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This paper was prepared while working as an economist in the IMF’s Middle Eastern Department. I am grateful to Michel Lazare, Edward Gardner, and Patrizia Tumbarello for their help in shaping this project. Thanks also go to Peter Allum, Robert Barro, David Burton, Philippe Callier, S. Nuri Erbas, Domenico Fanizza, Mangal Goswami, Hervé Joly, Edouard Martin, and Randa Sab for their helpful comments. All remaining errors are mine.
RTAs are considered of second-best nature compared to multilateral free trade because of the risk of trade diversion. Trade diversion occurs when import supply from countries outside the region is replaced by less efficient production from countries within the region. RTAs could even be worse than the status quo if trade diversion exceeded trade creation and other benefits of RTAs. However, this risk is reduced when the objective of the RTA is to promote exports and prepare the terrain for more effective competition outside the region instead of protecting import-substitution. RTAs have moved toward a more open kind of regionalism in the 1990s. For a discussion of the benefits and costs of RTAs, see for example De la Torre and Kelly (1992), and Baldwin and Venables (1995).
In the case examined by this paper (RTAs between developing countries), FDI inflows from outsiders are likely to account for the major part of FDI, since developing countries carry little outward FDI themselves. This makes it more likely that the creation of an RTA will increase the overall level of FDI into the region.
Such fears are believed to have been behind the surge in Japanese FDI into the European Single Market.
This finding applies mostly to FDI for acquisitions, and less so to FDI for start-ups, for which the size of the U.K. market remains as important as before.
The 1980 FDI stock was deflated using the average GDP deflator for 1976-80. FDI flows for each subsequent five-year period were expressed in 1995 U.S. dollars, using the average GDP deflator for the corresponding sub-period.
For each country, the stock of FDI in percent of GDP (FDI/Y) and the net FDI inflows in percent of GDP (I/Y) are related in the following way:
This section is based on the literature review of Lim (2001). More references can be found in this paper. Other reviews of the typical determinants of FDI can be found in Caves (1996), Singh and Jun (1995), and Michalet (1997).
Studies include expected market growth because FDI is typically a long-run and therefore forward-looking decision.
As mentioned before, the measure of regional market size is limited to countries which share a “South-South” regional trade agreement and ignores “North-South” regional trade agreements.
Denote FDI by x and the optimal level by *. If x adjusts sluggishly to its optimal level x*, i.e., x-x-1 = γ (x*-x-1) with 0<γ <1, it follows that x = (1- γ) x-1 + γ x*.
The model only includes the export-to-GDP ratio because export- and import-to GDP ratios are highly correlated. The logarithm of the export-to-GDP ratio is regressed on a constant and the country’s size, measured by the logarithms of population and area. The trade openness measure is the exponential of the residual (including the intercept term).
The partial correlation between a regressor and the dependent variable refers to the correlation between this regressor and the part of the dependent variable which is not explained by the other regressors. The calculation of the partial correlations is based on the competitive regional model reported in column 3 of Table 5.
Sevestre and Trognon (1996) discuss the potential for bias in the estimation of dynamic models with fixed effects.
The World Investment Report constructs the FDI stocks for Algeria and Morocco by accumulating flows since 1971. For Tunisia, estimates of the FDI stocks are available starting in 1990, and the stocks for 1980 and 1985 are constructed by subtracting flows. If the FDI stock for Morocco was constructed by subtracting flows from the recently published 2002 FDI stock of 31 percent of GDP (not available at the time of the analysis), it would be higher, of the order of 20 percent of GDP in 1990. Yet, the FDI stock-to-GDP ratio of Tunisia would still be significantly higher than those of Morocco and Algeria.
The predicted ratio would be even lower if we corrected for the fixed effect in the lagged value of the FDI stock-to-GDP ratio, one determinant of the current ratio.
The information on RTAs is taken from the World Bank website on Trade. Unless mentioned otherwise, the RTAs have been in effect during the entire period covered in this paper (1980–99).
Panama is not formally a member but has limited preferential agreements with individual members of the CACM.