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8 Impact of SAFTA on Inward and Outward Foreign Direct Investments INTRODUCTION Linkage between trade and FDI has now been established in theoretical as well as empirical literature. Studies that link trade to FDI fall under three categories. First, those that argue that the determinants of FDI and trade are similar and, therefore, what determines trade also determines FDI flows (Ekholm 2002). Second, those that estimate econometric models in which FDI, exports and imports are determined simultaneously and argue that all three are endogenous variables and, therefore, their interactions should be taken into account (Hejazi and Safarian 2003). Lastly, those that look at the impact of regional trade agreements on FDI flows (Banga 2004, Binh and Haughton 2002, Worth 2002). Banga (2004) shows that RTAs like ASEAN and APEC can influence FDI inflows into the region as the risks associated with investments decline with greater regional integration. Regional integration initiatives influence the level and pattern of FDI flows into the region as it lowers risk associated with investment and boost FDI flows between the member countries. The SAARC integration initiative has been accompanied by liberalisation process in all member countries. This has involved both trade and investment liberalisation. Though significant trade and investment barriers remain in place in many countries, the regional economies of SAARC are today far more open than they were until the late 1980s. There is a general acceptance that expanded trade, as well as FDI, confers large net benefits However, though intra- SAARC trade has been quite extensively analysed, the FDI-trade nexus has received relatively little research attention in South Asia. This chapter discusses the trends in FDI into and between the member countries of SAFTA. It provides a brief review of the studies that have analysed the impact of regional integration on inward FDI. The chapter further estimates the impact of trade within the region on inward FDI into the region and into the member countries. It presents the methodology and results of the econometric model. THEORETICAL FRAMEWORK AND REVIEW OF LITERATURE ON IMPACT OF REGIONAL TRADE AGREEMENTS ON FDI Following Mundell (1957), it was long thought that FDI substitutes trade. This proposition was challenged by Agmon (1979) and subsequently a number of studies emphasised the potential complementarities between FDI and trade (Ethier 1996 and Markusen 1995). Earlier literature suggests that FDI and trade are either substitute (in the case of tariff-hopping investment) or complementary to each other (in the case of intra firm trade). However, the relationship between FDI and trade has become far more complex in the WTO regime wherein several developing countries have initiated import liberalisation process that has drastically reduced trading costs and encouraged international vertical integration and intra industry trade. According to the theoretical literature, the H-O theory predicts that the lowering of tariff barriers in economic integration will increase income of importcompeting industries due to cheaper imports in the member countries. This will increase the return on capital in the integrated area. Hence inward FDI is also expected to increase. According the theory of international production, inward FDI is a strategic response to the common external tariff of custom unions (CUs) as multinational enterprises (MNEs) substitute foreign activities for exports. Moreover, MNE will take advantage of the dynamic effects of CUs by utilising the enlarged market (i.e. economies of scale). According to the theory of CUs and the internal market the strategic response of MNEs to the creation of CUs gives rise to ‘investment creation’ and ‘investment diversion’ effects. As cited in Yannopoulos (1990), basically
I MPACT OF SAFTA ON INWARD AND OUTWARD FOREIGN DIRECT INVESTMENTS 61 investment creation refers to a surge of inward FDI from non-member countries into the CUs and is regarded as the strategic response of MNEs to the trade diversion effects. Investment diversion refers to the shifting of FDI from one member of the CUs to another as a result of the trade creation effect. More recently, the blending of trade theory and industrial organisation in models that often explicitly incorporate scale economies (‘New Trade Theory’) has stimulated the development of a number of analytical models of the linkages between foreign trade and foreign investment (for a review, see Markusen, 2000) Traditionally, FDI decisions have been examined within the conceptual framework of the Ownership, Location, Internalisation model (OLI), introduced by Dunning (1958). This eclectic framework suggests that decisions of firms to engage in direct investment abroad are driven by factors related to cost advantages, market access, and the maintenance of knowledge assets internally. Locational advantages are enhanced by regionalism as with the decline in the barriers to trade and increase in the importance of networks, foreign investors find barriers to entry and less competitive environments less appealing. Further, considering the case of foreign direct investment and trade from the viewpoint of a firm’s location choices, whether FDI and trade are complements or substitutes depends on whether FDI is ‘horizontal’ or ‘vertical’. Horizontal FDI takes place when an MNE produces the same goods and services in multiple countries, in order to avoid paying the ‘trade costs’ of exporting goods from one country to another, but wishes to exploit its firm-specific advantages in production. With trade liberalisation, trade costs will come down, and the incentive to produce in multiple country locations will diminish, particularly if there are significant economies of scale. In this case FDI and trade are substitutes (Markusen 1984). Vertical FDI takes place when a firm geographically fragments production by stages, in order to take advantage of location-specific advantages such as lower factor prices in other countries. For example, FDI and trade are complements if an MNE relocates part of its production chain, e.g. its labour-intensive assembly plant, to a low-wage country, and exports headquarter services such as blueprints and management skills, and intermediate inputs to that country, and then re-exports final goods (Helpman 1984). Imports of the ‘home’ country increase as it imports products made by the foreign subsidiary, while its exports increase because the foreign subsidiary requires capital and intermediate goods from the home country to undertake production in the host country. RTAs can change the level and pattern of FDI, and thereby affect trade in ways that may not fully be captured in standard trade theoretic analyses of customs unions. Trade and investment liberalisation can change the location specific and firm-specific advantages. They can encourage geographical concentration as foreign firms can restructure their production bases to take advantage of reduced trade costs while exploiting scale economies and agglomeration advantages. This may lead to FDI outflows from countries that had earlier attracted ‘tariff hopping’ foreign firms to serviceprotected domestic markets because they can now be competitively supplied from production bases elsewhere. On the other hand, better access to a larger market may attract FDI (from within the region as well as from outside) to countries that have a strong locational advantage. Such locational advantages may arise from availability of cheaper resources, superior infrastructure, political stability, a more favourable policy regime, and a host of other factors. Ethier (1998) has shown that membership in RTAs can provide small but crucial competitive advantages to countries that can help them attract large FDI inflows. The empirical literature corroborates the above arguments. Chakrabarti (2001) argues that after market size, openness to trade has been the most reliable indicator of the attractiveness of a location for FDI. Studies that examine the impact of openness to trade and regional agreements for trade on FDI inflows and find them to be important determinants are Gastanaga, Nugent and Pashmova (1998), Taylor (2000), Chakrabarti (2001) and Asiedu (2002). Globerman and Shapiro (1999) find that Canada–US free trade agreement (CUFTA) and North American free trade agreement (NAFTA) increased both inward and outward FDI. Blomstrom and Kokko (1997) separate the effects of RTA along two dimensions, i.e. the indirect effect on FDI through trade liberalisation and the direct effects from changes in investment rules connected with the regional trade agreements. According to them lowering inter-regional tariffs can lead to expanded markets and increase FDI but lowering external tariffs can reduce FDI to the region if the FDI is tariff jumping. Impact of trade costs on FDI is mainly in terms of increasing and decreasing vertical and horizontal FDI. Vertical FDI is driven by availability of abundant cheap unskilled labour in the host economy. This is important for unskilled-labor intensive production activities. The main factors that govern these incentives are trade costs
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Preface Our consultations with seni
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viii CONTENTS 7. Revenue and Welfar
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Executive Summary OBJECTIVE This st
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Part I BENEFITS FROM TRADE, INVESTM
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APPENDICES
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Appendix 8 Intra SAARC FDI Collabor
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Appendix 11 Table A11.1 On an Emplo
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Appendix 12 Original Commitments/In
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Appendix 15 REFERENCE PAPER Scope T
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Bibliography Abelson, P. (1996),
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BIBLIOGRAPHY 241 Cuba (2002), Negot
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BIBLIOGRAPHY 243 (2004), Impacts of
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BIBLIOGRAPHY 245 Silva, Patricia an
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