Another possibility bypasses the PTA-growth link and considers instead the additional FDI generated through one of the channels discussed in the earlier sub-sections. As long as preferential liberalization results in a net increase in FDI inflows, we can rely on the FDI-growth linkages discussed earlier to generate additional growth and potentially give rise to the “virtuous circle” hypothesis. This possibility comes with many qualifications, since the suggested relationship is complicated and in any case requires an initial positive change in FDI to jump-start the dynamic PTA-FDI link. The direction of causality is also unclear, since larger and faster-growing economies may be better positioned to take advantage of regional integration and preferential liberalization may thus be an effect rather than a cause. At best, the “virtuous circle” may have many entry points. These could include PTAs, but other factors (e.g. institutions and geography) are likely to be more important. Therefore, although we may expect to see a positive long-run association between preferential trade liberalization and FDI through higher rates of economic growth, the relationship requires a number of rather restrictive initial conditions and is thus tentative at best.

## **2.6 Summary**

The above discussion shows that the possible interactions between PTAs and FDI are multifaceted and can act in opposite directions (see Table 2). In fact, even the signs of some individual effects are far from certain. To the extent that multiple transmission channels are present, theory does not establish their relative magnitudes and therefore provides no ready answer for the direction of the net effect. In addition, if there are budget constraints on an MNE’s ability to undertake additional FDI, preferential liberalization may result in reallocation of investment from some PTA members to others. Even if no such constraints are present, certain countries within PTAs are likely to benefit more than others because of stronger locational or other advantages. Due to these ambiguities, the sign and magnitude of the overall PTA-induced change in FDI inflows becomes a question for empirical analysis.

Table 2: Potential effects of <u>preferential</u> trade liberalization on FDI

|Transmission channel|Expected change in FDI|
|---|---|
|PTA investment provisions|Positive|
|Other “deep integration” provisions|Mostly positive|
|Trade-FDI elasticity|Ambiguous|
|Market size (both host and source)|Positive|
|Dynamic/growth efects|Positive, but highly uncertain|

# **3 Empirical evidence on the effects of PTAs on FDI**

Most empirical work dealing with the relationship between PTAs and FDI has until recently been limited to case studies of large, well-known agreements such as the EU, NAFTA, or MERCOSUR. Therefore, much of the evidence is largely descriptive. For example, Lim (2001) collects data on FDI as a percentage of GDP for Portugal, Spain, Mexico, Argentina, and Brazil, and notes that the post-PTA FDI share is more than double the pre-PTA share for all countries but Argentina, where the increase is 70 percent.<sup>11</sup> Lederman et al. (2005) show similar results for Spain and Portugal,

> 11Pre- and post-PTA time periods are defined as 1981-1985 and 1986-1990 for EU accession, 1989-1993 and 19941998 for NAFTA, and 1990-1994 and 1995-1998 for MERCOSUR.

10