Title:	Customs Unions and Foreign Investment:  Theory and Evidence From Mercosur's Auto Industry
Number:	01-06
Author:	Çaglar Özden and Francisco Parodi
Issue Date:	March 2001
Abstract:	This paper demonstrates how regional trade agreements (RTAs) can lead to both foreign direct investment creation and diversion effects. These two effects, in return, impact the endogenous formation of RTAs. The investment creation effect results from foreign firms' ability to serve a larger market from a single facility. The diversion effect occurs due to their desire to move their initial plants from high-cost member countries to low-cost ones. The diversion effect can overwhelm the creation 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 diversion problem by forcing firms to produce some models in Argentina and entices the governments to sign the RTA. JEL Codes: F13, F15, F12, F21 Keywords: Customs unions, foreign investment, investment creation and diversion, Mercosur

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