16.4 International trade and FDI

Recent theoretical and empirical work has focused on the interdependence of foreign investment and trade (Markusen, 1997). FDI and trade can be viewed as competing or as complementary modes of serving a particular market, depending on the strategy of the parent firm. Strategy is directly related to the reason for the investment: market-seeking investments tend to compete more with exports as a servicing mode whereas natural-resource-seeking investments tend to generate intrafirm trade flows.

The impact of economic integration on FDI inflows depends to a great extent on subsidiary import and export patterns and on the relative importance of intrafirm trade. Most commentators expect economic integration to accelerate international trade between the member countries . In industries where trade and FDI are already substitutes the relationship is unlikely to change substantially, although integration may favour trade as a mode of serving foreign markets because the transaction costs may be lowered by integration. Hence it is possible that local production in FDI plants will be discontinued if the removal of trade barriers results in imported products being cheaper than the locally produced ones.

In contrast, where trade and FDI are non-substituting modes of serving a particular market, as is typically the case with services, or where FDI supports trade (for instance local sales offices, distribution networks and marketing operations), integration is likely to increase both FDI and trade. Integration beyond a free trade agreement can pave the way for FDI in services because most services are difficult to sell when customers are located at a distance or across borders. At the same time service FDI may pave the way for intrafirm trade in goods and services.

Finally, if trade and FDI are complementary, in that they sustain each other or tend to reinforce each other integration is likely to promote FDI. This will apply especially to industries that are already vertically integrated across borders. In such industries, regional specialization may accelerate, as different stages of the production chain will be located at different sites according to specific resource endowments. FDI could be used to enhance this specialization, and would increase both imports and exports as goods are moved between locations. But horizontally integrated subsidiaries may also support a complementary pattern of intrafirm investment and trade based on product mandates and task divisions.

The literature discusses a further effect of integration called ˜ investment diversion , which is analogous to trade diversion. Investment diversion results when a favourable investment location in a third country is rejected due to the ˜artificial advantages of locating production or trading with a partner inside the integrated area (Baldwin et al. , 1996). Due to the large cost advantages of East European locations, it is possible that their accession to the EU will divert some FDI from other lowcost locations, for instance the CIS and North Africa.

Overall, from a theoretical viewpoint it can be concluded that integration will increase the flow of FDI to the newly integrated area and support a complementary relationship between trade and FDI. However the divestment of FDI projects could occur in industries where FDI and trade are alternative modes of serving a market.