Last Updated 27 May 2020

Are trade and capital mobility substitutes or complements

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As many people can notice, globalization is becoming a trend when more and more countries are trading their products with each other. In some cases, countries are willing to integrate their capital markets, that is improving capital mobility, so as to achieve freer trade. However, some might argue that trade and capital mobility are complements, which are casually related. To justify one of the two statements above, it is useful to first look at what 'capital mobility' means. There are physical capital and financial capital. Improving their mobility is to allow things like machines and foreign direct investment (FDI) to move freely in and out of countries.

The main objectives of FDI for foreign firms are to exploit competitive advantages, such as technology; to benefit from economies of scale; to gain access to cheaper labour or natural resources for production an to reduce trade costs, mostly tariffs. There are different types of FDI, for example, tariff-jumping, international specialization, horizontal and vertical disintegration.

It is called tariff-jumping when firms want to minimize trade costs by investing money into a market with very high tariffs or limited access in order to compete with domestic producers. This is clearly a substitute of trade. Horizontal disintegration is a similar type of FDI as firms try to diffuse their production units to access markets in other countries, so that they are able to avoid impediments like tariffs, quotas or even currency difference. The famous fast food chain, McDonald's, is initially an American company and it has now invested internationally.

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However, some types of FDI are the opposite, complements to trade. Some countries possess comparative or absolute advantages like higher level of technology or cheaper factors of production in general. For instance, cheaper labour is found in China while the US is better at advanced technology. If a firm wants to produce clothes, it might find China to be the optimal location for investment because labour and fabrics are cheaper. Similarly, a firm wants to produce or sell calculators might find Japan a suitable place to invest on. This is due to the effects of specialization, which one supposes to be a result of and also complement to international trade. Vertical disintegration FDI occurs when a firm decides to locate its production activities in a foreign country, for example, a firm producing cosmetics might locate its research and development department in India simply because of cheaper land in that country.

As for international specialization type FDI, one can argue that the intention of a foreign firm to set its production activities or to invest in a certain industry in a different country could be for an easier way to trade its products to that particular country. For instance, Nike, a trainers producing company, might want to move its production to China because of cheaper raw materials but meanwhile to gain access to the huge China market. This can reduce firms' trade costs, such as, environmental fines and advertising expenditure. This is why FDI could be substitutes for and complement to trade at the same time.

The Solow argument for capital market integration specially focuses on the dynamic effect of investment on growth.

The obvious effect would be an improvement in efficiency of allocation, which creates a rise in productivity, shown by a movement from point C to point. The dynamic effect would be an increase in investment rate because higher productivity means more ability to invest. This causes a movement from D to E. From another point of view, one can interpret higher productivity as more exports into a foreign country. It indicates a special interactivity between investment and trade.

Let this discussion take further from a more realistic angle. If we take the European Union (EU) as an example, statistical facts have shown that FDI actually increased four times faster than world GDP and three times faster than world trade since 1960, and EU has been the largest source of FDI. One would reckon that the faster growth in FDI than trade means FDI was more on the 'substitute for trade' side. Nevertheless, the most rapid growth of FDI was during 1980 to 1990, which some argue in this period of time, technological advancement made capital-market integration more and more crucial and economic integration was inefficient without capital-market integration.

It created a need of specialization, which means some countries specialize in high-tech goods and others in low-tech ones. This implies a possibility that it was very unlikely to increase trade without capital-market integration. A static analysis by Soete (1987) to explain the trade shares held by the wider circle of OECD member states by technology factors was undertaken. The results clearly showed that there is a role of the technology variable. By this result, we can pull trade and capital mobility back onto the line between substitutes and complements.

One of the objectives of international trade is to achieve a harmonized relationship between economies by an efficient allocation of resources. Theoretically, an integration of capital markets serves a similar purpose. Assuming there are two countries with fixed supply of capital, the simple model shows the price effect of the change from closed economies to total integration.

The model tells that removing restrictions on capital mobility between the countries would lead to more harmonized interest rates of capital. We can then compare the above argument to the statistics given by Eurostat about price dispersion. It proves that during the period 1975-1985, while the EU (former EC) was undergoing capital-market integration, the price dispersion of consumer goods came to about one fifth of the average price in the EU and was largely brought about by indirect taxes. It is very difficult to interpret this piece of information because there was wider dispersion in 1975-1980 but it narrowed down in 1980-1985. However, if we compare the prices of 1988 to 197, it is found that prices in the EU tended to converge eventually. Another fact from Eurostat also shows that trade within the EU has increase and their trade with third countries grew even faster in the same period. Therefore, in the part of prices, capital mobility has significantly contributed to increase in trade.

After looking at different issues, such as some types of FDI, technological influences, price effects and information from Eurostat, it is still ambiguous whether we should define trade and capital mobility as complements or substitutes. It is understood that the question covers various aspects and calculations that it is simply difficult to draw a conclusion.

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