Regulating Foreign Investment: Bilateral Investment Treaties, Investment Risk, and the Reallocation of FDI

We model the formation of the international investment regime as a network formation process where nodes (countries) choose which arcs to add (treaties to sign). The provisions of investment treaties are modeled as an enforcement technology that has the potential to increase the returns, and reduce the costs and risk of investing abroad. We model investment decisions as a mean-variance optimization process, explicitly accounting for the home-country bias in investment documented in the empirical literature. In deciding which treaties to sign, governments internalize the potential aggregate and distributive consequences of inward and outward investment. Signing investment treaties affects the mean and variance of the return to investment among signatory, and non-signatory parties. In equilibrium –when all potentially beneficial agreements have been signed and the network reaches a level of saturation– the signing and ratification of BITs would be consistent with a limited reallocation of investment capital across countries (or no reallocation of investment if BIT signing is defensive). Yet, we also predict that BITs are consequential: they are likely reduce investment and increase returns on investment to multinational firms, outcomes that are hard to observe. To test this prediction we develop a structural estimator that uses the observed allocation of FDI to estimate the variance of returns and expected returns to investment in the presence of BITs. We find that the allocation of investment is consistent with lower risk (and higher returns) in the presence of BITs. Our model and empirical strategy help explain the contradictory results in the empirical literature on the effects of BITs on FDI flows. ∗University of Houston, ppinto@central.uh.edu †Federal Reserve Bank of Richmond, Santiago.Pinto@rich.frb.org ‡Universidad Torcuato Di Tella, nstier@utdt.edu