percent foreign. If the foreign capital stock is only 7 percent of the total capital stock in Honduras while foreign investment is 16 percent of total investment, foreign capital must depreciate much faster than domestic capital to avoid a falling rental rate in the absence of any shocks. This is not very plausible; instead, it is likely that not all income from foreign capital is remitted abroad, and therefore payments to foreign capital should be higher than 7 percent of total capital value added. One solution is to use the ratio of total private investment to FDI, but this is problematic if we want to restrict our attention to the sectors mentioned above, due to the fact that foreign capital value added calculated in this way exceeds total payments to capital in these sectors. Instead, we assume that foreign capital stock accounts for 13 percent of total capital stock in Honduras, which ensures that both foreign and domestic capital grow at roughly the same rate under _BaU_ conditions (see the discussion in the following paragraph).

On the factor supply side, FDI and domestic investment are now treated separately, rather than both contributing to a single pool of investment which adds to the last period’s depreciated capital stock. Foreign capital is replenished exclusively through FDI, which grows at the same rate as GDP in the baseline.<sup>42</sup> We assume that all FDI is used as real investment in new assets, rather than the acquisition of existing assets. There is no easy way of separating the two in the model used in this paper; however, this implies that the numerical simulations that follow potentially overestimate the effects of new FDI on additional capital formation. Growth in the domestic capital stock in each period is determined by the volume of domestic investment, which is a fixed ratio of real GDP at market prices. The choice of the base year ratio of foreign to domestic capital stock ensures that both grow at approximately 4.3 percent per year. On the production side, we assume that foreign and domestic capital are imperfect substitutes.

In order to quantify the potential FDI gains for Honduras, we consider the changes in net FDI inflows and the FDI-to-GDP ratio in Mexico before and after NAFTA (Figure 2). Using the data from WDI, we calculate that the three-year averages for these variables increased by 133.2 and 143.7 percent, respectively. Since the two estimates are fairly close, we apply the increase in net FDI inflows (the former estimate) to the _BaU_ FDI path in order to calculate the FDI shock. Compared to the baseline, where FDI grows from 3,645 million lempiras in 2004 to 5,949 million in 2016, this approach to calculating the investment shock projects FDI to increase to 13,874 million by 2016. The average FDI-to-GDP ratio more than doubles, rising from 2.7 percent in the baseline to 6.1 percent.

It is important to emphasize that our estimate of the potential increase in net FDI inflows in Honduras is not a forecast but simply an input into a simulation exercise. We believe that the magnitude of the potential shock, derived from the Mexico analogy, represents a reasonable guess of the possible effect on FDI in Honduras. Yet, there are several reasons why this increase may be too optimistic. Unlike the pre-NAFTA Mexico, Honduras does not share a border with the US, already has virtually tariff-free access to the US market through the CBI, and has to compete with other developing members of DR-CAFTA (as well as other countries with which the US has a preferential trade agreement) for the potential new FDI inflows. Furthermore, China is a much bigger factor today than it was in the mid-1990s, when NAFTA was adopted, and the post-NAFTA global FDI environment was more favorable than it is today (i.e., there was a global boom in FDI in the mid-to-late 1990s). All these factors suggest that it is far from certain that Honduras may be able to reap similar FDI benefits from DR-CAFTA as Mexico was able to gain from NAFTA. Thus,

> 42The growth rate of FDI is set in foreign currency units, but its contribution to capital stock is valued at base year domestic prices. Therefore, changes in the real exchange rate will affect the growth rate of foreign capital stock. Furthermore, this setup assumes away joint ventures of local finance or MNE subsidiaries.

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