Trade protection backfires on FDI

Holger Görg, Christiane Krieger-Boden 09 June 2011

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International commerce worldwide was hit hard by the global crisis. Thus, both trade flows and foreign direct investment (FDI) flows underwent a substantial decline in 2009. Trade flows decreased from $33 trillion in 2008 by more than one-fifth to $25 trillion in 2009 (Figure 1). Also, worldwide FDI, after having climbed to an all-time high of $2.1 trillion in 2007, dropped substantially to $1.8 trillion in 2008 and further to $1.1 trillion in 2009. FDI flows gave in even earlier than trade volumes and decreased even stronger to almost half of the 2007 amount.

Figure 1. 

Source: WTO, Trade statistics; UNCTAD, World Investment Report.

During the crisis, many governments implemented new trade protection measures, as documented by the Global Trade Alert initiative (see Evenett 2011), particularly in 2009 (Figure 2). In 2010 and 2011, when the world economy regained strength, the number of newly implemented measures has decreased, and this is particularly true for discriminatory measures, while liberalising anti-discriminatory measures have increased.

Figure 2. 

Source: Global Trade Alert, Statistics; GTA Reports 1-8 – Own calculations.

The Global Trade Alert website reports that as of 18 May 2011, there had been 1,610 trade protection measures announced and implemented since November 2008. About 40% of countries have implemented some sort of protectionist measure captured in the GTA database. The majority of actions taken by these countries were trade protection measures in a narrow sense (Table 1). Less than 7% of all measures were more directly related to FDI by targeting investment (including local content requirements) and intellectual property rights.

Table 1. Share of measures by type

 

Type of measure

Percentage

 

 

investment

5.36

 

 

intellectual property rights

1.42

 

 

trade finance

0.87

 

 

trade protection

70.00

 

 

other

22.35

 

 

total

100.00

 

Source: Global Trade Alert

Mostly, it was the large and highly-developed countries that resorted to protectionist measures. Some summary statistics reveal that the average country that implemented measures (protectionist country) had a more than 30 times higher GDP than the average country that did not (see non-protectionist country, Table 2; for an overview on both types of countries see appendix Figure A1).

Table 2. Summary statistics for protectionist and non-protectionist countries

 

Average protectionist
country

Average non-protectionist country

GDP 2006

410,630.6

$ millions

12,537.4

$ millions

GDP 2009

449,779.3

$ millions

13,919.8

$ millions

Average annual GDP growth,
2006 – 2009

3.1

%

3.5

%

FDI inflows 2006

12,494.3

$ millions

1,149.2

$ millions

FDI inflows 2009

9,104.1

$ millions

1,229.1

$ millions

Percentage change inflows

-27.1

%

7.0

%

FDI outflows 2006

13,560.6

$ millions

1,722.5

$ millions

FDI outflows 2009

9,858.9

$ millions

2,033.1

$ millions

Percentage change outflows

-27.3

%

18.0

%

FDI openness 2006a

3.2

%

11.5

%

FDI openness 2009 a

2.1

%

11.7

%

 

Source: Own calculations based on data from GTA, WDI and UNCTAD. a Average of FDI inflows and outflows over  GDP.

In fact, the G20 countries were responsible for the lion’s share of protectionist measures (Evenett 2011). For instance, the US government followed an explicit “Buy American” policy, by expanding respective provisions for public projects in December 2009, or by imposing a new tax of 2% on foreign procurement of goods and services in December 2010 (whereas in June 2010 Buy-American standards had already been relaxed in the case of defence procurement).

Also, the US government in 2009 started a whole series of antidumping investigations against specific products imported from countries like China, Mexico, and India. Similarly, the EU in late 2009 / early 2010 started a series of antidumping investigations, imposing duties on several specific products imported from India, China, and Brazil. Moreover, the German government, among other things, amended an innovation aid scheme protecting its shipbuilding industry against foreign competitors.

Both the German and the French government also enrolled a car scrappage scheme in 2009 and 2008, respectively, which surprisingly did not discriminate against buying cars from foreign producers, however. Otherwise, the French government, too, introduced a large number of protectionist measures such as, only recently (February to April 2011), a temporary subsidy for interest rates, a temporary regime for state guarantees, a state guarantee for export credit insurance, a scheme for refinancing financial institutions, and a scheme for short-term export credits.

Besides these and other G20 countries, a number of intermediate emerging markets (such as Venezuela, Vietnam or Nigeria) are listed as being among the worst offenders. By contrast, the non-protectionist countries include one group of extremely small though highly developed countries (like Hong Kong and Liechtenstein) and another large group of rather backward countries.

As to FDI, the average protectionist country had much higher inflows and outflows of FDI than the average non-protectionist country. Still, former countries were considerably less open to FDI flows than the latter. Indeed, this was already the case before the global crisis and became even more so thereafter. During the crisis, the protectionist countries experienced severe declines of both FDI inflows and outflows while the average country that abstained from protection still realised substantial FDI growth rates.

Hence, at a first glance, there seems to be a negative association between the implementation of trade protection measures and changes in FDI. Of course, these relationships may be confounded by the influence of other bilateral characteristics. Much of the downturn in FDI activity can arguably be explained by adverse changes in economic fundamentals that determine cross-border investment activity. There have been sharp falls in consumer demand in various countries and GDP growth rates have dropped. Also, economic uncertainty in the face of the crisis is likely to have dampened international FDI activity.

Theoretical evidence, however, supports the idea of an association between trade protection and FDI, albeit with ambiguity as to the direction of the effect. One argument holds that trade protection may increase FDI, in particular horizontal FDI. Multinational firms may aim to enter markets that are protected by high trade barriers by setting up affiliates in the protectionist country, thus increasing FDI flows. By contrast, another argument holds that trade protection may in fact deter FDI, in particular vertical FDI. For one, multinational firms might find it less attractive to offshore affiliates that are part of the value chain if the import and export of intermediate and final goods is inhibited by trade protection measures.1 Furthermore, trade protection may discourage the takeover of domestic companies by foreign acquirers (Norbäck and Persson, 2004). More generally, trade protection may evoke distrust in possible foreign investors regarding future trade openness or other economic or institutional characteristics of a certain protectionist country.

Empirical evidence, too, substantiates the relationship between trade protection and FDI and confirms that it is negative. In recent research (Görg and Labonte 2011), we look at the short-run effects of these protectionist measures on bilateral FDI flows. The research uses data from the Global Trade Alert, combined with bilateral FDI data between OECD countries and a large number of partner countries for 2006 to 2009. The empirical approach taken is to estimate a gravity model of bilateral FDI flows taking into account the size and wealth of countries involved and the potential barriers to FDI between them such as distance and the actual protection measures. By distinguishing between countries that did or did not implement protectionist measures since 2008 (via a dummy variable), and by controlling further for various country-pair and time fixed effects, the non-protectionist countries are taken akin to a control group for the protectionist countries. This analysis allows us to identify the effect of protection measures on FDI flows in a difference-in-differences set-up.

The verdict is clear. A country that implements new protectionist measures should expect lower FDI inflows into its own economy. The point estimates from various empirical models suggest that the implementation of a trade protection measure is associated with about 40% to 80% lower FDI inflows. By contrast, trade protection does not appear to have any implications for the country’s FDI outflows. The negative effect on FDI inflows does not appear to be due to direct investment measures but rather to actions related to intellectual property rights protection or to more trade-related measures.

Conclusions

Measures implemented by governments to protect their own economies may backfire by deterring the highly desired influx of capital via FDI while they hardly do any harm to FDI outflows.

The reasons behind this may be that protectionist measures impede necessary trade flows along the value chain within multinational firms, and, more generally, that they may give potential investors a feeling of uncertainty and discomfort about future prospects of the protectionist country.

Several “offending” countries belong among the less and least developed countries; by protectionism they may try to follow an export-stimulating and import-substituting strategy. However, the harm done to their own economy may be particularly severe as it is well established that FDI into such economies may have particularly strong beneficial effects on economic growth, firm productivity, wages, and employment.

References

Evenett, SJ (2011), Tensions contained – for now: The 8th GTA Report, Global Trade Alert and CEPR.

Görg, H and P Labonte (2011), “Trade protection during the crisis: Does it deter foreign direct investment?”,Kiel Working Paper 1687, March.

Markusen, JR (2002), Multinational firms and the theory of international trade, MIT Press.

Norbäck, PJ and L Persson (2004), “Privatization and foreign competition”, Journal of International Economics, 62:409-416

UNCTAD (2010), World Investment Report 2010: Investing in a Low Carbon Economy, United Nations, New York.

 

Figure A1. Implementation of measures by country and severity categories


1 For example, the knowledge capital model (Markusen 2002) implies both of these possibilities for positive and negative relationships between trade costs and FDI when considering horizontal or vertical FDI, respectively.  

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Topics:  International trade

Tags:  foreign direct investment, protectionism