Relationship between FDI and Trade Flows

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This paper is the study of the relationship between FDI and trade flows from the perspective of inward and outward FDI for Vietnam in te 2001-2003 periods by applying a gravity model to panel data on the Vietnamese bilateral trade flows. The results of the study generally support the hypothesis of a weak complementary relationship between bilateral trade flows and FDI, while the impact of FDI on the trade balance is not as clear-cut. The results also confirm that FDI has different impacts on trade in various product groups according to their economic purpose.


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In several recent theoretical and empirical studies’, it emphasizes that foreign direct investment (FDI) has significantly influenced the trade patterns of host and investing countries in the last few decades. The activities of multinational enterprises (MNEs) involving FDI and intra-firm trade affect the trade patterns of countries both directly and indirectly through the various effects FDI has on capital formation, technology and managerial skill transfer, changes in competition etc. Central and Eastern Asian countries (CEECs) have experienced an increasing share in world trade and direct investment stimulated by the progress they have made in the transition process, trade and capital liberalization and regional economic integration. Vietnamese outward and inward FDl stock has been increasing at an average annual growth rate of approximately 10%, with outward FDI growth rates slightly exceeding those of inward FDI. In the same period, Vietnam has been facing a slow but persistent change in its trade structure, in terms of regional direction and product specialization according to economic purpose, accompanied by relatively large and persistent trade deficits.

International trade theories had examined the relationship and interaction between trade and FDI and these broad groups of theories were developed and applied separately but have been converging ever since Vernon’s (1966) theory of the product cycle addressed the dynamic aspect of the trade-FDI relationship. Within theories and analysis of the impacts of FDI the economy, capital stocks is adjusted through general-equilibrium mechanisms resulting in changes in production and consumption and, finally, in changing trade patterns. It is only when the concept of MNE was included in the models of international trade in the 1980s (Helpman and Krugman, 1986; Markusen, 1984 etc.) could the relationship between trade and FDI be studied explicitly within the framework of international trade theories (see section 2). FDI’s impacts on trade depend to a certain extent on the motives and organization of international business activities. Trade and FDI arc traditionally regarded as alternative strategies used by MNEs to service foreign markets and thus, as a starting point, assume a substitution relationship between exports and local production. Yet empirical studies show that the partial substitution of local sales for previous imports from an investing company, which is expected in the case of horizontal ‘market-seeking’ FDl, is often more than offset by the increase seen in imports of intermediate and investment goods and as well complementary final products from the parent company located in the investing country. The result may be a positive net impact on the host country’s imports. Similarly, FDI’s positive effects on trade flows are expected if FDI is primarily directed at efficiency gains (‘efficiency-seeking’) and tends to strengthen the host country’s comparative advantages, then exports to the investing country and to third countries arc likely to grow.

There are several empirical studies of the relationship between trade and FDI, providing mixed evidence on the trade-FDI relationship. It seems that the empirical results on the nature, magnitude and direction of the trade-FDI relationship are not neutral at the level of data aggregation (the firm, industry or macroeconomic levels), a country’s specific features and the time horizon of the analysis. It can be expected that more disaggregated data are more likely to yield net substitution (Blonigen, 1999). A review of the studies of trade and FDl interactions at different levels of aggregation, are discussed by Fontagnc (1999), Lipscy, Ramstetter and Blomstrom (2000). At the macroeconomic level, a complementary relationship tends to be strongly associated with the presence of spillovers between industries (Fontagne and Pajot, 1997) and efficiency enhancing, indirect effects.

The main purpose of the paper is to examine the relationship between foreign direct investment and trade at the macroeconomic level for Vietnamen in the 2001-2003 periods and the link between FDI and trade patterns simultaneously from the perspective of inward and outward FDI and, following theoretical predictions, further tests the relationship between FDI and trade for three main product groups according to their economic purpose; intermediate, investment and consumer goods. In testing the effects of inward and outward FDI on the volume, structure and direction of bilateral trade flows, a gravity model will be applied to panel data on Vietnamese bilateral trade flows with 51 partner countries in the 1995-2000 period. Through the gravity model to bilateral trade flows allows us to control for those country-specific factors that jointly determine trade and FDI. The paper answers the qestios, do Vietnamese trade and FDI flows substitute or complement each other?; does FDI differently affect trade in various product groups according to economic purpose?; and, can evidence be provided on the presence of a regional component (regionalism) in Vietnamese trade and FDI patterns?

In section 2, theories explaining the relationship between trade and FDI are studied and compared, while the main theoretical explanations of the trade-FDI relationship are outlined. section 3 specifies the model to be applied to Vietnamese bilateral trade flows, describes the data and methodology and, finally, presents the results of the empirical analysis. In the last section, the key results and implications are summarized and commented on.


The relationship between international trade and capital flows was first examined within the context of international trade theories by eliminating the standard assumption of international factor immobility. In international trade models, international capital flows3 arc generally considered movements of a physical, homogenous factor from one location to another without changes in ownership caused by differences in capital returns among countries (Ruffin, 1984). In the factor proportions theory, the basis for the relationship between trade and capital flows is the Rybczynski theorem, connecting a change in factor endowments with changes in the volume and structure of production and, consequently, in international trade.4 The factor proportions theory of trade is consistent with either a substitution or complementary relationship between capital and trade flows. Mundell (1957) demonstrated within the H-O-S model, in which international trade is caused solely by the differences in relative factor endowments, that international capital flows substitute trade flows. Factor (capital) mobility tends to equalize factor endowments across countries and thus erodes the basis for trade. Perfect factor mobility would bring about the same equilibrium as would perfectly free trade in conditions of international factor immobility. Capital and trade flows are substitutes in the sense of price equalisation, welfare implications and quantitative aspects. However, if the causes of trade are not the differences in relative factor endowments as in the H-O-S model but differences in technology, economies of scale, product differentiation etc., then international capital flows could stimulate trade flows. This complementary relationship was shown in various models by Kemp (1966), Markusen (1983), Wong (1986), and others. As Markusen (1983) showed, in these models factor prices in free-trade equilibrium are not equalized across economies, and consequently factors (capital) are stimulated to flow in response to the factor price differentials. Capital will move to those economies exporting capital-intensive goods and so reinforce the initial causes and contribute to greater trade.

These models apply to capital flows generally and do not consider the specifics of FDI flows. In most cases, FDI cannot be regarded solely as an increase in the capital stock of the host country since a transfer of technology, different skills, organizational knowledge etc. often accompany it. Including FDI flows and impacts within trade models requires abandoning the additional standard assumption of numerous trade theories. The simplified general theoretical concept of the one-plant, single-nation firm has to be abandoned due to the existence and size of MNEs. In general-equilibrium trade models with FDI and MNE, the trade-investment relationship crucially depends on whether firms are horizontally (an MNE produces the same product in multiple plants) or vertically integrated (an MNE geographically fragments production into stages).5 In these models, the key decision factors influencing the type of a firm’s integration arc transport costs, scale economies, and the relation between plant-level and fir vel scale economies.

In the models of horizontally-integrated firms, developed by Markusen (1984), Brainard (1993), Markusen and Venables (1995, 1996, 1998) and others, the substitution relationship between trade and FDI prevails. With the appearance of horizontally-integrated MNEs, caused by the introduction of trade barriers (such as transport costs and tariffs) and firm-level scale economies, the level of trade falls and is substituted by sales of affiliates in the local markets.6 Markusen and Venables (1998) show that MNEs become more important relative to trade as countries become more similar in size and relative factor endowments, and as world income grows. On the contrary, in the models of vertically-integrated MNEs, for example in the Helpman-Krugman’s model (1986), vertical intra-firm trade with intermediary products is also considered. The assumptions of zero trade costs and increasing returns to scale in each of the production stages result in the concentration of a particular production stage in one plant, located in that country where the relative factor endowments enable the cheapest production at a particular stage. In these models, the MNEs and FDl increase the level of trade, while trade in intermediaries always takes place as intra-firm trade (Bowcn, Hollander, and Viacne, 1998).


The theoretical explanations of the nature of the relationship between trade and FDI flows as set out in section 2 are in fact ambiguous. The actual nature of trade-investment interactions remains attractive for further empirical studies. In this section, we try to examine the relationship between bilateral trade flows and FDI at the macroeconomic level for Vietnam in the 1995-2000 periods. A problematic aspect of analyzing the relationship at the macroeconomic level is that there are specific factors which jointly affect trade and FDI (such as market size, proximity of the partner countries, regionalization processes etc). Such factors could create a fictive complementary relationship. By using bilateral data on trade and FDI this problem could, at least partly, be avoided by controlling for those country-specific factors that jointly determine trade and FDI (Lipsey and Weiss, 1981; Fontagne, 1999).

According to the gravity model, a positive effect of a partner country’s GNP per capita and population on bilateral exports/imports is expected. The distance between partner countries, based on levels of transport and communication costs, is expected to negatively affect bilateral trade flows. The magnitude of the relationship between variables reflecting the size of the economy (GNP per capita and population) and trade is predicted to be less than proportional. A statistically significant positive relationship between trade and FDI variables would offer basic support for the hypothesis of a complementary relationship between trade and investment flows. In general, we expect positive regression coefficients for the FDI variables, but they should differ for the various categories of economic purpose. According to the theoretical predictions, relatively stronger effects of FDI on trade flows with intermediate and capital goods arc expected.

3.2 Methodology and data

An expanded gravity model (2) will be applied to annual panel data on Vietnamese bilateral trade with 51 partner countries in the 1995 (1996)-2000(12) period.

Since we use panel data the estimation techniques allow us to control for partner country and time-specific effects and to thereby control for economic, cultural, institutional and other country-pair-specific factors that are constant over time and are not explicitly represented in the model. Two standard panel data models, fixed effects models (FEM) and random effects models (REM), will be estimated. The appropriateness of the model specifications will be tested on the basis of two tests, the Breusch-Pagan Lagrangian multiplier (LM) test and Hausman’s test. The appropriateness of the estimates based on the panel-data models compared to classical regression models is tested on the basis of the Lagrangian multiplier test. High values of LM favour one of the panel models. Hausman’s test is used to test the specification for the fixed versus the random effects model. High values of Hausman [chi]^sup 2^ statistics reject the null hypothesis that individual specific effects are not correlated to the explanatory variables, which is the assumption of REM. High values of Hausman’s statistics thus favour FEM. In addition, the appropriateness of one-way (taking into account only individual effects ([alpha]^sub i^)) and two-way (taking into account individual and time-specific effects ([alpha]^sub i^ and [gamma]^sub t^)) panel-data models will be considered on the basis of the F-test.

A potential concern in our model specification is the endogeneity of some explanatory variables, which can be reflected in the correlation between these variables and error term causing biased and inconsistent estimates. Two of the right-hand-side variables in gravity model specification (2), inward and outward FDI, could be influenced by bilateral export and import flows.14 To deal, at least partly, with this potential problem of the simultaneous causality between FDI and trade flows, the robustness of empirical results will be tested by an additional instrumental variable two-stage least squares estimation of gravity model (2). As lagged values of FDI variables are highly correlated to their contemporaneous values and can be reasonably assumed to be independent of current trade flows, lagged values of FDI variables may be regarded as possible instruments in our models.15

Data on inward and outward FDI are expressed as average stock of FDI in US dollars, calculated as the average of the stock at the end of the previous and end of the current years. Inward and outward FDI variables are used as stock variables for several reasons. First, as FDI has accumulative effects on trade, noting FDI as a flow variable would only capture the temporary influences of FDI. second, using the average stock data which could be regarded as independent of current trade flows due to the expected time lag in the impact of trade on FDI allows us to partly avoid the problem of simultaneous causality between FDl and trade. Finally, stock variables arc used to avoid negative values of FDI variables. To examine the regional component of Vietnamese trade, the partner countries are grouped into seven regions (the European Union, CEFTA, countries of former Yugoslavia, other Asian countries, America, Africa, with Australia). Variable descriptions and data sources are presented in Appendix 1.

3.3 Empirical results

The summary statistics and tests presented in Table 3 show that, for all estimated export and import gravity functions, the LM test at negligible risk confirms the appropriateness of the models based on panel data. Therefore, classical regression without taking into account group- and time-specific effects is inappropriate16. Hausman’s test indicates that for models of total exports and imports FEM provides a better specification, but for the models of disaggregated exports and imports according to economic purpose REM provides a better specification. The fixed-effects model’s estimated results reveal that partner-country-specific effects not captured in our explanatory variables explain more than 90% of the variability of the dependent variable (logarithms of exports and imports). Somewhat lower but still highly significant are the group effects for exports of investment goods, suggesting that exports of investment goods are relatively more sensitive to factors changing over time (such as economic activity in partner countries, price factors, expectations) than exports of other product groups.

TABLE 3: Summary and test statistics for FEM and REM estimations of export and import gravity functions

Presuming that the high significance of fixed-group (partner-country) effects is closely linked to the distance between partner countries, only REM estimations including the distance as the explanatory variable are presented (see Table 4). However, interpretation of the REM estimates for total exports and imports requires some caution, while Hausman’s test for these two models without distance included rejects the null hypothesis that individual specific effects arc uncorrclated to explanatory variables, which is the assumption of REM.

TABLE 4: Random Effects Estimations of Gravity Functions of Vietnamese Exports and Imports, 1995-2000(17

The standard independent variables of the gravity equations have the expected sign and are highly significant in all of the above models. According to the results, export flows are strongly negatively elastic on distance, namely a one-percent increase in the distance irom Vietnam is on average associated with more than a one-percent drop in bilateral exports, with all other things being equal. In general, negative elasticity on distance after controlling for regional effects is not significant for imports. Distance thus represents the biggest barrier to exports of intermediate goods. Due to its insignificant effects, the secondary school enrolment variable and FTA dummy variables are excluded from the models. The impact of FDI between Vietnam and ‘third’ partner countries on bilateral trade flows is not confirmed.

For the bilateral total trade flows with the 51 partner countries in the sample we find evidence of the connection between trade and FDl flows, which is mainly positive, but weak. Inward FDI has a significant positive impact on exports as well on imports, but the partial elasticity with respect to inward FDI is slightly higher for imports. The regression coefficients for outward FDI are positive but significant only for exports. The results generally suggest a complementary relationship between trade (exports and imports) and inward FDI, and between exports and outward FDI. The impact of FDI on the trade balance is not tested explicitly, but rough inferences may be indirectly drawn by comparing the partial elasticities of export and import flows with respect to FDI. The insignificant influence of outward FDI on total imports and the significantly positive influence on total exports in our empirical results suggest that outward FDI has a weak positive impact on the trade balance, while the impact of inward FDI on the trade balance is not as clear-cut.

The expectations that FDI has a different impact on trade in various product groups according to economic purpose arc confirmed. The positive effect of inward FDI on imports is statistically significant for imports of all three broad product groups categorised by economic purpose (see Table 4), and it is relatively higher for imports of investment and intermediate goods (approximately 0.34 and 0.21 respectively). A result that supports a complementary relationship between inward FDI and imports for all three main product categories. The relatively high partial elasticity of imports of investment goods suggests that foreign firms build in capital goods from the source country that could, in the case of an embodied technological progress and potential technological spillover effects for Vietnamese firms, contribute to improving the technological level and bring additional positive benefits to the host country. However, Damijan, Majccn, Knell and Rojcc (2001) confirmed FDI as an important direct channel for technology transfer to foreign investment enterprises in Vietnam, but did not find any evidence on positive intra-industry knowledge spillovers from foreign-owned firms to domestic firms. According to our expectations, the estimation results also provide evidence for the relatively high influence of inward FDI on imports of intermediate goods. The significant positive relationship between inward FDI and imports of consumer goods suggests that the local production of firms with foreign capital docs not displace purchases of final goods from the investing country.

The impact of inward FDI on Vietnamese exports in the 1995-2000 period is significant only for exports of consumer goods. This provides some evidence for our presumption that foreign investors locate in Vietnam to export back home and/or that the competitiveness of Vietnamese firms on the foreign markets improves due to positive spillover effects. Regarding the slightly higher elasticity of imports on inward FDl compared to export elasticity, a slightly negative impact on the trade balance is expected, particularly for trade in investment and intermediate goods, while the effect on the balance for trade in consumer goods is more uncertain.

The effect of Vietnamese outward FDI is positive and significant on exports of intermediate and investments goods in the period considered. In accordance with our expectations, Vietnamese direct investments to partner countries have the strongest impact on Vietnamese exports of investment goods, and the weakest on exports of consumer goods. The impact of outward FDI on imports is not significant for neither of the product groups which might indicate that ‘horizontal motive’ is important for Vietnamese outward FDI. In general, an increase in outward and inward FDI contributes more to an increase in the volume of trade than to the trade balance.

Following the arguments set out in section 3.2., we estimate the gravity model specification (2) with the one-year-lagged values of FDI variables used as instruments as an attempt to deal with the potential problem of endogeneity. In general, instrumental variable estimations give similar results to Ordinary’ panel data estimates from Table 4 confirming certain robustness of the estimation results. Based on ‘Sargan’ test of ovcridentifying restrictions for a panel data regression estimated via instrumental variables we can not reject the joint null hypothesis that export and import equations are properly specified and our instruments are valid instruments (i.e. uncorrelated with the error term). For inward FDI, instrumental variable estimations reveal a significant positive relationship between inward FDI and imports of all three product groups as it is the case in Ordinary’ panel data estimates, while for export of consumer products positive effect of inward FDI is no longer significant. Similarly, the estimated partial elasticities on the outward FDI variable have the same sign and arc slightly higher in absolute magnitude compared to Ordinary’ panel data estimates for all of the export and import functions. Therefore, we may conclude that these results are principally supportive of the conclusions based on panel data estimates from Tables 3 and 4.

We also test the model for possible nonlinearities by including the square of logarithms of explanatory variables in the empirical models. We obtain very similar results with respect to sign and significance of the FDI regression coefficients for all of the four export functions while for the import functions the results are less robust to the use of higher powers of regressors. After testing for nonlinearities in the model, the positive effect of inward FDI is no longer significant for imports of investment and consumer products. After the inclusion of time-region dummy variables to control for spatial correlation we obtain significant relation between outward FDI and exports of investment products and between inward FDI and imports of intermediate and investment products. We can conclude that positive relation between inward FDI and imports of intermediate products and positive effect of outward FDI on exports of investment products are robust to instrumental variable estimation, to inclusion of higher powers of explanatory variables and as well to allowing for time-region specific effects.


The paper examines the relationship between FDl and trade at the national level for Vietnam in the 1995-2000 period. The results of gravity model estimates, using annual panel data on Vietnamese bilateral trade with 51 partner countries, generally support the finding of a weak complementary relationship between bilateral trade and FDI flows, while the impact of FDI on the trade balance is not as clear-cut. The standard explanatory variables of gravity equations (population, GNPpc, distance) have the expected signs and arc highly significant. The impact of other variables including free-trade agreements on bilateral trade flows is not confirmed, but we find evidence of the presence of a regional component in Vietnamese foreign trade. Bilateral trade flows tend to be weakly positively connected to bilateral FDI, but the linkage between FDI with third countries and bilateral trade flows is generally not confirmed. The results also support the hypothesis that FDI has a different impact on trade in various product groups categorised by economic purpose. In general, the effects of bilateral FDI are the strongest for bilateral trade flows with investment and intermediate products which corresponds to the increasing share of these two product groups in Vietnamese trade flows. The relatively strong, positive effect of inward FDI on imports of intermediate and investment products suggests that firms with foreign capital in Vietnam build in capital goods from the source country. Vietnamese outward FDI particularly positively affects the level of exports of investment products, confirming the contribution of Vietnamese outward FDI to the above-average propensity of Vietnamese exports of investment products to countries of former Yugoslavia.

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APPENDIX 1: Variable descriptions and data sources

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