Trade and capital flows: Substitutes or complements? An empirical investigation

Abstract

This paper examines the linkages between the trade of goods and financial assets. Do both flows behave as complements (implying a positive correlation) or as substitutes (negative correlation)? Although a classic topic in international macroeconomics, the empirical evidence has remained relatively scarce so far, in particular for the Euro area where trade and financial imbalance played a prominent role in the build‐up of the European sovereign debt crisis. Consequentially, we use a novel dataset, providing estimates for financial flows and its four main categories for 42 countries and covering the period from 2002 to 2012, to test the so‐called trade‐finance nexus. Since theoretical models stress that both flows might be influencing each other simultaneously, we introduce a novel time‐varying instrumental variable based on capital control restrictions to estimate a causal effect. The results of the gravity regressions support theories that underline the complementarity between exports and capital flows. When testing the trade‐finance nexus for different types of capital flows, the estimated coefficient is most pronounced for foreign direct investment, in line with theories stressing informational frictions. Robustness checks in the form of different estimation methods, alternative proxies for capital flows and sample splits confirm the positive relationship. Interestingly, the trade‐finance nexus does not differ among countries belonging to the EMU, the European Union or among core and peripheral Euro area countries.

The effect of restrictive measures on cross‐border investment in the European Union

“…Our findings are also in line with and contribute to the literature on the links between regulatory barriers and trade flows, in particular looking at trade flows as complements to cross‐border capital flows (Belke & Clemens, 2018). Van der Marel and Shepherd (2013) analyse the relationship between trade in services and regulation, finding a negative link between regulatory restrictiveness and trade flows, whose strength results to vary across sectors.…”

“…We find a negative and significant relationship between distance and cross‐border flows, as we should expect in theory, but the variable expressing the time difference between countries is positively linked with M&A, supporting the view that it is a driving force of international relationship, possibly related to vertical integration in the production process (Marjit, 2007). Trade openness attracts investment, which suggests a complementarity between FDI and trade (Belke & Clemens, 2018). Positive and significant coefficients related to GDP in the host country confirm that wider market size makes cross‐border investments more attractive for foreign investors, in terms of additional possibility to expand businesses, create economies of scale or reduce production costs (Eicher et al., 2012).…”

The effects of restrictive measures on cross‐border investment: Evidence from OECD and emerging countries

“…28 If we consider the determinants and explanatory factors of FDI, the regulatory quality variable is positively related to cross-border FDI, highlighting the proactive role that public administration can exert to stimulate foreign investment (Gregori and Nardo, 2021). Trade openness attracts investment because of a complementarity between FDI and trade (Belke and Clemens, 2018). The dynamism of the destination economy has positive and significant impacts on FDI.…”

“…FDI ij,t−1 is one-year lagged dependent variable (Egger and Merlo, 2007). 11 Following Mistura and Roulet (2019), all explanatory variables are lagged by one year to reduce potential endogeneity issues. FDI RI s j,t−1 is our interest variable (FDI Regulatory Index), i.e.…”

“…The studies combine both horizontal and vertical FDI 11. They argue that ignoring the dynamic nature of FDI could lead to an overestimation of the effect of bilateral factors.…”