The relationship between FDI and international trade

30 September 2020 (Last Updated September 30th, 2020 08:13)

The relationship between FDI and international trade
A container ship unloads cargo from Asia at Long Beach port in California. However, the tit-for-tat war between China and the US over trade is affecting global trade volumes. (Photo by Mark Ralston/AFP via Getty Images)

Trade and foreign investment are different but related types of transactions that play fundamental roles in the global economy. By Jon Whiteaker of Investment Monitor.

Foreign direct investment (FDI) and international trade are both drivers of the global economy, facilitating the cross-border transfer of goods, services and capital around the world.

Research shows that the relationship between FDI and international trade is often complementary rather than competitive, although they represent different types of transaction and play different economic roles.

Neither has escaped criticism and both have faced growing opposition from protectionist governments, despite the positive impacts they can have on recipient countries.

What is FDI?

A foreign direct investment involves a company or individual based in one country investing business interests in another country. These investments are typically in foreign business operations or assets, rather than buying and selling equities that are considered portfolio investments.

Countries around the world track the levels of FDI they attract as an indicator of economic performance, with high inbound FDI seen as both a sign of economic growth and a creator of it.

Greenfield FDI involves setting up a new business, subsidiary or facility in a different country, and is associated with job creation and the transfer of goods and skills into the host country. Mergers and acquisitions can also be counted as FDI but only when they represent a change in active ownership rather than the trading of minority stocks and shares by passive investors.

FDI is typically split between horizontal, vertical and conglomerate investments:

• A horizontal investment sees an investor establishing the same type of business in a new market as to the one it operates in its country of origin.

 

• Vertical investments are made in different but related business activities.

• Conglomerate investments are made in business activities unrelated to those of its existing business in its home market.

When a manufacturing company builds a factory in a new country, this is horizontal FDI. When it then acquires an active interest in a foreign company that supplies raw materials for its manufacturing plants, this is vertical FDI. If it then decided to invest in a telecommunications company in the host country, this would be conglomerate FDI.

FDI can be measured in stock or flows. FDI stock measures all direct investments held by non-residents in a country during a specific reporting period. Inward stock is the value of investments owned by foreign companies in a host nation, while outward stock is the value of investment held by domestic companies overseas.

FDI flows relate to cross-border investment completed during the reporting period either into a country (inward flows) or out of a country (outward flows).

What is international trade?

International trade is the buying and selling of products and services on international markets. This activity increases consumer choice, creating competitive markets that should result in reduced end prices and increased quality of products and services.

Natural resources are unevenly shared across the globe, but international markets allow countries to trade what resources or capital they have for the resources they need.

The different forms of trade are import, export and entrepot:

• Imports are goods/services transported into a country.

• Exports are goods/services transported out of a country.

• Entrepot trade is when goods/services are imported into a country to be stored before being re-exported to another country.

International trade is widely seen as positive for the global economy, although it is argued that smaller countries can be disadvantaged due to specialisation.

Free trade leads to specialisation, where countries with a comparative advantage of producing certain goods domestically will become major exporters of those goods, while other countries will focus on goods that they have a comparative advantage in producing.

To protect industries potentially threatened by global trade, a government can choose to implement protectionist policies, such as tariffs or trade barriers. These will make it more difficult for foreign imports to compete with domestically produced goods.

Due to specialisation, free trade can lead to FDI. If a multinational enterprise needs goods that are cheaper to produce in a foreign market it is advantageous for it to establish operations in that market to benefit from its comparative advantage. Governments may seek to encourage this type of FDI if it brings jobs, skills and investment into their country.

Not always in the same direction

Trade and FDI contribute to a country’s gross domestic product (GDP) in different ways that are often linked.

Trends in FDI and international trade are not always correlated, however, particularly when viewed from a global perspective. Data from the World Trade Organisation (WTO) shows growth in trade slowing in 2019, while data from the UN Conference on Trade and Development (UNCTAD) shows FDI flows bouncing back to growth in the same year.

Trade data is typically split between trade merchandise and trade in service. According to the WTO, global merchandise trade declined 3% in 2019 while trade in commercial services rose 2.1%. They rose by 10.2% and 8.4%, respectively, the previous year.

UNCTAD data shows global FDI flows rising 3% in 2019, following steep declines in 2017 and 2018. This modest increase still put total global FDI inflows below the average for the previous ten years but showed a very different trend to that of global trade.

These headline figures do not reveal the relationship between international trade and FDI in any detail, however, as trends can differ greatly between countries and specific sectors. Any impact on trade caused by increased/decreased FDI is also likely to suffer a lag. Increased inward FDI into Singapore’s biotechnology sector may eventually boost the country’s biotech exports, for example, but it will take time before investment translates into higher production volumes or greater penetration of foreign markets.

FDI and trade correlations

Many studies have shown how FDI and trade can be complementary to each other and it is widely held that inward FDI has a net positive impact on a country’s exports. This is due to the transfer of technology and new products for export, facilitating access to international markets, increasing domestic capital, and providing training to the local workforce. FDI can facilitate the transfer of intangible assets such as skills and technological knowledge that trade cannot.

An OECD study from 1999 found that until the mid-1980s international trade helped to stimulate greater direct investment. After this period the relationship appears to have reversed, with direct investment then helping to stimulate growth in exports from originating countries. The OECD study analysed trade and FDI in 14 countries and found that for every dollar of outward FDI, two dollars of additional exports were produced.

However, inward FDI could potentially have a negative impact on a country’s exports if the technologies transferred are low level, if it inhibits the growth of domestic companies that are potential exporters, or if the investment only targets the domestic market. Most analysis shows the two have a positive correlation, however.

In the US, for example, analysis by Investment Monitor shows a positive relationship between exports and inward FDI stock.

Investment Monitor chief economist Glenn Barklie says: “We can see from the chart that, in general, FDI stock in the US has increased, as has its volumes of exports. The recession in 2008/09 shows that FDI stock was quicker to react, declining in 2008, whereas exports continued to climb, only to fall in 2009. Although there are other contributing factors, we can deduce there is a positive correlation between FDI and trade in this case.”

The US is by far the largest recipient country of FDI globally, but this trend has also been observed in countries that attract comparatively lower volumes of inbound FDI and whose outward FDI flows are greater than their inward flows.

A working paper published by Peterson Institute for International Economics (PIIE) in 1998 argued that data on South Korea and Taiwan showed little relation between outward direct investment and imports in those countries, though inward direct investment did appear to be complementary to exports.

Inward FDI could potentially crowd out domestic investment, particularly if the foreign investor has comparative advantages in products and access to financial markets. On the other hand, it often leads to technological transfers and increased competition that are beneficial to the host country.

Some weaker domestic companies may not survive the entrance of a foreign competitor, but any monopolistic positions will be challenged and a more competitive market should lead to better end products and often a better trained workforce. It can also lead to herd behaviour with other multinationals entering the market to increase competition further.

The PIIE working paper also noted that any fears that outward direct investment from these countries would lead to a “hollowing out” or “deindustrialisation” in either Taiwan or South Korea during the period of analysis proved misplaced.

Barriers and incentives

The US economy is comparatively less reliant on imports and exports than most other countries, as reflected in World Bank’s Trade Openness Index, which measures the sum of imports and exports as a percentage of GDP. The US recorded a trade openness score of just 27% for 2018 and its highest score since 2005 was 31% in 2011.

In comparison, Ireland recorded a score of 211% in 2018, reflecting a heavy reliance on trade economically, and its score has been trending upwards since 2005.

In Ireland, increasing trade volumes have coincided with increasing FDI stock over that period.

Barklie says: “When comparing the trade openness of Ireland to its volume of FDI stock there is a general positive correlation – FDI stock is higher when trade openness is higher. The points on the chart are data plots of FDI stock (Y axis) and trade openness (X axis). The relationship between the two is statistically significant at the 5% confidence level, with an R-squared of 0.74 indicating a strong positive relationship.”

As a small economy with relatively modest domestic demand, the government of Ireland has long pursued a policy of encouraging inward FDI to support exports. Ireland has a low corporate tax rate, no general restrictions governing FDI and no limits to foreign ownership of domestic companies.

Countries can use these and other policy tools, such as improving domestic training and education or relaxing land rights, to encourage inward investment. Reversing these policies, conversely, can discourage investors from targeting a country.

Countries, cities and states around the world have also created investment promotion agencies that are responsible for attracting increased inward investment through dialogue with potential investors and policy suggestions.

The main policy tools for influencing trade flows are tariffs on products or other types of trade barrier. Non-tariff barriers include import quotas and embargoes on certain goods.

The countries that have the highest average trade tariffs, according to the World Bank, are small or island nations such as Palau, the Solomon Islands and Bermuda.

Tariffs are paid by consumers rather than the foreign exporters, so while they do not stop the importation of goods they make these goods less competitive with domestically produced goods. Tariffs and trade barriers can be used to protect domestic industries from foreign competition, protect consumers from certain products, and as a useful way of generating tax revenues for countries with low export levels.

Recent years have seen a reversal of the long-term trend of bilateral and multinational trade deals reducing tariffs and trade barriers around the world. A simmering trade war between the US and China has led to a series of retaliatory trade tariffs on a range of goods, and protectionist policies are increasingly common in other countries too.

Restrictions on FDI have been increasing in recent years, with various countries strengthening their screening processes, particularly in sectors seen as related to national security.

The impacts of this rise in protectionism are likely to reveal further ways trade and FDI are related and how they influence each other.