Economic integration agreements and the location of vertical FDI

Juan Blyde, Alejandro Graziano, Christian Volpe Martincus, 13 May 2014

a

A

Production processes are becoming increasingly fragmented. Many goods that were manufactured in single countries are now sliced in different bundles assigned to plants around the globe, giving rise to what is commonly known as global value chains (GVCs). The emergence of GVCs is allowing nations to industrialise much more rapidly by joining international production networks rather than by building entire supply chains at home. This has been the path to industrialisation taken by some Asian countries and, more recently, by some eastern European countries as well (Baldwin 2012). It is then important, particularly for developing countries, to understand what are the forces driving these new trends in the international organisation of production.

Casual evidence points to economic integration agreements as one of the forces behind the formation of these international linkages. For instance, before the 1965 US-Canada Auto Agreement, trade in auto parts between these two countries practically did not exist. After the agreement was signed and tariffs were removed, auto trade soared igniting a US-Canada auto supply chain in which the US primarily exports to Canada engines and parts, whereas Canada ships back finished cars and trucks (Hummels et al. 1998). Likewise, investment flows from the old EU members to the new members increased to unprecedented levels in the run-up to the enlargement, with the main recipients being Hungary, the Czech Republic and Poland, the three countries that since then have become crucial parts of the European supply chain (Karkkainen 2008).

While suggestive, anecdotal evidence based on regional case studies does not inform the effects of integration agreements on the formation of GVCs. In order to estimate this effect, one first needs an adequate measure of GVC participation. Aggregate trade or foreign direct investment (FDI) flows are definitely not the right candidates because not all the trade or FDI flows are part of GVCs. Integration agreements can affect both trade in intermediate inputs and vertical FDI – which are typically associated with GVCs – and trade in final goods and horizontal FDI – whose links with GVCs are considered weak.1   Second, one has to properly address potential reverse causality. While integration agreements may induce the formation of production networks, existing production networks might also generate demand for integration agreements. Such a demand for deeper integration could, for instance, take the form of the elimination of technical barriers to trade which tend to be costly for offshoring (Lawrence 1996). These challenges explain the scarcity of analyses relating integration agreements and global value chains. The few studies available, however, unequivocally point to the existence of a positive relationship between integration agreements and production linkages across countries (e.g. Johnson and Noguera 2012; Orefice and Rocha 2011; Hayakawa and Yamashita 2011).

New evidence using FDI-related data

In a recent paper (Blyde et al. 2013) we present new evidence on the relationship between integration agreements and offshoring by exploiting a global dataset of establishments, the WorldBase, that reports the corporate linkages of each production unit. Combined with information from input-output tables, these data allow for constructing a precise investment-related measure of offshoring, i.e. the number of subsidiaries that produce inputs to parent companies in each foreign country, or vertical FDI (Alfaro and Charlton 2009). Accordingly, the paper analyses the effect of integration agreements on the decision of multinational companies to open vertically linked subsidiaries in a different destination.

Figure 1 shows the evolution of both the number of countries involved in agreements and that of the total number of vertically linked foreign subsidiaries over the 1980-2005 period. Agreements have become more pervasive. For instance, 90.2% of countries were members of agreements in 2005 as compared to 55.7% in 1980. Vertically linked subsidiaries have also expanded substantially. Their average number by country-pair more than doubled between these years.

Figure 1. Economic integration agreements and vertically linked subsidiaries, 1980-2005

Source: Authors’ calculations based on data from WorldBase and Baier et al. (2013). Note: the average number of vertically-linked subsidiaries per country-pair is computed across those pairs with positive numbers.

Our empirical examination, which addresses natural econometric concerns such as potential selection bias and potential reverse causality between GVCs and integration agreements, yields two main robust findings:

  • First, integration agreements have a positive and significant impact on the number of vertically linked subsidiaries hosted by partner countries, as shown in the upper section of Figure 2. In particular, according to our baseline estimate, countries with integration agreements have 8% more subsidiaries.
  • Second, deeper forms of integration agreements induce more cross-border production sharing than shallow forms. This is shown in the lower panel of Figure 2. More precisely, whereas preferential trade agreements (PTA) do not have a significant effect on cross-border production sharing, countries with free trade agreements (FTA) have 9% more subsidiaries and countries with deep trade agreements – customs unions (CU), common markets (CM) or economic unions (EU) – have 12% more subsidiaries than countries without trade agreements.

The latter finding supports the notion that deep integration agreements provide more incentives for the formation of global value chains than shallow agreements because they tend to incorporate disciplines beyond the simple reduction of tariff rates such as investment policy, services, standards, and/or customs procedures. In so doing, they address a number of dimensions that tend to be important for well-functioning supply chains (Baldwin 2012).

Figure 2. Estimated impact of trade agreements on vertical FDI

Source: Authors’ calculations. 

Agreements can lead to an increase the number of vertically linked subsidiaries through different channels and these can be explored with the dataset described above. In particular, the larger number of subsidiaries can be traced back to a larger number of subsidiaries opened by given parent companies or a larger total number of parent companies opening subsidiaries. Likewise, the increase in the number of subsidiaries can be driven by an expansion of the number of subsidiaries in the same sectors or by diversification of sectors in which these plants operate. The econometric results (shown in Figure 3) reveal that integration agreements can favour production fragmentation by primarily making it possible for more parent companies to open subsidiaries and by broadening the set of sectors of activity.

Figure 3. Estimated impact of trade agreements on vertical FDI, by channel

Source: Authors’ calculations.

Policy issues

Economic integration agreements seem to have significant positive effects on offshoring. Results specifically indicate that deep integration agreements have larger effects than shallow agreements. Incorporation of disciplines beyond the simple removal of tariffs that address issues critical for supply chains makes a difference for the development of regional production linkages. The same would apply for the multilateral system if it is to foster global production networks.

References

Alfaro, L and A Charlton (2009), “Intra-Industry Foreign Direct Investment.” American Economic Review 99, 5: 2096–2119.

Baier, S, J Bergstrand and M Feng (2013), “Economic Integration Agreements and the Margins of International Trade.” Clemson University and University of Notre Dame, mimeo

Baldwin, R (2012), “Global Supply Chains: Why They Emerged, Why They Matter, and Where They are Going.” CEPR Discussion Paper No. 9103.

Blyde, J, A Graziano and C Volpe Martincus (2013), “Economic Integration Agreements and Production Fragmentation: Evidence on the Extensive Margin.” Inter-American Development Bank, unpublished document. Washington, DC.

Hayakawa, K and N Yamashita (2011), “The Role of Preferential Trade Agreements (PTAs) in Facilitating Global Production Networks", IDE Discussion paper No. 280

Hummels, D, D Rapoport and K-M Yi (1998), “Vertical specialization and the changing nature of world trade.” Economic Policy Review. Federal Reserve Bank of New York.

Johnson, R. and G Noguera(2012), “Fragmentation and Trade in Value Added Over Four Decades”, NBER Working Paper No. 18186

Karkkainen, A (2008), “EU-15 Foreign Direct Investment in the New Member States.” Eurostat, Statistics in Focus, 71.

Orefice, G and N Rocha (2011), “Deep Integration and Production Networks: an Empirical Analysis”, WTO, Staff Working Paper ERSD-2011-11.


1  Vertical FDI consists of establishing affiliates that provide inputs to parent companies in other countries, while horizontal FDI refers to affiliates producing the same good as the parent company to serve a foreign market.

Topics: International trade
Tags: global value chains, trade agreements, vertical FDI

Senior Trade Economist, Inter-American Development Bank
Research fellow, Inter-American Development Bank
Lead Economist at the Integration and Trade Sector, Inter-American Development Bank

Most Read