Furthermore, larger firms may simply have more capacity to participate in new FDI projects due to scale economies. Since the market size of countries not party to a PTA remains unchanged, the extended market FDI effect is first and foremost an intra-PTA phenomenon; however, additional extra-PTA FDI could also be generated if MNEs’ capacity to undertake FDI increases. Thus, in contrast to the previous sub-section, the positive relationship between preferential liberalization and FDI could hold not only for host, but also for source countries.

One issue with the extended common market hypothesis of the relationship between PTAs and FDI is that its validity relies on a certain geographic and economic proximity between PTA members. This paper has argued that one of the distinguishing characteristics of the “third wave” of PTAs is that more agreements are being signed between distant countries who are not each other’s major trading partners. In this case, it is difficult to build a theoretical argument for the firms’ need to expand in order to serve geographically, economically, and culturally distant markets. For instance, even after the full implementation of the US-Morocco and US-Jordan free trade agreements, it would not be appropriate to view the partners’ economies as an extended common market, at least not in the same sense as NAFTA or MERCOSUR. On the other hand, to the extent that there is a certain level of demand for Middle Eastern products in the US, we would expect to see a concentration of production of these goods in the FTA beneficiaries following the phase-in of preferences.<sup>7</sup> In other words, production would be reallocated to Morocco and Jordan from neighboring countries without preferential access to the US, and the former would receive additional FDI.

The above discussion shows that the PTA extended common market effect on FDI is not automatic, and its magnitude depends on the economic and geographic proximity of the partners. Although preferential liberalization can potentially bring some FDI benefits even for distant countries, the impact is likely to be much stronger for closer-positioned partners with established economic ties. Therefore, while the sign of this effect is almost certainly positive, its relative size is likely to vary considerably across different PTAs.

# **2.5 FDI and growth**

The links between PTAs and FDI discussed in the previous sub-sections are all likely to be of short- or medium-term nature (the time frame during which relevant provisions are implemented and trade flows adjust). However, PTAs may also affect FDI through more dynamic means by generating additional economic growth. The complementarities between FDI and growth have been well documented in the empirical literature. A number of studies, including World Bank (2001) and UNCTAD (1998) have shown that, controlling for other factors, FDI flows are positively associated with economic growth. Unfortunately, the direction of causation is not clear: while a large literature documents the growth-enhancing knowledge and efficiency spillovers from FDI (see, for example, the review in Lim, 2001), other studies, most notably Rodrik (1999), have suggested that FDI tends to be located in more productive and faster-growing economies.<sup>8</sup> One solution to the question

> 7This assumes that the preferences granted to Moroccan and Jordanian exporters represent a significant cost advantage vs. exporting the same goods under the MFN regime. For many products, this may not be the case—see the discussion in Medvedev (2006), which noted that more than half of all trade between PTA partners takes place in goods with very low or zero MFN tariffs; furthermore, more than 35 percent of all US tariff lines carry a zero percent MFN duty.

> 8This line of reasoning is similar to the critique of trade and growth literature by Rodriguez and Rodrik (2001), who suggest that most of the trade policy variables used in previous studies are endogenous and serve mainly as proxies for macroeconomic stability. They argue that more successful and faster growing economies tend to trade more and have a better trade policy environment, while exogenous changes in trade policy are not a significant

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