The FTAA and the Location of FDI

Eduardo Levy Yeyati

Ernesto Stein
Christian Daude

V Meeting of the Trade and Integration

NetworkAugust 14-15, 2003
 Motivation
• Spectacular increase in FDI around the world in recent
years
• Similar trend in Latin America, starting in 1993
 FDI Inflows 1980-2001
Total Flows LAC Flows

1400000 140000

1200000 120000
Total FDI Flows
1000000 100000

800000 80000

600000 60000
Flows towards LAC
400000 40000

200000 20000

0 0
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
Source: IFS in millions of US dollars in 1995 constant prices
 Motivation
• Spectacular increase in FDI around the world in recent
years
• Similar trend in Latin America, starting in 1993
• FDI: major source of private capital inflows to Latin
America
 Net Private Capital Flows towards
Latin America
5

3
as a % of FDI

0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
-1

-2

-3
Private capital flows FDI Portfolio Other
 Motivation
• Spectacular increase in FDI around the world in recent
years
• Similar trend in Latin America, starting in 1993
• FDI: major source of private capital inflows to Latin
America
• At the same time, increase in number and depth of
regional integration agreements around the world.
• Latin America is no exception: NAFTA, Mercosur,
Andean Community, G-3, etc. Most notably, FTAA
scheduled for 2005
• What are the effects of RIA on FDI? In particular,
what should we expect from the FTAA?
 Motivation
• What effects should FTAA have on FDI from the US
and Canada to Latin American countries?
• How will FTAA affect FDI from the rest of the world?
• What should the effect be on Mexico, whose
preferential access to US and Canada is diluted?
• Should effects on the rest of the countries be similar,
or should we expect winners and losers?
 How should RIA affect FDI?
• Sparse empirical literature, based mostly on case
studies.
• Answer is not obvious. Depends on a number of
dimensions
– Drivers of FDI: vertical vs. horizontal
– Insiders vs. outsiders of a RIA
– Host and source country characteristics
 Vertical / Horizontal models of FDI
• Vertical FDI:
– Helpman (1984), Helpman and Krugman (1985)
– Firm engages in different activities (with different factor
intensities), which can be separated geographically without
costs (eg, corporate sector, production plant). No trade costs.
– Firms locate each “stage” of production according to CA
– No FDI if countries have similar factor proportions
– Vertical FDI complementary with trade
• Horizontal FDI:
– Markusen (1984)
– Firm produces homogeneous good in multiple locations
– Can serve markets through FDI or trade
– Key: interplay between economies of scale and trade costs
– FDI will arise when trade costs are large (tariff-jumping)
– Horizontal FDI is a substitute for trade
 Effects of RIAs on FDI
• Vertical integration: Lower tariffs  lower transaction costs for
firms to integrate vertically within the RIA  FDI creation
• Tariff-jumping: Lower tariffs  lower costs of serving markets
through trade  Should reduce FDI from RIA partners.
• FDI diversion: If a RIA makes the partner countries relatively
more attractive, non-members likely to get less FDI.
• FDI dilution: If a RIA expands, locational advantages of
original members are diluted. Example: Mexico in FTAA.
• Extended market effect: generates new investment in activities
with economies of scale. Larger markets make it more
worthwhile for outside FDI to “jump” external tariff.
• Redistributive effects: The regional effect is not evenly
distributed: New and existing FDI may be relocated to more
attractive countries  winners and losers.
 Data and empirical strategy
• Dependent variable: bilateral outward FDI stocks from
1982 through 1998 from OECD International Direct
Investment Statistics database.
• 20 source countries (from the North) and 60 host countries.
• Empirical model based on gravity equation.
• We modify the gravity equation in several ways:
– we include country pair fixed effects instead of distance,
adjacency, common language, etc (to focus on time series
dimension).
– we include time dummies (to control for FDI trend)
– we include different regional integration variables
 Regional integration variables

• Same RIA dummy = 1 when source and host country belong to

the same free trade area. Source: Frankel (1997)
• Extended market effect: host extended market: log of the joint
GDP of all the countries that are RIA partners of the host
country, including host country itself
• Diversion / dilution effects: source extended market: log of the
joint GDP of all the countries that are RIA partners of the
source country, including source country itself
• extended market variables capture the of size of the market to
which a firm in the country has access with zero tariff
 Basic specification

Log (1+FDIijt) = a + b1 lGDP hostijt + b2 lGDP sourceijt + g sameRIAijt

+ d1 EM hostijt + d2 EM sourceijt + fDij + jYt + eijt

– where FDIijt is the stock of FDI of source country i in

host country j at time t, as reported by the source
country.
– Dij is a vector of country pair dummies
– Yt is a vector of year dummies
Empirical Results
 Baseline Results
(1) (2) (3)

GDP Host 0.191 0.180 0.243

(5.864)*** (5.540)*** (6.546)***
GDP Source 0.518 0.518 0.510
(7.259)*** (7.288)*** (6.992)***
Extended Market Host 0.102 0.112 0.095
(5.684)*** (6.234)*** (5.209)***
Extended Market Source -0.048 -0.051 -0.028
(2.730)*** (2.905)*** (1.531)
Same FTA 0.2393 0.2821 0.2712
(3.983)*** (4.703)*** (4.562)***
Privatizations 0.041 0.035
(9.609)*** (8.105)***
Inflation 0.073
(2.125)**
Constant -6.955 -6.917 -7.464
(7.260)*** (7.249)*** (7.465)***

Observations 12483 12483 11706

Number of pairs 1083 1083 1045
R-sq between 0.5126 0.5072 0.523
F pair dummies [61.65]*** [61.54]*** [61.84]***
F year dummies [42.12]*** [40.45]*** [38.08]***

Absolute value of t statistics in parentheses. Absolute value of F statistics in square brackets. * significant at 10%; ** significant at 5%; *** significant at 1%
 Baseline results

Effect of same FTA

30
27%
25

20 Effect of doubling
extended market
15 of host country
10%
10

5
-5%
0

-5
Effect of doubling
extended market
-10
of source country
Potential impact of FTAA on bilateral FDI
from the US

Argentina Mexico

Same FTA
+26.2% 0
(0.2329)
Extended market +26.8% +1.25%
host (0.1020) [+921%] [+13%]

Extended market 0.71% 0.71%

source (- [+16%] [+16%]
0.0481)
Overall effect +60% +0.5%
 Regressions with interactions

(1) (2) (3) (4)

GDP Host 0.191 0.189 0.350 0.344

(5.864)*** (5.789)*** (7.879)*** (7.746)***
GDP Source 0.518 0.515 0.542 0.537
(7.259)*** (7.217)*** (6.616)*** (6.558)***
Extended Market Host 0.102 0.104 -0.060 -0.057
(5.684)*** (5.796)*** (2.639)*** (2.489)**
Extended Market Source -0.048 -0.049 0.044 0.043
(2.730)*** (2.784)*** (2.128)** (2.079)**
Same FTA 0.239 -0.345 0.130 -0.444
(3.983)*** (2.222)** (1.332) (2.613)***
Same FTA * Openness 0.009 0.008
(4.079)*** (4.113)***
Same FTA * Skill difference 0.010 0.011
(1.694)* (1.870)*

Constant -6.955 -6.905 -7.672 -7.578

(7.260)*** (7.212)*** (6.734)*** (6.658)***

Observations 12483 12483 8293 8293

Number of pairs 1083 1083 703 703
R-sq between 0.5126 0.5162 0.4973 0.5092
F pair dummies [61.65]*** [61.23]*** [69.37]*** [68.55]***
F year dummies [42.12]*** [42.15]*** [27.82]*** [27.89]***
 Openness and the Impact of Same RIA on FDI

600

500

400
Impact on RIA

300

200

100

0
0 50 100 150 200 250 300
-100
Average Openness
 Skill difference and
the Impact of Same RIA on FDI

120

100
Impact on RIA

80

60

40

20

0
0 10 20 30 40 50 60 70
-20
Absolute Difference in % of labor force with secondary education

.
 Winners and Losers - FTAA

Baseline Regression Regression with openness

regression with openness and skill difference
USA-CAN ROW USA-CAN ROW USA-CAN ROW
Argentina 58.93% 26.05% 1.87% 27.44% 21.70% 28.88%
Brazil 58.93% 26.05% 2.71% 27.44% 22.62% 28.88%
Canada 0.65% 1.43% 0.70% 1.50% 1.35% 1.57%
Chile 98.13% 57.15% 82.44% 60.54% 56.97% 64.10%
Colombia 81.81% 44.20% 34.20% 46.72% 11.43% 49.35%
Costa Rica 124.92% 78.40% 153.06% 83.35% 155.83% 88.57%
Mexico 0.03% 0.81% 0.05% 0.84% 0.67% 0.88%
Panama 136.11% 87.27% 161.87% 92.91% 206.02% 98.86%
USA 0.65% 1.43% 0.70% 1.50% 1.35% 1.57%
Venezuela 81.81% 44.20% 55.44% 46.72% 53.58% 49.35%
 Conclusions

• RIA increase FDI, both from insiders and outsiders,

• Effects are highly significant and large.
• FTAA is likely to increase FDI to Latin America, both
from within the FTAA and from outsiders.
• However, FDI benefits of FTAA likely to be very unevenly
distributed.
• Impact on Mexico should be negligible
• Countries that are more open to trade, and different in
terms of factor endowments from the source countries, are
likely to be the big winners