Deep Agreements and the Internationalization of Production

1. Deep Agreements and the Internationalization of Production Alberto Osnago, Nadia Rocha WTO Michele Ruta IMF University of Exeter, 30 May 2013

2. Deep agreements and int. production • Preferential trade agreements (PTA) are usually thought as tariff reductions (i.e. shallow agreements) • Deep agreements cover in addition many other provisions: • Technical barriers to trade (TBT) measures • Sanitary and phytosanitary (SPS) measures • Investment • Intellectual property rights (IPR) protection • Anti-corruption • Competition policy • … Deep PTAs and vertical FDI

3. Deep agreements and int. production • Depth of PTAs and the international fragmentation of production have changed over time Source World Trade Report (2011) Deep PTAs and vertical FDI

4. Deep agreements and int. production • This paper: • Digs further into the relationship between deep trade agreements and the internationalization of production • Specific question: • How are deep agreements and vertical FDI related? • General idea: • Deep provisions improve the contractual environment • However, different provisions affect the contractibility of various inputs differently • FDI respond to (and, possibly, determine) these institutional changes Deep PTAs and vertical FDI

5. Related literature • International organization of production • Antras (2003); Antras and Helpman (2004); Nunn and Trefler (2012); … • Domestic institutions and intra-firm trade • Grossman and Helpman (2005); Antras and Helpman(2008); Bernard et al. (2010); … • Trade agreements and internationalization of production • Lawrence (1996); Baldwin (2010); Orefice and Rocha (2012); Blanchard and Matschke (2012); Baltagi et al. (2008); … Deep PTAs and vertical FDI

6. Outline • Theory: Vertical FDI and deep PTAs • Antras and Helpman (2008) • Data description and methodology • Depth and composition of deep agreements • Vertical FDI • Empirical findings • Depth of PTAs and vertical FDI • Composition of PTAs and vertical FDI • Summary and work ahead Deep PTAs and vertical FDI

7. Vertical FDI and deep PTAs • Based on Antras and Helpman (2008) • Property rights approach of the international organization of production under asymmetric contractual frictions • Two countries: North and South • North is high-cost and has complete contracting • South is low-costand has weaker contracting institutions relative to North • Final good producers located in North • They have to produce headquarter (HQ) services, but can source components domestically or from South Deep PTAs and vertical FDI

8. Vertical FDI and deep PTAs • Final good production in an industry combines HQ service (h) and components (m) with technology • Sectors vary by intensity with which they use HQ services (η) • Firms within sectors vary by productivity () Deep PTAs and vertical FDI

9. Vertical FDI and deep PTAs • Each input is produced with a continuum of activities in the interval [0,1] with • Imperfect contractibility in South • Only activities in range with are contractible • Contractibility depends on domestic institutions in South (λ) and on PTA provisions (γ) and Deep PTAs and vertical FDI

10. Vertical FDI and deep PTAs • Differences in contractibility across production processes and countries reflect technological and institutional variation • Deep provisions in PTAs are a determinant of institutional variation and affect contractibility of inputs • Examples: • Anti-corruption provisions reduce contractual insecurity ( and ↑) • IPR provisions improve contractibility of HQ services (namely R&D) by protecting patents () • TBT/SPS provisions improve contractibility of components by promoting standardization / mutual recognition (↑) Deep PTAs and vertical FDI

11. Vertical FDI and deep PTAs • Final good producer has three alternatives to obtain components (m) • Domestic sourcing (D) • Foreign outsourcing (O) • FDI, i.e. foreign integration (V) • Profits depend on control and location choice and can be expressed with the standard form with where is a function of productivity θ and profitability depends on HQ intensity η (Antras, 2003) Deep PTAs and vertical FDI

12. Vertical FDI and deep PTAs • Domestic production, foreign outsourcing and FDI coexist πV πO πD ϑO ϑV ϑD ϑ -wNfD -wNfO Domestic prod Outsource FDI -wNfV Deep PTAs and vertical FDI

13. Vertical FDI and deep PTAs πV’ πV πO’ πO πD ϑO’ ϑO ϑV’ ϑV ϑD ϑ -wNfD -wNfO Outsourcing FDI -wNfV Deep PTAs and vertical FDI

14. Vertical FDI and deep PTAs • PTA provisions that improve contractibility of HQ services () decrease FDI πV’ πV πO’ πO πD ϑO’ ϑO ϑV ϑV’ ϑD ϑ -wNfD -wNfO Outsourcing FDI -wNfV Deep PTAs and vertical FDI

15. Vertical FDI and deep PTAs • Summary of model’s prediction: • Depth of agreements is associated to more offshoring, but relationship with FDI is ambiguous • Association is stronger for HQ intensive industries • Discipline improving contractibility of components (HQ services) are associated with increasing (decreasing) FDI • Property rights versus transaction cost (TC) model • Better contractual institutions are always associated to more outsourcing and less FDI in the TC model • Empirical analysis provides an indirect test of the two theories Deep PTAs and vertical FDI

16. Depth and composition of PTAs • We use WTO data on the content of PTAs • Comprehensive mapping and coding of 100 PTAs signed between 1958-2011 • We restrict the sample to PTAs signed by Germany (EU), Japan, and USA • We are left with 59 agreements (40 signed by EU, 12 by JAP, and 11 by USA) • PTA dataset has been constructed following the methodology of Horn et al.(2010) • Horn et al. (2010) identify a set of 52 policy areas • Legal enforceability of PTA obligations is established according to the language of the agreements Deep PTAs and vertical FDI

17. Depth and composition of PTAs Deep PTAs and vertical FDI

18. Depth and composition of PTAs • To analyze the depth of PTAs, we construct three variables (as in Oreficeand Rocha, 2013): • Total count of enforceable provisions (# Provisions) • Top 5 and top 10 provisions with the highest degree of commonality across the agreements • To analyze the composition of PTAs, we classify provisions into two groups: • HQ-provisions: GATS, TRIPS, IPR, investment, and movement of capital • M-provisions: SPS, TBT, consumer protection, customs, and export taxes Deep PTAs and vertical FDI

19. Depth and composition of PTAs Deep PTAs and vertical FDI

20. Number of agreements with specific provisions by country Deep PTAs and vertical FDI

21. Measuring vertical FDI • FDI data has been constructed using the ORBIS database assembled by Bureau van Dijk • ORBIS includes location, ownership, detailed sector level, and operational data (e.g. revenues) for more than 100 million firms in Europe, Americas, and Asia-Pacific region • We restrict our analysis to subsidiaries in any country owned by parent firms located in Germany, Japan, and USA in 2003, 2007, and 2011 • We have the revenues of 125,212 subsidiaries • We can identify 42,984 ultimate owner parents Deep PTAs and vertical FDI

22. Measuring vertical FDI • We follow the methodology in Alfaro and Charlton (2009) to identify • the ownership structure: • We consider a firm to be a parent if it owns a minimum of 25.01% of another firm • and the type of link between a subsidiary and its parent firm (i.e. vertical versus other forms of FDI): • Let S be the set of 6-digits NAICS codes of the subsidiary and P be the set of 6-digits NAICS code of the parent • An element x of S is an input of an element z of P if the total requirements coefficient of the US IO table > 0.03 Deep PTAs and vertical FDI

23. Measuring vertical FDI • We can identify 4 types of connections: • Horizontal FDI: if S and P share any element • Vertical FDI: if any element of S is an input of any element of P • Complex FDI: if S and P share any element and any element of S is an input of any element of P • Non-identified: if none of the above is satisfied • The share of vertical and horizontal links we obtain is in line with the findings of Alfaro and Charlton (2009) and Lanz and Miroudot (2011) Horizontal Complex Vertical Deep PTAs and vertical FDI

24. Measuring vertical FDI Deep PTAs and vertical FDI

25. Depth of PTAs and vertical FDI • Ideally, we would want information on intra-firm trade, but data are not available • Quantification of vertical FDI • FDIijktis the aggregate value of the revenues of subsidiaries in country (destination) j owned by parents operating in sector k, country i (US, Japan, or Germany) at time t • Example: • Vertical FDI of the car sector is the sum of revenues of all the foreign-owned subsidiaries that produce car inputs, such as plastic, seat-belts, glass. Deep PTAs and vertical FDI

26. Depth of PTAs and vertical FDI • Other explanatory variables: • HQ intensity (η) is constructed as the log of capital expenditures divided by total worker wages using data from the American Manufacturing Survey (AMS) in 2007 • Rule of law is taken from the Worldwide Governance Indicators database • GDP and GDP per capita come from the World Bank • Distance, contiguity, colony relationship, common language come from Mayer and Zignago (2011) Deep PTAs and vertical FDI

27. Depth of PTAs and vertical FDI FDIijkt=α+β1DEPTHijt + β2INSTITUTIONSjt+ γ1Xjt +γ2Xij + δt + δk + δi + δit (1) where k is sector, t is time, iand j are country indexes (i for the "origin" country and j for the "destination" country) • DEPTHijtis # Provisions and Top 5 and top 10 provisions • Xjtare controls for characteristics of the destination country that vary over time (GDP and GDP per capita) • Xijare country-pair variables (distance, contiguity, common language, colonial relationship) • δt, δk, δi, δitare time, sector, country (origin), and country-time fixed effect Deep PTAs and vertical FDI

28. Depth of PTAs and vertical FDI Deep PTAs and vertical FDI

29. Composition of PTAs and vertical FDI FDIijkt=α+β1μMijt+ β2μHijt + β3DEPTHijt+ β4INSTITUTIONSjt + γ1Xjt +γ2Xij + δt + δk + δi + δit (2) where k is sector, t is time, iand j are country indexes (i for the "origin" country and j for the "destination" country) • μMijt, μHijtdescribed below and DEPTHijtis as described above • Xjtare controls for characteristics of the destination country that vary over time (GDP and GDP per capita) • Xijare country-pair variables (distance, contiguity, common language, colonial relationship) • δt, δk, δi, δitare time, sector, country (origin), and country-time fixed effect Deep PTAs and vertical FDI

30. Composition of PTAs and vertical FDI • We construct two variables and : • Dummy = 1, if there is at least one provision of the l-type in the PTA 2 if all provisions of l-type in PTA • Discrete = 1 if at least one provision of l-type, 0 otherwise where Deep PTAs and vertical FDI

31. Composition of PTAs and vertical FDI Deep PTAs and vertical FDI

32. Conclusion –future work • So far we have said little about direction of causality • Control decisions of firms are expected to respond to depth and composition of PTAs, but firms lobby on content of trade agreements • These aspects are not captured by the model and empirical strategy • On the theory side: • Need to embed FDI decisions in a model of endogenous PTA formation • On the empirical side: • Need to instrument PTA depth and composition • For PTA depth between country i and country j , we can use instruments from poli-science literature (e.g. affinity of political systems) or average depth signed with other countries • Not obvious how to instrument for composition of PTA Deep PTAs and vertical FDI

33. Conclusion -summary • We use the AH model to guide our analysis of the relationship between deep PTAs and the internationalization of production • We exploit two new datasets on depth and composition of PTAs and on vertical FDI • Consistently with the theory, we find that: • Depth of PTA is associated to an increase in FDI (this finding is not robust) • PTA provisions that improve the contractibility of components relative to HQ activities are associated to more FDI (this supports PR over TC approach) Deep PTAs and vertical FDI

34. Transaction costs model πV πO’ πO πD ϑO’ ϑO ϑV ϑV’ ϑD ϑ -wNfD -wNfO Outsourcing FDI -wNfV Deep PTAs and vertical FDI

35. Intuition PR model • Higher component contractibility (left) increases the optimal revenue share of final good producer • Higher HQ contractibility (right) lowers the optimal revenue share of final good producer Β(η) Β(η) η η Deep PTAs and vertical FDI

36. Sectors with low HQ intensity • Domestic production and foreign outsourcing coexist, but no FDI πO πD πV ϑO ϑD ϑ -wNfD -wNfO Outsourcing Domestic prod -wNfV Deep PTAs and vertical FDI

37. Sectors with low HQ intensity πO’ πO πD πV’ πV ϑO’ ϑO ϑD ϑ -wNfD -wNfO Outsourcing -wNfV Deep PTAs and vertical FDI

38. Final-Good Producer inputs Offshoring Location choice Foreign sourcing Domestic sourcing Deep PTA Intra-Firm Trade Arm’s Length Trade Vertical Integration (FDI) Foreign Outsourcing Control choice

39. Location choice • Location choice in a simple model of global sourcing with heterogeneous firms πO πD ϑO ϑD ϑ -wNfD -wNfO Domestic production Offshoring Deep PTAs and vertical FDI

40. Location choice πO’ πO πD ϑO’ ϑO ϑD ϑ -wNfD -wNfO Offshoring Deep PTAs and vertical FDI

41. Ownership: ORBIS definition • The definition of ownership “concern the minimum percentage that must characterize the path from a subject company up to its Ultimate Owner” 54% 100% 35% Firm 2 Firm 3 Firm 1 Firm 4 • Considering a path of minimum 25.01%: the ultimate owner of firm 4 is firm 1 • Considering a path of minimum 50.01% : the ultimate owner of firm 4 is firm 3 Deep PTAs and vertical FDI

42. Distribution of Vertical, Horizontal, and Complex FDI • The share of vertical and horizontal links is in line with the findings of Alfaro and Charlton (2009) and Lanz and Miroudot (2011) Deep PTAs and vertical FDI