Relationship between fdi and world trade

relationship between fdi and world trade

Mylonidis in ETSG , examines the relationship between FDI and trade in the UK with its Finally, the world pattern of FDI is remarkably similar to the. This section provides an overview of the results of research on the relationship between FDI and trade, beginning with a brief. those left outside the international fragmentation of production. . In fact, the link between FDI and network trade seems to be ubiqui- tous for producer-driven.

By removing internal barriers to trade, a free trade area or customs union gives firms the opportunity to serve an integrated market from one or a few production sites, and thereby to reap the benefits of scale economies. This can have a pronounced impact on investment flows, at least while firms are restructuring their production activities. The single market program of the European Union stimulated substantial investment activity, both within the Union and into the Union from third countries, and similar effects on FDI flows have been observed for other regional trade agreements.

The most common form of regional trade agreement is a free trade area, which differs from a customs union in that each member retains its own external tariff schedule. Because rules of origin can have a protectionist effect if not an intentthey can affect the location of FDI.

Mexican clothing manufactures face a choice between sourcing all inputs beyond the fibre stage in North America to obtain free trade area treatment, or sourcing inputs outside NAFTA at potentially lower cost, but foregoing duty free access to its most important market. As MFN tariffs on clothing are still high, they may choose to source inside the area rather than outside. This obviously creates greater incentives for third country textile producers to invest in production facilities inside the NAFTA area to regain lost customers, than would less restrictive rules of origin.

Such trade arrangements distort the pattern of FDI because there is an added incentive to locate FDI in the hub, from which there is duty free entry to all three markets, rather than in one of the spokes, since goods do not move duty-free between the two spokes.

These examples indicate that trade policy can have a significant impact on FDI flows. The opposite relation also holds, as is shown in the next section. The origin of these views is the traditional thinking about FDI, which has focused on the possibility of using foreign production as a substitute for exports to foreign markets. Two developments explain much of this traditional view that FDI and home country exports are substitutes. A substitute relationship between capital flows and trade obviously is at the heart of this analysis.

The other development was the popularity of import-substitution policies in large parts of the developing world until the early s. Whatever its origin, this traditional view of trade and FDI as substitutes ignores the complexity of the relationship in the contemporary global economy.

To begin with, just because FDI causes the displacement of certain home country exports by production in the host country, it does not necessarily follow that the home country's total exports to the host market decline.

To see why, consider a firm which is initially prevented from undertaking FDI, and instead serves the foreign market through exports. If the firm is then allowed to invest in the foreign country, the total effect on the home country exports is the result of several forces. First, at given levels of sales in the foreign market, and with the same productive activities taking place within what is now an MNC as prior to the liberalization, there could be a replacement of previous exports of the final product by the new production in the foreign host country.

This could stimulate exports of intermediate goods or services from the home country, but with the MNC's total production of the final good or service unchanged, that would not be sufficient to prevent an overall decline in exports. This gain in competitive position may be due to access to cheaper labour or material inputs, but it may also stem from lower transactions costs, closer proximity to local customers, and so forth. Total sales are likely to increase as a result of the investment, which would imply increased demand by the affiliate for intermediate inputs.

This will increase home country exports, to the extent that the affiliate continues to purchase intermediate goods and services from the parent company, or from other firms in the home country. In addition, if the FDI stimulates economic growth in the host country, as appears to be the case see belowthe result will be an increase in demand for imports, including from the home country.

Now consider the impact of the FDI on home country imports. Some portion perhaps all of the inputs that were imported before the FDI for use in the production that is relocated abroad, will not be imported into the home country after the FDI has been undertaken.

On the other hand, the foreign affiliate may begin serving the home country market, and in which case imports of the final product would increase. Again, because of these and other possibly off-setting effects, there is no reason per se to expect FDI and home country imports to be either substitutes or complements.

The discussion so far has been concerned with the complexities of the relationship between FDI and home country trade. But it should be clear that, for many of the same reasons, it is no easier to determine a priori the relationship between FDI and host country trade. Again the question of the relationship between FDI and trade can only be settled by looking at the empirical evidence. Before turning to the empirical evidence, four points should be emphasized. First, the theory has only provided limited guidance to the empirical work.

This in turn makes it very risky to draw policy conclusions from individual studies. Second, because data problems are particularly acute with regard to service industries, most research on FDI focuses on goods.

This lack of empirical research on FDI in the services sector is increasingly troublesome, considering the growing importance of services in production, trade and investment.

Third, the theoretical literature is largely focused on analysing the impact of an individual marginal investment. At the margin, incremental investment may have a very different set of implications from those related to the entire trade and FDI regime. As a result, empirical research on MNCs is largely limited to firms from just a few countries, notably the United States, Sweden and Japan.

The relationship between outflows of FDI from the United States and exports from the United States has been examined in a number of studies. Tests of the effect of affiliate production on the total exports of parent firms to all destinations, suggested that the displacement of United States exports to third countries, if it existed, was not large enough to offset the positive effects on parents' exports to host countries.

In each industry, United States MNCs whose foreign production was above the industry average also had above-average exports from the United States. A more recent examination of the relationship between the stock of United States FDI abroad and United States exports, using data forandconcluded that United States exports were positively and significantly related to United States FDI stocks in all three years.

Infor example, each 1 per cent rise in the stock of FDI in a host country was associated with 0. Using a different statistical procedure, designed to correct for among other things the possibility that United States MNCs have a greater tendency to export to and invest in larger markets than in smaller markets, an even more recent study confirmed a complementary relation between FDI and exports for the world, as well as for East-Asian and European countries.

The apparent opposite or substitute relationship for the Western hemisphere countries could be explained by the Latin American countries' import substitution policies in the s and early s. The overall conclusion from studies of Swedish MNCs is that sales by foreign affiliates, to the extent that they affect exports from Sweden at all, contribute positively to home country exports. Similar results have been reported for Germany, Austria and Japan.

There has been relatively little empirical testing of the impact of outward FDI on imports by the home country. There is evidence that United States imports are not materially affected by the extent of United States investment abroad.

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In contrast, a given amount of outward Japanese FDI appears to have promoted about twice as much Japanese imports as exports, while German FDI outflows probably promoted German imports at the beginning of the s, but not necessarily at the end of the decade.

A more recent study found that, in the case of United States, there was weak evidence for a positive relationship between FDI stocks and imports in the manufacturing sector, whereas for Japanese FDI the results were inconclusive. To sum up, empirical research suggests that to the extent there is a systematic relationship between FDI and home country exports, it is positive but not very pronounced.

Certainly, there is no serious empirical support for the view that FDI has an important negative effect on the overall level of exports from the home country. There is less evidence on the relationship between FDI and home country imports, but what exists tends to suggest a positive but weak relationship. Detailed studies of FDI in mining and other natural resource-based industries have confirmed the expected strong positive correlation between FDI and the host country's exports.

Several studies covering a broader range of industries have also found a high positive correlation between aggregate inflows of FDI and the host countries' aggregate exports.

Indirect evidence based on sectoral studies indicates that FDI is often undertaken by companies that are already significant exporters. These findings are supported by studies which have found that foreign owned firms tend to export a greater proportion of their output than do their locally owned counterparts.

Presumably foreign firms typically have a comparative advantage in their knowledge of international markets, in the size and efficiency of their distribution networks and in their ability to respond quickly to changing patterns of demand in world markets. Empirical evidence from South East Asia strongly suggests that there has been such a learning process by local firms, and there is evidence that Mexican firms located in the vicinity of foreign MNCs tend to export a higher proportion of their output than do other Mexican firms.

There can also be policy-based linkages between FDI and host country exports. Performance requirements that require MNC affiliates to export a part of their production, and FDI incentives that are limited to or favour export-oriented sectors, are examples of policies that can produce or strengthen a positive correlation between inflows of FDI and exports. A conspicuous example of such policies is export processing zones EPZ. Many foreign firms have established operations in these zones, which have been set up by the host governments with the goal of stimulating exports, employment, skill upgrading and technology transfer.

While the evidence about the benefits from export processing zones to host countries remains mixed, particularly as regards the linkages with the rest of the host country's economy, there seems to be a fairly broad agreement that EPZ have played a positive role in stimulating the countries' exports, particularly in the early stages of encouraging the development of labour-intensive exports.

Turning to the interlinkages between FDI and host countries' imports, some studies indicate that the impact of inward FDI on the host country's imports is either nil or that it slightly reduces the level of imports.

However, most of the empirical research suggests that inward FDI tends to increase the host country's imports. One reason is that MNCs often have a high propensity to import intermediate inputs, capital goods and services that are not readily available in the host countries. These include imports from the parent company of intermediate goods and services that are highly specific to the firm. Concerns about the quality or reliability of local supplies of inputs can also be a factor.

In summary, the available evidence suggests that FDI and host country exports are complementary, and that a weaker but still positive relationship holds between FDI and host country imports. Except for the apparently stronger complementarity between FDI and host country exports than between FDI and home country exportsthese results are very similar to those reported for the relationship between FDI and home country trade.

The impact of FDI on the trade of the host and home countries was considered in the previous section and found to be generally positive.

Historically, the significance of the benefits and costs of FDI has been a matter of fierce controversy. On one side, supporters praise it for transferring technology to the host countries, expanding trade, creating jobs and speeding economic development and integration into global markets. On the other side, critics charge it with creating balance-of-payments problems, permitting exploitation of the host country's market, and in general reducing the host country's ability to manage its economy.

While the debate has increasingly favoured the pro-FDI view in recent years, as more and more countries have adopted development strategies based on increased integration in the global market, the critics continue to voice concerns. The essence of the view that an inflow of capital benefits the host country is that the increase in the income of the host country resulting from the investment will be greater than the increase in the income of the investor.

  • The Relationship Between Trade and Foreign Investment: Empirical Results for Taiwan and South Korea

In other words, as long as the FDI increases national output, and this increase is not wholly appropriated by the investor, the host country will gain. Beyond this, there are other benefits via externalities associated with the FDI, some of which are discussed below in connection with the transfer of technology. For the critics of FDI, this is a misleading, or at best incomplete picture because it ignores costs they believe are often associated with inflows of FDI.

Balance of payments effects. Critics argue that while the initial impact of an inflow of FDI on the host country's balance of payments may be positive, the medium-term impact is often negative, as the MNC increases imports of intermediate goods and services, and begins to repatriate profits.

The analysis in the previous section, which pointed to a stronger complementarity between FDI and host country exports than between FDI and host country imports, is relevant here. So is the finding that FDI in countries with high levels of import protection tends to be less export-oriented than FDI in countries with low levels of protection.

The repatriation of profits, of course, must also be taken into account.

relationship between fdi and world trade

Suppose that, in a particular situation, the demand for foreign exchange associated with an inflow of FDI ultimately exceeds the supply of foreign exchange generated by that FDI. Is this a sufficient reason to reject the FDI? The latter are considered in more detail below. Under flexible exchange rates, any disturbance to the balance between the supply and demand for foreign exchange is corrected by a movement in the exchange rate, in this case a depreciation.

If the country instead has a fixed exchange rate, a net increase in the demand for foreign exchange by the FDI project will result in a reduced surplus or increased deficit in the balance of payments.


It is important however, to keep this in perspective. First, the previously mentioned evidence strongly suggests that, on average, an inflow of FDI has a bigger positive impact on host country exports than on host country imports. Balance-of-payments problems, therefore, if they occur, are likely to be small. Second, FDI is far from unique as a source of fluctuations in the demand and supply of foreign exchange, and governments regularly use monetary, fiscal and exchange rate policies to keep the current account balance at a sustainable level in the face of a variety of disturbances.

Finally, the FDI is likely to bring a number of gains whose net benefit to the economy can exceed the cost of any possible balance-of-payments problems. Because they generally have more economic power than domestic competitors, it is argued that MNCs are able to engage in a wide variety of restrictive practices in the host country which lead to higher profits, lower efficiency, barriers to entry, and so forth.

Alternatively, of course, the entry of a MNC may have the effect of breaking up a comfortable domestic oligopolistic market structure and stimulating competition and efficiency.

And, of course, account must be taken of the host country's domestic anti-trust policies, which are as applicable to MNCs as they are to national firms. In short, the effect of FDI on market structure, conduct and performance in host countries is not easy to predict a priori. The empirical evidence, however, points strongly to pro-competitive effects.

National economic policy and sovereignty. Critics have also raised concerns about the effects of FDI on public policy, vulnerability to foreign government pressure, and host country national interests.

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They argue that, because of its international connections, the subsidiary of a MNC enjoys alternatives not open to domestically-owned firms, and that this makes possible, among other things, the evasion of compliance with public policies. For instance, confronted with new social or environmental legislation in the host country that raises production costs, the MNC can more easily shift its activities to another country.

Its ease of borrowing internationally may frustrate the use of direct macroeconomic controls for internal or external balance. These are understandable concerns. But, again, it is important to keep them in perspective. The costs associated with these concerns admittedly a very subjective calculation have to be compared with the costs of foregoing the benefits that would come with FDI.

Moreover, many of the concerns could be addressed in the course of negotiating a multilateral agreement on FDI. Similarly, a multilateral agreement would provide a forum for the settlement of disputes over MNC behaviour involving home and host governments.

Among the reasons which explain the change of attitude towards FDI on the part of many developing and transition countries is the belief that it can be an important channel for technology transfers, with technology being broadly defined to include not only scientific processes, but also organizational, managerial and marketing skills. This section first considers the ways in which FDI can enhance the efficient use of local resources through technology transfers, and then the empirical evidence on such efficiency-enhancing effects of FDI.

While the focus is on FDI's impact on the efficiency of locally owned firms, it should be noted that the host country will also benefit from the fact that the subsidiary of an MNC is itself likely to use host country resources more efficiently because of its superior technology. How FDI improves the efficient use of host country resources As suggested by the discussion of the motivations behind a decision to engage in FDI, there are good reasons to think that MNCs are important vehicles for the direct and indirect transfer of technology between countries.

Superior technology or capacity to innovate figure prominently among the attributes a firm engaging in FDI relies on to compensate for the cost disadvantage, relative to local firms, associated with foreign operations. This technological superiority of many MNCs has led researchers to emphasize the efficiency-enhancing characteristics of their foreign investment. FDI is very often associated with secondary benefits through the diffusion of technology to firms in the host country.

relationship between fdi and world trade

This diffusion may be deliberate, such as when technology is licensed by the affiliate to a domestic firm, or it can be in the form of a technological spillover which occurs when the activities of the multinational firm yield benefits for local economic agents beyond those intended by the multinational.

An example of a deliberate diffusion is the upgrading of the technological capabilities, by the MNC, of local firms doing business with the MNC, for example when such upgrading is required to meet specifications demanded by the MNC.

Technological spillovers can be horizontal or vertical. A horizontal technological spillover occurs, for example, when the affiliate has a new technology that is subsequently copied or learned by competing firms. Apart from the diffusion of MNC technology through spillovers, FDI may also produce other unintended efficiency-enhancing effects, as when local rivals are forced to upgrade their own technological capabilities as a consequence of competitive pressure from the local affiliate of the MNC.

In the United States, for example, the entry of Japanese automobile manufacturers into the local market via FDI caused the major domestic automobile producers themselves multinational firms to upgrade their own products and to increase the efficiency of their domestic production facilities. This has benefited all consumers in the United States, whether they purchased Japanese or United States brand automobiles.

There is considerable evidence that similar benefits occur in developing countries. Korean FDI, for example, contributed to the development of a locally-owned garment exporting industry in Bangladesh. In many circumstances, FDI may result in a greater diffusion of know-how than other ways of serving the market. While imports of high-technology products, as well as the purchase or licensing of foreign technology, are important channels for the international diffusion of technology, FDI provides more scope for spillovers.

For example, the technology and productivity of local firms may improve as foreign firms enter the market and demonstrate new technologies, and new modes of organization and distribution, provide technical assistance to their local suppliers and customers, and train workers and managers who may later be employed by local firms.

Foreign subsidiaries may themselves conduct research and development activities aimed at adapting the parent firm's innovation to local conditions. Clearly FDI leads to more extensive personal interaction with foreigners and exposure to new ways of doing things than does trade.

What the empirical evidence shows Empirical studies of FDI's role in the process of transfer and diffusion of technology approach the issue in various ways. Most of them provide evidence that FDI exerts an efficiency-enhancing effect on locally owned firms without, however, allowing the authors to disentangle the particular channels through which it has its impact.

During the first five years after their commercialization, evidence suggests that new technologies are introduced abroad primarily through foreign MNC subsidiaries rather than exports. Moreover, it appears that in most instances the average age of technologies transferred to affiliates was lower than the average age of technologies sold to outsiders through licensing or joint ventures.

This is consistent with the results of a study that found that flows of technology to MNC affiliates dominate all other types of formal technology transactions between countries. Buigues and Jacquemin's sample is pooled cross sectionally across seven industries six for the United States and ten years.

The same finding is reported with respect to foreign direct investment in Canada. The findings are aggregate and apparently based on time series analysis. Estimates are made of the elasticities of exports and imports with respect to Canada's outward investment and the latter are higher than the former. These estimated elasticities of trade with respect to investment stocks see Industry CanadaTable 7 are not, however, controlled for the influence of factors such as economic activity, comparative costs, or other variables that could affect the outcomes.

Grahamusing methodology similar to that reported later in this paper, found that complementary relationships exist between outward FDI and exports and outward FDI and imports for the United States and for Japan. Thus, all these studies involving developed countries have concluded that the relationship between FDI and exports is complementary. As is described in the next section, the results of our empirical investigations for two newly industrialized countries point to a consistent result, but with some twists.

One is that they only examine this relationship for industrialized countries. This relationship for the newly industrialized nations remains to be examined. Second is that most of the studies cited above could be criticized for ignoring the possible effects of simultaneous determination of FDI and exports which could be causing a spurious correlation between these two and hence lead to an erroneous interpretation of complementarity.

They could still be substitutes once the effects of market size were taken into account. Thus, the effort is made in the results reported here to control for these factors when examining the relationships between FDI and trade for Taiwan and South Korea. In particular, we remove factors that might simultaneously determine exports, imports, and FDI and then examine the residual relationship between the first two and the lattermost of these variables with the source of the simultaneity bias removed.

Specifically, a gravity model was used first to estimate the effects of three variables deemed to be very important determinants of both FDI and exports. The three variables chosen were 1 per capita income in each host nation market for which GDP per capita was used2 total size of this market for which total population was usedand 3 distance from the host to the home country.

The "distance" from the home country to the host country was from the home countries' capitals, i. The gravity specification was multiplicative, i.

The residuals from each of the two estimations exports and FDI as a function of the three variables were then regressed upon one another. The presumption was that if the gravity models have succeeded in removing simultaneity bias, then any correlation of the residuals would reflect some other causal relationship between FDI and exports-such as that due to sourcing substitution or to complementarities in production or distribution and marketing.

A positive correlation coefficient would suggest complementarity and a negative coefficient substitutability. Also performed were similar two stage analyses between imports and direct investment abroad. Results for Taiwan For Taiwan, the sample included 54 individual countries that were destinations of both Taiwan's exports and its direct investment.

These fifty-four countries accounted in for almost the entire stock of Taiwan's direct investment abroad and most of its manufactured goods exports. Separate analyses were performed using 1 the data for all countries with and without adjusting for language linkage, development status OECDand geographical location Asia ; and 2 the data for all countries except mainland China which, for reasons to be explained, might act as a distorting "outlier" in the sample with and without adjusting for language linkage, development status OECDand geographical location Asia.

Summary results of the gravity analyses are given in Table 1 below. As can be seen, absent the dummy variables, as an explanator of FDI, only market size population appears significant. As determinants of exports and imports, however, all three explanatory variables appear significant.

When using dummy variables to take into account language, development status, and geographical location, per capita income becomes positively and significantly related to Taiwan's outward FDI.

Also, although distance continues to be insignificant statistically, it continues to have negative sign, i. The language dummy does not appear to be important as a determinant of direct investment. This might be due to the fact that Chinese is rarely spoken in the world other than mainland China and Hong Kong. As determinants of exports and imports, all explanatory variables are of the expected sign and significant except for two dummy variables, language and OECD, both of which are not significant.

In contrast to FDI, distance is a significant determinant of both exports and imports of Taiwan. These exports and imports are not, however, affected by whether the destination country is a developed economy or not. As with FDI, language does not appear to be a determinant of either exports or imports.

Table 2 presents the second stage regressions.

relationship between fdi and world trade

As can be seen, the relationship between the remaining unexplained variation in Taiwan's outward direct investment in the manufacturing sector and the remaining unexplained variation in Taiwan's exports of manufactured goods for regressions with and without dummy variables is positive and significant at 99 percent significant level. This relationship indicates a strong complementary relationship between Taiwan FDI and exports.

The results of second stage regressions of the relationship between Taiwan's outward direct investment in the manufacturing sector and Taiwan's imports of manufactured goods are also indicated in Table 2. The coefficients, although positive, are not statistically significant for these regressions, either with or without dummy variables.

Therefore, the complementary relationship between FDI and imports appears weak if indeed there is one at all. Given Taiwan's recent large outward investment activities in Mainland China, one may wonder whether the results presented above could be biased because China of China's outlier status in the sample. This status arises because China has a huge population with a very low per capita income and is close geographically to Taiwan. To examine whether the outlier characteristics of China bias our results, we repeat the regressions dropping China from the sample.

The gravity model regression results are presented in Table 3. As can be seen, the results do not change much at all, except for the size of some coefficients and t-statistics.

Indeed, the complementary relationship between Taiwan's FDI and exports becomes slightly more significant, as the coefficients and t-statistics in Table 4 indicate. These results may also lead one to wonder whether the strong complementary relationship between outward FDI and exports, as found above, is unique to Taiwan. To answer this question, in next section, we present econometric results for South Korea, a newly industrialized country which also has experienced a rapid outward FDI in recent years.

Without adjusting for development status OECD and geographical location Asia of host nations 6South Korea's outward FDI is positively and statistically related to per capita income level unlike the case for Taiwan as well as market size.

relationship between fdi and world trade

Although the coefficient of the distance variable is positive-the opposite of the result for Taiwan-it is not significant. Similar to Taiwan, South Korea exports and imports are all significantly correlated with income, market size, and distance, the coefficients of all of these variables being of the expected sign.

However, after adjusting for development status and geographical location, FDI equation now is only marginally significantly correlated with per capita income and market size the coefficients are significant at only the 12 percent level. And, surprisingly, the coefficient on the distance variable now becomes significant and remains positive.

Although the coefficient of the Asia dummy is still statistically significant, the coefficient of the OECD dummy is not significant, but it is of positive sign. This finding seems to indicate that although the FDI made by South Korea companies are mainly in Asia, their FDI location decisions do not hinge heavily on host country market size and per capita income.

As for exports and imports, the results for South Korea are quite similar to those for Taiwan. All coefficients of explanatory variables are of the expected sign and all are significant except for that of the OECD dummy, which implies that the development status of a country is not an important factor in determining exports and imports to and from Korea. Table 6 presents the second stage regressions. As indicated, the relationship between the remaining unexplained variation in South Korea's outward direct investment in the manufacturing sector and in South Korea's exports of manufactured goods for regressions with and without dummy variables is positive and also significant at 99 percent significant level.

The relationship thus is strongly complementary. However, The results of the second stage regressions of the relationship between South Korea's FDI and its imports do not yield clear results.

Although this relationship appears to be complementary and statistically significant for the residuals from the first stage regressions performed without dummy variables, it is no longer significant once dummy variables are used in this first stage analysis. We are not entirely sure how to interpret this last result but, given that the second specification with dummy variables is more complete than the first, we are inclined to conclude that FDI and imports for Korea, as for Taiwan, do not appear to be significantly related.

Conclusions and Policy Implications The empirical evidence presented in the previous section is generally consistent with that of earlier studies on developed countries' FDI pattern reviewed in the introduction. The evidence tends to support that, as is the case for the industrialized countries, Taiwan's outward direct investment and Taiwan's exports in manufacturing are complements and not substitutes.