# **2.3 FDI and trade**

Despite the increased attention devoted to “third wave”/“deep integration” issues in recent PTAs, reduction of barriers to merchandise trade remains the focal point of any preferential agreement. Therefore, one of the main PTA-FDI interaction effects is the response of foreign investment to the PTA-induced changes in trade flows. The key determinant of the sign and magnitude of this effect is whether, at the margin, FDI and trade are substitutes or complements. Since intra- and extraPTA trade is affected differently by preferential liberalization (the famous issue of trade creation vs. trade diversion), we can expect the impact on incoming FDI to vary by source country. In line with standard trade theory, the following discussion will assume that intra-PTA trade increases following liberalization, and that extra-PTA trade does not.<sup>5</sup> The early literature on the interactions between investment and trade, as noted by Blomstr ̈om and Kokko (1997), conceptualized the two as different modes of reaching foreign markets. According to this view, FDI is attracted to protected markets, where it is cheaper to set up a subsidiary than pay the tariffs required to serve the market through exports (a practice referred to as “tariffjumping” FDI). This type of FDI has a long history, going back to the industrialization of Canada and Australia (Caves, 1996). Chapter 3 of World Bank (2002) cites studies that confirm that high tariff rates on imported goods induced FDI inflows into the United Kingdom (Dunning, 1958), Canada (Horst, 1972), and Australia (Brash, 1966). By lowering or eliminating tariffs between PTA members, preferential liberalization removes incentives for this type of investment, and we therefore expect tariff-jumping FDI to respond negatively to increased intra-PTA trade (which takes place as a result of lower tariff levels—the well-known trade creation result). On the other hand, as long as some trade diversion takes place following the PTA’s entry into force, the reduction in trade flows with non-PTA trading partners may be accompanied by increases in investment flows. However, in line with intuition, empirical evidence suggests that tariff-jumping FDI is “transient, lasting as long as the artificial policy-induced incentives” (Balasubramanyam, 2001).

More recently, studies have proposed that FDI need not be undertaken simply to circumvent trade barriers. Instead, the literature has focused on the role of intangible assets of MNEs as a major motivation for FDI (see, for example, Caves (1996) for review). Dunning (1977) provides a conceptual framework where a MNE’s decision to undertake foreign investment is guided by one or more of the following motivations: ownership advantage, where a firm’s ownership of a product or production process gives it market power in a foreign country, location advantage, where a firm enjoys benefits from relocating production abroad that exceed its plant-level economies of scale at home, or internalization advantage, where a firm gains more by internalizing production rather than licensing it to a foreign associate. Embedding these ideas in a general equilibrium model with endogenous MNEs, Markusen (2002) argues that “trade and investment are complements when the countries differ in relative endowments and investment is vertical, while trade and investment are substitutes when the countries are similar and investment is horizontal.” Contrary to conclusions of the earlier paragraph, this framework suggests that the relationship between preferential trade liberalization and FDI can be positive or negative, regardless of whether trade flows are intra- or extra-PTA.

Globerman (2002) develops an argument that FDI is likely to respond positively to preferential

> 5We assume that at least some trade creation takes place within a PTA: that is, no matter how little, some reduction in overall protection takes place between PTA partners. With regard to extra-PTA trade, there is no reason to expect increased trade between PTA partners and other countries as a result of the agreement—therefore we assume that the change in extra-PTA trade is non-positive. We make no assumptions about the relative magnitudes of the two effects—i.e. whether a PTA is net trade creating or diverting.

6