The Interaction of International and Domestic Institutions: Preferential Trade Agreements, Democracy, and Foreign Direct Investment

Abstract

Foreign direct investment (FDI) has come to be seen as a promising avenue for boosting economic development. As a consequence, most developing countries now seek to attract FDI, often by making ex ante promises to foreign investors not to pass laws or regulations — or refrain from other actions — that would diminish the value of the investment ex post. But how credible are such promises? A number of recent studies have examined the effect of domestic institutions (veto players, democracy, etc.) on the credibility of commitments by developing country governments toward foreign private economic actors, such as foreign investors. In addition, a few studies have examined the effect of international institutions on the credibility of such commitments. We examine the interaction of domestic and international institutions in promoting FDI. We show theoretically and empirically that democratic domestic institutions help attract more FDI into developing countries only in the context of economically liberal international institutions.

Keywords: foreign direct investment, institutions institutional interaction, trade agreements, PTAs, democracy, MNCs, political risk, credible commitment