FDI inflows and trade imbalances: evidence from developing Asia.

• Author: Tran, Thi Anh-Dao
• Position: Report

1. Introduction

   For most developing and transition countries, the relationships between trade and Foreign Direct Investment (FDI) are at the heart of globalization. On the one hand, overall growth dynamics in the developing regions have been stimulated by strong growth in their exports. On the other hand, the new international financial landscape has been characterized by an unprecedented growth in private financial flows to the detriment of official development assistance. Since 1993, FDI has become the most important external financing source in the developing world, followed by portfolio investment and private loans (see Figure 1). In 2010, the share of FDI inflows reached 51% of total capital flows to developing countries, while their inward stock of FDI amounted to about one third of their Gross Domestic Product (4) (GDP) compared to just 10% in 1980 (UNCTAD, 2011a).

   Among the developing regions of the world, East Asia and Pacific (EAP) have clearly been the most successful in increasing exports (by volume) and in attracting FDI. The increased international mobility of both goods, services and intangible assets, together with the greater flexibility and divisibility of the production process, has made the entry of Multinational Corporations (MNCs) into manufacturing and services the key vehicle for Asia's successful integration into the global economy. Boosted largely by MNCs from the North (as well as by those from the South), the increasing fragmentation of production in the global economy has in turn led to increased exports of manufacturing parts, components and associated services (see Figure 2). The largest wave of production-sharing schemes is to be found in developing countries, particularly in the dynamic Asian economies (UNCTAD, 2011b).

   The rapidly growing Asian countries' successful experience with exports and FDI has reinforced the tendency of international organizations to prescribe policies in favor of trade liberalization and foreign capital attraction. This means that the overall pattern of export growth is dependent on participation in production fragmentation or the "global supply chains" that link developing countries to international markets (UNCTAD, 2011b). However, many observers argue that the dynamics of trade and financial integration have increased the vulnerability of national economies to the risks incurred by different cost, market and production connectivities. In contrast to the industrial economies in the Bretton Woods system, the developing and transition countries are much more open, with a greater trade component and more prevalent capital inflows. Open economies today react differently to relative price shocks, or demand and supply factors. In particular, the development of international production networks and related FDI flows has increased the import content of export production. While they enjoy the benefits of the processing trade regime, of policies designed to promote FDI and of special economic zones, most developing countries still face balance of payments problems in conjunction with their export-oriented growth (Soukiazis and Cerqueira, 2012). Financial crises in emerging market economies illustrate the risks stemming from the volatility of private international capital flows, especially speculative short-term flows. However, few studies have investigated how export-led growth with massive capital inflows may result in current account imbalances.

   In view of this, the present research paper aims to investigate whether trade imbalances are linked to FDI inflows. Participation in production fragmentation operated by MNCs has enabled developing countries to enter international markets. However, one consequence of this is that their current account balances are increasingly shaped by FDI and trade. FDI can disrupt macroeconomic stability through monetary counterparts and relative price movements; it can also directly affect the balance of payments through the investment balance, as a share of GDP produced in the host country is repatriated abroad in the form of profits and dividends. However, little attention has been paid to the indirect macroeconomic effects of FDI on the current account through the trade balance. The indirect effects might outweigh the direct negative effects of FDI on the current account and moderate them; but conversely, if it creates trade deficits, FDI might contribute to the further deterioration of the current account balance and thereby exacerbate the negative effects (Mencinger, 2008).

   The purpose of our study is twofold. Firstly, it aims to examine the effects of FDI on the trade balance via exports and imports. An appropriate theoretical model of trade balance is formulated by extending the conventional model. Secondly, while the few existing studies that have investigated this issue relied on time-series data for individual countries, we conduct our investigation using panel data analysis techniques for the developing and transition countries in Asia, one of the most dynamic areas in these regards. By offering evidence of the short-run relationship between trade balance and FDI, our study will contribute to a better understanding of the factors underlying a country's balance of payments position.

   The remainder of this paper will be organized as follows. Section 2 provides an overview of trade and FDI in the developing world. This provides a basis for formulating a theoretical model in Section 3. Section 4 presents the general options of our econometric approach before analyzing our empirical findings. Section 5 concludes and summarizes the results.

2. The relationship between trade and FDI in developing Asia

   Regional integration in East and Southeast Asia has been intensifying since the 1990s. The plan to establish an ASEAN Economic Community by 2015 marks a further step towards the transformation of the ASEAN Free Trade Agreement (AFTA) into a single market (Fujita et al., 2012). Meanwhile, subsequent bilateral FTAs between ASEAN and China, South Korea and Japan (that is, ASEAN+3) were launched in 2005, 2007 and 2008 respectively, followed by agreements with India, Australia and New Zealand (the ASEAN+6 grouping). By deepening the connectivity and interpenetration of economic activity, the idea is to develop production networks and supply chains that span the region in order to take the fullest advantage of economic complementarity. Accordingly, developing Asia has been the recipient of substantial net capital inflows since the early 1990s.

   Figure 3 shows average FDI inflows and external balances for the period 19912011 and compares the East Asia and Pacific region (EAP) to the other developing regions in the world. Unsurprisingly, FDI was the largest component of capital inflows in the region and was the largest also as a share of GDP relative to other emerging economies in the world. Taken as a whole, the low and middle-income countries attracted FDI amounting on average to 2.5% of GDP during the period considered, while their trade balances were in slight surplus (0.44% of GDP). The same ratios in the EAP area were 3.4% and 3.2% respectively. EAP, Europe and Central Asia are the only regions that simultaneously attracted FDI without encountering trade deficits. By splitting the two decades under consideration into two sub-periods (1991-2000, 2001-2011), our calculation suggests that two developing regions--Latin America and Caribbean and the Middle East and North Africa--improved their trade position over the two decades while continuing to attract FDI. This result is explained by the favorable boom in primary product prices, most of these countries being oil or mineral exporters. In contrast, the two remaining developing regions of South Asia and Sub-Saharan Africa attracted even greater amounts of FDI but this trend coincided with an increase in trade deficits during the second decade.

   As current account balances are increasingly shaped by FDI and trade, this is an important issue for researchers. However, the consequences of FDI inflows for external balances and macroeconomic stability have been largely ignored in the existing studies (Menon, 2009). While most studies have exhaustively analyzed the determinants of FDI as well as its consequences, mainly for production, employment and productivity, one interesting implication of the literature concerns the indirect effects of FDI. A natural consequence of capital attraction is the burden of investment income and repayment over time, leading to negative effects on the current account. Besides these direct effects, the inflow of foreign capital might have indirect macroeconomic consequences for the current account via trade conducted through production networks. Firstly, exports depend much more on imported inputs in the FDI sector than they do in the domestic sector. Any increase in FDI might increase imports more than exports, creating trade deficits rather than trade surpluses (Pacheco-Lopez, 2005). Secondly, large FDI inflows might also become a threat to exchange rate stability, with adverse consequences for exports. Ultimately, trade imbalances may increase current account deficits in export-oriented countries instead of moderating them.

   This leads us to make a distinction between the direct and indirect effects of FDI on the current account balance: direct effects determine the investment account balance, while indirect effects influence the current account balance by shaping the trade balance (Mencinger, 2008). While the former are straightforward (FDI worsens the current account balance due to investment account deficits), the latter are less evident.

   A second set of figures is used to examine the correlation between FDI and a number of macroeconomic variables (see Figure 4). All figures support the well-known export-investment nexus that explains East Asian success (Akyuz et al., 1998). In the specific case of the Asian latecomers, foreign investment is a...