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The last decade witnessed a significant increase in the flows of foreign direct investment (FDI) into developing countries, particularly in Latin America. This increase is likely to continue as multinational corporations look for new markets and profitable opportunities to serve or produce abroad. The growth of FDI in the region calls for a search of the different antecedents of U.S. FDI inflows into Latin America. Knowing the different antecedents of FDI in the region is beneficial at a time a diversity of trade agreements are taking place while others wait for official signatures. A movement towards bilateral and multilateral trade agreements includes the U.S. The U.S. has come to play an important role in terms of expanding the horizon of what would constitute the free trade area of the Americas (FTAA). This study investigates the antecedents of U.S. FDI into Latin American countries, while paying special attention to the relationship between trade agreements and FDI inflows. This study also investigates concern for the foreign exchange market as a source of uncertainty to FDI. The empirical investigation uses a fixed effects panel data model to maximize degrees of freedom and to control for cross-country and inter-temporal heterogeneity.

The increasing openness of the world economy leads not only to expanded trade, but also to significant increases in foreign direct investment (FDI) in both developed and developing countries. The last decade is a case in point of a significant increase in the flows of FDI into developing countries, particularly in Latin America. Moreover, the increase is likely to continue as multinational corporations look for new markets and profitable opportunities to serve or produce abroad. In general, while Europe and Japan play an important role in terms of their share in FDI inflows into Latin America, the U.S. is still by far the main source with 37% of the total of this type of capital inflows (ECLAC, 2009). The literature on growth (Bénassy-Quéré et al., 2001, Goldberg and Klein, 1997 and Urata and Kawai, 2000) emphasizes the role of FDI in augmenting capital stock, employment, productivity and technological transfers. Also policy makers and analysts across the globe (see World Investment Prospects to 2010: Boom or Backlash? 2006, and World Investment Prospects to 2011: Foreign Direct Investment and the Challenge of Political Risk, 2007) acknowledge such a role of FDI. Since FDI motivates in a firm's prospects for making profits in production activities over the long run, FDI also implies a long-run commitment because it results in a more stable source of financing than portfolio investment. Along these lines, identifying strategies for attracting FDI becomes a priority for many Latin American countries. Prior studies show the impact of FDI on growth. For example, Calderón and Schmidt-Hebbel (2003) provide evidence that portfolio equity and debt flows do not impact growth while FDI is the only major category of capital inflows that is relevant for long-term growth in Latin America. In addition, Borensztein, De Gregorio and Lee (1999) find that FDI flows into developing countries contribute to economic growth in a proportion greater than domestic investment. Despite the growing interest in attracting FDI to the region, there is no information about the different antecedents of U.S. FDI inflows into Latin America. This lack of understanding is particularly troubling given the diversity of trade agreements that are taking place and that are waiting for official signatures. Historically, Latin American countries try to create common markets by signing into regional blocs. Examples of these are the Latin American Economic Association, MERCOSUR, and the Group of Three (G3). A recent movement towards bilateral and multilateral trade agreements includes the U.S. The U.S. also plays an important role in terms of expanding the horizon of what would constitute the free trade area of the Americas (FTAA). An example is the Central American Free Trade Agreement (CAFTA), which US legislators approved in July 2005 and signed into law on August 2, 2005. It is a comprehensive trade agreement between Central American countries and the United States. Currently discussions of bilateral agreements between the U.S. and Panama, the U.S. and Colombia, and the U.S. and Ecuador are under way in the U.S. Congress. The implementation of this new form of trade agreements offers enormous opportunities for expanded trade and commerce between the U.S. and Latin American countries. At the same time, this situation raises questions, and creates new challenges for both the U.S. and Latin American countries. In this context, two issues emerge. First, a thorough understanding of the antecedents of U.S. investment in Latin America is necessary. By being aware of the antecedents of FDI, countries in the region could identify public policy-oriented reforms in order to improve the conditions for attracting more and better quality FDI. This study explores the macroeconomic antecedents of U.S. FDI into Latin America while paying special attention to the role of trade agreements. Second, an accurate understanding the nature of foreign capital flows into these countries and the impact of trade agreements on FDI is necessary. Several theories argue that trade and FDI may be either substitutes or complements and few studies analyze this relation in terms of the implications of the recent U.S. bilateral negotiations and trade agreements with Latin American countries (see Levi-Yeyati et al., 2004 and MacDermott, 2007). According to the literature, if FDI and trade are substitutes then trade agreements may undermine the efforts of Latin American countries in order to attract more and better quality FDI. In addition, complementarily between FDI and trade implies significant positive externalities for the existing trade agreements as well as for those pending of their approval. Depending on the motive for foreign investment, the relaxation of trade barriers implicit in trade agreements may have completely different implications for the location of FDI. Following this introduction, Section 2 describes alternative hypotheses regarding the macroeconomic antecedents of FDI as well as the empirical evidence and theoretical assumptions. Section 3 offers an overview of the patterns of FDI to Latin America. Section 4 describes the data. Section 5 discusses the econometric methodology and empirical estimation. Section 6 analyzes the estimation results. Section 7 includes a summary, details of limitations of the study, suggestions for future research, and concluding remarks.

Latin American countries have instituted over the years market friendly reforms in order to attract FDI, perhaps in response to growing evidence that FDI can accelerate economic growth (see Calderón and Schmidt-Hebbel, 2003 and Borensztein et al., 1999). For example, Calderón and Schmidt-Hebbel (2003) show evidence that portfolio equity and debt flows do not impact growth while FDI is the only major category of capital inflows that is relevant for long-term growth in Latin America. Furthermore, Borensztein et al. (1999) find that FDI flows into developing countries contributed to economic growth in a proportion greater than domestic investment. In this context, identifying the determinants of FDI becomes not only an academic question but also of interest and significance from a policy-making standpoint. In this paper, the goal is to investigate the impact of the foreign exchange market on U.S. direct investment flows into Latin America. To this end, the study used data on U.S. direct investment into seven Latin American countries – Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela – for the period 1994–2005. In addition to currency returns and other common control variables, the study explores the role that exchange rate uncertainty plays in this process. The results of this study have important economic policy implications. These seven economies receive over 85% of the total FDI flowing to Latin American countries. Moreover, the U.S. is the main source of FDI flows into Latin America (ECLAC, 2005) over the period of study. Changes in the patterns of U.S. investment into these countries can potentially bring about important changes to the region. Accordingly, accounting for the antecedents of FDI including the exchange rate and exchange rate uncertainty is of relevance and of the most importance at a time when other countries outside the Western hemisphere are lining up with their FDI projects embedded in another currency numéraire. Overall, discrete variations in the real exchange rate do not impact FDI. That is, countries do not need to manipulate the exchange rate if their goal is to promote FDI inflows. A more or less depreciated real exchange rate does not seem to encourage or discourage FDI. By contrast, however, the level of real exchange rate uncertainty does matter and impacts the level of FDI received. Investors can deal with discrete changes in relative prices that arise through discrete exchange rate movements, but investors are less able to manage (or they do not tolerate) uncertainty in exchange rate movements. In particular, this study found that persistent uncertainty deters FDI. This finding derives from an extensive inquiry into uncertainty's impact on FDI using a battery of measures to proxy exchange rate uncertainty. First, the study uses an unconditional measure of volatility. Such a measure captures total variability — both predicted and unpredicted uncertainty. In addition, it uses conditional variances from GARCH and CGARCH models. The CGARCH estimation is of particular interest because it allows to decompose uncertainty into temporary (short-run) and permanent (long-run) components. The study finds a negative effect of uncertainty across specifications indicating that exchange rate uncertainty discourages U.S. investors. Persistent uncertainty rather than transitory uncertainty most deters foreign investment. See Table 6 for the estimated G/ARCH models. The study, however, has some limitations. For example, the study uses exchange rate uncertainty variables that are the result of generated regressors into the FDI equations. One normally should correct the standard errors of generated regressors to completely assess their significance in the regression equation. Correcting for the generated-regressor problem is impossible because the frequency of the data in the GARCH model does not match the frequency of the data in the FDI equation. The conclusions of this study indicate that policies with a better timing of permanent uncertainty would be important to implement in the event that policymakers desire to promote increasing levels of inward FDI. Although it is impossible to completely eliminate uncertainty, the costs imposed by an uncertain exchange rate are measurable. Pursuing policies that increase the predictability of economic fundamentals can go a long way in making the climate more favorable for foreign direct investment into the region for both the U.S. (i.e., the source) and the recipient countries.