The indirect effects of foreign direct investment on trade: A network perspective

• Author: Zhen Zhu,Massimo Riccaboni,Paolo Sgrignoli,Rodolfo Metulini
• DOI: http://doi.org/10.1111/twec.12504
• Published date: 01 October 2017
• Date: 01 October 2017

ORIGINAL ARTICLE

The indirect effects of foreign direct investment on

trade: A network perspective

Rodolfo Metulini

1

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Massimo Riccaboni

2,3

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Paolo Sgrignoli

3

|

Zhen Zhu

3*

1

Universit

a degli Studi di Brescia, Brescia, Italy

2

Department of Managerial Economics, Strategy and Innovation, KU Leuven, Leuven, Belgium

3

IMT School for Advanced Studies, Lucca, Italy

1

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INTRODUCTION

The relationship between international trade and foreign direct investment (FDI), which is one of

the main features of globalisation, is complex and it is not limited to the issue of whether they are

complementary

1

or not (Fontagn

e, 1999).

Previous studies on the effects of FDI on trade are by and large confined to a two-country set-

ting, where bilateral trade is solely determined by the characteristics of the two countries considered.

However, the empirical tests based on the two-country setting have concluded with mixed results.

For example, relying on a cross-sectional firm survey data set from the 1970s in the United States,

Lipsey and Weiss (1984) find that a US firm’s outward FDI to a foreign area is positively associ-

ated with its exports to that foreign area. Based on a panel of China’s bilateral data with 19 foreign

areas during 1984–1998, Liu, Wang, and Wei (2001) also show that the inward FDI from a foreign

area to China induces China’s exports to that foreign area. Conversely, Belderbos and Sleuwaegen

(1998) find a negative relationship between Japanese electronics firms’exports to Europe and their

investment in Europe in the late 1980s, when Europe adopted a strict antidumping policy. They also

find that more trade is created if the investment is related to global value chains (GVCs). Moreo ver,

Blonigen (2001) finds a mixed relationship between affiliate production and exports of Japanese

automobile products in the United States from the late 1970s to the early 1990s. Finally, Amiti and

Wakelin (2003) run a gravity model for every year in a panel of bilateral data between 36 countries

during 1986–1994 and find that FDI has a positive (or negative) effect on trade when countries are

different (or similar) in terms of factor endowments and when trade costs are low (or high).

Our paper investigates the effects of FDI on trade beyond the two-country setting. Before

examining its effects on bilateral trade, we quantify FDI from a network perspective and consider

*Authors are listed in alphabetical order

1

The reasoning behind is that the bilateral trade will be decreased if the bilateral FDI is horizontal or will be increased if the

bilateral FDI is vertical (Markusen, 1997, 2004; Markusen & Maskus, 2003).

DOI: 10.1111/twec.12504

World Econ. 2017;40:2193–2225. wileyonlinelibrary.com/journal/twec ©2017 John Wiley & Sons Ltd

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both the direct and indirect channels of FDI. The indirect channels of FDI can be explained by

firms’cost-minimisation strategies. Figure 1 shows an imaginary three-country example where

country aintends to conduct outward FDI to country c. The costs of doing so directly is sdir

a;cand

indirectly via country bis sindir

a;c, which is a combination of sdir

a;band sdir

b;c.

2

Note that it is possible

that sindir

a;c\sdir

a;cand country aprefers indirect FDI if this is the case. Below, we highlight some

concrete examples of costs that firms may take into consideration when undertaking indirect FDI.

First, firms may prefer indirect FDI so as to reduce their tax burden. Due to the varying availabil-

ity of tax and investment treaties across countries, a parent company may locate an affiliate in an

intermediate country to control another affiliate in the final destination country so as to receive the

most favourable tax and investment treatment in the host countries by profit shifting (B

enassy-Qu

er

e,

Fontagn

e, & Lahr

eche-R

evil, 2005; Gumpert et al., 2016; Hines & Rice, 1994; Van’t Riet et al.,

2014). For example, as a well-connected country in terms of tax and investment treaties, the Nether-

lands is the world’s largest pass-through country for approximately 1,600 billion euro of FDI in 2009

(Weyzig, 2013). Mintz and Weichenrieder (2010) also find that in 2012 about 15% of outbound Ger-

man FDI affiliates are held via an intermediate firm in a third country, with the Netherlands as the

most important location of the so-called conduit entities. Other famous examples include the FDI

“round-tripping”through Hong Kong to China and through Mauritius to India (Wei, 2005).

Second, another driver of indirect FDI is to reduce coordination costs. That is, a parent com-

pany may locate an affiliate in an intermediate foreign country if it is geographically, politically or

culturally closer to the final destination country so as to achieve more effective coordination (Kalo-

tay, 2012). For example, Russia indirectly invests in Central and Eastern European countries

through Cyprus, taking advantage of the latter’s accession in the European Union (Pelto, Vaht ra,

& Liuhto, 2004). Note that this driver may, to some extent, overlap with the above driver of tax

and investment treaties. The fact that Hong Kong and Mauritius serve as the gateways of inward

FDI to China and India, respectively, is also due to the geographical and cultural closeness.

Third, indirect FDI can be a dynamic process and can be considered as a growth strategy to

break barriers to market entry. In practice, facing high start-up costs if directly holding an affiliate

in the final destination country, multinational companies often divide a target region into several

clusters of countries and pursue a regional management structure, where regional management cen-

tres are established first with strategic and operational roles in each cluster (Amann, Jaussaud, &

Schaaper, 2014). Moreover, FDI can be a consequence of experience accumulated and can be con-

ceived as a sequential process when crossing multiple country borders (Kogut, 1983).

τ

dir

a,c

τ

dir

b,c

τ

dir

a,b

τ

indir

a,c

b

a

c

FIGURE 1 Direct and indirect costs

2

For simplicity, we only consider a single intermediate country b. But in principle, the number of intermediate countries can

be greater than 1.

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Our paper highlights the importance of indirect effects, and it is therefore related to the recent

literature of FDI and trade investigating the third-country effects (Baltagi, Egger, & Pfaffermayr,

2007; Blonigen, Davies, Waddell, & Naughton, 2007; Garretsen & Peeters, 2009). Besides the

simple dichotomy of horizontal and vertical FDI, the mixed nature of FDI has been noted in the

literature and new terms such as “complex FDI”and “networked FDI”have been created to

account for more structured forms of FDI such as export platforms and production networks (Bald-

win & Okubo, 2014; Ekholm, Forslid, & Markusen, 2007; Yeaple, 2003). However, our paper dif-

fers from these studies in at least two aspects. First, while they study the determinants of FDI, we

are interested in the consequences of FDI on trade.

3

Second, to capture the third-country effects,

they use spatial econometrics whereas we use the tools of network analysis.

4

To take into account both the direct and indirect channels of FDI, we use a unique data set of

international corporate control (as a measure of stock FDI) covering almost all countries over the

world, while previous results are often based on a small sample of countries or case studies due to

the paucity of FDI data.

Furthermore, we construct a corporate control network where the nodes are the countries and

the edges (both directed and weighted) are the corporate control relationships. Based on the corpo-

rate control network, the shortest path length (which can be either direct or indirect) and the com-

municability (which is an overall measure of “communication”between nodes) between each pair

of countries are computed. The shortest path length (or the communicability) complements (or sub-

stitutes) the direct corporate control intensity, and together, they provide a more complete account-

ing of the effects of FDI on trade.

Then, we find, using the Heckman two-stage (H2S) gravity model, a positive effect of FDI on

trade both for the direct corporate control intensity and the indirect measures, that is, the shortest

path length and the communicability. Therefore, our paper provides strong empirical evidence of

the importance of indirect effects of FDI on trade. We also identify a number of interplaying fac-

tors, including regional trade agreements (RTAs) and the region of Asia. We also find that, com-

pared with primary sectors such as oil extraction and agriculture, manufacturing sectors have more

pronounced indirect effects of FDI on trade.

The remainder of this paper is structured as follows: Section 2 introduces FDI and trade net-

works and describes the network measures of indirect effects; Section 3 describes our data set and

provides some exploratory analysis; Section 4 specifies our econometric methodology, Section 5

presents our main results, while some robustness checks are discussed in Section 6. Finally, Sec-

tion 7 concludes the paper.

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NETWORKS OF FDI AND TRADE

2.1

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Global systems as networks

There is a significant body of literature developed recently in studying economic phenomena from a

network perspective. For example, economic systems such as international trade (De Benedictis &

3

Even more recently, Park & Park (2015) study the effects of FDI on trade by considering the third-country effects. They

use spatial econometrics and focus on the inward FDI to China, whereas we use network analysis and a cross-country data

set.

4

In fact, we perform a spatial econometrics exercise with our data set and find a significant third-country effect, which moti-

vates us to study the indirect effects of FDI on trade from a network perspective. The spatial econometrics result is available

upon request.

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