Report

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