RESTRICTED
WORLD TRADE WT/WGTI/W/7
18September 1997
ORGANIZATION(97-3735)
Working Group ontheRelationship
between Trade andInvestment
THE RELATIONSHIP BETWEEN TRADE AND FOREIGN DIRECT INVESTMENT
Note bytheSecretariat1
Table ofContents
I. INTRODUCTION AND SUMMARY ..............................3
II. THE ECONOMICS OFMULTINATIONAL ENTERPRISES AND FOREIGN
DIRECT INVESTMENT ......................................6
II.1 TheOLI(eclectic) theory .................................7
II.1.1 (O)wnership ....................................7
II.1.2 (L)ocation ......................................7
II.1.3 (I)nternalization ..................................8
II.1.4 Summary .......................................9
III. THE RELATIONSHIP BETWEEN FOREIGN DIRECT INVESTMENT AND
TRADE .................................................12
III.1 Thetraditional view ....................................12
III.2 Themodern view ......................................13
III.2.1 Horizontal FDIandtrade ............................13
III.2.2 Vertical FDIandtrade ..............................16
III.2.3 Distribution FDIandtrade ...........................17
III.3 Thetrade effects ofFDIforhostandhome countries ................17
III.3.1 Home country trade andoutward FDI ....................17
III.3.2 Hostcountry trade andinward FDI......................19
III.3.3 TheroleofMNEs andFDIfortheexport performance of
developing countries ...............................20
IV. THE IMPACT OFTRADE POLICES AND MEASURES ONFOREIGN
DIRECT INVESTMENT ......................................22
IV.1 Thetariff-jumping argument ...............................22
IV.2 Arehighorlowtrade barriers more conducive toFDI? ..............23
IV.3 Concluding remarks ....................................25
1Thisnotehasbeen prepared onthesoleresponsibility oftheWTO Secretariat. Theanalysis, views and
opinions expressed herein should notinanywaybeattributed totheWTO Members, individually orcollectively.WT/WGTI/W/7
Page2
V. THE IMPACT OFINVESTMENT POLICIES AND MEASURES ONTRADE ...26
V.1 Investment incentives andperformance requirements ................26
V.2 Theeffects ofinvestment incentives andperformance requirements .......28
VI. THE IMPACT OFREGIONAL TRADE ARRANGEMENTS ONFOREIGN
DIRECT INVESTMENT ......................................30
VI.1 ThecaseoftheEuropean Community .........................31
VI.2 North-North, North-South andSouth-South agreements ..............32
VI.3 Rules oforigin andFDI..................................34WT/WGTI/W/7
Page3
I. INTRODUCTION AND SUMMARY
1. Atthemeeting oftheWorking Group ontheRelationship between Trade andInvestment of
2and3June1997, theWorking Group tooknoteofaChecklist ofIssues Suggested forStudy
(WT/WGTI/M/1, Annex 2).Withregard toItemIIofthisChecklist -theeconomic relationship between
tradeandinvestment -theWorking Group requested theSecretariat toprepare apaper onthetwofirst
indents (thedegree ofcorrelation between trade andinvestment flows andthedeterminants ofthe
relationship between trade andinvestment flows) and,totheextent thattimepermitted, onthetwo
indents concerning theimpact oftrade policies andmeasures oninvestment flows andofinvestment
policiesandmeasuresontrade(WT/WGTI/M/1,paragraph11).Thisnotehasbeenpreparedinresponse
tothisrequest.
2. Thenotebegins inSection IIwithanoverview ofmodern economic theory regarding the
determinantsofforeigndirectinvestment(FDI)asabackgroundtoananalysisoftherelationshipbetween
trade andinvestment inSection III.Thefollowing Sections focus onthepolicy dimension ofthe
relationship between trade andinvestment: theimpact oftrade policies andmeasures onFDI
(Section IV),theimpact ofinvestment policies andmeasures ontrade (Section V)andtheimpact of
regional trading arrangements onFDI(Section VI). Thepaper draws upon, andattempts tosetout,
themain points emerging from studies onthese subjects.2
3. Themain findings ofthenotecanbesummarized asfollows.
4. FDItends tooccur asaresult ofthreeinteracting circumstances. First, thefirmowns intangible
assets thatcanbeprofitably exploited onacomparatively large scale, including intellectual property,
organizational andmanagerial skills, andmarketing networks. Second, there mustbesome location
advantages individing production across countries compared toproducing inandexporting fromthe
home country exclusively. Third, theprofits ofexploiting theassets in-house must begreater than
from licensing theassets toforeign firms, andthebenefits must besufficient tomake itworthwhile
forthefirmtoincur theadded costs ofmanaging alarge, geographically dispersed organization in
different legalandcultural settings.
5. Inanalysing thecause andconsequences ofFDI,including thetradeeffects, itisuseful todivide
FDIintodifferent types.
6. Horizontal FDIrefers toinvestment inproduction units indifferent countries thatproduce
essentially thesame lineofproducts, e.g.,brand name softdrinks. Thistypeofinvestment tends to
occur when export isarelatively expensive mode ofsupplying amarket because ofhightransport costs
orhightrade barriers. Asageneral rule,scale economy considerations tendtofavour location in
countries withlargedomestic markets thatcanmore easily support production unitsofsufficient scale.
However, smaller countries mayserve asanexport platform fortheadjacent region iftheinfrastructure
isadequate. Interms ofthetrade effect, horizontal FDIdisplaces exports oftheproduct thatisnow
produced locally. However, thereduction inexports isoffset bytrade inintermediate goods thatthe
foreign subsidiary needs inorder toproduce locally. Inaddition, localproduction ofonelineofproducts
mayfacilitate thesales ofother product linesoftheparent company. Thenet-effect onexports of
thehome country ofoutward FDImaytherefore bepositive.
7. Vertical FDIrefers toinvestment inproduction unitsindifferent countries thatproduce different
stages ofaproduct (e.g., textiles usedinthemanufacturing ofwearing apparel). Thelocation ofeach
2Itmaybenoted thattheUNCTAD World Investment Report 1996 examines therelationship between trade
andFDIand,insodoing, alsodraws upon theliterature inthisarea. Therelationship between trade andFDI
isalsodiscussed intheWTO Annual Report 1996, Volume 1,Chapter 4.WT/WGTI/W/7
Page4
stageischosen soastominimize theoverall production costs. Forexample, extraction ofrawmaterial
isfornatural reasons located wherever therawmaterial isbountiful andeasily extractable;
energy-intensive processing wherever energy costsarelow; labour intensive stages incountries with
lowlabour costs; human capital stages incountries withanabundance ofskilled labour, andsoon.
Vertical FDIisbyitsverynature trade-generating. Bysub-dividing theproduction process invertical
stages between countries, trade isobviously created between thedifferent production units.
8. Distribution FDIrefers toinvestment abroad inlocalsalesoffices, distribution networks and
services facilities. Thereason forsuchinvestment maybetoensure asufficient number ofsalesand
services outlets. Such investment facilitates exports from thehome country.
9. Thecorrelation between outward FDIandexports ofthehome country hasbeeninvestigated
inmany empirical studies. Themain findings from these studies arethefollowing. First, local
production displaces exports offinalgoods atthesame timeasitcreates tradeinintermediate products
usedbytheforeign affiliate. Second, local production ofoneproduct lineseems tofeedbackinto
increased demand fortheother product linesoftheparent company thatarestillbeing exported. Third,
theexports oftheparent company tothird markets thatarenowserved bytheforeign affiliate are
reduced. Different studies conflict withregard tothenet-effect onhome country exports, themajority
suggesting acomplementary relationship between home country exports andoutward FDIandthe
minority suggesting asubstitute relationship. Allstudies agree thatthenet-effect onhome country
exports ofoutward FDIisnotverypronounced. Itshould benoted, however, thatthese studies focus
onaverage effects across industries andthattheeffects ofoutward FDIonexports mayvarysignificantly
among individual firms andindustries, depending upon thenature oftheinvestment (e.g.whether it
ismarket- orefficiency-seeking).
10. Regarding thecorrelation between inward FDIandexports ofthehostcountry ,thenotefocuses
ontheroleofinward FDIfortheexport performance ofdeveloping countries. Theempirical studies
indicate thatinward FDIcontributes totheexport performance ofdeveloping countries bothdirectly
through MNEs 'ownexport activities andindirectly byreducing thecostsandinformational obstacles
fordomestic firms tostartorexpand exporting. Inshort, theoverall correlation seems tobepositive.
11. RegardingtheimpactoftradepolicesandmeasuresonFDIflows,thefollowingpictureemerges:
bothhighandlowtrade barriers canattract FDI, butofdifferent types. FDIattracted toprotected
marketstendstotaketheformofstand-aloneproductionunitsgearedtothedomesticmarket.Incontrast,
lowtrade barriers, especially onintermediate goods, areconducive tovertical FDIattracted bythe
fundamental advantages ofthehostcountry. Onaverage, countries withanopentrade regime seem
toattract more FDIthancountries withaclosed trade regime. Moreover, thegains fromluring FDI
through hightradebarriers seem tobelimited. Onestudy found thatinflows ofFDIhaveasignificant
positive effect ontheGDP growth foroutward-oriented countries whereas noeffect canbediscerned
ontheGDP growth forinward-oriented countries. Thissupports theview thatFDIattracted by
fundamental location advantages ismore productive forthehostcountry thanFDIattracted by
protectionist policies. Thelatter maysimply induce FDIforwhich thehostcountry doesnothave
acomparative advantage, thereby drawing production factors from lessdistorted tomore distorted
sectors tothedetriment ofthedevelopment process.
12. Regarding theimpact ofinvestment polices andmeasures ontrade andFDIflows,ithasnot
beenpossible within thelimited timeavailable forthepreparation ofthisnotetoundertake ananalysis
ofgeneral investment policy measures aimed atattracting FDIthrough reducing barriers toFDIand
providing greater security forsuchinvestments. Instead, thenotefocuses ontwospecific aspects,
therelationship between investment incentives andperformance requirements, ontheonehand, andWT/WGTI/W/7
Page5
trade, ontheother. However, theeffects onimports andexports ofsuchgeneral investment policy
measures willobviously depend onthenature oftheinvestment attracted.3
13. Surveys undertaken onthemotivation forFDIindicate thatfundamental factors, suchasmarket
size,production costs, availability ofnatural resources, etc.,playamoreimportant rolethaninvestment
incentives andtaxbreaks. Nevertheless, when thefundamental determinants areattractive enough
foraninvestment tobeprofitable, andtheprofitability ismore orlesssimilar across alternative FDI
locations, incentives appear tohaveaneffect oninvestors 'decisions, especially forprojects thatare
cost-oriented andmobile. Moreover, ifonecountry offers incentives andanother country doesnot,
then,allother things being equal, foreign investors could beinfluenced intheirlocation choice between
countries. Performance requirements suchasdomestic content andexport performance requirements,
haveobvious tradeeffects. Domestic content rules, totheextent theyarebinding, forceforeign affiliates
tosource ahigher share oftheinputs from local sources thanthatmotivated bycostandquality
considerations. Inaddition toreducing imports ofsuchinputs, thiswillalsohavenegative repercussions
onexports since production costsgoupand/or quality down, making products lesscompetitive inthe
world market. Export performance requirements, totheextent theyarebinding, forceforeign affiliates
toexport alarger share ofthelocaloutput thanthatmotivated byprofit andcostconsiderations. A
complicating factor isthatperformance requirements areoftencombined with(paidforby)incentives.
Forexample, aforeign affiliate thatsubscribes tostricter domestic content requirements maybegranted
alonger taxholiday. Depending onhowdifferent incentives andperformance requirements arebundled,
thetrade effects maydiffer from those suggested above.
14. ThefinalSection considers theimpact ofregional trade agreements onFDIflows.Fourreasons
maybegiven whyregional trade agreements could induce higher levels ofFDI. First, market size
iscritical tothedecision toinvest inacountry. Regional integration istantamount toaneffective
"enlargement" ofmarket size,which encourages FDIbecause itallows foreign firms tosetupproduction
unitsofsufficient sizetobenefit fromscaleeconomies. Second, totheextent thataregional agreement
isexpected tospurgrowth, itwillincrease the(future) market sizeyetfurther, thereby adding tothe
attractiveness ofthelocation. Third, theremoval ofinternal tradebarriers between partner countries,
keeping external tradebarriers constant, willdivert some tradefromoutsiders toinsiders. Theprospect
ofloosing customers provides adefensive reason tochange fromexporting tolocalproduction inthe
region. Fourth, regionalism issometimes expected toleadtodeteriorating trading conditions foroutside
countries. Such fears, well-motivated ornot,canprovide anadditional defensive reason tomove
production intotheregion.
15. Empirical evidence largely confirms these predictions. Thehigher thepre-existing barriers
totrade andinvestment flows, andthestronger thelocational advantages, thestronger theimpact of
intraregional liberalization. Yet,theroleofregional agreements asamagnet forFDIshould notbe
exaggerated. Forexample, asshown byacasestudy oftheMERCOSUR agreement, domestic
macroeconomic andmarket-oriented reforms areatleastaspotent factors forcountries seeking toattract
FDI. Inother words, regional trade agreements arenotapanacea thatreplaces theneedfordomestic
reforms. However, aswaspointed outinthecasestudy ofNAFTA, regional agreements mayadd
credibility tothedomestic reform process (asinthecaseofMexico), thereby adding further momentum
toinflows ofFDI.
3Seethediscussion inparagraphs 6-8oftherelationship between different types ofFDI(horizontal, vertical
anddistribution FDI) andtrade.WT/WGTI/W/7
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II. THE ECONOMICS OFMULTINATIONAL ENTERPRISES AND FOREIGN DIRECT
INVESTMENT
16. FDIoccurswhenaninvestorinonecountry(thehomecountry)acquiresorexpandsitsownership
ofabusiness entity inanother country (thehostcountry) andtheequity participation issufficiently
large togivetheinvestor management control.4Thelatter qualification isimportant: itisthe
management dimension thatdistinguishes FDIfrom portfolio investment inforeign stocks andother
financial instruments. Foreign direct investors arepredominantly multinational enterprises (MNEs).5
Indeed, direct investment isthevehicle bywhich enterprises gomultinational. Justexporting toanother
market doesnotsuffice forthelabel"multinational", nordoesportfolio investment abroad orcontractual
supply orproduction arrangements withforeign firms. Itistheestablishment offoreign affiliates that
form anintegral partofthenetwork ofproduction andtrade activities under thecontrol ofacentral
decision-maker (theparent company) thatisthehallmark ofMNEs.6
17. Theclose relationship between MNEs andFDIisreflected intheacademic literature which
treats thetwoastwinsisters. Thefollowing questions haveproven critical tothedevelopment ofthe
theory ofMNEs, FDI,andtrade involving MNEs: Whydofirms invest abroad instead ofexporting
tothemarket fromthehome base(orimporting fromthemarket iftheobjective istosecure rawmaterial
orother intermediate goods)? Or,iftheinvestment isbased onsome asset controlled bytheparent
company, suchasapatented technology orproduct design, whynotlicense thetechnology orproduct
design toalocalfirmandprofit from theroyalties instead ofexploiting theassetin-house?
18. There isnowadegree ofconsensus thatFDI(andhence theexistence ofMNEs) istheoutcome
ofthree interacting circumstances. First, thefirmowns assets thatcanbeprofitably exploited ona
comparatively large scale, including intellectual property (such astechnology andbrand names),
organizational andmanagerial skills, andmarketing networks. Second, there mustbesome location
advantages individing production across countries compared toproducing inandexporting fromthe
home country exclusively. Third, theprofits ofexploiting theassets in-house must begreater than
from licensing theassets toforeign firms, andthebenefits must besufficient tomake itworthwhile
forthefirmtoincur theadded costs ofmanaging alarge, geographically dispersed organization in
different legal andcultural settings. Thisparadigm isknown asthe"eclectic" theory ofFDI, also
4Foramore extensive treatment ofthesubject matter ofthisnote, seethebooks byHood andYoung (1979),
Dunning (1993) andCaves (1996), ortheshorter surveys byAgarwal (1980) orRayome andBaker (1995).
5Othercommonlyusedtermsincludedmultinationalcorporations,multinationalfirms,transnationalcorporations
(which istheU.N. terminology), orsimply multinationals. There isnoclear indication intheliterature ofwhat
distinguishes onefrom theother.
6Theequity share needed togainmanagement control overalocal affiliate isanempirical issue. Aminority
equitystakemaysufficeinsomecaseswhilemajoritysharemayberequiredinothercases.Thissuggests,perhaps,
thateach investment should bejudged onitsownmerits forthepurpose ofdistinguishing between direct and
portfolio investment. Does itleadtocontrol, ordoesitnot? However, forthesakeoffacilitating international
comparability ofFDIflows, theIMFhasissued asetofguidelines (Balance ofPayment Manual, fifthedition,
1993) thatdraws thelinebetween portfolio anddirect investment atanequity capital stake of10%oftheordinary
shares orvoting power inanincorporated enterprise, ortheequivalent inanunincorporated enterprise. Provisions
aremade forwell-motivated derogations ifitisapparent thatlower equity share gives effective control, orvice
versa. These guidelines have notyetgained universal acceptance, however. Countries deviate bothupward
anddownward from the10% rule.WT/WGTI/W/7
Page7
known asthe"OLI" theory after three interacting components: (O)wnership, (L)ocation and
(I)nternalization advantages.7Thethree elements areoutlined below.
II.1 TheOLI(eclectic) theory
II.1.1 (O)wnership
19. FDIdiffers from portfolio investment inthatitinvolves asufficiently large equity stake to
givetheparent company management control. Ifweconsider anacquisition FDI,thequestion arises
whytheinvestor would takeanactive roleintheoperations rather thanbeing apassive stake holder.
Theanswer tothisquestion isthattheparent company canenhance theprofitability invarious ways
byemployingtheassetsatitsdisposal.Forexample,itmaybringinsuperiormanagementandmarketing
skills, newtechnologies, oritmayexploit synergy effects withtheotheractivities oftheparent company.
20. Onamore general level, MNEs basetheiractivities ontheownership ofvarious assets that
canbeexploited inmany markets atthesametime. Surveys haveshown thatMNEs regard technology
advantages astheirmostpotent competitive advantage vis-à-vis domestic firms, followed bymarketing
andmanagerial assets.8,9Ithasalsobeenobserved thatMNEs areparticularly common inindustries
withhighoutlaysonR&Dandadvertizing,whichareexpendituresthatareincurredtocreateandenhance
themarket value ofintangible assets.10Other studies haveshown thatthevalue ofMNEs 'intangible
assets (asapproximated bythedifference between themarket value ofthefirmminus thebook value
ofthetangible assets) tends tobelarge, relative topurely national firms.11
II.1.2 (L)ocation
21. Thesecond element oftheOLIparadigm dealswiththelocation ofvarious production activities
within amultinational firm,andhence thepattern ofFDIandrelated trade. What determines thelocation
ofvarious activities isofcourse theadvantages offered bydifferent locations inrelation tothepurpose
andcharacteristics oftheinvestment project under consideration.
22. Formany services industries, cross-border transaction costsmaysimply disqualify othermodes
ofsupply thanacommercial presence intheconsuming country. Acaseinpoint ishotel services.
Other types ofservices could theoretically belocated outside theconsuming country although ata
considerable competitive disadvantage. Forexample, while newcommunication technologies enable
cross-border supply ofsome banking services, foreign banks maystillfinditnecessary toestablish
alocal network ofoffices tocompete efficiently withdomestic banks (andforeign banks already
established inthehostcountry). Trade insome types ofservices andFDIarethusintrinsically linked.12
7Thedifferent bitsandpieces ofthetheory were firstputtogether byDunning (1977). Hereferred tohis
approach as"eclectic" asitdrew together different disjoined elements intoacoherent framework.
8Bertin andWyatt (1988, pp.25-29)
9NotethatthesearethesortofbenefitsthatmakeFDIattractiveformanyhostcountries,especiallyconsidering
thescope fordomestic firms tolearn from interaction withforeign multinationals.
10SeeCaves 1996, chapter one,fordetails andreferences.
11Morck andYeung (1991)
12Foratreatment ofFDIandmultinational firms inservices, see,e.g., UNCTC (1989).WT/WGTI/W/7
Page8
23. Tominimize production cost, MNEs often place different stages oftheproduction process
indifferent countries. Forexample, labour intensive production stages tendtobelocated incountries
withlowlabour costs; human capital intensive stages inlocations withanabundance ofskilled labour,
andsoon.Theassociated FDIisoften referred toasvertical FDIbecause ofthesubdivision ofthe
production process invertical stages.
24. Itisalsocommon tolocate similar oridentical production activities inmore thanonecountry.
Theassociated FDIisreferred toashorizontal FDI. Themotivation forhorizontal FDImaybeto
avoidhightransportationcostsassociatedwithacentralproductionunitservicinggeographicallydispersed
markets around theworld. Local production maybeespecially profitable forproducts withahigh
weight/value ratio(such ascement). Themotivation mayalsobeto"jump" (bypass) ahightariffwall
orother trade barriers thatrender exports unprofitable orimpossible. Horizontal FDImayalsobe
undertaken forother proximity reasons. Forexample, amarket presence mayhelpfirms toobserve
andrespond tochanges inconsumer demands aswellastoprovide necessary after-sales services.
Moreover, consumers maysometimes bemore prone toaccept foreign products iftheyareproduced
locally. However, fragmentation canonlybetaken sofar.Duplication ofproduction units comes
atthecostofforegone scaleeconomies. Consequently, thenumber oflocations mustbelimited. As
ageneral rule,scaleeconomy considerations tendtofavour location incountries withlarge domestic
markets thatcanmore easily support production unitsofsufficient scale. Indeed, asshown inmany
empirical studies, market sizeisacritical consideration inthelocation ofFDI.13However, smaller
countries mayserve asanexport platform fortheadjacent region iftheinfrastructure isadequate.
25. Another aspect withabearing onwhere tolocate various activities isriskdiversification. In
choosing among available projects, MNEs (likeportfolio investors) areoften believed tobeguided
bybothexpected returns andriskconsiderations. Aproject withaslightly lower expected return may
bepreferred toaproject withahigher expected return iftheformer islessrisky and/or serves asa
hedge against other activities ofthefirm. Forexample, acounter-cyclical project maybeundertaken
forthepurposeofcounter-balancingpro-cyclicalactivitiesandtherebysmoothingthecashflow(earnings)
overthebusiness cycle. Ifthereturns onactivities indifferent countries arenotperfectly correlated,
afirmcould reduce theoverall riskexposure byspreading itsactivities across countries. FDIcould
therefore bemotivated byinternational riskdiversification atthecorporate level.14
II.1.3 (I)nternalization
26. Thethirdandfinalelement oftheOLIparadigm deals withtheinternalization aspect ofFDI,
thatis,theexploitation ofthefirm'sassets in-house rather thanthrough acontractual arrangement
withalocalentrepreneur.15Theadvantage ofthelatter strategy isthatitcould reduce thecosts of
entering anewmarket withanunfamiliar legalandinstitutional setting, different business customs,
anewlanguage, andsoon.Byengaging alocalfirm, entry costs canbeholddown toaminimum,
including thecosts should theproject fail.However, contractual arrangements arenotwithout their
13See. e.g., Rowthorn (1992)
14Statistical evidence indeed confirms thatMNEs enjoys diversification gains. (SeeCaves 1996, chapter 1,
forreferences).However,itcannotbeconcludedfromthisevidencethatriskdiversificationistheprimemotivation
forFDI. Theultimate diversification gainwould accrue totheMNE ifitacquired foreign subsidiaries diversified
inproduct linesaswellasgeographical space, butsuchconglomerate (diversified) MNEs arelesscommon than
MNEs focusing onafewcoreactivities. Thissuggests thatthere arecertain costs ofdiversifying intounrelated
business activities thatmayoutweigh thepotential diversification gains.
15ThisinternalizationaspectofFDIhasbeendevelopedby,interalia,Williamson(1975),BuckleyandCasson
(1976), Rugman (1980), andHorstmann andMarkusen (1987).WT/WGTI/W/7
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ownproblems. Forexample, theowner ofanewtechnology mayshow acertain apprehension in
revealing alldetails toapotential licensee. After all,thelicensee could reject thedealanddevelop
acompeting technology onthebasisoftheinformation received. Conversely, thelicensee willhardly
strike adealunless alltheinformation isonthetable, sothatthevalue oftheassetcanbeassessed.
Inlinewiththisargument, ithasbeenobserved thatnewtechnologies arepredominantly exploited
in-housewhereasoldertechnologiesareoftenmadeavailableviacontractualarrangementstoindependent
firms.16Another problem arises because theassets maybedifficult todecouple fromthestaffofthe
MNE. Forexample, acomplicated production process requires notjustablueprint describing how
things work intheory. Italsorequires skilled personnel withtheability tohandle problems asthey
occur. Transferring suchassets istherefore acomplicated process involving training andcontinuous
support tothefirmacquiring theasset.17Itmayalsobedifficult toensure thatthelicensee behaves
properly soasnottoundermine thereputation ofthelicensor. Forexample, ifquality control inthe
manufacturing ofalicensed medicine islax,thismaynotjusthaveserious consequences forpatients,
butthereputation ofthelicensor maybeundermined eveninother markets, evenifpoorquality control
wasaclearbreach ofcontract. Finally, thejudicial system toenforce contracts maybeweak inthe
hostcountry, andfewcompanies maytaketheriskofrevealing business secrets orlicense technologies
iftheyhavenojudicial recourse incaseofmisconduct. Contractual andenforcement costs maythen
tipthebalance towards in-house exploitation (internalization) oftheassets owned byMNEs.
27. Theinternalization aspect ofFDIisintrinsically linked tothetheory ofthefirmdeveloped
byCoase (1937). Theexistence oflargeintegrated firms restsonthefoundation thatinternal transactions
costs arelower thanexternal (market-based) transaction costs between independent firms. Thatis,
while acomplex production process could inprinciple besubdivided between different independent
firms, theassociated coordination andtransaction costs maysometimes beprohibitive. Empirical
evidence suggests thattransaction costsareparticularly highinvertically integrated process industries,
high-tech industries, andquality (reputation) sensitive industries.18Industries withhightransaction
costs tendalsotobedominated bymultinational firms.19
II.1.4 Summary
28. Tosummarize, FDItends tooccur asaresult ofthree interacting circumstances. First, the
firmowns intangible assets thatcanbeprofitably exploited onacomparatively large scale, including
intellectual property, organizational andmanagerial skills, andmarketing networks. Second, there
mustbesome location advantages individing production across countries compared toproducing in
andexporting from thehome country exclusively. Inservices industries there maybenoviable
alternativetoacommercialpresence.Inothercases,commercialconsiderationsmaydictateasubdivision
16Cheng (1984)
17Teece (1986)
18There isample evidence thatactors invertically integrated process industries donotfeelcomfortable relying
entirely onshort-run contracts forinputs. Forexample, tobecostefficient refineries need tooperate onfull
capacity andthisrequires aconstant flowofcrude oil.Backward integration thatreduces uncertainty about oil
supply cansaverefiners large investments instorage capacity (Greening, 1976). Moreover, itcanbecostly
torelyonthemarket mechanism because ofhighswitching costs. Forexample, alumina refining facilities are
optimized forbauxite ofacertain quality andtheswitching ofsuppliers because ofastalemate overprices means
costly adjustments oftheproduction process (Stuckey, 1983). Ithasalsobeen observed thatJapanese process
industries have become involved inextractive activities asaconsequence ofsuppliers reneging onlong-terms
supply contracts (Tsurumi, 1976).
19Buckley (1988)WT/WGTI/W/7
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oftheproduction process invertical stages, putting labour intensive stages inlocations withlowlabour
cost,human capital intensive stages inlocation withanabundance ofskilled labour, andsoon(vertical
FDI). Inyetother cases itmaybebeneficial toproduce thesame lineofproducts inmany countries
tobypass trade barriers orsaveontransport andmarketing expenditures (horizontal FDI). Third,
theprofits ofexploiting theassets in-house mustbegreater thanfrom licensing theassets toforeign
firms, andthebenefits mustbesufficient tomake itworthwhile forthefirmtoincur theadded costs
ofmanaging alarge, geographically dispersed organization indifferent legal andcultural settings.
Asummary ofthedetermining factors ofvarious kinds ofFDIisprovided inTable I.
29. Asafinalword, there isnopresumption thatallindustries willchoose thesame mode of
supplying amarket, oronlyoneofthemodes. Indeed, theprevalence ofFDIdiffers considerably
between sectors. FDIisespecially common inindustries where transaction costsbetween independent
parties aredeemed tobehigh, suchasvertically integrated process industries, high-tech industries,
andquality andreputation sensitive industries.WT/WGTI/W/7
Page11
Table I
Types ofInternational Production: Some Determining Factors
Types of
international
production(O)
Ownership
advantages (The
'why'ofMNE
activity)(L)
Location advantages
(The'where 'of
production)(I)
Internalization
advantages (the
'how'of
involvement)Strategic(s) goals
ofMNEsIllustration oftypes of
activity thatfavour
MNEs
Natural resource
seekingCapital, technology,
access tomarkets;
complementary
assets; sizeand
negotiating
strengths.Possession ofnatural
resources andrelated
transport and
communications
infrastructure; tax
andother incentives.Toensure stability
ofsupplies atright
price; control
markets.Togainprivileged
access to
resources vis-a-vis
competitors.(a)Oil,copper, bauxite,
bananas, pineapples,
cocoa, hotels
(b)Export processing,
labour intensive products
orprocesses.
Market seeking Capital, technology,
information,
management and
organizational
skills; surplus R&D
andother capacity;
economies ofscale;
ability togenerate
brand loyalty.Material andlabour
costs; market size
andcharacteristics;
government policy
(e.g. withrespect to
regulations andto
import controls,
investment
incentives, etc).Wish toreduce
transaction or
information costs,
buyer ignorance,
oruncertainty,
etc;toprotect
property rights.Toprotect existing
markets,
counteract
behaviour of
competitors; to
preclude rivals or
potential rivals
from gaining new
markets.Computers,
pharmaceutical, motor
vehicles, cigarettes,
processed foods, airline
services.
Efficiency seeking
(a)ofproducts
(b)ofprocessesAsabove, butalso
access tomarkets;
economies ofscope,
geographical
diversification, and
international
sourcing ofinputs.(a)Economies of
product
specialization and
concentration.
(b)Lowlabour
costs; incentives to
local production by
hostgovernments.(a)Asforsecond
category plus
gains from
economies of
common
governance.
(b)Theeconomies
ofvertical
integration and
horizontal
diversification.Aspartof
regional orglobal
product
rationalization
and/or togain
advantages of
process
specialization.(a)Motor vehicles,
electrical appliances,
business services, some
R&D.
(b)Consumer
electronics, textiles and
clothing, cameras,
pharmaceutical.
Strategic asset
seekingAnyoffirstthree
thatoffer
opportunities for
synergy with
existing assets.Anyoffirstthree
thatoffer
technology, markets
andother assets in
which firmis
deficient.Economies of
common
governance;
improved
competitive or
strategic
advantage; to
reduce orspread
risks.Tostrengthen
global innovatory
orproduction
competitiveness;
togainnew
product linesor
markets.Industries thatrecord a
highratiooffixed to
overhead costs andwhich
offer substantial
economies ofscale or
synergy.
Trade and
distribution (import
andexport
merchanting)Market access;
products to
distribute.Source ofinputs and
local markets; need
tobenear
customers; after-
sales servicing, etc.Need toprotect
quality ofinputs;
needtoensure
sales outlets and
toavoid under
performance or
misrepresentation
byforeign agents.Either asentry to
newmarkets oras
partofregional or
global marketing
strategy.Avariety ofgoods,
particularly those
requiring contact with
subcontractors andfinal
consumers.
Support services Experience of
clients home
countries.Availability of
markets, particularly
those of'lead'
clients.Various (see
above categories).Aspartof
regional orglobal
product or
geographical
diversification.(a)Accounting,
advertising, banking,
producer goods.
(b)Where spatial
linkages areessential
(e.g. airlines and
shipping).
Source: Reproduced from Table 4.2inDunning (1993).WT/WGTI/W/7
Page12
III. THE RELATIONSHIP BETWEEN FOREIGN DIRECT INVESTMENT AND TRADE
30. Against thebackground ofthereview intheprevious Section ofthedeterminants ofFDI,this
Section examines therelationship between FDIandtrade. Isincreased trade associated withlessor
withmore FDI,or,conversely, isincreased direct investment associated withlessorwithmore trade?
Inshort, aretrade andinvestment substitutes orcomplements?
III.1 Thetraditional view
31. Thetraditional viewholds thatdirect investment andtrade arealternative ways ofsupplying
amarket, i.e.,trade andFDIaresubstitutes. Thisviewwasdeveloped inthemid-1950s when FDI
wasstillperceived asaspecial caseofportfolio investment. Noparticular rolewasassigned toMNEs
inthisanalysis. Theargument wasformalized byMundell (1957) whoinvestigated theconsequences
ofinternational factor movements using thestandard factor-endowment model oftradeassociated with
twoSwedish economists, Heckscher andOhlin. TheHeckscher-Ohlin model views trade ingoods
andservices asessentially indirect tradeinfactor endowments. Allowing forfactor movements would
thennaturally reduce trade, asobserved byMundell. Thesalient features oftheargument areprovided
inBox1.
32. TheHeckscher-Ohlin-Mundell model isuseful forexplaining thebroad picture ofinter-industry
tradeandinternational factor movements. Forexample, itprovides auseful framework forexplaining
thebasic trade pattern between developed anddeveloping countries where theformer tendtoexport
(human) capital intensive products andimport labour intensive products andrawmaterial. Itisalso
useful forexplaining whycapital abundant developed countries arethemainsource ofoutward-oriented
FDI-thedeveloped countries arecurrently home tosome 92%oftheworld 'sFDIstock andhostto
73%oftheworld 'sFDIstock (WTO, 1996) -andwhylabour migration tends togointhedirection
from developing todeveloped countries. However, itdoesnotshedmuch lightonthetrade and
investment flows between countries withsimilar factor endowments, technological capabilities and
income levels. Interms ofsheer volume, suchflows dominate overtradeandinvestment flows between
countries withdifferent factor endowments.
33. Moreover, theHeckscher-Ohlin-Mundell model doesnotassign anyroletoMNEs. Yet,
UNCTAD (1995) estimates thatroughly onethirdofworld trade isintra-firm trade between related
parties andanother thirdistrade between MNEs andunaffiliated firms. Thatis,roughly twothirds
ofworld trade involve MNEs inonewayortheother. Furthermore, alarge partofworld trade is
inintermediate products, forwhich theHeckscher-Ohlin model provides littleexplanation. According
toWyckoff (1993), theratioofintermediate imports tototalimports ranges fromsome 50%inCanada,
Germany, theUnited Kingdom andtheUnited States toalmost 60%inFrance andperhaps 70%in
Japan. Much oftheimports ofintermediate goods aredonebyvertically integrated MNEs thatundertake
different stages oftheproduction process indifferent countries. Allthissuggests thattherelationship
between trade andFDImaybefarmore complex thanthesubstitute relationship suggested bythe
traditional factor endowment model. Thenextsubsection examines howthismorecomplex relationship
isexplained inthemodern literature thatseeks toaccount explicitly fortheroleofMNEs asvehicles
forFDI.WT/WGTI/W/7
Page13
Box1
TheRelation between Trade andFactor Movements intheHeckscher-Ohlin-Mundell Model
Toshow thepoint made byMundell thatfactor movements substitute fortrade,
consider firsttheextreme caseofautarky, thatis,where there isnotrade ingoods and
services, noranyfactor movements between countries. Assume thatconsumer preferences and
production technologies aresimilar across countries atthesame timeastheendowments of
production factors differ. Thetheory thenholds thatcapital intensive goods would berelatively
cheap toproduce incapital abundant countries, andlabour intensive goods would berelatively
cheap toproduce inlabour abundant countries. Ifcountries would nowopen upfortrade,
while retaining restrictions oncapital andlabour movements, themodel predicts thatcapital
abundant countries willexport capital intensive goods inexchange forlabour intensive goods
from labour abundant countries. Inasense, countries trade factor endowments indirectly
through thefactor contents oftheirexports andimports.
Ifthecountries instead reduce thebarriers oninternational capital flows, while retaining
restrictions ontrade andlabour migration, capital would tendtoflowfrom capital abundant to
capital scarce (labour abundant) countries because ofhigher returns onthemargin inlocations
where capital isrelatively scarce. (Arelaxation oftherestrictions oflabour migration would
induce aflowoflabour intheopposite direction.) Intheextreme, international capital and/or
labour flows would tend toequalize thecapital-labour ratio across countries andthereby
eliminate theincentives totrade onthebasis ofdifferences infactor endowments. Thus, inthis
model, international movements ofproduction factors (capital and/or labour) substitute for
traditional "comparative advantage" based inter-industry trade.
III.2 Themodern view
34. TheFDItheory outlined inSection II(theOLItheory) hasquiterecently beenintegrated with
modern tradetheory thatemphasizes intra-industry tradeindifferentiated goods (two-way tradewithin
thesame industry classification), scaleeconomies, andimperfect competition.20There areessentially
twostrands intheliterature. Onestrand considers thedeterminants andeffects ofhorizontal FDIand
associated trade, andtheother strand considers vertical FDIandassociated trade.21
III.2.1 Horizontal FDIandtrade
35. Horizontal FDIrefers toinvestment induplicative production unitsindifferent countries that
produce essentially thesamelineofproducts. Thetheoretical literature hasdemonstrated thathorizontal
FDItends tooccur when exporting isarelatively expensive mode ofsupplying amarket because of
hightransport costs ortariffs (orother trade barriers).22Firms arefaced withtheintricate problem
ofchoosing theoptimal number ofproduction unitsandtheirbestlocations, subject tothebasictrade-off
between scale economies ofcentralized production andproximity advantages (lowtrade costs) of
20Forarelatively simple treatment ofthenewstrand ofFDIandtrade literature seeMarkusen (1995).
21These models donottreatthe"internalization" aspect oftheOLItheory; itissimply assumed thatthe
licensing alternative isnotprofitable. Thedecision iswhether toexport tothemarket orserve themarket through
local production.
22See,forinstance, Horstmann andMarkusen (1992), Brainard (1993a) andMarkusen andVenables (1995).WT/WGTI/W/7
Page14
geographically dispersed production. Thecost-minimizing solution foreachindustry depends onthe
degree ofscaleadvantages, transport costs andthetrade barriers thatapply. Asageneral rule,scale
economy considerations tendtofavour location incountries withlargedomestic markets thatcanmore
easily support production units ofasufficient scale.23However, smaller countries mayserve asan
export platform fortheadjacent region iftheinfrastructure isadequate. Location considerations also
favour countries inwhich production conditions (factor endowments) aresimilar tothose ofthehome
base, asthisallows firms toduplicate theproduction process withminimum adjustments.
36. Anattractive feature ofthese models isthattheypredict two-way direct investment between
countries withsimilar factor endowments, which iswellsupported byempirical evidence, suchasthe
two-way flowofdirect investment between developed countries.24
37. There isaninteresting difference between analytical models thatinclude MNEs asmajor players
andtrademodels where firms arepurely national. Thetrademodels withpurely national firms predict
thatthevolume ofintra-industry trade willincrease ascountries become more similar overtimein
terms oftheirfactor endowments.25Atthesametime, inter-industry tradewillbecome lessimportant.26
Incontrast, themodels withhorizontally integrated MNEs suggest thatthevolume ofintra-industry
trade willdecrease relative tolocalsalesbyforeign affiliates ascountries converge inrelative factor
endowments andincome, unless tradecosts(such astariffs andtransport costs) arefalling atthesame
time. Markusen andVenables (1995) present some datathatsupport thishypothesis. They point to
thefactthatfrom1966to1991, two-way trade between theUnited States andEurope rose12.8times
innominal value, while thevalue ofFDIstocks (United States owned inEurope andEuropean owned
intheUnited States) rose20.3times invalue. During thisperiod, Europe wasgradually catching
upwiththeUnited States interms ofGDP percapita.
38. Thehorizontal trade andFDImodels findstrong empirical support. Intheperhaps most
comprehensive empirical study tothisdate,Brainard (1993b), using bilateral databetween United States
and27partner countries in64different industries, found strong empirical evidence thattheshare of
totalsalesaccounted forbyforeign affiliates (i.e., theshare ofthemultinational firms'salesthatis
produced locally) isgreater thehigher arethetransport costs between thehome market andthehost
market,thehigherarethetradebarriers,andthelowerareplantscaleeconomiesandinvestmentbarriers.
These areverymuch thepredictions thataregenerated inthetheoretical models. Other studies have
confirmed thedifferent elements ofthetheory. Forexample, Horst (1972) found thattheratioofUnited
States MNEs exports toCanada inrelation tolocalproduction bytheirCanadian affiliates washigher
23Asnotedbefore,marketsizeisacriticalconsiderationforlocationbecauseofeconomiesofscaleinproduction
(Rowthorn, 1992).
24Incontrast, theoldHeckscher-Ohlin-Mundell model predicts onlyone-way flows, whereas theportfolio
approach cangenerate acertain amount oftwo-way flows forthepurpose ofriskdiversification.
25Theconcept of"factor endowments" isarguably abitmisleading since itsuggests thatproduction factors
aregiven once andforall.Thisisquestionable fornatural resources thatcanbedepleted, andeven more so
forlabour andcapital. The"quality" oftheworkforce canbeaugmented byinvestment inhuman capital through
schooling andonthejobtraining, andcapital "endowments" areaugmented bothinterms ofquantity andquality
throughdomesticandforeigninvestment.Indeed,thereisacertaindegreeof"convergence"infactorendowments
intheworld among asubset ofcountries. Forexample, thesaving andinvestment rates (asapercentage of
GDP) inEastAsiahavebyfarexceeded those oftheOECD countries overthelastdecades. Asaconsequence,
EastAsiahasgrown considerably faster thantheEuropean Union andtheUnited States. Aspredicted bymodern
trade models, thetrade hasalsoshifted character from theprevious emphasis ofinter-industry trade based on
differences infactor endowments tointra-industry trade indifferentiated industrial products.
26SeeChapter 8inHelpman andKrugman, 1985.WT/WGTI/W/7
Page15
thesmaller wastheCanadian market (fortheparticular product) relative tothatoftheUnited States,
presumably indicating thedeterrent effect oflocalproduction ifscaleeconomies aresubstantial. Buckley
andPearce (1979) alsonoted thatMNEs active inindustries withsubstantial scale economies tended
torelymore onexports from acentral production unitthanonlocal production. Anderson and
Fredriksson (1993) found thatforeign affiliates export more thefewer thecountries inwhich theparent
company hasaffiliates, indicating theneedtolimitthenumber ofproduction unitsforscaleeconomy
reasons. Moreover, many studies haveconfirmed thattrade barriers (actual orpotential) cantipthe
balance infavour oflocalproduction overexport.27
39. Itisalsoclear thathorizontal FDIdisplaces some exports ofthehome country. Increased
local production reduces theneedtoexport theproduct thatisnowproduced inthehostcountry.
However,thisdoesnotnecessarilymeanthatoverallexportsbytheparentcompany(anditsthirdcountry
affiliates) tothehostcountry willdecline. Horizontal FDI, while arguably displacing trade infinal
goods, tends togenerate offsetting trade inintermediate goods.28Thatis,thechange inmodes from
exports tolocal production isoften followed byincreased trade inintermediate goods usedinthe
production ofthefinalgood. Thisvertical aspect ofhorizontal FDIisonlypartially covered inthe
models above which donotidentify anyintermediate goods except for"headquarters services" (R&D,
management, andmarketing services). Yet,empirical evidence points tosignificant increases inthe
trade ofphysical intermediate goods following FDI. Forexample, Swedenborg (1985, pp.233-236)
showed thatSwedish exports toforeign affiliates increased withtheaffiliates 'production.29
40. Whether thenetvalue oftrade willincrease ordecrease isdifficult tosay.Ontheonehand,
ifthevolume produced locally isjustequal tothevolume thatwasexported tothemarket before, it
isclearthatthevalue oftrade mustdecline. Thevalue ofimported intermediates mustlogically be
lower thanthevalue ofdisplaced finalgoods unless thelocalvalue added isnegative. Ontheother
hand, thereisnoreason tobelieve thatthesaleswould stayconstant. Thereason whytheMNE started
toproduce locally inthefirstplace ispresumably thatthetotalcostofsupplying themarket from a
localproduction unit(including tariffs, which tendtobehigher onfinalgoods thanonintermediates)
islower thanforexports. Ifthissaving ispassed ontolocalconsumers, saleswillarguably behigher
thanbeforeandthiswillincreasethedemandforimportedintermediates.Thelattereffectmaydominate,
leading tomore exports forthehome country. Theexports ofthehome country mayalsoincrease
forother reasons. Forexample, establishing localproduction ofoneproduct, say,aspecific carmodel,
mayspillover inincreased demand forotherproducts exported bytheMNE (other carmodels). Indeed,
foreign affiliates oftenserve thedualroleofproduction unitandmarketing armfortheparent company 's
product line. Thenetresult onhome country exports cantherefore goupordown depending onthe
circumstances.
41. Related totheabove point, itshould benoted thatthecomplementary relationship between
horizontal FDIandtrade inintermediate goods mayweaken overtimefortworeasons: Firstly, it
takes timeforforeign affiliates tofindsuitable domestic partners tosupply intermediate goods. The
import content maythengradually decrease overtimeasthevertical supply linkages areestablished
withthelocaleconomy. Forexample, McAleese andMcDonald (1978), studying Irishmanufacturing
during theperiod 1952-1974, found thatlocal purchases increased asforeign affiliates matured.
Secondly, thistendency issometimes reinforced bygovernment measures, especially indeveloping
27SeeSection IV.
28With "final goods" wemean thegood thatisproduced bytheforeign affiliate. Thisgood could inturn
beaninput inyetanother higher stage oftheproduction process.
29SeeSection III.3.1 foradetailed discussion oftheempirical evidence onthetrade effects ofoutward FDI
onhome countries.WT/WGTI/W/7
Page16
countries. Forexample, itisnotuncommon thathostgovernments impose localcontent requirements
asaprerequisite forFDI,or,alternatively, grant more favourable investment incentives tofirms that
source more inputs locally. Such domestic content requirements areoften phased ingradually after
aninitial grace period.30Thus, bothfornatural andpolicy related reasons, foreign affiliates tendto
source more inputs locally astheinvestment matures. Hence, aninitial complementary relationship
between trade andFDImayeventually turnintoanetsubstitute one.
III.2.2 Vertical FDIandtrade
42. AsdiscussedinSectionII,MNEsoftenlocatedifferentstagesofaproductionprocessindifferent
countries inorder tominimize production costs. Theassociated FDIisreferred toasvertical FDI
because ofthesubdivision oftheproduction process invertical stages. Vertical FDIisbyitsvery
nature trade-generating. Bysubdividing theproduction process invertical stages between countries,
trade isobviously created (compared tothesituation where allstages areundertaken inonecountry).
43. Tobeworthwhile, thecostsavings ofavertical subdivision ofproduction between countries
must outweigh theadditional expenditures ontariffs andtransportation costs. Each stage ofthe
subdivision addsanother tariff andtransportation margin, andifthegains from eachstepoffurther
subdivision arediminishing, thevertical division willeventually come toahalt. Trade barriers, or
trade costs ingeneral, thusdiscourage vertical FDI,whereas theymayencourage horizontal FDI(as
shown intheprevious Section).31
44. However, itshould bepointed outthatthedistinction made intheliterature between vertical
andhorizontal FDIisnotalways clear-cut inreality. Asmentioned previously, evenhorizontal FDI
tends togenerate asubstantial amount ofvertical tradeofintermediate inputs fromtheparent company
toitsforeign affiliates.32Thedifference between thetwotypes ofinvestment isperhaps more inthe
purpose oftheinvestment thaninthetradeeffects. Horizontal FDIismade forthepurpose ofbypassing
tradebarriers oreconomizing ontransport anddistribution costs. There mayalsobeother advantages
ofbeing close tothefinalconsumers, suchasovercoming aresistance tobuyforeign produced goods
andservices orfacilitating theprovision ofafter-sales services tothecustomers. Thedraw-back is
forgone scaleeconomies ascentral production isreplaced bylocalproduction ineachmarket. Inthe
caseofvertical FDI, thevertical trade isclosely related tothepurpose oftheinvestment, namely,
toexploit international costdifferences forvarious stages oftheproduction process. Vertical FDI
istherefore byitsverynature trade-creating while horizontal FDIgenerates tradeinintermediate goods
andservices asaside-product, atthesame timeasitdisplaces some trade infinalgoods thatarenow
30SeeSection V.2foradiscussion oftheimpact ofsuch investment measures.
31Itshould benoted thatitisnotjustthetrade barriers ofthehostcountry thataffect vertical FDI: thetrade
barriers ofthehome country alsomatter. Anexample mayclarify thispoint. Consider aproduct thatisproduced
intwostages. Assume thatbothstages areinitially undertaken inthehome country (denoted A),which isalso
thecountry where thefinalproduct isconsumed. Thesumoftheproduction costs ofthetwostages isC1
A+
C2
A.Assume nowthatavertical FDIisundertaken inorder toproduce stage twoincountry B.Assume that
Bimposes atariff tBonthecomponents produced inAduring thefirststage. Thelocal valued added incountry
BisC2
B.Theprocessed product isthenre-imported bycountry A,subject toatariff tA.Thefinal costofthe
product isthenequal toC1
A+C2
B+tB+tA(thetariffs areassumed tobespecific). Comparing thetwo
alternatives (with andwithout FDI), theinvestment isprofitable ifthecost-savings arelarger thantheincurred
tariffexpenditures:C2
A-C2
B>tB+tA.Thisexampleillustratesthattheprofitabilityofout-sourcingofproduction
stages (through vertical FDI) depends bothonthetariff structure ofthehostandhome country.
32Foraunified treatment ofhorizontal andvertical FDI, seethepaper byMarkusen, Venables, Konan and
Zhang (1996).WT/WGTI/W/7
Page17
produced locally. Again, theneteffect ontrade ofhorizontal FDImaystillbepositive, especially
ifthetrade costforthefinalgood ishighsothatthemarket wasnotserved toitsfullpotential before
theestablishment ofalocalsubsidiary.
III.2.3 Distribution FDIandtrade
45. MNEs donotjustinvest inproduction facilities abroad, butalsoinmarketing, distribution
andservice-related activities. Some reasons tointernalize suchactivities (asopposed tousing local
agents under contract) weregiven inTable I.Forexample, thereason maybetoensure asufficient
number ofsalesoutlets andtomaintain acertain standard ofinformation andafter-sales services to
customers. There islittleneedtodwell onthetrade effects ofsuchinvestment. Ifforeign producers,
foronereason ortheother, cannot findsuitable outlets ofthenecessary standard, thereislittleoption
buttoinvest andrunanownnetwork ofoutlets andservices facilities. Thealternative isnottoserve
themarket atall,oronlypartially. These investments aretherefore complementary totrade. Itfollows
thatgovernment restrictions onacommercial presence ofdistribution andservices facilities retard trade.
III.3 Thetrade effects ofFDIforhostandhome countries
46. Thissubsection reviews theempirical literature onthetrade effects ofoutward andinward
FDIonhome andhostcountries.
III.3.1 Home country trade andoutward FDI
47. Therelationship between outflows ofFDIfromtheUnited States andexports fromtheUnited
States hasbeenexamined inanumber ofstudies. Early work, based ondatafrom the1970s, found
apositive relationship between United States exports in14industries to44countries andthelevelof
localproduction byUnited States-owned affiliates (Lipsey andWeiss, 1981). Inasubsequent study,
Lipsey andWeiss (1984) sharpened theprediction byhaving access tofirmleveldata(asopposed to
industry leveldata). Dividing home country exports intofinalproducts andintermediate products they
found theexpected complementary relationship between production offoreign affiliates andexports
ofintermediate goods fromtheparent company. Interestingly, theUnited States exports offinalgoods
alsoincreased inafewindustries, while theydidnotshow anysignificant decline inother industries.
Theexplanation given forthisresult wasthatlocalproduction ofoneproduct facilitates thesalesof
other products exported bytheparent company. Asmentioned before, localaffiliates donotjustserve
asaproduction unit,butareoften engaged inthemarketing ofthewhole product lineoftheparent
company. Thiswillimprove thecompetitive situation oftheinvesting firmvis-à-vis localfirms and
exporters fromother nations. Inlinewiththisargument, Lipsey andWeiss (1981) found thatUnited
States FDItends toreplace theexports ofother nations rather thantheownexports, underlining the
importance ofFDIinthecompetition formarket shares.33
48. AmorerecentstudybyHufbaueretal.(1994)alsofoundthatUnitedStatesexportsarepositively
related toUnited States FDIstocks. Similar results wereobtained fortheregression between Japanese
FDIstocksandexports,andbetweenGermanFDIstocksandexports,althoughtheestimatedcoefficients
were somewhat lower andnotalways statistically significant. Graham (1996) alsoconfirms a
complementary relationship between United States exports andFDIflows tovarious partsoftheworld,
withthenotable exception ofLatin America. Graham suggests thattheLatin American exception was
duetothosecountries 'import substitution policies inthe1970s andearly1980s, which stillhadachilling
33Inthiscontext, itmaybeworth mention theobservation ofKnickerbocker (1973) thatFDIbyonefirm
isoften followed byFDIofcompeting firms torestore thecompetitive balance.WT/WGTI/W/7
Page18
effect onUnited States exports. Acomplementary relationship wasalsofound byBlomström etal.
(1988) onSwedish data, although theeffect wasstatistically insignificant insome industries.
49. Astudy bySvensson (1996) addsanother twist. Benefitting fromexceptional micro-data on
trade andFDIflows ofSwedish multinationals, heestablishes thefollowing pattern: First, increased
foreign production reduces theparent company 'sexports offinalgoods tothehostcountry, i.e.,the
goods thattheforeign subsidiary isnowproducing. Secondly, andatthesame time, theexports of
intermediate goods goup,butnotquiteenough tooffset thereduction inexports offinalgoods. Thirdly,
apoint overlooked bytheother studies, theexports oftheparent company tothirdmarkets nowserved
in"competition" withforeign subsidiaries arereduced. Theneteffect onSwedish exports, accounting
forthirdmarket effects, wasfound tobesomewhat negative.
50. Inconclusion, while itsseems clearthatFDIcandisplace tradeinfinalgoods atthesame time
ascreating trade inintermediate goods, theempirical evidence conflicts withrespect totheneteffect
onhome country exports. Studies based onmore aggregate industry dataseem toindicate anoverall
complementary relationship between outward FDIandhome country exports, although thisdoesnot
holdforallindustry sectors. These studies suggest thatincreased local sales, andthedemand that
thisgenerates forimported intermediates, compensate fordisplaced trade infinalgoods. Onestudy
evenfound thattheexport offinalgoods, albeit notthesame asthose produced locally, mayincrease
withoutward FDI. Thereason ispresumably thattheforeign affiliate engages inthemarketing of
thewhole product lineoftheparent company (Lipsey andWeiss, 1984). Ontheother hand, taking
intoaccount alsothattheforeign affiliates mayreplace some oftheparent company 'sexports tothird
countries, Svensson (1996) found anegative relationship between home country exports andFDIby
Swedish multinationals.
51. Afinalnoteofcaution arises fromthefactthatitisnotknown whattheparent company would
havedonewiththefunds atitsdisposal haditnotinvested intheforeign affiliates. Would thefunds
havegonetoexpanding domestic capacity forexport production orwould thefunds havebeendistributed
totheshareholders forlackofprofitable domestic investment alternatives? Orisdomestic investment
actually stimulated byFDI, assuggested bythestudies thatfindacomplementary relation between
foreign production anddomestic exports? Forexample, out-sourcing ofcertain stages oftheproduction
process cutscosts andincreases thecompetitiveness oftheparent company, which intunmayfeed
intomore exports.
52. Inanyevent, although different studies havearrived atdifferent conclusions -themajority
suggesting acomplementary relationship between home country exports andoutward FDIandthe
minority suggesting asubstitute relationship -allstudies seem toindicate thattheneteffect onhome
country exports isnotverypronounced. Itshould benoted, however, thatthesestudies focus onaverage
effects across industries andthattheeffects ofoutward FDIonexports mayvarysignificantly among
individual firms andindustries, depending upon thenature oftheinvestment.WT/WGTI/W/7
Page19
Table II
TheRelationship between Outward FDIandHome Country Exports
Study Year Home
CountryEffect on
home ExportsNotes
Lipsey and
Weiss (1981)1970 U.S. positive United States FDIdisplaced other countries 'exports tothe
hostcountry.
Lipsey and
Weiss (1984)1970 U.S. positive Positive correlation between exports ofintermediate goods
andforeign production. Moreover, foreign production of
oneproduct lineseems tostimulate theexports ofother
product lines.
Blomström et
al.(1988)1982 (U.S.)
1978 (Swe.)U.S.,
Swedenoverall
positiveOverall complementary relationship, except forafew
industries withasubstitute relationship.
Hufbauer
etal.(1994)1980-1990 U.S.,
Japan,
Germanypositive Thecomplementary relationship wasmore pronounced for
theUnited States andJapan thanforGermany.
Graham (1996) 1991 (U.S.)
1993 (Japan)U.S.,
Japanoverall
positiveTherelationship between United States exports andFDIin
Europe andEastAsiawaspositive, while FDIinLatin
America seems, onbalance, tosubstitute forexports.
Svensson (1996) 1974-1990 Sweden negative Thestudy finds anoverall negative effect ofoutward FDI
onSweden 'sexport, including reduced exports tothird
country markets served bytheforeign affiliates.
53. Theimpact ofoutward FDIonimports bythehome country seems nottohaveattracted much
attention intheliterature. Onatheoretical level onecould argue thatvertical FDIshould leadto
increased imports asout-sourced production stages arebeing re-imported forfurther processing or
finalconsumption.HorizontalFDImayhavethesameeffectonimportstotheextentdomesticoperations
areclosed andthedomestic market isbeing served fromabroad. Thestudy byHufbauer etal.(1994)
found evidence thatUnited States imports increased bytheextent ofUnited States investment abroad,
butlesssothanexports. Thestudy alsofound thatoutward Japanese FDIpromoted about twice as
much imports asexports.34Itisunclear whyJapanese FDIwould generate proportionally more imports
thanexports compared toUnited States FDI,butitcould berelated toahigher degree ofvertical FDI,
leading tore-imports ofoutward-processed goods.
III.3.2 Hostcountry trade andinward FDI
54. WithregardtotheimpactoninwardFDIonhostcountryimports,itisunclear,fromatheoretical
point ofview, whether inward FDIwillbeaccompanied byincreased ordecreased imports. Indeed,
onecaneasily construct examples thatgiveeither result. Forexample, ifFDIisexport-oriented and
theforeign affiliate sellsonlyafraction oftheoutput inthehostmarket, there willnotbemuch
displacement ofimports offinalproducts andthepredominant impact onimports willinstead bethrough
theuseofimported intermediates inproduction. Export-oriented FDIistherefore likely tobe
accompanied byincreased imports.35Theopposite mayholdtrueforhostmarket-oriented FDI. If
34Itshould benoted, however, thatarecent MITI study provides evidence showing thatoutward Japanese
FDIgenerates more exports thanimports.
35Ofcourse, thisisnottosaythatthetrade balance ofthehostcountry willdeteriorate. Ifanything, the
trade balance willimprove through export-oriented FDI.WT/WGTI/W/7
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thelocalaffiliate predominantly replaces previous imports, either theimports oftheparent company
itself ortheimports ofrivalfirms exporting tothemarket, thevalue ofimports maywellgodown.
However, thevolume effect must alsobetaken intoaccount. Local production mayboost sales in
thehostmarket. Thiswillincrease thedemand forimported intermediates andthenetresult maybe
anincrease inimports. (Asnoted intheprevious Section, outward FDIcreates newtrading opportunities
inintermediate goods thatcanmore thanoffset thereplaced trade infinalgoods.) These examples
illustrate thatimports cangoeither wayfollowing aninflow ofFDI. Tosome extent therelationship
alsodepends onthepolicies ofthehostcountry, suchaslocalcontent requirements.
55. There issome empirical evidence suggesting thatinflows ofFDIareaccompanied byincreased
imports inthefirstyears although thetidemaysubsequently turn. Forexample, studying thetrade
balance effects ofFDIinUnited States manufacturing during theperiod 1967-1989, Orr(1991) found
thatimports increased intheformative years ofaninvestment. However, healsomakes thecasethat
imports willeventually decline asinvestment matures andthesupply linkages withthehosteconomy
(theUnited States inthiscase) arestrengthened, andasimports offinalgoods arefurther displaced
when theproduction offoreign affiliates gains momentum.36
III.3.3 TheroleofMNEs andFDIfortheexport performance ofdeveloping countries
56. Thissubsection examines theavailable empirical evidence regarding theroleofMNEs and
FDIfortheexport performance ofdeveloping countries. Thediscussion draws mainly onastudy by
Blomström (1990), commissioned byUnited Nations Centre onTransnational Corporations (UNCTC).
57. IninvestigatingtheroleofMNEsfortheexportperformanceofdevelopingcountries,Blomström
distinguishes between direct andindirect effects. Direct effects refertoexports from hostcountries
bylocalaffiliates ofMNEs, andindirect effects refertovarious spillover andstructural effects that
canboost productivity andfacilitate export performance ofdomestic firms. Forexample, domestic
firms maybenefit from theinfrastructure oftransport, communication, financial andother ancillary
services thattendtofollow inthefootsteps ofMNEs. Andbylinking upassubcontractors, orsimply
observing theactivities ofMNEs, domestic firms maygainvitalknowledge about foreign markets,
including consumer preferences anddistribution channels. Also, theincreased competitive pressure
mayboost theproductivity ofdomestic firms byintroducing newtechnologies andmodern business
practices, which areingredients thatareessential tosucceed intheworld market. Theempirical focus
ofBlomström 'sstudy isonthedirect effects, thatistheexport performance oflocalaffiliates ofMNEs.
Unfortunately, fewhostcountries provide trade statistics thatdistinguish between trade byforeign
multinationals andtrade bydomestic firms. Toovercome thisobstacle, Blomström usesdatafrom
three home countries -Japan, Sweden andtheUnited States -thatundertake occasional surveys of
theforeign trade activities oftheirmajority-owned multinationals.
58. ThemainfindingsofBlomströmsstudywerethefollowing.WithregardtoUnitedStatesMNEs'
exports ofmanufactures from developing countries, there hasbeenasteady increase intheirshare
ofworld trade from0.43% in1966 to0.99% in1986. Moreover, exports ofUnited States affiliates
havegrown faster thanthose ofdomestic firms, except innewly-industrializing countries inEastAsia.37
36Oneoftheassumptions isthatJapanese autotransplants willeventually increase theirUnited States sourcing
from some 50to75%, achieving almost thesame domestic sourcing rateasthatofUnited States producers.
37Many other studies haveconfirmed thatforeign multinationals tendtohaveahigher export propensity than
domestic firms. Forexample, studying FDIandtrade intransition economies, Naujoks andSchmidt (1995)
observed thattheexport propensity (share oflocal production exported) wasapproximately twice ashighfor
foreign-ownedcompaniesthanforlocal-ownedcompaniesinHungary.Theyalsoobservedthatexportperformance
(continued...)WT/WGTI/W/7
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Outofthetotalgrowth ofexports ofthehostcountries, United States affiliates accounted forsome
7.4%, buttherewerebigdifferences among countries andindustries. Forexample, inMexico, United
States affiliates accounted foralmost athirdoftheexport growth between 1966 and1986. Interms
ofsectors, United States affiliates contributed themosttotheexport growth ofdeveloping countries
inmachinery(19.6%)andtransportequipment(26.2%).TheexportpropensityofUnitedStatesaffiliates
located indeveloping countries hasincreased considerably overtime. Roughly onethird oflocal
production wasexported in1986 compared tolessthan10%twenty years earlier. Thismeans that
theexport propensity isapproaching thatofaffiliates located indeveloped countries (38%). Afinal
observation isthatabout twothirds oftheexports ofUnited States affiliates aredestined fortheUnited
States.38Thefindings fortheexport performance ofJapanese andSwedish multinationals indeveloping
countries arelargely similar.39
59. Turning nowtoindirect effects ondomestic firms, many studies havetriedtoestimate theeffects
ofMNEs ontheproductivity ofdomestic firms arising from, forexample, dissemination oftechnology,
training ofworkers andtheexpansion ofproducer services. They often findpositive spillover effects
onthehostcountry fromthepresence offoreign multinationals.40Unfortunately, thereareonlyafew
studies thatfocus ontheimpact offoreign multinationals ontheexport performance ofdomestic firms.
Aitken, Hanson andHarrison (1994) testthehypothesis thatexport activities ofmultinational firms
reduce thecostfordomestic firms toengage inexporting. They findthatMexican firms located near
multinational exporters aremore likely toexport thanareother domestic firms.41Similarly, Kokko,
Tansini andZejan (1996) findthatthepresence offoreign MNEs raises thelikelihood thatlocal
Uruguayan firms getinvolved inexporting. There isalsosome anecdotal evidence thatseems tosupport
thishypothesis. Forexample, theentry ofsingle Korean garment exporter inBangladesh isbelieved
tohavepaved thewayforhundreds oflocalentrepreneurs toengage insuccessful exporting; today
garment exports arethesingle largest source offoreign exchange earnings forBangladesh.42
60. Inconclusion, there isbothanecdotal andstatistical evidence suggesting thatthepresence of
multinational firms mayhavepaved thewayfordomestic firms'export endeavours. Thepotential
forspillovers fromMNEs todomestic firms derives fromtheformer 'smulti-market presences which
37(...continued)
offoreign-owned companies wasespecially highinmanufacturing ofmetal products, mechanical engineering,
machinery andequipment, andtextiles andclothing. These areindustries characterized byvertical division of
theproduction process. Thestudy alsogives some insights intotheimportance of"outward processing" for
thetransition economies. Outward processing iscontractual arrangements between unrelated parties (noequity
participation isinvolved) where thecontractor delivers semi-processed goods forfurther processing bythe
subcontractor. Trade incomponents foroutward processing between theEuropean Community andCentral and
Eastern Europe almost doubled between 1989 and1993. OutofECtotalimports from theregion, almost 18%
ofimports in1993 were re-imported processed goods.
38Partofthereason ispresumably thattheUnited States hasaspecial import provision forreimported processed
goods.
39However, there isonenotable difference. Japanese affiliates seem tohaveahigher average propensity toexport
thanUnited States andSwedish affiliates. Thismaybeastatistical artifact reflecting differences inthedistribution
ofFDIover industries andhostcountries.
40Forarecent review oftheliterature, seeBlomström andKokko (1997a).
41These results arerobust totheinclusion ofother variables thatmayaffect export propensities, suchasoverall
industry activity inaregion, proximity tothecapital ortheborder, andother factors.
42Rhee andBelot (1990)WT/WGTI/W/7
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maycreate opportunities fordomestic firms toacquire vitalinformation about foreign markets and
export opportunities. Moreover, infrastructure investment undertaken byMNEs, orfortheMNEs
bythehostgovernment, reduces thecosttodomestic firms ofengaging inexport activities. Thus,
FDIcontributes totheexport performance ofdeveloping hostcountries bothdirectly through MNEs '
ownexport activities andindirectly byreducing thecosts andinformational obstacles fordomestic
firms tostartorexpand exporting.
IV. THE IMPACT OFTRADE POLICES AND MEASURES ONFOREIGN DIRECT
INVESTMENT
61. ThisSection summarizes thetheoretical andempirical literature ontheimpact oftradepolicies
andmeasures oninvestment flows.
IV.1 Thetariff-jumping argument
62. Bypassing protectionist measures byestablishing production facilities intheprotecting country
isperhaps theoldest explanation forFDI. IntheOLIframework, hightariffs belong tothelocational
"advantages" ofthehostcountry inthattheyfavour local production overexports. Ofcourse, a
distinction mustbemade between tariffs ontheproduct thattheinvestor intends toproduce inthehost
country andtariffs onintermediate goods needed inproduction. While theformer canarguably lure
certain investment, asshown inmany empirical studies (seebelow), hightariffs onintermediate goods
havetheopposite effect. Andthisistrueevenifthere islocalproduction oftheintermediate goods
sincetradebarriers donotjustelevate thepriceofimported intermediates butalsoofcompeting domestic
ones. Inother words, itisthecombination ofahightariff onthefinalgood, andlowtariffs onthe
intermediate goods (tariff escalation43),thatcanprovide amotive fortariff-jumping investments.
63. There aremany empirical studies thatsupport thetariff-jumping argument. Using detailed
dataonUnited States outward FDIto27partner countries, including bothdeveloped anddeveloping
countries, Brainard (1993b) found that,other things equal, theshare oftotalsales accounted forby
affiliates salesisgreater thehigher thehostcountry 'strade barriers are.Horst (1972), using dataon
production byUnited States affiliates inCanada, found theverysame result. Several casestudies of
particular industries alsosupport theargument. Forexample, arecent study byGoodman, Sparand
Yoffie (1996) showed thatdumping petitions andescape clause actions resolved by"orderly market
arrangements" (OMAs) and"voluntary export restraints" (VERs) induced Japanese andother foreign
firms toshiftmode from exports tolocal production intheUnited States oftypewriters, colour
televisions, automobiles, steelandsemiconductors. Along thesameline,Barrell andPain(1997) found
thatJapanese FDIintotheEuropean Community andtheUnited States overtheperiod 1981 to1991
wassignificantly influenced by(cumulative) anti-dumping actions.
64. Amere threat ofprotection maysometimes suffice toinduce FDI. Forexample, astudy by
Azrak andWynne (1995) found thatJapanese FDIincreased withthenumber ofdumping petitions
filedwiththeUnited States International Trade Commission, andwithestimated probabilities ofan
affirmative decision (63% ofthepetitions resulted inanaffirmative decision during theperiod of
investigation, 1976-1992). Along thesamelines, Blonigen andFeenstra (1996) found thatanti-dumping
cases andescape clause actions strongly influenced Japanese FDIintotheUnited States. What ismore,
43Assuggested bytheterm, tariff escalation refers toatariff structure withhigher tariffs onmore processed
goods. Tariff escalation iscommon indeveloped anddeveloping countries alike. Itshould benoted thateven
ifthestatutory tariff ratesdonotshow much escalation, dutyexemptions onintermediate inputs andrawmaterial
have justthesame effect.WT/WGTI/W/7
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inlinewiththeso-called "quid proquo"hypothesis44,these investments seemed toreduce subsequent
risksofbeingsubjectedtocontingentprotection.45Precautionaryinvestmentmaythereforebeundertaken
asaresponse toadeteriorating tradeclimate, bothtodefuse theprotectionist treatandtoinsure against
lostgrounds should thethreat becarried out.
65. Toconclude, thereislittledoubt thatactual protection aswellasthreats ofprotection caninduce
tariff-jumping FDI. However, itcannot beconcluded fromthisfinding thatprotection isamoreefficient
policy tooltoattract FDIthanareopentrade policies. Aspointed outbyHufbauer etal.(1994), one
problem withthetariff-jumping argument isthatthetariffs ofdeveloped countries forindustrial products
areoften below 5%,yetdeveloped countries attract thelion'sshare oftheworld 'sFDI. However,
itshould berecalled thatnon-tariff barriers, suchasanti-dumping duties canarguably constitute
substantial obstacles toexports andthereby favour FDI,asshown bytheempirical evidence presented
above. Hufbauer etal.alsoobserve thattheFDIboom indeveloping countries hascoincided with
agreat dealofliberalization oftariff andnon-tariff barriers. Ofcourse, itshould alsobetaken into
account thatthesetradereforms wereoftenundertaken aspartofageneral overhaul ofmacroeconomic
policies, privatization initiatives, andliberalization oftheinvestment regime. ThenextSection discusses
theissue ofwhether highorlowtrade barriers aremore conducive toFDI.
IV.2 Arehighorlowtrade barriers more conducive toFDI?
66. Toshedsome lightontheissue raised above, itisuseful toreview some empirical studies
thattrytoexplain thetotalinflows ofFDIbyanumber ofeconomic variables, suchasmarket size
(asmeasured bypopulation orGDP), growth inGDP, the"openness" ofthetrade regime, andahost
ofother economic andpolitical variables.
67. Oneproblem facing thisliterature ishowtomeasure the"openness" ofthetraderegime. Had
investment dataexisted byrelatively narrow sector definitions itwould bepossible (albeit very
time-consuming) tocollect information onthetrade barriers thatapply ineachsector andcountry,
including trade barriers onimported intermediates. However, formany developing countries, data
onlyexistonaggregate inflows ofFDIasreported inthebalance ofpayment accounts. Thequestion
thenarises howtoaggregate alltradebarriers intoasingle index withabearing ontheinflow ofFDI.
Should oneusetheaverage tariff rateortheimport-weighted average tariff rate? Andifnon-tariff
barriers areimportant, howshould these barriers beaccounted forinthe"openness" index? Most
researchersfindthedataproblemsoverwhelming,especiallysinceacross-countryregressionmayinclude
50ormore countries overa10-year period. Thepragmatic solution istousethetrade share ofGDP
(exports plusimports overGDP, exports overGDP, orimports overGDP) asaproxy fortheorientation
ofthetrade regime. Thepresumption isthatcountries withhightrade shares haveamore "open"
trade regime (i.e., lesstrade barriers) thancountries withlowtrade shares.46
44Fordetails onthequidproquoargument, see,e.g., Wong (1989) andBhagwati etal.(1992).
45Theprospect ofdefusing aprotectionist threat wasfound todepend onthetypeofinvestment. Greenfield FDI
hasastronger defusing effect thanacquisition FDI. Theauthors explain thisresult withthe"illwill" thataforeign
acquisitionofteninducesinthepubliceyes.Theyciteanecdotalevidencethatnewproductionfacilitiesaregenerally
more favourably received thanareforeign acquisitions ofdomestic production facilities. Also, thestudy suggests
thatitismore difficult todefuse threats ofanti-dumping actions thanthreats ofescape clause actions.
46While thisisnotanunreasonable assumption, itshould beemphasised thattheindex isfarfrom perfect. For
example, itiswellknown thatsmall countries, other things equal, tendtohave higher trade shares thanlarge
countries. Small countries tendtobemore dependent ontrade forthesimple reason thattheycannot produce
allgoods without forgoing thescale advantages thatspecialization andtrade make possible.WT/WGTI/W/7
Page24
68. Hufbauer etal.(1994) provide cross-country regression ondirect investment fromGermany,
Japan andtheUnited States tosome 50hostcountries fortheyears 1980, 1985, and1990. Theyconfirm
whatisknown frommany otherstudies, thatFDIstocks arestrongly correlated withindicators ofmarket
size(population andincome percapita). They alsofindthatinflows ofFDIarepositively and
significantly related tothetrade"openness" index. Specifically, theyfindapositive correlation between
theopenness index, asmeasured bythesumofexports plusimports overGDP, andthestock ofFDI.
Thatis,countries thattendtotrade more alsotendtohaveahigher stock ofFDI.
69. Asimilar study wasundertaken byBalasubramanyam andSalisu (1991) oninflows ofFDI
percapita using asample of38developing countries overtheperiod 1970-1980. They found a
statistically significant positive effect onFDIoftheirproxy fortrade"openness", inthiscasemeasured
bytheimport share ofGDP. Asanalternative variable, theyuseacomposite distortion index devised
bytheWorld Bank. Thisindex doesnotaccount fortrade distortions persebutforvarious other
distortions inproduct andfactor markets. Itturns outthathigher distortions reduce theinflows of
FDI. Sodoesahighinflation rate,which isusedasaproxy formacroeconomic imbalances. Referring
backtoBhagwati (1978)47,theauthors hypothesise thathighdistortions inproduct andfactor markets
andmacroeconomic imbalances aretypical ofimport-substituting development strategies, whereas low
distortions areatoken ofexport-oriented development strategies. They conclude thattheregressions
lendsupport toBhagwati 'shypothesis thatexport-oriented development strategies aremore conducive
toFDIthanareimport-substituting policies.
70. Akther (1993) arrives atessentially thesame conclusion using dataoninflows ofFDIover
theperiod 1980to1983in12developing countries. The"openness" indicator, asmeasured byexports
plusimports overGDP, isfound tohaveasignificant positive effect ontheinflows ofFDI. Finally,
Singh andJun(1996), using adatasample of31developing countries overtheperiod 1970-1993, find
thattheratioofexports toGDPispositively correlated withinflows ofFDI. However, when thedata
aredivided intotwosub-samples withlow-FDI andhigh-FDI countries,48thecoefficient onexport
isonlystatistically significant forthehigh-FDI group.
71. Insummary, cross-country regressions tendtofindthatinflows andstocks ofFDIarepositively
correlated withthe"openness" ofthetrade regime, asmeasured bythehostcountry 'strade share of
GDP. Itistempting indeed toconclude, asdotheauthors ofthese studies, thatanopentrade regime
(high trade shares) induces FDI. However, thepositive correlation could equally wellindicate that
FDIinduces hightradeshares (an"open" traderegime). Anexample mayclarify thispoint. Consider,
forexample, aUnited States computer company undertaking finalassembly inMexico. TheMexican
affiliate imports components forUS$450 thatareassembled atacostofUS$50 percomputer (thelocal
value added). Thefinalcomputer isthenshipped backtotheUnited States adding US$500 toMexico 's
exports. Theexport-processing thusaddsUS$950 toMexico 'strade(imports plusexports) andUS$50
toitsGDP. Asaresult, Mexico 'strade share ofGDP willgoup.Thisillustrates thatthecausality
maygointheother direction from inflows ofFDItohightrade shares, rather thanfrom hightrade
shares tohighinflows ofFDI.
47They citethefollowing paragraph inBhagwati (1978): "With dueadjustment fordifferences among countries
fortheireconomic size,political attitudes towards FDIandpolitical stability, boththemagnitude ofFDIinflows
andtheirefficacy inpromoting economic growth willbegreater overthelonghaulincountries pursuing export
promotion (EP) strategy thanincountries pursuing theimport substitution (IS)strategy."
48Low-FDI countries aredefined asthose countries thatoverthesample period (1970-1993) received onaverage
inflows ofFDIoflessthanonepercent ofGDP.WT/WGTI/W/7
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72. Theonlystudy thatexplicitly addresses theissue ofcausality isthestudy ofSingh andJun
(1996). Theresults aremixed. Forfiveoutoftwelve High-FDI countries theexport share ofGDP
(the"openness" indicator) isfound to"cause" FDI49,andforonecountry FDIisfound to"cause"
theexport share. Fortheother sixcountries thecausality could notbedetermined. Notestswere
reported forlow-FDI countries. Theauthors conclude thatFDIandtrade areperhaps bestdescribed
asbeing simultaneously determined, which indeed iswhatthetheory says. Atthesame time, they
suggest thatthefeedback from trade toFDIisstronger thanthefeedback from FDItotrade. They
argue thatthese findings support thegeneral notion thatan"open" trade regime isconducive toFDI.
IV.3 Concluding remarks
73. Inconclusion, there aresome studies thatsuggest thatan"open" trade regime, asindicated
byahightrade share ofGDP, isconducive toFDI. Atthesame time, there areother studies that
indicate thathightradebarriers caninduce FDI. These seemingly contradictory results canbeexplained
asfollows. Ontheotherhand, lowtradebarriers onintermediate goods areaprerequisite forhorizontal
FDI,andlowtradebarriers ingeneral forvertical FDI. AsputbyBrahmbhatt, Srinivasan andMurrell
(1996), "because foreign investors, notably multinational enterprises, increasingly operate complex
global production andsupply networks, protection anditsassociated redtapereduces acountry 's
attractiveness inthesenetworks". Thus, bothhighandlowtradebarriers canattract FDI,butofdifferent
types. Asnoted byUNCTAD (1995, p.286), FDIattracted toprotected markets tends totakethe
form ofstand-alone production unitsgeared tothedomestic market. Incontrast, lowtrade barriers,
especially onintermediate goods, areconducive tovertical FDIattracted bythefundamental advantages
ofthehostcountry, suchaslowlabour costs, natural resources andgenerally favourable economic
conditions. Judging from thecross-country regressions oninflows ofFDItodeveloping countries,
countrieswithan"open"traderegimeseemonaveragetoattractmoreFDIthancountrieswitha"closed"
trade regime.50
74. Afinal, andperhaps more important point isthatthegains fromluring FDIthrough hightrade
barriers maybelimited. Acompelling caseforthisviewismade inarecent study byBalasubramanyam,
Salisu, andSapsford (1996) thatassesses thecontribution tothehostcountry 'sGDP growth ofFDI.
Thestudy looks atthegrowth experience of34developing countries overtheperiod 1970 to1985.
Dividing thesample intoinward- andoutward-oriented countries according totheWorld Bank's
classification (seethe1991 issue oftheWorld Development Report), theyfindthatinflows ofFDI
haveasignificant positive effect ontheGDP growth foroutward-oriented countries whereas noeffect
canbediscerned ontheGDPgrowth forinward-oriented countries.51Thissupports theviewthatFDI
attracted byfundamental location advantages ismore productive forthehostcountry thanFDIattracted
byprotectionist policies. Thelatter maysimply induce FDIforwhich thehostcountry doesnothave
49Thecausality testemployed (theGranger causality test)doesnotreally testforcausality (i.e., Xcauses Y)but
rather precedence inalead-lag relationship (Xprecedes Y).
50However, thecross-country studies mayattribute toomuch tothetrade regime. Badpolices inoneareatend
tobefollowed bybadpolicies inother areas. AsFDIdoesnotjustrespond tothetrade regime, butrather to
theoverall conditions oftheeconomy, cross-country regressions thatfailtocontrol forother policy variables
(astheysometimes do)mayattribute toomuch oftheFDIinflows tothetrade regime. Forexample, themassive
inflows ofFDItoChina overthelastdecade havepresumably more todowiththemarket-oriented reforms that
unleashed tremendous growth andinvestment opportunities thanwith the(modest) trade reforms thatwere
simultaneously undertaken.
51Theestimated growth effect ofFDIoninward-oriented countries isactually negative, albeit statistically
insignificant.WT/WGTI/W/7
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acomparative advantage, thereby drawing production factors from lessdistorted tomore distorted
sectors tothedetriment ofthedevelopment process.
V. THE IMPACT OFINVESTMENT POLICIES AND MEASURES ONTRADE
75. ThisSection reviews theeffect ofinvestment policies andmeasures ontrade. Forreasons
setoutintheintroduction, thediscussion islimited tothose investment incentives andperformance
requirements thataremost directly related totrade.
V.1 Investment incentives andperformance requirements
76. Investment incentives, asdefined inarecent UNCTAD report (1996b, p.3),are"measurable
economic advantages afforded tospecific enterprises orcategories ofenterprises by(oratthedirection
of)governments, inorder toencourage them tobehave inacertain manner". TheUNCTAD report
divides investment incentives intothree categories: fiscal incentives, financial incentives, andother
(orindirect) incentives. Fiscal incentives areprovisions designed toreduce thetaxburden forforeign
investors. Forexample, many developing countries grant time-bound taxholidays tonewFDI,
sometimes formore than10years. Standard fiscal incentive packages mayalsoinclude exemptions
fromimport duties onrawmaterials, intermediate inputs, andcapital goods related totheproduction
process.
Table III
Main Types ofFiscal Incentives forFDI
Profit-based Reduction ofthestandard corporate income-tax rate;taxholidays; allowing losses incurred
during theholiday period tobewritten offagainst profits earned later(orearlier).
Capital investment-based Accelerated depreciation; investment andreinvestment allowance.
Labour-based Reductions insocial security contributions; deductions from taxable earnings based onthe
number ofemployees oronother labour-related expenditure.
Sales-based Corporate income-tax reductions based ontotalsales.
Value-added-based Corporate income-tax reductions orcredits based onthenetlocal content ofoutputs; granting
income-tax credits based onnetvalue earned.
Based onother particular
expensesCorporate income-tax deductions based on,forexample, expenditures relating tomarketing and
promotional activities.
Import-based Exemption from import duties oncapital goods, equipment orrawmaterials, parts andinputs
related totheproduction process.
Export-based a)Output-related, e.g., exemptions from export duties; preferential taxtreatment ofincome
from exports; income-tax reduction forspecial foreign-exchange-earning activities orfor
manufactured exports; taxcredits ondomestic sales inreturn forexport performance.
b)Input-related, e.g., dutydrawbacks, taxcredits forduties paidonimported materials or
supplies; income-tax credits onnetlocal content ofexports; deduction ofoverseas
expenditures andcapital allowance forexport industries.
Source: Reproduced from Table 1.1.UNCTAD (1996b).
77. Financial incentives involve theprovision offunds directly tofirms tofinance newforeign
investment orcertain operations. Themost common types aregovernment investment grants and
subsidized credits. Government equity participation mayalsoactasafinancial incentive, especially
forinvestment involving highcommercial risks.WT/WGTI/W/7
Page27
Table IV
Main Types ofFinancial Incentives forFDI
Government grants Avariety ofmeasures (also loosely referred toas"direct subsidies") tocover (partof)capital,
production ormarketing costs inrelation toaninvestment project.
Government credit at
subsidized ratesSubsidized loans; loanguarantees; guaranteed export credits.
Government equity
participationPublicly funded venture capital participating ininvestments involving highcommercial risks.
Government insurance at
preferential ratesUsually available tocover certain types ofriskssuchasexchange-rate volatility, currency
devaluation, ornon-commercial riskssuchasexpropriation andpolitical turmoil (thistypeof
insurance isoften provided through aninternational agency).
Source: Reproduced from Table 1.2.UNCTAD (1996b).
78. Other (indirect) incentives include agroup ofmiscellaneous measures designed toenhance the
profitabilityofFDIinvariousindirectways.Examplesincludedesignatedinfrastructureandgovernment
servicesatless-than-commercialprices,includingland,buildings,transportservices,telecommunications,
electricity andwater supply. Another important category involves thegranting ofaprivileged market
position. Thelatter maytaketheform ofpreferential access togovernment contracts, government
granted monopolies, theclosing ofthemarket forfurther entry, orprotection fromimport competition.
Table V
Main Types ofOther (Indirect) Incentives forFDI
Provision ofdedicated
infrastructureInclude provision, atless-than-commercial prices, ofland, buildings, industrial plants, orspecific
infrastructure, electricity andwater supply.
Provision ofservices Services offered mayinclude assistance inidentifying finance; implementing andmanaging
projects; carrying outpre-investment studies; information onmarkets, availability ofraw
materials andsupply ofinfrastructure; advice onproduction processes andmarketing
techniques; assistance withtraining andretraining; technical facilities assistance withtraining
andretraining; technical facilities fordeveloping know-how orimproving quality control.
Market preferences Preferential government contracts; closing themarket forfurther entry; protection from import
competition; granting ofmonopoly rights.
Preferential treatment on
foreign exchangeSpecial exchange rates; special foreign debt-to-equity conversion rates; elimination ofexchange
risksonforeign loans; concessions offoreign exchange credits forexport earnings; special
concessions ontherepatriation ofearnings andcapital.
Source: Reproduced from Table 1.3.UNCTAD (1996b).
79. Performancerequirementsaremeasuresaimedatmodifyingthemarketbehaviouroftheinvesting
firmtoachieve certain national objectives. Forexample, thehostgovernment mayrequire theinvesting
firmtosource acertain percentage ofinputs domestically (domestic content rules). Itmayalsorequire
theinvesting firmtoexport acertain fraction ofoutput (export performance requirements), or,
alternatively, stipulate thatimport outlays mustbebalanced byexports (trade-balancing requirements).
Athirdcategory involves mandatory localequity participation, either bythehostgovernment itself
orbyprivate investors.WT/WGTI/W/7
Page28
Table VI
AnInventory ofPerformance Requirements
Local content requirements minimum share ofinputs thatmust besourced locally
Substitution rules requirement touselocal substitutes forimported inputs whenever "similar" domestic
inputs areavailable
Export performance minimum share ofproduction thatmust beexported
Trade-balancing requirements requires MNEs toexport foratleastthesame value astheyimport
Local equity participation mandatory local equity participation; either bythehostgovernment itself oralocal
entrepreneur
Technology transfer requirement touseaspecific technology ofinterest forthehostcountry
Local hiring targets national participation inmanagement, quotas ofexpatriates, etc.
80. According toUNCTAD (1996b, ch.III),therange ofincentives available toforeign direct
investors, aswellasthecountries thatemploy suchincentives, haveincreased considerably since the
mid-1980s. Thisdevelopment reflects partly theongoing reappraisal among developing countries of
thebenefits ofFDI,andpartly increased investment competition among hostcountries. The1996issue
oftheWorld Investment Report (UNCTAD, 1996a) reports thatoutof485changes intheinvestment
regimes in57countries between 1991and1995, virtually all(98%) wentinthedirection ofmoreliberal
investment rulesoroutright promotion. Thetypeofchanges introduced in1995fellintothefollowing
groups: 32%ofthechanges introduced more incentives, 30%more liberal operational conditions (less
performance requirements), 15%more liberal foreign ownership orsectoral regulations, 10%more
liberal approval procedures, 9%more guarantees, and4%lesscontrol (SeetableV.1andfigure V.1
inUNCTAD, 1996a). Asageneral rule,developed countries make more useoffinancial incentives
thanfiscal ones. Thesuggested reason isthat"fiscal incentives arelessflexible andinvolve more
difficult parliamentary procedures forintroducing them" (UNCTAD 1996b, p.18). Incontrast,
developing countries tendtousemorefiscal incentives, suchastaxholidays andimport dutyexemptions.
Thereason ispresumably thatdeveloping countries cansimply notafford tocompete withfinancial
incentives thatcanrunintosixdigitnumbers (inUS$) perjobforthemostcoveted investment projects.
V.2 Theeffects ofinvestment incentives andperformance requirements
81. Doinvestment incentives andperformance requirements make adifference inhowfirms invest
andoperate? Withrespect totheimpact ofincentives oninvestment decisions, theevidence thatexists
isbased onsurveys inwhich investors havebeenasked torankanumber offactors determining their
investment decisions, including investment incentives andtaxbreaks. Onestudy reviewed byUNCTAD
(Reuberetal.,1973)foundthatexport-orientedinvestorsvaluedfiscalincentives(includingtaxholidays,
dutyremissions andaccelerated depreciation) more highly thanprotection ofthemarket orother
incentives. Market-seeking investors, ontheother hand, valued protection ofthemarket more than
fiscal orother incentives. Another study reviewed byUNCTAD (Guisinger andAssociates, 1985)
reaches essentially thesameconclusion. Of36projects oriented towards thedomestic market, 23would
nothavegone ahead ifthere hadbeennoprotection ofthedomestic market, while onlytwowere
dependent onfiscal orfinancial incentives. Incontrast, forprojects oriented towards theregional or
world market, 15of38investments would nothavematerialized without fiscal orfinancial incentives.
Athird study reviewed byUNCTAD (Lecraw, 1990) found thatthetariff ratewasasignificant
determinant ofinvestment oriented towards thedomestic market, butnotforexport-oriented ornatural
resource-seeking investment. Thelatter group wasmore prone torespond tofiscal incentives. YetWT/WGTI/W/7
Page29
another study reviewed byUNCTAD (Kumar, 1994) found thatexport-oriented FDIinasample of
40countries wassignificantly influenced bythelength ofthehostcountry 'staxholiday.
82. Thisevidence lendsfurther support totheprevious conclusion thatmarket-seeking FDIresponds
tohightradebarriers (tariff-jumping). Incontrast, export- andresource-oriented investment responds
tofiscal incentives suchasdutyremissions onimported intermediates andtaxholidays. However,
theimportance ofinvestment incentives should notbeexaggerated. Thesurveys indicated thatother
fundamental factors, suchasmarket size,production costs, availability ofnatural resources, etc.,play
amore important rolethaninvestment incentives andtaxbreaks.52Nevertheless, when thefundamental
determinants areattractive enough foraninvestment tobeprofitable, andtheprofitability ismore or
lesssimilar across alternative FDIlocations, incentives appear tohaveaneffect oninvestors 'decisions,
especially forprojects thatarecost-oriented andmobile. Moreover, ifonecountry offers incentives
andanother country doesnot,then, allother things being equal, foreign investors could beinfluenced
intheirlocation choice between countries.
83. Needless tosay,thisconclusion doesnotsuggest thatincentives areaneffective instrument
toattract FDI,or,forthatmatter, thatthebenefits exceed thecosts. Byplaying outdifferent locations
against eachother, MNEs canpossibly squeeze outallthesurplus thatotherwise would haveaccrued
tothehostcountries. Yet,intheabsence ofabinding agreement ontheuseofinvestment incentives,
itmaybedifficult indeed totemper theiruseandmisuse.
84. Performance requirements affect theoperation offoreign affiliates onceaninvestment decision
hasbeenmade. Theimpact isobvious where suchrequirements arebinding, thatis,theyforce some
behavioural changes (which isnotalways believed tobethecase). Domestic content rules, totheextent
theyarebinding, force theforeign affiliates tosource ahigher share oftheinputs fromlocalsources
thanthatmotivated bycosts andquality considerations. Thiswillalsohavenegative repercussions
onexports since production costsgoupand/or quality down, making products lesscompetitive inthe
world market. Theimpact ofexport performance requirements isequally obvious. They force, to
theextent theyarebinding, foreign affiliates toexport alarger share ofthelocal output thanthat
motivated byprofit andcostconsiderations. Thisisakintoakindofbundling. Foreachunitsold
domestically, theaffiliate hastoexport, say,three units. Ifthemotivation fortheFDIwastojump
ahightradebarrier, theprofits earned onthedomestic market cross-subsidize theexport sales. Trade
balancing requirements areeffectively acombination ofdomestic content rulesandexport performance
requirements. They force, totheextent theyarebinding, foreign affiliates tobalance theirimport
outlays byexports. Itisdifficult tosaywhich margin theforeign affiliate would adjust inthiscase.
Itdepends onwhether itislesscostly tousemore domestic inputs thanotherwise, orexport more
thanotherwise. Aneducated guess would bethatbothmargins areadjusted.
52Moreover, thesurveys should perhaps beviewed withsome caution because oftheself-interest oftheresponding
firms inportraying incentives andtaxbreaks asmore important thantheyactually are.WT/WGTI/W/7
Page30
Table VII
TheEffects ofCommon Performance Requirements
Performance requirement Theoretical impact ontrade behaviour
Affiliates 'imports Affiliates 'exports
Local content negative negative
Export performance positive
(ifimported inputs isneeded)positive
Trade balancing negative
(possibly zeroifalladjustment ison
theexport side)positive
(possibly zeroifalladjustment ison
theimport side)
Source: Itisassumed thattheperformance requirements areactually binding, andnotoffset byincentives.
85. Acomplicating factor isthatthese performance requirements areoften combined with
(paid forby)incentives. Forexample, aforeign affiliate thatsubscribe tostricter domestic content
requirements maybegranted alonger taxholiday. Depending onhowdifferent incentives and
performance requirements arebundled, thetrade effects maydiffer from those suggested above.
VI. THE IMPACT OFREGIONAL TRADE ARRANGEMENTS ON FOREIGN DIRECT
INVESTMENT
86. Fourreasons maybegiven forwhyregional trade agreements could induce higher levels of
FDI. First, asmentioned previously, market sizeiscritical tothedecision toinvest inacountry.
Market sizevariables arealways positively correlated withFDIinempirical studies ofthedeterminants
ofdirect investment. Thetheoretical argument isthatalarger market canmoreeasily support production
unitsofsufficient sizetoallow scaleeconomies tobefullyexploited. Regional integration istantamount
toaneffective "enlargement" ofmarket size. Themostobvious example is,ofcourse, theEuropean
Union which iswellonthewaytocreating atruesingle market outof15national markets. Other
well-known examples areNAFTA, MERCOSUR, EFTA, andASEAN which tovarious degrees have
eliminated intra-regional trade barriers.53Second, totheextent aregional agreement isexpected to
spurgrowth, itwillincrease the(future) market sizeyetfurther, thereby adding totheattractiveness
ofthelocation. Indeed, inflows ofFDIareoften found tobepositively correlated withGDP growth.
Third, theremoval ofinternal tradebarriers between partner countries, keeping external tradebarriers
constant, willdivert some trade from outsiders toinsiders. Consumers andfirms thatpreviously
purchased goods andservices fromother regions maychange suppliers asthetrade barriers withthe
partner countries areremoved. Thisisthewell-known "trade diversion" effect ofcustoms union and
freetrade areas.54Theprospect ofloosing customers provides adefensive reason tochange from
exporting tolocalproduction intheregion. Fourth, itissometimes feared thatregionalism maylead
todeteriorating trading conditions foroutside countries. Suchfears, well-motivated ornot,canprovide
anadditional defensive reason tomove production intotheregion.
87. Howdothesetheoretical arguments match upwiththedata? Dunning (1990, pp.10-11) notes
withrespect tothecreation oftheEuropean Community inthelate1950s that: "United States-based
53Foracomprehensive treatment ofregional agreements intheworld economy, seeWTO (1995).
54Viner (1950)WT/WGTI/W/7
Page31
surveys ...revealed thatUnited States firms were stepping uptheirinvestments intheCommunity
inanticipation ofthebenefits likely tobeincurred byfirms producing intheCommunity and,noless
important, toavoid thecosts likely tobeincurred bythose remaining outside." Andwithrespect to
thereactions tothesingle market program, initiated in1985, Dunning (1990, p.24)notes that: "The
years 1986 to1988 haveshown amarked increase inUnited States direct investment inallEuropean
Community countries. Numerous surveys ...allpoint totheexpectations ofUnited States firms about
theeffects ofthecompletion oftheinternal market ashaving distinct effect onthelevelanddirection
ofUnited States direct investment abroad." With respect totheeffects ofNAFTA, JETRO (1993,
p.13)notes that: "With NAFTA settostarton1January 1994, Mexico isinafavourable position
toattract foreign investment, poised asitisasagateway totheUnited States market."
VI.1 ThecaseoftheEuropean Community
88. Dunning (1997a, 1997b) provides acomprehensive survey ofempirical studies assessing the
effects ofthecreation oftheEuropean Community anditssubsequent developments withaccessions
ofnewmembers anddeeper integration (theinternal market programme). With respect tothefirst
phase ofEuropean integration, thatis,from thecreation oftheEuropean Community (EC) in1957
tothelaunching oftheinternal market program in1985, Dunning (1997a) makes thefollowing summary
observations: "[I]nshort, thefirstphase ofEuropean integration wasaccompanied byasubstantial
netincrease inbothEC-related intra- andextra-FDI andtrade flows. However, thelargest increases
inFDIwere from countries outside theEC; andtheevidence strongly suggests thatUnited States
(andlaterJapanese) MNEs wereabletotakeadvantage oftheremoval oftariffbarriers, andsurmount
thetransaction costsoftheremaining non-tariff barriers better thantheirECequivalents. Although,
during theperiod 1958 to1985, there wasasizeable increase inintra-EC FDI, intra-EC trade grew
much faster -andagreatmajority ofthiswasbetween, rather thanwithin, firms. Bycontrast, United
States FDIintheECincreased more rapidly thanUnited States exports forthefirst20years ofthe
ECM (European Common Market), afterwhich (until 1985atleast) exports rosemore rapidly. But,
during thisperiod, themostimpressive trading performance wasrecorded bytheECaffiliates ofUnited
States MNEs. Thefactthatbetween 1957and1982theshare ofexports tonon-United States countries
(mainly European) oftheirsalesrosethree-fold, andovertwothirds ofthistradewasintra-firm, points
strongly tothecomplementary interplay between extra-ECFDIandintra-ECtrade."
89. With respect tothesecond phase oftheEuropean integration, starting withthelaunching of
theinternal market program in1985, Dunning (1997b) notes thefollowing stylized facts: "FDI in
theEChasrisen faster thaninmost other parts oftheworld (save parts ofEastAsia); butthere is
littlereason tosuppose thatthishasbeenattheexpense ofnon-EC FDI. Within theEC,there have
beensome discernable changes, bothinindustrial structure andinthegeographical distribution of
economic activity. Oftheformer, therelative growth ofFDIintechnology andinformation intensive,
andespecially inservices related activities, is,perhaps, themostsignificant trend. Ofthelatter, the
accession ofGreece, Portugal andSpain -andparticularly Spain -hasledtoamodest decentralization
ofotherthanthemosttechnological andinformation intensive activities fromthesixcoreECcountries."
90. Inexplaining these stylized facts, Dunning makes thefollowing summary observations: "(1)
[It]isdifficult toperceive howglobalization could havehadtheconsequences ithasinEurope ifthe
internal market program (IMP) hadnotcome about. (2)...[The] main dynamic impact oftheIMP
onFDIflows isthrough itseffects onother variables affecting FDI-andmostnoticeably market size,
income levels, thestructure ofeconomic activity andagglomeration economies ....But,even
considering theIMPasanindependent variable, ...all[studies] generally agree thatithasstimulated
bothexternal andintra-EC FDI,buttheformer more thanthelatter. (3)Itseems clearthattheeffects
ofIMPareindustry specific, andthereissome evidence that,ashypothesized bytradeandFDItheory,WT/WGTI/W/7
Page32
extra-ECFDIhasincreasedmoreinsensitivesectorsthaninnon-sensitivesectorssincetheearly1980s.55
(4)...[There] isonlylimited evidence thatthegeographical concentration ofeconomic activity [within
theEC]hasincreased,eveninsectorswhichbenefitfromtheeconomiesofagglomerationandsubstantial
plant economies ofscale. ...[There] isacomplementarity between FDIandtrade inmost of(but
notall)industrial sectors, andtheIMPhasdonenothing tolessen thiscomplementarity. However,
thisrelationship islessstrong forintra-EC thanforextra-EC FDI. (5)Asubstantial proportion of
extra- andintra-FDI intheECoverrecent years hastaken theform ofMergers andAcquisitions;
andpartoftherationale forthishasbeentoacquire strategic assets toadvance theregional and/or
global competitiveness oftheacquiring firm."
91. Insum,theevidence surveyed byDunning shows that,inthecaseoftheEuropean Community,
increased inflows ofFDIhavebeenlargely complementary totrade, butmoresoforinflows ofextra-EC
FDIthanforintra-EC FDI. TheFDIflows havebeenparticularly marked insectors thathavebeen
significantly liberalized bytheinternal market program. Atthesame time, themain impact ofthe
internal market program onFDIflows seems tobethrough itseffects onother variables affecting FDI
-andmostnoticeably market size,income levels, thestructure ofeconomic activity andagglomeration
economies.
VI.2 North-North, North-South andSouth-South agreements
92. TurningnowtotheimpactoftradeandFDIonotherregionaltradingarrangements,theevidence
ismorescantandsketchy.ArecentpaperbyBlomströmandKokko(1997b)providesausefuldiscussion
ofthepossible effects ofdifferent "types" ofregional trading arrangements: North-North, North-South,
andSouth-South arrangements. Thecasestudy foreachtypeistheCanada-United States FreeTrade
Agreement (CUSFTA); theNorth American Free Trade Agreement (NAFTA), focusing onthe
investment effects onMexico (theSouthern partner), andtheSouthern Common Market between
Argentina, Brazil, Paraguay andUruguay (MERCOSUR). These trade agreements arediscussed in
terms oftheresulting "environmental changes" fortradeandinvestment, andinterms ofthe"locational
advantages" ofthemember countries involved.
93. IntheirinvestigationoftheCUSFTAagreement,theauthorsnotethatitwentbeyondthephasing
outofbilateral tariffs between Canada andtheUnited States. Itincluded alsosome investment
provisions, suchasright-of-establishment andnational treatment, although arange ofprominent sectors
suchasbasictelecommunication wereeffectively excluded fromcoverage. Moreover, Canada 'sexisting
screening procedures forFDIwerealsoleftintact. Theresulting environmental change wasclassified
asbeing moderate because ofthealready lowtrade andinvestment barriers thatexisted between the
countries beforehand. Regarding thelocational advantages ofCanada withrespect totheUnited States
andrestoftheworld, theyargued thattheywereonthewhole moderate. Consequently, theinvestment
effects oftheCUSFTA were notexpected tobedramatic. Indeed, theempirical investigation by
Blomström andKokko failed todetect anysystematic changes ininvestment patterns. Themaineffect
seems instead tohavebeenincreased bilateral trade between thetwopartner countries.
94. Withregard totheNAFTA, thestudy focused ontheeffect onMexico. Inaddition toextending
thefreetradeareabetween Canada andtheUnited States toMexico, thenewtreaty includes provisions
onintellectual property andinvestment rights, including binding arbitration procedures incaseof
investment disputes. Because ofthepolicy reforms andMexico 'sposition asalowcostgateway to
theUnited States andCanada, theauthors argue thatoneshould expect significant inflows ofFDIto
Mexico andincreased trade withthenorthern partners. Theempirical evidence alsoindicates that
55By"sensitive" sectors Dunning means sectors thatusedtobeprotected byintra-EC non-tariff barriers before
theliberalization measures introduced bytheIMP.WT/WGTI/W/7
Page33
United States firms haveexpanded theirpresence inMexico, although much oftheincreased investment
tookplace before theformal discussions onNAFTA began. Thelargest inflows ofFDItoMexico
havebeenfromnon-NAFTA countries thatuseMexico asagateway totheUnited States (andtolesser
extend theCanadian) market. Thestudy citesevidence thatMNEs haveplayed animportant roleby
converting Mexican import-substituting industries intoexporting industries. Thevalue ofMexico 's
exports totheUnited States market hasalsoquadrupled since theendofthe1980s, withthelargest
increase occurring from1992 onward. Atthesame time, Blomström andKokko suggest that,while
NAFTA hasplayed animportant role,theacceleration ofFDIflows toMexico inrecent years isto
alargeextent duetoMexico 'sdomestic reform programme, starting inthemid-1980s (intheaftermath
ofthedebtcrises). They conclude thattheexperience ofMexico suggests thatNorth-South integration
maybegreatly beneficial fortheSouthern partner(s), especially inconjunction withdomestic market
reforms thatcanbe"locked in"bytheregional agreement.
95. Thefinalcasestudy istheMERCOSUR agreement which hasitsroots inthe1986 bilateral
trade agreement between Argentina andBrazil, extended in1991 toinclude Paraguay andUruguay.
In1995, thefourmember countries introduced acommon external tariff (CET), albeit withsome
remaining time-bound flexibility formembers todeviate fromtheCETinrespect ofalimited number
oftariff lines. Inaddition tothetrade arrangements, apartially newinvestment regime hasbeen
introduced topromote andprotect investment intheMERCOSUR region.
96. TheauthorsnotethatFDIintheregionmorethantripledbetween1988and1993,withArgentina
andBrazil receiving thelion'sshare andthatthetrend seems tocontinue. Forexample, in1995, the
United States stocks ofFDIintheregion grew bysome 25%. However, notalloftheinvestment
effect canbeattributed toMERCOSUR. Rather, thetiming oftheinvestments suggests thatdomestic
reforms played acritical role. Forexample, Argentina wasinitially more successful inattracting FDI
thanthemuch larger market ofBrazil, which Blomström andKokko ascribe toitsearlier successes
inrestoring macroeconomic balance andintroducing market reforms including privatization ofpublic
firms. They conclude thatdomestic policy reforms havebeenarelatively more important factor for
FDIthanhasMERCOSUR, atleastupto1995.56
97. Insum,regional integration canhaveasignificant impact onFDI. Thehigher thepre-existing
barriers totrade andinvestment flows, andthestronger thelocational advantages, thestronger the
impact ofintraregional liberalization. Thecasestudy oftheNAFTA agreement showed thatregional
agreements along North-South linescanbebeneficial tothesouthern partner(s), notleastbecause such
agreements canlendcredibility tothedomestic reform process. South-South agreements canalsoelicit
strong investment effects because ofthegenerally higher pre-existing trade andinvestment barriers
indeveloping countries. Yet,asthecasestudy oftheMERCOSUR agreement showed, domestic
macroeconomic andmarket-oriented reforms areatleastaspotent factors forcountries seeking toattract
FDI. Inother words, regional trade agreements arenotapanacea thatreplaces theneedfordomestic
reforms. Finally, asnoted above, FDIattracted byfundamental location advantages ismore productive
forthehostcountry thanFDIattracted byprotectionist policies.57Inaregional context, thissuggests
that"open regionalism" (open totherestoftheworld) hasthepotential ofdrawing more useful
investment projects totheregion thanapolicy of"closed regionalism".
56Interms ofthetrade effects, Olarreaga andSoloaga (1997) observed thatintra-regional trade hasincreased
atanaverage rateof28.5% peryearsince 1991, which isthree times faster thantherateofgrowth oftheregion 's
totaltrade (andfivetimes therateofgrowth ofworld trade). Some authors, notably Yeats (1997), argue that
thisstronggrowthperformanceofintra-regionaltradeispartlyduetotradedivertingforces,i.e.,regionalsuppliers
replacing more competitive extra-regional suppliers because ofthenewly-won tariff advantage vis-à-vis thelatter.
57SeeBalasubramanyam, Salisu, andSapsford (1996).WT/WGTI/W/7
Page34
VI.3 Rules oforigin andFDI
98. Inconnection withtherelationship between FDIandregional trading arrangements, thepossible
effects ofrules oforigin needtobetaken intoconsideration. Thisissue arises forregional trade
agreements thattaketheform ofafreetrade area, thatis,where eachmember stateretains itsown
external tariffschedule (andother forms ofexternal tradebarriers). Thepurpose oftherulesoforigin
istodetermine whether aproduct thatusesimported intermediates fromtherestoftheworld iseligible
forfreetrade treatment between themember countries. Oneormore ofthree testsmaybeusedto
determine the"origin" ofaproduct: (1)whether therehasbeenachange inthetariffheading between
stages ofproduction (forexample, fromtheimports ofsteelfromtherestoftheworld toproduction
ofbicycles); (2)whether thelocalvalue added within thefreetradeareaisabove aminimum threshold;
or(3)whether alistofspecific processing operations hasbeenundertaken within thefreetrade area.
99. Rules oforigin can,atleasttheoretically, affect thelocation ofFDI.58Forexample, under
NAFTA rulesoforigin, clothing produced inMexico gainstariff-free access totheUnited States market,
provided itmeets the"yarn forward" rule,which formany products requires virtually 100% sourcing
ofinputs inNorth America. Mexican clothing manufactures faceachoice between sourcing allinputs
beyond thefibrestage inNorth America toobtain freetradeareatreatment, orsourcing inputs outside
NAFTA atpotentially lower cost,butforegoing duty-free access toitsmost important market. As
MFN tariffs onclothing arestillhigh, theymaychoose tosource inside thearearather thanoutside.
Thisobviously creates incentives forthirdcountry textile producers toinvest inproduction facilities
inside theNAFTA areainorder toholdontotheircustomers.
100. Ontheother hand, strict rules oforigin mayreduce theincentives toinvest inafreetrade
areaforproducers offinalgoods. Forexample, clothing manufacturers maybediscouraged toinvest
intheregion since theymayhavetodiscontinue theuseofcompetitive international textiles toearn
intraregional freetrade treatment. Rules oforigin areinthissense similar todomestic content rules
thatraisethecostsofinputs byforcing thefirms tosource fromuncompetitive suppliers. Thus, while
strict rulesoforigin mayencourage investment infacilities thatproduce intermediate goods (textiles),
theymayatthesame timediscourage investment infacilities producing finalgoods (clothing). Itis
difficult tosaywhether strictrulesoforigin willdiscourage more FDIoffinalgoods thanitencourages
FDIproducing intermediate goods. Unfortunately, therewould appear tobenoempirical studies that
canshedlightonthisissue.
58See,forexample, Hindley (1990) andKrueger (1995).WT/WGTI/W/7
Page35
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