Definition of trade "Trade" refers to cross-border exchange of goods (merchandise) and services.

Definition of FDI Foreign direct investment (FDI) occurs when an investor based in one country (the home country) acquires an asset1 in another country (the host country) with the intent to manage that asset. The management dimension is what distinguishes FDI from portfolio investment in foreign stocks, bonds and other financial instruments. There are three main categories of FDI: 1. Equity capital: the value of the MNC's investment in shares of an enterprise in a foreign country. This category includes both mergers and acquisitions and greenfield investments (the creation of new facilities). 2. Reinvested earnings: the MNC's share of affiliate earnings not distributed as dividends or remitted to the MNC. Such retained profits by affiliates are assumed to be reinvested in the affiliate. This can represent up to 60 per cent of outward FDI in countries such as the United States and the United Kingdom. 3. Other capital: short or long-term borrowing and lending of funds between the MNC and the affiliate. Why are we interested in learning about FDI? It is too big to ignore. It provides evidence for globalization: the increased importance of foreign-owned production and distribution facilities in most countries is cited as tangible evidence of globalization.

Why do countries engage in FDI? Foreign direct investment is viewed as a way of increasing the efficiency with which the world's scarce resources are used. For example, FDI can stimulate economic growth in many of the world's poorest countries. It can be a source not just of badly needed capital, but also of new technology and intangibles such as organizational and managerial skills, and marketing networks. FDI can also provide a stimulus to competition, innovation, savings and capital formation, and through these effects, to job creation and economic growth.

*An asset is property or an item controlled by an economic entity as a result of a past transaction or event. Assets can be categorized into three basic types: current assets, fixed assets and intangible assets. Current assets are cash, accounts receivable, materials and inventories that in the ordinary course of operation are likely to be consumed or converted into cash within 12 months of the last financial year. Fixed assets include items such as buildings and machinery. Intangible assets include patents and goodwill, etc.

Relationship between trade and FDI Trade policies can affect the incentives for FDI A sufficiently high tariff may induce tariff jumping FDI to serve the local market. Other types of import barriers can have the same effect, of course. It is no coincidence that Japanese automobile manufacturers began producing in the European Union and the United States following the imposition of so-called voluntary export restraint agreements (VERs) limiting the number of automobiles that could be shipped from Japan. FDI may also be undertaken for the purpose of defusing a protectionist threat. Such quid pro quo investments are motivated by the belief that the added cost of producing in the foreign market is more than compensated by the reduced probability of being subjected to new import barriers on existing exports to that market. There is evidence, for example, that the perceived threat of protection had a substantial impact on Japanese FDI in the United States in the 1980s, and that these investments reduced the subsequent risk of being subjected to contingent protection resulting from anti-dumping and escape clause actions.

Regional trade agreements can affect where, and whether, FDI occurs Changing market size: Market size is an important consideration for an MNC contemplating a particular FDI. By removing internal barriers to trade, a free trade area or customs union gives firms the opportunity to serve an integrated market from one or a few production sites, and thereby to reap the benefits of scale economies. This can have a pronounced impact on investment flows, at least while firms are restructuring their production activities. The single market program of the European Union stimulated substantial investment activity, both within the Union and into the Union from third countries, and similar effects on FDI flows have been observed for other regional trade agreements. Rules of origin and protectionism in Free Trade Areas: Because rules of origin can have a protectionist effect (if not an intent), they can affect the location of FDI. For example, under NAFTA rules of origin, clothing produced in Mexico gains tariff-free access to the United States market, provided it meets the yarn forward rule, which for many products requires virtually 100 per cent sourcing of inputs in North America. Mexican clothing manufactures face a choice between sourcing all inputs beyond the fibre stage in North America to obtain free trade area treatment, or sourcing inputs outside NAFTA at potentially lower cost, but foregoing duty free access to its most important market. As MFN tariffs on clothing are still high, they may choose to source inside the area rather than outside. This obviously creates greater incentives for third country textile producers to invest in production facilities inside the NAFTA area to regain lost customers, than would less restrictive rules of origin.

The overall picture is complex and differs between countries and sector. Overall, the clearest conclusion is that trade policy can have a significant impact on FDI flows and vice versa. Country and sector-specific traits determine whether the relationship is complementary or competitive. Reference: http://www.wto.org/english/news_e/pres96_e/pr057_e.htm