# **4 Model setup and estimation results**

In this section, we investigate the empirical relationship between preferential trade liberalization and net FDI inflows using a panel of 143 countries over the 1980–2003 period. Given the weaknesses in earlier studies (identified in section 3), this essay distinguishes itself from previous efforts by considering the broadest sample of PTAs available, rather than a handful of the most well-known agreements. In addition, we employ estimation methods that remain consistent in the presence of panel-level heteroscedasticity and autocorrelation. However, due to data limitations, we do not consider the differential impacts of various types of agreements, leaving this as an area for future research. The main contribution of this study lies in determining the links between preferential liberalization and FDI for the largest possible sample of countries and PTAs.

The choice of net FDI inflows as the dependent variable<sup>18</sup> imposes several important limitations on the direction of our analysis and we acknowledge these at the outset. First, this precludes the use of bilateral datasets, and therefore does not allow us to distinguish FDI by source. This implies, for example, that we cannot separate intra-PTA FDI from investment that comes from outside the preferential trade area, and we cannot readily differentiate between FDI from high income and developing countries. Second, our choice of the dependent variable as a net value carries an implicit acknowledgment that we cannot distinguish whether, for example, a positive change in net FDI inflows is driven by increased inflows or reduced outflows. This implies a certain difficulty in the comparison and interpretation of the results, since a similar change in the dependent variable may be driven by inflows in some countries, outflows in others, and yet other countries may experience varying combinations of the two effects. This is particularly important for the PTA-growth-FDI link proposed in section 2.5, since the technology content of new investment inflows may be different from the composition of the existing stock.

Despite these difficulties, our choice of the dependent variable has some important advantages. Unlike several studies mentioned in section 3, we consider FDI flows rather than stocks in order to improve our tracking of the variation in the data. Globerman and Shapiro (2002) point out that “to the extent that inward and outward FDI have been going on for a long time, recent and relatively large changes in FDI behavior may not be apparent if FDI stock figures are used.” That is, as long as FDI stocks are relatively large, annual innovations to these stocks are likely to be marginal, causing an empirical model to have difficulty identifying the determinants of change in the dependent variable. In addition, the calculation of FDI stocks is often not homogeneous across countries (Globerman and Shapiro, 2002). Regarding the issue of bilateral FDI flows vs. net flows by country, the bilateral data are quite scarce and are usually limited to high income countries as the source of foreign investment. Focusing on total net FDI inflows of each country allows us to significantly increase the sample size and also to include South-South FDI flows, albeit implicitly. Furthermore, the exact origin of FDI may not be as important as the type of investment, which is not country-specific. For example, it is not clear that US- and EU-sourced FDI is qualitatively

> 18The full series name is “foreign direct investment, net inflows” (see Appendix A for more details). This corresponds to the increase in holdings of foreign enterprises inside a country less the decreases in domestic asset holdings by the same enterprises. It is important to distinguish our dependent variable from net FDI, which is the difference between net FDI inflows and net FDI outflows (the net increase in home country MNE assets abroad). Using the net inflows definition would imply, for example, that FDI would increase in both the US and Canada if the two countries began investing more into each other after the implementation of CUFTA. Contrast this with the net FDI definition, which under the same circumstances could show little or no change in the FDI position of either country (if the bilateral flows would be of the same magnitude and thus cancel out). It is our belief that the former definition represents a more intuitive way of capturing cross-country changes in FDI flows, and also reflects the policy goals of most countries in seeking PTAs as a way to attract net FDI inflows.

14