Substitutes for rule of law? How BITs deepen but do not broaden U.S. investment in developing countries

By specifying investment terms between signatory countries, bilateral investment treaties (BITs) can encourage foreign direct investment (FDI). Theory and evidence are less conclusive, however, for whether BITs substitute for or complement host countries’ rule of law institutions. In this note, we investigate the differential interactive impact of BITs and institutions on multinational corporations’ (MNCs) FDI decisions along the intensive and extensive margins of investment, which we argue results from firms’ varying risk tolerances. Using investment data from U.S. MNCs, we find that BITs substitute rather than complement institutions, but solely along the intensive margin of investment. The evidence suggests that, while BITs in weak states improve confidence such that existing firms deepen their investments, these agreements are not strong enough to compel new firms to take on potentially risky investments. The most substantial substitutive effects are associated with judicial constraints, reflecting the particular utility of BITs in places with poor judicial institutions. We also find evidence suggesting that firms’ differential startup costs can moderate these effects. Overall, these findings show that BITs disproportionately spur FDI in weak judicial environments, while simultaneously demonstrating the importance of considering variation by investment margin.