Trade liberalization and foreign direct investment in producer services

This paper examines the effect of trade liberalization on the growth of foreign direct investment (FDI) in intermediate services, alternatively known as producer services. The core hypothesis is that trade liberalization affects incentives for FDI in intermediate services through derived demand effects from tradables sectors. This is due to the auxiliary role of such services in the production, trade, and distribution of final goods. Given an appropriate production and factor intensity structure, trade liberalization may increase the demand for producer services and induce inflows of resources specific to the production of these services. The hypothesis is based on country-specific and regional experiences which indicate that trade policies affect the level and composition of FDI.;The paper demonstrates this hypothesis theoretically using a three sector Heckscher-Ohlin model and in the context of a case study of Spain. It shows that trade liberalization in a unilateral or regional context may create incentives for foreign direct investment in producer service industries. The paper also examines other reasons for the growth of FDI in intermediate services, in particular, the impact of regulatory changes in producer services. This is done in the context of an increasing returns to scale model and with brief industry studies. The analysis suggests that one of the driving forces underlying the recent expansion of foreign direct investment in producer services is the liberalization of FDI regulations in the service sector. In addition, recent trends in unilateral and regional trade liberalization have also contributed towards this phenomenon.