The Politics of Foreign Direct Investment into Developing Countries: Increasing FDI through International Trade Agreements?

Abstract

The flow of foreign direct investment into developing countries varies greatly across countries and over time. The political factors that affect these flows are not well understood. Focusing on the relationship between trade and investment, we argue that international trade agreements-GATT/WTO and preferential trade agreements (PTAs)-provide mechanisms for making commitments to foreign investors about the treatment of their assets, thus reassuring investors and increasing investment. These international commitments are more credible than domestic policy choices, because reneging on them is more costly. Statistical analyses for 122 developing countries from 1970 to 2000 support this argument. Developing countries that belong to the WTO and participate in more PTAs experience greater FDI inflows than otherwise, controlling for many factors including domestic policy preferences and taking into account possible endogeneity. Joining international trade agreements allows developing countries to attract more FDI and thus increase economic growth. F oreign direct investment (FDI) by multinational corporations (MNCs) has grown rapidly in recent decades, 1 and developing countries have attracted an increasing share of it: $334 billion in 2005, or more than 36% of all inward FDI flows (UNCTAD 2006, xvii). Its importance for developing countries' economies also has increased, from an average of barely 1% of GDP in the 1970s to about 2.5% of GDP on average by 2000. Yet, the magnitude and especially the timing of increases in FDI into developing countries have varied greatly. What explains this variation?To answer this question, we develop a theoretical argument emphasizing political factors and empirically examine FDI flows into 122 developing countries. Since Tim Büthe (corresponding author) is assistant professor of political science, Duke University, on leave 2007-09 while a RWJ Foundation

International Institutions and Domestic Politics: Can Preferential Trading Agreements Help Leaders Promote Economic Reform?

“…Several economists have theorized about PTA effects on economic reform (Ethier 1998;Fernandez and Portes 1998), but these studies do not provide empirical evidence. Some political scientists have noted that PTAs can increase foreign direct investment (Büthe and Milner 2008;Manger 2009), but these studies do not theorize about the circumstances in which an international institution is a necessary substitute for domestic policy reform. Other political scientists argue that the United States has used PTAs to force developing countries to implement economic reforms (Shadlen 2008), but the evidence provided for this claim is limited to one multilateral agreement.…”

“…First, international institutions allow credible policy commitments (Büthe and Milner 2008;Mansfield and Pevehouse 2006). If a leader joins an international institution that increases the cost of reneging on liberalization, the extent of reform increases.…”

“…35 According to Büthe and Milner (2008), PTAs hold potential for improving FDI policy in developing countries. Thus, we search for structural breaks in the general quality of FDI policy in countries that did (and did not) negotiate a PTA with the EU and the United States.…”

“…Moreover, the competitive nature of PTA formation may result in defensive PTA formation, whereby the EU and the United States forms a bilateral trade treaty to offset the competitive advantages that corporations from other countries have formed through PTAs (Manger 2009). PTAs generally increase FDI inflows to countries that are potential FDI recipients (Büthe and Milner 2008). PTAs enable a credible commitment to liberal policies, protecting IPRs, and liberalizing services.…”

“…First, it explicitly codifies legally binding rules (Büthe and Milner 2008;Ethier 1998;Mansfield, Milner, and Rosendorff 2002). Failure to comply with international law undermines a country's reputation, thus reducing future opportunities to cooperate on related issues (Guzman 2008).…”