Regional Integration and the Location of FDI

1. Regional Integration and the Location of FDI Eduardo Levy Yeyati Ernesto Stein Christian Daude

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

3. Flows towards LAC Total Flows 1000000 100000 900000 90000 800000 80000 700000 70000 Flows towards LAC 600000 60000 500000 50000 400000 40000 300000 30000 Total Flows 200000 20000 100000 10000 0 0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Note: Millions of Dollars, 1996 constant prices FDI Inflows 1980-1999

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. 4 3.5 3 2.5 As % of GDP 2 1.5 1 0.5 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 -0.5 -1 Net private Capital Inflows Portfolio FDI Loans Source: Balance of Payments, IMF Net Private Capital Flows towards Latin America

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.

7. 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.

8. 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. • What should we expect in terms of FDI to the region in light of a future FTAA?

9. Policy questions • 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?

10. How should RIA affect FDI? • Sparse literature. No systematic empirical evaluation of large set of countries • Answer is not obvious. Depends on a number of dimensions • Drivers of FDI • Insiders vs. outsiders of an RIA • Host and source country characteristics

11. Drivers of FDI: Standard models • Vertical (Helpman, 1984; Helpman and Krugman, 1985): Single-product firm with two separable production stages with different skilled-labor intensity; no trade costs Trade-complementary, vertical FDI between “dissimilar” countries (with different factor endowments) • Horizontal (Markusen, 1984): Single-product firm with (plant- and firm-level) scale economies; trade costs Trade-substitutive, horizontal FDI between similar countries if trade costs are large (tariff-jumping, distance, etc.)

12. North - North and North - South FDI What should we expect? • Factor proportions  Horizontal North-North FDI and vertical North-South FDI • Trade barriers  Vertical North-North FDI (location) and horizontal North-South FDI (tariffs, as, e.g., the auto industry during ISI) • Evidence: FDI-trade complementarity in developed economies  Horizontal model + country-specific preferences (large cars in the U.S., small cars in Europe) Trade-complementarity, horizontal FDI between similar countries if trade costs are large

13. Effects 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  FDI destruction • FDI diversion/dilution: Non-members (or old members) become relatively less attractive. • Extended market effect: Fosters tariff jumping in activities with economies of scale  higher FDI from outsiders. • Redistributive effects: The regional effect is not evenly distributed: New and existing FDI may be relocated to more attractive countries  winners and losers.

14. Data and empirical strategy • Dependent variable: bilateral outward FDI stocks from 1982 through 1998 from OECD International Direct Investment Statistics database • 20 source countries and 60 host countries: 1200 country pairs, 20400 observations • Same FTA dummy based on Frankel et al, 1997 • Caution: Very few North-South FTA pairs (developing countries do not report their outward FDI)

15. Basic specification Log (1+FDIijt)= a + b1 lGDP hostijt + b2 lGDP sourceijt + g sameftaijt + + d1 EM hostijt + d2 EM sourceijt + fDij + jYt + eijt • where FDIijtis the stock of FDI of source country i in host country j at time t, as reported by the source country. • Dijis a vector of country pair dummies • Yt is a vector of year dummies

16. FDI diversion and extended market variables • Diversion / dilution effects: • source extended market: log of the joint GDP of all FTA partners of the source country, including source country itself • Extended market effect: • host extended market: log of the joint GDP of all FTA partners of the host country, including host country itself

17. (1) (2) (3) (4) 0.862 0.879 0.895 0.896 (14.676)** (14.917)** (12.931)** (12.948)** -0.136 -0.134 -0.203 -0.203 (1.314) (1.297) (1.848) (1.844) 0.060 0.050 0.045 0.042 (2.668)** (2.213)* (1.900) (1.774) -0.268 -0.270 -0.264 -0.265 (11.756)** (11.860)** (10.879)** (10.906)** 0.770 0.818 0.769 0.783 (9.507)** (9.945)** (9.278)** (9.305)** 0.020 0.006 (3.324)** (0.977) 0.025 0.024 (1.546) (1.460) -9.218 -9.448 -8.007 -7.976 (2.900)** (2.973)** (2.312)* (2.303)* 18308 18308 16739 16739 1140 1140 1100 1100 0.2658 0.2662 0.2652 0.2653 18.89** 18.91** 17.95** 17.92** 41.32** 36.45** 36.52** 33.94** Baseline results GDP Host GDP Source Extended Market Host Extended Market Source Same FTA Privatization Inflation Constant Observations Number of pair R2 Within test F Pair Effects test F Time Effects

18. (1) (2) (3) (4) (5) 0.862 0.854 0.866 0.847 0.766 (14.676)** (14.540)** (12.409)** (14.159)** (8.744)** -0.136 -0.137 -0.168 -0.179 -0.363 (1.314) (1.331) -1.53 (1.707) (2.727)** 0.060 0.065 0.044 0.064 -0.020 (2.668)** (2.913)** -1.783 (2.832)** (0.681) -0.269 -0.296 -0.266 -0.273 -0.268 (11.756)** (11.817)** (12.426)** (11.519)** (9.211)** 3.168 1.152 0.770 0.123 -2.044 (9.507)** (0.563) (7.150)** (3.017)** (9.021)** 0.009 (3.161)** 0.119 (3.639)** 0.425 (10.535)** -0.347 (2.285)* -0.780 (4.186)** -9.21 -9.097 -7.877 -7.876 1.828 (2.900)** (2.863)** (2.265)* (2.441)* (0.428) 0.319 -1.545 1.460 1.152 1.004 0.829 0.795 0.870 1.447 3.072 0.442 -0.325 18308 18308 16341 17957 12343 1140 1140 1105 1104 740 0.2658 0.2662 0.2780 0.2664 0.2791 18.89** 18.84** 16.23** 18.72** 18.04** 41.32** 18.04** 35.34** 40.97** 41.33** Vertical vs. Horizontal GDP Host GDP Source Extended Market Host Extended Market Source Same FTA Same FTA * Openness host Trade Same FTA * Trade Same FTA * Distance Same FTA * Av Diff in capital / worker Constant Effect of Same FTA (MIN) Effect of Same FTA (MEAN) Effect of Same FTA (MAX) Observations Number of pair R2 Within test F Pair Effects test F Time Effects

19. Dependent variable : Stock of FDI Independent Variables Coefficient t statistic 0.849 (11.51**) GDP Host GDP Source -0.095 (-0.74) Extended Market Host 0.080 (8.34)** Extended Market Source -0.233 (2.86)** Same FTA 0.319 (4.88)** (23.78)** Distance -0.747 Border 0.0602 (0.6) Colonial Links 0.146 (0.9) Common Language 0.619 (8.49)** Host Effects 43.12** Source Country Effects 195.75** Year Effects 108.94** Observations 18013 Adjusted R2 0. 7145 FDI as a beauty contest: Attractiveness

20. (1) (2) (3) (4) (5) 0.864 0.862 0.855 0.8421 0.8022 (14.676)** (14.543)** (14.536)** (14.316)** (13.648)** -0.136 -0.1314 -0.131 -0.1335 -0.1328 (1.314) (1.268) (1.265) (1.289) (1.286) 0.060 0.062 0.006 0.0266 0.0208 (2.668)** (2.784)** (0.104) (1.125) (0.883) -0.268 -0.269 -0.268 -0.2714 -0.2747 (11.756)** (11.814)** (11.779)** (11.909)** (12.089)** 0.7702 2.060 2.135 1.9369 2.0558 (9.507)** (4.090)** (4.197)** (3.842)** (4.089)** 0.341 0.364 0.2954 0.3125 (2.595)** (2.736)** (2.243)* (2.380)* -0.016 (1.068) 0.1749 0.2037 (5.023)** (5.848)** 0.618 (10.160)** -9.218 -9.201 -9.498 -8.6671 -10.1947 (2.900)** (2.896)** (2.978)** (2.728)** (3.215)** 0.446 0.408 0.538 0.576 0.791 0.777 0.837 0.892 1.407 1.436 1.370 1.457 18308 18308 18308 18308 18308 1140 1140 1140 1140 1140 0.2658 0.2660 0.2661 0.2671 0.2715 18.89** 18.73** 16.58** 18.51** 18.62** 41.32** 41.37** 41.43** 41.29** 38.8** Attractiveness GDP Host GDP Source Extended Market Host Extended Market Source Same FTA Same FTA * Attract Extended Market Host * Attract Extended Market Host * Most Attractive Extended Market Host * Biggest Constant Effect of Same FTA (MIN) Effect of Same FTA (MEAN) Effect of Same FTA (MAX) Observations Number of pair R2 Within test F Pair Effects test F Time Effects

21. Baseline Regression With Openness Host Country All countries ALCA countries Rest of the countries All countries ALCA countries Rest of the countries Argentina 105.34% 137.51% 14.25% 39.97% 48.52% 15.74% Brasil 94.02% 137.51% 14.25% 37.79% 49.81% 15.74% Canada -2.55% -2.82% 0.79% -2.49% -2.77% 0.86% Chile 141.52% 177.82% 33.63% 125.98% 155.76% 37.48% Colombia 59.78% 142.13% 16.46% 37.74% 74.89% 18.21% Costa Rica 134.04% 199.21% 43.92% 160.31% 240.66% 49.15% Mexico -2.58% -2.93% 0.67% -2.48% -2.89% 0.73% Panama 183.92% 212.73% 50.42% 216.82% 251.39% 56.56% USA -0.75% -2.79% 0.79% -0.52% -2.74% 0.86% Venezuela 92.26% 142.09% 16.43% 70.06% 104.19% 18.18% Winners and Losers - FTAA

22. Conclusions • Common membership in a FTA with source country increases bilateral FDI (trade complementarity) from within the region and the rest of the world • Effects are highly significant and large • However, regional integration agreements will likely to produce winners and losers, as FDI to countries with deficient investment environment is likely to decline