Of Handcuffs and Signals: Investment Treaties and Capital Flows to Developing Countries

Abstract

This article examines the potential association of investment treaties with the quantity and cost of capital flows to developing countries. Whereas previous research on the effect of bilateral investment treaties (BIT) on capital flows has focused almost exclusively on direct foreign investment (DFI), this article examines total flows of all types. It also asks a question ignored by previous studies: Do investment treaties affect the cost that a developing country must pay for the capital it receives? Instead of viewing investment treaties as just international legal instruments prescribing rights and duties, the article also examines their role as information to international capital markets. Relying on insights from the economics of information and signaling theory, it argues that investment treaties influence capital flows through the signals they send to international capital markets. Accordingly, it creates a model of a “Strong BIT Signal Country” and proceeds to identify twenty-six countries that fit the model, while identifying for comparative purposes fifteen countries deemed to be “Weak Signal BIT Countries.” An analysis of capital flows to both groups of countries finds that the Strong Signal BIT Countries experienced significant increased capital inflows following the completion of their BIT negotiation program and also reveals that they outperformed the Weak Signal BIT countries in this respect. Using data on sovereign credit ratings and World Bank governance indicators on the rule of law, the author also finds that several countries experienced an improvement in both indicators following the conclusion of their BIT programs, leading to the inference that such improvement might also be associated with a reduction in a country’s risk premium and therefore a decline in its cost of capital.