Benefits and Costs of Regional Integration: The Impact of NAFTA on the Mexican Economy

  I  

Contents

1  Introduction 1  Introduction................................................................................................................1

1.1  A Decade of Debate 1  

1.2  Objective and Structure of the Thesis 2  

2  Regional Integration 4  

2.1  Definition Forms and Objectives 4  

2.2  Welfare  Implications............................................................................................6

2.2.1  Static Welfare Effects 6  

2.2.2  Dynamic Welfare Effects 10  

2.3  North-South versus South-South  Integration.....................................................13

2.4  Spatial Inequality in the Integration Process 15  

3  NAFTA as an Example of Regional Integration 19  

3.1  Mexico s Way into NAFTA 19  

3.2  Design and Coverage of the NAFTA Provisions 22  

3.3  NAFTA in the Light of Integration Theory: Expected Effects 24  

4  NAFTA s Impact on Mexico after One Decade 28  

4.1  Static Benefits 28  

4.1.1  NAFTA s Impact on Trade 28  

4.1.2  Trade Creation Diversion and Mexican Terms of Trade 32  

4.2  Dynamic Benefits 34  

4.2.1  NAFTA s Impact on Foreign Direct Investment 34  

4.2.2  Dynamic Spillovers Productivity and Growth 38  

4.2.3  Catching Up with the North 41  

4.3  Adjustment and Divergence 45  

4.3.1  Growing Disparities and Intra-Mexican Divergence 45  

4.3.2  Migration Adjustment Mechanism for the NAFTA-Neglected 49  

5.  Conclusions and Policy  Implications......................................................................54

5.1  Summary and Discussion of Results 54  

5.2  Policy Implications and Outlook 57  

Appendix ...........................................................................................................................61  NA  

  II  

Figures

  Figure 1: Trade Creation and Diversion in a Free Trade Area 8  

  Figure 2: Exemplary Effects of the Formation of an FTA on Countries Industry Share  

  and Welfare 18  

  Figure 3: Mexican Trade Flows  1980-2002......................................................................29

  Figure 4: FDI Inflows to Mexico  1980-2002....................................................................35

  Figure 5: GDP Per Capita Growth of Mexico and the U S 1993-2002 42  

  Figure 6: Migration from Rural Mexico to the United States 1980-2002 51  

  III  

Tables

Table 1:  FDI Inflows as a Percentage of Gross Fixed Capital Formation 36  

Table 2:  Poverty in Rural and Urban Areas 1984-1994 50  

Table 3:  Income from Household Remittances 1996-2002 53  

− −

IV

Abbreviations

Art. Article

CET common external tariff

CGE computable general equilibrium

CUSFTA Canada-United States Free Trade Agreement

EEC European Economic Community

EFTA European Free Trade Association

EMU Economic and Monetary Union

FDI foreign direct investment

FTA free trade area

GDP gross domestic product

GNP gross national product

MFN most-favored nation

MNE multinational enterprise

NAFTA North American Free Trade Agreement

PRI Partido Revolucionario Institucional

p.a. per annum

R&D research and development

RIA regional integration arrangement

ROW rest of the world

TFP total factor productivity

TRIMS Accord on Trade-Related Investment Measures

U.S. United States

− −

1

1 Introduction

1.1 A Decade of Debate

In January 1994, after two and a half years of negotiation, the North American Free Trade Agreement (NAFTA) came into force. The treaty between Canada, Mexico and the United States has created the largest economic area in the world, slightly surpassing the European Union in market size. But NAFTA is also outstanding in a second aspect: it has constituted the first major regional integration arrangement between two highly devel- oped countries, the United States and Canada, and a developing country, Mexico. The North-South nature of North American integration has polarized the debate about

NAFTA from the earliest stage on. On the one hand it was unclear how much the U.S.

would gain from the agreement. Would it stabilize its southern neighbor and thus benefit the U.S. economically and politically? Or would it cause the “giant sucking sound” Ross Perot feared, drawing thousands of jobs from the U.S. over the border (Thorbecke/Eigen- Zucchi 2002, p. 648)? Regarding these concerns, Canada was at most a side-player, pos- sessing neither intense trade relations nor geographical proximity to Mexico. Mexico’s gains from NAFTA, on the other hand, seemed even more unsure. The agree- ment’s effects on the southern member state, whether positive or negative, were expected to be unequally greater than on the U.S. On the one hand, it seemed, Mexico could gain immensely through improved access to the North American market, increasing trade, attracting foreign investment, and importing growth and stability. On the other hand, some trade economists, such as Arvind Panagaria (1996, pp. 512-513) warned that Mex- ico could only lose when opening its market to its powerful northern neighbors, while receiving little in return that it would not have obtained anyway. Furthermore, would Mexico’s move towards regional integration hamper any further step into the direction of multilateral opening, after promising reforms had been started in the mid-1980s? Concerns also regarded the adverse effects of NAFTA within Mexico. These centered around large adjustment costs from sectoral restructuring and resource reallocation. This would occur if inefficient, partly subsidized Mexican industries declined after removing tariffs and non-tariff barriers, allowing the North American competition to enter the na- tional market. In addition, would this hit mostly those Mexican regions that were poor anyway?

− −

2

The Mexican government was convinced of the miracles of regional integration and acted as the main driver in the negotiation process between the three North American nations. Nevertheless, ten years after NAFTA’s start the debate about its benefits for the Mexican economy is more polarized than ever. On the one hand, NAFTA’s champions, such as the then Mexican minister of trade and industrial development, Jaime Serra, still argue forcefully in favor of NAFTA’s blessings regarding trade and investment (Serra/Espinosa 2002, pp. 60-62). On the other hand, many Mexicans appear disap- pointed by unattained social goals. In addition, activists from all over the world regard

NAFTA as a prime example of the negative effects of free trade, denouncing working

conditions in and the environmental impact of the maquiladora plants, essentially seeing Mexico on the ground after a race-to-the-bottom.

In the face of the controversy about NAFTA’s effects, it is important to establish an un- biased evaluation of the benefits and costs that regional integration has brought to Mex- ico after a decade. Not least because the outcome of the experiment of North-South inte- gration is of considerable importance for other developing countries trying to liberalize, whether preferentially or multilaterally, and for which NAFTA may or may not serve as a model.

1.2 Objective and Structure of the Thesis

The question around which this thesis centers is, therefore, where and to what extent Mexico has gained from regional integration in the form of NAFTA and where it has experienced adverse effects and costs from it. These gains and losses can cover a large variety of issues, the examination of all of which would exceed the scope of any single thesis by far. The economic effects of trade liberalization are one possible area of inves- tigation, another one would be the impact of NAFTA on Mexican politics, policy reform and political stability. Political economy approaches can explain the role of and the effect on interest groups in regional integration arrangements. Lastly, NAFTA’s environmental impact could be an issue.

This thesis focuses on the economic implications of NAFTA, leaving aside the other is- sues above. The problem is further broken down into three specific questions: First, what have been the traditional static gains from integration for Mexico? Second, which dy- namic effects has NAFTA brought about, especially on foreign investment, its impact on productivity and growth, and have these led to economic convergence? And third, what have been the costs of adjustment resulting from the static and dynamic effects?

− −

3

This allows a theoretically well-founded analysis of benefits and costs of this specific case of regional integration in order to carry through a reasonable evaluation of NAFTA’s impact on Mexico. A thorough comparison between regional integration and multilateral trade opening as alternative approaches to economic liberalization, however, lies beyond the scope of the thesis.

The existing literature on NAFTA’s effects on Mexico can essentially be divided into two groups. The first group consists of ex-ante studies that have been published since the first announcement of a North American free trade area in the early 1990s. Some of the literature qualitatively analyzes NAFTA’s potential effects applying concepts of the the- ory of regional integration, such as Ramirez de la O (1993) and Ohr (1995). A vast amount of ex-ante studies, however, conducts simulations based on computable general equilibrium (CGE) models, and range from estimations of trade and investment effects over the impact on certain sectors such as agriculture and manufacturing to the effects on

labor and wages. 1 The second group of literature consists of ex-post studies that evaluate NAFTA’s impacts with hindsight. Individual studies focus on a multitude of different issues, such as the

impact on trade, using a traditional Vinerian framework 2 of analysis (e.g. Krueger 2000), or foreign direct investment and dynamic effects (López-Córdova 2002; Romalis 2003). Some other works have used a more comprehensive approach and combined different aspects (e.g. Ramirez 2003). One of the most thorough analyses has been conducted by a recent World Bank report (Lederman et al. 2003), which combines existing literature with more far-reaching econometric exploration of several important issues.

The purpose of this thesis is to use the benefit of hindsight to combine, structure, and critically evaluate the results of the multitude of existing (ex-post) studies and thus pro- vide answers to the three research questions detailed above. In order to do this, it first develops a theoretical framework using insights from theories of regional integration and the new economic geography. This framework is then used to examine the North Ameri- can Free Trade Agreement and formulate expectations about its probable effects. These are subsequently discussed within the analysis and compared to the actual developments, thus bringing together theory and empirical evidence. In contrast to several existing re-

1 Comprehensive and readable surveys of the studies using CGE models are Brown (1992), Brown et al.

(1992) and Kehoe/Kehoe (1994). Models of labor implications are reviewed by Hinojosa-

Ojeda/Robinson (1992). Generally these models predict income gains for Mexico, which are higher in

the models accounting for dynamic growth effects.

2 See chapter 2.

− −

4

view studies 3 , special attention is paid to separating NAFTA’s impact from those of other influential factors to provide an as accurate as possible picture of the former. Chapter 2 provides the theoretical framework of the study. After introducing the main forms and characteristics of regional integration, potential welfare effects are considered. These are split into static and dynamic effects, an analytical separation that is upheld throughout the course of the study. Derived from these, the welfare implications of North-South and South-South integration for developing countries are discussed. Finally, the issue of convergence, divergence and regional inequality, mainly represented by the new economic geography, is added as an essential element of analysis.

Chapter 3 then deals with NAFTA as an example of regional integration. First, Mexico’s way into NAFTA as a gradual path to liberalization is depicted, being crucial to the un- derstanding of post-NAFTA developments. After briefly addressing the consequent ex- pectations of Mexico versus North American free trade, the main provisions and negotia- tion outcomes of NAFTA are discussed. Subsequently, expectations of NAFTA’s effects in the areas depicted above are formulated in order to test and discuss them in chapter 4. Chapter 4 analyzes NAFTA’s impacts on Mexico after the first ten years of the agree- ment. The first area to be examined is the static effects concerning trade creation and diversion, based on a Vinerian framework. Second, dynamic effects are discussed, focus- ing on foreign direct investment, its contribution to technological spillovers and growth, and subsequent intra-NAFTA convergence. Lastly, the attention turns to the adjustment effects resulting from trade liberalization, with a special focus on intra-Mexican diver- gence and adjustment through migration.

Chapter 5 concludes the thesis by discussing the findings from chapter 4, outlining limi- tations of the study, deriving policy implications and presenting an outlook.

2 Regional Integration

2.1 Definition, Forms and Objectives

Different definitions exist for the term ‘regional integration’. One of the most common is Balassa’s 4 , which will be adopted for the purpose of this thesis:

“[Economic integration can be defined] as a process and as a state of affairs. Regarded as a process,

3 A notable exception being Lederman et al. (2003).

4 Balassa’s definition in fact relates to ‘economic integration’. Both terms will be used interchangeably in

this study. A similar definition is given by El-Agraa (1989, p. 1).

− −

5

it encompasses measures designed to abolish discrimination between economic units belonging to

different national states; viewed as a state of affairs, it can be represented by the absence of various

forms of discrimination between national economies.” (Balassa 1962, p. 1)

The dual nature of integration as process and state demonstrates that integration can be

seen as a continuum (Blank et al. 1998, p. 31), and thus must be typified accordingly. 5

A classification that has found wide acceptance is the distinction between preference

area, free trade area, customs union, common market, and economic union (Balassa 1962, p. 2; Ohr/Gruber 2001, p. 3), where a preference area constitutes the weakest form

of integration and an economic union the strongest. 6 Table A.1 7 (p. 62) summarizes these forms of integration and their main characteristics.

In a preference area the participating countries grant each other preferential conditions for the trade of certain, specified product categories, usually in the form of a partial or

total removal of tariffs for these products. 8

A free trade area (FTA) is an agreement between two or more economies in which tar-

iffs and non-tariff barriers, such as import quotas, are abolished for imports from the par- ticipating economies. In this, FTAs can be seen as a special case of a preference area, extended to all product categories. The elimination of tariffs generally only relates to products that have been produced entirely or to a large extent within the FTA. Imported products from external countries are still subject to national tariffs. Respectively, within an FTA there is no coordination of trade policies between the member countries. Hence, each country individually pursues national trade policies versus non-member states. This results in the necessity of ‘rules of origin’. These rules prevent externally imported goods from entering the FTA via the member with the lowest tariffs, circumventing the higher tariffs of other members (‘trade deflection’). In contrast to stronger forms of regional integration, an FTA allows its members to retain a large amount of independence in trade policy-making (Blank et al. 1998, pp. 57-58; Kaiser 2003, p. 27). Prominent examples of FTAs are NAFTA and the European Free Trade Association (EFTA).

In customs unions, which have been in the center of integration research until the 1990s (Krueger 1997a, p. 177), member countries introduce a common external tariff (CET)

5 However, while different forms of integration to be presented are continuously measured by the degree of integration, they each represent a single, independent state the attainment of which does not necessar- ily require to undergo previous states or proceed to higher degrees of integration. See, e.g., Stange (1994, pp. 9-10).

6 Interestingly, the preference area does not form part of Balassa’s original classification. See also Blank et al. (1998), pp. 32-33. A slight variation of this typology is, e.g., presented by Jovanovic (1992, p. 9).

7 Tables and figures that are labeled with an “A” can be found in the Appendix.

8 One example of a preference area is the British Commonwealth Preference Scheme, that has been founded in 1932 by Great Britain and former Commonwealth countries (Blank et al. 1998, p. 32).

− −

6

vis-à-vis non-member countries, while internal import and export tariffs are entirely eliminated. This implies that the members’ trade policies are jointly coordinated – mem- bers give up a significant part of their policy-making independence. This loss of inde- pendence may be a reason why today customs unions are less abundant than FTAs (Kaiser 2003, p. 27). One example of a customs union, is the European Economic Com- munity (EEC) of 1957.

While FTAs and customs unions limit integration to the product markets, the move to a common market, as happened in the European Community after 1992, implies the inte- gration of product and factor markets, in which there is unlimited mobility of labor and capital. Respectively, a higher degree of harmonization of economic policies becomes necessary, regarding both competition and fiscal policies (Blank et al. 1998, p. 33). The highest level of regional integration of sovereign states is reached by forming an economic union. As Balassa puts it, this “[…] total economic integration presupposes the unification of monetary, fiscal, social, and countercyclical policies and requires the set- ting-up of a supra-national authority whose decisions are binding for the member states” (1962, p. 2). Economic union can go hand in hand with monetary union, as is the case with the European Economic and Monetary Union (EMU).

Following Ohr/Gruber one may define the goal of regional (market) integration as the “optimization of the allocation of resources and hence, an enhancement of economic effi- ciency and macroeconomic welfare in the integration area” (2001, p. 4). According to economic theory, however, efficiency and welfare are maximized when there is world- wide free trade, as suggested by the most-favored-nation (MFN) principle of the General Agreement on Tariffs and Trade (GATT) and the World Trade Organization (WTO). Taking into account the imperfectness of the world trading system, however, regional integration arrangements (RIAs) may be seen as a second-best solution (Blank et al. 1998, p. 21).

2.2 Welfare Implications

2.2.1 Static Welfare Effects

During the first half of the 20 th century it was widely assumed that the conclusion of preferential trading agreements was necessarily trade liberalizing and therefore welfare

− −

7

increasing (Krueger 1997a, p. 175). 9 Regional integration arrangements have thus been welcomed as a move towards free trade. Viner’s (1950) comparative static analysis 10 of customs unions, however, showed by introducing the concepts of trade creation and trade diversion that the welfare effects of regional integration arrangements are indeed ambiva-

lent. 11 Krueger notes that “[…] a customs union (or other preferential agreements) might result in the attainment of a Pareto-

superior situation for one trading partner (due to the predominance of trade creation) and of a

Pareto-inferior situation for the other trading partner, with either a Pareto-superior or –inferior situa-

tion for the union (or FTA) members as a group.” (Krueger 1997a, p. 176)

Trade creation occurs when regional integration leads to the shift of demand from ineffi- cient, uncompetitive domestic producers to efficient producers in a partner country, thus resulting in a more efficient allocation of resources and increased trade between the countries within an FTA or a customs union. Trade diversion, on the other hand, occurs when trade is shifted away from a non-member country to a member country due to pref- erential treatment of the member’s goods, although the non-member country’s producers are more efficient and can, with non-discriminating tariffs, offer more competitive prices (Viner 1950, pp. 44-45; Balassa 1962, p. 25).

The effects of trade creation and diversion can be shown using a simple model with two

countries, A and B, the world market, and a tradable good. 12 Figure 1 shows the market for good x in country A, where D A is country A’s demand for good x; S A is country A’s domestic supply, which is imperfectly elastic; S W is the perfectly elastic world market supply; and S B is country B’s supply, which is also assumed to be perfectly elastic. Initially, country A raises a non-discriminatory tariff t against all imports, so that the price of goods from country B is P B +t and the world market import price is P W +t. In this situation country A produces OX 0 and imports X 0 M 0 from at P W +t. Country B’s prices are not competitive. If country A enters into a free trade area with country B, B’s price

9 The scope of this thesis does not allow for a detailed discussion of why trade liberalization in general is considered welfare increasing. For a short overview over the subject see, e.g., Krugman/Obstfeld (1994, pp. 1-8).

10 As commonly understood, the comparative static analysis comprises changes in the equilibrium states of a model as assumptions are altered. Here, static effects are primarily understood as the changes in the structure of trade as an economy participates in a regional integration scheme.

11 Most of the fundamental analytical work from Viner on is concerned with customs unions, while free trade areas and other forms of regional integration have only recently received more attention (Krueger 1997a, p. 177). Most of their treatment is based on the adaptation of customs union theory, so that a theory of free trade areas has not existed independently. Rather, relative advantages and dis- advantages of free trade areas versus customs unions have mostly been analyzed (Pelkmans 1980, pp. 340-341; Stange 1994, p. 37). Here, however, the example of a free trade area is chosen due to its relevance for the thesis’s subject.

12 This example is based on Blank et al. (1998, pp. 60-61).

− −

8

will be P B , while imports from the world market remain at P W +t. Hence, country A’s production decreases to X 1 and imports amount X 1 M 1 .

Several effects can now be observed. First of all, consumption increases from M 0 to M 1 due to the lower price. The result will be a consumer surplus gain of area d. Areas i and j would be the additional gain from free trade. Second, domestic production decreases from X 0 to X 1 , which is the replacement of domestic products by more efficiently pro- duced foreign imports. This leads to production cost savings of area b as a net gain. With free trade, areas f and g would additionally be realized. The consumption and production effects jointly represent the trade creation effect. At the same time, area a shifts from producer to consumer surplus.

Figure 1: Trade Creation and Diversion in a Free Trade Area

But the FTA in the model also diverts all trade away from the world market to less effi- cient producers in country B. While without integration areas c and h represented tariff revenues, area c now adds to the consumer surplus. Area h, however, is lost and repre- sents the welfare loss from trade diversion. The net welfare effect of the FTA is conse- quently +b+d-h and depends on the relative size of the consumer surplus gains, on the one hand, and the loss in tax revenue on the other.

The ambivalent effects of regional integration on national and world welfare reflect the

theory of the second best: 13 they demonstrate that an incomplete move towards free trade, encompassing only a few countries, is not necessarily beneficial. The illustration above

13 The theory of the second best says that, “[…] if is impossible to satisfy all the optimum conditions […],

then a change which brings about the satisfaction of some of the optimum conditions may make things

better or worse” (Lipsey 1960, p. 498, emphasis in original).

− −

9

suggests that FTAs are beneficial as long as trade creation outweighs trade diversion (Balassa 1962, p. 26; Ohr/Gruber 2001, p. 10).

The relative sizes of the opposing effects depend on several factors. 14 One important de- terminant thereof is the level of the preexisting tariffs of a country. The higher the tariffs, the smaller will be the amount of trade between countries A and C prior to regional inte- gration, resulting in fewer trade diversion. Furthermore, the higher the tariff, the larger the potential for trade creation with country B. A higher preexisting tariff therefore in- creases the potential benefits of a free trade area or a customs union (Kaiser 2003, pp. 77- 78).

The amount of trade diversion also depends on the price difference between imports from the third country (country C) and the one with which a regional integration arrangement is to be formed (country B). The lower the price of imports from C compared to B, the greater are the efficiency advantages of country C and the negative impact of regional integration on country A in terms in trade diversion (Kaiser 2003, p. 78).

A third determinant is the level of preexisting trade among members of a RIA before

integration. The higher the trade among members, and the lower the trade between mem- bers and non-members, the more likely it is that trade creation outweighs diversion (Krueger 1997a, p. 176; Stehn 1993, p. 4). The assumption that this is mainly the case for countries located in one geographical region gives rise to the ‘natural trading partner hy- pothesis’ (Krugman 1991b, p. 19). Here, the main argument is that the level of trade strongly depends on transport costs, which are lower the closer countries are located to

each other. 15 In an FTA, the rules of origin necessary to prevent trade deflection may be an additional cause of trade diversion. The reason is that, in the face of content requirements which remove tariffs from products only if they contain a certain percentage of components from within the FTA, producers may have an incentive to source from FTA-internal high-cost suppliers instead of from external lower-cost suppliers in order to fulfill the rules of origin (Krueger 1997a, p. 179).

In the case of a customs union, the members may experience an increase in their terms of trade. This is the case if the customs union is sufficiently large to influence the world market price of a good through a change in its common external tariff. In this case a ris- ing CET lowers the world market price and raises the value of the customs union’s ex-

14 For a more complete overview of these factors see Viner (1950, pp. 51-52).

15 The notion of natural trading partners has, however, received substantial amounts of criticism. See, e.g.,

Bhagwati et al. (1998, pp. 1132-1134) and Panagariya (1996, pp. 488-492).

− −

10

port compared to its imports, leading to a welfare increase. This welfare increase, how- ever, is achieved at the expense of the rest of the world and thus can be described as a

“beggar-thy-neighbor effect” (Krugman 1991b, pp. 13-16). 16 In conclusion, the comparative static analysis of regional integration arrangements intro- duces the concepts of trade creation and diversion, the relative size of which determines the welfare effect of an FTA or a customs union, abstracting from terms-of-trade ef-

fects. 17 These effects, however, have to be complemented by the dynamic effects of inte- gration, without which an evaluation of a RIA would be incomplete.

2.2.2 Dynamic Welfare Effects

Over time, the impact of dynamic welfare effects is considered more important than the purely static effects described above (Schiff/Winters 1998, p. 178; Ohr/Gruber 2001, p.

13). 18 Dynamic effects are understood as those that occur in an economy over time as it adjusts to observed disequilibrium states. Within the present context, specifically those dynamic effects are considered which affect a country’s economic growth over the long

and medium term. 19 While a large amount of literature exists on the general relationship between growth and economic openness, few studies specifically focus on RIAs (Schiff/Winters 1998, p. 183). Those that do mainly discuss two channels through which integration can incur growth effects: technology and investment (Vamvakidis 1999, p. 45).

Under the first of these one may subsume economies of scale, technological spill-over effects and enhanced innovation. Economies of scale can be achieved through the market enlargement that results from economic integration. Firms can hereby increase their pro- duction and, with increasing marginal rates of return, produce at lower average costs than before (Corden 1972, pp. 465-474). Through these efficiency improvements domestic firms may become competitive at an international level, even if the RIA has originally been trade diverting. Additionally to firm-internal economies, external, sector-wide scale economies can occur as stronger firm specialization leads to sector-wide infrastructure

16 For a graphical analysis of the terms-of-trade effects in customs unions see Blank et al. (1998), pp. 98- 102. See also Viner (1950), pp. 55-58.

17 Some argue that trade creation or diversion misrepresent static welfare effects. For example, if in addi- tion to the ‘inter-country substitution’ effect analyzed by Viner the effect of consumer’s changes in consumption due to the relative prices of commodities (‘inter-commodity substitution’) are taken into account, the latter can partly compensate welfare losses from trade diversion (Lipsey 1960, p. 504).

18 One reason why still the majority of studies focuses on static effects of integration (Kaiser 2003, p. 94) might be seen in the fact that dynamic effects are considerably harder to measure than static effects.

19 For such an understanding of dynamic integration effects see also Schiff/Winters (1998, p. 179).

− −

11

improvements or enhanced cooperation in research and development (Ohr/Gruber 2001, p. 13). Evidently, this type of dynamic gain will be the greater the larger the share of sec- tors with economies of scale in total output in an integration area.

One might furthermore expect the removal of trade barriers to trigger intensified competi- tion. Monopolies and oligopolies existing prior to integration are, in the face of competi- tion, pressurized to increase their productivity, leading to the reduction of x-

inefficiencies 20 . Additionally, firms will have incentives to pursue process and product innovations (Stehn 1993, p. 5). 21 .

But especially developing countries can also benefit from foreign research and develop- ment (R&D). Coe et al. have found that trade is an important vehicle of technological spillovers (1997, p. 147). Specifically, this can happen through the import of larger varie- ties of intermediate products and capital equipment, enhancing the productivity of a country’s own resources, as well as through cross-border communication and learning, and the copying and imitation of foreign technologies (Coe et al. 1997, p. 136). The second channel through which growth may be fostered is investment. For developing countries the role of foreign direct investment (FDI) is of particular importance. FDI serves as a harbinger of confidence and, secondly, as a means of modernizing the econ- omy (Schiff/Winters 1998, p. 180). Here, the potential of FDI to transfer production know-how, technology and managerial skills is well recognized. Additionally, spillover effects to other firms can be expected. In developing countries technological progress usually accounts for a relatively small proportion of growth, because the conduct of re- search and development (R&D), and thus the generation of new knowledge, is con- strained by a low volume of human capital and adequate skills. FDI, as well as trade, can

bridge this gap by importing the lacking skills. 22 This finally enhances the marginal pro- ductivity of the host countries’ capital stock and thus promotes growth (Balasubramanyam et al. 1996, pp. 6-7).

Unfortunately, theory does not convey a very clear picture of how FDI flows will be af- fected by regional integration. Traditionally, trade and capital movement in form of for- eign investment have been regarded as substitutes, making FDI a device for “tariff-

20 X-inefficiencies are inefficiencies that result from slack within the firm if available resources are not used efficiently.

21 One example demonstrating such positive effects is the European Common Market, founded in 1958, where strong diversionary effects seemed likely – however, a large increase in intra-industry trade in manufactures and a rationalization of production resulted (Krugman 1991b, p. 13).

22 However, imported skills and technologies are still property of the foreign entity. Hence the benefit of FDI also depends, among other things, on the ‘absorptive capacity’ of firms in the host country (Kinoshita 2000, p. 1).

− −

12

jumping”. One may hence reason that regional integration leads to decreasing FDI from bloc partners for whom the tariff reduction makes the trade option more attractive (Blomström/Kokko 1997, p. 5). This argument is, for instance, valid for horizontally or-

ganized multinational enterprises (MNEs) 23 . However, investment in developing coun- tries is often based on the use of differential factor endowments, such as the abundance of unskilled labor, presuming the predominance of vertical MNEs (Waldkirch 2002, p. 2). Further, a trade-creating RIA could entail shifts in production structures which may

result in additional intra-regional FDI (Blomström/Kokko 1997, p. 5). 24

FDI from third countries could be expected to increase, because the possibility of access-

ing the larger market at low (or zero) tariffs from the internal country presents an addi- tional incentive to invest. Conversely, a reduction of external FDI is thinkable if compa- nies possess horizontally organized subsidiary networks. In the case of integration, such a structure might become sub-optimal and result in a rationalization of the network, lead- ing to disinvestment somewhere in the integration area (Blomström/Kokko 1997, p. 6). Hence, from the trade-barrier motive, it is difficult to draw conclusions, although espe- cially for FDI from third countries the pro-FDI argument seems stronger.

While important, trade-barrier related motives are not the only determinants of FDI. For once it must be recognized that specific investment provisions included in preferential

trade agreements may have a large influence on the development of internal FDI. 25 Their practical relevance, though, depends strongly on the level of preexisting investment bar- riers abolished by the provisions and on the extent of host government discrimination against foreign investors (Blomström/Kokko 1997, p. 9).

Secondly, investor confidence is a prerequisite for access to international capital. Confi-

dence can be provided through the credibility of government reforms. 26 Especially re- forms in developing countries often lack credibility due to time-inconsistent policies

(Schiff/Winters 1998, p. 181). 27 It is therefore worthwhile to explore the relationship be-

23 An MNE is horizontally organized when it produces similar products or services in multiple countries. It is vertically organized when it fragments the production process and distributes various stages of pro- duction over different countries (Aizenman/Marion 2001, p. 2).

24 In this sense, FDI can also be a direct consequence of the static effects of integration. Analytically, how- ever, FDI will be treated as a dynamic phenomenon in accordance with the understanding of dynamics presented (see p. 10).

25 Yet another motive may be the internalization of intangible firm-specific assets (Blomström/Kokko 1997, p. 7). But since these do not help to resolve the relevant debate about the nature of integration- induced FDI, they will not be looked at further.

26 Also, provisions of integration agreements, such as dispute settlement mechanisms, can help to increase the confidence of intra-regional investors (Blomström/Kokko 1997, p. 10).

27 In international trade, problems of time inconsistency can occur if governments are tempted to use sur- prise trade policy actions in the absence of other first-best instruments, resulting in suboptimal equi-

− −

13

tween credibility and regional integration. 28 Fernández/Portes suggest that a RIA can be more efficient than multilateral liberalization under GATT since in the former there are higher incentives to punish members deviating from the rules, and because the intrinsic

incentive to stay within a RIA is stronger than for the latter (1998, p. 205). 29 Two condi- tions for a RIA to enhance credibility in trade policy are, however, that a country’s poli- cies are time-inconsistent prior to the RIA and that the costs of exiting the RIA are higher than the gains of returning to time-inconsistent policies (1998, p. 204). Others have sug- gested that RIA’s can also serve as a commitment device for credibility in other policy areas, such as micro- and macroeconomic reforms (Whalley 1996, p. 16).

In conclusion, regional integration arrangements may incur dynamic effects that poten- tially outweigh static gains from trade, since they can influence a country’s economic growth past the short run and lift a country on a higher growth path in the long run.

2.3 North-South versus South-South Integration

After having discussed static and dynamic effects of regional integration, this section takes on the perspective of developing countries. Which types and which properties of economic integration are more likely than others to have a beneficial impact on them? Developing countries generally possess different factor endowments and economic struc- tures from more advanced economies, the former being rather labor- and natural re- source-intensive, and the latter predominantly capital- and technology-intensive. Consid- ering that developing countries wishing to join a RIA generally have the options of South-South integration (i.e. integration between developing countries) and North-South integration (i.e. integration between developing and industrialized countries), the ques- tion of South-South versus North-South can at least partially be discussed on the basis of integration of rival versus complementary economic structures.

Both constellations receive some theoretical support. According to the Heckscher-Ohlin

theorem 30 , a wealth increase is a function of the difference in the countries’ factor en- dowments that determine the pattern of trade, where gains are the larger the greater these

libria, if the promise not to intervene is not credible. E.g. country may use tariffs to compensate wage differentials across sectors, resulting from a terms-of-trade shock that leads to a productivity loss. The result would be that, in anticipation of the intervention, more workers than otherwise remain in the in- jured sector (Fernández/Portes 1998, p. 203).

28 This link is, among others, explored by Whalley (1996), Francois (1997), and Baldwin et al. (1996). 29 This, however, presumes that the benefits, e.g. from foreign investment, for a country will indeed be higher than in a multilateral liberalization.

30 For a detailed discussion of the Heckscher-Ohlin model see Siebert (1991), pp. 53-78.