Deep trade agreements and vertical FDI: The devil is in the details

Abstract

Abstract Although pre‐1990s preferential trade agreements focused mostly on tariff liberalization, recent agreements increasingly contain deep provisions in diverse areas, such as intellectual property rights, investment and standards. At the same time, there has been a remarkable increase in the internationalization of production through foreign direct investment and outsourcing. This paper studies how deep trade agreements affect the international organization of production. Using new measures of the depth and content of preferential trade agreements and of vertical foreign direct investment, the analysis finds evidence that the depth of trade agreements is correlated with vertical foreign direct investment. Furthermore, this relationship is driven by the provisions that improve the contractibility of inputs provided by suppliers, such as standards, while provisions that increase the contractibility of headquarter services, such as intellectual property rights and investment protection, are generally negatively correlated with foreign investment. This finding is consistent with the so‐called “property rights” theory of the multinational firm according to which improving the contractibility of an input reduces the importance of giving incentives through ownership.

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