Academic journal article Atlantic Economic Journal

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

Academic journal article Atlantic Economic Journal

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

Article excerpt


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 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 a priori. 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.


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. …

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