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MindMap Gallery Does economic distance affect the flows of trade and foreign direct investment?
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Does economic distance affect the flows of trade and foreign direct investment?
Economic distance encompasses a variety of factors including differences in economic size, income levels, market structures, cultural and institutional disparities, and geographic distance. This mind map will serve as an exploration of the relationship between economic distance and the flows of trade and foreign direct investment (FDI).
Edited at 2022-09-28 07:21:37
Does economic distance affect the flows of trade and foreign direct investment?
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- Outline
Understanding Financial Systems: Components, Functions, and Regulatory Bodies
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Does economic distance affect the flows of trade and foreign direct investment? Evidence from Vietnam
1. INTRODUCTION
Career satisfaction
Purpose
This study investigates how the relative economic distance (RED) between countries influences bilateral foreign trade and foreign direct investment (FDI), using Vietnam as a case study. This is an under-researched topic because many international studies have focusedon how differences in the physical and cultural distance between countries impact on trade and FDI flows, while relatively neglecting the effect of economic distance (Tsang & Yip, 2007)
Reason use Vietnam as a study case
Vietnam provides an interesting case study, as she is one of the fastest growing economies of the ASEAN region, as a result of increased trade and FDI, since the late 1980s (Das & Tuen, 2016, p. 249). Although, Vietnam’s trade expansion was hindered by the 1997 Asian financial crisis, her economic development process has substantially been supported by the economy’s export orientation and integration into the world economy (Abbott & Tarp, 2012)
In terms of FDI, the promulgation of the Law of Foreign Investment has successfully attracted huge amounts of foreign investments to Vietnam, since the late 1980s (Das & Tuen, 2016). This has helped to revitalize the private sector, as well as transform the economy from an agriculture-based economy to an industrializing one (ADB, 2006).
Empirical Analysis
This study examines the extent to which the RED between countries impacts on the flow of foreigntrade and FDI in Vietnam.The empirical analysis employs a gravity-type model going beyond traditional geographical distance dimensions to include some socioeconomic and institutional variables.
Theoretical and practical contributions
On the theoretical side, the concept of RED is particularly critical in the literature of development economics in general and the field of trade and investments in particular. However, it has not been widely utilized in existing studies.
In the case of Vietnam, while there are a significant number of studies examining trade and investment issues, to the best of my knowledge, none of them have explicitly included “economic distance” as a variable in the regressions (see, for instance, Abbott, Bentzen, & Tarp, 2009; Anwar & Nguyen, 2011; Binh & Haughton, 2002; Hoang, 2013; Thanh & Duong, 2011; Trinh & Nguyen, 2015; Xaypanya, Rangkakulnuwat, & Paweenawat, 2015; Xuan & Xing, 2008)
Furthermore, most of these studies on Vietnam fail to take into account“multilateral resistance” which can result in severe omitted variable biases (Anderson,2011;Anderson & van Wincoop, 2003, 2004; Egger, 2008).
2. LITERATURE REVIEW
Economic Distance and The Flows of Trade
Two Different Types of Potential Trade
The first is “existing trade” which exploits the current comparative advantages between thetwo countries or regions
The second is “new trade” which refers to trade that did not exist in the past.The considerable factors for this new trade include economies of scale, input sharing, imitation, technology transfer and distance. In theory, economic distance has two contradictory effects on trade
Negative Effects
According to the Linder (1961) effect, higher economic distance between trading countries may hinder their bilateral trade, since higher economic distance implies difference in the demand structure. Countries with different demand structures import and export less horizontally differentiated products. As such, the volume of bilateral trade reduces with higher economic distance.
Positive Effects
On the contrary, the Heckscher–Ohlin (H-O) effect, where inter-country differences in factor scarcity is represented by per-capita income differences, argued that higher economic distance might foster inter-industry trade (IIT) between trading countries. Flam and Helpman (1987) proposed that higher income individuals tend to consume higher quality products
In this approach, there is a positive relationship between the share of vertical intra-industry trade and differences in per capita income, as long as differences in GDP per capita are proxies for differences in relative wage
Economic Distance and FDI
Multinational corporations (MNCs) exploit their existing resources through FDI in host countries. Besides, they also explore opportunities for new resources (Makino, Lau, and Yeh (2002).
MNCs are keen on investing in host countries that are less developed than their home countries for the opportunity of resource exploitation. On the other hand, they tend to invest in host countries that are more developed than their home countries for the prospect of resource exploration.This is because the technological, managerial, and marketing levels of a country are related to her economic development.(Tsang & Yip, 2007).
Hence, inbound foreign firms can exploit their firmspecific advantages. In addition, local firms in transitional economies may not even be capable tocompete in market-based economic systems (Child & Markóczy, 1993).
MNCs are keen on investing in host countries that are less developed than their home countries for the opportunity of resource exploitation. On the other hand, they tend to invest in host countries that are more developed than theirhome countries for the prospect of resource exploration (Tsang & Yip, 2007)
Regarding a resource exploration perspective, investing in host countries that are more developed than MNCs’ home countries tend to increase the firms’ strategic assets over time. This is an essential part of its dynamic ownership advantages, which have become more and more important in the knowledge-based global economy (Dunning, 2000)
The Proxy For “Economic Distance” Variable
The key ingredient in the analysis is the measure of economic distance. A natural first candidate for economic distance is geographic distance. In the increasingly integrated and globalized world, however, geographic distance among countries might not be as critical as it was in the past. A significant number of countries divided by thousands of miles may get close to each other in education, culture, economics, and technology or in access to information through the Internet
Two measures of economic distance were employed by Conley and Ligon (2002)Accordingly, transportation costs between economies were used as the first measure, which dealt with physical capital.Meanwhile, the cost of airline fares between countries’ capitalswas selected as the second measure. This measure relates to human capital (e.g. thecost of flight tickets of a consultant)
3. METHODOLOGY
The Benchmark Model
To capture the difference or similarity in relative endowments, the proxy for economic distance between Vietnam and her partners is included in the equation in order to assess the impact of countries’ similarity in size, on bilateral trade flows and FDI inflows into Vietnam. The economic distance between Vietnam and her partner countries, as specified earlier, is measured as the difference between ln (yi ) and ln yVN , where yVN and yirepresent the real GDPs per capita in US dollars of Vietnam and her partner countries, respectively.
To examine the subject matter, besides including the three variables of interest: FDI, trade and economic distance, the baseline model also controls other variables, including: exchange rate, governance indicator, FTAs, which are commonly known to have an effect on the relationships among the three main variables
Regarding the role of institutions (governance indicator) to trade, de Groot, Linders, Rietveld, and Subramanian (2004) argued that institutional quality and homogeneity plays a critical role in determining bilateral trade between two countries.
Hoang (2013) argued that ahigher real exchange rate implies the devaluation of the domestic currency, which may attract FDI inflows and vice versaNguyen (2010) mentioned two reasons for augmenting the gravity model with the exchange rate variable in his study.
First, the theoretical linkage between the exchange rate and exports as well as imports is well-known in economics literature and supported by a large number of empirical research.
Second, he opined that many studies related to gravity models indicate that exchange rate is a critical explanatory variable.
As for the effects of FTAs, Vietnam has signed a number of FTAs with major partners, including AFTA with ASEAN countries, ACFTA with China, AKFTA with Korea, JVEPA with Japan, AANZFTA with Australia and New Zealand. In theory, these FTAs facilitate bilateral trade (Nguyen & Xing, 2008). As such, following Hoang (2013), binary dummies are created accordingly, which are expected to capture the possible effects of bilateral and regional trade agreements on FDI inflows to Vietnam.
The baseline model also considers the traditional elements of a gravity model including geographical distance and border effect. The geographic (physical) distance between two countries is commonly known as a proxy for transportation and transaction costs.A longer distance means that the two countries are located far away from each other, which implies higher transport costs and hence,likely to cause a negative impact on the bilateral flows of trade and FDI.Finally, border effect matters as whether two countries share the land border or not, influences the bilateral flows of trade and FDI.
This study takes the idea of multilateral resistance to its logical conclusion in a panel context by including time-varying importer and exporter fixed effects in estimation equations to examine the determinants of Vietnam’s FDI and bilateral trade flows. Beyond capturing multilateral resistance, country fixed effects control for other sources of endogeneity bias (Head &Ries, 2010).
Data Descriptions
The investigation period in this study spans from 1996 to 2012 (T = 17). The sample consists of Vietnam’s twenty-five (25) major trading and FDI partners, including: Australia, Belgium, Canada, China, Denmark, France, Germany, Hong Kong, India, Indonesia, Italy, Japan, South Korea, Laos, Malaysia, Netherlands, New Zealand, Philippines, Poland, Russia, Singapore, Switzerland, Thailand, United Kingdom (UK), and United States (US) (N = 25).
Interestingly, Vietnam’s main investors are also her major trading partners
Estimation Method
The study first calculates a modified Wald statistic for group wise heteroskedasticity in the residuals of a fixed-effect regression model, following Greene (2003, p.598).
The results,indicate heteroskedasticity across panels for all equations
The results suggest the existence of common, not panel-specific, first-order autocorrelation.Consequently, the classical fixed- or random-effects panel estimators cannot be employed
Instead, this study estimates all the specification models using the Prais–Winsten panel-corrected standard error (PCSE) estimator.
4. RESULT AND DISCUSSION
Result
a large part of the FDI inflows to Vietnam could be explained by a number of factors including geographical and economic distance, the interaction in governance, the export, import and bilateral trade flows between Vietnam and her partner countries.The variables indicate a significantly positive effect
Among these factors, only geographical distance shows a significantly negative impact on FDI flows to Vietnam
geographical distance, economic distance, bilateral/regional trade agreements of Vietnam and FDI inflows to Vietnam appear to have significant influences on the amount of Vietnam’s exports, imports and bilateral trade flows with her major partners
only the impact of geographical distance is negative whereas the other variables have positive effects.
The findings indicate a bidirectional and positive relationship between FDI inflows to Vietnam and export, import and bilateral trade flows with her major partner countries. This resultindicates that for Vietnam, trade and FDI interact in such a way as to be mutually promoting
This is particularly true given that Vietnam possesses a large stock of export-oriented FDI, coupled with the country’s continuous efforts in implementing numerous incentives to promote export-oriented investments such as simplifying administrative procedures, building centralized industrial zones and export processing zones with adequate physical infrastructures and preferential conditions
The feedback and significantly positive relationship between Vietnam’s trade (exports and imports) and FDI inflows also suggests that investment policies could be revised and reviewed in order to attract foreign investments in export production
Demands and join in the global supply chain, especially in manufacturing mechanics, electronics andinformatics, automobile components, garment and textile, footwear and high technology.
The geographical distance between Vietnam and her partners, lnDISvni, its impact on FDI inflows, export, import and trade flows is significantly negative.
This is expected in theory as the variable DISvni is a proxy for transport and transaction costs. When two countries are far fromeach other, transport andtransaction costs are likely to be high. The farther two countries are, the less FDI and trade flows (including import and export) between them.
This study does not find any significant impact of the border effect on any of the dependent variables in the specification models.
This result has to be interpreted with care. The insignificant impact of the border effect does not necessarily mean that barriers implied by the border are negligible and countries have become more integrated. Instead, it could be explained as due to changes in the extent of integration among regions of the same country (Clark & van Wincoop, 2001).
The coefficient of the exchange rate is not statistically significant as expected, suggesting that the exchange rate regime did not influence the FDI inflows and trade flows of Vietnam.
This could be explained by the fact that the Vietnamese Dong has adopted a “crawling peg” with the US dollar. Given the fact that the US is no longer the sole important partner to the economy, Vietnam should adopt an exchange rate mechanism based on a basket of major foreign currencies, or of foreign currencies of its major trading partners.
The interaction of governance indicators between Vietnam and her partner countries appears to have a significant influence on the amount of FDI inflows to Vietnam but not on the country’s import,export, and trade flows.
This finding suggests that the interaction of governance factors did induce FDI inflows to Vietnam, but not trade flows. This implies that to attract stable investment from overseas partners in the long term, Vietnam should improve on the competitiveness and transparency of its business environment by implementing further administration reforms, removing foreign trade barriers, completing infrastructure projects, and improving human resources.
Subsequently, the finding shows that economic distance has a significantly positive impact on FDI inflows, export, import, and trade flows of Vietnam. Vietnam receives nearly all (about 90%) her FDIinflows from countries which are more developed.
Since Vietnam is less developed than most of the FDI donors, she could offer inbound foreign firms the opportunity to exploit their firm-specific advantages and operate profitably. Vietnam’s major exports are unprocessed items, The main export markets for these items of Vietnam are the EU, the US, Japan, China, South Korea, Malaysia, India, all of which are more developed than Vietnam. Meanwhile, Vietnam’s primary imports are manufactured goods and processed items
In a nutshell, Vietnam’s major exports are unprocessed items while her major imports are manufactured goods and processed items.
It suggests that Vietnam has heavily relied on imports for her exports, as the country has weak supporting industries. In the future, Vietnam’s orientation would be to increase the export of manufactured goods while decreasing the export of unprocessed items.
Finally, the study finds significant positive effects of the various FTAs on FDI inflows and trade flows of Vietnam. Specifically, the estimated results in several models show that AKFTA, ACFTA and USBTA facilitate FDI capital to the country.
Almost all the bilateral or regional free trade agreements signed by Vietnam have significantly and positively impacted trade flows between Vietnam and her major trading partners.
Robustness Checks
It is worth noting that logarithmic difference is a good approximation of the percentage difference in real GDP per capita when yVN and yi are not too far away from each other (Tsang & Yip, 2007).
It is worth noting that logarithmic difference is a good approximation of the percentage difference in real GDP per capita when yVN and yi are not too far away from each other (Tsang & Yip, 2007).
The findings are qualitatively the same and the geographical distance between Vietnam and her trading partners continue to have a negative and significant influence on FDI inflows to Vietnam
The impacts of the other variables (including the economic distance, government interaction, as well as the export, import, and bilateral trade flows between Vietnam and her partner countries) continue to have a significantly positive impact.
This study also conducts robustness checks using nominal exchange rate instead of real exchange rate.
The degrees of significance of all these variables are found to be similar to what is obtained using real exchange rate as aforementioned and so the qualitative findings are mostly retained
5. CONCLUDING REMARKS
Conclusion
The results indicate that there is a positive feedback between Vietnam’s trade (exports and imports) and FDI inflows
This suggests that investment policies could be reviewed to attract foreign investments in export production.
Economic distance between Vietnam and her partner countries appears to have a significantly positive influence on her bilateral trade flows and FDI inflows.
This is consistent with the fact that Vietnam’s major exports are unprocessed items while her major imports are manufactured goods and processed items. It suggests that Vietnam has weak supporting industries so she has heavily relied on imports for her exports.Vietnam should move toward increasing the export of manufactured goods while decreasing the export of unprocessed items
Recomendation
The countries should implement policies to promote domestic production of potential exports of high growth rate and high added value like building materials,petrochemicals, rubber, and hi-tech products and promote economic restructuring.
The country should further renew technologies and invest in human capital to improve labor productivity in these industries.