Overcoming Institutional Voids: International Institutions and the Investment Climate

Abstract

Firms in many emerging markets face significant institutional voids. To overcome the liabilities of weak domestic institutions, some states (not firms) participate in international institutions, trading sovereignty for institutional credibility. We examine whether states’ compliance with international institutions impacts firms’ assessment of the domestic investment climate. Focusing on the global investment treaty regime that allows firms to bring legal claims for alleged property rights violations against sovereign states, we argue that a ruling in favor of the state by a neutral international body will be perceived by observer firms as a legitimating symbol of stronger property rights and domestic courts. In contrast, a ruling against the state leads to firms assessing domestic legal institutions as more challenging. By comparing 14,338 firm responses across 16 countries prior to and after a tribunal ruling, we find support for the hypothesized effect of international institutions. We further find that the effects are conditioned by whether the observer firm is in the same industry as the litigant firm and whether it is a foreign firm. These findings suggest an alternate pathway by which firms can overcome institutional voids in emerging markets.