This column summarizes a study that offers a new perspective on how multinational firms adapt to significant tariff changes during an era of globalization. Specifically, it examines the impact of tariff shocks in destination markets on Korean firms’ outward foreign direct investment (FDI) from 2010 to 2018. The findings reveal an asymmetric impact of tariffs: significant decreases in tariffs lead multinational enterprises (MNEs) to reduce the number of subsidiaries, rather than reducing the average investment per subsidiary. In contrast, the effects of tariff increases on FDI are muted. The study also highlights that more productive firms are more likely to reduce the number of subsidiaries they maintain in developing countries when faced with substantial tariff decreases. These findings underscore how MNEs adapt to evolving trade policies, reallocating resources among their foreign subsidiaries.

Tariffs and FDI

Global trade is constantly shifting, and tariffs—as taxes on imports—play a crucial role in influencing how exporting firms and multinational enterprises (MNEs) participate in international trade. One aspect of this issue is whether tariffs also affect MNEs’ decisions to invest abroad. Typically, high tariffs often lead firms to establish production facilities in the local market, a practice called “tariff-jumping.” (e.g., Blonigen, 2002) This approach allows firms to bypass import taxes and access local markets more efficiently. However, as the trend of globalization has led to a general reduction in tariffs worldwide (at least up to 2018), one may question whether this phenomenon would influence the pattern of firms’ foreign direct investment (FDI). Specifically, when tariffs in the destination country decrease significantly, do firms stop investing directly and instead choose to export, or do they adapt in other ways?

South Korea’s economy, with its active global investment footprint, offers a valuable perspective for studying this issue. Between 2010 and 2018, South Korean firms invested heavily overseas, accounting for approximately 2% of the country’s GDP¹ each year (around 30 billion USD). My research (Pyun 2023) reveals how significant changes in tariffs influence MNEs’ investment strategies, focusing on outward FDI by South Korean firms over the period from 2010 to 2018.

Identifying Tariff Shocks and Assessing Their Impact on FDI Decisions

Using firm-level data from the Korean manufacturing industry, my research analyzes how significant changes in tariffs—both increases and decreases—affected the number of foreign subsidiaries (extensive margin) and the amount invested in each subsidiary (intensive margin). I classified industry-level tariff changes imposed on Korea by countries worldwide into positive and negative tariff shocks based on the magnitude of these changes: I consider tariff changes that are one standard deviation from the mean, specifically those in the top 16th and bottom 16th percentiles of all tariff changes by industry (note that the results remain consistent using different cutoff points, such as the 10th and 90th percentiles, as well as with continuous tariff changes).

I then begin to analyze the correlation between negative tariff shocks at the industry level and the number of foreign subsidiaries established by Korean MNEs, as well as the average FDI per subsidiary in a given industry and country. While there is no significant correlation between negative tariff shocks and the average amount of FDI per subsidiary, the analysis does reveal that the number of foreign subsidiaries tends to be lower when negative tariff shocks occur. Since this correlation does not establish a direct causal relationship, he conducts a more systematic analysis to capture causal inference by controlling for determinants of FDI, as well as firm, industry, and country characteristics.

The Asymmetric Effects of Tariffs: Lower Tariffs Lead to Resource Reallocation

Korean firms respond to significant decreases in tariffs in destination markets by reducing the number of subsidiaries they maintain in those markets. However, they did not exit these markets entirely; instead, they concentrated their resources in a smaller number of key foreign subsidiaries due to higher investment costs relative to the reduced trade costs that result from lower tariffs. This suggests that lower tariffs encourage firms to streamline their operations, focusing on efficiency rather than expanding their footprint. However, there is no significant impact on the average investment in foreign subsidiaries when tariff shock occurs, implying that firms are not immediately shifting their strategy from FDI to exporting, despite a decline in trade costs, because they have already incurred the sunk costs of FDI.

Another interesting finding is that both firm productivity and its investment destinations play a significant role in shaping FDI. More productive firms respond more strongly to decreasing tariffs. These firms are more likely to reduce the number of subsidiaries they have in developing countries while maintaining investments in advanced economies. This reflects productive MNEs’ strategic reallocation of resources, favoring quality over quantity in developing countries, where they rely on inexpensive inputs, in contrast to investments in advanced countries aimed at gaining market access.

Lastly, contrary to expectations, I found limited evidence that significant increases in tariffs affect FDI patterns. This asymmetry suggests that firms are more sensitive to the opportunities presented by tariff reductions than the challenges posed by tariff increases during an era of globalization.

Lessons Learned about FDI Patterns Following a Tariff Shock

The mainstream literature maintains that trade liberalization, which impacts firms engaged in global trade, promotes efficiency across the global economy (e.g., Melitz 2003). However, this study shows that lower tariffs can lead to even more streamlined and efficient foreign investment strategies. Furthermore, high-productivity MNEs are likely to adapt more effectively to changing trade policies. This aligns with the idea that allocating resources strategically to core markets and subsidiaries can help maintain a firm's competitiveness in a rapidly evolving trade environment. The result also highlights that tariff-driven resource reallocation, reflected in a decrease in the number of foreign subsidiaries following declines in tariffs, is more pronounced in developing countries than in advanced countries. Hence, developing nations should consider how reducing their tariffs not only affects their imports but also their ability to attract and retain productive foreign MNEs, as foreign MNEs tend to reduce the number of their subsidiaries in response to tariff reductions.

In the past, during an era of trade protectionism, MNEs recognized trade barriers and sought more efficient ways to internationalize, such as engaging in tariff-jumping FDI by relocating production facilities. However, in an era of globalization—characterized by a steady decline in tariffs—MNEs adjust to changes in trade policy by reallocating resources, not only by choosing between exporting and relying solely on sales from foreign subsidiaries, but also by deploying resources selectively among those subsidiaries. However, a sudden resurgence of protectionist policies--as is now being realized with the new U.S. administration--raises important questions regarding how firms will adjust to these new challenges. Will they revert to tariff-jumping strategies, or will they discover a new path?

Author's Note

This column is based on the following paper. Pyun, J.H. 2023. “(Asymmetric) Tariff‐driven Foreign Direct Investment: Evidence from Korean Firm‐level Data.” The Developing Economies 61(4): 297-323.

Note:

1. South Korea’s GDP is 1.5 trillion current USD in 2015.

References

Blonigen, B. A. 2002. “Tariff-jumping Antidumping Duties.” Journal of International Economics 57(1): 31-49.

Melitz, M. J. 2003. “The Impact of Trade on Intra‐industry Reallocations and Aggregate Industry Productivity.” Econometrica 71(6): 1695-1725.

Pyun, J. H. 2023. “(Asymmetric) Tariff‐driven Foreign Direct Investment: Evidence from Korean Firm‐level Data.” The Developing Economies 61(4): 297-323.

Author's Profile

Ju H. Pyun is a Professor at Korea University Business School (KUBS). Prior to joining Korea University, he worked as a research fellow at Korea Institute for International Economic Policy (KIEP). He received his Ph.D. in Economics from the University of California, Davis.

* Thumbnail image: Concept of Tariff Barriers, 3d rendering. © mesh cube.
** The views expressed in the columns are those of the author(s) and do not represent the views of IDE-JETRO or the institutions with which the authors are affiliated.