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Customs Unions And Foreign Investment: Theory And Evidence From Mercosur’s Auto Industry

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  • Çaglar Özden
  • Francisco J. Parodi
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    Abstract

    This paper demonstrates how regional trade agreements (RTAs) can lead to both foreign direct investment expansion and relocation effects. These two effects, in return, impact the endogenous formation of RTAs. The investment expansion effect results from foreign firms’ ability to serve a larger market from a single facility. The relocation effect occurs due to the firms’ desire to move their initial plants from high-cost member countries to low-cost ones. The relocation effect can overwhelm the expansion effect for the high-cost members and lead to the collapse of socially efficient RTAs. The auto industry in Mercosur is a great example to study these phenomena. Argentina was worried that low-cost Brazil would attract all of the foreign investment and dominate both markets. To convince Argentina to agree to free trade in automobiles (and to Mercosur), the auto sectoral agreement included the Compensated Trade Clause (CTC) which requires each firm to balance its trade between these countries. This mitigates the relocation problem by forcing firms to produce some models in Argentina and entices the governments to sign the RTA..

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    File URL: http://www.bcentral.cl/estudios/documentos-trabajo/pdf/dtbc282.pdf
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    Bibliographic Info

    Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 282.

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    Date of creation: Dec 2004
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    Handle: RePEc:chb:bcchwp:282

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    1. Grossman, G.M. & Helpman, E., 1992. "Protection for Sale," Papers 162, Princeton, Woodrow Wilson School - Public and International Affairs.
    2. Eugene Beaulieu & Annette Hester, 1999. "Regional Trade Agreements, Country Risk and Foreign Direct Investment in Latin America," Working Papers 1999-10, Department of Economics, University of Calgary, revised 02 Jan 1999.
    3. Olarreaga, Marcelo & Soloaga, Isidro, 1998. "Endogenous Tariff Formation: The Case of Mercosur," World Bank Economic Review, World Bank Group, vol. 12(2), pages 297-320, May.
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