North-South Customs Unions and International Capital Mobility

February 1996 North-South trade accords can serve as credibility-enhancing mechanisms for the treatment of foreign investment, inducing additional inflows of foreign capital. The presence of sovereign risk changes the tradeoffs between trade creation and diversion, enhancing the potential for welfare-increasing, trade-diverting North-South regional trade accords. North-South integration involves different issues than did previous trade accords, but a nation still does best by the integration that yields the greatest gains from trade. The primary distinction in a North-South trade accord is likely to be that the Southern nation experiences more capital scarcity than its Northern trade partner. So the trade accord's impact on the Southern trading partner's ability to attract capital may have welfare implications for both nations. Fernandez-Arias and Spiegel extend the traditional analysis of customs unions to allow for international capital movements. Their results indicate that trade accords may affect the ability of Southern nations to attract capital and may divert capital between Southern nations. Moreover, the welfare implications of North-South trade accords may differ from those that predict the North American Free Trade Agreement's (NAFTA) minor third-country effects, holding factor endowments constant. The key implications of North-South trade accords such as NAFTA are generally perceived to involve their impact on investment flows. Fernandez-Arias and Spiegel try to understand the channels through which trade accords can affect North-South investment flows. A potential link between trade accords and investment flows may be how the accords affect the ability of the Southern partner government to make commitments about the treatment of foreign investment. They show that these accords can affect both the magnitude and pattern of inward foreign investment and production, implying the possibility that both trade and financial diversion can stem from a bilateral regional trade accord. Novel effects that emerge under sovereign risk must be addressed when assessing the welfare implications of trade accords. The greatest gains from integration are still achieved when integration takes place between the countries with the greatest potential gains from trade. But Fernandez-Arias and Spiegel make a distinction: these gains now include both current trade and inter-temporal trade through foreign investment. This paper -- a product of the International Finance Division, International Economics Department -- is part of a larger effort in the department to analyze foreign investment in emerging markets.