United States Foreign Direct Investment into Canada: An Empirical Analysis with Emphasis on the Free Trade Hypothesis
Peter J. Buckley, Jeremy Clegg, Nicolas Forsans and Kevin T. Reilly
Contact Author and Address: Nicolas Forsans Centre for International Business University of Leeds (CIBUL) Maurice Keyworth Building Leeds LS2 9JT United Kingdom 44-(0)113-233-4497 44-(0)113-233-4465 (FAX)
[email protected] (E-Mail)
June 2000
Peter J. Buckley is Professor of International Business and Director of CIBUL, Jeremy Clegg is Jean Monnet Senior Lecturer in European Integration and International Business Management in CIBUL, Nicolas Forsans is Foundation for Management Education (FME) Research Fellow in International Business in CIBUL, Kevin T. Reilly is Lecturer in Economics at Leeds University Business School, University of Leeds.
United States Foreign Direct Investment into Canada: An Empirical Analysis with Emphasis on the Free Trade Hypothesis
Abstract: In the tradition of Raymond Vernon’s work, this paper examines the effect of regional economic integration on the foreign direct investment (FDI) decision of US multinationals in Canada. We present improvements to the modelling of the labor and foreign exchange markets. In particular, we move beyond the traditional use of manufacturing wages and introduce labor cost and productivity variables for the host economy, and include a measure of instability in the exchange rate. Using these innovations we focus on the period 1961 to 1998. We find that a relatively parsimonious expansion of our improved specification allows us to capture the effect of the introduction of CUSFTA and NAFTA, suggesting a significant growth in US FDI into Canada. Given that one of the possible incentives for regional integration is to bolster a declining share of FDI, on the findings of this research, it appears that integration has conferred on Canada a means of re-establishing a measure of influence over US MNEs’ global investment decisions.
June 2000
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INTRODUCTION The threats of globalisation are well recognised by both home and host countries. They arise from the challenge to the ability of the nation state to secure and retain its desired share of world investment, income, employment and growth (Vernon, 1998). With the secular decline of traditional trade barriers, countries have had to seek new means of attracting inward foreign direct investment (FDI), and of holding on to the investment expenditure of their home-grown multinationals. The changing nature of the relations between multinational firms (MNEs) and governments is nowhere better exemplified than in the rise of economic regionalization as tool to mitigate the threats and to exploit the opportunities of globalisation. Regionalization appears to be “a regional counter to globalization” (Rugman, 2000, p.96). The trade and investment models of the 1960s, including notably the Product Cycle Model of Raymond Vernon (Vernon, 1966), emphasised the importance of market size and income levels for attracting FDI. This pioneering work has been incorporated as a central hypothesis in explaining FDI between developed countries. Vernon’s later work encapsulated the market structural determinants of the FDI decision (Vernon, 1971) against the backdrop of multinationals attempting to increase market share at the national level. During the 1980s, the central role of national market size has given way to the key role of the regional economy, as competition for global direct investment has intensified. Growing numbers of countries choose to co-operate on a regional basis in order to provide an environment favourable to MNEs. By embracing regional economic integration, many countries have effectively made absolute market size endogenous, thereby exploiting the theoretical relationship with FDI identified by Vernon (1966). The market size hypothesis can be taken one step further in the context of regional economic integration. In the context of an expanding market engendered by regional economic integration, firms have an incentive to enter this market to become insiders, to
2 operate on a pan-regional basis, and to influence the evolution of regional integration in their favour. This moves the market size variable beyond its traditional role of capturing economies of scale to playing a more strategic role in the FDI decision. The Canadian market in particular has been the subject of a long literature emphasising the industrial organisation aspects of inward FDI (e.g., Baumann, 1974; Caves, 1974; Horst, 1972). Trade and investment barriers segment national markets and limit international interaction between potential rivals, who are often domestic oligopolists operating under conditions of scale economies. Barriers removal can be expected to have a similar effect to the breakdown of international collusion. In these circumstances, analysed in the oligopolistic product cycle model (Vernon, 1971) and by Casson (1987), rivalistic and defensive foreign market entry via FDI is likely to occur in order to prevent the growth of competition in the foreign market. This more assertive view of MNEs and FDI contrasts sharply with the 1960s and 1970s view of MNEs responding slavishly with trade barrier-jumping FDI to host country protection. This explanation of MNE behavior has become less and less plausible with each round of GATT-WTO negotiations. Further, if FDI were entirely motivated by trade barriers, when these barriers come down FDI would be expected to decline. However, there is little support for this view of present-day FDI. For instance, Dunning (1997a and 1997b), in his examination of European integration, finds no evidence of a positive correlation between the reduction in common external trade barriers and FDI into the European Union. It seems more likely that trade barrier reduction and market liberalisation through regional integration fosters regionally-integrated investment strategies on the part of firms. Regional integration allows firms to realise potential comparative advantage using their firm-specific ownership advantages (Vernon, 1974). This translates into the categories of reorganisation and rationalised FDI, which flourish when trade barriers decline.
3 With this new configuration of MNE-government relations as its starting point, this paper investigates the significance and importance of regional economic integration for US MNEs' FDI behavior in Canada. We focus on the behavior of American investors, using official Canadian FDI statistics. The US is still by far the most important foreign investor into Canada, accounting for the two-thirds of the stock of FDI in Canada in 1998. We will first review briefly in the next section the theoretical and empirical literature on inward FDI with two goals. First, to improve on the traditional empirical specification with an emphasis on better modelling of the labor market and exchange rate effects on the FDI decision. Second, to examine explicitly the issue of regional economic integration and how best to model its effect on the inward FDI decision. The third section of this paper briefly introduces the data and presents the results of the modelling of inward FDI from the USA to Canada. The results show that it is important to account for the change in the environment brought about by the Canada-United States Free Trade Agreement (CUSFTA) and North American Free Trade Agreement (NAFTA) on inward FDI from the USA. In particular it will be shown that, prior to these agreements taking force, a traditional inward FDI equation performs well, but that failure to control for these policy changes leads to extremely unsatisfactory results. The familiar results for the traditional variables are only observed again when a parsimonious specification of the free trade effect is included in the specification. In the final section we will conclude with what has been learned from this paper.
RESEARCH ON THE DETERMINANTS OF INWARD FDI Market Size and Growth Factors The desired level of the foreign capital stock for any firm is linked to its sales within the foreign market being serviced (whether local, regional or international) via the investment
4 demand function. According to international business theory the representative firm has a choice of method in foreign market servicing. The firm may employ direct exports, production licensed to a foreign firm to which there is no equity relationship, or production by a foreign affiliated firm (Buckley and Casson, 1976, 1981; Dunning, 1977, 1993). As the absolute size of the foreign market share attributable to the firm grows, the cost of local production (FDI or unrelated contract-based production) declines relative to the cost of exporting. Local production is better able to avoid the naturally-occurring transport costs, as well as artificially-occurring trade barriers such as tariffs and non-tariff barriers. In a simple model of the world, a reduction in either type of barrier, e.g., via transport innovation or through a change in trade policy, will tend to reduce the business case for local production and strengthen it for exports. However, CUSFTA and NAFTA contain both trade and investment provisions. Furthermore, the economic and geographical proximity of the USA and Canada, unlike the trans-Atlantic international business characterised by Hymer (1960, 1976) and Vernon (1966), is likely to cause US firms to treat the Canadian market as an extension of their own, albeit segmented to some degree. Indeed, for many US firms in areas bordering Canada, the distance to market will actually be less to the north than to the south. Once the firm has FDI in place, the growth of the host market will tend to generate increases in the FDI stock to service the local demand. In addition to the expansion of existing FDI, firms will switch from low commitment modes of foreign market servicing (e.g., export) to FDI, as market size increases. Therefore, FDI tends to account for an increasing proportion of total foreign sales in the host country the larger the market. An interesting, but relatively unexplored, aspect of the market growth variable is that it may be a key indicator of the approach of sustained economic growth in the business cycle. Market growth may have a character more akin to an expectations variable. Market growth would then herald the appropriate timing for firms to seize investment opportunities that were
5 previously not available, e.g., when commercial conditions change under regional integration. The importance of the business cycle for the growth of FDI is generally acknowledged (UNCTAD, 1992), and in the next section we will see a stark example of this macroeconomic effect1. The lesson to be drawn is that the lag between policy change and impact on FDI will be influenced by the delay to the next upswing in the business cycle. Empirical research on the role of market size factors confirms their place in econometric investigation. For instance, domestic market size, proxied by GNP, in the United States (US) was supported in Hultman and McGee (1988), with FDI and explanatory variables expressed as percentage deviations from trend from 1970 to 1986. A broad study of aggregate investment from all countries into Canada, and to all countries from Canada, for 1951-95 by Globerman and Shapiro (1999), with the quantitative variables in terms of annual first differences, finds real Canadian GDP to have a significant positive sign. To date, most of the empirical research on market size and growth has been focused on explaining inward FDI to Europe. As a UNCTC report (UNCTC, 1992) concludes, FDI appears strongly related to the level of GNP (or GDP) but little evidence emerges of a clear relationship with market growth. Aristotelous and Fountas (1996) found market size to be significant in the 1980s and early 1990s for US and Japanese FDI into the European Union, but found no evidence of the hypothesised effect for market growth. Existing empirical work shows that the influence of the creation of the European Union and subsequent enlargements have probably helped to sustain market size as a leading determinant of FDI flows (Dunning, 1997b). In North America, the creation of CUSFTA and its extension into NAFTA should be expected to reproduce the internal trade creation effects of regional integration in Europe and we consider this effect explicitly in the Free Trade sub-section below.
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Labor Market Factors International business theory has long predicted that labor costs should exert a perceptible effect on the location of production, e.g., as found in Dunning’s eclectic paradigm (Dunning 1977; 1993). In general studies have relied on the use of manufacturing wages to model these labor costs. In spite of this strong theoretical expectation, variables to capture the effect of wage costs frequently fail to achieve significance. Partly this is the result of the inadequacy in the data, e.g., limitations by sector, but it also can reflect inappropriateness in the question being asked. Over time manufacturing FDI has become less important with the general industrial structural transformation towards the service sector in the developed economies. In FDI between economic regions comprising developed countries (e.g., North America to the EU), wages are often of secondary importance as opposed to, for example, FDI in low-wage south east Asian countries. However, within developed economic regions, wage levels combined with productivity levels can again assume importance in determining the location of production between countries, as would be the case between the USA and Canada. It is not then surprising that wage rate variables have a chequered history in empirical research. The reasoning of the eclectic paradigm (Dunning 1977, 1993) drawing on the theory of comparative advantage, suggests that it is relative factor costs that should determine location. This would be true for any production stage of given factor intensity. Employing standard theoretical reasoning on disaggregated data, the ideal variable would seem to be relative wage costs, which are suitable for explaining the locational choice in production, e.g. FDI versus exporting. However, when working with aggregate data on FDI, the correct manner of posing the hypothesis is rather different. The higher the degree of aggregation, the more likely are inconclusive results, as it is relative total production costs that assume the greatest importance. Over the years inconsistently significant or insignificant findings for
7 wages variables have been reported by Dunning and Buckley (1977), Dunning (1980) and Papanastassiou and Pearce (1990) on different datasets. The most successful formulation to date has been achieved by Globerman and Shapiro (1999), explaining aggregate FDI flows into Canada, using the annual first difference in Canada-US relative wages for the manufacturing sector. The literature based on the experience in Europe suggests that existing inward investing firms will engage in rationalised production following regional integration (Dunning and Robson, 1988). This is a process in which MNEs substitute largely identical (horizontally integrated) plants in each state with vertically specialised plants linked through intra-firm trade. The location of investment then becomes more responsive to specific immobile factors because trade in intermediate and final products is less encumbered. These key factors comprise professional, technical and research manpower, and low-cost labor. The inclusion of a labor cost variable without a productivity variable risks disregarding the fact that different production stages require contrasting types of manpower. On its own, a single measure of manpower costs may fail to explain aggregate FDI. Low labor cost locations might attract routine production stages, but they are less likely to attract stages that are intensive in professional skills. Treating the two as one form of investment will tend to generate insignificant results. When employing aggregate data, a wage cost variable specified for the host country for all sectors, run in an equation that includes an average (per worker) productivity variable, offers the best prospect of testing for the role of wage costs in determining FDI. This is the strategy pursued in this paper and it represents an innovation in the modelling of FDI.
Financial Factors A key weakness of much econometric research on the determinants of FDI is the frequent failure to model both the real and the financial character of FDI. In many early
8 studies, FDI was modeled as if it were a real variable, that is, as if the real book value of FDI were truly representative of the capital stock of foreign affiliates. In fact, there are many reasons for believing that FDI values rise and fall because of the financial behavior of multinational enterprises (MNEs) (e.g., Gilman, 1981), without signifying any change at all in the productive capital actually controlled by the parent firms. These fundamental issues were more thoroughly discussed in the earlier literature on FDI and the MNE (notably in Dunning, 1973) and remain relevant to time-series studies such as we are pursuing in this paper. The effect of exchange rates is a case in point. This can be expected for both the optimal capital stock in the host country, and the way that it is financed, e.g., via local borrowing rather through parental equity. Similarly, international differences in the cost of borrowing, especially as between the home and host countries, can be expected to influence the decision to finance FDI via borrowing from the parent (which increases FDI attributable to the parent) versus refinancing via local borrowing (which reduces FDI). The level of the real rate of interest itself also assumes significance (e.g., in the host country) as a macroeconomic factor influencing the aggregate level of investment. In principle, financial factors can raise or lower the optimal real foreign capital stock in the host country, and determine the optimal financial positioning of MNEs. Desired real inflows to the host can be mitigated by opposing financial pressures, or reinforced by confluent ones. Generally researchers focusing on the financial aspects of FDI employ flow data. Although FDI flows can assume negative as well as positive signs, real factors normally dominate to promote the growth of FDI over time. The standard expectation in the literature is that an appreciation in the host country currency relative to the home currency will lead to a decrease in FDI inflows (Cushman, 1985). Stevens (1977) developed three alternative models of FDI behaviour to show that a
9 dollar (US as home country) devaluation could assume either a positive or negative sign. The theoretical impact of the exchange rate on FDI is also complicated by the fact that there are likely to be several simultaneous influences having opposite effects, even for a single firm. As a consequence, it is difficult to make a firm prediction without making an assumption about the dominant character of FDI in question. Market-seeking (import substituting) FDI would associate the host exchange rate negatively with FDI, as a host appreciation would both render imports cheaper in terms of host currency and host assets more expensive in terms of foreign currency, thereby reducing the profitability of FDI (Logue and Willet, 1977; Kohlhagen, 1977). It is probable that the precise strategy of the investing firm largely determines what the effect of the exchange rate will be (Stevens, 1977). It follows that the significance and the sign of the effect of the exchange rate can perform as a diagnostic tool, by telling us something about the nature of FDI in the host country. To date the weight of empirical work has concentrated on the USA as the host country (Bailey and Tavlas 1991; Caves 1990; Cushman 1985; Ray 1989). The evidence suggests a negative sign for a host exchange rate appreciation (Stevens, 1993). However, unusually but pertinent to Canada, Globerman and Shapiro (1999) found that a variable for the annual first difference in the US dollar price of the Canadian dollar positively influenced FDI inflows, pointing to a distinctive relationship between the USA and Canada. Exchange rate instability is commonly viewed as inimical to the promotion of FDI between the economic regions of the world. This view misses the point that from the MNE’s perspective FDI can be an export substituting operation in which the firm is attempting to minimize exchange rate risk (Buckley and Casson, 1998). Empirical research in this area is limited; however, Barrell and Pain (1999) fail to find a significant effect for exchange rate stability on Japanese FDI flows to the European Community. In this paper we will pursue this hypothesis to attempt to add to this body of evidence.
10 Our final financial hypothesis is that if the host country cost of borrowing rises relative to that in the home, then foreign affiliates will tend to reduce their local borrowing and increase their borrowing from the parent firm, thereby increasing the FDI stock and outflow. This behaviour falls within the corporate treasury function of MNEs, and is a mimicking of the behaviour of portfolio investment in the external market, which exploits short-lived international differentials. Most of the impact of interest rate changes on FDI occur within relatively short periods, certainly less than a year, and are temporary, affecting only the timing of FDI flows rather than the eventual amounts of real investment expenditure (Boatwright and Renton, 1975). With annual (e.g., as compared with quarterly) data, much of the variation in this variable is lost. Insignificance of the relevant interest rate spread variable is therefore not surprising, e.g., as found by Culem (1988) for US FDI in the EC. To date little consistent support has been found for this hypothesis, though it remains theoretically important.
The Free Trade Factor The variables to capture the effects of shifts in commercial policy have evolved from the statistical work conducted on FDI into the European Union. This empirical literature is reviewed by Dunning (1997a, 1997b). The CUSFTA and its successor NAFTA, represent the creation of a free trade area rather than a customs union, i.e. there is no provision for a common external tariff. In the earliest work on the European Union, capturing the effect of the ‘tariff wall’ was a preoccupation. However, the hypothesised effect of this ‘tariff wall’ has lost currency over the years. The continued multilateral trade barrier reductions under the GATT provide little evidence of a rising wall (Mayes, 1998). Opinion today inclines to the view that the effect of regional integration on FDI owes more to the internal trade creation effects of barrier reduction than to trade diversion effects (UNCTC, 1992).
11 The two treaties signed by the Canadian and US governments have created a zone in which they are now both insiders in a North American economic zone; in principle this suggests a tangible effect on US FDI into Canada arising from the elimination of trade and investment barriers. Insiders benefit from increased opportunities to rationalise and/or reorganise production across the members of a free trade area according to members’ comparative advantages. They are also able to serve the (expanded) internal market through exports from their home base without being discriminated against by tariff- and non tariffbarriers that still apply to outsiders (Buckley, Clegg, Forsans and Reilly, 2000). A priori this rationalization effect on FDI could result in a positive or negative effect on the stock of FDI. Recent empirical work by Globerman and Shapiro (1999) conclude that CUSFTA and NAFTA have exerted a significant positive effect on the flow of aggregate inward FDI into Canada from all countries. However, as this earlier study combines the stocks of both insiders and outsiders, we can not take this finding directly as a guide for our results. The justification for including a policy change variable in econometric work has been analysed by Dunning (1997b). It is Dunning’s view that in the steady state policy changes impact on FDI by causing shifts in the regular (non-integration) determinants variables in the equation. The only justification for keeping a policy change variable switched on is therefore if the policy change has not yet worked through the regular variables (which may be expected to take several years), or if the policy continues to change. It follows that policy change variables are of most use at the inception of the change, when they are able to capture the effect on the expectations of foreign investors. The formal start of CUSFTA was 1989 and that of NAFTA was 1994. Although the principle feature of NAFTA was the extension of the free trade agreement to Mexico (Rugman, 1994), it nevertheless signified policy change in Canada. As Globerman and Shapiro (1999) point out, the NAFTA added strength to some of the protections of the CUSFTA, e.g., at the state and province levels, regarding national
12 treatment to foreign investors, and they themselves employ a combined CUSFTA and NAFTA policy dummy variable2. For this reason, we maintain our dummy variable at a value of one for 1989 onwards.3.
DATA AND FINDINGS Data Data used in this study was obtained from three sources: (1) Statistics Canada (1999) data on international investment; (2) Statistics Canada’s Cansim database and (3) International Monetary Fund’s (IMF) Statistical Yearbook from various years. The data on US FDI into Canada is from Statistics Canada (1999) and this was converted into 1985 Canadian dollars using the Gross Domestic Product (GDP) deflator reported in the IMF Statistical Yearbook. This was converted into 1985 Canadian dollars using the exchange rate (market rate, period average) reported in the IMF’s Statistical Yearbook. Our GDP numbers were obtained from the IMF Statistical Yearbooks and were converted into 1985 Canadian dollars using the GDP deflator. The Canadian interest rate variable is the yearly average on a three-month Canadian government bond. The US interest rate variable used in calculating relative real interest rate is a three-month Treasury bill rate. For both interest rates they were converted into real interest rates using a GDP deflator. The exchange rate used here is the number of Canadian dollars per US dollars and was obtained from the IMF statistical Yearbook. Our measure of volatility in the exchange rate is the squared deviation from mean exchange rate for the 1960-1998 period. Our measure of labor productivity is real Canadian GDP divided by the number of hours worked for the whole economy. The man-hours data was obtained from the Cansim Data base, item number I605501 (matrix 9471). Labor costs were measured as unit labor cost (at constant prices) for the whole economy and was obtained from the Cansim data base, item number I604001 (matrix 9468). In the case of the
13 man-hours and unit labor costs this information is only available for 1961 to 1998. So the use of these variables required that we drop the 1960 FDI observation at the regression stage. Finally, we chose the implementation year of the Canada-United States Free Trade Agreement to set our dummy variable to be equal to one and this along with an interaction term to capture the lag in business response to the policy change (described below). ******************* Figure One Here ******************* ******************* Figure Two Here ******************* Figure One presents the time pattern of US FDI into Canada between 1960 and 1998. Over this period this capital stock has increased by 131 percent in real terms. However, as the figure makes clear, most of this growth has occurred post 1993 — this short five-year period accounts for almost 82 percent of the growth. This timing suggests that US firms were either slow to react to the change in the trading environment brought about by CUSFTA or that it had no effect on the FDI decision. However, both of these interpretations ignore the fact that there are other factors in the firm’s decision to change its capital stock. In particular if we examine the state of the Canadian economy at this period of time this delayed effect on FDI is perfectly reasonable. Figure Two presents the growth rate in Canadian GDP between 1960 and 1998. As it is clear, at the time of the implementation the Canadian economy was headed into the severe early 1990s recession. Given the limited opportunities in the early implementation period of CUFSTA it suggests that firms will delay FDI decisions until the “market” improves. To control for this possibility masking the effect of the free trade agreements we will interact the dummy variable with the growth rate in Canadian GDP. ******************* Table One Here *******************
14 Table One presents the definition of the variables used in this investigation and the expected directions of the relationships between the dependent and independent variables. ******************* Table Two Here *******************
The Results Table Two presents the results of our attempts to model the stock of US FDI in Canada.4 Column (1) presents the results using a standard specification for the period 1961 to 1984. We chose 1984 as a cut-off because the Canadian economy was at the peak of the last cycle prior to the negotiations and implementation of the Canada-US Free Trade Agreement. During this early time period the traditional model performs well in that four of the seven regressors are statistically significant in explaining the stock of US FDI. Further, in these significant cases we obtain the expected sign on the coefficient. Market size is positively related, as has been consistently found in the literature. Internalisation theory suggests that the larger is the size of market to be served, the more foreign firms will find it economic to replace exporting (and any contractual arrangements) by equity-based involvement, be it wholly owned or collaborative, and to expand existing investments. This result should apply more fully to market-oriented FDI, although we have been unable here to differentiate by type of FDI. The exchange rate results suggest that as the US dollar appreciates against the Canadian dollar, US firms find it more profitable to create or acquire assets in Canada. This is likely to be particularly true for export-oriented FDI, as exports from Canada are then made cheaper in US dollar prices. Also, a depreciation of the Canadian dollar against the US dollar makes the purchase of Canadian assets cheaper in terms of the foreign currency, so a positive sign on this variable is consistent with received economic theory, especially in the case of import substituting FDI. It is perfectly possible that, for some firms, the depreciation of the
15 host currency causes a material depression in the expected remitted earnings of the US parent. In which case the response of the firm would be a reduction in the real desired FDI capital stock. However, our results are net effects, that is net of gross effects that might be pulling in different directions. From a behavioural point of view, it seems that the bulk of FDI is encouraged by a higher home currency value, as surmised by Stevens (1993). The volatility of the exchange rate exerts a positive and strongly significant effect on US FDI. In other words, as currency risk increases, US MNEs increase their FDI operations in Canada. This is as expected, and not a surprising result, as increased volatility encourages US firms to engage in import-substituting FDI to trade in the currency of the local market. Our findings for the exchange rate diverge from Globerman and Shapiro (1999) although they employed first differences rather than the levels we use here. In addition the inclusion of the volatility variable in our equations may result in our obtaining the expected sign for the exchange rate variable. Canadian labor costs have a negative and strongly significant effect on US FDI in Canada. This is most likely to be true of the case for labor-intensive, export-oriented FDI. US firms have the opportunity to relocate segments of the production process in places where inputs, such as the labor force, can be used more efficiently. Although the labor productivity variable is insignificant, its role is to control for the effect of productivity, in order to better observe the significant effect of unit labor costs on FDI. This provides support for the view that even at the aggregate level it is advisable to hold “productivity” constant to generate an effect for the costs variable. The insignificant regressors (growth in GDP and relative interest rates) while unexpected, are not surprising given other researchers’ experience of similar variables. In Column (2) of Table Two we ignore the effect of the free trade agreements and maintain the traditional specification. Unlike column (1) no variable, except the volatility of
16 the exchange rate, exerts any significant impact on explaining the stock of US FDI in Canada. The reason why our model performs so badly is precisely because it fails to capture the impact of free trade in North America. As mentioned earlier in this paper, the trend of US FDI into Canada has changed over the period, with 1993 being the turning point. The stock of US FDI into Canada has increased dramatically since that year. This means residuals have not been captured by this version of our model, because it does not incorporate the changing economic and business environment in Canada. Column (3) presents our results using the free trade dummy and the interaction term to control for business cycle effects on the delay on the decision to invest in Canada. Firstly, we observe that the results obtained on the traditional variables in terms of both size and significance are similar to the results in column (1). When run alongside the traditional determinants of direct investment abroad, our free trade dummy is positive and strongly significant. This demonstrates that US FDI into Canada has been encouraged by the CanadaUnited States Free Trade Agreement, and thereafter by NAFTA. Economic integration between the two countries has led to a significant rise in US FDI in Canada that is not captured by our first model.
CONCLUSION The decline of conventional barriers to trade as a means of protection for domestic industries has provided the incentive for countries to pursue economic integration on a regional basis. Of the developed economies, it was first those of Europe that ventured down this path, seeking to emulate the economic efficiency and power of the USA. Now, in turn North America has embraced the logic of regional integration. But what precisely does this logic deliver in terms of international business?
17 This paper has taken the perspective of Canada, to evaluate to what, in terms of impact on inward FDI, free trade in North America has amounted. The focus on inward FDI from the USA recognises that this is the pre-eminent investor and insider country within North America. An impact on US FDI in Canada would indicate both the success of Canada in stabilising its share of North American investment, and the improvement in US firms’ business expectations of the prospects of higher earnings. These earnings would arise from efficiency gains, much as those sought in the European Union5. We must also remember that an impact on FDI could arise from the creation of a more competitive market. If this market exhibited the hallmarks of oligopolistic interaction and rivalry, exacerbated by overcapacity, then increased FDI would be likely. Unfortunately, it is not possible on aggregate data to investigate behaviour to this level of precision. The stability of our model from 1961 to 1984 demonstrates the existence of an underlying US pattern of FDI behaviour in Canada, predicated upon the USA and Canada as discrete, if contiguous, markets. The inability of this version of the model to explain data covering the entire period 1961 to 1998 was hypothesised to indicate the impact of free trade. The formal inclusion of a variable to capture CUSFTA and NAFTA re-establishes the expected pattern of significance in the underlying model, while demonstrating the likely importance of the policy impact on FDI. The standard positive findings for the Canadian host market size and the exchange rate are in line with theory, as is the exchange rate volatility variable. This last variable shows that the acceleration of changes in the exchange rate fosters FDI. This result reveals something of the distinctive nature of Canada-US economic relations. Unpredictable exchange rate changes are inimical to trade. However, via the internal markets of MNEs, the impacts of volatility can be mitigated, or even exploited. The readiness of US firms to increase their investment suggests that they are taking a long-term view of the Canadian
18 market. US MNEs, through their internal firm-level economies, are engaging in what amounts to private economic integration — integrating the two economies through the medium of the firm. This is consistent with the notion that US firms are not seeking shortterm returns from the Canadian market. Notwithstanding these results, it is evident that further research on the distinctive nature of exchange rate effects between the USA and Canada is required. One of the possible incentives for Canada to move towards economic integration with the USA has been its declining share of US outward FDI. Despite its proximity to the USA Canada was losing ground over a long period to other regions and countries of the world. In 1993 the rate of this decline slowed significantly, almost to the point of becoming stable. We adduce this as support in interpreting our empirical findings that the free trade agreements have had a positive impact on US FDI into Canada. We subscribe to the caveats of Globerman and Shapiro (1999) and resist coming to hard and fast conclusions on the basis of this empirical work. It is impossible to exclude fully extraneous factors that may cloud our results, such as the effect of the business cycle and the general liberalisation in trade and investment barriers worldwide, within the framework of multilateral trade negotiations. The delay in the surge of US investment in Canada between 1989 and 1993 inclusive does indicate additional factors at work, most likely of a macroeconomic character. In view of this, we have endeavoured to isolate the true impact of free trade by employing the market growth interaction term. North American regional economic integration on the scale of CUSFTA and NAFTA is a new venture. Embedding it within the literature on the determinants of FDI is a challenge. Many of the tools for the job have been furnished by Raymond Vernon, who emphasised the primacy of the market, of location cost and of strategic behavior. It is a measure of his insights that we are able to test only two of these. Vernon’s arguments encompassed both the
19 macroeconomic and the industrial; it follows that more detailed empirical research at the industrial level should yield still richer findings on the impact of policy on foreign investment behavior. This is an imperative if we are to understand and properly evaluate the incentives to governments of pursuing regional economic integration. On the findings of this research, regional integration appears to offer governments a means of re-establishing a measure of influence over MNEs’ investment decisions.
20 REFERENCES Aristotelous, Kyriacos & Stilianos Fountas. 1996. An empirical analysis of inward foreign direct investment flows in the EU with emphasis on the market enlargement hypothesis. Journal of Common Market Studies, 34, 4: 571-583. Bailey, Martin J. and George S. Tavlas. 1991 Exchange rate variability and direct investment. In The Annals of the American Academy of Political and Social Science: Foreign Investment in the United States, Michael Ulan, editor, number 516, July: 106-117. Barrell, Ray and Nigel Pain. 1999. Trade restraints and Japanese direct investment flows. European Economic Review, 43: 29-45. Baumann, H.G. 1974. The determinants of the pattern of foreign direct investment: Some hypotheses reconsidered. Paper presented at the University of British Columbia, August 1st. Boatwright, B.D. and Renton, G.A. 1975. An analysis of United Kingdom inflows and outflows of direct foreign investment. Review of Economics and Statistics, 57, 4: 478486. Buckley, Peter J. & Casson Mark C. 1976. The future of the multinational enterprise. London: Macmillan. Buckley, Peter J. & Casson Mark C. 1981. The optimal timing of a foreign direct investment. Economic Journal, 92, 361: 75-87. Buckley, Peter J. & Casson Mark C. 1998. Models of the multinational enterprise, Journal of International Business Studies, 29,1:21-44. Buckley, Peter J., Clegg, Jeremy, Forsans, Nicolas & Reilly, Kevin T. 2000. Increasing the Size of the “Country”: Regional Economic Integration and Foreign Direct Investment in a Globalized World economy. Management International Review, forthcoming. Casson, Mark C. 1987. Foreign investment and economic warfare: Internalizing the implementation of threats. In The Firm and the Market, Mark C. Casson, Oxford: Blackwell: 50-83. Caves, Richard E. 1974. Causes of direct investment: Foreign firms’ shares in Canadian and United Kingdom manufacturing industries. Review of Economics and Statistics, 56, August: 279-293. Caves, Richard E. 1990. Exchange rate movements and foreign direct investment in the United States. In The Internationalization of US Markets, David B. Audretsch and Michael P. Claudon, editors, New York: New York University Press: 199-229. Cecchini, Paolo, Michael Catinat and Alexis Jacquemin. 1988. The European challenge 1992: the benefits of a single market. Aldershot, Hants: Wildwood House. Clegg, Jeremy. 1996. United States foreign direct investment in the European Community: The effects of market integration in perspective. In Chapter 10 in The Changing European Environment, Fred N. Burton, Mo Yamin, and Stephen Young, editors, London: Macmillan: 189-206. Culem, Claudy G. 1988. The locational determinants of direct investments among industrialised countries. European Economic Review, 32, 4: 885-904. Cushman, David O. 1985. Real exchange rate risk, expectations, and the level of direct investment. Review of Economics and Statistics, 67: 297-308.
21 Dunning, John H. 1980. Toward an eclectic theory of international production: Some empirical tests. Journal of International Business Studies, 11, Spring/Summer: 9-31. Dunning, John H. 1977. Trade, location of economic activity and the multinational enterprise: A search for an eclectic approach. In The International Allocation of Economic Activity, Bertil Ohlin, Per-Ove. Hesselborn and Per Magnus Wijkman, editors. London: Macmillan: 395-418. Dunning, John H. 1993. Multinational enterprises and the global economy. Wokingham, Berks: Addison-Wesley. Dunning, J.H. 1997a. The European internal market programme and inbound foreign direct investment - Part I’. Journal of Common Market Studies, Vol. 35, No. 1, pp. 1-30. Dunning, John H. 1997b. The European internal market programme and inbound foreign direct investment - Part II’. Journal of Common Market Studies, 35, 2: 189-223. Dunning, John H. & Peter J. Buckley. 1977. International production and alternative models of trade. The Manchester School of Economics and Social Sciences, XLV, December: 392-403. Dunning, John H. & Peter Robson. 1988. Multinational corporate integration and regional economic integration. In Multinationals and the European Community, Dunning, John H. and Peter Robson, editors, Oxford: Blackwell, 1-23. European Commission. 1998. Foreign Direct Investment, The Single Market Review, Impact on Trade and Investment, IV, 1, Luxembourg: Office for Official Publications of the European Communities/Kogan Page Publishers. Gilman, Martin G. 1981. The Financing of Foreign Direct Investment: A Study of the Determinants of Capital Flows in Multinational Enterprises. London :Frances Pinter. Globerman, Steven & Daniel M. Shapiro. 1999. The impact of Government Policies on Foreign Direct Investment: The Canadian Experience. Journal of International Business Studies, 30, 3: 513-532. Horst, Thomas O. 1972. The industrial composition of US exports and subsidiary sales to the Canadian market. American Economic Review, 62, March: 37-45. Hultman, Charles W & L. Randolph McGee. 1988. Factors influencing foreign firms in the US 1970-1986. International Review of Economics and Business, XXXV. October/November: 1061-1067. Hymer, Stephen H. 1976. The international operations of national firms: A study of direct foreign investment. Unpublished 1960 PhD dissertation, Massachusetts Institute of Technology, Cambridge, MA: MIT Press. International Monetary Fund. Various Years. International Financial Statistics Yearbook, Washington, DC. Kohlhagen, Steven W. 1977. The effects of exchange-rate adjustments on international investment: Comment. In The Effects of Exchange Rate Adjustments, Peter B. Clark, Dennis E. Logue and Richard James Sweeney, editors, Washington, DC: US Government Printing Office: 194-197. Logue, Dennis E. and Thomas D. Willet. 1977. The effects of exchange-rate adjustments on international investment. In The Effects of Exchange Rate Adjustments, Peter B. Clark, Dennis E. Logue and Richard James Sweeney, editors, Washington, DC: US Government Printing Office: 137- 150.
22 Mayes, David G. 1998. Factor mobility. In The European Union: History, Institutions and Policies, Ali M. El-Agraa, editor. London: Prentice Hall Europe: 444-473. Papanastassiou, Marina & Robert D. Pearce. 1990. Host country characteristics and the sourcing behaviour of UK manufacturing industry. University of Reading, Department of Economics, Discussion Papers in International Investment and Business Studies, Series B, Volume II, number 140. Ray, Edward John. 1989. The determinants of foreign direct investment in the United States: 1979-1985. In Trade Policies for International Competitiveness, Robert C. Feenstra, editor, Chicago: University of Chicago Press: 53-83. Rugman, Alan M. 1994. Foreign Investment and NAFTA. University of South Carolina Press. Rugman, Alan M. 2000. The End of Globalization. London: Random House. Statistics Canada. 1999. Canada’s International Investment Position, Ottawa: Balance of Payments and Financial Flows Division, March. Stevens, Guy V.G. 1977. The effects of exchange-rate adjustments on international investment: Comment. In The Effects of Exchange Rate Adjustments, Peter B. Clark, Dennis E. Logue and Richard James Sweeney, editors, Washington, DC: US Government Printing Office: 183-188. Stevens, Guy V.G. 1993. Exchange rates and foreign direct investment: A note. International Finance Discussion Papers, Washington, DC: Board of Governors of the Federal Reserve System, April, number 444,. United Nations Centre on Transnational Corporations (UNCTC). 1992. The determinants of foreign direct investment: A survey of the evidence. New York: United Nations. Vernon, Raymond. 1966. International investment and international trade in the product cycle. Quarterly Journal of Economics, 80: 190-207. Vernon, Raymond. 1971. Sovereignty at bay: the multinational spread of US enterprises. New York: Penguin Books. Vernon, Raymond. 1974. The location of economic activity. In Economic Analysis and the Multinational Enterprise, John H. Dunning, editor, London: Allen and Unwin: 89114. Vernon, Raymond. 1998. In the Hurricane’s Eye: the Troubled Prospects of Multinational Enterprises, Cambridge, Mass.: Harvard University Press.
23 Figure One US Direct Investment Stock in Canada, 1960-1998 (Millions 1985 Cdn$)
120,000
100,000
80,000
60,000
40,000
20,000
0 1960
1964
1968
1972
1976
1980
1984
1988
1992
1996
24 Figure Two Annual growth rate of the Canadian Gross Domestic Product, 1960-1998.
8
6
4
2
0 1960 -2
-4
1964
1968
1972
1976
1980
1984
1988
1992
1996
25 Table One The definitions of variables and the expected directions of the relationships between the dependent and independent variables
REAL VARIABLES Natural Log of US FDI in Canada Growth Canada GDP Natural Log of Real Canada GDP Canadian Labor Productivity Canadian Unit Labor Cost Free trade * Growth Canada GDP Free Trade
Sign
Description and outline definition
..
Annual real stock of US FDI in Canada, 1960-1998, natural log.
+
Annual percentage growth rate of Canadian real GDP. Real Canadian GDP, natural log. value
+ −
+
FINANCIAL VARIABLES United States− Canada Exchange Rate + Volatility United States-Canada Exchange rate + Canada-United States Relative Real Interest Rate
Annual average real labor productivity in the Canadian economy (Canadian real GDP/aggregate man-hours). Annual average real unit labor costs in the Canadian economy (average labor cost per man-hour in Canada). Interaction term between the Free Trade dummy and the growth of the Canadian GDP Dummy variable to capture the effect of the formation of the CanadaUS Free Trade Agreement and subsequently the North American Free Trade Agreement, assuming a value zero up to 1988, and of one from 1989 onwards.
Level of the bilateral exchange rate of the Canadian to the US dollar (Canadian dollars per US dollar). Volatility in the level of the bilateral exchange rate of the Canadian to the US dollar, measured by the squared annual deviation of the current level from the period mean. The spread between the Canadian and the US real interest rate (Canadian minus US), measuring the relative cost of borrowing in the host to the home country.
26 Table Two Determinants US FDI Stock in Canada Dependent Variable: Natural Log of US FDI Stock in Canada Independent (1) (2) (3) Variables Basic Basic Free Trade Specification Specification Specification 1961-1984 1961-1998 1961-1998 0.231 Free Trade (0.056) [.000] -0.005 Free Trade*Growth (0.012) Canada GDP [.670] 0.877 0.299 0.612 Natural Log of Real (0.167) (0.317) (0.190) Canada GDP [.000] [.942] [.003] -0.007 .0008 -0.003 Growth Canada GDP (0.006) (0.005) (0.004) [.251] [.893] [.462] 0.004 0.008 0.001 Canada-United States (0.006) (0.010) (0.006) Relative Real Interest [.562] [.456] [.923] Rate 1.020 -0.015 0.479 United States-Canada (0.245) (0.199) (0.352) Exchange Rate [.011] [.952] [.023] 2.182 3.2237 4.052 Volatility United States(0.585) (1.289) (0.752) Canada Exchange Rate [.000] [.001] [.006] 0.001 -0.020 0.002 Canadian Labor 0.024 (0.039) (0.026) Productivity [.418] [.960] [.981] -1.132 -1.544 -0.080 Canadian Unit Labor (0.462) (0.190) (0.311) Costs [.004] [.678] [.001] 3.052 -0.347 7.190 Constant (1.859) (3.394) (2.032) [.854] [.043] [.144] (.) are Newey-West standard errors and [.] are Probability Values.
27
ENDNOTES 1
US FDI in the European Union manifests a strong periodic pattern linked to the business cycle (Clegg, 1996). 2
This argument suggests why Globerman and Shapiro (1999) were unable to find effects for Canadian Foreign Investment Review Agency (FIRA) and the Canada-United States Autopact. In both cases these are long standing programs which have been internalized by the other variables and hence do not need to be controlled for explicitly. 3
This follows the practice of Globerman and Shapiro (1999), who add that there is no evidence that the individual policies identified within CUSFTA and NAFTA were systematically strengthened or weakened during their duration (footnote 28, page 530). 4
Unlike the results of the Globerman and Shapiro (1999) study, the residual for the complete model over all data points marginally rejects the unit root hypothesis for our model (Column (3) in Table 2). So unlike Globerman and Shapiro we do find a cointegrating relationship in the levels. For this reason we just correct the standard errors for an arbitrary form of heteroscedasticity and first order autocorrelation. These are the Newey-West standard errors referred to in Table Two. We attribute this difference in results on the requirement to difference the data to three factors. First, we are using US inward FDI series and Globerman and Shapiro work with the all country inward FDI into Canada series. Second, we deal with a different time-period, 1961 to 1998 while they cover the period 1951 to 1995. Finally, we have used a log specification of the dependent variable compared to the linear specification in Globerman and Shapiro. 5
The gains to market integration in Europe were reviewed in Cecchini, Catinat, and Jacquemin (1988) and the impact of market integration on FDI was surveyed in European Commission (1998).
