Evaluating the effect of Bilateral Investment Treaties on Foreign Direct Investments and the role of Democracy

Abstract: Foreign direct investments (FDI) have in later years become regarded as a key engine to economic growth, which many developing countries find appealing. Developing countries do however often find it hard to attract FDI since they have an unstable political environment due to inferior levels of democracy. To overcome this issue, they turn to bilateral investment treaties (BITs) with the hope that they will increase their chances of attracting FDI. BITs provide a safety mechanism for foreign investments, and the question is whether the effect of such agreements is depending on the level of democracy in the host country. Using a sample of FDI flows of 20 source OECD countries with 89 partner countries covering the time period of 1996-2013, this paper has its focus on whether the effect of BITs on FDI is affected by the degree of democracy in the host country. Estimations are obtained by using a gravity model approach alongside with knowledge-capital model variables. To estimate the effect of democracy, two democracy indicators provided by the Kaufmann indices have been employed. Our empirical findings suggest that BITs do not have any effect on FDI while the democracy variable of rule of law has a positive effect on FDI. However, our findings cannot show evidence of democracy having an impact of the effect of BITs and hence not confirm the link between BITs’ effect on FDI and the level of democracy in the host country.