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Foreign Investment America

NAFTA, Economic Freedom, and

Foreign Direct Investment in Latin America

The Research Issue

There is a general consensus in development economics literature that the inflow of foreign direct investment (FDI) can play a critical role in the growth dynamics of recipient countries. The literature holds that FDI can fill at least three “development gaps” in developing countries. FDI can fill, first, the “investment gap” by providing the much-needed capital for domestic investment; secondly, the “foreign exchange gap” by providing foreign currency through initial investments and subsequent export earnings; and finally, the “tax revenue gap” by generating tax revenues through creation of additional economic activities (Smith 1997). FDI can also help generate domestic investment in matching funds, facilitate transfer of managerial skills and technological knowledge, increase local market competition, create modern job opportunities, increase global market access for locally produced export commodities, etc., all of which should ultimately contribute to economic growth in recipient countries.

Recognizing the benefits of FDI, developing countries have generally eased restrictions on the inflow of foreign capital since the early 1980s. Furthermore, the end of the Cold War in the early 1990s resulted in a new political dynamics that not only ended the foreign aid programs sponsored by the erstwhile Soviet Union in left-leaning LDCs, but also diminished the strategic alliances between the US and the pro-US developing nations resulting in a sizable reduction in the US-sponsored foreign aid programs. The new political reality has forced LDCs, hitherto heavily dependent on foreign public aid regardless of their political ideological leanings, to seek out alternative sources of foreign private capital. As a result, the annual FDI inflow to developing countries has increased manifold from $24 billion in 1990 to almost $178 billion in 2000 (from 24% of total foreign investment in 1990 to 61% in 2000) (World Bank 2001).

The increasingly significant role of FDI in the growth dynamics of developing countries has created much research interest among development economists. Consequently, a sizeable empirical literature has evolved on the determinants of FDI. These studies have identified a number of variables, such as market size, wages, inflation, political instability, etc. as key determinants of FDI. However, due to non-availability of reliable and consistent set of quantitative data on investment climate, the literature has generally excluded the domestic investment climate in recipient countries as a determinant of FDI. Two recent studies of the determinants of FDI, Quazi (2006) and Quazi and Mahmud (2006), have used the Index of Economic Freedom, an annual publication by The Heritage Foundation and The Wall Street Journal since 1995, as a reliable proxy for domestic investment climate.

The primary focus of the proposed research project is to investigate whether, in addition to the other variables routinely used in the literature, economic freedom is also a significant determinant of FDI in Latin America. Among the developing regions, this particular region receives a disproportionately high share of FDI, which is perhaps due to the geographical proximity of this region to the U.S. and Japan - the two most significant source countries of FDI. One country in the sample that deserves special attention is Mexico, which, due to its membership in NAFTA, has become a magnet for FDI and is currently among the most popular destinations of FDI in the world. This research project will also estimate the effects of NAFTA membership on the FDI inflow to Mexico, which will shed light on the likely effects of the proposed Free Trade Agreement of the Americas (FTAA) on FDI inflow to member countries in the region. The results from this study will further our knowledge of the determinants of FDI, which is crucial for devising strategies to promote economic development --a course that holds much at stake not only for Latin America, but also for developing countries in general.

Methodology

Employing 1995-2005 panel data, this project will study the determinants of FDI in 18 countries in Latin America - Argentina, Belize, Bolivia, Brazil, Chile, Colombia, Costa Rica, Ecuador, El Salvador, Guatemala, Honduras, Mexico, Nicaragua, Panama, Paraguay, Peru, Uruguay, and Venezuela. A general-to-specific modeling approach comprising the following equation will be used to estimate the panel regression models (subscript i refers to countries and t refers to time).

FDI_i,t = a + b₁DFDI _i,t-1 + b₂Economic Freedom_i,t+ b₃Trade Openness_i,t

+ b₄Per Capita Income_i,t+ b₅Political Instability_i,t+ b₆Human Capital_i,t

+ b₇ Quality of Infrastructure_i,t + b₈ Rate of Return_i,t + b₉ Inflation_i,t

+ b₁₀ Financial Liberalization_i,t + b₁₁ Dummy_Mexico,t + e

Data on annual FDI inflow, inflation rate, money supply, trade openness, quality of physical infrastructure, literacy rate, etc., will be collected from the World Development Indicators (World Bank 2006), while data on economic freedom will be collected from the Index of Economic Freedom (Heritage Foundation/Wall Street Journal 2006). The effects of NAFTA on FDI will be measured by a dummy variable for Mexico. To ensure robustness of the estimated results, models will be estimated in both the Generalized Least Squares (GLS) and Random Effects techniques. The estimated results will be analyzed to examine the following issues:

What are the significant determinants of FDI in Latin America? Is economic freedom a significant determinant of FDI in Latin America?

How has NAFTA affected the FDI inflow to Mexico? Accounting for the economic fundamentals, does Mexico still appear to be a significantly different FDI destination from other countries in Latin America?

What would be the policy implications for devising effective policies to attract FDI in Latin America?

Planned Time Line

Literature survey, data collection, and model estimation will be completed in summer 2006.

The write-up will be completed in fall 2006, following which the paper will be added to the COB online faculty working paper series and presented in the research seminar series in spring 2007. I will also utilize any opportunity to present the paper at a national/regional conference.

The final version of the paper will be submitted to a refereed journal, such as the Latin American Journal of Economic Development or the International Journal of Business.

IV. Success Factors

The author has published ten articles in peer-reviewed journals in the last five years, many of which are in the area of international trade and business. Therefore, the research project has a very high probability of success in culminating into a refereed journal publication.

The author has attended many Faculty Development in International Business (FDIB) workshops, which have honed his research expertise in international business fields.

The findings from this research project will lend themselves well to class discussions in international trade and international business courses, which the author regularly teaches at both undergraduate and graduate levels.

The author is in a unique position to present the findings from this research project in international business outreach workshops, which will assist local business firms in their pursuit of acquiring greater knowledge of the global economy.

References

Bird, G. “How Important Is Sound Domestic Macroeconomics in Attracting Capital Inflows to

Developing Countries?” Journal of International Development, 11, 1999, pp. 967-991.

Chakrabarti, A. “The Determinants of Foreign Direct Investment: Sensitivity Analyses of Cross-

country Regressions”, KYKLOS, 54, 2001, pp. 89-114.

De Mello, L. “Foreign Direct Investment in Developing Countries and Growth: A Selective

Survey”, Journal of Development Studies, 34(1), 1997, pp. 1-34.

Gastanaga, V., Nugent, J. & Pashamiova, B. “Host Country Reforms and FDI Inflows: How

Much Difference Do They Make?” World Development, 26(7), 1998, pp. 1299-1314.

Haque, N., Mathieson, D. & Sharma, S. “Causes of Capital Inflows and Policy Responses to

Them”, Finance & Development, March 1997, pp. 3-6.

Heritage Foundation/Wall Street Journal. 2006 Index of Economic Freedom, The Heritage

Foundation, Washington, DC.

Lucas, R. “On the Determinants of Direct Foreign Investment: Evidence from East and South-

East Asia”, World Development, 21, 1993, pp. 391-406.

Noorbakhsh, F., Paloni, A. & Youssef, A. “Human Capital and FDI Inflows to Developing

Countries: New Empirical Evidence”, World Development, 29(9), 2001, pp. 1593-1610.

Quazi, R. “Economic Freedom and Foreign Direct Investment in East Asia”, Journal of the Asia

Pacific Economy, Revised and resubmitted, 2006.

Quazi, R. and Mahmud, M. “Determinants of Foreign Direct Investment in South Asia”, The

International Journal of Business and Public Administration, Forthcoming, 2006.

Rodrik, D. “Policy Uncertainty and Private Investment in Developing Countries”, Journal of

Development Economics, 36(2), 1991, pp. 229-242.

Smith, S. (1997) “Restrictive Policy toward Multinationals: Argentina and Korea”, Case Studies

in Economic Development, Second Edition, 178-189.

Tuman, J. & Emmert, C. “FDI in Latin America, 1979-1992”, Social Science Quarterly, 80(3),

2000, pp. 539-555.

World Bank. Global Development Finance, 2001.

World Bank. World Development Indicators, 2006.

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