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Free Trade Agreements and Foreign Direct Investment: The Role of Endogeneity and Dynamics

Economic Research Institute (82-2-759-5416) 2011.01.10 4304
Author : Cristina Lira , Junsoo Lee, Byung Ki Lee, and Robert Reed

The relationship between Foreign Direct Investment (FDI) and Free Trade Agreements (FTA) has been extensively analyzed in theoretical and empirical literature given their widespread diffusion and their important consequences in terms of growth and welfare.

There are theoretical arguments that support a positive relationship (complementary) between FTA and FDI but others that suggest a negative link (substitution) and empirical findings are mixed.   Previous empirical literature do not fully address the endogeneity of FDI in association with FTA, the fact that the relationship between FTA and FDI is dynamic and the possibility of a feedback effect between FDI and FTA.   Using a panel of countries for the years 1990-2006, this paper analyzes if FDI and FTA are complements or substitute by employing a gravity model as empirical specification.   Various empirical strategies are compared and discussed.

Overall, we find that the effect of FTA on FDI is small or negative, but tends to be estimated as positive if some important econometric issues are not controlled.

1 . Introductio n 1

2 . Trade, FDI and FTA 4

3 . Econometric Issues and Estimation Strategies 6

4 . Data and Empirical Estimation Results 13

5 . Conclusion 22