The Effects of East Asian Free Trade Agreements on Foreign Direct Investment

Abstract

The proliferation of Free Trade Agreements (FTAs) in East Asia has triggered extensive studies about the economic effects of FTAs. With trade and welfare effects as the focuses of many studies, the Foreign Direct Investment (FDI) effect has attracted relatively less attention. Given that attracting FDI is a common goal of FTAs, it is important to fill this gap. This thesis fills the gap by assessing the FDI effects of ASEAN-China Free Trade Agreement (ACFTA) through econometric models and by simulating the FDI effect of Regional Comprehensive Economic Partnership (RCEP) through a Computable General Equilibrium (CGE) model. I summarized three effects of Free Trade Agreements (FTAs) on FDI from the literature regarding theoretical links between trade liberalization and FDI. First is the vertical fragmentation effect. Reduction in trade costs of intermediate goods increases the incentive for multinationals to split production processes into different countries to take advantage of favorable conditions in each. Thus, vertical FDI would increase after FTA. Second is the market expansion effect. The preferential access to partner countries expands the domestic market to partners’, increasing the attractiveness of member countries to marketseeking FDI. Third is the plant rationalization effect. Reduction in trade costs encourages firms to choose trade rather than FDI to supply partners’ markets. Thus, trade substitution may decrease FDI. ACFTA is the first important free trade agreement for China and a significant development in East Asian integration. The study of ACFTA has two steps. First, I adopted an econometric model to examine the overall FDI effect of ACFTA. The model is based on the knowledge-capital theory of FDI and captures third country effects, which enables it to explain not only horizontal and vertical FDI, but also complex FDI such as export platform and complex vertical FDI. The model has been found to suit FDI study in East Asia. ACFTA shows a positive and significant FDI-promoting impact, indicating that the market expansion and vertical fragmentation effects dominate the FDI-decreasing effect of plant rationalization. I then conducted a more detailed study about ACFTA, aiming to explore the mechanism of how the agreement positively affected FDI. The target of this study is to detect the two FDI-promoting effects (the market expansion and vertical fragmentation effects) of ACFTA. This is the first time to examine these individual effects of an FTA and there is no existing methodology. Innovatively, I adopted an FDI industry model to test different effects of ACFTA on various industry sectors. The approach is adopted based on the two effects’ definitions. The definition of vertical fragmentation effect suggests that it would mainly affect pro-fragmentation sectors, while the definition of market expansion effect indicates that it would mainly affect export-increasing sectors. The FDI effects of ACFTA on these sectors reflect the two corresponding effects. These sectors are identified through analyses of total trade, and trade in intermediate goods. The FDI industry model shows that both the market expansion and vertical fragmentation effects exist in ACFTA, with the latter a little stronger on China. The effects of ACFTA mainly come from trade liberalization in goods but not services. Given the big share of services in FDI, it is important to include services liberalization in assessing the effects of FTAs on FDI. With this target, I developed a CGE model to simulate the potential effect of RCEP, which is expected to include liberalization of services trade. The CGE model utilizes the firm heterogeneity framework in analyzing FDI effects. The model incorporates FDI by sourcing capital to home region and differentiating firms by ownership. Given the importance of services to FDI, the model carefully deals with services barriers. Based on empirical evidence, the services barriers are modeled as tax equivalents that raise costs to imports and generate rents to incumbent firms. Simulation results show that RCEP can promote FDI to China, and services dominate the FDI increase. Specifically, comprehensive liberalization on trade in goods and services with a more than 50% reduction in services barriers in China can promote FDI flow to China by US$2.8 billion and increase its welfare by US96 billion. If RCEP can help member countries to improve their business environments so as to reduce fixed trading costs, the gains of China in FDI and welfare would be even bigger. In summary, this thesis examines the FDI effects of ACFTA through econometric studies and experiments with RCEP through a CGE model. Both ACFTA and RCEP are found to promote FDI to member countries. While the econometric finding of ACFTA suggests a significant FDI effect of goods trade liberalization, the CGE simulation results of RCEP show that the effect of services liberalization is much stronger.