The Relationship Between Trade Openness and FDI - Literature review Example

?The Relationship Between Trade Openness and Foreign Direct Investment (FDI) There is a vast body of literature to show the cause-and-effect relationship between trade openness of a country and the growth of income. The concept that increase of trade results in increase of incomes lays the basis of endogenous, classical and neoclassical theories of growth. This review of literature is directed at finding the measures leading to increased foreign direct investment (FDI) for a country. Although there is a whole range of factors that cause an increase in the foreign direct investment in a country, yet one of the most significant factors has been found to be the country’s openness towards trade. Openness as a concept, has been defined in a number of ways by the researchers in the past. A comprehensive definition of openness is presented below: (t)he concept of openness, applied to trade policy, could be synonymous with the idea of neutrality. Neutrality means that incentives are neutral between saving a unit of foreign exchange through import substitution and earning a unit of foreign exchange through exports. Clearly, a highly export oriented economy may not be neutral in this sense, particularly if it shifts incentives in favor of export production through instruments such as export subsidies. It is also possible for a regime to be neutral on average, and yet intervene in specific sectors. A good measure of trade policy would capture differences between neutral, inward oriented, and export-promoting regimes. (Harrison, 1996, p. 20). Trade openness has conventionally been scaled by different researchers in different ways, but in a vast majority of cases, trade openness has been measured by its contribution to the overall gross domestic product (GDP) of a country. Factors that have conventionally been employed for the measurement of trade openness include but are not limited to intensity of import trade, intensity of export trade, intensity of trade, intensity of adjusted trade, and the intensity of real trade (Squalli and Wilson, 2006, p. 22). Three models of adjusted trade intensity have conventionally been tried to measure the trade openness. One of them is adjusted trade intensity in which the outliers having high import for the re-rexport are handled with the modification of denominator. This measure was first proposed by Andersen (1994). The second of them is adjusted trade intensity accompanied with the alternative technique to tackle the outliers as initially proposed by Frankel (2000). The third of them is adjusted trade intensity. This is a modified form of the model originally proposed by Frankel (2000). The modification was suggested by Li et al (2004). The seven measures of openness were also cited by the famous economists Kumar and Kandzija (n.d., p. 13) in their article in which they analyzed the integration and trade theory to evaluate the perspectives of trade in Western Balkans. For the purpose of this research, intensity of trade, the three models of intensity of adjusted trade as discussed before, real trade intensity, real world trade intensity (RWTI) and composite trade intensity (CTI) will be used. They will be evaluated with a view to identifying the one that is the most accurate as a measure of openness. Of all the measures, three of the most commonly employed are trade intensity (TI), import trade intensity (M/GDP) and export trade intensity (X/GDP). Trade intensity is obtained by dividing the sum of import (X) and import (M) by the GDP. According to Alcala and Ciccone (2004), the estimate generated by TI upon income is affected by the non-tradable on productivity, and is thus, biased downwards. Thus, in their opinion, it is advisable to divide the nominal trade by the real GDP. The different measures of trade openness lay the basis for a technique to find out the extent to which a country is open to the global trade as well as to the consequential advantages of income growth. For instance, the higher a country’s TI, the increased openness of its economy towards the advantages retrieved from trade. Use of TI to measure a country’s openness towards trade is advantageous in that these measures are not arbitrary binary in nature. While using the TI measures that are based on the outcomes of income levels and trade, countries are commonly represented upon a continuum that runs from open to close end. Economies like Hong Kong and Singapore lie on the very open end. The openness of economies decreases as the continuum is followed through to the other end. Countries lying at the bottom with closed economies are not able to make use of the trade for the growth of their income. These countries include but are not limited to Argentina, Japan, America, Brazil, and India. Thus, if TI is used as a measure of a country’s openness of trade, America which happens to be the biggest trading country in the whole world appears to be a fairly closed economy in that the share of her trade in the total revenues is negligible as per the standards of other countries of the world. Labeling America as a closed economy challenges the reliability of TI as a measure of trade openness because America is too smart to continue being the biggest trading country of the world had the practice not generated fruitful results. For measuring trade openness, TI and many like it turn out to be one-dimensional since these measures consider only the relative status of the trade performance of a country in comparison to its domestic economy. They only check the magnitude of share of the total income of a country that is linked with the international trade. One important aspect of the trade openness that these measures tend to overlook is the importance of a specific economy to the global trade. In other words, these measures do not perceive the significance of the openness of a country to the global trade. In their research, Squalli and Wilson (2006) found that the set of countries with closed economies was altogether different when evaluated on the scale of the relative world trade intensity (RWTI) as compared to the set of countries that were found to be closed economies in the scale of TI. The expression for RWTI is as follows: n “RWTIi = (X + M)i / ? (X + M)i” (Squalli and Wilson, 2006, p. 6). j=1 RWTI is a measure of a country’s trade in relation to the total global trade. On the scale of RWTI, five countries that were found to be obviously open economies towards trade were China, Russia, America, UK, and Germany. This contradicts the results derived from the scale of TI. Same countries had ranked 113th, 77th, 133rd, 97th, and 86th on the scale of TI. On theoretical grounds, trade always results in benefits related to income irrespective of a country’s low or high TI provided that the country sustains trade channels with other countries spread far and wide across the world. When only TI is used for measuring the trade openness of a country, its dimension that speaks of the income related benefits resulting from global trade is overlooked. Thus, there has to be a second method of measurement of trade openness that combines the two aspects i.e. RWTI and TI. In order to correctly measure the trade openness of a country, it is imperative that it is perceived as a two-dimensional subject. Each of the two dimensions captures the objectivity of dependence of a country’s economy upon the global economic activity in its own individualistic manner. The first dimension tends to estimate a country’s linkage of income to the global trade, which can be measured by TI. In an attempt to make an innovative approach towards identifying the measure of trade openness with increased accuracy, Squalli and Wilson (2006) combined a country’s trade intensity with its relative share in the global trade which resulted into the composite trade intensity (CTI). CTI reflects the extent of true trade openness of a country in a more sensible manner. Use of CTI as a measure of trade openness has enabled big trading economies including Germany and USA to be referred to as open economies and be placed in the group of countries that have conventionally been described as open economies like Hong Kong and Singapore. According to Kumar and Kandzija (n.d.) countries can be ranged in accordance with their relative openness using the suggested approach of trade openness measurement. However, there was a lot of subjectivity in the consideration of the cause-and-effect relationship between the growth of trade and the national income. In their research, Dollar and Kraay (2001) found a group of developing economies which have experienced increased trade volume and decreased tariffs since the year 1980. With countries like India and China included in this group, these globalizing economies cover more than half of the total population of the developing countries. These globalizing economies have been found to display a completely different pattern of tariff and GDP change as compared to the developing countries excluded from their group. Since 1980, this group of developing countries experienced an overall increase in GDP from 16 per cent to 32 per cent whereas GDP of the excluded developing countries has seen a decline from 60 per cent to 49 per cent ever since. Also, the developing countries included in the group have seen a 22 point reduction in the tariff while tariff reduction in the excluded developing countries has not exceeded 10 points since 1980. These globalizers have seen an uninterrupted growth in the three decades starting from 1970s. Their growth rate in the 1990s was 5 per cent per capita. This was a two-fold increase as compared to the growth rate of the rich economies showing a growth rate of 2.2 per cent per capita while the growth rate of the excluded developing countries was no more than 1.4 per cent per capita. This has created a gradual but great difference between the economic strength of globalizers and non-globalizers over the decades. While doing cross-country regressions, Dollar and Kraay (2001) also found a robust relationship between the alterations in growth rates and the changes in the volumes of trade, while no consistency was determined between the alterations in household income inequality and the changes in trade volumes. The open trade regimes in the globalizers have accelerated their growth rate in the last two to three decades and have thus caused a decline in their poverty. A channel used by trade to improve the growth of a country according to the new growth theory is “that a country can obtain advanced technology from its trading partners through trade. If this channel is more important than the other channels, countries may benefit more from trading with developed countries” (Yanikkaya, 2003, p. 72). Increase in the economic growth and stability of a country positively influences the flow of FDI to it, which in turn, promotes economic growth and stability (Hasen and Gianluigi, 2007, p. 17). Hence, the two are inter-related and have a dual cause-and-effect relationship with each other. Tayyebi and Hortamani (n.d.) have made an attempt to determine the drivers of FRI inflows between 1992 and 2003 among all members of EU15 and ASEAN+3, which are two of the most significant blocks of regional integration. As a result of their research, Tayyebi and Hortamani (n.d.) found that FDI implying the promotion of investment in EU15 and ASEAN+3 is considerably affected by the regional integration in East Asia. It was concluded that flows of FDI between the two blocks can be enhanced by 0.6 per cent on average through ASEAN+3 membership and a growth of bilateral trade flows of 1 per cent. The expansion of export market results in increase of the trade integration within EU15 and ASEAN+3 that can in turn, generate increased FDI. This can also be achieved by the liberalization of trade between European and Asian countries. The results derived by Tayyebi and Hostamani (n.d.) second the findings of past researchers that referred to the effect of increased bilateral trade resulting from the trade integration agreement (TIA) launch upon the FDI as a favorable outcome of a country’s openness. Thus, it can be inferred that “a move towards the TIA of the Asian nations would considerably bolster North-South FDI flows to particularly some low income countries in ASEAN” (Tayyebi and Hortamani, n.d., p. 12). FDI is very suitable for the developing countries as a capital inflow given the reduced susceptibility of such investment to sudden stops and crises. Hasen and Gianluigi (2007) conducted a research to determine the factors affecting the flows of FDI to the Arabian countries from 1990 to 2006 including Algeria, Libya, Morocco and Tunisia. They found that real growth of the inflation rate, lagged FDI, expenditure by government and domestic GDP was significant in the observed countries in all these years. Existing FDI stock and expansion of the local market were found to be the main drivers of further FDI flows whereas high expenditure by the government, inflation and such other factors of macroeconomic mismanagement discouraged the inflow of more FDI. Busse and Hefeker (2007) conducted a research to evaluate the function of political institutions and risks as drivers of FDI in the developing countries. According to the results obtained from the cross-country analysis ranged over two decades, three fundamental elements of the political risk and institutions as indicators were found to be intrinsically linked with FDI, namely democratic accountability, religious conflicts and the stability of government. However, a potential drawback of adopting this approach for determining the drivers of FDI is that alterations in the variables of interest with time are overlooked. Determinants of FDI can vary from region to region which speaks of the fact that there are several factors beyond the traditionally discussed ones that control the FDI in a region. This can particularly be assessed from the conclusions drawn by Asiedu (2001) who made an attempt to identify the determinants of FDI in developing countries. Asiedu (2001) particularly focused upon the case of Sub-Saharan Africa (SSA) who in spite of the policy reform has not been quite successful in increasing FDI. Results of his research the drivers of FDI have conventionally had a differential effect upon the flow of FDI in SSA. Factors that have primarily enhanced FDI in the non-SSA countries include increased return upon the capital and the development of infrastructure. When SSA is compared to the non-SSA countries in this respect, it becomes clear that these two factors did not drive FDI to SSA unlike the non-SSA countries. “Openness to trade promotes FDI to both SSA and non-SSA countries, however, the marginal benefit from increased openness is less for SSA ?- suggesting that trade liberalization will generate more FDI to non-SSA countries than SSA countries” (Asiedu, 2001, p. 1). Asiedu (2001) also found that countries in the SSA are susceptible to gaining lesser FDI because of their distinctive geographical location. All of these conclusions present Africa as a different region with its own determinants of FDI that may not be so in the non-SSA countries. References: Andersen, PS 1994, Discussion in Lowe, P. and Dwyer, J. (Eds.) International Integration of the Australian Economy. Australia, Reserve Bank of Australia. Alcala, F and Ciccone, A 2004, Trade and Productivity, Quarterly Journal of Economics, vol. 119, pp. 613-646. Asiedu, E 2001, On the Determinants of Foreign Direct Investment to Developing Countries: Is Africa Different? University of Kansas, pp. 1-24. Busse, M, and Hefeker, C 2007, Political risk, institutions and foreign direct investment, European Journal of Political Economy, vol. 23, pp. 397–415. Dollar, D, and Kraay, A 2001, Trade, Growth, and Poverty, Development Research Group, The World Bank, pp. 1-45. Frankel, JA 2000, Assessing the Efficiency Gains from Further Liberalization, In Porter, RS, P, Subramanian, A and Zampetti, A. (Eds.) Conference in Efficiency, Equity and Legitimacy. Harrison, A 1996, Openness and growth: a time series, cross-country analysis for developing countries, Journal of Development Economics, vol. 48, pp. 419– 447. Hasen, B, and Gianluigi, G 2007, The Determinants of Foreign Direct Investment, Liverpool John Moores University, pp. 1-33. Kumar, A, and Kandzija, V n.d., Theory of Trade and Integration Applied for Trade Perspectives in the Area of Western Balkans, pp. 1-15, viewed, 7 September, 2011, . Li, K, Morek, R, Yang, F, and Yeung, B 2004, Firm-Specific Variation and Openness in Emerging Markets, The Review of Economics and Statistics, vol. 86, pp. 658-669. Sqaulli, J, and Wilson, K 2006, A New Approach to Measuring Trade Openness, pp. 1-35. Tayyebi, SK, and Hortamani, A n.d., The Impact of Trade Integration on FDI Flows: Evidence from EU and ASEAN+3, University of Isfahan, pp. 1-17. Yanikkaya, H 2003, Trade openness and economic growth: A cross-country empirical investigation, Journal of Development Economics, vol. 72, pp. 57– 89. Read More