Foreign direct investment and institutional environment: the impact of bilateral investment treaties

ABSTRACT

Institutional factors are a critical driving force for the rapid growth of outward foreign direct investment (FDI) in developing countries. This article attempts to explain how developing countries can take advantage of bilateral investment treaties (BITs) to reduce investment uncertainties caused by informal institutional distance and help domestic companies invest abroad. The results confirm that the cultural difference between China and a host country is negatively associated with the likelihood of FDI entry into the host country. BITs function as a substitute for the host country’s institutional environment by reducing investment uncertainties caused by cultural distance. Moreover, state-owned enterprises are less responsive to BITs in host countries than private enterprises, suggesting that private firms rely more on BITs to reduce their investment risks abroad.

KEYWORDS:

• Foreign direct investment
• bilateral investment treaties
• cultural distance
• mixed logit model

JEL CLASSIFICATION:

• C25
• F13
• F23

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ The original dimensions of national culture are Power Distance, Individualism, Masculinity, and Uncertainty Avoidance. The four dimensions’ scores are available for 74 of the 86 countries in our dataset (Hofstede 2001). We retrieved the scores for 12 more countries through extending the area scores of ‘East Africa,’ ‘West Africa,’ and ‘Arab world’ to more countries than those initially included in Hofstede’s study. In our models using the full sample of 86 host countries, we replace missing values of the cultural distance index with means.

² The World Governance Indicators include six indexes: voice and accountability, political stability, government effectiveness, regulatory quality, the rule of law, and control of corruption.

³ The horizontal axis is the cultural distance between China and the host country, and the vertical axis is the number of investment projects corresponding to each cultural distance.

⁴ IIA means that the odds ratios are independent of other alternatives, and adding/subtracting choices to/from the existing set of choices does not affect the relative odds between any two alternatives.

Additional information

Funding

This work was supported by the National Natural Science Foundation of China [72002166, 71832009, 71672138].