Abstract
When is a commitment mechanism employed as a solution to a time-inconsistency problem? This article provides a nuanced answer to this question by studying bilateral investment treaties (BITs). We develop a game theoretic model of BIT signing in which the government of a capital-importing country and an investor from a capital-exporting country strategically interact. The model predicts that, on the one hand, when host states highly value foreign direct investment (FDI), the likelihood of BITs increases as their judicial institutions lack credibility. On the other hand, when their preferences for FDI are only modest, the likelihood of BITs increases as their judicial institutions become more credible. We employ Cox proportional hazard models to test our hypotheses, and the results largely support our theory. Our findings have broad implications for the large literature on credible commitment, which has paid insufficient attention to the interplay between preferences and credibility.
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Notes
We discuss measures of the intensity of FDI preferences in detail in sections that follow.
Online Appendices are available on this journal’s webpage.
The investor’s profit could be stochastic. As long as the regulatory policy decreases the marginal profit in its expected value, our findings would be unaltered.
This means that, in a given dyad, if the host state signs a BIT, the investment increases compared to the off-the-equilibrium-path (i.e., the counterfactual) in which the BIT is not signed. As our focus is not on the effects of BITs on FDI, we do not attempt to derive the implications of the proposition on the FDI data which in principle is a collection of observations of on-the-equilibrium-path. Earlier empirical studies, in this regard, generally failed to find significant effects of BITs on FDI inflows. Yet, more recently, “mounting evidence shows that BITs in the aggregate are associated with greater inward FDI” according to Allee and Peinhardt (2011, 405). They point out that “the most robust finding is that the number of BITs a country signs is positively correlated with inward FDI” and that “the validity of this finding is enhanced by that fact that these studies examine a wide range of countries over a long time-series and utilize more reliable country-level FDI data” (405). They include the following studies among others: Allee. T. and Peinhardt (2011), Büthe and Milner (2008, 2009),Egger and Pfaffermayr (2004), Haftel (2010), Kerner (2009), Neumayer and Spess (2005), and Salacuse and Sullivan (2005), and Tobin and Rose-Ackerman (2011).
Our model shows how BITs work as a commitment device in a symmetric information setting. BITs might also function as a costly signal. Adding asymmetric information to our model and thus modeling BITs as a signal would not change our predictions, whether the signal incurs only ex post costs as in the current model or there are some additional ex ante costs. As Kerner (2009) discusses, the two mechanisms of BITs–hand-tying and signaling– have different implications on FDI inflows. However, the two theories are not differentiated by their predictions about who signs BITs, which is our main subject.
Formal derivation of D is in Online Appendix A.
Pinto (2013) argues that left-wing governments may prefer FDI more than right-wing governments if the core constituency of the left is organized labor and FDI complements labor. We are open to such a possibility (especially when the sample is limited to rich democracies and some developing countries), but believe that the two conditions are unlikely to hold simultaneously for most developing host countries, in which the core constituency of the left-wing governments are composed of not only organized labor in the export-oriented manufacturing sectors but also agricultural workers in large rural sectors and the poor in urban informal sectors.
For example, we say the effect of p 0 on the likelihood of BITs decreases when the slope of the graph of the likelihood as a function of p 0 changes from +1 to −2 as well as from −1 to −3.
Considering a random event 𝜃 as a summary of what might happen after the BIT signing decision, we assume that α is independent of the distribution of 𝜃. If the government ideology affects the demand of regulation as well as the need for FDI inflows, then 𝜃 may not be independent of α. In that case, a left-wing government who has weak preference for FDI may confront strong demand for capital regulation frequently. Such dependence between α and 𝜃 does not necessarily change our predictions. Indeed, Proposition 3 would hold true even if we allow F to depend on α. However, whether Proposition 4 holds or not would depend on the shape of F. We thank an anonymous reviewer for raising this issue.
These hypotheses are derived from the first part of Proposition 4. Symmetrically, from the second part, we may write three alternative hypotheses that the effects of the three measures of α decrease as rule of law becomes stronger.
A bilateral treaty is not legally binding, however, until it goes into effect by both signatories’ actual ratifications. Ratifying a treaty also involves significantly higher political costs, as it typically requires more than executive decisions. As such, signed, but unratified BITs might not be as effective as a credibility-enhancing device. See Simmons (2009) and Haftel (2010). We therefore cross-check the validity of using year of signing with an alternate measure using the year in which a BIT goes into effect as the event time.
Our sample contains all pairs comprised of each of the original 22 OECD members and each of non-OECD, independent states in the UNCTAD database, excluding Hong Kong, Macao, Monaco, and Palestine as well as those for which variables used in regressions are missing. The number of dyads included ranges from 1,349 to 2,268 depending on the availability of the measures employed.
As a robustness check, however, we also test our hypotheses using a sample of all dyads excluding only OECD pairs.
We employ this model because it allows us to estimate the coefficients of our explanatory variables without any assumption on the baseline hazard.
Precisely, each of the three measures is standardized to range from zero to one, and the average of the three standardized measures is the composite index.
It is worthwhile to note that the empirical cases that do not support the hypothesis are rare in the data. The distribution of Rule of law is skewed to the right. With the median at 0.27, roughly three quarters of the host LJI scores are less than 0.46, and those with 0.6 or higher belong to the top ten percentile. The range of the LJI scores that produce the unexpected marginal effects is scarcely populated by real observations.
In Online Appendix C, we check the robustness of the findings by broadening the scope of relevant dyads to allow any two countries to form a home-host pair so long as they both are not OECD countries. We designate countries with higher income as the home and those with lower income as the host as measured by GDP per capita following previous studies (Allee and Peinhardt 2010; Elkins et al. 2006; Jandhyala et al. 2011). This results in a fourfold increase in the number of dyads in the sample and a twofold increase in the number of BITs signed during the analysis period; yet no material changes in the key findings are made.
For instance, Jandhyala et al. (2011, 5) argue that “we should expect to observe BITs involving countries with the greatest potential unrealized FDI due to problems of commitment. … These commitment problems are particularly acute in countries with few checks and balances.”
Left parties, for instance, are said to be more likely to adopt fixed exchange rates precisely because they lack anti-inflation credibility compared to Right parties. See, for example, Garrett (1995).
For instance, Mansfield and Pevehouse (2006) claim that transitional democracies are more likely to enter international organizations because leaders are unable to credibly commit to liberal reforms. Similarly, Moravcsik (2000) argues that it was newly established democracies that were most vigorously supportive of the creation of the European Convention for the Protection of Human Rights and Fundamental Freedoms (ECHR) because they had the greatest interest in securing democratic stability against future illiberal threats.
Allee and Peinhardt (2010, 19) for instance, argue that “[l]eaders who govern in relatively corruption-free environments, where the rule of law prevails and political institutions constrain the power of executives, have … no reason to fight for domestic dispute resolution over delegation … because in neither case can they influence the dispute outcome.”
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Acknowledgments
The authors are grateful to Drew Linzer and Jeffrey Staton for generously providing the Latent Judicial Independence dataset, and to Susan Hyde, David Leblang, Daniel O’Neill, Erica Owen and seminar participants at Columbia University, at Seoul National University, and at Yale University for their useful comments. All errors are our own.
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Cho, Sj., Kim, Y.K. & Lee, CS. Credibility, preferences, and bilateral investment treaties. Rev Int Organ 11, 25–58 (2016). https://doi.org/10.1007/s11558-015-9218-8
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DOI: https://doi.org/10.1007/s11558-015-9218-8