The link between trade and foreign investment

Almost everybody acknowledges nowadays that international trade entails a myriad of beneficial effects for countries and regions: increases in productivity and competitiveness, access to technological advances, gains in market share and ultimately, more economic growth, per capita income and prosperity.

What is perhaps less known is that openness to trade is also positively related with the attraction of foreign investment.

In a recent paper downloadable here, Marta Bengoa-Calvo, Yochanan Schachmurove and myself have explored empirically this issue for a sample of Latin American countries.

Countries in Latin America have engaged historically in different, often conflicting, approaches to trade liberalization and Foreign Direct Investment. Inward oriented policies, characterized by import substitution, export subsidizing and hostility towards foreign investors, were prevalent in this geographic zone several decades ago.

Not any more. Now these strategies have been left behind by many nations which are, instead, promoting integration mechanisms and processes. The signature of trade and investment agreements are mportant elements of these new approaches.

Regional trade agreements or RTAs are mainly directed to foster trade; sometimes they also contain provisions about FDI. Bilateral Investment Treaties or BITs specify conditions under which foreign investment should operate in the host country.

What is the impact of these agreements on foreign investment? Are they effective? Since they involve long hours of negotiations, are they worthwhile? There is some controversy in the literature about these issues.

In order to shed some light on this topic we have looked at a panel data detailing intra-regional bilateral FDI for eleven Latin American countries over the period 1995–2018. The theoretical framework for our research is the structural gravity model, which has proved very useful to understand the underlying forces driving trade and investment flows.

The intuition behind this economic model, reminiscent of physics , is quite simple: trade or investment flows among countries positively depend on their size, measured by Gross Domestic Product or population, and negatively depend on the distance between them. This setup can also include other variables such as trade policies, inputs endowments and institutional factors.

One of the initial steps in our work has been to identify the main trade and investment agreements in the area. Among the first category, two treaties stand out: ALADI and Mercosur.

What are ALADI and Mercosur ?

The Latin America Free Trade Association was created in 1962 as the first component of a large integration project. It was superseded by ALADI in 1980. ALADI provides a general framework which intends to foster integration in the region.

Since its inception, individual countries have engaged in bilateral or multilateral treaties with other ALADI members. De facto, ALADI now encompasses various free trade agreements within its framework. Not all countries within ALADI, however, have yet established substantial trade agreements among themselves. Hence the gradual integration that ALADI envisaged is still in process.

Mercosur was signed in 1991 by Argentina, Brazil, Paraguay and Uruguay. It was more ambitious than ALADI, intending not only to provide an umbrella for trade negotiations among members but to help reduce actual trade barriers. It was quite successful: approximately 90% of the trade within the members was already liberalized by 1997.

Mercosur soon engaged in negotiations with other Latin American countries to establish free trade agreements, oriented as well to the reduction of tariffs and non-tariff barriers.

Bilateral Investment Treaties as policy tools

Bilateral Investment treaties became widespread in the world economy in the 1990s. Latin American countries signed an increasing number of BITs between 1995 and 2007. There is heterogeneity among countries regarding the number of agreements in which they participate and their stance towards foreing investment.

Chile, for example, has been very active and has signed a remarkable number of BITs, usually granting a high degree of protection to foreign investors. Colombia and Mexico, instead, have taken part in fewer BITs, which in turn are characterized by a lower degree of investment protection. Brazil has been quite reluctant traditionally to ratify any BIT, although since 2015 this attitude is starting to change.

Why do Bilateral Investment Treaties impact FDI? Three main reasons have been advocated.

BITs signal that governments are willing to create an adequate institutional and economic environment for FDI.

– They provide an insurance for foreign investors by establishing compensation schemes and conflict resolution procedures.

– Finally, they deter non-compliance of treaties because of the potential reputation costs.

Main empirical results

Our empirical analysis has unveiled some interesting patterns in the data.

First, our results suggests that Mercosur and ALADI, together with BITs, do help attract FDI inflows to their members. The link between these treaties and foreign investment, however, is nuanced. 

According to our empirical evidence, Mercosur exerts a larger impact than either ALADI or the presence of BITs on intra-bloc foreign direct investment. Our estimates suggest that since Mercosur entered into force, FDI flows to its members have increased on average by 14-16 % per year. Belonging to ALADI helps attract foreign investment, too, but the effect in this case is smaller, around 5-6.4% per year.

The different degree of integration provided by the agreements can explain the dissimilar effects of Mercosur and ALADI. Mercosur is a consolidated, common market RTA that has promoted a certain degree of stability within the region. The FTAs within ALADI, instead, do not necessarily exert a significant impact on the macroeconomic environment of the host country, nor contribute to the harmonization of legislation and standards between them. Their impact on FDI, therefore, while relevant, is more subdued than that of Mercosur. We conclude that the impact of a trade agreement is positively correlated with the degree of integration it provides.

Our analysis suggests that BITs help attract FDI as well, but the yearly effects of BITs  are more modest than Mercosur’s and lie in the range 5.3-8.5%.

Is it possible that not only the quantity of BITs, but also their quality, impact foreign investment? To test this hypothesis we have constructed an index capturing the degree of protection each particular BIT confers

Our findings suggest that BITs granting  a higher level of protection to foreign investments – in the form of less stringent establishment prerequisites, assurance of fair and equitable treatment, allowance for transfer of funds and design of sound dispute settlements mechanisms –   help attract more foreign investment.

It is plausible that BITs exert heterogeneous effects not only because of their own characteristics but also due to the nature of the signatories in terms of economic and institutional development. To assess this possibility we have classified the countries in our sample in two categories, according to their income level. Results suggests that the effects of BITs are larger for middle income countries than for low-middle income economies.

Findings also show that the interaction of Mercosur and BITs has a positive and significant impact on FDI whereas the combination of ALADI and BITs also displays a positive effect, although smaller in size and less significant. There is a phasing out effect of agreements whereby their effects come about gradually over time.

Other relevant factors for FDI

Furthermore, the analysis points out that the market of the host country exerts a large influence on the decision to invest. This result makes economic sense: a big market represents a dynamic expected demand by potential consumers which, in turn, entails a higher level of revenues for firms offering that particular good or service. In this kind of setting, fixed costs related to the establishment of a firm in a foreign market can be supported by a larger number of products, hence reducing total costs per unit.

The market potential of trade partners is also key; our data show that foreign firms choose their location in Latin America not only to satisfy the local market of the destination country but also to access their neighbors more easily via an export platform strategy.

The effect of the variable capturing differences in factor endowments is positive and highly significant. Intuitively, if labor is relatively more abundant in the host country than in the home country, it will also be cheaper, thus creating incentives for foreign firms intending to rationalize their employee costs

Political risk  exerts a significant and negative impact on FDI. Since it proxies for the institutional environment, our results suggest that more stable countries attract higher amounts of FDI, while political unrest acts as a deterrent. Countries with larger degrees of macroeconomic and political stability and well-established political institutions provide more predictable environments and reduce the uncertainty associated with new investments, thus fostering the attraction of FDI.

Conclusion

Our analysis implies that Mercosur and ALADi help attract FDI to their members, the effect being larger in the case of Mercosur. BITs are effective when there is a sizeable degree of institutional development in the host country or a high degree of investment protection entailed by the treaty. Nevertheless, the impact of BITs (as captured either by the variable number of BITs or BIT index) is still lower than that of Mercosur but larger than ALADI’s.

Are there any policy implications? Empirical results suggest that trade and investment treaties are important. They must be complemented, however, with other measures in order to succeed. Governments wanting to atract FDI should strive as well to consolidate the economic, institutional and social environment in their countries.

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