Academic journal article Atlantic Economic Journal

Foreign Direct Investment Liberalization between Canada and the USA: A CGE Investigation

Academic journal article Atlantic Economic Journal

Foreign Direct Investment Liberalization between Canada and the USA: A CGE Investigation

Article excerpt

Introduction

On January 1, 1989, Canada and the United States of America (USA) signed a free trade agreement (FTA), the Canadian-United States Free Trade Agreement (CUSFTA). Virtually all tariffs on Canada-USA trade in goods originating in the two countries were eliminated. CUSFTA was incorporated into the North American Free Trade Agreement (NAFTA) in January 1994, which extended the free trade arrangements to Mexico. Almost all tariffs on goods originating in Canada, USA, and Mexico will be eliminated by January 1, 2008. However, barriers to trade in services and foreign direct investment (FDI) remain, particularly in banking and other financial services, and control by a foreigner of a communication services company is precluded.

Fifteen years later and amidst continued controversy about the impacts and benefits for Canada from the two landmark agreements, debates about new initiatives to promote further regional economic integration continue apace. Fuelled by the September 11 terrorist attacks, scenarios are rampant ranging from a selective application of a custom union to particular industries to a full economic union that will include a common Canada-USA currency. In this context and without prejudging the outcome of the debate over deeper integration, which is largely a political decision, it is nevertheless useful to ground the discussion of the economic costs and benefits of further economic integration on as rigorous a basis as possible.

In this paper, we develop a computable general equilibrium (CGE) model to shed quantitative light on the implications of a scenario of deeper economic integration, where the barriers for foreign direct investment are preferentially eliminated. Our model distinguishes between the activities of domestic and foreign-owned firms at the microeconomic level, both in terms of demand and production characteristics, as inspired by similar approaches by Petri (1997) and Verikios and Zhang (2001). The paper proceeds as follows: the next section gives of a brief overview of the impact of Canada-USA CUSFTA and NAFTA to provide a context for the prospect of further economic integration and then we present the model structure of the CGE model; we continue by presenting and analyzing the results, before concluding.

Setting the Context: Assessing the Impact of CUSFTA and NAFTA

Empirical evidence is persuasive that CUSFTA/NAFTA increased trade. Clausing (2001) finds that 54% of the $42 billion increase in USA imports from Canada between 1989 and 1994 was due to the CUSFTA. Treffler (2004) finds that CUSFTA tariff reductions explained most of the increase in imports from the USA in industries whose tariff cuts exceeded 8%, in the 1988-1996 period, though industries with tariff cuts between 4% and 8% were not impacted by the tariff cuts. According to Romalis (2005), the CUSFTA increased bilateral trade by 5.35%. The impact of CUSFTA and NAFTA on foreign direct investment is more ambiguous both theoretically and in terms of empirical evidence. Economic theory of free trade predicts that within the free trade zone, trade creation will promote accompanying investment by firms from partner countries. However, as the need to circumvent tariffs dissipates with free trade, trade could displace inward foreign direct investment from partners. The net effect of these opposite outcomes is uncertain, particularly for Canada, who has relied extensively on USA FDI. Globerman and Shapiro (1999), using 1950-1995 time series data, conclude that CUSFTA and NAFTA increased in Canada's inward and, especially, outward FDI. Feinberg et al. (1998) find that as tariff rates fell, USA multinationals increased their capital and employment in Canada, thus contradicting the view that tariff liberalization would lead to an exit of US firms from Canada. Minas and Scholnick (1998) suggest trade creation and the FDI enhancing effects of the CUSFTA have prevailed over tariff jumping production. …

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