Impacts of regional trade agreement on FDI location choice

The number of regional trade agreements (RTA) has been increasing rapidly in the world since the early 1990s, and there are 379 bilateral and plurilateral agreements in force as of July 2013. A number of empirical studies confirmed that RTAs have trade creation and diversion effect on trade in goods. On the other hand, while many studies have attempted to examine the impact of RTAs on foreign direct investment (FDI), they have shown mixed results. Based on traditional theory of multinational firms, horizontal FDI is decreased by removal of trade barrier under RTA in consequence of its substitutional relationship between trade and investment while vertical FDI is increased by enforcement of RTA since investment and trade are complementary. Recent theoretical studies, however, point out that multinational firms have more complex strategies of cross-border investment. Not a few multinational firms set up subsidiaries in order to both serve local consumers and export to third countries in the same host country. Given such complicated strategy of FDI by modern multinational firms, the effect of RTA on FDI is not simple. The strategy of multinational firms may be affected by not only RTA between investment country and host country but also RTAs between host country and the third countries. This paper examines the effects of RTAs on firm’s location choice in view of indirect effect of RTAs between host country and the third countries. Applying Japanese firm level panel data, we estimate both direct and indirect RTAs effects. Using spatially weighted third country effects, we investigate indirect RTA effects on firm level location choice by applying spatial heteroskedasticity and autocorrelation consistent (HAC) estimator. Based on the results of analysis both direct and indirect RTAs effect on cross-border investment behavior of modern multinationals, we discuss policy implications of RTA design to facilitate cross-border investment in an increasingly complex RTA networks.