A theory of North-South customs unions

We examine the implications of a North-South trade accord where investments in the Southern partner nation exhibit country risk. Our analysis demonstrates that treatment of foreign investment, inducing additional foreign capital inflows. Moreover, the impact of the accord on Southern credibility is directly increasing in the gains from trade between the two partner countries. We also demonstrate that 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.