Reputational shocks and commitment devices: Differential effects on foreign direct investment in developing economies

Why capital doesn't flow from rich to poor countries is a relevant but not at all new question. As such it has gotten many answers since it was first posted by Lucas in 1990. The literature has shown that institutional quality is a key factor in explaining this paradox. But how do investors find out about the quality of a country's institutions? Investor-State Dispute Settlement (ISDS), an institutional arrangement present in Bilateral Investment Treaties (BITs), should work as a mechanism where institutional quality gets revealed. Having a “case” would imply a negative reputational shock and the country's future foreign direct investment (FDI) should diminish, even more if the country loses it. Since most disputes occur in the context of a BIT, which functions as a commitment device, the overall result should also include this effect. I test this hypothesis and identify both the reputational and the commitment device effects by estimating a structural gravity equation using a Poisson pseudo maximum likelihood method. Results for my benchmark model show a reputational shock that reduces FDI inflows by USD 20 million one year after a dispute. This is more than compensated by the commitment device effect that increases these flows by USD 95 million. My analysis of heterogeneous effects shows that negative results are driven by a subsample of countries with a large history of disputes. This shows that the reputational effects are small and that the interaction of the whole set of institutions promotes FDI in developing economies.