NAFTA, Economic Freedom, and
Foreign Direct Investment in Latin America
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.
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).
FDIi,t = a + b1 DFDI i,t-1 + b2 Economic Freedom i,t + b3 Trade Openness i,t
+ b4 Per Capita Income i,t + b5 Political Instability i,t + b6 Human 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 DummyMexico,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:
IV. Success Factors
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