Estimating Trade and Investment Flows: Partners and Volumes

I present a new stylized fact from a large sample of countries for the period 2000-2006: bilateral foreign direct investment (FDI) flows are almost never observed in the absence of bilateral trade flows. I document a similar pattern using bilateral foreign affiliate sales (FAS), aggregating them up from a large firm level dataset (ORBIS), which includes over 45,000 firms. I propose a model where heterogeneous firms can decide whether to serve foreign markets through export or FDI. I derive theory-based gravity-type equations for the aggregate bilateral trade and foreign affiliate sales (FAS) flows. I then suggest a two-stage estimation procedure structurally derived from the model. In the first stage, an ordered Probit model is used to retrieve consistent estimates of the terms needed to correct the flows equations for firms’ heterogeneity and selection into exports and FDI. In the second stage, a maximum likelihood estimator is applied to the corrected trade and FAS equations. The main results of the analysis are as follows: 1) The impact of distance, border and regional trade agreements on the amount bilateral foreign affiliate sales becomes substantially smaller after controlling for selection and firms’ heterogeneity (hence separating the impact on the extensive versus the intensive margin). 2) The same “attenuation” result is found also for the trade equations, consistently with previous literature. 3) When FAS are observed, failing to take this into account when correcting for heterogeneity and selection in the trade equations does not leads to significant differences in the estimated coefficients.