The Company You Keep: How Membership in Regional Trade Agreements Affects Investor Risk in Developing Countries

This paper seeks to establish empirically that institutions matter to financial markets. To this end, I look at the impact of five different regional trade agreements (RTAs) on a composite of four different financial instruments that account for default risk on sovereign debt in developing countries. As expected, some of the agreements have a stronger impact on default risk than others. Although I do not explore the exact theoretical mechanisms of that impact, I measured those trade agreements along five different dimensions: wealth of the richest trading partner in the agreement; and tariff protection, volume of trade, strength of dispute settlement, and institutional quality of the countries in the trade agreement. I find that the institutional quality of the trading partners in the agreement seems to be driving market responses to that agreement. RTAs whose members have strong institutional quality have some negative effect on risk; more strikingly, RTAs whose members have weak institutional quality make perceptions of risk increase substantially.