Effects of Trade and Investment Liberalization on Korea’s FDI

Jong Duk Kim, Seungrae Lee, Jungu Kang and Hyuk-Hwang Kim

After Korea-Chile FTA became effective since 2004, Korea has made multiple free trade agreements with 47 countries including United States and European Union, and is currently negotiating upcoming free trade agreements with other countries, such as Indonesia, China, Vietnam, Australia, and New Zealand. Along with the global spread of trade liberalization, it is necessary to evaluate the post-effects of FTA that came into effect and the strategies for the upcoming FTAs. However, prior reports and papers analyzing the effects of FTA were mainly focused on evaluating its economic effects on goods, while most of FTAs are influential not only on product sector but also on investment and service sectors. In particular, since foreign direct investment (FDI) is directly and indirectly related to goods trade, FTA is also associated with foreign direct investment sectors. This report analyzes the effects of FTA on outward and inward foreign direct investment (IFDI and OFDI) of Korea. Our report provides detailed analysis on the contents of FDI openness in the trade agreement and construct FDI openness indices by dividing investment sectors from the previous 8 free trade agreements that became effective into 5 sectors and 25 sub-sectors and quantifying FDI openness based on those sub-sectors. By adding our constructed FDI openness indices to the regression, we find that FTA significantly increases both IFDI and OFDI in the short run. Examining the effects of investment liberalization on IFDI and OFDI, the results indicate that investment liberalization from FTA increases IFDI. In particular, its magnitude becomes larger as investor-state dispute settlement is included in the chapter of agreement. On the other hand, the results imply that FTA has heterogeneous effects on OFDI from different industry sectors on the basis of investment related articles. For instance, OFDI from manufacturing sectors is likely to increase to FTA partner as agreement involves high FDI openness articles in general, while OFDI from wholesale and retail sectors is more likely to increase as agreement involves FDI openness articles on service related sectors. Furthermore, based on the relative GDP per capita difference between Korea and its FTA partner, we find that IFDI flow increases from FTA partners that have similar GDP per capita with Korea, while GDP per capita difference and FDI openness indices have interaction effects on OFDI flow from different industry sectors. For instance, we find that FDI openness indices have significant and positive effects on OFDI from manufacturing sectors to FTA partners that have higher income-level but small GDP per capita difference with Korea. Alternatively, OFDI from wholesale and retail sectors are likely to increase to FTA partner as a country has higher income-level and large GDP per capita difference with Korea, with high FDI openness on service sectors included in the agreement.
Based on the results, our report provides policy implications for expanding Korea's OFDI and IFDI. We find that Korea’s OFDI and IFDI have increased at the aggregate level and they are positively affected by trade and investment liberalization. As our results indicate that FTA significantly increases OFDI and IFDI, we should carry forward upcoming FTAs more aggressively. In particular, upcoming FTA negotiations should focus on including FDI openness in service sectors, FDI regulation and protection, and investor-state dispute settlement provision. Furthermore, as trade and investment liberalization are known to have different effects on OFDI and IFDI based on the GDP per capita difference between Korea and its FTA partner, upcoming negotiations should be proceed by considering country’ GDP per capita relative to Korea and the agreement should include investment related articles that could have positive effects on OFDI and IFDI from different industry sectors.