International Trade and Foreign Direct Investment (FDI) have grown at fast paces during the last decades. At this point, however, it is not clear whether trade and investment are regarded by firms as complementary ways of accessing other markets, or, instead, if they are employed as alternative strategies. This paper examines this issue empirically, for the particular case of Europe, an area in which commercial and economic integration has gained remarkable momentum since 1992. More specifically, it tests whether the reduction of trade barriers over time among the members of the European Union (EU) has increased not only trade flows but also FDI within those countries. A gravity model is estimated using the Hausman-Taylor estimation technique—to circumvent time invariability and endogeneity—for intra Europe FDI and, separately, for FDI to the EU members with origin in third countries. In addition to trade integration measures, this paper also analyzes the potential role of other traditional determinants of FDI, as the market size of the host country and the cost differential among home-host economies. The results suggest that EU commercial integration and FDI reinforce each other, thus being complements rather than substitutes in Europe. This effect is apparent for the intra-EU FDI and also for investment coming from countries outside the EU. Cost differentials are not as relevant as the possibility of gaining market share which leads us to conclude that in the EU the FDI pattern follows a horizontal strategy rather than a FDI vertical model.
KeywordsInternational TradeFDIGravity ModelHausman-Taylor EstimationEuropean Union
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