Investment Monitor | 12 February 2021
What do trade deals mean for FDI?
By Ben van der Merwe
Attracting foreign investment is often a core objective of countries pursuing trade deals – but whether trade deals actually promote investment, and what variety, is a complex question without clear answers.
The most obvious way in which a trade agreement might be expected to boost foreign direct investment (FDI) flows is through an investment chapter, a set of provisions intended to raise the profile and attractiveness of the country for investors.
Since the 1990s, trade deals have frequently included binding consent to international arbitration in the case of investor-state disputes – a system known as investor-state dispute settlement, or ISDS. Under ISDS, investors can sue states for compensation over breaches of their rights, as enshrined in the treaty’s investment chapter.
These rights are often broadly worded, providing a powerful form of insurance against political risk as well as an incentive for states to avoid policies that harm the interests of foreign investors. In theory, this might be expected to increase FDI that would otherwise be deterred by the threat of expropriation, changes in regulation or other political risks.
ISDS has limited impact upon foreign investment
In practice, however, ISDS seems to have little effect on FDI flows. Alhough there have been many successful claims against states under the system, with awards averaging about $500m, the legal and reputational costs of launching a case are too great for all but the largest investors.
This may be why investment protection has received less attention in the most recent trade agreements. According to the World Trade Organisation (WTO), just 32% of trade agreements in the past five years contained investment protection provisions, down from 43% in the previous five-year period, and 55% in the five years before that.
However, this could also be a sign of the saturation of the international system with ISDS commitments and other forms of investment protection. These provisions largely reside not in trade deals but in a network of thousands of bilateral investment treaties. Despite growing international pressure to reform or abolish ISDS, few countries have significantly rolled back their commitments to the system.
As well as investment protection, many trade agreements have also included measures aimed at investment liberalisation – that is, opening up domestic markets to foreign investors. The financial sector in particular has been a key proponent and beneficiary of investment liberalisation through investment treaties.
In the North American Free Trade Agreement, or Nafta, for instance, US banks played a key role in lobbying for the inclusion of provisions liberalising their entry into Mexican retail finance, while US utility companies pushed to open up access to Mexican government contracts. When the agreement came into force, US retail and specialist banks took quick advantage of their superior competitive position to Mexico’s own recently privatised and under-capitalised banks.
Europe’s own trade deal with Mexico was similarly pushed by its own financial sector, and largely in response to Nafta. Spanish banks in particular were keen to gain access to Mexican financial markets on equal terms to their US and Canadian competitors. Some of these banks also had a direct interest in broader investment liberalisation, whether due to direct holdings in non-financial companies looking to invest in Mexico or a desire to profit by financing such investments.
Today, Mexico hosts 158 foreign subsidiaries of western European financial corporations, of which 81 are Spanish, making Mexico the continent’s largest destination for financial FDI outside the US and Brazil.
However, investment liberalisation provisions have also become less prevalent in recent trade agreements. For example, according to data from the World Bank, the proportion of international investment agreements (excluding bilateral investment treaties) containing public policy exceptions fell from 72% to 49% over the three five-year periods up to 2020.
Tariffs are of vital importance to investors
Trade deals allow countries to apply to one another a preferential lower tariff below the base-level tariff applied by default to all trading partners. This base-level tariff, known as the ‘most favoured nation’ (MFN) tariff, is subject to negotiation not through trade deals but through the WTO.
One of the main reasons companies choose to invest abroad is to move part of their production process to an area with lower costs, better infrastructure, laxer regulations or greater access to technology. Lowering tariffs reduces the additional costs associated with producing across borders, incentivising this kind of FDI (known as vertical FDI, efficiency-seeking FDI or offshoring).
The rapid growth of cross-border production chains during the 1990s is evident in the rising volume of trade in intermediate goods – that is, goods destined not for consumers but for further production. The rise of cross-border production was enabled by an equally rapid fall in the average tariff applied to such goods, allowing them to flow back and forth across borders at much lower cost.
For this reason, companies engaged in vertical FDI have often been the chief advocates of trade liberalisation. In the case of Nafta, for instance, US auto manufacturers played a major role in lobbying for the agreement.
Trade deals did little to reduce tariffs on intermediate goods
However, Investment Monitor’s analysis shows that trade deals appear to have played little role in reducing tariffs on intermediate goods. The reduction in the average tariff applied to intermediate goods, from 5% in 1994 to just 1% in 2019, is closely correlated with the decline in MFN tariffs through the WTO.
The gap between MFN tariffs and applied tariffs, largely attributable to the preferential tariffs obtained in trade deals, barely shifted over the entire period.
WTO negotiations broke down in 2007, potentially explaining why tariffs have hardly fallen since then. The value of trade in intermediate goods, relative to world GDP, also began to stagnate at around this time.
Whether through the WTO or through trade deals, tariff liberalisation is generally expected to boost vertical FDI between signatories. Other aspects of trade deals, however, could diminish it – in theory, at least.
When companies decide to move part of their production process abroad, they are faced with what is known as a ‘make-or-buy’ decision – that is, whether to make the component abroad themselves through vertical FDI or to buy it from a foreign company, a process known as outsourcing. The liberalisation of tariffs on intermediate goods reduces the costs of both vertical FDI and outsourcing, but other aspects of trade deals could increase the relative advantage of outsourcing over vertical FDI.
Among the reasons why companies may choose vertical FDI over outsourcing are concerns about quality control or contractual incompleteness. Trade deals that address these concerns, such as through improved monitoring and enforcement of contracts and regulatory standards, could answer these concerns, raising the relative attractiveness of outsourcing as an alternative to vertical FDI.
“[However,] trade agreements are only one among many factors that influence both outsourcing and vertical FDI,” says Christine Zhenwei Qiang, global manager for investment climate at the World Bank.
“Depending on the global value chain archetype, the importance of having control over the production process may matter less or more.
“In labour-intensive global value chains, such as textiles or footwear, companies are more likely to outsource to save costs. On the other hand, if you are looking at knowledge-intensive global value chains, such as R&D and IT, then companies are more likely to engage in FDI to prevent data and technology leakages.
“These are simplified examples, but they really show that the decision between outsourcing and FDI depends on so many factors. It goes way beyond the tariff policy.”
Not all FDI benefits from tariff liberalisation
The effect of tariff liberalisation on market-seeking FDI is more ambiguous still.
Market-seeking FDI, also known as horizontal FDI, is where a company chooses to invest abroad not in order to reduce production costs, but in order to reach a foreign market shielded by barriers such as tariffs. For instance, US auto manufacturers can get around the EU’s 10% tariff on imported cars by establishing factories within the bloc’s borders.
By cutting tariffs, trade deals are likely to reduce the incentives for companies from the other signatory state to engage in this kind of ‘tariff-jumping’ or ‘market-seeking’ FDI.
“There are scenarios where liberalising trade policy may reduce horizontal FDI flows, while trade restrictions can raise short-term FDI inflows,” says Qiang of the World Bank.
“One recent example is actually from Brexit, where the British government is currently suggesting to its companies to set up affiliates in the EU. So, that is outward FDI from the UK. The purpose of such advice is to avoid new border restrictions and administrative rules, so this is an example where restrictions may artificially inflate FDI to avoid new regulations.
“For us, it is important to note that […] the FDI that arises from specific regulatory distortions, whether it be tariffs or tax havens, tends to be narrow with limited benefits for a country’s productivity or employment or development as a whole.”
The attraction of horizontal FDI
However, while horizontal FDI between parties to the trade agreement can be expected to suffer, horizontal FDI from outside parties may increase. Larger markets are much more attractive destinations for market-seeking FDI, and so trade deals that effectively conglomerate two markets into one may raise the attractiveness of both to third-party investors.
Trade deals therefore open up greater possibilities for export-platform FDI, which is where an investor enters a host economy to sell products not on the host’s market, but on a market connected to the host via a trade agreement.
For instance, one consequence of the EU’s internal elimination of tariffs is that US auto manufacturers looking to enter the high-wage Dutch market can save money on wages by building their car plants in low-wage Bulgaria, and then exporting tariff-free to the Netherlands.
Trade deals are particularly likely to boost export-platform FDI to countries signing trade deals with economies much larger than themselves.
Between 2003 and 2004, for instance, companies operating in Slovakia went from having tariff-free access to a $46bn economy to having tariff-free access to an $11.4trn economy, thanks to the country’s accession to the EU.
Over the same period, Slovakia recorded a much stronger increase in FDI from countries outside the bloc than from those within it, suggesting that much of the growth in inward investment came from export-platform FDI.
Several academic studies have similarly found that the increases in FDI flows experienced by countries after signing a trade deal have not been from their new co-signatories, but from outside countries.
For instance, Korean researcher Hyejoon Im found that the increase in FDI resulting from trade deals with the US came mainly from beyond the US. Similarly, the increase in inward FDI that followed the creation of the South American trade bloc Mercosur was found to have mostly come from outside the group.
Hamstrung by empirical issues
However, attempts to test on a broader scale whether the behaviour of investors conforms to economists’ theories have frequently been beset by empirical and theoretical difficulties.
Prominent among these difficulties is the lack of a distinction between horizontal and vertical FDI in official statistics. Some studies have attempted to get around this problem by using other data to estimate the extent to which a country’s FDI is vertical or horizontal.
For instance, Im attempted to distinguish vertically and horizontally oriented foreign subsidiaries of US companies using sales data. Subsidiaries that sold mainly back to the US were classed as vertical investments, while those mainly sold on the host state’s market were classed as horizontal investments. Im found that, as expected, trade agreements diminished horizontal FDI but were a boon to vertical and export-platform FDI.
Im’s measures, however, are far from perfect. Whether a product is sold at home or abroad is a poor proxy for whether it is sold for consumption or further production, and increasingly so in a world of evermore complex global production chains.
Not only is large-scale quantitative data separating vertical and horizontal FDI unavailable, but firm motivations are often difficult to categorise, even through surveys or interviews.
“The reality is that almost all multinational companies actually have multiple motivations,” says Qiang. “Even in relatively small markets – you would think it is largely efficiency-seeking or resource-seeking, but often it is multiple things.
“Therefore, we find it very difficult to use the framework of vertical versus horizontal. We find the framework very useful to conceptualise FDI motivations, but when it comes to actual data-based research it is less helpful because the data doesn’t really separate different motivations. So, we moved from that framework to more sector-based or company-based analysis – using the actual investment in different sectors, transactions between companies, and looking at the patterns.”
Is there a reciprocal relationship between FDI and trade deals?
Another major empirical obstacle is that while trade deals may promote FDI, FDI may in turn promote trade deals. Countries that anticipate rising volumes of cross-border investment may be more likely than others to sign trade agreements. The growth in bilateral FDI that follows such an agreement could easily be mistaken for an effect of the agreement itself, rather than its cause.
For instance, although US FDI in Mexico rose sharply following the ratification of Nafta, this may have been just the continuation of a longer-running trend.
In 2016, a team of US researchers studying the outbound FDI of 20 OECD states attempted to account for this possibility. The researchers found that when they did so, the apparent positive effect of trade deals on outward FDI flows disappeared.
A related problem is the possibility that countries tend to sign trade deals while undertaking other investment-promoting measures at home, and that the effects of the two are confused.
For instance, Slovakia’s accession to the EU was preceded by a decade of pro-corporate tax cuts and deregulatory measures. One influential study similarly found that the apparent effects of Mexico’s ratification of Nafta were really due to domestic reforms it had been undertaking since the 1980s.
In addition to these trade-specific issues, there are the broader problems associated with FDI data that make it challenging to draw firm conclusions about its causes and effects.
At the most basic level, there is often a discrepancy between the FDI stocks reported by host and home states – a discrepancy that can reach enormous levels. For instance, while UK data recorded an outward FDI stock in the Netherlands of $189bn in 2018, the Netherlands valued this stock at $545bn – almost three times as much.
These discrepancies result from a mixture of differences in accounting practices, the use of opaque holding companies and tax-avoiding cash flows mistakenly classified as FDI.
Regardless of their cause, these fundamental issues with FDI data only add to the theoretical difficulties associated with making categorical claims about the impact of trade deals on investor behaviour.