1. 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

2. Motivation
Spectacular increase in FDI around the world in recent years
Similar trend in Latin America, starting in 1993

3. FDI Inflows 1980-2001 Total Flows LAC Flows 1400000 140000 1200000
Total FDI Flows
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

4. 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

5. Net Private Capital Flows towards Latin America5 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

6. 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?

7. 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?

8. 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

9. 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

10. 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.

11. 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

12. 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

13. 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

14. Empirical Results

15. 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%

16. 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

17. 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 ( )
[+16%]
[+16%]
Overall effect
+60%
+0.5%

18. 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]***

19. 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

20. 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 .

21. 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%

22. 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