Reform Creating Regional Trade Agreements and Foreign Direct Investment: Applications for East Asia

Abstract

The spread of regional trade agreements (RTAs) is strongly motivated by the desire for more foreign direct investment (FDI) flows. The net benefits from freer capital flows are expected to trigger a domino effect of new regionalism. However, this is still an empirical question to be tested, especially for the case of East Asia. This paper quantitatively estimates the investment creation and diversion effects of RTAs by using an extended gravity equation focusing on domestic reform as a commitment device for RTA membership. As a case study, we investigate whether reform-minded less developed countries (LDCs) can trigger this domino effect by actively participating in RTAs. Moreover, in order to search for the most preferable member pair among the proposed East Asian RTAs, we estimate the likely impact of the East Asian RTAs on inward FDI stock. From our empirical analyses, we find that (i) reform-creating RTA membership, larger market size, better skilled labor, and lower trade costs all contribute positively and significantly to inward FDI stock; (ii) reformatory LDCs attract more FDI in addition to the investment creation effect of their RTA membership; and (iii) most of proposed East Asian RTAs promote intra-bloc FDI. In particular, both South-North and North-North RTA such as an ASEAN-Japan and a Japan-Korea RTA prove to be more preferable membership combinations to South-South RTAs in East Asia.