How do Rules of Origin Affect Investment Flows?: Some Hypotheses and the Case of Mexico

Nov 2006
The proliferation of free trade agreements around the world has accentuated the role of preferential rules of origin (RoO) in global companies¿ sourcing and investment decisions. However, there are few theoretical and practically no empirical analyses on the effects of RoO on foreign direct investment (FDI). This paper strives to shed light on the relationship between RoO and FDI. We put forth a set of hypotheses on the impact of RoO on FDI, and perform an empirical exercise on the effects of RoO of the North American Free Trade Agreement (NAFTA) on FDI in 122 Mexican manufacturing industries 1994-2000. The findings indicate that NAFTA RoO have played a central role in foreign investors' cost assessments of locating production to Mexico, and that FDI in post-NAFTA Mexico has flowed in sectors with flexible RoO. This suggests that NAFTA-era investment in Mexican final and intermediate goods industries has been made by efficient, globally competitive firms that thrive on flexible RoO.