Multilevel Analysis of Free Trade Agreements and Foreign Direct Investment in the Asia Pacific Region

This paper seeks to investigate the linkage between free trade agreements (FTAs) and firms' foreign direct investment (FDI), with a focus on firm size. As small and medium-sized enterprises (SMEs) face relatively higher costs when utilizing FTAs, responses to effective FTAs are expected to vary across firms with different scales. A large-scale database is utilized for making multi-level analyses to this effect. The Poisson regression analysis shows that the intensity to undertake initial FDIs becomes stronger under the existence of an FTA (after controlling for the gravity factors of gross domestic product (GDP) and distance). A multi-level analysis reveals that (1) larger-scale initial FDIs are undertaken in FTA-partner countries; (2) the profit margin of firms established after the coming-into-effect of an FTA tends to be higher; and (3) the profit margin of those firms grouped under the service (non-manufacturing) sector tends to be higher. As for the service sector, the degree of restriction (measured by the Hoekman Index under an FTA) is not statistically significant, while the existence of FTAs is significant. Thus, a sunk cost associated with undertaking FDIs, which is deemed to be rather neutral to the degree of investment regulation, could be a critical factor in the conduct of FDIs. As a policy implication, reduction of such sunk costs (e.g., through information sharing of best practices among potential investors) could be an indispensable policy focus for making FTAs effective in terms of content.