Effect of FDI on Bilateral Trade


Contemporary literature refers to trade and Foreign Direct Investment (FDI) as alternative strategies. The debate is mainly between two notions: (1) that FDI displaces trade, and (2) that FDI and trade complement each other. Literature on FDI talks about the effect of foreign investments on trade. Lipsey (2002) mentions that outward FDI may decrease or increase (or have no effect on) exports of home country. These effects depend largely on the competitiveness of the host country and the motives behind investment by the home country in the host country. This paper is aimed at studying the effect of FDI on bilateral trade as well as effect at the aggregate level especially in the developed-developing nation paradigm.


Literature suggests that there are a number of motives on which FDI takes place across nations. Most of the firms in the developed countries will go for foreign investment once they fulfill their domestic market and they in order to grow will go to foreign market. In this case the main motive of a firm is to tap new markets. This entry of one firm in to a foreign market will create a bandwagon effect thorough which their competitors will also enter that market. Again, when the competition sets in the foreign market, companies will be forced to take cost reduction measures to achieve higher profits will look for other destinations which have lower cost of production and thus the motive will become efficiency seeking and the cycle continues (Sethi et al, 2003). FDI is the measure of foreign ownership of productive assets. FDI can be through investments, participation in management, JVs, M&A, transfer of technology/ knowhow/ skills, creating a subsidiary or a new firm. Studies have shown that FDI involves change in share of production of domestic firms and foreign firms; this is to say that FDI has an impact on countries domestic production and thus on employment, wage level and productivity. Several studies have shown that employment relocation due to FDI is not an universal phenomenon though observed in some countries but the universal phenomenon is higher pay levels of foreign owned firms compared to local firms this has spillover effect in the economy, same case is with respect to productivity but spillover effect in not universal (Lipsey, 2002).

Pantula and Poon (2003) talk about simultaneity bias in the FDI-Trade literature, they argue that, this bias may result in because of some other factor is the common source of variation for both FDI and trade. Under such condition the causality will be two directional. He found out through literature per capita GDP is one such measure which affects both FDI and Trade. They found significant relationship between FDI stock and both for imports and exports un US thus they are trade creating in nature, where as in case of Japan both stock and flow had significant effect on exports only.

Chakraborty and Basu (2002) used co-integration approach to find out the long run relationship between FDI and GDP in India, they found one-way causality flowing from GDP to FDI. While studying the short run dynamics of FDI, they found out that trade liberalization policy had a positive impact on FDI. With respect to Unit labor cost, they found that FDI in India is labour displacing. The authors took size of the market as one of the control variable. They studied long run and short run relationship between FDI and growth in India using co-integration approach.

James (1991) found that FDI in USA will likely improve trade balance (at economy level and at sectoral level (automobile, steel, electronic equip, chemicals)) over the longer term by replacing imports from the parent company, supply side effects of foreign direct invest (Technology or other competitive source) will increase exports.

There is also difference across countries in the motives of FDI. Brouthers et al (1996) argues that firms go to advanced industrialized nations market seeking where as they go for Developing nations for resource seeking. But the effect of FDI on host countries trade is non conclusive in the literature, we have evidence for positive, negative and neutral effects (Lipsey, 2002). The effect of FDI on country's trade depends on the motives of the FDI, thus the effect of FDI on trade is moderated by the motives of the firms which are investing in the host country. The market seeking FDI will result in trade deficit because the exports will decrease while that of factor seeking results in trade surplus for the home country (Brouthers et al, 1996).

Objective of the study

Keeping the above theories in our mind and in order to understand these relationships in India's context, an empirical approach is proposed based on analysis of bilateral trade and FDI (country wise data). In this paper we would like to test the effect of FDI (inward FDI) by 8 OECD countries on bilateral trade with India.

The specific hypotheses are

  • H0a: FDI has no impact on exports at the aggregate level
  • H0b: FDI has no impact on exports at the bilateral level
  • H0c: FDI has no impact on imports at the aggregate level
  • H0d: FDI has no impact on imports at the bilateral level


  1. For India in order to check the impact of inward FDI on Trade at the aggregate level, we have adopted the following models:
  2. Total Imports = f (inward FDI, GDP, Exchange rate)

    Total Exports = f (inward FDI, GDP, Exchange rate)

  3. To find out the effect of FDI on bilateral trade, we follow

Country's imports = f (country's FDI, India's GDP, Exchange rate)

Country's exports = f (country's FDI, India's GDP, Exchange rate)


  1. ln Expj = b0 + b1 ln FDIj + b2 ln GDP+ b3 ln ex_rate + e
  2. ln Impj = b0 + b1 ln FDIj + b2 ln GDP+ b3 ln ex_rate + e

We have used Multivariate data analysis (multiple regressions) to analyse the data and draw conclusions. Data has been obtained from different databases mainly UNCTAD database, OECD database, RBI database, CMIE database, DIPP database. We have used for our aggregate analysis quarterly data from December 2000 to December 2009, where as for bilateral analysis data period is again quarterly but from December 2005 to December 2009.

Results and Discussion

Aggregate level

At aggregate level our data gives the following estimates of parameters

Export model: ln Exp = -2.67 + 0.45 ln FDI*** + 1.12 ln GDP*** - 1.84 ln ex_rate***

All the estimates are very significant at 0.001 levels. The R square for the model is 0.95. The signs of the estimates are also on expected level, FDI elasticity of exports is 0.45, and it means that for every one percent increase in FDI our exports are going up by 0.45 %. Thus FDI inflow has favorable effect on India's export. We can conclude from this that, foreign firms are using India as their base for production and then exporting the products from India to some other countries, thus this FDI has efficiency motive.

Import Model: ln imp = -0.73 + 0.65 ln FDI*** +1.04 ln GDP** - 2.54 ln ex_rate***

In this case also all the estimates are significant at 0.001 level except GDP which is significant at 0.01 level. The R square for the model is 0.94. The co-efficient of FDI in this model has positive sign meaning that as FDI is coming in imports are also going up with elasticity of 0.65. one reason could be, as foreign firms are investing in india, they are setting up facilities which are peripheral in nature and the core raw materials has to come from their parent firm which is there in other country. This reason seems to be possible for strategic reasons and this is very much evident from the pattern in which FDI is affecting our imports and exports. On one hand imports are increasing and at the same time exports are also increasing. Thus, we can infer that most of the firms are using India as a low cost base to produce their peripheral goods and exporting them back either to their own country or export to some other country.

Bilateral level relation

The following table highlights the estimates of parameters for different country specific regression models. Model 1 is for exports and model 2 is for imports.

Effect of inward FDI on bilateral exports

As we can see from the table, inward FDI has positive and significant effect on bilateral level export trade in Germany, Netherlands and Switzerland. This shows that the FDI coming from these countries has complementary effects on their respective exports. Where as, in case of South Korea it is found that the relationship is negative and significant showing the substitution effect on Koreas export. For other countries like France, Japan, U.K and USA the relation found to be non significant and thus we conclude that inward FDI has neutral effect on their respective exports.

Effect of inward FDI on bilateral imports

Our analysis shows that, in all the cases inward FDI has no significant effect on the respective imports of the 8 countries thus we can conclude that FDI has neutral effect on home countries imports. The possible reason could be that FDI from these countries constitute only a small fraction of their trade with India and thus any movement in FDI will show negligible impact on the imports.


From our analysis we found that, at aggregate level in india inward FDI has positive effect on India's export as well as imports showing efficiency motive while at bilateral level, FDI from Germany, Netherland and Switzerland has increased their exports to India showing complementary effects while that for South Korea showed substitution effect. For all the countries, FDI outflow has neutral effect on their respective imports.


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