1. PTA effects, including a PTA membership dummy, an expected PTA dummy, a measure of the size of the extended common market, and an investment diversion variable;<sup>21</sup>

2. Global effects, including world GDP growth, world FDI, and global interest rates (proxied by the return on a one-year US treasury bill); 3. Local effects, including the level of GDP and its growth rate, outward orientation of the economy, per capita income relative to the US, inflation, and current account balance; 4. Institutional effects, including indices of government stability, rule of law, and quality of bureaucracy.

In attempting to replicate the results of the Lederman et al. (2005) study, we will consider only a subset of the explanatory variables above in order to maximize efficiency and data coverage. The data for all series have been collected from the World Development Indicators (WDI) database of the World Bank. Our criteria for variable choice include ease of data collection, sound theoretical justifications, and the variable’s robustness in the estimates presented by the authors. For example, among the variables listed under item 1, we will only consider the extended common market variable and the expected PTA dummy. We will not use the investment diversion variable due to the difficulties involved in its construction and the fact that its coefficient was never significantly different from zero in any of the specifications presented by Lederman et al. (2005). Similarly, we will not use the PTA dummy to capture the potential FDI gains from preferential liberalization. This is because the dummy offers no additional information in the presence of an extended market variable (which, like a dummy, carries a value of zero for countries that are not members of any PTAs, and a positive value for PTA members) and may lead to a violation of the full rank assumption. In fact, Lederman et al. (2005) include the PTA dummy in only half of their specifications and always find the variable insignificantly different from zero, confirming our suspicions. We therefore choose to drop the insignificant variable (PTA dummy), a decision that is also more defensible on theoretical grounds. This is because the PTA common market variable, despite its potential problems, is likely to explain more of the variation in net FDI inflows than a simple dummy since the former allows the model to differentiate across PTAs by the cumulative size of their country members.<sup>22</sup> We are thus left with an expected PTA dummy and the extended common market size as variables that will be used to capture the potential link(s) between preferential liberalization and FDI.

In order to construct both of the above variables, data on PTA membership by country have been obtained from the PTA database of Medvedev (2006), which provides comprehensive coverage of PTAs in force.<sup>23</sup> Overall, our panel takes into account 196 preferential agreements (both regional and bilateral), many of which overlap and which encompass the vast majority of sample countries. For countries that are members of at least one PTA, the _PTAGDP_ variable is defined so that it is equal to zero for all years prior to the PTA entering into force, and the log of the combined GDP

> 21Lederman et al. (2005) describe the investment diversion variable as a “weighted sum of the GDP of all the sample countries participating in FTAs, with the weight of each countrys GDP given by the fraction of worldwide GDP covered by its FTA arrangements.”

> 22Recall that the simple version of this variable does not take into account the geographic and economic distance between PTA partners. We will consider these issues in more detail during specification tests in section 4.3, where, for example, we will investigate the effects of using the dummy variable alone, as well as the appropriateness of alternative versions of the PTA extended common market variable.

> 23This dataset improves upon previous sources by including agreements that have not been notified to the WTO as well as PTAs found in the WTO database. This addition is important since the PTAs that have not been notified to the WTO account for more than 45% of the total number of PTAs in force.

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