Report

62 QUANTIFICATION OF BENEFITS FROM ECONOMIC COOPERATION IN SOUTH ASIA
and skill difference between the home and the host
economies. As trade cost increases in the host country,
firms with vertical FDI will have to import goods from
the host country at a higher cost (Joon 2007). If the
difference in skill between the home and host countries
increases however, relative wages for low skilled labor
will decrease, thereby increasing the incentive for firms
to exploit this lower production cost by producing in
the low wage economy. Consequently, vertical FDI will
increase as trade costs decrease and skill difference
increases (Yeyati, Stein and Daude, 2003 and Lesher
and Miroudot 2006). Based on the above, the
Knowledge-Capital model, analyses the impact of the
given factors (market size, trade costs and skill difference
between the two countries) and their intersections.
The Knowledge-Capital model was empirically
tested by Carr et al. (2001), and one of the important
results obtained was that trade costs positively impact
FDI when the skill difference between home and host
country is small and negatively impact FDI when large
skill differences exist between the two countries. From
their study one can infer that in the presence of small
skill differences between parent and host economies, a
rise in trade cost will result in the impact of an increase
in horizontal FDI dominating the decrease in vertical
FDI. In the presence of large skill differences. On the
other hand, decrease in vertical FDI is larger than the
increase in horizontal FDI, when trade costs rise.
Jang (2007) defines decreased trade costs as an FTA
and tries to test this relationship. According to the
Knowledge-Capital model, one may expect the decrease
in horizontal FDI to be greater than the increase in
vertical FDI when trade costs declines in the presence
of small skill differences between the parent and the
host countries, and vice versa in the presence of large
skill differences. Since vertical FDI dominates horizontal
FDI in countries where skill difference is large, one
should expect an FTA involving member countries with
large differences in skill levels to have a positive impact
on FDI. Similarly, reduced trade costs act as a disincentive
for building plants in the host economy, which in
the presence of small skill differences, causes a decrease
in horizontal FDI to dominate the increase in vertical
FDI. Therefore, FTAs with member countries with small
skill differences can be expected to discourage FDI
between those economies.
Many empirical studies have tried to study the
impact FTAs have on intra-regional and extra-regional
FDI. Yeyati et al. (2003) find that regional integration
on the whole contributes to attracting FDI. A study by
Velde and Bezemer on the other hand, established that
the impact on FDI would be different for different types
of regions and the position of countries within a region
would be pivotal for attracting FDI. In the context of
Korea–US FTA, Kang and Park found that FTA
increased FDI by 14–35% from member countries and
by 28–35% from non-member countries. Baltagi et al.
(2005) conducted a study on bilateral outward FDI
stocks into Europe over 1989–2001 and found that an
RTA increases FDI up to 78% among European
countries.
With respect to South Asia, very few studies have
estimated the impact of intra-regional trade on inward
and intra-regional FDI. One of the reasons for this is
lack of bilateral data on FDI over time. This chapter
attempts to estimate the impact of intra-regional trade
on inward FDI into member countries of SAFTA and
domestic investments in the member countries.
TRENDS IN INWARD AND INTRA-REGIONAL
FDI IN SOUTH ASIA
Trends in Inward FDI in South Asia
Inward FDI into South Asia has increased exponentially
since the last decade. FDI inflow increased from US$
575 million in 1990 to US $ 9.8 billion in 2005 and
reached US$ 22 billion in 2006. The stock of FDI
increased from US $4 billion in 1990 to US $ 72 billion
in 2006. The turn of the century marked the growth of
inflow of FDI into the region. The average annual trend
growth in FDI inflow from 2000 to 2006 increased to
28% from 10% in the period 1980 to 1990 and 20%
in the period 1990 to 2000.
With respect to share of SAFTA member countries
in inward FDI in South Asia, India receives almost 77%
of the inward FDI flows. Pakistan receives around 15%
and Bangladesh and Sri Lanka 5% and 3% respectively.
Fig 8.1 Extent of Inward FDI in South Asia:
1980–2006
Source: UNCTAD