Bilateral Investment Treaties and FDI: Does the Sector Matter?

Developing and transition countries have increasingly engaged in the signing of bilateral investment treaties (BITs) in order to attract FDI, based on the widely shared view that FDI can contribute significantly to economic development and poverty reduction. However, the degree to which foreign investments can be expected to generate employment, offer access to international technology and know-how, and ultimately create growth, varies considerably depending on the type of investment. It is therefore important to determine what type of FDI is attracted by BITs. By providing a legal commitment to the fair and equitable treatment of foreign investors, BITs aim to decrease investment risk and to attract foreign investors. We argue that BITs can be expected to be most effective in those sectors of the economy with a larger risk of expropriation, i.e., sectors characterized by large sunk costs, relatively low levels of firm-specific know-how, and in sectors that are politically sensitive to foreign ownership.This paper represents the first attempt to empirically study the heterogeneous effect that BITs may have across different sectors of investments. We analyze investments made in 13 countries in the former Soviet Union and Central and Eastern Europe, disaggregated over seven sectors. We indeed find the effect of BITs to differ considerably across sectors of investment. Using capital intensity as a proxy, we confirm that FDI in those sectors with higher sunk costs responds more strongly to the signing of BITs. Given the considerable differences in the development impact that can be expected from FDI in different sectors, it remains to be shown whether BITs are an effective tool to attract those types of investments that are most beneficial for the development of the host economy.