EXPORT PERFORMANCE AND THE ROLE OF FOREIGN DIRECT

INVESTMENT

BY

NIGEL PAIN AND KATHARINE WAKELIN†

NATIONAL INSTITUTE OF ECONOMIC AND SOCIAL RESEARCH

&
MAASTRICHT ECONOMIC RESEARCH INSTITUTE ON INNOVATION
AND TECHNOLOGY

Abstract:

This paper explores the relationship between the location of production and the trade
performance of 11 OECD countries since 1971. The paper augments a standard export
demand model, which includes relative prices, market size and measures of relative
innovation, with indicators of both inward and outward investment levels. Common long-run
parameters are accepted for market size, relative prices and relative patenting, but not for the
direct investment effects. The sign and magnitude of the direct investment effects vary by
country. Outward investment has a generally negative impact on trade shares, while inward
investment has a generally positive one.

December 1997.

†We are grateful to Ray Barrell, Nigel Driffield, Michael Pfaffermayr, Leo Sleuwaegen, Ron
Smith, Martin Weale, two anonymous referees and other participants at the EARIE
conference in Vienna, September 1996, the IESG Easter Conference at Nottingham, April
1997 and the Money, Macro and Finance Conference at Durham, September 1997, for
helpful comments on this work. Financial support was provided by the ESRC (grant number
R022250035).

Correspondence to:
Nigel Pain Katharine Wakelin
National Institute of Economic and Social Research MERIT
2 Dean Trench Street P.O. Box 616
Smith Square 6200 MD Maastricht
London SW1P 3HE, United Kingdom The Netherlands
E-mail: npain@niesr.ac.uk k.wakelin@merit.unimaas.nl
I. Introduction

The extent of multinational activity in the world economy, and the share of world trade
accounted for by multinational enterprises, has risen steadily over time. These developments
have been accompanied by significant changes in both trade patterns and the trade
performance of many countries, with speculation that multinational enterprises have begun to
displace trade in particular industries (Markusen, 1995). The value of sales by the foreign
affiliates of multinational firms is estimated to have exceeded the value of world exports of
goods and non-factor services by over one-quarter in 1993 (UNCTAD, 1996, Table I.6). The
main channel for multinational expansion is foreign direct investment (FDI). Flows of FDI
have expanded rapidly in recent years aided by the removal of many national barriers to
capital movements and measures to enhance integration within regional markets. This paper
investigates whether the expansion of FDI has had any significant effect on the export
performance of a number of OECD economies.

The potential impact of FDI on recipient and investing economies is of considerable policy
interest. Within the United Kingdom for example, there are frequent claims that inward
investment has helped to transform the supply-side of the economy (Eltis, 1996). This view
would appear to be widespread, given the increasing efforts being made by many countries
to attract new investments from abroad. At the same time there have been renewed concerns
about the extent to which outward investment may lead to ‘job exporting’, particularly in the
US debate over the impact of NAFTA, and within some continental European countries
where an expansion of outward investment has coincided with rising unemployment (OECD,
1995).

In spite of the widespread interest in the impact of FDI on trade, relatively little empirical
evidence exists. The majority of existing studies use cross-section data. A useful overview of
this literature is provided in the 1996 Annual Report of the World Trade Organisation
(WTO, 1996). The questions examined in a cross-sectional data set may be very different
from those that can be addressed from a panel data set. The levels of exports and FDI have
both risen over time due to general economic growth in the world economy. It thus makes
little sense to investigate the impact of FDI on exports over time in isolation, as the results
would have to point towards complementarity. The relevant questions are whether national
export performance, that is exports relative to foreign market size, has been affected by FDI,
and whether an increase in either inward or outward FDI raises or lowers exports compared
to the level they would otherwise have achieved given the level of foreign demand and the
other characteristics of domestically produced goods. Such investments can alter the range

1
and technological characteristics of the goods and services produced within a country and
hence affect the share of export markets met by firms located within the exporting economy.

Econometric evidence has an important role to play in investigating the relationship between
multinational activity and export performance since theory offers relatively little guidance as
to what might be expected. The impact of production relocation can differ according to
whether it is to exploit natural resources, improve access to local markets or is simply part of
the international division of labour within the firm (Cantwell, 1994). Thus significant
differences might be observed across countries or industries. Such heterogeneity is reflected
in our empirical findings.

This paper builds on the earlier analysis of UK export performance by Blake and Pain
(1994). Their results suggested that net inward investment into the UK had a significant
effect on export performance after allowing for the impact of relative price and non-price
factors. We present empirical evidence for 11 OECD economies from 1971 to 1992, using
panel data on manufacturing exports. The choice of countries was largely determined by the
extent to which sufficient information is available to permit the construction of consistent
measures of inward and outward direct investment stocks over time. We focus on both
inward and outward direct investment in order to allow for the fact that most countries
import and export capital simultaneously. At the sector level, export displacement arising
from outward investment within one industry could easily be offset by export enhancing
inward investment within another industry.

Our paper also sheds light on the long-standing debate over the factors behind movements in
the trade shares of many OECD economies. Conventional econometric models of the
aggregate export performance of these economies relate export sales to market size and
indicators of price and non-price competitiveness, and typically ascribe structural changes in
performance to variation in the income elasticity of demand over time (Landesmann and
Snell, 1993). This provides an indication that the trade share has changed, but does not really
explain why such a shift has occurred. The results of Anderton (1991), who includes a
stochastic time trend in export share equations for the G7 countries, also imply that relative
performance has changed over time, particularly for the US, UK and Japan. However it is far
from clear what lies behind these developments since a stochastic trend captures the impact
of all relevant variables excluded from an otherwise conventionally specified equation. We
find that we can accept a unit demand elasticity within our panel, implying that direct
investment provides an important part of any explanation of cross-country movements in
export shares.

2
The structure of this paper is as follows. In Section II we review the existing literature on the
interrelationships between international production and trade and consider what can be
inferred from existing empirical studies. The following section sets out the model to be
tested, and Section IV presents a brief overview of the actual changes in export shares and
direct investment levels of the countries we consider. Section V contains the main
econometric results, which suggest that there is evidence of a significant relationship
between export performance and direct investment for the majority of the countries. We also
discuss the extent to which movements in FDI can account for changes in export
performance since the early 1980s and report some preliminary results which suggest that the
trade-investment relationship may have changed over time. Section VI gives some
concluding comments.

II. International Production and International Trade

The theoretical literature on both international trade and the behaviour of multinational firms
does not give a clear indication as to whether foreign production is a substitute for, or
complement to, international trade. In part this reflects the separate development of general
equilibrium models of trade and models of foreign investment based around the behaviour of
individual firms. We begin this section by discussing the relationship between trade in goods
and international production of goods and services in theoretical models of trade under both
perfect and imperfect competition. We then consider some of the issues raised by recent
papers on the determinants of foreign direct investment, before reviewing a number of
existing empirical studies.

II.1 Theoretical Issues

In conventional two country trade models based on the Heckscher-Ohlin-Samuelson

framework with perfectly competitive product markets and no transportation costs, the
equalisation of factor prices across countries can be brought about either through
international trade or through the international mobility of factors of production. In the latter
case factor mobility may substitute for trade if production functions are identical (Mundell,
1957), but may expand trade if capital flows into foreign industries in which domestic
investors are at a comparative disadvantage (Kojima, 1975).

Related results can also be obtained from some recent trade models which assume imperfect
competition (Markusen, 1995). The key features of such models arise from the interaction
between scale economies, transport costs, differences in national factor endowments and the
existence of firm-specific knowledge-based assets such as managerial and production

3
expertise and process innovations. Such assets can act as ‘joint’ inputs across multiple plants
within a single firm. The extent to which firms elect to engage in trade rather than establish
foreign affiliates depends on the benefits of proximity to final markets relative to the benefits
of concentrating production in one location and exploiting scale economies (Brainard, 1997).
If country endowments differ, then single-plant firms may remain more profitable than
multinational firms. The latter have to locate some capacity in a location with higher relative
factor costs, as well as incur the fixed costs associated with the establishment of an
additional production facility. If country endowments are similar and transport costs (or
more generally barriers to trade) are high, then multinational firms are relatively better
placed than single-plant firms since they have lower marginal costs per market if they
possess knowledge-based assets. One implication from variants of this model is that as
national income levels converge, (horizontal) foreign production may displace intra-industry
trade (Markusen and Venables, 1996), so that particular types of trade and direct investment
may eventually be substitutes.

The models outlined above view multinational enterprises as horizontally integrated firms.
An alternative approach is to view MNEs as vertically integrated, with ‘headquarter services’
(Helpman, 1984) located in the home country and the choice of the location of production
facilities being driven by relative factor costs and resource endowments. One example of this
is direct investment in order to exploit natural resources not available in the home country.
These investments are more likely to create (inter-industry) trade, by raising exports of
capital equipment and factor services from the home country and exports of resource-based
products from the host economy. Such investments are likely to be particularly important in
developed countries with a high level of natural resources such as Canada and Australia, as
well as in many developing economies.

The literature on direct investment also fails to yield clear implications for the impact of
direct investment on trade in manufactures. Simple supply-side models would suggest that in
the absence of decreasing returns to scale and barriers to market entry firms would choose to
produce in a single low-cost location and serve final markets through trade rather than local
production. Implicitly outward FDI in manufacturing industries and exports of goods from
the investing country would be substitutes, while inward investment and exports from the
host country would be complements. In the 1960s the dominant model of FDI was based on
the ‘product cycle’ paradigm. This suggested that product innovation would take place in the
home country, with foreign markets initially entered by means of exports. Eventually
production would move to lower-cost locations as firm-specific knowledge came to be
acquired by competitors. For a single product firm, foreign investment was thus viewed as a
substitute for trade.

4
In practice the level and location of foreign investment can be influenced by a wide range of
factors, including the desire to gain market access by bypassing national and regional trade
barriers and the desire to expand market access by offering improved customer support
through investment in service sector facilities. Firms may have an incentive to establish
operations within ‘closed’ regions in order to gain barrier and tariff-free access to the
regional wide market. Evidence presented in Barrell and Pain (1997b) for instance,
illustrates the extent to which the increasing use made of contingent protection within
Europe and the United States has served to increase the level of foreign direct investment by
Japanese companies in these regions. Investments to bypass trade barriers and investments in
the service sector may improve export performance by increasing the size of the foreign
market for finished goods, with any decline in the exports of finished products being more
than offset by higher exports of intermediate goods and factor services to assembly plants
within regional markets.

One reason for studying the aggregate effects of foreign investment on trade performance as
well as examining data at the level of the firm (if available) is that even if direct investment
improves market access for the parent firm, this may be at the expense of other firms
exporting from the home economy. Direct investment may be motivated by strategic
considerations as much as by a desire to seek out low-cost locations (Buigues and
Jacquemin, 1994). If product markets are imperfectly competitive, the sunk-costs occurred in
undertaking foreign direct investment may be a means of achieving the market power
required to exploit intangible assets such as brand names, managerial expertise and other
firm-specific knowledge.

Overall it is possible that international production may either create or displace trade, with
the particular effect likely to differ between economies and industries, and between inward
and outward investment. The relationship may also vary over time. In general it is likely that
the need to undertake investment in order to bypass barriers to market entry has lessened
over time, particularly for firms making intra-regional investments within large regional
markets such as North America and the European Union.

II.2 Empirical Studies

On balance the available evidence suggests that inward investment is perhaps more likely to
raise exports from the host economy than outward investment. A number of studies have
suggested that inward investments in open economies such as Ireland (O’Sullivan, 1993),
Portugal (Cabral, 1995) and the UK (Blake and Pain, 1994) act to raise the exports of the

5
host economies. In these cases foreign investment in one country is designed to serve a wider
regional market.1

In accounting terms a high level of inward investment by export-orientated firms may affect
the variety and quality of products produced within the host economy and change the
proportion of the (given) world market accounted for by exports from that country. Failure to
allow for the relocation of production in conventional trade relationships may thus be one
potential explanation of apparent shifts in the income elasticity of demand for exports.2 Such
factors cannot be fully accounted for by including relative price and non-price factors in an
export demand model since the relocation of production can change export market share
irrespective of the relative investment propensities of multinational firms or the extent to
which they transfer technological expertise.

The existing empirical evidence on the impact of outward investment on exports is mixed. In
spite of the widespread discussion of the possible linkages between trade and investment
there have been relatively few empirical studies that have sought to investigate the
relationship between outward investment and the export performance of the investing
country over time. The majority of existing studies adopt a cross-sectional approach, utilising
detailed firm and industry level data on the activities of US and Swedish multinationals
(Lipsey and Weiss, 1981 and 1984; Blomström et al, 1988). The balance of this evidence
points to a positive relationship for both Sweden and the US between foreign affiliate sales
and exports, although a negative relationship was obtained for a minority of US industries.3

More recent studies suggest that the relationship between foreign production and exports
may be very different when viewed in a time series context. For instance Ramstetter (1991)
obtains a significant negative relationship between foreign affiliate activity and parent
company exports using US industry-level data for export growth between 1977 and 1982,
suggesting the need for further research within a dynamic context. Many US foreign
affiliates now have a relatively high local content in their output, possibly reflecting the
relative age of many investments and the extent to which affiliates have come to resemble

1
There is little evidence of a negative relationship between inward investment and export performance
in developed economies, although in theory such a relationship is possible. For example, exports of
intermediate products from the host economy may decline if an importing country relocates assembly
activities to the exporting country.
2
A related point is made by Krugman (1989) who argues that the apparently high elasticity of demand
faced by producers in fast growing economies such as the Asian NICs reflects an expansion in the range
of goods produced, with ‘aggregate’ exports changing in a manner consistent with an outward shift in
demand.
3
Useful surveys of a number of other early studies are given by Cantwell (1994) and WTO (1996).

6
their locally-owned competitors (McGuire, 1995). Thus any initial stimulus to exports of
intermediate goods may fade over time. Svensson (1996) also obtains evidence of a
substitution effect using more recent Swedish data, with exports to third parties from the
foreign affiliates of Swedish companies being at the expense of exports from the parent firm.
Previous research using data from the 1970s and early 1980s had typically concluded that
FDI had a complementary net effect on domestic exports.

A similar result is obtained by Blake and Pain (1994), using time series data for the UK.
Multivariate cointegration techniques were employed to establish that there is an unique,
stable long-run relationship between UK exports, market size, relative prices, net FDI and
proxies for relative product quality, with net inward (outward) foreign direct investment
shown to have improved (worsened) export performance over time. However the estimated
elasticity was small, with a 1 per cent rise in the net stock of inward investment ultimately
raising the volume of exports by around 0.15 per cent for a given market size.

Other studies suggest that the time series relationship between outward investment and
exports may vary across countries. Eaton and Tamura (1996) employ a gravity-type model to
explore the choice between exports and foreign investment, using annual data on Japanese
and US exports and FDI to 72 other countries between 1985 and 1990. Their empirical
results highlight some interesting distinctions between the US and Japan. For both countries
direct investment is favoured over trade with more distant countries. However whilst there is
some evidence that US FDI rises relative to exports as destination countries become more
advanced, Japanese exports and FDI show the opposite pattern. Pfaffermayr (1994 and 1996)
also finds evidence of a significant complementary relationship between exports and FDI for
Austria, with causation in both directions.

Overall, there does not appear to be any single conclusion regarding outward FDI and
exports that can be drawn with confidence from the range of studies we survey. As might be
expected the results appear to be sensitive to the choice of explanatory variables and the time
period of study. The recent WTO (1996, pg.54) survey concluded that ‘there is no serious
empirical support for the view that [outward] FDI has an important negative effect on the
overall level of exports from the home country’. It seems clear from our review of the
literature that such a view can only be justified from a relatively narrow selection of existing
studies. On balance the evidence from cross-section studies and panel studies with a limited

7
time dimension suggests that the two are complements, whereas studies with a greater time
dimension obtain stronger evidence that the two are substitutes.4

III. The Empirical Model

The underlying export demand relationship which lies at the heart of our empirical analysis
can be expressed as:

ln(Xit) = αi + βiln(Sit) + δiln(RPit) + ηiln(RQit) + γiln(OUTit) + ϕiln(INit) + εit [1]

for t=1,....n, where Xit is the total volume of manufactured exports from country i at time t, S
is a measure of world demand, and RP is the relative price of home country exports. If β=1,
then (1) becomes a relationship for the export share and can be used to account for changes
in export performance. This restriction is explicitly tested in the empirical work. The model
extends the basic demand model used in Anderton (1991) and Landesmann and Snell (1993)
by allowing export demand to be affected by both the non-price characteristics of national
products and the product range. In order to capture these factors indicators of product quality
(RQ) and the constant-price stocks of outward and inward foreign direct investment for the
exporting country (OUT and IN) are included in the model. Country-specific fixed effects αi
allow for unobserved influences that remain constant over time. This could include
characteristics and preferences which are individual to the country but are not explicitly
included in the model. All other influences will be contained in the disturbance term εi,t . The
FDI terms allow for the possibility that the level of exports may change as a consequence of
production relocation even if the level of foreign demand and the other characteristics of
domestically produced goods remain unchanged. A related approach is adopted by Blake and
Pain (1994).

The relative price measure uses home country export prices relative to a (double) weighted
average of the prices of competing countries on world markets. World demand is based on a
weighted average of import volumes in the main export markets of each country, providing
an indicator of potential market size (Blake and Pain, 1994). The use of a country-specific
measure is preferred to the use of a single aggregate measure derived from the total level of
world trade as the latter will overstate the actual growth in the potential markets open to
many countries. For instance the decision of a Japanese firm to relocate from Japan to within

4
It is also worth noting that all the studies surveyed above do not consider the impact of FDI on trade in
services. Even if outward investment does displace exports of finished goods, it might still raise exports
of management and financial services. We do not pursue this question in the present paper, although it is
undoubtedly worthy of further research.

8
East Asia and export finished goods back to Japan raises the recorded level of world trade.
However, such trade is unlikely to be captured by any producers other than the original
Japanese firm.

Non-price competitiveness is often a reflection of technological differences, although it may

also reflect intangible benefits such as brand loyalty. Previous cross-country studies on the
role of relative technological advantages point to the importance of including proxies for
product quality (Fagerberg (1988), Magnier and Toujas-Bernate (1994)). Such measures
allow differences in national innovation performance to affect export shares over time.

One empirical problem is the difficulty of choosing an appropriate proxy for innovation.
Whilst there are some direct measures of innovation for single countries, such as the SPRU
survey of innovations for the UK, such data are not available on a comparable basis across
countries. The standard measures used for innovation are based on either national R&D
expenditures, or patents registered in the US. The latter is the preferred source of patent data
as it includes patents originating in a large number of countries which are internationally
comparable.5 Our measure is based on manufacturing patents taken out in the US by
companies resident in each exporting country, relative to a weighted average of patents taken
out in the US by competitors. As there may be a lag before the innovations come into
operation the patents, registered by the date granted, are cumulated over three years. Relative
product quality (denoted RQ), proxied by patents, is expected to have a positive impact on
the long run export share.

In the empirical work the level of foreign-owned operations is proxied by the stock of
foreign direct investment at constant prices. Although this will understate the level of
multinational activity, since it does not include operations financed by funds raised from
outside the home country (of the investor), the approximation is unavoidable given the
relative paucity of consistent cross-country time series data on the activities of the foreign
affiliates of domestic companies. Indeed a considerable amount of work has been required in
order to construct a consistent series for the investment stock for a number of economies in
our panel. Further details on our data sources are provided in an appendix to this paper. The
constant price series were obtained by deflating the nominal stocks by national GDP
deflators and converting the resulting series into dollars using bilateral exchange rates in a
common base year.

5
Each proxy measures a different aspect of innovation; R&D expenditure is an input into the innovation
process, while patents are an output from it, and both have a number of limitations as proxies (Griliches,
1980). However, evidence from the USA (Acs and Audretsch, 1988) indicates a strong positive
correlation between company R&D expenditure, patents and actual innovations.

9
All the variables used are in logarithms. Eleven countries are considered in our sample, the
US, Japan and nine EU economies - the UK, Germany, France, Italy, Spain, Sweden,
Finland, the Netherlands and Denmark. We use semi-annual data from the second half of
1971 to 1992, and pool the data, giving a panel with 473 observations in all. The panel size
is partially determined by the availability of sufficient information on direct investment to
allow us to construct consistent time series estimates of inward and outward stocks. One
limitation of our data is that we have to use aggregate direct investment rather than just
manufacturing investment. This reflects a lack of detailed information on the sectoral
composition of investments in most countries before the 1980s.

We extend [1] to allow for adjustment costs and thus estimate a dynamic panel model. We
experiment with three particular specifications; the first is a conventional dynamic model of
the form:

∆ln(Xi,t) = αi + λ1∆ln(Si,t) + λ2∆ln(RPi,t) + λ3ln(Xi,t-1) + λ4ln(Si,t-1) + λ5ln(RPi,t-1)

+ λ6ln(RQi,t-1) + λ7ln(OUTi,t-1) + λ8ln(INi,t-1) + vi,t [2]

Here dynamics in exports, world demand and relative prices are included.6 The model allows
for country-specific fixed effects, but imposes homogeneity on the slope parameters.7
Restrictions of this type will yield biased and inconsistent parameter estimates if significant
heterogeneity is present in the panel (Pesaran et al., 1996). This is particularly likely if non-
stationary regressors are being used and the long-run relationship differs between panel
members, since the pooled regression will introduce a non-stationary component into the
error term. The diverse predictions of the theoretical models discussed above suggest that
there could easily be heterogeneity in the relationship between trade and international
investment across countries.

An alternative procedure is to use the mean-group estimator, with the model being estimated
separately for each panel member and the ‘panel’ coefficients being obtained by averaging
the individual group estimates. Such an estimator provides consistent slope estimates even if
significant heterogeneity is present.

6
We do not include the growth rates of either the relative quality or direct investment variables as some
semi-annual data has been obtained through interpolation, rather than by simply averaging (or
aggregating) published quarterly data. Lagged measures of foreign direct investment are used in an
attempt to avoid any problems with potential endogeneity. The validity of such an approach rests on the
assumption that there is an unique long-run relationship between the variables of interest within each
country.
7
Although use of a fixed effects estimator can lead to bias in dynamic panels (Nickell, 1981), this is
unlikely to be a significant problem here because of the large time dimension of our panel.

10
In this case [2] becomes:

∆ln(Xi,t) = αi + λ1i ∆ln(Si,t) + λ2i∆ln(RPi,t) + λ3iln(Xi,t-1) + λ4iln(Si,t-1) + λ5iln(RPi,t-1)

+ λ6iln(RQi,t-1) + λ7iln(OUTi,t-1) + λ8iln(INi,t-1) + ui,t [3]

A convenient reparameterisation of [3] is the non-linear model [4]:

∆ln(Xi,t) = αi + λ1i∆ln(Si,t) + λ2i∆ln(RPi,t) + λ3i[ln(Xi,t-1) - βiln(Si,t-1) - δiln(RPi,t-1) - ηiln(RQi,t-

1)

- γiln(OUTi,t-1) - ϕiln(INi,t-1)] + ui,t

[4]

The form of [4] allows us to test the imposition of common long-run parameters across the
panel, as well as the imposition of common parameters on the dynamic terms.8

IV. The Pattern of Export Shares And FDI

In this section we briefly discuss the broad trends in export performance and FDI in our
chosen sample of countries. The export shares of each country are reported in the upper
panel of Table 1, with countries ranked by their share in 1993. These numbers differ slightly
from those we use in the empirical work as they are value shares, with each country’s exports
expressed as a proportion of a common measure of market size, total world exports. Most
countries in our sample have experienced a decline in their overall trade share over the thirty
year period, with the decline being particularly marked for the US, Germany, France, the UK
and Sweden. In contrast, Japan, Spain and, to a lesser extent, Italy have all experienced some
improvement in market share. Two of the smaller countries, Denmark and Finland, have
managed to maintain a roughly constant market share over time.

The pattern of direct investment across the countries in our sample is reported in the lower
panel of Table 1. Each country’s inward and outward stock is expressed as a share of the
total investments by all 11 countries. Taken together the group of countries are net outward
investors in the rest of the world. The only common element is that the ratio of the stocks of
inward and outward investment to GDP is higher at the end than at the start of the sample
period. Three of the countries considered, the US, UK and Netherlands had relatively large

8
Non-linear dynamic models of this kind are frequently used in the estimation of dynamic consumer
demand models, see Pain and Westaway (1996).

11
stocks of outward investment in 1970, and have continued to invest heavily overseas since
that time, even whilst the level of inward investment has risen.

12
 Table 1. World Trade And Investment Shares

Value Shares of World Trade In Manufactures

1963 1973 1983 1993
USA 17.4 12.8 12.4 13.4
Germany 15.7 17.0 13.6 12.4
Japan 6.1 10.0 13.4 13.0
France 7.1 7.3 6.4 6.0
Italy 4.7 5.3 5.9 5.6
UK 11.4 7.0 5.5 5.3
Netherlands 3.3 3.9 3.0 2.9
Spain 0.3 0.9 1.3 1.7
Sweden 2.7 2.6 2.0 1.6
Finland 0.8 0.8 0.9 0.7
Denmark 0.9 1.0 0.8 0.8

Value Shares of Direct Investment Stocks

Outward Direct Investment Inward Direct Investment
1970 1980 1995 1970 1980 1995
USA 60.4 49.4 32.9 22.6 33.2 38.1
Germany 4.7 9.7 11.0 20.6 14.6 9.1
Japan 0.8 4.2 14.3 1.3 1.3 1.2
France 4.2 5.3 9.4 15.1 9.0 11.0
Italy 1.5 1.6 4.0 7.9 3.6 4.4
UK 17.2 18.1 14.9 19.8 25.2 16.5
Netherlands 8.9 9.5 4.0 6.2 7.7 6.9
Spain 0.8 0.3 1.6 0.6 2.1 8.7
Sweden 1.2 1.3 2.9 3.6 1.4 2.2
Finland 0.1 0.2 0.7 0.5 0.2 0.4
Denmark 0.2 0.5 0.9 1.8 1.7 1.5
All 11 / World n/a 86.7 78.5 n/a 51.9 55.7
Source: World Trade Organisation (1996, Table II.11), UNCTAD (1996, Annex Tables 3
and 4) and authors’ calculations.
Notes: The FDI data are shown as a proportion of the total inward and outward FDI stocks
of all eleven countries. Total world figures are derived from UNCTAD estimates. The trade
data express exports as a share of total world trade.

13
The experience of the US and UK in the 1980s is of some interest, in that both managed
some relative improvement in their export performance at a time when inward investment in
their economies was rising relatively quickly. Indeed the share of inward investment
attracted by the United States has risen steadily over time. In contrast the level of inward
investment in Japan has remained relatively low, throughout the period, even though
outward investment rose rapidly after 1980. A number of European countries, such as
Germany, France, Italy and Sweden, all had a net stock of inward investment in 1970,
reflecting post-war investments made by American companies. The growth of outward
investment only accelerated once capital controls were liberalised in the 1980s. By 1995 all
had a net stock of outward investment.

V. Econometric Results

The initial panel data results are summarised in Table 2, with the implied long-run
elasticities reported at the foot of the table. Country-specific fixed effects are included, but
not reported. We initially estimated two versions of model [3] using two different
estimators, the mean-group estimator and the standard panel within-group estimator.
Columns (2.1) and (2.3) allow the long-run demand elasticity to be freely estimated, whilst
columns (2.2) and (2.4) impose a unit elasticity.

The results are suggestive of the presence of significant heterogeneity. Most notably the test
for common slope parameters in the standard panel models (2.3) and (2.4) is decisively
rejected. The effect of enforcing slope homogeneity in the standard panel estimates is much
as expected given the analysis in Pesaran et al. (1996). The short run parameters on the
dynamic terms in world demand and relative prices appear to be consistently estimated, but
the coefficient on the lagged dependent variable is pushed towards zero. There is some
evidence that the heterogeneity may be arising from the direct investment effects, as the two
FDI stocks both appear significant in the panel estimates but are not significant in the mean-
group estimates, implying that there is no systematic relationship across countries between
FDI and exports.

In other respects the results from the mean-group estimators are encouraging. The long-run
world demand elasticity is insignificantly different from unity in (2.1) and there are
significant effects from both relative prices and relative quality. The relative price elasticity
of -1.13 per cent is considerably higher than that obtained in other cross-country studies such
as Carlin et al. (1997), and suggests that changes in the real exchange rate can have large
effects on trade performance if not offset by corresponding improvements in product quality.

14
 Table 2. Basic Panel Regressions

Dependent Variable: ∆ ln(Xi) Sample: 1971H2-1992H2

Mean-Group Estimates Panel Estimates

(2.1) (2.2) (2.3) (2.4)
ln(Xi)t-1 -0.5417 (0.074) -0.4891 (0.057) -0.1666 (0.020) -0.1579 (0.020)

ln(Si)t-1 0.6184 (0.089) 0.4891 (0.057) 0.1992 (0.027) 0.1579 (0.020)

ln(RPi)t-1 -0.5750 (0.088) -0.5023 (0.071) -0.2370 (0.031) -0.2248 (0.031)

ln(RQi)t-1 0.1007 (0.057) 0.1409 (0.051) 0.0379 (0.010) 0.0367 (0.010)

∆ ln(Si)t 0.8522 (0.073) 0.7935 (0.079) 0.8118 (0.069) 0.7796 (0.068)

∆ ln(RPi)t -0.3633 (0.084) -0.3481 (0.076) -0.3977 (0.053) -0.4028 (0.053)

ln(FDIOUTi)t-1 -0.0104 (0.033) 0.0036 (0.027) -0.0170 (0.006) -0.0082 (0.004)

ln(FDIINi)t-1 -0.0082 (0.031) 0.0141 (0.027) 0.0101 (0.006) 0.0158 (0.005)

R2 0.412 0.407

S.Error 0.0365 0.0367

Common slopes 0.0035 0.0015
[p value]
Fixed Effects LR(10)=80.27* LR(10)=75.96*
Long-run Elasticities

Demand 1.1952 (0.153) 1.0000 (-) 1.1956 (0.085) 1.0000 (-)

Prices -1.1379 (0.141) -1.1483 (0.177) -1.4231 (0.162) -1.4231 (0.172)

Quality 0.1628 (0.097) 0.2604 (0.080) 0.2274 (0.054) 0.2322 (0.058)

Outward FDI -0.0097 (0.057) 0.0206 (0.050) -0.1020 (0.033) -0.0520 (0.026)

Inward FDI -0.0586 (0.062) -0.0054 (0.049) 0.0608 (0.034) 0.1002 (0.030)

Note: standard errors in parentheses

15
One possible explanation for our results is that many previous studies have excluded
indicators of product quality. If quality improves, this may be signalled by both a rise in
relative prices and a rise in export demand. Failure to include a quality indicator might result
in some downward bias to the estimated relative price elasticity, since demand has risen
despite an apparent loss of price competitiveness. A second explanation is that many cross-
country models of this kind often omit long-run levels effects, and simply consider dynamic
terms (Fagerberg, 1988). The impact relative price elasticity in our model is only -0.36 per
cent, well below the implied long-run elasticity.

An important role is also found for the relative technology measure. The size and
significance of this variable confirms the importance of including non-price characteristics in
trade demand models, and the extent to which national differences in technology can
influence trade performance. The patents elasticity is estimated at between 0.15-0.25 per
cent, broadly in line with the cross-country evidence of Fagerberg (1988) and Magnier and
Toujas-Bernate (1994) and the UK evidence in Blake and Pain (1994). In contrast the
average patents elasticity of 0.43 per cent found by Amable and Verspagen (1995) is higher
than that found here, although this may reflect differences in the degree of sectoral
disaggregation.9

Further details on the properties of the individual country regressions employed to calculate
the mean-group estimator are given in Table 3. In a number of countries it can be seen that
the two FDI measures are jointly significant.10 Taken with the aggregate mean-group results
the single country evidence suggests that the relationship between exports and FDI must vary
significantly between countries. The diagnostic tests provide some asymptotic evidence in
favour of cointegration, and thus the existence of a meaningful long-run relationship, in all
countries, using the test proposed by Dolado et al. (1992).11

9
In contrast to Amable and Verspagen we only impose the market share restriction on the long-run
world trade parameter. Imposition of a unit coefficient on the market growth term in our model would be
rejected by the data.
10
LR is a likelihood ratio test corrected for sample size as proposed by Evans and Savin (1982). In
principle correction factors can also be applied to the critical values of the chi-square distribution in
order to obtain an exact test. This would not alter any of the main conclusions from the use of the
unadjusted asymptotic critical values with the test statistics reported here.
11
Strictly this is only valid if the cointegrating relationship is unique. Blake and Pain (1994) establish
that there is a single cointegrating vector amongst these variables for the UK, but it remains to be
established for all the other countries. One difficulty in testing this is that the results from using a
Johansen analysis will potentially be affected by the need to interpolate some of the data in a number of
countries.

16
17
 Table 3: Properties of Model (2.2)

Cointegration Significance of FDI LM(2) NORM(2) ARCH(1)

(tECM test)

USA -5.48 LR(2)=10.34** 1.36 1.74 0.02

Germany -2.94 LR(2)=5.81* 4.79 1.49 0.40

France -5.17 LR(2)=24.48** 7.02** 2.79 0.01

Spain -5.39 LR(2)=254.9** 4.85* 0.29 0.06

Finland -2.68 LR(2)=2.43 0.20 1.35 7.39**

Sweden -3.04 LR(2)=1.82 5.27* 1.07 1.65

Netherlands -4.06 LR(2)=2.12 1.49 3.02 0.09

UK -4.50 LR(2)=14.50** 0.91 0.93 0.09

Italy -3.13 LR(2)=11.16** 4.49 9.86** 0.33

Japan -3.37 LR(2)=5.71* 0.97 0.49 0.27

Denmark -4.34 LR(2)=43.19** 3.67 2.66 2.17

Notes: A ** indicates significant at the 5% level, * indicates significant at the 10% level. All
the cointegration tests are significant at the asymptotic 5% level.

The evidence for a significant relationship between exports and FDI is is not simply a
reflection of correlations induced by the decision to convert both into dollar series. Given
that the conversion of the domestic currency constant price series uses bilateral dollar
exchange rates in a base year, the use of a log-linear model and the inclusion of country-
specific fixed effects ensures that the results are invariant both to the choice of currency and
choice of base year.

It is possible that the biases arising from heterogeneity in the panel estimates in Table 2
simply reflect the imposition of a common impact effect from, for instance, outward foreign
direct investment in [2] (λ7), as well as the imposition of a common long-run effect (-λ7/λ3).
To investigate this further we turn to the non-linear model [4], which distinguishes the long
run parameter (γi) from the impact parameter (-λ3iγi). In this model it is possible to impose
cross-country restrictions giving a common long-run response, whilst allowing for short-term

18
differences in the dynamics. Such a model is equivalent to the Pooled Mean Group estimator
proposed by Pesaran et al.(1997).

The initial step was to check the validity of the findings from Table 2 by testing the
restrictions required to treat the data as a panel, with common slope parameters imposed
across all countries. Again these restrictions were decisively rejected against the unrestricted
model [LR(80)=176.13], as were similar restrictions on the long-run parameters alone
[LR(50)=127.84], suggesting that the export demand relationship varies significantly
between countries even in the long-run.

However there was clear evidence of a significant relationship between export and direct
investment, at least in some countries, as the joint exclusion of all the direct investment
effects (γi = ϕi = 0) was rejected [LR(22)=46.83]. The impact of direct investment was found
to differ across countries, with the imposition of separate, common long-run parameters on
outward and inward investment also being rejected [LR(20)=90.80]. In contrast, as might be
expected from the results in Table 2, it was possible to impose common parameters on the
remaining long-run determinants of exports, market size, relative prices and relative patents
[LR(31)=43.01], with the world trade elasticity restricted to unity (βI=1).

For nine out of the eleven countries it also proved possible to impose equal and opposite
long-run coefficients on inward and outward direct investment within individual countries,
as found for the UK by Blake and Pain (1994) [LR(9)=11.34]. This restriction, giving a
relationship between net investment and exports, was only rejected for the United States and
Spain. Finally it was possible to impose common parameters on the net FDI variables for two
sub-groups, one with a negative effect from net outward investment and one with a positive
effect from it [LR(5)=4.39].

The full set of long-run parameters from the final restricted panel are reported in Table 4,
along with the parameter on the equilibrium correction term (λ3i). In all cases there is
evidence that the long-run relationships are reasonably well determined, with the coefficient
on the equilibrium correction term being significantly different from zero. Attempts at
imposing a common coefficient on the equilibrium correction parameter were rejected,
implying that the speed of adjustment to changes in demand and the real exchange rate
differs significantly across countries.

19
 Table 4. Export Performance and Foreign Direct Investment
Tests Of Restrictions
Exclusion of FDI LR(22) = 46.83*
Common Slope Parameters LR(80) = 176.13*
Common Long-Run Parameters LR(50) = 127.84*
Common Long-Run Market Size, Prices & Quality LR(31) = 43.01
Common Long-Run FDI LR(20) = 90.80*
Country-Specific Net FDI LR(9) = 11.34

Dependent Variable: ∆ln(Xi) Sample Period: 1971H2-1992H2

Common Long-Run Parameters
βi 1.0 (-)
δi -1.3024 (0.096)*
ηi 0.1438 (0.033)*
Country-Specific Parameters
Outward FDI (γγi) ϕi )
Inward FDI (ϕ Equilibrium
λ3i)
Correction (λ
USA -0.2480 (0.035)* 0.1653 (0.023)* -0.2749 (0.049)*
Spain -0.2104 (0.045)* 0.2937 (0.019)* -0.7708 (0.131)*
UK -0.0746 (0.017)* 0.0746 (0.017)* -0.1522 (0.058)*
Germany -0.0746 (0.017)* 0.0746 (0.017)* -0.1720 (0.058)*
France -0.0746 (0.017)* 0.0746 (0.017)* -0.5314 (0.102)*
Sweden -0.0746 (0.017)* 0.0746 (0.017)* -0.2889 (0.068)*
Netherlands -0.0746 (0.017)* 0.0746 (0.017)* -0.3278 (0.092)*
Japan 0.0952 (0.010)* -0.0952 (0.010)* -0.2985 (0.085)*
Italy 0.1906 (0.020)* -0.1906 (0.020)* -0.3033 (0.071)*
Denmark 0.1906 (0.020)* -0.1906 (0.020)* -0.4143 (0.096)*
Finland 0.0012 (0.047) -0.0012 (0.047) -0.1837 (0.045)*

R 2 = 0.518; Fixed Effects: LR(10)=38.75*

Note: standard errors in parentheses.

20
There are a number of interesting points about the restrictions accepted for the panel model.
First, the acceptance of a unit world trade elasticity indicates that the additional variables
included to capture product quality and production relocation can successfully account for
the observed movements in trade shares, in contrast to models which exclude such variables,
and rely on relative prices and market size alone (Landesmann and Snell, 1993). The impact
of relative prices and relative quality remains close to that derived from the mean-group
estimates in Table 2, with respective elasticities of -1.30 and 0.14 per cent. Second, the
heterogeneity of direct investment effects predicted in Section II, and apparent from the
findings in Table 2, is readily observed in Table 4. As the results show, the direct investment
effects vary both in sign and magnitude according to the country under consideration. This
may well reflect the range of factors influencing the decision to produce overseas, and the
different forms of direct investment which occur. The impact of service sector investments
on export performance might be expected to differ from that of investments within tradable
sectors for example.12

On balance the evidence in Table 4 suggests that outward direct investment leads to a
reduction in export market share, for a given market size, whilst inward FDI results in an
improved export performance. The estimated elasticities are generally not that large,
although there is some significant variation between countries. France, the UK, Germany, the
Netherlands and Sweden all have the same negative effect from net outward FDI, implying
that a ten per cent rise in the net stock of outward foreign direct investment will ultimately
reduce the export share by 0.75 per cent.

Substantially larger effects from outward investment are obtained for the US and for Spain,
with a one per cent rise in the stock of outward direct investment leading to a decrease in
export share of 0.25 per cent for the USA and 0.21 per cent for Spain. These two countries
also experienced large effects from inward FDI, although the relative size of the two effects
varies between the two countries. For the USA the positive effect on trade shares from
inward FDI is half the negative one resulting from outward FDI. For Spain the opposite is
true, with Spain experiencing a positive effect from inward FDI nearly 50 per cent higher
than its negative effect from outward FDI. This indicates the extent to which the higher level
of inward investment in Spain following moves towards greater integration within the then
European Economic Community had a beneficial effect on Spanish export performance.

12
We hope to be able to investigate this issue further in subsequent work. The lack of consistent cross-
country time series data on foreign direct investment disaggregated by sector prevents us from doing so
across our present sample.

21
In contrast, net outward investment improves export performance for Japan, Italy and
Denmark, with the latter two countries having a common elasticity of 0.19 per cent. It is
possible that over the period under consideration, inward investment in these countries has
been aimed at the relatively closed domestic market, rather than using the country as an
export base. The finding for Japan is consistent with what is known about the high level of
capital goods exports by parent companies to Japanese affiliates overseas, particularly in East
Asia (Kojima, 1995). For Denmark and Italy the results may provide an explanation as to
why domestic producers have been able to maintain their share of world markets during their
participation in the ERM, even though the trade shares of fellow participants such as France
and Germany have declined.13 Finally, for Finland direct investment effects do not appear to
be significant, either for inward or outward investment, although it would be possible to
impose a common coefficient with the large group with a negative effect from net outward
investment.

The statistical adequacy of the restricted panel model reported in Table 4 was investigated
using a test of second-order serial correlation (as semi-annual data is being used). An
auxiliary regression procedure was adopted, with the lagged own-country residuals being
added in as additional regressors.14 The coefficients on the lagged residuals were jointly
insignificant [LR(2)=4.04], suggesting that there is no evidence of significant serial
correlation.

We also tested for heteroscedasticity by investigating whether there was evidence of a

change in the error variance over time common to all panel members. To do this we used the
second test proposed by Barrell and Pain (1997, Appendix A), with the squared residuals
from the preferred model being regressed on a constant term and a set of (n-1) column
dummies set to unity for observation j of each panel member. A variable deletion test
indicated that the coefficients on these dummies were jointly insignificant [LR(42)=32.63],
suggesting that the errors from the preferred model are homoscedastic. Taken together, the
results of these diagnostic tests suggest that the restricted panel model in Table 4 can be
regarded as a statistically adequate model of export performance.

13
It is also of interest to note that at the end of our sample period countries such as Japan and Italy where
we obtain a positive effect from outward investment had a much higher proportion of investments in the
tertiary sector than other countries such as the United States, United Kingdom and Germany where we
obtain a negative effect on outward investment (OECD, 1996). Investments in the tertiary sector are
more likely to support exports rather than substitute for them.
14
The use of lagged residuals implies that either the estimation period should be reduced by one year or
that values should be supplied for 1970H2 and 1971H1, since the estimation period begins in 1971H2.
As the former course would result in the loss of twenty-two observations we use the asymptotically valid

22
We have continually referred to our estimated equations as an export demand model, even
though variables such as direct investment could also affect export supply. Whilst it should
be clear that we have not estimated a reduced form model, since prices are still included in
an equation where quantities are the dependent variable, it is possible that our model is one
of export supply rather than export demand. To investigate this we tested whether a measure
of relative export profitability, defined as export prices relative to domestic manufacturing
prices, was significant if added to the model in Table 4. If export prices rise relative to
domestic prices than it would be expected that export supply would change, with production
being switched to export markets, particularly in small open economies. In fact the export
profitability terms were jointly insignificant across the eleven countries [LR(11)=14.52].
Hence, on balance it would appear that our basic model is capturing export demand
behaviour.

V.1. Accounting For Changes In Export Share

In order to evaluate the extent to which FDI can help to account for changes in export
performance over time, we can decompose the change in trade share into the contributory
factors included in our model. These factors are relative prices, relative quality, outward and
inward investment and ‘other’ changes which are otherwise unexplained and reflected in the
residual. The long-run solution of our basic model can be expressed as:

η γ ϕ
X it = α Sit RPitδ RQ it OUTit IN it [5]

Thus the growth in the export share of country i between time t and time t+n that can be
accounted for by our model is given by:

η γ ϕ
( X / S ) i, t + n RPitδ + n RQ it + n OUTit + n IN it + n
= [6]
η γ ϕ
( X /S)it RPitδ RQ it OUTit IN it

This expression can be used to obtain estimates of the contribution of each of the main
explanatory variables to the change in the export share for each country.15 In doing so
account also needs to be taken of the dynamic nature of the estimated model, see Pain (1997,
Appendix). Thus in practice the estimates of the extent to which movements in, say, relative
prices can account for the change in the stock of inward investment between 1982 and 1992

procedure suggested by Godfrey (1988, p.117) and set the pre-sample residuals to zero, their value under
the null of no serial correlation.
15
For example, the contribution of relative price movements can be calculated from (RPi,t+n/RPi,t)δ, where
δ=-1.3024.

23
reflect the extent to which a distributed lag of relative prices from 1980 to 1982 differed
from an equivalent distributed lag of relative prices from 1990 to 1992.

Illustrative results for the period from 1982-92 in some of the key economies in our panel are
summarised in Table 5, using the parameter estimates from Table 4. The reported
contribution from FDI gives the net effect from movements in outward and inward
investment. Taking the United States figures for 1982H2-92H2 as an example, we find the
actual trade share rose by 22.5 per cent. This is equivalent to an improvement in market
share from, say, 10 percentage points to 12.25 percentage points.16 Movements in relative
prices over this period, helped by the substantial depreciation of the dollar, should have
raised market share by 17.1 per cent, other things being equal. On balance growth in the FDI
also raised market share significantly, by 9 per cent, since inward investment grew more
rapidly than outward investment. However this was offset by the impact of a decline in
relative quality. These three factors together (i.e. multiplying the three growth rates) imply
that the trade share should have improved by 24.8 per cent. Thus there is an implicit residual
factor which has varied sufficiently to reduce export share by 1.8 per cent
[100*(1.225/1.248 - 1)].

Table 5. Accounting For Changes In Export Performance 1982 -1992 (per cent)

Trade Share Contributory Factors

Change
Prices Quality FDI
USA 22.5 17.1 -2.2 9.0
Japan -15.7 -16.7 9.8 2.5
Germany -14.4 -10.1 -0.7 -1.7
France -8.5 -4.7 -0.1 -4.2
UK -3.3 4.4 -2.2 1.0
Sweden -17.7 -5.5 -4.5 -5.8
Spain 4.2 -28.0 7.1 27.6

16
The movements in export share differ from those reported in Table 1 as we are using data at constant
prices and each economy has a different measure of world market size.

24
The first point that stands out from Table 5 is how important movements in the real exchange
rate can be in explaining movements in export shares, even over a decade or more. The
depreciation of the US dollar and, to a lesser extent, sterling from their peak levels in the
early 1980s is estimated to have had a significant positive effect on US and UK export
performance. In contrast much of the decline in Japanese market share can be accounted for
by the ongoing sustained appreciation of the Yen in real terms. All the four continental
European economies have also experienced some appreciation in their real exchange rates
over the period shown.

The impact of movements in relative quality is generally small, with the exception of Japan
and Spain, whose patent levels have grown more rapidly than those of their competitors. The
impact of FDI is mixed, reducing export shares in three countries and raising export shares in
the other four. The growth in outward investment from Germany, France and Sweden since
the early 1980s has been faster than the growth of inward investment, giving a negative
impact on export performance. In contrast, inward investment has grown more rapidly than
outward investment in the US, UK and Spain, helping to improve export performance.
Inward direct investment is clearly a particularly important element behind the growth of
Spanish exports since the early 1980s. Finally, we also estimate that FDI raised Japanese
exports over this period. This reflects the combination of the positive coefficient on net
outward investment, along with the growth in such investments, particularly in the middle of
the 1980s.

V.2. Has The Trade-Investment Relationship Changed Over Time?

One possible explanation for the differences between our findings and those from earlier
cross-sectional studies on data in the 1960s and 1970s is that the effects of foreign direct
investment depend on the maturity of the investments and the accumulation of investments
over time. Long-established foreign affiliates increasingly come to have a relatively high
local content in their output after having initially been established with capital goods
imported from the investing country. It is also well known that the evolution of capital
market controls has had an important impact on the level of inward and outward investment
in many economies, particularly within Europe since 1986 (Pain, 1997; Pain and Lansbury,
1997).

One difficulty in testing whether the relationship between trade and investment has changed
over time is that the timing of any structural change may differ across countries, because of
differences in the timing of capital market liberalisation and trade liberalisation.

25
 Table 6. Allowing For Structural Change in the FDI-Export Relationship

Date Outward FDI Elasticity Inward FDI Elasticity

1971-1985 0.0402 (0.060) 0.0569 (0.121)

1986-1992 -0.1363 (0.168) 0.0989 (0.061)

Notes: Standard errors in parentheses.

As a first step, we returned to equation [4], and allowed the parameters on the intercept, the
equilibrium correction term and the two direct investment stocks to change from 1986
onwards. The resulting mean-group estimates of the long-run FDI elasticities are reported in
Table 6.

The results suggest that the relationship between FDI and exports may have changed in
recent years, with a more negative coefficient being obtained on outward investment and a
larger, positive effect being obtained for inward investment since 1986. It is not possible to
draw any firm conclusions as both sets of parameters are not particularly well determined,
although the parameter on outward investment from 1986 is more than two standard errors
away from the parameter prior to that point. These results must be regarded as preliminary.
However they do suggest that one of the reasons why we find different results from earlier
papers may simply be that we have been able to take account of more recent developments
arising from the rapid growth of direct investment in recent years. In a separate analysis for
the EU economies Pain and Wakelin (1998) report evidence that the trade and investment
relationship appears to have shifted since the advent of the Single Market Programme.

VI: Conclusions

In this paper we have sought to investigate the time series relationship between
manufacturing exports and foreign direct investment for a number of OECD economies. Our
results suggest that export performance is significantly affected by changes in the location of
production, even after allowing for the impact of changes in relative prices and quality on
export demand. We can accept the restriction of a long-run unit elasticity on market size,
implying that the inclusion of direct investment helps to solve the widely debated puzzle
over the factors responsible for observed movements in the trade shares of many OECD
countries. The growth of inward investment is found to be particularly important in attempts
to explain the improvements in US and Spanish export performance since the early 1980s.

26
We find evidence of heterogeneity in the linkages between investment and exports across
countries, as might be expected given the diverse motivations that are known to drive
investment decisions. On balance our evidence points to a small negative impact of outward
investment on home country export performance, offset by a corresponding positive impact
from inward investment on host country export performance. This evidence is consistent
with the majority of the findings from the small number of existing time series studies, but is
contrary to the findings from earlier cross sectional studies using data in the 1970s. One
possible reason for this is that the trade and investment relationship has evolved over time.
In the 1960s and 1970s investment was often undertaken to bypass barriers to market entry,
and hence had little effect on exports of finished products. More recently trade and capital
market barriers have been lowered and hence investment is more likely to represent a
deliberate decision to serve foreign markets from foreign production, at least in the tradable
goods sector. We report some preliminary evidence consistent with this hypothesis, which
shows that the negative relationship between outward investment and export performance
has strengthened over time.

There are a number of ways in which this analysis might usefully be extended. For example,
a more disaggregated approach would allow us to ask whether outward investment in
manufacturing facilities had a different effect from outward investment in service sectors
designed to improve market access. It would also be of interest to explore whether the short-
run relationship between investment and exports differs significantly from the long-run
relationship considered in this paper. The primary difficulty here is one of data availability,
particularly across countries.

The relationship between international trade and investment also highlights the extent to
which a sole focus on trade statistics fails to provide an accurate picture of the relative health
of a country’s tradable goods sector (Blomström and Lipsey, 1989; Julius, 1991). If it is
more profitable for domestic firms to locate overseas, national income may still rise as a
results of profits earned abroad even if export performance is adversely affected. It would
thus be of use to place our findings within a wider general equilibrium analysis, possibly
using a structural macroeconometric model. We feel such a step is required before it is
possible to address the question of whether outward investment is simply ‘job exporting’. To
answer this question we also need to be able to say what is responsible for the higher level of
outward investment and whether the investment has any consequences for economic growth,
and hence the demand for imports in the host economies, and the income received by
domestic residents.

27
 Appendix. Foreign Direct Investment Data Sources
This appendix provides a short summary of the data sources we have used to construct the
national stocks of inward and outward direct investment for our sample countries. Where
national country sources are not readily available we have made use of two OECD
publications, the International Direct Investment Statistics Yearbook (1993-96, hereafter
refered to as OECD1) and Recent Trends In International Direct Investment (1987, refered
to as OECD2). Data from the latter publication were rescaled if there were differences in the
estimates in the link year between the two publications. Missing stock data were derived by
interpolation using annual flows of direct investment. We would expect that this
approximation will be more accurate for inward investment than outward investment, since
the latter may be affected by exchange rate fluctuations. Some additional estimates of FDI
stocks in 1980 can be found in the World Investment Report (UNCTAD, 1996).

Denmark - stock data for 1970-81 from OECD2; data for 1982-92 derived by interpolation
using flow data in OECD1.

Finland - stock data for 1982-92 from OECD1; stock data for 1970-81 from OECD2.

France - stock data for 1989-92 from Banque de France, La Balance Des Paiements De La
France; outward stock data for 1987-88 from OECD1; data from 1970-86 derived by
interpolation using flow data in La Balance Des Paiements De La France.

Germany - stock data for 1976-92 from Deutsche Bundesbank, Kapitalverflechtung mit dem
Ausland, various issues. Data for 1970-75 derived by interpolation using flow data in
OECD2. The inward investment series from 1970-88 was adjusted to account for a break in
definition in 1989.

Italy - stock data for 1983-92 from OECD1; stock data for 1971-82 from OECD2; 1970
figure derived using flow data in OECD2.

Japan - Bank of Japan data on disbursed stocks. Data for 1982-92 from OECD1. data for
1975-81 from OECD2. Data for 1970-74 derived by interpolation using flow data in
OECD2.

Netherlands - stock data for 1982-92 from OECD1; stock data for 1973-81 from OECD2.
Data for 1970-72 dervied by interpolation using flow data in OECD2.

Spain - stock data for 1983-92 from OECD1 (summary tables V and V1). Data for 1970-82
derived by interpolation using flow data from the IMF International Financial Statistics
Yearbook (1975-82) and OECD2 (1970-74).

Sweden - stock data for 1986-92 from OECD1; data for 1980 from UNCTAD (1996). Data
for 1970-79 and 1981-85 derived by interpolation using flow data from OECD1 and
OECD2.

United Kingdom - stock data from United Kingdom Balance of Payments.

28
United States - stock data for 1982-92 from OECD1; stock data for 1970-81 from OECD2.

29
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