Analysis of developments in the fields of direct investment and M&A (mergers and acquisitions) – Part II

Sector: Finance | Financial markets and Institutions
Client: EC DG Internal Market and Services
Published: November, 2011
Document type: Report 
Tagged: other international quantitative analysis

This report consists of three papers providing analyses of topics relevant to foreign direct investment: bilateral investment treaties, a financial transactions tax and investment screening mechanisms.

Bilateral investment treaties

An empirical analysis of the influence bilateral investment treaties (BITs) on the pattern of FDI flows in the EU was carried out. A gravity model of FDI was developed and estimated in panel form using a variety of econometric techniques.

The economic function of BITs, inter alia, is to solve the commitment problem of non-expropriation of foreign investors. BITs may therefore encourage FDI flows. Empirically, however, our analysis showed that BITs do not impact bilateral FDI flows within the EU27. This may be due to the high level of institutional proximity within the EU (e.g., safety of private property from expropriation).

Other key results were as follows. Bilateral FDI flows are larger between EU15 Member States. The size of the receiving economy has a highly significant and positive impact on the likelihood of receiving FDI. Taxes, particularly corporate taxes, have a negative impact on FDI flows. And, low levels of corruption in the receiving Member State have a highly significant and positive impact on FDI.

A financial transactions tax

A theoretical analysis of the impact of a financial transaction tax (FTT) or Tobin tax on FDI was provided. Based on a neoclassical model, we find that an FTT has a small effect on the cost of funds. Specifically, under a wide range of assumptions, an FTT of 0.1% is likely to cause FDI to decline by less than 1%.

Investment screening mechanisms

The impact of investment screening mechanisms on FDI was investigated for the EU27. Investment screening mechanisms can be as restrictive as limiting FDI to projects that serve a national interest or as lax as constituting a pre-notification requirement for investors. In their strictest form, investment screening mechanisms are particularly relevant to the operation of the EU single market.

The main finding of the empirical analysis is that formal investment screening mechanisms do not influence patterns of FDI flows. However, despite accounting for the main factors affecting FDI flow covered in the economic literature, inflows are over-/under-predicted for certain Member States. This suggests certain country-specific factors are at play, of which informal screening mechanisms may be one.