Trade costs and the pattern of Foreign Direct Investment: evidence from five EU countries

Abstract

According to the theoretical models of the multinat ional enterprise, trade costs play a fundamental role in determining the pattern of foreign direct investment (FDI). The aim of this paper is to assess the impact of trade policie s on the outward and inward stocks of FDI of the EU. We estimate a model based on the knowledge-capital theory of the multinational enterprise over the period 1995-2008 by using a sample of five EU countries and 26 partner countries. We consider, first, manufacturing sector as a whole an d, then, six manufacturing industries defined at the two-digit level of the NACE classification. Exp lanatory variables include an index of applied bilateral tariffs and a dummy to capture the presen ce of Bilateral Investment Treaties (BITs). From an econometric point of view, a dynamic panel model is estimated through the generalized method of moments (GMM) estimator, taking also into account the heterogeneity bias and the endogeneity of regressors. The results show that that the patte rn of the outward FDI is a mix of vertical and horizontal FDI. BITs in force have a significant an d positive impact on the outward FDI. The impact of tariffs varies across industries, suggest ing the predominance of horizontal in some industries and the existence of vertical FDI in oth ers. Estimates also indicate that the stocks of th e inward FDI of the EU countries are mainly driven by similarity between countries in the labour skills, while tariffs have not been found to exert any influence.