# **5 Conclusion**

A large and growing body of literature has been devoted to understanding the trade creation and diversion effects of preferential trade agreements. On the other hand, the investment consequences of preferential liberalization have received relatively little theoretical and empirical attention. This paper adds to the small but growing literature on the links between PTAs and FDI by establishing a robust positive relationship between preferential trade liberalization and net FDI inflows for a large panel of countries and preferential agreements. There are four main messages emerging from our work. First, our results show that the FDI benefits of preferential liberalization are increasing with the size of PTA partners and their proximity to the host country. Second, we establish both a threshold (membership) and a market size component to the PTA-FDI relationship, although the latter seems more important. Third, we find that this relationship is mainly driven by the developing countries in our sample, which implies that the effect is due mostly to North-South PTAs. Finally, we show that the link between preferential liberalization and FDI is strongest in the late 1990s and early 2000s—a period when most “deep integration” agreements have been signed.

We identify five major channels through which preferential liberalization may affect FDI. The direct effect, observable in many but not all preferential agreements, is the influence of investment liberalization provisions on both incoming and outgoing FDI. The indirect effects include overall strengthening of the investment climate, access to larger markets, and the response of investment to changes in trade flows. In particular, “deep integration” provisions other than investment clauses, such as service sector liberalization and mechanisms for dispute settlement, are likely to result in greater FDI. Similarly, closer integration of PTA partners following preferential liberalization creates a larger common market which may bring in additional FDI due to economies of scale. On the other hand, the relationship between changes in trade flows and FDI is much more complicated. While some models point to a negative association (e.g. tariff-jumping FDI), others maintain it to be positive, and yet other models link the sign of the effect to the type of production structure of the MNE undertaking the investment. Finally, to the extent that preferential liberalization may stimulate additional growth which requires and attracts more investment, one may also expect to see a dynamic relationship between PTAs and FDI. However, the direction of causation is not clear, and PTAs are unlikely to be a major determinant of economic growth.

Since the theory behind the interactions between preferential liberalization and investment does not clearly determine the magnitude or sign of the relationship, we examine the effects of PTAs on net FDI inflows in a panel of 87 countries over the 1980–2004 period. Our pooled estimates take explicit account of both the time-series and cross-sectional correlations in the data, and rely on a comprehensive database of PTAs, which includes both WTO-notified and unnotified agreements. We find evidence that entering into PTAs with more and/or larger partners has a positive effect on an average country’s net FDI inflows, while being located further away from these PTA partners tends to dampen the FDI stimulus effect. The former is captured by an extended market size variable, which is the sum of GDP of all PTA partners of a given country. The estimated elasticity of this effect in the baseline model is 0.06, which implies that a country like Costa Rica can expect its net FDI inflows to rise by 11.5 percent after signing a preferential agreement with a high income partner like the United States. On the other hand, signing a PTA with Ecuador, whose GDP is only 60 percent larger than Costa Rica’s, results in almost no change in the latter’s FDI. The proximity effect is captured by average distance to all of the country’s PTA partners and carries an estimated elasticity of -0.16. This implies, for example, that Costa Rica’s FDI increase would be reduced to 9.6 percent if the USA were as far away from it as Germany.

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