Vertical Intra-Industry Trade and Foreign Direct Investment between Japan and European Countries

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The formation of stronger economic ties between European countries due to the creation and expansion of the EU contributed to an increase in intra-industry trade (IIT) among European countries (Fontagne et al., 2006) (1). The emerging economies in Central and Eastern Europe also reoriented their trades from within former bloc states to the EU member countries, and the share of IIT with the EU also increased (Hoekman and Djankov, 1996). The importance of bilateral trade flows within industries for European countries extends even with respect to non-European countries, including Japan. Given the extensive degree of Japanese foreign direct investments (FDI) and exports to Europe, it is worthwhile to solely focus on IIT between Japan and European countries. In this paper, we investigate vertical intra-industry trade between Japan and European countries, including both old and new EU members, as well as emerging Central and Eastern European countries.

For theoretical models with differentiated products (Helpman and Krugman, 1985), intra-industry trade increases with an increase in the similarity of endowments of two economies, resulting in more horizontal IIT (HIIT, differentiated products of same quality). On the other hand, a country may export a product whose quality is different from its corresponding import, as in the North-South trade model of Flare and Helpman (1987) and Falvey and Kierzkowski (1987). In both models, demands for different quality products are driven by heterogeneity in consumers' income. These models suggest that vertical IIT (VIIT), with price ratios of export to import deviating substantially from unity, is more likely to be observed between countries with different incomes. We expect to find this VIIT between Japan and less-developed European countries while HIIT is likely to be observed between Japan and more advanced old EU countries.

Additionally, emerging economies in Eastern Europe provide opportunities for foreign direct investments, resulting in an increasing parts and components trade between subsidiary and parent firms, or intra-firm trade. According to a fragmentation model presented in Jones and Kierzkowski (1990), a firm can take advantage of differences in factor endowments by fragmenting the production process across regions where intensively used factors may be more productive or available at lower costs. In a two country framework, a fragmented production process (which occurs somewhere in the middle of the entire production process) in a foreign country requires inputs from the home country and the ability to ship outputs back to the home country (2), resulting in increased VIIT. (Markusen and Maskus 2002) provide a unified treatment of FDI and intra-industry trade with multinational firms. Their model indicates that VIIT may increase with FDI between emerging European countries and Japan. At this point, it is important to make a clear distinction between the two driving forces of VIIY. We define the first case, in which consumers demand for different quality of products (Flam and Helpman 1987; Falvey and Kierzkowski 1987), as quality-based VIIT and the second case, in which multinationals fragment productions across regions via FDI (Markusen and Maskus 2002), as FDI-based VIIT (3).

For the measurement of vertical intra-industry trade, the threshold values of 15% and 25% differences in the relative price of exports and imports are used extensively to disentangle vertical IIT from horizontal IIT (4) in the previous empirical studies. Although this strategy can successfully differentiate HIIT from VIIT, VIIT measured at these magnitudes of price differences embraces both quality-based and FDI-based VIIT. Price differentials between export prices and import prices are likely to be wider for FDI-based VIIT (i.e., intra-firm trade) because typical intra-firm trade involves parts and components going in one direction and finished or assembled products going in the opposite direction. …