Higher domestic institutional quality has been statistically shown to lead to increased FDI inflows (Li & Resnick 2003; Busse & Hefeker 2007; Jensen 2008). Countries with higher quality governance infrastructure, which I define as the core institutions within a state that facilitate government competency and economic efficiency, signal to economic actors that the states in question are committed to providing a stable macroeconomic environment, market friendly policies, and efficient institutions, thereby reducing transaction costs. This can be viewed as a classic imperfect information game, in that the states have more information on the quality of their respective institutional environments than do the firms looking to invest in foreign markets. Therefore, states that are in competition for limited foreign direct investment convey this information through their quality level of governance infrastructure. In this paper, I develop a formal signaling model that explicitly demonstrates this theoretical link. To empirically examine this model, I interact previous FDI inflows, considered one the strongest signals regarding the quality of a state's investment environment, with different aspects of a developing state's domestic institutional environment. These institutional aspects included, veto players, regime stability, regime type and governance infrastructure. Preliminary results demonstrate that when a state's prior FDI inflows are sufficiently low the quality level of a state's governance infrastructure provides a strong signal regarding its level of commitment to maintaining an investment-friendly environment. However, as previous FDI reaches a large enough level the signal sent by governance infrastructure is overwhelmed by this stronger and more readily visible signal. Moreover, the other aspects of a developing countries domestic institutional environment appear to not send significant signals to investors. This paper demonstrates, conceptually and empirically, that governance quality is an important signal in determining where firms invest
