FDI and the cost of trading

India and China are whispering sweet nothings into each other's ears. Indian firms are investing in China, and vice versa, too.

The trend is likely to grow. Over the next decade or so, China and India will become to each other what the US and the EU are -- close but with a clear understanding of who the elder brother is.

An interesting sub-question that arises in this context is, how will location decisions be taken? That is, what will be the determinants of entry into China for Indian firms? The answer holds an important lesson for India.

In a recent paper, Mary Amiti and Beata Smarzynska Javorcki of the International Monetary Fund have examined these determinants at the provincial level during 1998-2001. Their analysis focuses on the importance of market and supplier access effects both within and outside the province of entry, relative to production costs.

"The results indicate that market and supplier access are the most important factors affecting foreign entry." Access to the rest of China is not an issue.

The authors say that this is "consistent with market fragmentation due to underdeveloped transport infrastructure and informal trade barriers." In short, it is not the market size but the logistics that are important.

Their study also reveals that foreign investment goes to provinces that are more open to foreign trade. That is, provinces that seek to protect their firms don't get much foreign investment.

Infrastructure is an obvious factor: the better it is, the more foreign direct investment that comes in. If a province has good infrastructure and low internal barriers to trade, FDI starts coming out its ears. The linkages to neighbouring regions are also an important factor.

Thus, say the authors, "our results suggest that local governments may do well by reducing inter-provincial barriers, and hence increasing the extent of market and supplier access in surrounding provinces, in order to attract foreign investment."

It is interesting, in this context, to see that the Chinese are really not very different from us. The authors report that "shipments to other provinces are occasionally stopped by local rail officials for two to four weeks for no apparent reason."

Other bureaucratic problems, doubtless with the same objectives as in India, are also present. "The administrative units of the industry and commerce department were reportedly obstructing access to markets through audits or local registration requirements."

Much of the paper's findings may appear fairly obvious, and in a sense, it is. But the importance of this paper lies in its focus on trade costs as a factor in determining FDI and in taking the debate away as low wage costs as the key determinant of FDI. The higher the trade costs are, the lower you can expect FDI to be, never mind how low wages are.

At a recent conference organised by the UN Economic and Social Commission for Asia and the Pacific and the Asian Institute of Transport Development, I was asked to present a paper on transport and regionalism.

I had argued that, in the end, what will determine the success of regionalism -- internal or across borders is a not very important -- is the cost of trade, not the availability of markets. It is good to see some independent corroboration of that, albeit in a different context.

The basic reasoning, however, is the same. Distance is an important factor in trade, however much we may pretend to the contrary -- except in the case of the disembodied delivery of services.

This essential fact must never be lost sight of in the zeal for multilateralism or in the case of nations, balanced regional growth via force-feeding.

In this context, the authors make another point that is of relevance to India and to the United Progressive Alliance government in particular. This is that "if China's Central government is serious about redressing regional inequality, it must address the issue of local protection and high internal trade costs. Dismantling inter-provincial barriers, and improving transport infrastructure will increase market and supplier access for both Chinese and foreign producers, attracting entry of new firms."