A General Equilibrium Analysis of the Interplay between
Foreign Direct Investment and Trade Adjustments
byHiro Lee
International Centre for the Study of East Asian Development
11-4 Otemachi, Kokurakita, Kitakyushu, 803-0814, Japan
E-mail: hlee@icsead.or.jp

Dominique van der Mensbrugghe
Development Prospects Group, The World Bank
1818 H Street, NW, Washington, DC 20433, USA
E-mail: dvandermensbrugg@worldbank.org

March 2001
(Revised: July 2001)

Abstract
The theoretical literature on trade and foreign direct investment (FDI) indicates that they
could be either substitutes or complements. The empirical evidence on U.S.-Japan and
APEC countries suggests that trade and FDI exhibit a complementary relationship. In thispaper, we employ a six-region applied general equilibrium model that incorporates FDI toevaluate the impact of APEC trade and investment liberalization on output and theinterplay between FDI and trade adjustments. The preliminary results suggest that FDI
liberalization would bring about greater benefits to most of the APEC economies thantrade liberalization. In the manufacturing sector, trade and FDI are found to becomplements in the APEC regions.
JEL classifications: F13; F15; F21; O53
Keywords: APEC liberalization, foreign direct investment, CGE model1

1.

Introduction
In the past two decades, inflows of foreign direct investment (FDI) have facilitatedeconomic development and technology transfer in many developing countries. During the
1986-99 period, world FDI flows increased at an annual rate of 22.9 percent, significantly
faster than the growth rate of world trade (UNCTAD, 2000). Developing countries hosted
30.1 percent of inward FDI stock in 1999, sharply higher than 21.0 percent share in 1990.
Among developing countries, East and Southeast Asia hosted 51.4 percent of inward FDI
stock in 1999, down slightly from 52.8 percent share in 1997. The relative decline in FDI
flows to this region may be attributable to the Asian economic crisis of 1997-98.
FDI is subject to a number of impediments, including restrictions on entry andestablishment, ownership and control restrictions, operational restrictions (e.g., local
content requirements), and lack of transparency in laws and regulations. 1 Such
impediments distort capital allocation across countries, between foreign and domestic
investment, and between FDI and portfolio investment (Hardin and Holmes, 1997).
Barriers to FDI are relatively high in services, such as finance, insurance, andcommunications.
Host countries may not benefit from inward FDI when there are domestic
distortions. Naya (1990) shows that liberalization of FDI could reduce economic welfare
in a protected economy. This is because protection in the host country would induce
foreign investors to make non-optimal FDI decisions. Fry (1993) finds that inward FDI
contributed significantly to economic growth in East Asian developing countries where theextent of domestic distortions, such as trade controls and financial repression, wererelatively low. By contrast, in a group of developing countries with relatively highdomestic distortions, inward FDI were associated with a low or negative growth.2
FDI and trade can be substitutes or complements. The theoretical literature
indicates that they can be either of them depending upon the assumptions (e.g., Mundell,

1

See PECC (1995, Chapter 6) and Hardin and Holmes (1997) for further information on
impediments to FDI, particularly in the APEC economies.

2

Fry (1993) divides the sample of sixteen developing countries between one group consisting offive East Asian countries (Korea, Indonesia, Malaysia, Philippines, and Thailand) and the otherconsisting of Argentina, Brazil, Chile, Egypt, India, Mexico, Nigeria, Pakistan, Sri Lanka, Turkey,
and Venezuela. The estimation period is 1966-88 with the exception of Brazil (1966-85), Chile(1966-84), Indonesia (1967-88), and Pakistan (1968-88).

2

1957; Markusen, 1983; Neary and Ruane, 1988; Wong, 1986, 1995). The empiricalevidence on the United States and Japan suggests that bilateral FDI and trade flows arecomplements in many manufacturing sectors (Kawai and Urata, 1998; Lee and RolandHolst, 1998). Petri (1997) finds that not only inward and outward FDI stocks are reduced
when investment liberalization is excluded from APEC liberalization but trade flows also
tend to decline, particularly for China and ASEAN-4 countries, compared with full
liberalization. This result suggests that FDI and trade are likely to be complements at theeconomywide level in the APEC economies.
To evaluate the impact of APEC trade and investment liberalization on economic
welfare and the interplay between FDI and trade adjustments, we use a six-region, threesector computable general equilibrium (CGE) model. The next section provides an
overview of FDI patterns and barriers in the APEC economies. Section 3 contains a brief
description of the model used for quantitative assessments. In section 4, we present theaggregate and sectoral results of liberalization experiments, and the final section offers
conclusions.

2.

FDI Patterns and Impediments in the APEC Economies

2.1

Patterns of FDI
Developing members of APEC have benefited from FDI inflows from moredeveloped members. The growth in FDI flows has generally led to greater diversificationof production and higher rates of growth in trade and productivity. Although the Asianfinancial crisis of 1997-98 caused a sharp decline in real GDP in several East Asian
countries, FDI flows to most of the APEC economies have remained at high levels, withthe exception of Indonesia.
Table 1 provides inward and outward FDI stocks of selected economies in 1995.
UNCTAD computes these stock values as the accumulation of FDI flows at historical cost.
The original source of the data on FDI inflows and outflows is International Monetary
Fund’s Balance of Payments Statistics Yearbook. For some economies (e.g., Hong Kong),
FDI flows are estimated because there are no balance of payments data.3 The world FDI

3

See UNCTAD (1999, pp. 465-476). Ramstetter (2000) provides estimates for FDI flows in eleven
Asian economies during the 1980-99 period.

3

stock was about $2.8 trillion in 1995. About 38 percent of inward FDI was hosted by theEuropean Union, 19 percent by the United States, and 5 percent by China. The European
Union, the United States, and Japan owned 46, 25, and 8 percent, respectively, of theworld FDI stock.

Table 1. Inward and Outward FDI Stocks of Selected Economies, 1995

United States
CanadaAustralia
New Zealand
Japan
China
Hong Kong
Korea
TaiwanSingapore
Indonesia
Malaysia
Philippines
Thailand
MexicoChile
European Union
World

Inward FDI Stock
US$ million% of GDP

Outward FDI Stock
US$ million% of GDP

535,553
123,335
100,390
26,17733,531
131,241
70,951
10,47815,73659,58250,601
27,094
6,086
17,452
41,13015,547
1,066,934
2,789,585

696,092
120,297
47,186
7,675
238,452
15,80285,156
10,231
25,14435,0501,295
11,143
1,209
2,173
4,132
2,815
1,295,941
2,840,216

7.7
22.0
28.8
43.8
0.7
18.8
50.6
2.3
6.0
71.2
25.6
31.8
8.2
10.5
14.3
23.1
12.7
9.9

10.0
21.5
13.5
12.8
4.7
2.3
60.7
2.2
9.7
41.9
0.7
13.1
1.6
1.3
1.4
4.2
15.4
10.2

Source: UNCTAD (1999), pp. 489-500, 513-524.

Among the APEC economies, Singapore, Hong Kong, New Zealand, and Malaysia
have had high inward FDI stock to GDP ratios. By contrast, Japan has attracted very little
FDI relative to the size of its economy. According to the data on the FDI stocks by sourceand destination regions that are calibrated to the FTAP model (Hanslow et al., 1999),
Japan and the United States together accounted for more than 50 percent of inward FDI
stocks in Hong Kong, Korea, Philippines, Taiwan, and Thailand in 1995. Singapore andTaiwan each accounted for over 10 percent of Malaysia’s inward stock, whereas the EU
contributed over 20 percent of inward stock in Singapore. Over a half of inward FDI stockin China was sourced from Hong Kong. It is important to note, however, that a large share4

of Hong Kong’s outward FDI is undertaken by foreign-owned firms,4 a sizable portion ofwhich is “round-tripping FDI” that originates from parent firms in China and is thenchanneled back into China through affiliates in Hong Kong (Low et al., 1996; Ramstetter,2000).
2.2

Barriers to FDI
According to UNCTAD (1996), barriers to FDI may be classified into thefollowing three categories:(1) Restrictions on market entry, which include restrictions on the share of foreign
ownership, screening and approval, restrictions on the legal form of the foreign
entity, minimum capital requirements, and conditions on location.
(2) Ownership and control restrictions, which contain compulsory joint ventures withdomestic investors, limits on the number of foreign board members, government
approval required for certain decisions, and mandatory transfer of some ownershipto locals after a specified time.
(3) Operational restrictions, which include performance requirements (e.g., minimum
exports to output ratios), local content requirements, restrictions on imports oflabor, capital, and intermediate inputs, and restrictions on repatriation of capitaland profits.
Previous studies that estimate barriers to FDI have concentrated on services sectors(e.g., Hoekman, 1995; Hardin and Holmes, 1997; Hanslow et al., 2000, Kaleeswaran et al.,
2000; Warren, 2000). This is because commercial presence abroad, primarily through FDI,
is the most important means of delivering services to other countries. Hoekman (1995)
uses frequency ratios of services barriers to estimate tariff equivalent measures of relative
restrictiveness of barriers to services trade across countries and sectors. His estimates are
based on judgmental benchmark tariff equivalents for each sector to reflect a country thatis highly restricted in market access.
Hoekman’s (1995) estimates have been used by Brown et al. (1996) and Petri(1997) in their model simulations. Table 2 summarizes ad valorem equivalents of FDI
barriers used by Petri. The rates for the services sector are based on Hoekman’s estimates,
whereas the rates for the primary and manufacturing sectors are assumed to be one-half as

4This pattern is also observed in Singapore.

5

high (relative to total costs) as tariff equivalents for these sectors that are available in the
GTAP database, version 3 (Hertel, 1997).

Table 2. FDI Barriers Used by Petri (1997)(percent)

Primary
Manufacturing
Services

UCANa

Japan

NIEsb

ASEAN-4

China

ROW

6.4
34.6
80.7

48.3
25.7
79.1

34.7
22.7
70.4

14.5
44.6
70.1

21.6
61.1
77.0

16.6
32.5
76.6

Notes: a) United States, Canada, Australia, and New Zealand.
b) Korea, Taiwan, Hong Kong, and Singapore.
Source: Petri (1997).

Hardin and Holmes (1997) develop alternative indices of the relative
restrictiveness of FDI. Their estimates are based upon information on actual restrictions
not only on market access but also on other aspects of FDI. The weights on different typesof barriers are set to reflect their relative restrictions. It is found that communications andfinancial services have some of the highest FDI barriers in the APEC economies. In
communications, Thailand has the highest restrictiveness index (0.84), followed by China(0.82) and Philippines (0.76). In financial services, countries with high FDI restrictions
include Philippines (0.95), Korea and Thailand (both with the value of 0.88).5
Hanslow et al. (2000) compute ad valorem equivalents of barriers to establishment(impediments on capital) and those of barriers to ongoing operation (impediments on
output) for both domestic and foreign firms. The results are provided in Table 3, which are
based on estimates of impediment rates in banking (Kaleeswaran et al., 2000) andtelecommunications (Warren, 2000).
Compared with Hoekman’s (1995) estimates on relative restrictiveness of barriers
to services trade, the rates of impediments to establishment derived by Hanslow et al.
(2000) are lower in all regions with the exception of China. Compared with Hardin andHolmes’s (1997) FDI restrictiveness indices, these rates are generally lower in all the
APEC regions with the exceptions of China and Indonesia. Hanslow et al.’s (2000)

5

See Hardin and Holmes (1997, pp. 112-113) for detailed results.

6

estimates have some shortcomings, however, because they are derived from theimpediment rates in only banking and telecommunications services.

Table 3. Ad Valorem Equivalents of Barriers to Establishment and Ongoing Operations in
the Services Sector(percent)
Barriers to Establishment
Barriers to Ongoing Operations
Domestic
Foreign
Domestic
Foreign
United States
CanadaAustralia
New Zealand
Japan
China
Hong Kong
Korea
TaiwanSingapore
Indonesia
Malaysia
Philippines
Thailand
MexicoChile
Rest of Cairns
European Union
Rest of World

0.0
0.5
0.6
0.4
0.3
123.4
1.3
1.9
1.9
2.4
22.7
15.3
7.5
12.2
0.6
14.1
7.2
1.3
39.4

3.8
6.3
14.3
4.3
3.0
252.1
5.2
22.6
18.7
23.9
68.2
37.9
53.7
36.5
11.1
20.6
19.4
6.4
87.8

0.1
0.3
0.0
0.0
3.6
19.0
1.4
5.1
2.9
3.5
13.3
3.6
8.5
4.7
2.2
3.0
1.0
0.1
5.0

1.1
1.7
0.7
0.8
4.7
36.6
2.3
6.9
4.9
8.5
28.2
10.6
22.8
13.7
5.5
4.1
5.5
1.2
13.9

Source: Hanslow et al. (2000), Table 4.

3.

The Model
Distinguishing between the activities of domestic and foreign-owned firms is an

important feature of a CGE model that incorporates foreign direct investment. Petri (1997)
assumes that product varieties are differentiated by firms headquartered in different
regions. Under his demand structure, a foreign variety can be purchased from the local
subsidiary of a foreign firm, the parent abroad, and the foreign firm’s subsidiaries locatedin third countries. A domestic variety can be obtained either from domestic producers orfrom foreign subsidiaries of the domestic firm.
We have extended a simple world CGE model developed by van der Mensbrugghe(2000) to include features of FDI, closely following those developed by Petri (1997). As in
7

Petri the model contains six regions – UCAN (consisting of the United States, Canada,
Australia, and New Zealand), Japan, NIEs (consisting of Korea, Taiwan, Hong Kong, andSingapore), ASEAN-4, China, and the rest of the world – and three sectors (primary,manufacturing, and services).
The model equations are presented in the Appendix. Products are identified byownership of capital, and these are called varieties. Thus output, XPr,i,v, is identified byregion of production (r), by sector (i), and by variety (v). Similar to the simple model,
production is modeled as a series of nested CES functions. However, each variable in thenest is associated with both a sector and a variety, and not simply a sector (see Eq. A.1,
A.3 and A.5 in the Appendix). The main deviation from the simple model is that foreignowned production is assumed to import essential imports from its ‘home’ base. For
example, Japanese auto plants in the United States import directly a fixed share (relative to
output) of intermediate goods from Japan.
Household and government accounts are consolidated. The consolidated household
sector accrues income from factor remuneration as well as tax receipts (Eq. A.11). Gross
capital income is distributed three ways. Domestic households receive a share of after-tax
capital remuneration. The share is determined by ownership percentage. By definition,
domestic-variety capital is 100 percent owned locally. FDI-based capital is assumed tooperate as a joint venture, where the share of foreign ownership, χ, is fixed. Thus
χ percent of after-tax capital remuneration flows overseas (local re-investment of earnings
is not allowed in the current version of the model). The third component of gross capital
remuneration is the tax on capital. Impediments to FDI flows are modeled as ad valorem
taxes on capital, and the capital tax rate, τk, is specific to varieties (Eq. A.13).
One important aspect in which our model differs from Petri is the order of CES
nesting of demand for goods. In Petri’s demand structure, each agent first allocates
expenditures between an aggregate of goods produced by firms headquartered in the homeregion and an aggregate of those produced by firms headquartered in foreign regions. In
our model, as in Figure 1, each agent first allocates expenditures between an aggregate ofgoods produced domestically, including those produced by foreign plants located in thedomestic economy, and an aggregate of all imports (Eq. A.24 and A.25). Aggregate
demand for goods produced domestically is split across all plants located domestically(Eq. A.27). At the other nest, we disaggregate by “own” varieties, i.e., those produced bydomestic firms located abroad and an aggregate of foreign varieties produced abroad
8

(Eq. A.29 and A.30). Own varieties are allocated across plant locations (Eq. A.32 andA.33), 6 whereas an aggregate of foreign varieties are first disaggregated by foreign
ownership and finally across plant locations (Eq. A.35 and A.37).7
The order of our demand nesting appears to be in accord with reality, particularly
in services. For example, foreign banks in any given country generally provide services tofulfill the needs of domestic consumers. Thus, goods and services provided by domestic
and foreign-owned firms in a given location appear to be closer substitutes than those
provided by firms headquartered in the same country but produced in different locations.
The allocation of capital is modeled using the same CET transformation structure
as in Petri (1997), which is shown in Figure 2. First, aggregate wealth for each region, Wr,
is allocated across sectors as a function of the relative rate of return on capital invested invarious sectors (Eq. A.51). Second, capital in each sector is allocated between domestic
market and an aggregate of foreign markets (Eq. A.53 and A.54). Finally, foreign capital isallocated across plant locations (Eq. A.56). A reduction in FDI barriers would raise theafter-tax rate of return to capital, PKn, which leads to an increase in the inward FDI stock(Eq. A.53 and A.56). The world capital stock is assumed to be fixed. With finite
elasticities of transformation, capital is less than perfectly mobile across regions andsectors.
Labor is assumed to be freely mobile across sectors but not across regions(Eq. A.49). Thus there is a single equilibrium wage rate for each region. The supply oflabor is held constant. To produce output overseas, subsidiaries employ local labor, thestock of FDI, inputs sourced from parents, and other intermediate inputs. In the current
version of the model, we assume constant-returns-to-scale technology in all sectors andcompetitive product markets.8

6Equation (A.33) would typically be redundant. However, due to aggregation of regions, intraregional imports (imports of the domestic variety from r to r) would be represented by variable
WTFra,i , d ,r .

7

The structure of demand nesting is similar to the one adopted in the FTAP model (Hanslow et al.,1999).

8

It may be more realistic to assume increasing-returns-to-scale and imperfectly competitive
product markets. See, e.g., Brown and Stern (1999).

9

Figure 1. Structure of Domestic Demand

XA: Armington demandσm

XMT: Total demandfor import goods

XDT: Total demand fordomestic goods

σd

XDd

σv

XDf

XMTFor: Imports offoreign varieties

XMTOwn: Imports of‘own’ varieties

σfv

σo

FV: Import acrossforeign varieties

WTF: ‘own’
imports by regionof origin

σf

WTF: foreignimports by regionof origin

10

Figure 2. Allocation of Wealth

Wealth (capital stock)

ωSec

Capital stock by sector

ωkx

Aggregate FDI outflow

Capital stock
allocated fordomestic production.

ωkf

FDI abroad allocated byregion of destination.

11

The model is calibrated to social accounting matrices (SAMs) of the six regions forthe year 1992, constructed primarily from the GTAP database, version 3 (Hertel, 1997).
We are currently in the process of updating to a more recent database.
Three caveats are needed to interpret the results of APEC trade and FDI
liberalization experiments presented in the next section. First, we used the same protection
rates on FDI as Petri (1997) in this preliminary version, and we suspect that theseestimates are likely to be too high. Second, the process of APEC trade and investment
liberalization started in 1997, but some APEC countries reduced trade and FDI barriers
significantly between 1992 and 1997. Third, the current model is static and does notaccount for capital accumulation. However, the capital stock is expected to increase overtime, particularly when the real return to capital increases. The first two factors would
overestimate the results while the last factor would underestimate them.

4.

Computational Results
We have conducted three APEC liberalization experiments: (1) the five APEC

regions remove trade barriers on a Most-Favored Nation (MFN) basis, (2) they reducebarriers to FDI by 50 percent on an MFN basis, and (3) the combination of (1) and (2). We
first examine aggregate results in section 4.1, followed by assessments of sectoral results
in section 4.2.
4.1

Aggregate Results
Table 4 summarizes aggregate results from three APEC liberalization experiments.

In the aggregate, world real GDP would gain $100 billion from trade liberalization, $339
billion from FDI liberalization, and $441 from the combination of the two. Theseestimates should be interpreted with caution because the ad valorem equivalents of FDI
barriers used in the model may be biased upward, particularly for UCAN.
All five APEC regions would realize gains in real GDP from trade liberalization,
ranging from 0.2 percent for UCAN to 2.5 percent for ASEAN-4 (column 4). Both imports
and exports increase substantially with the exception of the rest of the world (ROW). It
may be puzzling at first why ROW’s GDP and exports fall despite APEC tradeliberalization is nondiscriminatory toward ROW. It is mainly caused by a large decline inits exports of primary products to Japan and NIEs. UCAN is the leading supplier of12primary products to these regions, and its exports of primary products surge after theremoval of trade barriers. This is because the export price of UCAN relative to that of
ROW falls, resulting from a reduction in the average cost brought about by a fall in theprice of imported intermediate inputs.

Table 4. Aggregate Results from APEC Liberalization
Absolute changes ($bn)
Trade
FDI
Trade andLib.
Lib.
FDI Lib.
(1)
(2)
(3)

Percentage changes
Trade
FDI
Trade andLib.
Lib.
FDI Lib.
(4)
(5)
(6)

Real GDP
UCANa
Japan
NIEsb
ASEAN-4
China
ROW
World

13.8
48.6
20.4
9.0
10.6
-2.7
99.7

324.2
-5.7
28.5
38.9
20.9
-67.9
338.9

UCAN
Japan
NIEs
ASEAN-4
China
ROW

189.9
130.7
92.2
36.2
57.3
25.6

2.0
18.9
12.5
10.9
5.3
30.7

UCAN
Japan
NIEs
ASEAN-4
China
ROW

177.6
121.4
94.2
44.7
64.4
-14.7

99.6
-24.9
15.1
28.5
13.3
-56.8

341.8
37.0
48.4
53.7
35.2
-74.9
441.2

0.2
1.3
2.2
2.5
2.1
0.0
0.4

4.7
-0.2
3.1
10.7
4.2
-0.6
1.5

5.0
1.0
5.3
14.9
7.1
-0.7
1.9

0.3
5.8
2.7
8.2
6.0
1.9

23.9
47.2
23.5
40.8
74.2
3.8

13.0
-6.5
3.8
20.6
9.5
-4.0

36.9
24.7
28.4
62.1
60.5
-5.1

93.6
51.8
34.9
41.5
70.5
-3.7

98.1
57.4
40.1
50.3
104.1
-5.2

19.2
57.8
39.8
40.0
55.3
32.4

18.4
64.9
49.1
54.7
72.5
34.4

Aggregate Imports
194.1
154.2
109.6
53.9
65.5
61.6

23.4
40.0
19.8
27.4
64.8
1.6

Aggregate Exports
281.7
95.2
112.2
85.9
84.0
-72.4

23.2
31.5
23.8
32.3
46.4
-1.0

Inward FDI Stocks
UCAN
Japan
NIEs
ASEAN-4
China
ROW

2.4
0.2
0.9
0.8
1.0
-1.6

60.0
2.3
7.1
8.5
3.2
-4.3

62.9
2.5
8.1
10.2
4.7
-6.1

3.8
5.3
4.5
4.0
22.1
-1.3

Outward FDI Stocks
UCAN
-0.4
13.2
12.7
Japan
1.8
22.2
25.0
NIEs
0.7
4.6
5.7
ASEAN-4
0.1
0.4
0.5
China
0.0
0.1
0.1
ROW
1.6
36.2
38.5
Notes: a) United States, Canada, Australia, and New Zealand.
b) Korea, Taiwan, Hong Kong, and Singapore.

13

-0.6
4.7
6.0
11.4
13.2
1.4

The real GDP effect of FDI liberalization depends upon whether a region attracts
or loses foreign capital, which in turn is affected by the magnitude of initial FDI barriers,
the share of output produced by multinational firms in total output, and the initial stock of
inward FDI relative to outward FDI, among many factors. UCAN, NIEs, ASEAN-4, andChina would realize gains in real GDP because the increase in the inward FDI stock islarger than the increase in the outward FDI stock while the opposite is the case for Japanand ROW (column 2 of Table 4). 9 In percentage terms the impact on real GDP isextremely large in ASEAN-4 largely because the share of output produced bymultinational firms in total output is the highest among the APEC regions. 10 A large
injection of new foreign capital to the already high initial inward FDI stock relative to thetotal capital stock would substantially expand output of multinational firms located in
ASEAN-4.
The results reported in Table 4 suggest that at the aggregate level, trade and FDI
exhibit a complementary relationship. That is, an increase in imports resulting from tradeliberalization leads to an increase in inward FDI (column 4), and a rise in inward FDI
resulting from FDI liberalization induces an expansion of imports (column 5). Home
sourcing of intermediate inputs by foreign subsidiaries can partly explain the latter
causality. We have no strong reason to believe why the removal of trade barriers would
attract foreign capital at the aggregate level, and we postpone our assessment until we
examine the sectoral results.
4.2

Sectoral Results
Tables 5 and 6 present each region’s sectoral adjustments in output, trade, andinward and outward FDI stocks for the three experiments. Not only the magnitude of theadjustments but the sign often changes with the transition to a more microeconomic
perspective. The removal of trade barriers is expected to lead to large contractions in
output of primary products in Japan and NIEs, resulting from a sharp increase in demandfor imported goods. Since UCAN and China export relatively large shares of their primary9

FDI liberalization would raise after-tax rate of return to capital in APEC regions relative to ROW.
This induces capital to move from ROW to APEC regions, reducing the capital stock and output
produced in ROW.

10

For individual APEC economies, this share is the highest in Singapore, followed by Hong Kong.
For the regional aggregation used in this paper, however, the share is significantly higher in
ASEAN-4 than the NIEs.

14

products to Japan and NIEs, export expansion resulting from trade liberalization would
sharply raise domestic output. This appears to cause a strong resource-pull effect in
UCAN and China. As the primary sector expands substantially in these regions, factors of
production would be diverted from the manufacturing and services sectors, causing an
output contraction in these sectors. However, this assumes that labor is homogeneous andperfectly mobile across sectors. If labor demand was disaggregated by type and skill,
however, limited labor mobility might dampen contraction in non-primary sectors.
The manufacturing output in Japan, NIEs, and ASEAN-4 increases, driven byexport expansion. Had more disaggregated data been available, we would expect that
output of some labor-intensive sectors (such as processed food and apparel) to contract inJapan and that output of some capital-intensive sectors (such as steel and transportationequipment) to decline in ASEAN-4.11
FDI liberalization leads to an expansion of output in all three sectors in UCAN,
NIEs, ASEAN-4, and China (Table 5). As already mentioned in section 4.1, the regionsthat attract net inward FDI experience a positive output effect. Extremely large percentage
increases in both inward and outward FDI in services are observed (Table 6). This isbecause the rates of FDI protection are highest in the services sector in every region.
Although not reported in Table 6, the absolute change in the services sector’s inward FDI
stock is larger than that in its outward FDI stock in every APEC region except Japan.12 An
increase in output of services in Japan may be attributable to inter-sectoral domestic
capital mobility. With primary production declining, capital installed in that sector moves
to manufacturing and services, with the latter more important than the net decline in FDI.
Note that in ASEAN-4 output of manufactures is expected to rise more drastically than
output of services mainly because the share of output produced by multinational firms in
total output is several times greater in manufactures (0.69) than in services (0.09). Theremight also be some feedback from ‘home’ inputs from FDI installed abroad although themagnitude is probably not large.

11

Because of data limitations on FDI, we were not able to disaggregate the manufacturing sector
further. See Lee, Roland-Holst, and van der Mensbrugghe (1999) for the sectoral output effects of
APEC trade liberalization at a 20-sector level of disaggregation.

12

In Japan the inward FDI in services increases from $0.5 billion to $2.1 billion, whereas theoutward FDI in services increases from $10.7 billion to $28.6 billion.

15

Table 5. Sectoral results from APEC liberalization(percentage changes)
UCANa

Trade liberalization

Primary
Manufacturing
Services
FDI liberalization
Primary
Manufacturing
Services
Trade & FDI liberalization Primary
Manufacturing
Services

Japan

NIEsb

ASEAN-4

China

ROW

-32.7
4.2
0.8
-2.3
-1.2
0.3
-35.0
2.8
1.1

Output
-20.3
-7.4
10.0
10.3
0.5
1.7
7.4
5.3
1.3
18.9
2.8
9.2
-13.3
-2.4
11.4
35.0
3.3
10.7

5.9
-5.6
-0.8
1.2
5.0
4.3
6.9
0.8
3.5

-1.9
-0.1
0.3
-1.5
-1.1
-0.3
-3.3
-1.4
0.0

39.5
71.2
-5.1
8.8
5.7
4.0
52.3
80.3
-1.3

-0.3
2.6
-0.2
0.9
1.8
3.0
0.6
4.9
2.7

155.4
35.1
22.6
-0.1
11.5
-3.8
150.4
52.6
18.4

-12.2
2.1
0.9
-4.9
-3.5
-4.8
-16.3
-1.8
-3.8

11.8
-3.8
-0.1
3.5
4.3
5.3
15.6
0.6
5.2

Trade liberalization

Primary
Manufacturing
Services
FDI liberalization
Primary
Manufacturing
Services
Trade & FDI liberalization Primary
Manufacturing
Services

13.8
28.4
-0.9
-0.5
1.7
-8.9
14.5
30.2
-9.2

79.7
35.2
5.6
1.8
8.1
6.3
83.6
45.9
10.5

Imports
59.9
39.5
15.8
27.8
4.1
-10.5
-0.3
14.3
3.5
8.0
0.1
-5.3
61.6
61.2
20.4
40.8
4.4
-13.4

Trade liberalization

136.0
9.6
1.9
10.5
12.8
15.1
150.3
22.9
16.0

26.3
36.6
-7.0
-0.5
-6.0
-10.5
32.5
29.8
-14.6

Exports
13.2
-12.7
32.5
50.3
-5.3
27.4
33.4
-0.2
2.2
31.5
-1.8
4.5
49.4
-15.8
35.5
98.1
-7.2
27.8

Primary
Manufacturing
Services
FDI liberalization
Primary
Manufacturing
Services
Trade & FDI liberalization Primary
Manufacturing
Services
Notes:a) United States, Canada, Australia, and New Zealand.
b) Korea, Taiwan, Hong Kong, and Singapore.

For UCAN and China, expansions of the manufacturing and services sectors under
FDI liberalization are larger than contractions of these sectors under trade liberalization,
resulting in expansions of all three sectors in these regions when both trade and FDI areliberalized. For Japan, NIEs, and ASEAN-4, the combination of trade and FDI
liberalization leads to expansions of manufacturing and services output.

16

Table 6. Sectoral FDI impacts results from APEC liberalization(percentage changes)
UCANa
Japan
NIEsb

ASEAN-4

China

ROW

Trade liberalization

Primary
Manufacturing
Services
FDI liberalization
Primary
Manufacturing
Services
Trade & FDI liberalization Primary
Manufacturing
Services

10.7
3.0
-1.4
4.5
26.2
294.3
15.5
31.4
291.7

-27.5
8.6
1.8
57.2
15.2
291.6
14.4
24.8
298.0

Inward FDI stock
-12.4
-9.1
15.6
15.5
1.8
-5.0
37.9
14.8
9.7
35.3
150.0
140.0
22.6
4.6
27.3
61.4
157.0
133.7

51.7
8.4
-5.7
16.1
76.1
200.3
74.4
103.4
189.6

-4.4
-0.3
-0.7
-2.1
-3.1
-11.1
-6.4
-3.6
-11.9

Trade liberalization

-4.2
2.6
-1.0
12.2
7.3
100.1
7.2
10.3
98.7

31.4
6.4
-2.7
-1.2
16.1
168.8
31.0
26.8
163.8

Outward FDI stock
12.2
1.9
4.9
18.6
-4.7
3.1
8.4
14.3
38.8
14.7
113.9
235.7
22.5
16.2
49.9
37.6
106.3
246.3

-3.4
19.9
0.9
64.9
10.2
329.9
65.6
33.6
337.3

-0.3
2.4
0.0
1.6
5.4
204.9
1.3
8.7
206.0

Primary
Manufacturing
Services
FDI liberalization
Primary
Manufacturing
Services
Trade & FDI liberalization Primary
Manufacturing
Services
Notes:a) United States, Canada, Australia, and New Zealand.
b) Korea, Taiwan, Hong Kong, and Singapore.

Finally, we examine whether trade and FDI are complements at the sectoral level.
Trade liberalization leads to an increase in the inward and outward FDI stocks of the
manufacturing sector in every APEC region, whereas it has an ambiguous effect on the
FDI stocks in the primary and services sectors (Tables 5 and 6). At the same time, FDI
liberalization leads to an increase in imports and exports of manufactures in every APEC
region with the exception of Japanese exports. Again, the effect on the primary andservices sectors is ambiguous.
The results are consistent with our a priori expectation that horizontal FDI is themost prevalent in the manufacturing sector, where trade and FDI linkages are extensive.
Thus the removal of trade barriers in host economies is likely to promote production offoreign subsidiaries. In the primary sector, motives of FDI might include securing energy
and/or natural resources for the home country, and this type of FDI is expected to be lesssensitive to changes in the height of trade barriers in the host country. In the services

17

sector, a change in trade regime is unlikely to affect the level of FDI extensively because
FDI is often the only means to provide foreign services to local consumers.

5.

Conclusions
Despite a significant economic setback experienced by several East Asian

economies during 1997-99, the Asia-Pacific region has been the fastest growing
multilateral trading area of the world. In this paper, we have evaluated the impact of
APEC trade and investment liberalization using a CGE model that incorporates FDI. The
preliminary results suggest that FDI liberalization would bring about greater benefits tomost of the APEC economies than trade liberalization. More accurate estimates of FDI
barriers would be helpful in assessing the benefits of APEC liberalization more precisely,
and we plan to refine and update the database.
In the manufacturing sector, trade and FDI are found to be complements in the
APEC regions. Trade liberalization leads to an increase in the inward and outward FDI
stocks, and FDI liberalization leads to an increase in imports and exports of manufactures.
The only exception is that when Japan liberalizes FDI barriers, it leads to an increase inimports but not in exports. However, this may be treated as a special case because Japan’s
inward FDI stock is extremely small relative to its capital stock. The result oncomplementarity suggests that gains from trade liberalization would be amplified in thepresence of FDI. At the same time, FDI liberalization would increase both FDI and tradeflows, which brings additional gains in the worldwide production.

18

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22Appendix: Model Specification

Indicesi, jr, sf, d, v

Sector indices
Regional indices
Varieties – f represents foreign varieties only, whereas d represents the domestic variety,i.e. production from home owned and based plants. v represents both f and d (i.e. it is theunion of f and d).

Equations
Production
NDrd, j ,v = and rd, j ,v XPr , j ,v

PNDrd, j ,v =

∑ ad

(A.1)

d
r ,i , j , v PAr ,i(A.2)

WTF fp, j ,d ,r = and rm, j , f XPr , j , f(A.3)

PND rm, j , f = PM f , j , d ,r(A.4)

VAr , j ,v = ava r , j ,v XPr , j ,v

(A.5)

i

Ldr , j ,v =α

K rd, j ,v =σplr , j ,v αPVAr , j ,v  r , j ,v
VAr , j ,v
W
r



(A.6)

σ rp, j ,v

PVAr , j ,vkr , j ,v 

PK
r
,
j
,
v



VAr , j ,v

(A.7)

1−σ p
1−σ p
PVAr , j ,v = α rl , j ,vWr r , j ,v + α rk, j ,v PK r , j ,vr , j ,v 



(

1 / 1−σ rp, j ,v

)
(A.8)

VCr , j ,v = avar , j ,v PVAr , j ,v + and rd, j ,v PNDrd, j ,v + and rm, j ,v PNDrm, j ,v()

PPr , j ,v = 1 + τ rp, j VCr , j ,v

(A.9)

(A.10)

Income Distribution
YH r∑∑ W L

=

r

i

v

d
r ,i ,v +∑∑ (1 − χ )PKr ,i ,vindr ,i ,v K r ,i ,vv+ TYrk + TYrm + TYr p + TYrx

(A.11)+ InFlowYrk
TYr p =∑∑τ VCpr ,ii(A.12)

r ,i ,v XPr ,i ,vv

23

TYrk =∑∑τikdr ,i ,v PK r ,i ,v K r ,i ,v(A.13)v∑∑ χ

InFlowYrk =i

OutFlowYrk =nds ,i ,r PK s ,i ,r K s ,i ,r(A.14)

s

∑∑ χ
i

n
d
r ,i , s PK r ,i , s K r ,i , s(A.15)s

PINVr Invr = S rh + P MUV S rf

(A.16)

Domestic demand
Yr* = YH r −∑ (1 + τ ) PA θ

(A.17)µ r ,iYr*
1 + τ rc,i PAr ,i(A.18)cr, j

r, j r, jj

XAcr ,i = θ r ,i +( )S = YH − ∑ (1 + τ ) PA XAc
h
r

c
r, j

r

r, j

(A.19)

r, j

j



σ ri


PINVr
 Invr
XAir ,i = α
i

PA
1
τ
+
r ,i
r ,i 
i 
r ,i 

()


1−σ ri 
PINVr =  α ri ,i 1 + τ ri ,i PAr ,i

 i


∑ ((

XAr ,i =

∑∑ ad
v

)

)

(A.20)(

1 / 1−σ ri)(A.21)ddr ,i , j ,v NDr , j ,v + XAcr ,i + XAir ,i(A.22)](A.23)

j[

TYrx = ∑ τ rc,i PAr ,i XAcr ,i + τ ri ,i PAr ,i XAir ,iiTrade
σ rm,i PAr ,i 
XDTr ,i = α rd,i PDTr ,i 

XAr ,i(A.24)

XAr ,i(A.25)

σ rm,i PAr ,i 
XMTr ,i = α rm,i  PMTr ,i 

[

1−σ m

1−σ m

PAr ,i = α rd,i PDTr ,i r ,i + α rm,i PMTr ,i r ,i]( )1 / 1−σ rm,i(A.26)σ rd,i

 PDTr ,i 
XDr ,i ,v = α rxd,i ,v  PPr ,i ,v 

XDTr ,i(A.27)24
1−σ d PDTr ,i = ∑α rxd,i ,v PPr ,i ,v r ,i 
 v


(

1 / 1−σ rd,i)(A.28)

σ rv,i

 PMTr ,i 
= α rOwn
XMTrOwn
,i
,i 
Own 
PMT
r ,i



XMTr ,i(A.29)

XMTr ,i(A.30)

σ rv,i

 PMTr ,i 
= α rForXMTrFor
,i
,i 
For 
 PMTr ,i 

Own 1−σ r ,iFor 1−σ r ,i 
PMTr ,i = α rOwn
+ α rFor,i (PMTr ,i ),i (PMTr ,i )d

 PMTrOwn,i
WTFsa,i ,r ,r = α rOwnx,i , s PM s ,i ,r ,r 



PMT

(

1 / 1−σ rd,i)(A.31)σ ro, i

 PMTrOwn
,ia
Ownx 

WTFr ,i ,d ,r = α r ,i ,d PM r ,i , d ,r 


Own
r ,i

d

XMTrOwn,i(A.32)

XMTrOwn,i(A.33)σ ro, i
1−σ ro,i 
1−σ ro,i 
Ownx
(
)
(
)
PM
α
PM
=  ∑α rOwnx+
s ,i ,r ,rr ,i ,dr ,i ,d ,r
,i ,s


 s


For


xf  PMTr ,i 
FVr ,i , f = α r ,i , f
 PFVr ,i , f 

(

1 / 1−σ ro,i)(A.34)

σ rfv,ifor ∀f ≠ r

XMTrFor,i
1−σ fvPMTrForα rxf,i , f PFVr ,i , f r ,i 
,i = 
 f ≠ r∑(

1 / 1−σ rfv,i(A.35))(A.36)σf PFVr ,i , f  r ,i , f
WTFsa,i , f ,r = α rForx
FVr ,i , f,i , f , s 

PM
s
,
i
,
f
,
r


 PFVr ,i ,s 

WTFsa,i ,d ,r = α rForx,i , d , s  PM s ,i ,d ,r 

for

f ≠r

σ rf,i , s

FVr ,i , s

for s ≠ r

1−σ rf,i , f 
1−σ rf,i , f 
ForxPFVr ,i , f =  α rForx
for,i , f , s PM s , j , f ,r  + α r ,i , d , f PM f ,i , d ,r 

 s


∑

PM r ,i ,v ,s = (1 + τ rm,i ,s ) (1 + ξ r ,i ,s ) PPr ,i ,v

TY

m
r

(A.37)(A.38)f ≠r(A.39)(A.40)

τ sm,i ,r PM s ,i ,v ,r(= ∑∑∑ WTFs p,i ,v ,r + WTFsa,i ,v ,r )
msiv
 (1 + τ s ,i ,r )


25

(A.41)

International Trade and Transport Services[]

XWM = ∑∑∑∑ PPr ,i ,vξ r ,i ,s WTFr p,i ,v ,s + WTFra,i ,v ,s / PWM
riv(A.42)sσt PWM  XWM
XMarg r = α rt  PMarg r t PWM = ∑α rt PMArg 1r−σ 
 r


(

1 / 1−σ t(A.43))(A.44)XMGr ,i = α rmg,i XMArg r(A.45)

PMArg r = ∑α rmg,i PPr ,i ,d(A.46)

i

Goods market equilibrium
XPr ,i , f = XDr ,i , f +∑ [WTF](A.47)[](A.48)

pa
r ,i , f , s + WTFr ,i , f , ss

XPr ,i ,d = XDr ,i ,d + ∑ WTFr p,i ,d ,s + WTFra,i ,d ,s + XMGr ,is

Factor market equilibrium∑∑ L(A.49)

Wr = PWrWr ,0(A.50)

Lsr =dr , j ,v

j

v

Sec


Sec PK r ,i
K rSecγ=,ir ,i PWrω rSec

Wr
PWr

Sec

Sec 1+ω r ,i 
PWr = ∑ γ rSec,i (PK r ,i ) i PK rn,i ,d 
K rs,i ,d = γ rDom
,i 
Sec 
PK
,
r
i


K

For
r ,i

PK

=γ

Sec
r ,i

For
r ,i


 PK rFor,i PK Sec r ,i 


(A.51)(

1 / 1+ω rSec
,i)(A.52)

ω rkx,iK rSec,i(A.53)

ω rkx,iK rSec,i(A.54)

1+ω r ,in
For 1+ω r ,i = γ rSec+ γ rFor,i (PK r ,i ,d ),i (PK r ,i )


kx

 PK nf ,i ,r χ f ,i ,r K sf ,i ,r = γ rkf,i , f 
For 
PK
r
i
,



kx

(

1 / 1+ω rkx,i)(A.55)

ω rkf,iK rFor,i(A.56)

26

PK

For
r ,i


1+ω kf = ∑ γ rkf,i , f (PK nf ,i ,r ) r ,i 
 f


(

1 / 1+ω rkf,i)(A.57)

K rs,i ,v = K rd,i ,v(A.58)

PK rn,i ,v = (1 − τ rk,i ,v ) PK r ,i ,v(A.59)

Numéraire and closure

P MUV∑ ∑ ∑∑ PP (WTF=∑ ∑ ∑∑ PP (WTFr∈OECD i∈Manu vr∈OECD i∈Manu v

r ,i ,vp
r ,i ,v ,s , 0+ WTFra,i ,v ,s ,0 )r ,i ,v , 0p
r ,i ,v ,s , 0+ WTFra,i ,v ,s ,0 )s

(A.60)

s

Dropped balance of payments equation

The following equation is deduced as a linear combination of the regional equations:P MUV S rf

 PM s ,i ,v ,r∑∑∑  (1 + τ ) (WTF + WTF )
)]− ∑∑∑ [PP (WTF
+ WTF
=

s

i

m
s ,i , rv

r ,i ,vs−ips ,i ,v , rp
r ,i ,v , sas ,i ,v , rar ,i ,v , s

v

∑ PP

k
k
r ,i , d XMGr ,i − InFlowYr + OutFlowYriDefinition of Variables and Parameters
Endogenous Variables
Production
NDd
PNDd
WTFp
PNDm
VA
Ld
Kd
PVA
VC
PP

Aggregate intermediate demand
Price of aggregate intermediate demand‘Home’ imports for production by foreign-based investment
Price of ‘home’ imports
Aggregate value added
Labor demand
Capital demand
Price of value added bundle
Unit cost of production
Producer price

Income
YH
TYp
TYk
TYm

Household income
Production tax revenues
Capital tax revenues
Tariff revenues

27(A.61)

TYx
InFlowYk
OutFlowYk
Inv

Indirect tax revenues
Capital income from abroad
Capital income flowing abroad
Investment volume

Domestic demand
Y*
XAc
Sh
XAi
PINV
XA

Supernumerary income
Armington demand by households
Household savings
Armington demand for investment expenditures
Investment price deflator
Aggregate Armington demand

Trade
XDT
XMT
PA
XD
PDT
XMTOwn
XMTForPMT
WTFa
PMTOwnFVPMTForPFV
PM

Aggregate demand for goods produced domesticallyAggregate demand for imports
Armington price
Demand for goods produced domestically
Price of aggregate demand for domestic goods
Aggregate import demand for ‘own’ imports
Aggregate import demand for ‘foreign’ varieties
Aggregate import priceWorld trade flow for imports (excluding ‘home’ imports)
Price of aggregate import demand for ‘own’ imports
Import demand for aggregate foreign varieties
Price of aggregate import demand for ‘foreign’ varieties
Price of import demand for aggregate foreign varieties
Tariff inclusive bilateral import priceInternational Services
XWM
XMarg
PWM
XMG
PMarg

Aggregate demand for international trade services
Regional supply of international trade services
Aggregate price index of international trade services
Sectoral supply of international trade services
Regional supply price of international trade services

Goods
XP

OutputFactors
Wage
W
KSec
PW
Ks
KFor
PKSec
PKFor
PK
PKn

Wage rate
Value of wealthAggregate sectoral capital supply
Price index of wealth
Sectoral capital supply by region and variety
Aggregate foreign capital allocation
Price of aggregate sectoral capital supply
Price of aggregate foreign capital allocation
Price of capital
Price of capital net of taxes

28

Exogenous Variables
τp
τk
τm
τc
τi
ξ
Ls
W0
Sf
PMUV

Output tax
Capital tax
Tariff rate
Indirect tax on consumption
Indirect tax on investment expenditures
International trade and transport margin
Aggregate labor supply
Initial (volume of) wealthForeign saving
World price index (of industrial countries’ manufacturing exports)

Parameters
add
andd
andm
ava

αl
αk
αi
αxd
αOwn
αFor
αOwnx
αxf
αForx
αt
αmg
σp
σi
σm
σd
σv
σo
σfv
σf
σt
χ
θ
µ

γSec
γDom
γFor
γkf
ϖSec
ϖkx
ϖkf

Share parameter for Armington intermediate demand by sector of input
Share parameter for aggregate intermediate Armington demand
Share parameter for aggregate intermediate home demand
Value added share in production
Labor share parameter in value added
Capital share parameter in value added
Investment expenditure share parameter
Share parameter for domestic demand of domestically produced goods
Aggregate share of own variety in aggregate imports
Aggregate share of foreign varieties in aggregate imports
CES share parameters for importing own varieties
Share parameter for aggregate demand of foreign variety f
Share parameters for allocating demand for foreign varieties across regions
CES share parameter for demand of international trade services
Technical coefficient for supply of international trade and transport services
Capital-labor substitution elasticity across varieties
Investment expenditure substitution elasticity
Substitution elasticity between domestic goods and imports
Substitution elasticity of demand across domestic goods by variety
Substitution elasticity of imports for own versus foreign firms
Substitution elasticity of imports across regions of origin for own products
Substitution elasticity of imports across varieties for foreign firms
Substitution elasticity of imports across regions of origin for firms of type f
Substitution of demand for international trade and transport services
Share of installed FDI owned by foreigners
Household subsistence minima
Household marginal propensity to consume
CET share parameters for top-level CET capital nest
Domestic capital share by sector
Foreign capital share by sector
CET share parameter for allocation of FDI across regions by sector
CET transformation elasticity for top-level CET capital nest
Transformation elasticity between domestic and foreign capital
Transformation elasticity of FDI across regions of destination

29