The welfare effect of a free trade agreement in the presence of foreign direct investment and rules of origin

• Date: 01 September 2017
• Published date: 01 September 2017
• DOI: http://doi.org/10.1111/roie.12282
• Author: Hiroshi Mukunoki

ORIGINAL ARTICLE

The welfare effect of a free trade agreement in the

presence of foreign direct investment and rules of

origin

Hiroshi Mukunoki

Faculty of Economics, Gakushuin

University, Tokyo, Japan

Correspondence

Faculty of Economics, Gakushuin

University, Mejiro 1-5-1, Toshima-ku,

Tokyo 171-8588, Japan;

Tel: 181-3-5992-1275;

Fax: 181-3-5992-1275;

Email: hiroshi.mukunoki@gakushuin.

ac.jp

Funding information

Japanese Society for the Promotion of

Science Grants-in-Aid for Scientific

Research (JSPS KAKENHI) Grant

Numbers 16H03620 and 26380310

JEL Classification: F12, F13, F15

Abstract

This paper investigates the welfare effect of forming a free

trade agreement (FTA). To receive tariff-free treatment,

firms must comply with the rules of origin (ROO). Outside

firms could undertake either market-oriented or export-

platform foreign direct investments (FDIs). ROO have the

following effects: (i) An infeasible FTA may become feasi-

ble by deterring outside firms’FDIs, (ii) an FDI of a less

efficient firm could replace that of an efficient firm, or (iii)

FDIs made before the FTA is concluded might be elimi-

nated. These potential effects complicate the welfare effect

of the FTA and could decrease the consumer surplus.

KEYWORDS

free trade agreements, rules of origin, foreign direct invest-

ment, internati onal oligopoly

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INTRODUCTION

Regional trade agreements (RTAs) have increased significantly worldwide. As of December 2016, 431

RTAs were in effect and reported to the World Trade Organization (WTO) compared with 28 in 1990.

By forming an RTA, member countries reciprocally remove their trade barriers while maintaining such

barriers for nonmember countries. There are two types of RTAs, free trade agreements (FTA) and cus-

toms unions (CU). Each FTA member independently sets external tariffs on nonmember countries

while CU members jointly set common external tariffs. Because the external tariffsofFTAscandiffer,

without rules to distinguish between the products originating within an FTA and those originating

from outside an FTA, nonmembers would supply their goods to member countries through the mem-

bers with the lowest tariff. To prevent such tariffcircumvention, rules of origin (ROO) are indispensa-

ble for the implementation of FTAs. ROO require goods to be certificatedasproducedwithinanFTA

only if a “substantial transformation”occurred within the FTA.

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The methods to check the substantial transformation within an FTA are as follows: (i) changes in

tariff-classification (CTC) criterion, (ii) value-content (VC) criterion, and (iii) specific-process (SP)

Rev Int Econ. 2017;25:733–759. wileyonlinelibrary.com/journal/roie V

C2017 JohnWiley & Sons Ltd

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Received: 10 October 2015

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Revised: 4 October 2016

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Accepted: 12 December 2016

DOI: 10.1111/roie.12282

criterion.

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The CTC criterion grants the origin if several imported intermediates of member countries

are transformed into products with a different tariffclassification. The VC criterion requires producers

to add more than a minimum percentage of value within the FTA. The SP criterion requires that certain

production or processing be conducted within the FTA. Although the CTC criterion is commonly used

in FTAs, the other two methods are frequently combined with the CTC criterion.

To meet ROO, the production of the good basically must use a certain fraction (denoted by gin

this paper) of parts and components that originate within the FTA. The fraction gis explicitly specified

when the ROO is based on a VC criterion. The CTC and the SP criteria do not explicitly require the

local sourcing of parts and intermediates, but firms must practically use a ce rtain fraction of l ocally

sourced parts and intermediates to change the tariffclassification of goods produced with imported

inputs and undertake specific processes in local production.

Although the primary purpose of ROO is to prevent tariffcircumvention, they can have many side

effects. ROO has similar properties to local content requirements (LCRs) imposed on FDI. Both ROO

andLCRsrequiretheinvestingfirms to devote a certain amount of local parts or intermediates to local

production and have become an impediment to FDI. An important difference is that although LCRs

are prohibited under WTO rules, incorporating ROO when forming an FTA is legitimate policy despite

the risk of distorting firms’location choices as LCRs may. Another important difference is that inves-

ting firms have an option not to comply with ROO and not to use tariff-free access within the FTA, but

they are obliged to meet the content rule in the case of LCRs.

The main focus of this paper is to examine the ways in which the formation of an FTA changes the

pattern of foreign direct investments (FDIs) made by non-FTA country firms and the ways in which

the changes are connected to the restrictiveness of the ROO. Because FTAs build free trade zones

among member countries, establishing a plant in one member country gives the investing firm an

opportunity to make t ariff-free exports to other member countries. Therefore, the formation of an FTA

attracts FDI from an outside country to a member country. This type of FDI is referred to as a “third-

country export- platform FDI”(P-FDI hereafter).

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Some empirical studies showed that FTAs promote FDIs from outside countries. For instance,

Blomstr€

om and Kokko (1997) found that the U.S.–Canada FTA increased FDIs into Canada, and the

North American Free Trade Agreement (NAFTA) promoted FDIs into Mexico. With a large sample of

countries, Levy-Yeyati, Stein, and Daude (2003) explored the positive effect of RTAs on FDIs from

outside countries. These FDIs should include P-FDIs. For instance, Ito (2013a) pointed out that the

third-country exports of U.S. FDI are significantly larger for the plants operated in the Association of

South-East Asian Nations (ASEAN). Ito (2013b) obtained the same result for Japanese plants operated

in ASEAN and NAFTA. There is also anecdotal evidence that FTAs promote P-FDIs. It is reported

that Sumitomo Chemical Co. Ltd., a Japanese chemical company, established a new plant in Korea for

exporting its products to the United States by utilizing the U.S.–Korea FTA.

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After the formation of

the ASEAN Free Trade Area (AFTA), a German automaker, BMW, newly established a plant in Thai-

land and has been supplying cars in Thailand and also exporting them to Indonesia.

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Because firms must meet the requirements of the ROO to enjoy tariff-free exports within FTAs,

ROO is associated with outside firms’gains from P-FDI. Specifically, stricter ROO increase the cost of

obtaining a certificate of “FTA origin”and reduces outside firms’incentive to undertake P-FDI. Este-

vadeordal, L

opez-C

ordova, and Suominen (2006) reported that FDI into Mexico after the implementa-

tion of NAFTA has flowed in sectors with less stringent ROOs.

However, if the aim of undertaking an FDI is to serve the local market of the host country, which

is referred to as a “market-oriented FDI”(M-FDI hereafter), ROO has no effect because firms need not

comply with ROO. Therefore, ROO only raises the cost of undertaking P-FDI and does not affect the

cost of undertaking M-FDIs. For instance, Honda Motor Co. Ltd. has plants in both the United States

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MUKUNOKI