The impact of policy heterogeneity on trade and direct investment in services

1. The impact of policy heterogeneity on trade and direct investment in services Arjan Lejour, Henk Kox

2. Frankenstein visits Lisbon

3. Why so little trade in services? • Technical reasons: • most service products cannot be shipped in boxes • physical proximity of service producer and consumer often required • Alternative international supply form: setting up a local subsidiary (FDI) • Regulation-based trade barriers • Directly trade barriers (non tariff) • Non-tariff barriers caused by regulation of service markets

4. Regulation-based trade barriers for services • Many different types • additional diplomas, certificates, licenses, requirements on input use, marketing, local professional insurance, membership of professional association, juridical form, etc. (EC, 2002) • common element: qualification costs • Different motives for regulations: • ensure quality of the service or • reliability of the service provider • protect incumbent firms • satisfy special domestic interest groups

5. Nature of regulation-caused trade cost barrier • Qualification costs for service providers: mainly fixed costs • Form an entry barrier that also affects domestic service providers • Like all fixed costs, regulation-caused costs could be a source of scale economies...... if borders were open!

6. Main barrier for service trade: not regulation as such but regulation heterogeneity • Each country regulates in a different way • Foreign service regulation comes on top of regulation in home market • Causing fixed compliance costs, specific for that export market • Compliance costs are independent of firm size → press hardest on SME

7. Costs of regulation heterogeneity

8. The effects of regulation heterogeneity on trade and FDI • Prior work: OECD researchers developed relative measures of regulation intensity level per country (Nicoletti et al.) • They found negative impacts of regulation levels on bilateral trade and FDI in services • Problem with levels: two countries with same regulation level may have very different regulations in place • causes additional costs for exporters

9. Indicator for bilateral policy heterogeneity • For explaining bilateral trade and direct investment patterns we need a quantitative measure for bilateral policy heterogeneity • Use OECD International Regulation database • Database: 1600 regulation items • Selection of 200 items in product market regulation • For each regulation item pair-wise comparison of countries • yields a matrix of bilateral indicators for policy heterogeneity

10. Refinements • Heterogeneity indicator: • an indicator for regulation-caused NTBs • increases in the level of policy heterogeneity between countries • specific for each country pair • Decomposable for separate regulation domains: • Barriers to competition • Administrative burdens on startups • State control • Regulatory and administrative opacity • Explicit barriers to trade / investment

11. Bilateral commercial services exports (ln), 1999-2001, 480 obs

12. Results for trade regressions • "Traditional" gravity variables: • all were significant and had the expected signs • Heterogeneity in market regulation has a strong negative impact on bilateral trade in commercial services • strongest effect: sub-indicator for 'barriers to competition' • Several methods (OLS, FE, TLS / SUR) used for testing robustness

13. Bilateral direct investment, 1999, 252 obs

14. Results for bilateral FDI • Non-policy variables: • gravity variables all significant and expected sign • Technology variable (service productivity in origin country): significant positive effect • Heterogeneity in market regulation has significant negative impact: • strongest for regulation domain "Barriers to competition“ • and FDI restrictions • Some policy heterogeneity domains affect choice between exporting and FDI

15. Policy context: • EC (2004): new proposals that should boost internal service market by 2010. Principal instruments: • reduce regulation heterogeneity • Country of origin principle • abandon discriminating regulations • single point of contacts for foreign service firms • Use our regression results for quantifying possible effects of EU proposals • Close reading of proposals and establish their probable impact on heterogeneity

16. Impact of proposed EU directive on heterogeneity indicators

17. Simulated effect of new EU proposals on service trade and investment

18. Conclusions • Heterogeneity in regulation hampers trade and FDI in services • In particular barriers to competition • Analysis of effect non-tariff barriers was always elusive (NTBs difficult to quantify) • our analysis from perspective of policy heterogeneity seems fruitful • Follow-up: test its explanatory power for the OECD as a whole • Results may have implications for future GATS negotiations • More emphasis on mutual recognition