Impact of Trade Facilitation on Foreign Direct Investment

29 August 2014

Countries that implement trade facilitation reforms and enhance trade efficiency and connectivity are generally expected to attract more foreign direct investments. This paper is a first attempt to quantify the potential impact of trade facilitation on FDI flows. Using a unique bilateral dataset on FDI flows covering both OECD and developing economies in Asia and the Pacific, we estimate gravity models of FDI featuring relevant trade costs and trade facilitation indicators. A host country’s quality of business regulatory environment generally matters most, but high trade costs also have a significant impact on FDI. A one percent reduction in comprehensive international trade costs (excluding tariff) between source and host country leads to a 0.8 percent increase in FDI inflows on average. Import tariffs of the host country are also found to have a significant but small negative on FDI inflows.

Focusing on the Asia-Pacific region, taking steps to reduce average tariff of high-tariff countries to the developing country average would result in a 6-7% increase in FDI inflows to the region, while reducing other types of trade costs in high-cost countries in Asia-Pacific to the developing country average can be expected to increase FDI flows by 20%. In turn, a moderate improvement in the quality of the domestic business environment in host countries, by just 10% on average across the region, would increase FDI flows by over 60%. Improving liner shipping connectivity of all lagging countries in the sample to the developing country average would also significantly increase FDI, but this would likely require massive investment in maritime infrastructure in many countries. Overall, the analysis fully support the notion that trade facilitation should be a core component of any foreign direct investment development strategy and provides further evidence of the benefits associated with enhancing trade efficiency.