How trade constraints and confusion imperil FDI

In the context of rising geoeconomic and geopolitical fragmentation, governments are imposing more and more trade restrictions. These are justified on grounds of national security, support for domestic production and jobs or corrective responses to perceived unfair foreign trade practices. 

Uncertainty over trade policies has also reached historically high levels across a broad set of economies, meaning firms find it harder to form reliable expectations about future market access and policy conditions. The overall result is a less stable and less predictable global trading environment.

The two variables of trade restrictions and uncertainty are usually thought about as primarily impacting cross-border trade. Less thought has been given to how such factors impact cross-border flows of capital, in particular foreign direct investment (FDI). This is a notable omission because while some countries may question the value of free trade in goods – decrying its impact on domestic manufacturing and jobs when large emerging markets abuse the system through state subsidies and undervalued currencies – few question the value of FDI in raising the competitiveness of national economies and boosting domestic growth and employment. 

In theory, the impact of trade restrictions on FDI is ambiguous. Tariffs, quotas, export controls and other policies that raise trade costs can deter efficiency-seeking and export-oriented FDI. These forms of investment rely on stable and open trade regimes, as multinational enterprises split production across borders and depend on the seamless exchange of intermediate goods within global value chains. However, trade barriers may encourage other forms of FDI. Through market-seeking or ‘tariff-jumping’ FDI, firms establish production facilities within protected markets to preserve market access and avoid import duties.

Trade policy uncertainty, however, seems unambiguously to deter FDI. Uncertainty among firms about market access and policy conditions tends to add to country risk premia and production costs, constraining cross-border economic activity. 

A new assessment of how trade restrictions and trade policy uncertainty affect FDI shows that, while both types of shock dampen FDI (both inflows and outflows), when the shocks are standardised to be comparable, the uncertainty shock is far more damaging (more than three times larger). This reflects how investment decisions involving large sunk costs are highly responsive to expectations about future regulatory environments. When trade policy uncertainty increases, investors will sit on the sidelines, scaling back or delaying investments until there is clarity about what tomorrow’s trade policy will be.

The damage to FDI appears to be greatest when host and source countries have been close trading partners. Where relationships are more distant, the damage is less. Trade policy uncertainty hurts FDI more when it comes from trade and geopolitical friends, than from more distant cousins.

The message is clear. Trade policy has much broader effects than those typically expected. Trade restrictions damage not only trade and growth but also imperil FDI. Trade policy uncertainty is even more damaging. If a country wishes to restrict cross-border trade while encouraging FDI, trade policy uncertainty is a self-inflicted wound. If trade restrictions are nonetheless desired because they are seen as instruments to grow domestic manufacturing or buttress national security, a stable and transparent policy is far preferable to a volatile regime.