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 Total FDI Flows 1000000 100000 800000 80000 600000 60000 Flows towards LAC 400000 40000 200000 20000 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 4 3 2 as a % of FDI 1 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 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 Log (1+FDIijt) = a + b1 lGDP hostijt + b2 lGDP sourceijt + g sameRIAijt + d1 EM hostijt + d2 EM sourceijt + fDij + jYt + eijt

Empirical Results

Baseline Results GDP Host 0.191 0.180 0.243 (5.864)*** (5.540)*** (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%

Effect of doubling extended market Baseline results Effect of same FTA 27% 30 25 20 Effect of doubling extended market of host country 10% 15 10 5 -5% -5 Effect of doubling extended market of source country -10

Potential impact of FTAA on bilateral FDI from the US Argentina Mexico Same FTA +26.2% (0.2329) Extended market +26.8% +1.25% host (0.1020) [+921%] [+13%] Extended market 0.71% 0.71% source (-0.0481) [+16%] [+16%] 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 600 500 400 300 Impact on RIA 200 100 50 100 150 200 250 300 -100 Average Openness

the Impact of Same RIA on FDI Skill difference and the Impact of Same RIA on FDI 120 100 80 Impact on RIA 60 40 20 10 20 30 40 50 60 70 -20 Absolute Difference in % of labor force with secondary education .

Winners and Losers - FTAA Regression with openness 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