country size effect supports the inclusion of the interaction
term, denoted by GDPSK, which is non-zero if SK > 0.7 The bilateral size-related
interaction term is defined as GDP SK. In Table 1, the last three interaction terms refer
to specifications estimated in Markusen and Maskus (2002). Finally, BITs should reduce
the impediment to foreign investment and foster FDI, irrespective of whether horizontal
or vertical MNEs are considered. We distinguish between the anticipation effect (BITS)
and the ratification effect of BITs (BITR). Hence, the variable BITS is coded 1 after the
date of signing and 0 before, and the variable BITR is defined analogously for ratification.
One set of specifications includes BITR only, while the other one includes both BITS and
BITR. By itself, BITR measures the overall effect of a BIT after it has been implemented;
however, if BITS is also included in the regressions, BITR reflects the additional impact of
ratification. In the latter case, the overall effect equals the sum of the estimated BITS and
BITR coefficients.
We deflate nominal outward FDI stocks in US dollars and employ home-country investment deflators from the World Bank, using 1995 as the base year to approximate real
stocks of outward FDI. The explanatory variables consist of real GDP, tertiary school enrollment, population figures, and bilateral distance between capitals. Information on signed
and ratified BITs is available from the World Bank for the years from 1959 to 1999. Table 1
provides details on the definition of variables and Table A.1 identifies the data sources. Due
to missing FDI and school enrollment data, we restrict ourselves to the period from 1982

6 Carr et al. (2001) and Markusen and Maskus (2002) use the squared difference in bilateral GDP instead

of SIMI. Whereas SIMI rises if two countries are similar with respect to GDP, the squared difference in GDP
declines. Therefore, we expect a positive sign on the coefficient for SIMI (Egger and Pfaffermayr, 2004a).
7 A large difference between the parent and the host countries skilled to unskilled labor endowment ratio
(SK) is associated with both more horizontal and more vertical FDI, because skilled-labor-abundant countries
have a comparative advantage in inventing blue prints and setting up firms or multinational networks. However,
this effect applies less to large parent economies (GDP SK). Blonigen et al. (2003) argue that (GDP)2
|SK| should be used instead. Ekholm (1998) motivates a similar, although more parsimonious, specification.
In a reply to Blonigen et al. (2003), Carr et al. (2003) verify that the simple difference rather than the absolute
difference in factor endowments should be used as a regressor. Moreover, Carr et al. (2003) and Markusen and
Maskus (2002) recommend a specification that allows a positive skill difference to exert a different effect than a
negative skill difference. In our case, the specification issue has an impact neither on the sign of the dummies for
BITs nor on their significance.

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793

to 1997. The full design matrix for this period would contain 16,017 observations, whereas
only 4291 remain after adjusting for missing values, mainly of FDI stock data.
In Table 2, we report summary statistics for the key variables in the whole sample and
also in the two most important sub-samples of the data, namely intra-OECD relations with
2789 observations and OECD-non-OECD relations with 1446 observations. Both bilateral
stocks of outward FDI and bilateral country size are higher on average for intra-OECD
relations. Consistent with stylized facts, OECD countries are more similar in terms of both
size (SIMI) and relative factor endowments (SK). Overall, about three times as much
BITs are signed and ratified between the OECD and non-OECD countries than between
the current OECD economies in our sample. Most of existing intra-OECD BITs were negotiated and signed in the early 1990s between old members and former non-members that

Table 2
Descriptive statistics
Variable

Mean

Full sample (4235 observations)


ln real outward FDI stocks (dependent)
5.58
27.84
GDPij t
1.67
SIMIij t
16.82
SKij t
30.06
DISTij D+ SKij t
38.76
GDPij t D+ SKij t
577.06
GDPij t D+ SKij t
106.39
GDPij t D SKij t
0.20
BITSij t (BIT signed)
0.15
BITRij t (BIT ratified)
Intra-OECD sample (2789 observations)
ln real outward FDI stocks (dependent)
6.00
27.92
GDPij t
1.54
SIMIij t
8.43
SKij t
44.63
DISTij D+ SKij t
20.23
GDPij t D+ SKij t
394.79
GDPij t D+ SKij t
158.09
GDPij t D SKij t
0.11
BITSij t (BIT signed)
0.10
BITRij t (BIT ratified)
OECD-to-non-OECD sample (1446 observations)
ln real outward FDI stocks (dependent)
4.77
27.69
GDPij t
1.94
SIMIij t
33.00
SKij t
1.95
DISTij D+ SKij t
74.49
GDPij t D+ SKij t
928.63
GDPij t D+ SKij t
6.68
GDPij t D SKij t
0.35
BITSij t (BIT signed)
0.25
BITRij t (BIT ratified)
Note. OECD countries are defined according to 2003 membership.

Std. dev.

Min

Max

2.69
1.07
1.06
26.34
84.26
73.35
590.60
287.31
0.40
0.36

4.31
23.35
6.27
69.80
0.00
150.75
0.00
1885.48
0.00
0.00

11.60
30.13
0.69
94.40
544.40
389.86
2603.92
0.00
1.00
1.00

2.73
1.03
0.96
24.77
100.43
53.73
499.78
341.51
0.32
0.30

4.23
25.38
6.27
69.80
0.00
150.75
0.00
1885.48
0.00
0.00

11.60
30.13
0.69
83.20
544.40
376.27
2280.02
0.00
1.00
1.00

2.43
1.11
1.18
21.24
12.07
90.86
593.57
41.74
0.48
0.43

4.31
23.35
6.20
17.00
0.00
120.45
0.00
448.32
0.00
0.00

10.13
29.72
0.69
94.40
141.42
389.86
2603.92
0.00
1.00
1.00

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P. Egger, M. Pfaffermayr / Journal of Comparative Economics 32 (2004) 788804

Table 3
New BITs from 1982 to 1997
Country
Algeria
Argentina
Australia
Austria
BelgiumLuxembourg
Brazil
Bulgaria
Canada
Chile
China
Colombia
Costa Rica
Czech Republic
Denmark
Egypt
Finland
France
Germany
Greece
Hong Kong
Hungary
Iceland
India
Indonesia
Israel
Italy
Japan
Korea
Kuwait
Malaysia
Mexico
Morocco
Netherlands
Norway
Panama
Philippines
Poland
Portugal
Romania
Russia
Saudi Arabia
Singapore
Slovak Republic
Slovenia
South Africa
Spain
Sweden

New BITs signed

New BITs ratified

overall

thereof with OECD

overall

thereof with OECD

5
38
12
19
27
10
33
17
29
71
3
3
43
30
21
27
48
66
18
11
44
1
11
18
12
43
3
38
15
35
2
15
44
15
6
10
53
19
53
32
1
6
25
9
9
37
25

4
20
3
6
4
9
18
4
13
24
2
3
22
6
10
5
4
4
4
11
22
0
6
10
3
5
1
12
7
9
2
12
5
4
6
8
23
4
21
22
1
2
17
5
8
7
4

3
25
11
14
14
10
20
9
7
53
3
0
31
22
7
20
29
41
12
6
33
1
3
10
5
24
3
28
7
15
2
9
36
14
5
4
50
9
40
11
1
4
23
3
9
27
22

2
16
3
6
4
9
14
4
4
22
2
0
20
6
6
5
4
5
4
6
20
0
3
9
3
3
1
10
5
11
2
8
5
4
5
4
23
3
18
10
1
1
16
2
8
5
3

(continued on the next page)

P. Egger, M. Pfaffermayr / Journal of Comparative Economics 32 (2004) 788804

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Table 3 (Continued)
Country
Switzerland
Thailand
Turkey
Ukraine
United Arab Emirates
United Kingdom
United States
Venezuela

New BITs signed

New BITs ratified

overall

thereof with OECD

overall

thereof with OECD

43
14
36
26
8
69
37
15

6
6
15
15
6
5
4
10

32
7
20
12
3
58
21
7

5
4
11
7
2
4
4
4

Notes. 1. Data are from the International Centre for Settlement of Investment Disputes.
2. OECD economies as of 2003 are printed in bold face.

have since joined the OECD, e.g., the Czech Republic, Hungary, Poland, or the Slovak
Republic. Only a smaller portion of these treaties has been concluded between two states
belonging to the OECD at the date of signing the BIT, e.g., the US and Turkey in 1990,
Mexico and Spain in 1995, and Mexico and Switzerland. Hence, the typical BIT is negotiated between a highly developed country and a less-developed partner. Table 3 provides
information on ratified and signed BITs between 1982 and 1997 for all countries in the regression sample. Appendix A supplies further details on the covered 19 home and 54 host
countries. Not all BITs are implemented immediately so that some signed BITs are still
ineffective. On average, about 66% of the BITs signed by the countries in the sample were
implemented within this 16-year period. Noteworthily, we define the OECD as of 2003 in
Table 3.
Using this database, we estimate the impact of ratifying a BIT on bilateral outward FDI.
Moreover, we investigate whether significant anticipation effects occur from signing a BIT
only. Our choice of controls is guided by recent general equilibrium models of trade and
FDI. Hence, the key determinants are related to economic size, relative factor endowments,
and impediments to both trade and FDI.

3. Empirical results
In this section, we estimate the following basic specification:
Fij t = 1 GDPij t + 2 SIMIij t + 3 SKij t + 4 DISTij D+ SKij t
+ 5 GDPij t D+ SKij t + 6 GDPij t D+ SKij t + 7
GDPij t D SKij t + 8 BITSij t + 9 BITRij t + ij + t + ij t ,
where Fij t denotes the log of real stocks of outward FDI of home country i in host country j for year t. The explanatory variables are defined in Table 1. In all regressions, we
include fixed country-pair effects (ij ) to correct for omitted, time-invariant, geographical
or cultural variables, and fixed time effects (t ) to control for omitted time-variant effects
that affect all country-pairs in the same way. The usual error term is denoted by ij t .

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Table 4
The impact of BITs
Explanatory variables

Model I

Model II

Model III

Model IV

GDPij t

3.692***
(11.92)
0.203
(1.17)

0.004***
(3.88)
0.000***
(3.17)
0.000**
(2.51)

0.264***
(2.62)

30.231**
(2.32)

3.718***
(12.00)
0.230
(1.32)
0.052
(1.17)
0.003
(1.07)
0.004***
(3.42)
0.002
(1.35)
0.003*
(1.77)

0.262***
(2.60)

29.914**
(2.31)

3.639***
(11.72)
0.212
(1.23)

0.004***
(3.93)
0.000***
(3.28)
0.000***
(2.57)
0.126
(1.62)
0.214**
(2.05)
13.223
(1.51)
23.521*
(1.83)

3.666***
(11.80)
0.239
(1.38)
0.051
(1.16)
0.003
(1.04)
0.004***
(3.47)
0.002
(1.35)
0.003*
(1.75)
0.124
(1.60)
0.212**
(2.03)
13.050
(1.49)
23.302*
(1.82)

4235
0.97
329.80
0.00

4235
0.97
418.28
0.00

4235
0.97
269.77
0.00

4235
0.97
346.33
0.00

88.08
0.00
29.56
0.00

87.21
0.00
28.54
0.00

87.02
0.00
29.29
0.00

86.15
0.00
28.32
0.00

SIMIij t
SKij t
DISTij D+ SKij t
GDPij t D+ SKij t
GDPij t D+ SKij t
GDPij t D SKij t
BITSij t (BIT signed)
BITRij t (BIT ratified)
BITS-effect in % (Kennedy, 1981)
BITR-effect in % (Kennedy, 1981)
Observations
Adjusted R 2
Hausman (1978) test
p-value
F -tests:
Country-pair effects
p-value
Time effects
p-value

Notes. 1. The figures in parentheses are t-statistics. 2. t-statistics in bold face for the BITS and BITR coefficients
are based on the approximated standard errors suggested by van Garderen and Shah (2002).
* Significance at the 10% level.
** Idem., 5%.
*** Idem., 1%.

Table 4 reports the estimated coefficients measuring the impact of the explanatory variables on outward FDI. We use tertiary school enrollment as a proxy for a countrys skilled
to unskilled labor ratio. In models I and II, we include only BITR, i.e., 8 = 0; in models III and IV, we consider additional anticipation effects captured by the coefficient of
BITS. Models I and III, which exclude the distance interaction term, are closest to the
specifications estimated by Markusen and Maskus (2002). Models II and IV both include
SKijt and the interaction term DISTij D+ SKij t as suggested by Egger and Pfaffermayr (2004b). In all cases, we exclude extreme outliers defined as falling in the outer two
percentiles of the distribution of residuals and we report only heteroskedasticity-robust

P. Egger, M. Pfaffermayr / Journal of Comparative Economics 32 (2004) 788804

797

t-statistics. The country-pair and time effects always enter significantly and the random
effects model is rejected firmly when compared to its fixed effects counterpart. The high
adjusted R 2 statistics corroborate the appropriateness of our specification. Moreover, the
jointly significant size variables underscore the importance of horizontal FDI, whereas the
parameters of the skill difference variable and the interaction terms indicate that vertical
MNEs are also present. Hence, the signs of these knowledge capital model coefficients are
consistent with the theoretical predictions and with Markusen and Maskus (2002).
Regarding the impact of BITs, several findings are worth emphasizing. First, in all the
models in Table 4, the coefficient of BITR is significantly different from zero and it ranges
from 0.21 to 0.26. Hence, the estimated impact is relatively unaffected by the choice of
specification.8 Second, we find weak evidence for an anticipation effect from the coefficients of BITS in models III and IV. Third, the estimated effect of signing a treaty (BITS) is
always smaller than that of ratifying it (BITR). Since FDI stocks are measured in logs, we
must transform the BITs effect and its standard deviation to percentage figures. Following
Kennedy (1981) and van Garderen and Shah (2002), the overall effect of implementing a
treaty is calculated as 100 exp(9 0.5 Var(9 ) 1). According to Table 4, this estimated
impact amounts to about 30% in models I and II. However, the point estimate of the combined effect of BITS and BITR is even higher. Nonetheless, since the coefficient for BITS
is not significant, the parsimonious models I and II are preferred.
In Table 5, we check the robustness of our findings. First, we include additional control
variables to insure that the estimated BITs coefficients do not include effects from other
omitted variables. We take account of EU and NAFTA membership for two reasons. Daude
et al. (2002) argue that FDI regressions should consider the relevance of trading bloc effects for MNEs; both the EU and NAFTA are multilateral investment treaties that might
generate different effects from their bilateral counterparts.9 As suggested by HallwardDriemeier (2003), we account for the change in the political system in Central and Eastern
Europe in the 1990s by introducing a dummy variable equal to 1 in 1990 or later if the host
country belongs to this group. Furthermore, we include the host countrys corporate tax
rate and three host country infrastructure variables, namely, telephone mainlines per 1000
people, the size of the road network in kilometers, and the electricity supply in kilowatt
hours. Tables A.1 and A.2 provide details on data sources and summary statistics. Summing up the results, the estimated BITR parameters do not change much in the augmented
specifications and are slightly lower compared to their counterparts in Table 4. However,
the BITS parameters are now estimated more precisely.
Second, we run this augmented specification but use real GDP per capita instead of
tertiary school enrollment to measure the skill difference. This change does not alter the
point estimates of BITS and BITR substantially, but the t-statistics are higher as in Table 3
because we now have more observations. Third, we estimate the augmented specification
measuring the skill difference by secondary rather than tertiary school enrollment. The
8 UNCTAD (1998) and Hallward-Driemeier (2003) do not identify any important, significant effect of BITs,
probably because UNCTAD relies on cross-section analysis and Hallward-Driemeier focuses on developing
economies and FDI flows rather than stocks.
9 We do not report these effects in Table 5. The EU dummy tends to be positive but insignificant; the NAFTA
effect is almost always negative and significant, indicating that NAFTA favored trade at the expense of FDI.

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Table 5
Sensitivity analysis
Including additional controlsa
Model I
Model II

BITS (BIT signed)

BITR (BIT ratified)

0.254***
(4.46)
0.209**
(2.31)
0.156*
(1.67)
0.155*
(1.66)

0.139*
(1.87)
Model IV
0.138*
(1.85)
Secondary instead of tertiary school enrollment plus additional controlsa
Model I

Model II

Model III
0.140**
(2.02)
Model IV
0.114
(1.60)
As in Table 4, but excluding transition countriesb
Model I

Model II

Model III
0.100
(1.51)
Model IV
0.097
(1.20)
Real GDP/capita instead of tertiary school enrollment plus additional controlsa
Model I

Model II

Model III
0.143**
(2.55)
Model IV
0.140**
(2.50)
As in Table 4, but excluding Hungary, Mexico, and Poland
Model I

Model II

Model III
0.070
(0.79)
Model IV
0.069
(0.77)
Model III

0.204***
(2.61)
0.221***
(2.81)
0.147*
(1.77)
0.173**
(2.05)
0.218**
(2.15)
0.220**
(2.13)
0.182**
(2.41)
0.180*
(1.67)
0.259***
(4.52)
0.254***
(4.46)
0.204***
(3.21)
0.201***
(3.18)
0.172**
(2.36)
0.171**
(2.34)
0.144*
(1.66)
0.142*
(1.64)

(continued on the next page)

P. Egger, M. Pfaffermayr / Journal of Comparative Economics 32 (2004) 788804

799

Table 5 (Continued)
BITS (BIT signed)
As in Table 4, but including an interaction term of BITR with DC-LDCc
Model I

Model II

Endogenous BITR plus additional controlsd


Model I

Model II

BITR (BIT ratified)


0.209*
(1.81)
0.203*
(1.75)
0.252**
(2.37)
0.228**
(2.14)

Note: The figures in parentheses are t-statistics.


a Indicates that additional controls are EU and NAFTA dummies, a dummy capturing the political change in
the CEEC after the fall of the iron curtain (1 after 1989 for CEEC and 0 else), the average corporate tax rate, and
three variables capturing infrastructure endowments in host countries (road network in km, telephone main lines
per 1000 people, and electricity production in kWh).
b Indicates that Bulgaria, Czech Republic, Hungary, Poland, Romania, Russia, Slovak Republic, Slovenia, and
Ukraine are excluded from the sample.
c The main BITR effect is the basis and a dummy capturing OECD outward FDI to non-OECD countries is
interacted with BITR and included as well. The corresponding parameter estimates are 0.14 with a t-statistic of
1.05 and 0.15 with a t-statistic of 1.10, respectively.
d The Difference-in-difference matching approach proceeds in three steps. In the first step, a probit model is
estimated for each year with all exogenous variables plus two outside instruments, the home and host country
overall number of BITs, excluding the respective bilateral agreement. In the second step, the Mills ratio is computed for each year. In the third step, a fixed effects model is estimated, including the Mills ratio derived in the
second step. We include the same controls as listed in a except for the potentially endogenous EU and NAFTA
dummies and the corporate tax rate. An alternative specification, which also excludes the three infrastructure
variables mentioned in a , yields very similar but slightly higher BITR parameter estimates. We obtain virtually
the same results from an alternative model that does not use any outside instruments.
* Significance at the 10% level.
** Idem., 5%.
*** Idem., 1%.

corresponding BITS and BITR estimates are somewhat smaller than in Table 4, but BITR
is always positive and significant. Fourth, we exclude the new OECD members, namely,
Hungary, Mexico, and Poland, from the sample to investigate to what extent the estimation
results are driven by these countries. In this regression, we obtain a slightly smaller BITR
point estimate, but it remains positive and significant.
Fifth, we exclude all of the transition countries in the sample, namely, Bulgaria, Czech
Republic, Hungary, Poland, Romania, Russia, Slovak Republic, Slovenia, and Ukraine, and
find the BITS and BITR parameter estimates to be almost unchanged. Sixth, we construct
an interaction term between BITR and a dummy variable equal to 1 for FDI between OECD
and non-OECD countries. We re-estimate models I and II including both the BITR main
effect and this interaction term.10 If the parameter estimate of the interaction term were
significant, ratified BITs would exert a different impact on FDI between OECD and non10 Due to high correlations, both BITS and a similar interaction term cannot be used.

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P. Egger, M. Pfaffermayr / Journal of Comparative Economics 32 (2004) 788804

OECD countries than on intra-OECD FDI. Most of the intra-OECD BITs were signed
and ratified between old and new OECD members before the latter joined the OECD.
Accordingly, the coefficient of the interaction term indicates whether fast growing, recently
joining OECD members are affected differently by BITs than are old OECD members.
The parameter estimates for this interaction term are 0.14 and 0.15, respectively. Since the
corresponding t-statistics are only 1.05 and 1.10 and the coefficients of BITR in models I
and II do not change much, we conclude that no differences of this kind exist.
Finally, we check for possible endogeneity of the BITR effect in model I of Table 4.
The fixed-effects estimator provides an unbiased estimate of BITR only if the selection
into treatment, i.e., ratifying a BIT, is dominated by time-invariant variables (Wooldridge,
2002). If there is endogenous selection and the time-varying treatment is correlated with
time-variant unobservables, the fixed-effects estimate is biased. Since we have no fixedeffects panel estimator for endogenous dummy variables available, we follow Blundell
and Costa Dias (2002) and apply a matching estimator in a difference-in-difference framework. The proposed estimator compares the change in bilateral FDI stocks between the
periods before and after a BIT was ratified with the change in a properly defined control
group. Hence, we obtain the average treatment effect of the treated, which is defined as the
counterfactual impact of abolishing an earlier-ratified BIT in the presence of self selection.
Furthermore, by taking the difference of differences approach, we eliminate all unobserved
time-invariant effects.
The estimation procedure involves four steps. First, we calculate averages of log FDI
stocks for the two-year period before and after a BIT has been ratified. The second twoyear period includes the ratification year itself. Second, we calculate the change in log FDI
between these two periods for both the country pairs that ratified a BIT and the control
group. The control group is constructed for each year separately and consists of all country
pairs that did not ratify a BIT until the end of the two years defined as the ratification
period. Third, we estimate a probit model using the controls of model I, with GDP per
capita as a measure of relative factor endowments to obtain more observations. In addition,
we apply several external controls, i.e., the home and host country overall number of BITs,
excluding the respective bilateral agreements, the telephone main lines per 1000 people of
the importing country, the dummy variable for CEEC in the 1990s, and time dummies.11
Fourth, based on the scores derived in step three, we apply a simple one-to-one matching
estimator and a radius matching estimator. The corresponding standard errors are derived
by bootstrapping with 100 replications.
The additional controls in the probit model are highly significant but they do not differ significantly between the group of countries that have ratified BITs and the matched
control group. Thus, the balancing property is satisfied and, conditional on the explanatory variables in the probit regression, all country pairs are equally likely to ratify a BIT.
The estimated BITR-effect remains highly significant and it is even slightly higher, when
the endogeneity of BITR is taken into account. The point estimate equals 0.457 with a
t-statistic of 2.44 in the one-to-one matching and 0.373 with a t-statistic of 4.28 in the
11 Hallward-Driemeier (2003) uses similar variables to instrument her dummy variable for BITs in a two-stage
least-squares framework.

P. Egger, M. Pfaffermayr / Journal of Comparative Economics 32 (2004) 788804

801

radius matching. The matching estimates indicate that the standard fixed-effects estimates
in Tables 4 and 5 may be downward biased. Hence, they represent lower bound estimates
of the impact of BITs on FDI stocks.
To summarize, our findings of a positive and significant impact of BITs on bilateral FDI
stocks are robust to the inclusion of infrastructure variables, corporate tax rates, and trading
bloc effects, to the use of alternative measures of relative factor endowment differences,
to the exclusion of new OECD members, and to an endogenous treatment of BITs. Furthermore, BITs do not affect FDI between OECD and non-OECD economies differently
than intra-OECD FDI. By taking explicit account of the endogeneity of BITs, we estimate
a slightly higher effect of the counterfactual abolishing of an earlier-ratified BIT.

4. Conclusion

In the last four decades, the number of BITs signed has been large and the pace is accelerating. We investigate whether these treaties are signed only for political reasons or
whether they remove important economic obstacles. To do so, we concentrate on FDI and
analyze whether bilateral real outward FDI stocks rise as new treaties are signed or implemented. Hence, we hypothesize that bilateral investment treaties reduce barriers to FDI.
Embedded in alternative specifications of the knowledge capital model, we estimate the ratification effect of BITs. In addition, we look at potential anticipation effects after signing
and before ratifying a BIT. We use the largest available set of bilateral outward FDI stock
data from the OECD and a comprehensive data set on bilateral investment treaties from
the World Bank. We control for the importance of time-invariant and common-cycle fixed
effects as well as for the potential influence of outliers and use heteroskedasticity robust
estimates. We find an overall BIT ratification effect on FDI of about 30% in the preferred
specifications. Moreover, if it has an impact at all, signing a treaty exerts a significantly
lower impact on real FDI stocks. Our results are robust to alternative measures of relative
factor endowment differences, to the impact of trading blocs such as EU or NAFTA, and
to infrastructure endowments. In all our estimated specifications, BITs exert a positive and
significant effect on real stocks of outward FDI, with a lower bound of 15%.

Acknowledgments

Numerous helpful suggestions by the Editor and two anonymous referees are acknowledged gratefully. Egger acknowledges financial support by the Fonds zur Foerderung der
wissenschaftlichen Forschung through the Erwin Schroedinger Auslandsstipendium Grant
J2280-G05.

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P. Egger, M. Pfaffermayr / Journal of Comparative Economics 32 (2004) 788804

Appendix A. List of countries in the sample


(A) Home countries: Austria, Australia, Canada, Denmark, Finland, France, Germany,
Iceland, Italy, Korea (Republic of), Netherlands, New Zealand, Norway, Poland, Portugal,
Sweden, Switzerland, United Kingdom, and United States.
Table A.1
Data sources
Variable

Source

Bilateral stocks of outward FDI in current US$

Foreign Direct Investment Statistics Yearbook 2002


(OECD)
World Development Indicators (World Bank)
World Development Indicators (World Bank)
World Development Indicators (World Bank)
World Development Indicators (World Bank)
World Development Indicators (World Bank)
Own calculations of greater circle distance
World Bank
World Bank
World Development Indicators (World Bank)
World Development Indicators (World Bank)
World Development Indicators (World Bank)
World Development Indicators (World Bank)

Investment deflators in constant 1995 US$


GDP in constant 1995 US$
Population
Secondary school enrollment share
Tertiary school enrollment share
Bilateral distance in miles
Bilateral investment treaties signed (BITS)
Bilateral investment treaties ratified (BITR)
Host country corporate tax rates
Host country telephone main lines (per 1000 people)
Host country roads, total network (km)
Host country electricity production (kWh)

Table A.2
Descriptive statistics for variables used in the sensitivity analysis
Variable

Mean

Endowment variables (GDP/capita)


0.83
SKij t
0.92
DISTij D+ SKij t
1.75
GDPij t D+ SKij t
26.34
GDPij t D+ SKij t
3.35
GDPij t D SKij t
Endowment variables (secondary school enrollment)
15.48
SKij t
DISTij D+ SKij t
35.06
28.74
GDPij t D+ SKij t
560.14
GDPij t D+ SKij t
132.91
GDPij t D SKij t
Dummy variables
EU membership
0.05
NAFTA membership
0.00
Central and Eastern Europe after 1989
0.05
Other variables
Host country corporate tax rates
30.98
Host country telephone main lines (per 1000 people)
340.62
Host country roads, total network (1000 km)
372.04
Host country electricity production (in billion kWh)
263.00
Note: The number of observations is 3904.

Std. dev.

Minimum

Maximum

1.29
2.20
3.46
32.32
8.05

2.79
0.00
16.62
0.00
74.64

4.86
19.87
18.33
131.91
0.00

28.11
71.62
61.46
620.86
266.70

55.57
0.00
234.59
0.00
1506.17

102.60
513.88
342.48
2747.15
0.00

0.21
0.07
0.22

0.00
0.00
0.00

1.00
1.00
1.00

14.67
226.38
977.80
587.00

0.00
3.00
0.00
2.25

76.90
1147.00
6300.00
3560.00

P. Egger, M. Pfaffermayr / Journal of Comparative Economics 32 (2004) 788804

803

(B) Host countries: Algeria, Argentina, Australia, Austria, Belgium-Luxembourg,


Brazil, Bulgaria, Canada, Chile, China, Colombia, Costa Rica, Czech Republic, Denmark, Egypt, Finland, France, Germany, Greece, Hong Kong, Hungary, Iceland, India,
Indonesia, Ireland, Israel, Italy, Japan, Korea (Republic of), Kuwait, Malaysia, Mexico,
Morocco, Netherlands, New Zealand, Norway, Panama, Philippines, Poland, Portugal, Romania, Russian Federation, Saudi Arabia, Singapore, Slovakia, Slovenia, South Africa,
Spain, Sweden, Switzerland, Thailand, Turkey, Ukraine, United Arab Emirates, United
Kingdom, United States, and Venezuela.

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