metadata: authors: 0: author: Fernandez-Arias, Eduardo
1: author: Spiegel, Mark M.
docna: 0: docna: North-South customs unions and international
            capital mobility
docty: Policy Research Working Paper
subtopic: Climate Change Mitigation and Green House Gases,Macro-Fiscal Policy,Taxation & Subsidies,Economic Adjustment and Lending,Public Sector Economics,Trade Policy,Hydrology,International Trade and Trade Rules,Public Finance Decentralization and
            Poverty Reduction
teratopic: International Economics and Trade
abstracts: cdata!: The primary distinction in a North-South
            trade accord is likely to be that the Southern nation
            experiences more capital scarcity than its Northern trade
            partner. So the trade accord's impact on the Southern
            trading partner's ability to attract capital may have
            welfare implications for both nations. The authors extend
            the traditional analysis of customs unions to allow for
            international capital movements. Their results indicate that
            trade accords may affect the ability of Southern nations to
            attract capital and may divert capital between Southern
            nations. Moreover, the welfare implications of North-South
            trade accords may differ from those that predict the North
            American Free Trade Agreement's (NAFTA) minor
            third-country effects, holding factor endowments constant.
            The key implications of North-South trade accords such as
            NAFTA are generally perceived to involve their impact on
            investment flows. The authors try to understand the channels
            through which trade accords can affect North-South
            investment flows. A potential link between trade accords and
            investment flows may be how the accords affect the ability
            of the Southern partner government to make commitments about
            the treatment of foreign investment. They show that these
            accords can affect both the magnitude and pattern of inward
            foreign investment and production, implying the possibility
            that both trade and financial diversion can stem from a
            bilateral regional trade accord. Novel effects that emerge
            under sovereign risk must be addressed when assessing the
            welfare implications of trade accords. The greatest gains
            from integration are still achieved when integration takes
            place between the countries with the greatest potential
            gains from trade. But the authors make a distinction: these
            gains now include both current trade and inter-temporal
            trade through foreign investment.
repnme: repnme: North-South customs unions and
            international capital mobility
display_title: North-South customs unions and
            international capital mobility
listing_relative_url: /research/1996/02/696768/north-south-customs-unions-international-capital-mobility
topicv3: Water m1326522 137,Trade m1326924 698,Climate Change Mitigation m1327079 579,Taxation m1327615 1121,Customs Unions m1504280 2578
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: International Economics and Trade
origu: EFI - Prospects Group (EPGDR)
no_of_pages: 36
model_extractions: | POLIcY RESEARCH WORKING PAPER 1573

# Summary findings

The primary distinction in a North-South trade accord is likely to be that the Southern nation experiences more capital scarcity than its Northern trade partner. So the trade accord's impact on the Southern trading partner's ability to attract capital may have welfare implications for both nations.

Fernandez-Arias and Spiegel extend the traditional analysis of customs unions to allow for international capital movements. Their results indicate that trade accords may affect the ability of Southern nations to attract capital and may divert capital between Southern nations.

Moreover, the welfare implications of North-South trade accords may differ from those that predict the North American Free Trade Agreement's (NAFTA) minor third-country effects, holding factor endowments constant.

The key implications of North-South trade accords such as NAFTA are generally perceived to involve their impact on investment flows. Fernandez-Arias and Spiegel try to understand the channels through which trade accords can affect North-South investment flows.

A potential link between trade accords and investment flows may be how the accords affect the ability of the Southern partner government to make commitments about the treatment of foreign investment. They show that these accords can affect both the magnitude and pattern of inward foreign investment and production, implying the possibility that both trade and financial diversion can stem from a bilateral regional trade accord.

Novel effects that emerge under sovereign risk must be addressed when assessing the welfare implications of trade accords. The greatest gains from integration are still achieved when integration takes place between the countries with the greatest potential gains from trade. But Fernandez-Arias and Spiegel make a distinction: these gains now include both current trade and intertemporal trade through foreign investment.

- This paper -a product of the International Finance Division, International Economics Department is part of a larger effort in the department to analyze foreign investment in emerging markets. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Sheilah King-Watson, room N3-040, telephone 202-473-1047, fax 202-522-3277, Internet address skingwatson@'worldbank.org. February 1996. (26 pages)

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be used and cited accordingly. The findings, interpretations, and conclusions are the authors' own and should not be attributed to the World Bank, its Executive Board of Directors, or any of its member countries._ Produced by the Policy Research Dissemination Center
North-South Customs Unions and International Capital Mobility _Eduardo Fernandez-Arias_ International Economics Departnent The World Bank _Mark M Spiegel_ Department of Economic Research Federal Reserve Bank of San Francisco Helpful comments were received from Jonathan Eaton, Jim Markusen, Ronald McKinnon, Andres Velasco, and seminar participants at the Fed Systems Committee Conference, the FRBSF and CEPR conference, and the University of Colorado, Boulder. The views presented in this paper are those of the authors alone and do not necessarily reflect those of the Federal Reserve Bank of San Francisco, the Board of Governors of the Federal Reserve System, or the World Bank.
# **I. Introduction**

The recent debate concerning the North American Free Trade Agreement (NAFTA) in both policy circles and the popular press suggested that the primary impact of the regional trade accord would not be a small reduction in already low tariff levels between the NAFTA partners, but a fundamental change in the attractiveness of Mexico as a location for investment, resulting in a large amount of capital movement between the Northern and Southern trading partners. This claim was popularized by such opponents of NAFTA as Ross Perot who claimed that NAFTA would create a "large sucking sound" as capital flowed from North to South in response to the trade accord. Indeed, there is some evidence that "financial diversion" has taken place in response to North-South integration, both in the case of Portugal and Spain in the EEC and Mexico under NAFTA [Primo Braga (1993)].

Despite the consensus that the impact of trade accords on capital movements is potentially important, the issue seems to have received less attention in the standard literature on the welfare implications of customs unions,1 which center on the trade-off between trade creation and trade diversion.<sup>2</sup> We should note that this is even true of more recent analyses of trade accords which stress both strategic issues [McLaren (1993), Bagwell and Staiger (1993)] and the political-economic implications of trade accords [Grossman and Helpman (1993)]. The reason for this gap in the literature is probably historical. Prior to NAFTA, successful regional trade 1See Lipsey (1960) and de Melo et al (1993) for extensive early and more recent surveys.

2Notable exceptions include Miyagiwa and Young (1986) who explicitly introduce factor mobility into their analysis of customs unions in a different context, and Manchester and McKibbin (1994) who analyze the implications of an ad hoc decrease in Mexico's risk premium as a result of the NAFTA accord.

1
areas tended to be between Northern countries, such as the EEC and the US-Canada free trade area. As the first major North-South free trade area, the NAFTA raises issues which are not central to North-North trade accords.

The primary distinction in a North-South trade accord is likely to be that the Southern nation is physical capital scarce relative to its Northern trade partner. Consequently, the impact of the trade accord on the ability of the Southern trading partner to attract capital may have welfare implications for both Northern and Southern nations. In this paper, we extend the traditional analysis of customs unions to allow for international capital movements. Our results indicate that trade accords may affect the ability of Southern nations to attract capital, and may divert capital between Southern nations. Moreover, the welfare implications of North-South trade accords may differ from those which predict minor third-country impacts of NAFTA holding factor endowments constant [Safadi and Yeats (1993)].

We begin by introducing a model of a bi-lateral free trade accord between a Northern and Southern nation which relies on capital from the North for production in its foreign sector. The model is one where the Southern nation faces a standard timing-inconsistency problem concerning levels of taxation on foreign investment. The Southern nation then commits to national treatment, or equal levels of taxation, towards foreign investments under the trade accord. We then show that the trade accord can be an effective mechanism for achieving enlarged levels of commitment towards foreign investments and therefore can generate additional capital inflows from the North.

There is some anecdotal evidence that Southern nations already understand the potential of bi-lateral and multilateral treaties as a mechanism for achieving greater international credibility. Mexico has explicitly committed to national treatment and codified numerous investment regime liberalizations towards its NAFTA 2
partners under the NAFTA accord, even though it had previously underwent a large reform program in 1989 [Hufbauer and Schott (1992)]. Apparently, the reason for repeating these liberalizations under NAFTA was that tying their commitments to the trade accord provided an explicit mechanism for penalizing their violation towards investors from NAFTA partner countries. For example, prior to the NAFTA accord, Hufbauer and Schott (1992) predicted that "Since regulations are more easily changed than laws, the United States and Canada are likely to seek commitments from Mexico in the NAFTA to make regulatory reform more permanent." Along similar lines, Chile offered to unilaterally commit to some liberalizing policies under the Uruguay round of the GATT.<sup>3</sup> The ability to use trade accords as credibility-enhancing mechanisms may therefore be an aspect of regional trade accords which may be particularly important in North-South agreements.<sup>4</sup> We next examine the implications of a trade accord between a Northern nation and a Southern nation in a 3-country model of foreign direct investment in which Northern investors choose the magnitude of investment in the Southern partner nation and an alternative potential Southern target nation. We demonstrate that the standard analysis of trade-diverting customs unions must be adjusted to account for changes from the union in the risk characteristics of the trading partners. The union enhances the safety of investments in the Southern partner nation, increasing the 3We thank Andres Velasco for providing this example.

> 4 Perroni and Whalley (1993) interpret the same liberalizations as concessions to larger entities in return for insurance against trade wars. These two interpretations do not necessarily conflict; if a mutually beneficial agreement requires these liberalization "concessions," a Southern trade partner may be unable to achieve the agreement in the absence of the greater commitment capacity the accord brings in the context of our analysis below.

3
gains experienced by the Northern partner nation from trading with its Southern partner. This enhances the potential for the regional trade accord to be welfare increasing, even when trade is diverted from a more productive alternative Southern location for production.

The remainder of this paper is divided into three sections. Section 2 introduces the basic model and demonstrates how the trade accord can affect the credibility of the Southern partner government and the magnitude of its capital inflows. Section 3 examines the 3-country case with both trade creation and diversion. Section 4 concludes.

**II.** A **Simple Two-period Model of Foreign Direct Investment Under a Trade Accord** _2.1 Setup_

In this section, we introduce a simple two-period model of foreign direct investment from a Northern nation to a Southern nation enforced by a bi-lateral trade accord. We assume that there are 2 countries in the accord, which we call the Northern partner and the Southern partner. The Southern partner nation produces a single good, _s,_ and exports that good to the Northern partner. For simplicity, we assume that all output is exported, so that the Southern partner government is only interested in maximizing domestic income. In the absence of a trade accord, the Northern partner charges its "most-favored-nation" tariff of **_T_** on all imports of _s,_ including those from the Southern partner.

We take the exports of the Northern partner as numeraire, and assume that the Northern partner nation is large relative to the Southern partner nation. The Southern partner enjoys a tariff advantage under the trade accord. Exports originating in the Southern partner nation earn price _P(1_ **_+T)_** (the consumer price inclusive of the tariff) under the accord, and P in its absence.

4
The Southern partner nation is endowed with a domestic sector which produces quantity _ss_ of good s, where _s_ is taken as exogenous. The foreign sector produces quantity _sn_ of good _s_ using its imported foreign capital K , which is determined below, according to the constant returns production function:

# (1)

where A is a constant.

The Southern partner charges a tax on the output of domestic and foreign owners of capital, and is assumed to have made a "pledge" of national treatment towards foreign investment. Formally, we model the implications of this pledge as a commitment to tax domestic and foreign output at the same rate, which we designate as t. In the absence of a trade accord, the only mechanism which binds this commitment is the value that the Southern partner government places on its "goodwill" in the international community.<sup>5</sup> We model the penalty for loss of goodwill as a proportion of the value of the economic resources of the economy. Since the importance of goodwill is uncertain to investors, and likely to be affected by external parameters, we specify this proportion as a stochastic function, 02, where 0 is an exogenous positive constant fraction and o is distributed according to the density function f(n) along the interval _[0,11,6 f'>O._ Note that since _f(Q)_ is invariant with respect 5National treatment is assumed only for concreteness; the results hold true for any given tax pledge t. Here we assume that the nationality of foreign investors cannot be observed and, therefore, the loss of "goodwill" applies equally to all foreign investment and all Northern investors equally benefit from the accord. In practice, some degree of nationality discrimination favoring firms associated with the Northern partner nation is likely to be feasible.

> 6 The restriction to the unit interval is done for notational simplicity and without _5_
to _t,_ a Southern partner nation choosing to abrogate national treatment will choose to fully tax the proceeds of the Northern subsidiary.<sup>7</sup> The strategic interaction between the North and the South has the following extensive form: In the first stage, Northern investors choose the magnitude of capital, _Kn,_ to extend to the Southern partner. In the second stage, Q is realized and the penalty faced by the Southern partner for violating her pledge of national treatment to foreign investors is determined. In the third stage, the Southern partner decides whether to comply with its pledge of national treatment or to tax foreign investment at a higher rate. We assume that all government revenues are distributed lump-sum to domestic agents.

# _2.2 Southern Partner Government Taxation Decision._

To insure sub-game perfection, we begin with the stage three decision of the Southern partner concerning compliance with national treatment. The Southern partner government is assumed to levy a domestic tax of rate t on output _(t<l),_ which we take as given.<sup>8</sup> any loss of generality (provided that _$2_ is in the unit interval) since we have placed no restriction on the form of _f(n)._ 7While our simple specification yields full taxation under violation of national treatment, actual expropriation of foreign investment is relatively rare, particularly recently [Kobrin (1984)]. Nevertheless, this simplification drives none of the qualitative results.

8The analysis begs the question of the "optimal tax" for maximizing government revenues from the foreign sector. However, we do not pursue the analysis here both because domestic taxes are the outcomes of much more complicated processes and because even within the confines of this simple model we found that the optimal level 6
The Southern partner government then chooses whether to comply with national treatment and charge t to its foreign investors or to violate national treatment and fully tax foreign sector output. We assume that the Southern partner nation is expelled from the trade accord under violation of national treatment. Consequently, under compliance, Southern partner nation income is equal to:

# (2)

while under full taxation income satisfies:

# (3)

The trade accord therefore enhances the potential penalty for violation of national treatment. In the absence of the trade accord, only the goodwill penalty can be applied. Under the trade accord, however, violation leads to the goodwill penalty plus the loss of terms of trade advantage.

Define _Q_ as the realization of _Q_ which leaves the Southern partner government indifferent between compliance with national treatment and full taxation of the foreign sector (W= _RW._ The existence of such a realization _Q_ requires the realistic assumption that the probability of violation of national treatment is * strictly between _0_ and 1, so that _O<Q <1._ This is ensured by assuming that in the absence of country risk, investment would earn positive profits. _Q_ satisfies:

# (4)

Equation (4) demonstrates the characteristics of the Southern partner government taxation decision. First, the larger is the foreign sector output _Sn,_ ceteris paribus, the more likely is full taxation, since the gains from full taxation of t turns out to be very poorly behaved as a function of T.

7
are larger. This is similar to the "opportunism" case in Cole and English (1991). Second, the risk of full taxation is decreasing in the level of the national treatment tax rate, _t._ The intuition behind this result is that the larger is the level of the domestic tax rate on the foreign sector, the lower the additional gains from full taxation. Third, since both the gains from, and the penalties for, violation of national treatment are proportionate to the price level, the price level does not enter as an argument. Finally, the risk of violation of national treatment is decreasing in the tariff advantage enjoyed under the trade accord, r.

We can then define o as the probability that the Southern partner complies with national treatment. o satisfies:

# _(5)_

Combining equations (4) and (5), o is a function of _Kn_ and _T._ We can then characterize the relationship between o and _K_ and _T_ as: _n_

## _(6)_

## _2.3 Northern Agents' Investment Decision._

The Northern investors are assumed to be risk neutral and have access to international capital markets at rate _r._ We assume that the investment of the representative owner of foreign capital in the Southern partner nation is sufficiently small that its liability associated with this investment is not limited. Since individual foreign investors are small relative to the Southern partner nation, they also take o as given when making their investment decision. The zero-profit condition then satisfies: 8
(8) _e(1-t)P(1+T)A = r_ The above expression implicitly defines the equilibrium solution Kn(i). As a notational convenience, we can express the price earned by the Southern partner nation as _P(1_ **_+T),_** where in the absence of the accord **_T=O_** and under the accord T=T. Substituting _Tr_ for **_T_** in (6), (7), and (8) and totally differentiating yields: There are two independent channels, which are captured by the numerator of (9), through which an increase in **_T_** serves to attract foreign capital. The first term reflects the terms of trade improvement experienced by the Southern partner nation. The second term reflects the decrease in the probability of expropriation due to the enhanced potential penalty associated with the price effect of losing the trade accord. The greater are the price benefits of the accord to the Southern partner nation as measured by **_T,_** therefore, the greater is the increase in the penalty for expropriation and hence the increase in the magnitude of capital inflows.

# _2.4 Impact on Southern Partner Income_

While the small country assumption maintained in this section precludes any welfare implications for the North, the current setting provides a good overview of the income implications of the trade accord for the Southern Partner nation.

Define _E(U)_ as the expected income earned by the Southern partner nation. _E(U)_ satisfies:

# (10)

Invoking the envelope theorem, differentiating _E(U)_ with respect to -r 9
yields: Equation (11) identifies two channels through which the welfare of the Southern partner nation is affected by the trade accord: The first term reflects the direct positive increase in earnings due to the tariff advantage. The second term reflects the increase in expected revenue from the foreign sector due to the increase in foreign investment, defined by equation (9). Both of these terms are positive.

It is interesting to note the characteristics of the Southern partner nation which would cause it to experience greater income gains from the trade accord. First, the increase in income will be greater the greater is the magnitude of trade with the Northern partner nation. This stems both from the direct price effect on Southern exports and from the impact of the trade accord on the magnitude of capital inflows the Southern partner nation can attract, as shown in (9). Second, the Southern partner will experience greater benefits from the trade accord the greater is the initial safety of the Southern partner nation. Since increasing **T** enhances the payoff under compliance with national treatment and fails to affect the payoff under violation, the impact of a change in the initial safety of the Southern partner nation will be a greater increase in the magnitude of capital inflows.

# **III. Extension to Two Potential Target nations**

## _3.1 Setup_

In this section, we extend the analysis to allow the trade accord to affect the pattern of investment across the South. This requires us to treat the Southern partner country as "large" in terms of having market power with respect to the price of its export good. To accomplish this in as simple a manner as possible, we assume 10
that there are two potential locations of production: Country A, the Southern partner nation, and country _B,_ an alternative location, that can be thought as the rest of the South. We assume that the output of the two nations are perfect substitutes and maintain the assumption that individual northern firns behave competitively, despite the fact that their country has market power in aggregate. We also maintain the above assumption that all output is exported to the Northern partner nation, so that exports from country _A_ earn price _P(1+T)_ while exports from country B earn price P.

Let reflect the output of the foreign sector of country _Z (Z=A,B)._ We assume that the production function for SZ satisfies:

# (12)

where a and _b_ are constants representing the productivity of the Southern target countries _A_ and _B_ respectively, while _Kn_ is the magnitude of foreign capital _n_ attracted by country Z.

Let reflect the total output of exportables in country Z, _Sz=Sz+_ where _s4_ represents the output of country Z's domestic sector and let s represent aggregate industry output, _s=sA+sB._ The demand for the output of the Southern nations is assumed to be a downward-sloping function of output. Market demand satisfies _P(1+T)=D(s),_ where **_D'S50._** As in equation (4), the zero-profit conditions for foreign investments in countries _A_ and _B_ with country A in the trade accord satisfy:

## (13a)

## (13b)

In addition to the producer terms of trade, P, there are four determinants of the magnitude of foreign investment which will be attracted by the target countries. The first is country risk, determined by _eA_ and 0B, the probabilities that 11
countries A and _B_ will comply with national treatment. The second is _tA_ and _tB,_ the tax rates faced in the two countries given compliance. The third determinant is the relative productivity in countries A and _B,_ determined by parameters a and _b._ The last determinant is the magnitude of the terms of trade advantage enjoyed by the Southern partner nation, T.

## _3.2 Target nation taxation decision._

We again assume that both Southern nations have committed to national treatment towards foreign investors. We also assume that each nation faces a penalty of losing a OZQ share of its output for violation of national treatment where z is an exogenous constant fraction and 0 is defined as above.<sup>9</sup> Let WB represent the payoff to country _B_ from choosing compliance with national treatment. WB satisfies:

# (14)

Alternatively, let WB represent the payoff to country B from choosing complete taxation, which satisfies:

## _(15)_

Let _QB_ represent the realization of 2 which leaves country _B_ indifferent between compliance and complete taxation _(W_ B=W4). _OB_ satisfies:

## (16)

> 9 Allowing the countries to have different distributions of Q would produce qualitatively the same results and would only be relevant in terms of diversification potential, which we do not focus on in this paper.

12
When making its taxation decision, country A must consider the additional loss from losing the benefits of the trade accord. Let _WA_ represent the payoff from complete compliance with national treatment. _W_<sup>_4_</sup> satisfies:

## (17)

Alternatively, let ;V<sup>4</sup> represent the payoff to country A from choosing complete taxation, which satisfies:

# (18)

Let _OA*_ represent the realization of _n_ which leaves country A indifferent between compliance and complete taxation _(W=A4)._ QA satisfies:

### (19)

As noted in the previous section, a positive probability of full taxation requires a parameter restriction.<sup>10</sup> To motivate this parameter restriction, we make the assumption that under national treatment investment in countries _A_ and _B_ would earn positive profits in the absence of country risk. This is ensured by the constraint:

### (20)

equation (5) above. Totally differentiating with respect to _KAand_ KByields: 10Altematively, we could have generalized the analysis to include zero foreign investment in the form of corner solutions.

13
<!-- Start of picture text --> (21) 8 = - f( 4 *)(1+i)a(J-tA)sA/,1A(s4;s+4)2 < o<br>aK4<br><!-- End of picture text --> and: As above, we express the price earned by the Southern partner nation as _P(I_ +-r), where in the absence of the accord **T=** **_0_** and under the accord **T=T.** Substituting T for T and totally differentiating yields: (23b)

# _3.3 Implications for International Capital Flows_

We can again examine the impact of the trade accord by conducting comparative static exercises concerning the implications of an increase in **T.** We show in the appendix that the comparative static results satisfy: (24b) where A is the determinant of the matrix of the system shown to be positive in the appendix and _P'=8P/8s50d_ The comparative static exercises demonstrate that the impact of the trade accord is an increase in investment in the Southern partner nation and a decrease in investment in the other Southern nation. The magnitude of this impact for both 14
nations is increasing in _OA,_ the probability of compliance by country A with national treatment, and _aeA/aT,_ the increase of this probability due to increases its terms of trade advantage under the trade accord. Consequently, the trade accord, by enhancing Southern partner credibility through granting it a tariff advantage, generally increases investment in the Southern partner nation at the expense of the Southern non-partner nation.

It is easy to show by contradiction that the expansion in output in country A must be larger than the contraction in output in country B, resulting in a price decline. Assume that P does not decline. Equations (lOa) and (lOb) imply that in equilibrium both countries would be riskier (oZ would be smaller). This is possible only if investment increases in both countries, which implies higher output and a decline in price. More formally, recall that the change in output with respect to -r in country _Z (Z=A,B)_ satisfies zaKZ/la. The relative output change in the two countries satisfies: which demonstrates that aggregate output increases.

However, the impact on aggregate foreign investment is ambiguous depending on the relative productivity of the Southern partner. By equations (21a) and (21b): Examining equation (26), if _asb_ (the Southern partner is less efficient than the rest of the South), the increased output must be supported by increased investment. If _a>b,_ however, the superior productivity of the Southern partner may lead to smaller aggregate foreign investment from the North. In this case, while Southern aggregate output expands, investment from the rest of the South is diverted more than fully.

15
The potential for investment diversion will also depend on the relative size of the Southern partner nation to other potential Southern locations for investment. To see this, let A represent the relative size of the Southern partner nation within the South, _x =sB1(sA +sB),_ and £ represent the elasticity of Northern demand, _£=-D'sID._ Substituting into (24) then yields:

# (27)

where _m=- (aEB/aKe)(P_<sup>_2_</sup> _/sA)_ > _0_ and bounded.

If the Southern partner nation represented the entire South, A converges to _0_ and the offsetting effects vanish. For more moderate values of A, the results depend on the value eX. Smaller aggregate investment would result if the Southern partner is more productive _(a>b)_ and _eA_ is large enough (i.e. demand is highly elastic and/or the Southern partner is relatively small within the South). An interesting extreme case is obtained when the Southern partner is extremely small within the South (i.e. _A_ is close to 1). In that case it is easy to obtain that in the limit equation (21a) converges to equation (9). In general, the expressions obtained in the previous section correspond to the limiting cases A = 1, or the Southern partner being "small" within the South.

# _3.4 Welfare Analysis_

# 3.4.1 Impact on Northern Partner Welfare

Finally, we turn to the question of the welfare implications of the trade accord. Since citizens of countries A and B do not consume the output of the industry and production is competitive with the world rate of interest r taken as given, there are two channels for the trade accord to affect welfare in this simple model: By affecting consumer surplus in the Northern partner nation, and by affecting the 16
# expected magnitude and distribution of Southern income.

We begin by analyzing the welfare impact of the trade accord on the Northern partner nation. As we showed above, the existence of the trade accord will result in a diversion of investment from country _B_ to country A. See Figure 1. Let _PO_ and Pl represent the equilibrium consumer price in the absence and presence of the trade accord respectively. The trade accord achieves a reduction in the price paid by consumers in the Northern trade partner from _P0_ to _P1._ However, only imports of the B non-partner nation, represented in the graph by _sI,_ are subject to tariff. Assuming that all tariff revenues are repatriated to consumers, then, the net impact of the trade accord on Northern partner consumer surplus is equal to the area of region III (reflecting the mitigation of the trade distortion), plus area V (reflecting the _B_ price reduction in the portion of trade subject to tariffs, _s1 )_ minus area IV (reflecting the reduction in tariff revenue in the portion not subject to tariffs, in excess of the price decline).

We analyze the impact of the trade accord formally by positing that the accord yields an advantage of terms of trade advantage of **_T,_** where _OT5-Tr,_ and then integrating the implications of changes in _T_ from _0_ to _T._ Let _AWN_ represent the resulting welfare change in the Northern partner nation. We show in the appendix that _AWN_ satisfies: where 1P is defined in the appendix. _T>0_ is a necessary, but not sufficient, condition for _AWN>O._

> AP is of ambiguous sign due to the loss in tariff revenue from country _B_ resulting from trade diversion under the trade accord. This loss is increasing in _b_ and oB, two terms which reflect the attractiveness of country _B_ as a location for 17
production. Given that ' is positive, which necessarily holds when the Northern partner nation benefits from the accord, (26) demonstrates that _AWN_ is increasing in both _A_ and (aoA/a-). Integration with country A is more likely to be welfare enhancing for the Northern partner country the greater the security of investments in the Southern partner nation, and the greater the positive impact of the trade accord on the riskiness of investments in that country.

The intuition behind this result follows from the traditional customs union analysis of the trade-off between trade creation and trade diversion. Lowering the sovereign risk of your trading partner enhances your gains from trade with that trading partner. In the traditional literature, the welfare analysis of tradediverting customs unions centers on choosing the proper customs union partner, i.e. that with which you will enjoy the greatest gains from trade. The trade accord, by enhancing the environment for foreign investment in country A, actually enhances the gains from trade with that country.

Moreover, the degree to which the trade accord enhances the penalty faced by the Southern partner nation for non-compliance with national treatment is directly increasing in the gains from trade between the Northern and Southern partner. Consequently, the impact of the accord on sovereign risk provides an independent reason that the potential for welfare gains are increasing in the gains from trade between the two partners.

# 3.7.2 Impact on Southern income.

The trade accord will affect the income of the two Southern nations through its impact on the value of the output the domestic sector of those nations and through its impact on tax revenues generated by foreign direct investment. Note that expected revenues must include payoffs in states where expropriation takes place.

18
Define _E(LF)_ as the expected income earned by country _Z (Z=A,B). E(UZ)_ satisfies:

# (29)

Invoking the envelope theorem, differentiating E(U4) with respect to _T_ yields:

### (30)

where:

## (31)

Equation (30) identifies three channels through which the welfare of the Southern partner nation is affected by the trade accord: The first term reflects the direct positive increase in earnings due to the tariff advantage. The second term reflects the decline in terms of trade suffered by the Southern partner nation due to the increase in supply. The third term reflects the increase in expected revenue from the foreign sector due to the increase in foreign investment. While the first and third terms are positive, the net impact on the Northern partner nation is ambiguous because of the negative terms of trade effect captured by the second term.

Similarly, differentiating _E(W_<sup>_3_</sup> _)_ with respect to r yields: The components of (32) are analogous to the final two components of (30). The first term reflects the decline in terms of trade suffered by country _B_ due to an increase in supply from the South, while the second term reflects the decrease in country _B's_ expected revenue from its foreign sector, due to the decrease in its foreign 19
investment. These two effects are both negative, leading to the unambiguous result that the trade accord reduces the welfare of the alternative Southern nation.

With the possible exception of a large drop in market price due to the erosion of monopoly power, then, the accord favors the Southern partner nation and harms the other Southern nation. The impact on the South as a whole is therefore ambiguous. Combining equations (30) and (32) and simplifying yields: Equation (33) indicates the ambiguity in the impact of the trade accord on Southern welfare as a whole. The second term in (33) is unambiguously negative, reflecting the deterioration in the terms of trade for the South due to the increase in output. To the degree that the trade accord erodes the ability of the South to exercise its monopoly power, it can lead to a deterioration in Southern terms of trade. Consequently, holding all else equal, the trade accord will be more likely to be welfare increasing for the South as a whole the greater is the elasticity of demand for its exports in the North.

Looking at the first term in (33), we see the direct impact of the increase in terms of trade for the Southern partner nation and the tradeoff between the impact of the increase in investment in the Southern partner nation and the decrease in investment in the alternate nation. This term is of ambiguous sign. Nevertheless, it is interesting to note that the term is increasing in oAtA and decreasing in _OBtB._ 20
Holding all else equal, the welfare impact on the South as a whole is greater the larger is the relative tax rate weighted by the probability of compliance with national treatment in the Southern partner nation. The intuition behind this effect is that shifting output from a high tax country to a low tax country, holding capital inflows constant, results in a net loss in Southern tax revenues. This can also be understood as an "erosion of monopoly power" effect. The ability of country B to tax its foreign sector and still attract capital inflows is hindered by the quality of the environment of country A as a haven for foreign investment. The trade accord, by enhancing this environment, can actually harm the income of the South as a whole.

# **IV. Conclusion**

The general perception is that the most important implications of NorthSouth trade accords such as NAFTA are likely to concern their impact on investment flows. In this paper, we have made an initial effort to understand the channels through which trade accords can affect North-South investment flows. Our analysis shows a potential link between trade accords and investment flows through the impact of the accords on the ability of Southern partner governments to make commitments concerning treatment of foreign investment. We show that these accords can affect both the magnitude and the pattern of inward investment and production, implying the possibility of both trade and financial diversion stemming from a bilateral regional trade accord.

While the paper demonstrates that novel effects emerge under sovereign risk which must be addressed when assessing the welfare implications of trade accords, the qualitative policy conclusions from the paper are similar to those in the old tradediverting customs union literature [Viner (1950)1: The greatest gains from integration still are achieved when integration takes place between the countries 21
which have the greatest potential gains from trade. The distinction introduced here is that these gains now include both current trade and inter-temporal trade through foreign investment. For example, in our welfare analysis in the previous case, the possibility of Northern partner welfare loss from the accord was greatest when the "net-of-expropriation-risk" high productivity target nation was not included in the accord. Consequently, while North-South integration highlights different issues than those in previous trade accords, a nation still does best by integrating with those which yield it the greatest gains from trade.

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