The Trade Balance Effects of U.S. Foreign Direct Investment in Mexico

PETER WILAMOSKI AND SARAH TINKLER*

This paper examines the effect of U.S. foreign direct investment (FDI) in Mexico on U.S. exports to and imports from Mexico. The rise of intrafirm exports and imports following U.S. FDI in Mexico suggests that FDI affects trade flows. Empirical estimation proceeds with tests for stationarity and cointegration. The finding of cointegration among the variables leads to estimation of the hypothesized relationships with a vector error-correction model. Impulse response functions and variance decomposition reveal that FDI leads to increased exports and imports during the time period considered. (JEL F21)

Introduction

The 1993 ratification of the North American Free Trade Agreement (NAFTA) is the most visible symbol of the deepening relationship between the U.S. and Mexico. However, earlier bilateral agreements and Mexico's joining the General Agreement on Tariffs and Trade had already moved the two economies inexorably closer.

This relationship poses unique challenges to the U.S. and Mexico. The principle popular concern expressed in the U.S. about NAFTA is that it will export jobs to Mexico, a concern immortalized in Ross Perot's statement that NAFTA would create a "giant sucking sound" as U.S. firms migrate across the border, taking U.S. jobs with them. Indeed, NAFTA does contain provisions to encourage U.S. investment in Mexico, including the establishment of the North American Development Bank to finance Mexico- U.S. projects.

The second major criticism of NAFTA is related to the first. Critics contend that NAFTA will worsen the U.S. trade balance because additional investment in Mexico, coupled with the elimination of tariffs, will increase U.S. imports from Mexican affiliates of U.S. firms. Also, a greater Mexican industrial base might reduce the demand for U.S.- made goods in Mexico. On the other hand, those supporting NAFTA suggest that the removal of barriers to investment will allow U.S. firms to establish a presence in the Mexican market. This would increase their sales and require the Mexican subsidiary to import inputs from the U.S. parent firm and capital goods from unaffiliated U.S. firms.

This paper examines the effect of U.S. FDI in Mexico on U.S. trade. The second section explains how FDI may affect trade flows. The third section reports the growth of aggregate and sector-level U.S.-Mexico trade and FDI. The fourth section presents estimates of the effects of U.S. FDI in Mexico on both aggregate U.S. exports and

*Weber State University--U.S.A.

24

WILAMOSKI AND TINKLER: FOREIGN DIRECT INVESTMENT 25

imports and intrafirm trade using classical regression techniques. Empirical estimation proceeds with tests for stationarity and cointegration. Impulse response functions and variance decomposition are utilized to reveal the dynamic effect of FDI on exports and imports. The fifth section concludes this paper.

FDI and Trade Flows

Theoretically, FDI and exports can be substitutes [Mundel, 1957] or complements [Markusen, 1983; Helpman, 1984] and the effect on imports cannot be predicted apriori. Table 1 summarizes several ways FDI can affect exports and imports. If FDI substitutes Mexican for U.S.-manufactured goods for sale in the Mexican market, then U.S. exports will fall. However, exports will rise if Mexican production requires inputs from the U.S. parent or unaffiliated firms. U.S. exports of inputs will rise if lower Mexican production costs raise Mexico's demand for the multinational corporation's (MNC) product [Blomstrom et al., 1988]. Also, if the MNC's Mexican market grows due to falling production costs, then a market for the MNC's higher-end, home-produced goods may arise. Imports may rise or be unaffected by U.S. FDI in Mexico.

TABLE 1 Possible Relationships Between FDI and Trade

Effect on Home Nation

FDI Activity Exports Imports

Host nation production requires home nation capital goods.

Host nation affiliate production requires inputs from parent firm.

Host nation is a low-cost source of production for sale in host nation (substituting for home production).

Host nation is a low-cost source of production for sale in home nation (substituting for home production).

Parent has unexportable firm-specific advantages (FDI raises demand for parent firm's product).

Host nation affiliate production raises demand for higher-end products from home nation.

As host nation supplier network grows, inputs from parent firm decrease. Transfers of technology and management skills increase competitiveness of host nation f'Lrms.

FDI raises host nation growth rate.

positive

positive

negative

positive

positive

negative

negative

positive

positive

positive

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The effect of FDI on exports has been examined by Orr [1991], Blomstrom et al. [1988], Pfaffermayr [1994], and Lin [1995]. Only Orr examined the trade balance effects of inward FDI to the U.S. For the U.S., he suggests that FDI improves the competitiveness of U.S. firms in both U.S. and international markets. He finds an elasticity of U.S. aggregate exports to FDI of .21 which suggests that FDI in the U.S. during the late 1980s raised U.S. exports by roughly 20 billion dollars over the long term.

Orr hypothesized that inward FDI should lead to lower U.S. imports, but, empirically, an increase in FDI appears to raise aggregate imports even after several years. However, this finding does not hold up at the industry level. For example, Orr finds that FDI in the U.S. auto industry initially raised the trade deficit as imports of capital goods and parts offset the reduction in imports of finished automobiles. However, after four years, FDI led to a trade surplus in automobiles as imports of capital goods and parts fell and domestic content rose.

Orr's findings suggest that U.S. FDI in Mexico may initially raise U.S. exports and improve the U.S. trade balance. However, Mexico's imports of U.S. goods may eventually fall and U.S. imports from Mexico may eventually rise. Total U.S. exports could rise if the U.S. parent would ship inputs to Mexico for final assembly before shipment back to the U.S. and if lower production costs in Mexico create a larger U.S. market for the good than would otherwise exist.

The Growth of U.S.-Mexico FDI, Exports, and Imports

Table 2 shows the growth of aggregate U.S. merchandise exports to and imports from Mexico as well as aggregate U.S. FDI. Growth in trade and investment has been steady since the late 1980s when Mexico joined the General Agreement on Tariffs and Trade and began unilaterally dismantling its external barriers. U.S. merchandise exports increased dramatically to about 50 billion dollars by 1994. From 1988 to 1994, growth of U.S. merchandise exports and imports averaged about 25 percent and 17 percent a year, respectively. The U.S. ran trade deficits with Mexico from 1982 to 1990 but began a series of trade surpluses in 1991.

TABLE 2 U.S. Merchandise Exports and Imports and FDI in Mexico (in Billion Dollars)

Year Exports Imports Total FDI* Total U.S. FDI** U.S. Share***

1980 15.146 12.835 8.46 5.99 .690

1981 17.789 14.013 10.16 6.96 .680

1982 11.817 15.770 10.78 5.54 .680

WILAMOSKI AND TINKLER: FOREIGN DIRECT INVESTMENT

TABLE 2 (CONT.)

27

Year Exports Imports Total FDI* Total U.S. FDI** U.S. Share***

1983 9.082 17.019 11.47 4.99 .663

1984 11.992 18.267 12.90 4.59 .660

1985 13.365 19.392 14.62 5.07 .673

1986 12.392 17.558 17.10 4.82 .648

1987 14.582 20.502 20.90 4.93 .655

1988 20.473 23.534 24.10 5.69 .621

1989 24.969 27.590 26.60 7.34 .631

1990 28.375 30.797 30.30 9.36 .629

1991 33.276 31.866 33.90 11.57 .634

1992 40.598 35.886 37.0t 13.33 .617

1993 41.635 40.745 40.5t 14.14 - -

1994 50.840 50.356 43.8t 16.37 - -

Notes: * denotes Mexican FDI figures from the General Directorate of Foreign Investment [ SeCoFI, 1994] and adapted from NAFTA andForeign Investments in Mexico [Ortiz, 1994]. ** denotes data for U.S. FDI in Mexico from the Survey of Current Business [U.S. Department of Commerce, various issues]. *** denotes U.S. share of FDI in Mexico from the General Directorate of Foreign Investment [SeCoFI, 1994]. The figures are not consistent with the Survey of Current Business figures as SeCoFI reports much higher U.S. FDI in Mexico. For 1991, SeCoFI reports cumulative U.S. FDI as 21 billion dollars and the Survey of Current Business reports cumulative U.S. FDI as 11.57 billion dollars, t denotes the estimate is based on U.S. FDI in Mexico and U.S. share of FDI in Mexico.

In 1989, regulations concerning FDI were significantly liberalized to allow up to 100 percent foreign ownership if certain criteria are met [Lustig, 1992].1 NAFTA extends the areas of permissible FDI and protects foreign investors with a dispute settlement mechanism. Mexican (Banco de Mexico and SeCoFI) and U.S. (Bureau of Economic Analysis) statistics for U.S. FDI in Mexico differ but, by any measure, FDI soared in the early 1990s.

To what extent has FDI driven trade? Table 3 shows total U.S. FDI exports and imports as well as FDI exports and imports for U.S. multinationals and their Mexican affiliates in specific sectors. Trade between U.S. parents and their Mexican affiliates grew more rapidly than arms-length trade, suggesting that part of the rise in U.S.-Mexico trade is the result of earlier FDI by U.S. f'Lrms in Mexico. U.S. MNC's intrafirm trade accounted for 28 percent of U.S. exports to Mexico and 24 percent of U.S. imports from Mexico in 1992- -up from 23 percent and 20 percent, respectively, in 1983.

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TABLE 3 FDI by Manufacturing Sector and Intrafirm Exports and Imports

(in Billion Dollars)

FDI Exports Imports

Sector 1983 1992 %A 1983 1992 %A 1983 1992 %A

Total 4.990 13.330 167.0 2.187 11.867 442 1.893 10.817 462

All Manufacturing 3.680 9.281 152.0 2.067 8.916 331 1.853 8.396 353

Food .298 1.340 349.0 .008 .114 1,325 .006 .077 1,183

Chemicals .763 1.949 251.0 .090 .234 160 .014 .065 364

Metals .503 .350 -30.4 .025 .021 -16 .006 .037 502

Machinery .281 .435 54.8 .073 .332 354 .031 .307 912

Electronics .349 .610 74.7 .978 2.534 163 .954 2.552 167

Transportation .490 2.533 421.0 .519 4.700 805 .442 4.539 927

On average, 68 percent of the output of U.S.-owned Mexican subsidiaries is sold locally with considerable variation at the industry level. In the case of food and like products, 99 percent of output is sold locally while in electronic equipment nearly 100 percent of output is exported to the U.S. Eventually, U.S. exports of finished goods might fall as industries other than food and like products make inroads in the Mexican market.

Estimating the Trade Balance Effects of FDI

How does U.S. FDI in Mexico affect trade? Aggregate trade and trade between U.S. MNCs and their Mexican affiliates are both examined using annual data and classical regression analysis. 2 To test for properties of stationarity, estimates of the effect of FDI on aggregate trade flows are made using quarterly data. 3 The following model is estimated with all variables expressed as logarithms and in real terms:

S t = X 1 + x2Yt , raex + x3Rt+ x 4 F D I t + x s ~ C F D l t _ I + u t , (1)

M t = m 1 + m2Yt , us + m 3 R t + m 4 ~ C F D I t _ I + u t , (2)

where: X t is U.S.-manufactured exports to Mexico; M t is U.S.-manufactured imports from Mexico; Yt, i is gross domestic product (i is country) with expected sign of x 2, m 2 > 0 ; R t is real exchange rate with expected sign of x 3 > 0 and m 3 < 0; F D 1 t is

WILAMOSKI AND TINKLER: FOREIGN DIRECT INVESTMENT 29

U.S. FDI in Mexico in year t with expected sign of X 4 .9, and C F D I t is cumulative U.S. FDI in Mexico to year t with expected sign of x s , m 4 .9. Current FDI captures U.S. exports of capital to Mexico and the inclusion of past values of cumulative FDI (CFDI) allows for lag effects between FDI and subsidiary production.

Table 4 presents ordinary least squares (OLS) estimates of (1) and (2) using annual data from 1977 to 1994, correcting for serial correlation. Mexican and U.S. sources give different figures for U.S. FDI. Both measures were initially used to estimate the equations, but the results were qualitatively similar, so only the results based on U.S. measures of FDI are reported.

TABLE 4 Trade Balance Effects of FDI on Aggregate and Intrafirm Trade: 1977-94

Explanatory Variable

Aggregate Intrafirm

Exports Imports Exports Imports

(1) (2)

Intercept 16.280 21.350 -.615 -.470 -6.170 (1.720) (2.380) (-.450) (-.110) (-1.050)

Mexican GDP 4.070 3.970 .889 (1.430) (1.250) (.670)

U.S. GDP 1.480 3.460 (4.130) (3.470)

Real Exchange Rate 1.430 1.290 .077 .445 -.290 (2.980) (2.630) (.490) (1.667) (-3.260)

FDI Flow .116 .091 .085 (1.880) (1.590) (1.620)

CFDI (-1) .662 2.340 .353 -.420 (1.760) (3.500) (3.410) (-.850)

CFDI (-2) -1.670 1.520 (-2.690) (3.150)

R 2 .996 .956 .992 .984

DW 2.090 1.690 2.120 1.940

.467 (1.990)

.991

2.060

Notes: All variables are entered in logarithmic form, therefore, the coefficients are elasticities. The t-statistics are reported in parentheses. All equations are corrected for serial correlation. DW denotes the Durbin-Watson test. GDP denotes gross domestic product.

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Coefficients display the expected signs and are inline with prior estimates. Both the real value of the peso and Mexican GDP raise U.S. exports. At the aggregate and intrafirm level, there is a small positive relationship between current FDI and U.S. exports. This is consistent withthe hypothesis that investment in Mexico requires U.S. capital goods. CFDI raises aggregate U.S. exports after one year but lowers them after two years. No effect of FDI on exports is found after two years. The net effect on exports is positive though small. These findings suggest that FDI will eventually lower U.S. exports as Mexican content rises. The exchange rate appears less important for intrafirm exports than for aggregate exports, and the positive effect of CFDI on exports to subsidiaries comes after two years.

The sum of the coefficients on CFDI for total U.S. exports to Mexico (.67) indicates that FDI has a small positive effect on total U.S. exports to Mexico. The 7 billion dollars increase in U.S. FDI from 1990 to 1994, along with the elasticity of exports to FDI of .67, suggests that exports to Mexico were about 4.5 billion dollars higher because of the increased FDI. Total exports were more than 50 billion dollars, so FDI raised exports by about 8 percent and can explain about 25 percent of the 22 billion dollars increase in exports during that time.

The results for imports indicate that U.S. FDI to Mexico will raise U.S. imports from Mexico after one year. The coefficients are not statistically different for aggregate imports and intrafirm imports. The FDI coefficient of.35 suggests that, as a result of the 7 billion dollars increase in FDI from 1990 to 1994, U.S. imports were about 2.5 billion dollars higher than they would otherwise be. Also, increased FDI can explain about 8 percent of the 20 billion dollars increase in imports over that period. The results for aggregate exports and imports indicate that the net trade balance effect of FDI between the U.S. and Mexico is slightly positive.

These estimates, as well as those of Orr [1991], Blomstrom et al. [1988], and Lin [1995], were obtained by estimating conventional trade models without considering the stationarity properties of the relevant time series. If the variables are not stationary, this method will generate spurious results, that is, test statistics that are biased toward finding significant relationships that do not exist. To overcome this problem, Pfaffermayr [1994] examines FDI and Austrian exports using vector autoregression (VAR) analysis.

To test for stationarity and the order of integration of the relevant time series, augmented Dickey-Fuller tests (ADF) are applied. If a group of variables is integrated of order one, that is, they are stationary only in first differences, then it is necessary to test whether the group is cointegrated before estimating a VAR in first differences. A model estimated in first differences removes common influences but also information about long- run relationships among the variables. A group of nonstationary variables will be cointegrated if some linear combination of them is stationary.

The long-run cointegration relationships can be estimated and used as cross-equation restraints in VAR models, making them vector error-correction (VEC) models. To test for cointegration, the ADF and DW tests are applied to the residual series obtained from estimating the long-run relationship in levels.

W I L A M O S K I AND T I N K L E R : F O R E I G N D I R E C T I N V E S T M E N T 31

Because exports may cause FDI, as well as FDI causing exports, VAR analysis is useful since it treats all variables symmetrically. To determine if feedback effects exist, the dynamics of the adjustment process must be identified by estimating a VAR model and using the innovation accounting techniques of VAR analysis to measure the speed and strength with which one variable responds to shocks arising with another. Innovation accounting is undertaken using impulse response functions and variance decompositions. 4 ADF unit root tests of the stationarity of the time series in levels and differences on quarterly data from 1977 to 1994 for aggregate U.S.-Mexico exports and imports reveal that all the series are nonstationary in levels but are stationary in first differences.

Estimation continues with the two-step methodology developed by Engle and Granger [1985]. In step one, the hypothesized relationship (the cointegrating regression) is estimated in levels using OLS without any dynamic components, providing estimates of the long-run effect on trade of the explanatory variables. The residuals from this regression are tested for stationarity using the ADF and DW tests. Both equations were tested for cointegration and these results are reported in Table 5. The ADF test statistics exceed the critical value, rejecting the hypothesis of no cointegration for both exports and imports with respect to FDI.

TABLE 5 Cointegration Test

Explanatory Variable Exports Imports

Mexican GDP .845 (4.32)

U.S. GDP 1.41

FDI 1.79 (18.70) 2.12

Real Exchange Rate 1.21 (9.34) -.42

Constant -14.81 (-6.31) -8.53

ADF t-statistic -2.68

MacKinnon Critical Value* -2.58

DW t-statistic** 1.46

-2.72

1.22

(2.27)

(7.42)

(-2.52)

(-5.69)

Notes: * and ** denote null of no cointegration is rejected at 10 and 5 percent levels, respectively.

The analysis proceeds with a two-equation VEC model for exports and CFDI and for imports and CFDI. A VEC model is, in essence, a VAR model that incorporates an error- correction term which, here, is the residual series from the cointegrating equation, lagged one period. The inclusion of an error-correction term in a VAR model allows the

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estimated model to reflect long-run equilibrium constraints while, at the same time, permitting flexibility in the short-run dynamics captured by the VAR.

The real exchange rate and GDP are taken as exogenous. The Akaike information criterion is used to identify the proper number of lags. Granger causality tests are conducted using the lag specification determined in the VEC analysis to determine the nature of the relationship between FDI and exports and FDI and imports. The null hypotheses (that exports are not Granger-caused by FDI and that imports are not Granger- caused by FDI) are both rejected at the 5 percent level. The test results also indicate a bidirectional relationship, that is, exports and imports both help explain FDI.

To assess the effect of FDI on exports and imports, the analysis proceeds by examining the impulse response functions and variance decompositions of the system. The results of the impulse response functions are traced out in Figures 1 and 2. The impulse response function for the effect of a one-unit innovation to FDI on exports indicates a small positive effect that continues for two years before tailing off. The effect of FDI on exports, again, turns slightly positive after 13 quarters. The dynamics revealed by the impulse response function suggest that the effect of new FDI on U.S. exports of capital goods and production inputs to U.S.-owned manufacturing subsidiaries is complete within two years.

FIGURE 1 Response of U.S. Exports to a One-Standard Deviation Innovation in FDI

0.07

0.06

0.05

0,04

0.03

0.02

0.01

0.00

Y

The small positive effect witnessed after three years suggests that, over time, U.S. FDI raises Mexican income and supports the growth of new Mexican firms needing U.S. inputs. 5 The cumulative response after eight quarters to an innovation in FDI is about a

WILAMOSKI AND TINKLER: FOREIGN DIRECT INVESTMENT 33

.345 standard deviation change in U.S. exports to Mexico and, after 16 quarters, is about

.475. Over the sample period, the standard deviation for CFDI was about 4 billion dollars. For exports, it was about 15 billion dollars. Back-of-the-envelope calculations suggest that the 7 billion dollars increase in FDI to Mexico from 1990 to 1994 accounts for about 11 billion dollars of extra U.S. exports, explaining about 50 percent of the 22 billion dollars in increased exports over that time. These estimates are higher than those found using the long-run elasticities from Table 4.

FIGURE 2 Response of U.S. Imports to a One-Standard Deviation Innovation in FDI

0.06

0.04.

0.02.

0.00

-0.02

/

. . . . . . . . . . 1 - 2 ' ' ' 2 4 6 8 10 14 16

The variance decompositions are reported in Tables 6 and 7. SE represents the forecast error of exports and imports at points in the future. The percentage of the variance due to innovations in. trade and FDI is also given. For exports, FDI explains a rising portion of the forecast error, reaching 28 percent after one year and 32 percent after two years. 6

The impulse response function for U.S. imports indicates that, following an innovation in FDI, initially, there is almost no effect on imports. However, after two years, there is a steady, positive effect that reaches a cumulative value of about .45 after four years. The variance decompositions for imports reveal that almost none of the forecast error can be explained by FDI after eight quarters, but, by the 16th quarter, more than 40 percent of the variation in the forecast error is caused by innovations in FDI. Again, back-of-the- envelope calculations indicate that the rise in FDI from 1990 to 1994 of 7 billion dollars suggests an increase in imports of more than 10 billion dollars out of the total increase in imports of 20 billion dollars over that period. When the results for imports are viewed along with the impulse response function for exports, they suggest that the effect on the

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U.S. trade balance with Mexico is positive for the first two years. However, gradually rising imports reduce the positive effect of exports, leaving net exports unchanged. This result is different from that found using the elasticities reported in Table 4 which concluded that FDI would improve the U.S. trade position with Mexico.

The Granger-causality results and the impulse response functions reveal that both exports and imports positively affect FDI. This result is not surprising given that 60 percent of new FDI into Mexico is in retailing and wholesale distribution. Rising export sales provide an incentive for U.S. firms to invest in better distribution networks for their products.

TABLE 6 Variance Decompositions: Exports

Variance Decomposition of Exports

Period SE Exports FDI

Variance Decomposition of FDI

SE Exports FDI

1 .082380 98.06023 1.93977 .013721 0.00000 100.00000

2 .130504 85.41642 14.58358 .020971 2.43643 97.56357

3 .163323 77.26559 22.73441 .027903 13.53984 86.46016

4 .188303 72.13344 27.86656 .036742 21.84510 78.15490

5 .207405 71.00482 28.99518 .044043 25.73601 74.26399

6 .222006 68.87857 31.12143 .050145 29.06322 70.93678

7 .233623 68.97745 31.02255 .055030 31.51119 68.48881

8 .237072 68.69030 31.30970 .059328 34.86454 65.13546

9 .239309 69.02928 30.97072 .063634 38.33583 61.66417

10 .240899 69.22632 30.77368 .067580 41.19720 58.80280

11 .242071 69.39342 30.60658 .071458 43.77337 56.22663

12 .242914 69.25094 30.74906 .075597 46.17462 53.82538

13 .244128 69.27351 30.72649 .079719 47.83714 52.16286

14 .245474 68.88067 31.11933 .083876 49.10171 50.89829

15 .247831 68.45000 31.55000 .087791 49.91830 50.08170

16 .250190 67.67783 32.32217 .091363 50.46065 49.53935

Notes: Ordering is log of cumulative foreign direct investment (LCFDI) and log of U.S. exports to Mexico (LUSX).

WILAMOSKI AND TINKLER: FOREIGN DIRECT INVESTMENT

TABLE 7 Variance Decompositions: Imports

35

Variance Decomposition of Imports Variance Decomposition of FDI

Period SE Imports FDI SE Imports FDI

1 .09 98.04 1.96 .01 0.00 100.00

2 .11 98.60 1.40 .02 2.15 97.85

3 .12 98.04 1.96 .03 14.07 85.93

4 .12 98.08 1.92 .04 20.50 79.50

5 .13 98.16 1.84 .05 23.28 76.72

6 .14 96.63 3.37 .06 26.57 73.43

7 .14 96.43 3.57 .06 28.00 72.00

8 .15 93.08 6.92 .07 29.31 70.69

9 .16 87.87 12.13 .08 30.31 69.69

10 .16 83.64 16.36 .08 30.25 69.75

11 .17 78.71 21.29 .09 29.73 70.27

12 .18 73.53 26.47 .10 28.99 71.01

13 .19 69.11 30.89 .11 27.91 72.09

14 .20 64.29 35.71 .11 26.77 73.23

15 .20 60.13 39.87 .12 25.63 74.37

16 .21 56.30 43.70 .13 24.46 75.54

Notes: Ordering is log of cumulative foreign direct investment (LCFDI) and log of U.S. imports from Mexico (LUSM).

Summary

Opponents of NAFTA were concerned that trade and investment liberalization between the U.S. and Mexico would cause U.S. jobs to migrate to Mexico. This paper has indirectly examined that question by addressing the effects of U.S. FDI in Mexico on trade flows. The empirical results presented here suggest that U.S. FDI in Mexico raises total U.S. exports to and imports from Mexico. Results from traditional OLS estimates indicate a small positive effect on the U.S. trade balance with Mexico from increased FDI, but the contribution to exports and imports is relatively small compared to other determinants of trade.

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To ensure that the empirical results generated by classical regression procedures are not spurious, stationarity tests and VAR analysis are conducted to examine the relationships among the variables. The results of Granger-causality, impulse response analysis, and variance decompositions reveal information about the relationship between trade and FDI not found in the OLS analysis. Impulse response functions, which allow the dynamic nature of the relationship between FDI and trade to be observed, show that the positive effect on exports is complete within a couple of years, while the effect on imports does not begin for a couple of years. Given similarities in the size and growth of exports and imports over the sample period, the impulse response function results suggest, first, that FDI explains a substantial portion of the rapid increase in trade between the two nations and, second, that the initial, small positive effect on the U.S. trade balance with Mexico resulting from new FDI will diminish over time.

Footnotes

1. Prior to 1989, FDI in Mexico was regulated by the 1973 Law to Promote Mexican Investment and Regulate Foreign Investment which created four categories of activity: 1) activities reserved exclusively to the Mexican state (for example, petroleum); 2) activities reserved exclusively to Mexicans (television, transportation, and forestry); 3) activities in which foreign investment was subject to percentage limitations ranging from 0

percent to 49 percent foreign ownership (for example, automobile components); and 4) activities where foreign ownership could not exceed 49 percent. In 1984, the Guidelines for Foreign Investment and Objectives for Its Promotion [United Nations, 1992, p. 14] was issued to encourage foreign investment in activities that were oriented toward exports or that required high investment requirements per person-hour.

2. Data on aggregate U.S. exports to and imports from Mexico are from the Direction o f Trade Statistics [International Monetary Fund, various issues]. Data for trade between U.S. multinationals and their affiliates are from the Survey o f Current Business [U.S. Department of Commerce, various issues].

3. On a quarterly basis, U.S.-Mexico trade statistics are created from data on aggregate exports and imports for Mexico, adjusted for the share of U.S.-Mexico trade over the period 1977:1- 1994:3 (fromInternational Financial Statistics [International Monetary Fund, various issues)]

4. An impulse response function will separate the determinants of a change in exports or imports into innovations that can be identified with FDI. It traces the effect on current and future values of exports or imports of a one-standard deviation change in the innovation. In this case, it is the change in FDI. Forecast error variance decompositions reveal the proportion of movement in a variable due to its previous values and the proportion that can be attributed to some other variable. Developing an impulse response function requires the imposition of an identification restriction through a Cholesky decomposition which constrains the system so that, in a two- equation system ofx and y for a particular ordering, a one-unit innovation to x t will affect x and y, but a one-unit shock to Yt will only affect y. A different ordering will change the effect of a one-unit innovation to x t and Yt on x and y and will result in a different impulse response function. Theory could be used to determine the ordering, but the ordering does not matter if the correlation coefficient between the error terms in each equation is low (less than .2). If the correlation coefficient is large, however, the impulse response function from each potential ordering should be obtained and the results compared. In this case, the ordering of the

.

6.

WILAMOSKI AND TINKLER: FOREIGN DIRECT INVESTMENT 37

variables does not appear to matter. The reported results use an ordering of FDI and then exports or imports in calculating the impulse response function. Estimates using FDI flows rather than CFDI resulted in the effect of FDI on exports falling to zero after 10 periods (results available from the authors). A long-run model treating GDP and the exchange rate as endogenous variables was also found to be cointegrated and a VEC model estimated. The impulse response function between exports and FDI was strikingly similar to that reported in Figure 1. However, the variance decomposition, including the new endogenous variables, showed that FDI explained a much smaller portion of the forecast error in exports (7 percent) with GDP and the exchange rate explaining the difference (results available from the authors).

References

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