The Trade-FDI Nexus: Evidence from the European Union

Abstract

The objective of this paper is to examine the relationship between international trade and Foreign Direct Investment (FDI) empirically. It analyses whether the reduction of trade barriers over time has increased FDI for the particular case of the European Union (EU) during the period from 1995 to 2009. To analyze this issue the authors estimate in first place the European Border Effect by means of a gravity equation. Once the border effect is obtained we test whether there is a positive (complementary) or negative (substitution) relationship between this border effect and the FDI within the European countries. A gravity model for trade and FDI is estimated using the Poisson pseudo-maximum likelihood. The results suggest that there is a positive and decreasing border effect up to 2007 while it turns upward for 2008 and 2009, offsetting the previous decline. For the particular case of the EU, commercial integration and FDI reinforce each other, thus being complements rather than substitutes. In addition to trade integration measures, this paper also analyzes the potential role of other traditional determinants of FDI, as the market size of the host country and the cost differential among home-host economies. Cost differentials are not as relevant as the possibility of gaining market share which leads us to conclude that in the EU the FDI pattern follows a market-seeking strategy rather than a cost-efficient model.