International trade and investment

The place of production is often on the other side of the border from the country where the product is consumed. The difference in locations creates challenges and opportunities and gives rise to international trade and investment. Both are the centerpiece of economic globalization and the subject of much controversy. Free trade and international capital mobility are good for the average citizen, say some; free trade and investment wipe out the economic security of many people, say others. There is truth in both viewpoints. It is, however, not our task to take sides in what follows and to provide yet another opinion. Instead, our objective is to explain in simple terms the main issues, facts, and concepts about international trade and investment so that the reader can arrive at informed opinions on his or her own.

1. What is different about international trade?

International trade occurs when products produced in one country are consumed in another country. The existence of a border between the producing and the consuming country creates a number of issues. There could be restrictions on imports and exports in the form of tariffs, quotas, and product requirements. A tariff is a tax on the products or the service that is levied at the border. For example, in 2010 the U.S. imposed a tariff on tire imports from China and, in return, China imposed a tariff on imports of poultry from the U.S. A quota is a restriction on the amount of a product that can be imported or exported. For example, Canada restricts the amount of dairy products that can be imported into Canada each year.

Most countries use different currencies and therefore international transactions have currency conversion costs. Also, traders have to consider whether currency values would change over time. They may have to sign contracts now for delivery of the products and payments in the future when currency values have changed. Hedging, i.e. protecting oneself, against such currency changes is costly.

There could be different languages, customs, laws and procedures that make the entry into a foreign market more difficult. There could also be additional transport costs if countries are not close to each other or their transport networks are not well connected.

Yet, international trade is alive and well. World exports increased from 12 percent of world GDP in 1960 to 30 percent in 2015.

2. What is produced where?

Economic theory tells us that a product will be produced in the country where it is most efficiently made, i.e. where we get a lot of output from relatively little inputs such as labor, machines, land, etc. More precisely, the product will be produced in the country where the output/input ratio is the highest of all countries. By output we mean the quantity and quality of a product. A high output/input ratio shows that a country has comparative advantage for that product.

For example, the U.S. is the world’s top producer and exporter of grains. It’s vast and fertile agricultural lands give economies of scale and allow it to squeeze a lot of output from each hectare of land using relatively few additional resources. In 2014, the agricultural output per agricultural worker was 78,224 dollars in the U.S and only 41,776 dollars in the U.K. Clearly, the U.S. is a better place to grow crops and then export to the U.K.

The question why countries have comparative advantage for various products is more difficult to answer. The most obvious reason is that they have nature-given or history-given advantages, including:

Natural resources. Kuwait specializes in the production of petrol.

Geographical situation. Countries with sea borders specialize in transport logistics and ship building. A good example is South Korea.

Abundant and relatively cheap labor. Vietnam specializes in textile production that requires many workers.

Abundant land. The U.S. is an important producer of grains.

Traditions developed over time. The Swiss have perfected watch making over the centuries as described here:

The Swiss watch making history:

The Swiss watch and clock industry appeared in Geneva in the middle of the 16th century. In 1541, reforms implemented by Jean Calvin and banning the wear of jewels, forced the goldsmiths and other jewellers to turn into a new, independent craft : watchmaking. By the end of the century, Genevan watches were already reputable for their high quality, and watchmakers created in 1601 the Watchmakers' Guild of Geneva, the first to be established anywhere. One century later and because Geneva was already crowded with watchmakers, many of them decided to leave the city for the receptive region of the Jura Mountains.

Watchmaking in the Jura remains indebted to a young goldsmith called Daniel Jeanrichard (1665-1741), who, for the first time, introduced the division of labour in watchmaking. In 1790, Geneva was already exporting more than 60,000 watches.

The centuries were rich in inventions and new developments. In 1770, Abraham-Louis Perrelet created the "perpetual" watch (in French "Montre à secousses"), the forerunner of the modern self-winding watch. In 1842, pendant winding watches were invented by Adrien Philippe, one of the founders of the famous Patek Philippe watch company.

The mass production of watches began at the turn of the 20th century, thanks to the researches and new technologies introduced by reputable watchmakers such as Frédéric Ingold and Georges Léchot. The increase of the productivity, the interchangeability of parts and the standardization progressively led the Swiss watch industry to its world supremacy.

The end of World War I corresponds to the introduction of the wristwatch which soon became very popular. Its traditional round shape was generally adopted in 1960. In 1926, the first self-winding wristwatch was produced in Grenchen, the first electrical watches being introduced later in 1952.

In 1967, the Centre Electronique Horloger (CEH) in Neuchâtel developed the world first quartz wristwatch - the famous Beta 21. Since then, major technical developments followed without interruption: LED and LCD displays, Swatch, quartz wristwatch without battery, etc.

Since more than four centuries now, tradition, craftmanship, high technologies and permanent innovation have allowed Swiss watchmaking industry to keep its leadership in the world watch market.

Source: Federation of the Swiss Watch Industry


The history makes clear that the comparative advantage for watch making in Switzerland is not related to natural resources. Instead it is a story of continuous innovation in an effort to stay competitive. However, it also illustrates the so-called agglomeration forces. The more watches were made in Switzerland, the greater the competition among watchmakers and the greater the rate of innovation. It seems like a virtuous cycle – success begets success. If we look at comparative advantage from that perspective, then the watch making could have developed in France or Austria instead of in Switzerland. In other words, it may not be predetermined what product is produced where. A country that does not have high-technology industries may still hope to develop them and gain comparative advantage over time.

Based on that logic, governments sometimes protect their industries from international competition until they grow and mature. The objective is to set the virtuous cycle in motion so that the more the industry expands, the more competitive it becomes. It is an effort to create comparative advantage. The track record of such “infant industry” policies is mixed. Countries in South East Asia, most notably South Korea and its electronics and shipbuilding industries seem to have benefited from such policies. However, there were many other factors at play there including strong education and an expanding labor force. More often than not, the effort to create competitive industries via government policies does not give results.

3. Why is there opposition to free trade?

Free trade raises the living standard of the average person but it may lower it for many separate groups of individuals. Consider the impacts of NAFTA, the North American Free Trade Agreement that eliminated most trade restrictions between the Canada, Mexico, and the U.S. in 1994. U.S. companies started to relocate their production facilities to Mexico to take advantage of the cheaper labor. It is more efficient to produce a car just south of the border at a lower cost and the ship it (drive it) to the U.S. than to make it in the U.S. where wages are much higher. As more and more production shifted abroad, U.S. consumers could enjoy lower prices for a variety of products. That, however, was of little interest to the laid-off U.S. workers from the auto and other industries.

NAFTA also gave U.S. farmers greater access to sell their produce in Mexico. The U.S. has a highly efficient agricultural sector that generates vast quantities of grains and other products at competitive prices. Shipping these products to Mexico lifted the living standard of the Mexican consumer. However, it also put strain on many Mexican farmers who could not survive the competition and went bankrupt. Some farmers then decided to go (legally or illegally) to work in the U.S. putting pressure on the wages of U.S. workers in agriculture and construction. Again, there were benefits from free trade but there was also significant cost to many individuals that fueled opposition to free trade. Governments try to respond by providing a safety net in the form of unemployment and welfare benefits as well as job retaining but that is only a partial compensation.

4. Foreign investment

There are two types of foreign investment: foreign direct investment (FDI) and portfolio investment. Foreign direct investment (FDI) is the ownership of production facilities in a foreign country. To be classified as FDI, a foreign investor has to own at least 10 percent of a local company. The investment could be in manufacturing, services, agriculture, or other sectors. It could have originated as green field investment (building something new), as acquisition (buying an existing company) or joint venture (joint ownership with a local company).

Otherwise, if an investor obtains less than 10 percent ownership in a foreign company, the investment is classified as portfolio investment. International lending from banks, firms, governments or individuals in one country to banks, firms, governments or individuals in another country is also portfolio investment. A bank deposit in a foreign country is also classified as portfolio investment.

To get some perspective on the magnitudes of international investment, consider the U.S. in 2011. Its net equity investment, i.e. the value of U.S. equities purchased by foreigners minus the purchases of foreign equities by U.S. citizens and firms was 27.3 billion dollars. In other words, only in 2011, 27.3 billion dollars flowed into the U.S. stock market from abroad. During the same year, net FDI into the U.S. was -178.3 billion dollars. In other words, U.S. companies invested 178.3 billion dollars more in foreign countries than foreign countries invested into the U.S.

A couple more numbers. The stock of U.S. foreign direct investment abroad, i.e. the cumulative value of all foreign direct investment from the U.S. around the world for all years combined, was 4,499.9 dollars billion in 2011. Put differently, the total value of U.S. production assets in foreign countries that have accumulated over the years was four and a half trillion dollars. In contrast, the total value of foreign company assets in the U.S. was 3,509.4 billion dollars: about 1 trillion dollars less but still a very large number.

Looking at the stock of FDI in 2011, the top ten recipients of foreign direct investment were, in that order, the U.S., the U.K, Hong Kong, France, Belgium, Germany, China, Brazil, Spain, and Canada. The top ten investors internationally are the U.S., the U.K., Germany, France, Hong Kong, Switzerland, Japan, Belgium, the Netherlands, and Canada. It is clear that much of the international investment activity is between the developed countries. The biggest exchange of investment in the world is between the U.S. and the U.K.

Reasons to invest internationally

In order to invest internationally, multinationals must see a benefit to their bottom line from:

- Access to a large local market – that explains a lot of the foreign investment into the U.S.;
- Access to labor at lower wages – much of the textile industry moved to South East Asia for that reason;
- Access to natural resources – Shell, an energy company, has investments in all countries with significant oil resources;
- Low taxes and subsidies – many companies opened facilities in Ireland in the 1990’s to take advantage of the lowest taxes in the European Union;
- Agglomeration: a large cluster of companies that work on related products and services – there is substantial foreign investment in the tech industry in Silicone valley.

A country could be attractive to foreign investors because of one or more of these attributes. The U.S., for example, offers an enormous domestic market, a vast network of suppliers, better access to financing than many other countries, and much more. Ireland offers low taxes and access to the large European Union market. Countries in Eastern Europe offer high skilled labor at lower wages than in Western Europe. Many countries on the African continent offer abundant natural resources.

Below are excerpts from an article showing the push for international presence by Coca-Cola, the most recognizable brand in the world. Coca-Cola is determined to continue its 100-traditon of international expansion.

Coca-Cola to spend $30 billion to grow globally

By Leon Stafford, The Atlanta Journal-Constitution, Sept. 9, 2012

By the year 2020, more than 2 billion people around the world are expected to join the middle class or move from rural and farming areas into big cities. Coca-Cola hopes they’ll be thirsty.

In a bid to broaden its international appeal, the Atlanta-based beverage giant has announced investments of more than $30 billion in markets around the world over the next five years. The investment boost, which will be done in conjunction with Coca-Cola’s bottling partners, is part of the company’s “2020 Vision,” a strategy to double Coca-Cola’s revenue — it was about $100 billion in 2010 — in the next eight years.
…….
The company is certainly no novice to growth beyond its borders. Coca-Cola first expanded outside the United States into Canada, Cuba and Panama in 1906. It entered the Asian market in the Philippines in 1912. That expansion helped the company’s name become universal — the one word understood in almost every language, experts say. That said, the company wants to expand its footprint even further. In December 2011, it purchased half of one of the biggest beverage companies in the United Arab Emirates, Aujan Industries. Three months later, it opened its 42nd bottling plant in China.
...
A critical part of Coca-Cola’s growth strategy will be partnering with bottlers or buying some outright that can move the company’s product. In September 2011, Coca-Cola announced it and its bottling partner, Coca-Cola Hellenic, would commit $3 billion over the next five years in Russia, including the opening of a plant in the country’s Rostov region.

5. What are the benefits from FDI for the host country?

There is considerable debate whether foreign direct investment benefits the receiving countries. On one hand, foreign companies could increase employment and introduce new technologies that raise the productivity of the economy. On the other hand, they may be interested only in resource extraction with little benefits for the receiving country (the recent surge of Chinese investment on the African continent has raised such concerns); or they may specialize in low-skill activities that have little or no spillover effects to the rest of the economy. Therefore, generalizations cannot be made and the benefits from foreign direct investment have to be evaluated on a case by case basis.

In principle, however, if there are benefits, they would be related to the following.

Growth in employment. When foreign companies start operation they usually hire people, especially if the investment is greenfield, i.e. if a new facility is created and if the production is more labor intensive, i.e. requires many people. Often, local companies become suppliers to a large new foreign investor and they also increase employment.

Increased foreign exchange reserves. When U.S. companies invest in Mexico, they exchange dollars for pesos to buy land and equipment and to pay wages. The U.S. investors purchase dollars from the Mexican banks. The banks can lend the dollars to Mexican firms and households or they can sell the dollars to the Mexican central bank. When the dollars end up with the Mexican central bank, it keeps them in reserves so that Mexico can pay its international debts and imports.

New technology. Foreign companies often introduce new technologies and train local personnel. Sometimes, after working at the foreign company for several years, an employee would leave and start his/her own business or would be hired by a domestic company. In that way the knowledge is transferred from the international company to the domestic companies.

Better managerial know-how. Multinationals have well functioning management structures that can be observed by local employees. These employees could spin off local companies using that managerial know-how.

New export markets. Foreign companies usually have established channels for placing their output on international markets. For example, if Ford starts making cars in Mexico, they already have plans to sell them back in the U.S. and other countries.

6. Happy times and sudden stops

Whether or not it contributes to economic development, one of the main advantages of foreign direct investment compared to portfolio investment is its stability. Companies are careful when they decide to open international facilities and even more careful when they decide to close down their international facilities. Therefore, foreign capital flows into the receiving country gradually and does not leave on a short notice.

In contrast, international credit and investments in equities (the stock market) can come into a country very rapidly and can leave just so rapidly. The 1997 financial crisis in Thailand, Indonesia, Malaysia and South Korea was preceded by exactly such massive inflow of foreign money. These countries offered excellent investment opportunities and foreign investors poured billions of dollars to finance them. Then, in 1997, they got panicky and pulled out. Investments dried up, the currencies plummeted, and the economies went into steep recessions. The reversal of portfolio capital flows even has a name: “sudden stop.”

Why do countries allow investment to come in and out so quickly? One reason is that when times are good, the foreign money helps economic growth by providing financing for new ideas and projects. At that time, everyone, borrowers and lenders, brim with optimism and no policymaker wants to spoil the party. Besides that, however, even if policymakers want to slow down the inflow of foreign money, it is very difficult to do so. It comes into the country through the banking system, multinationals, remittances, real estate purchases, and many other channels. If there is profit to be made somewhere on the planet, the money seems to find a way to get there.

Additional resources

World Trade Organization, the main international organization monitoring and promoting international trade. The website offers country information, data, and analyses. Available from: http://www.wto.org/

Foreign Direct Investment database (UCTAD), the best data base for FDI; published by the United Nations - FDI data.

International trade and market access data from the WTO. Available from: http://www.wto.org/english/res_e/statis_e/statis_e.htm

International banking data from the Bank for International Settlements, the main monitor of international banking. Available from: http://www.bis.org/statistics/bankstats.htm

U.S. exports and imports from the U.S. Census. Avaialble from: http://www.census.gov/foreign-trade/

Recommended academic readings (advanced, with quite a bit of math)

Krugman, Paul. “Increasing returns, monopolistic competition, and international trade” Journal of International Economics, 1979.

Mundell, Robert A. "The Pure Theory of International Trade," American Economic Review, 301-322, 1960.

Mussa, Michael. "Tariffs and the Distribution of Income: The Importance of Factor Specificity, Substitutability, and Intensity in the Short and Long-Run," Journal of Political Economy, 82 (6) 1191-1203, 1974.

Markusen, James and Anthony Venables. “Foreign direct investment as a catalyst for industrial development,” European Economic Review, February, pages 335–356, 1999.

Schneider, Friedrich. “Economic and political determinants of foreign direct investment,” World Development, February, pages 161–175, 1985.


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