Foreign Direct Investment and Regional Trade Agreements: The Market Size Effect Revisited

IMF Working Papers, November 1, 2004

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Research question: whether the market size of a regional trade agreement (RTA) determines foreign direct investment (FDI) received by RTA member countries.
Sample and period: 71 developing countries during 1980-99.
Main approach: empirical testing of the RTA market-size hypothesis and simulation of FDI effects for a proposed RTA among Algeria, Morocco, and Tunisia.

RTA market size had a positive impact on the FDI received by member countries.
The positive impact was stronger in the 1990s when RTAs were revived and became more widespread.
Domestic population size also mattered, possibly via availability of labor supply.
Distributional effects within RTAs:
- Countries with a relatively more educated labor force attracted a larger share of FDI at the expense of less-educated partners.
- Countries with a relatively more stable financial situation tended to attract a larger share of FDI at the expense of RTA partners.
Evidence of a partial negative correlation between FDI received by RTA countries and FDI received by non-RTA countries, suggesting possible diversion of FDI from non-RTA to RTA countries.

It is essential for all RTA countries to improve their business environment to the best available in the region to ensure more equitable FDI distribution across members.
Policies that enhance labor education and financial stability can increase a country's share of FDI within an RTA.

The paper illustrates FDI benefits by simulating the creation of a regional trade agreement between Algeria, Morocco, and Tunisia.

IMF Working Paper — Florence Jaumotte, November 1, 2004.