Detecting positive effects of the ASEAN-China free trade agreement on foreign direct investment

Empirical findings suggest that forming Free Trade Agreement (FTA) could be an efficient way of attracting inward Foreign Direct Investment (FDI). With an aim to explore the mechanism of how FTA encourages FDI, this study detects its two FDI-promoting effects identified in theoretical studies. One is the effect of market expansion and the other is the effect of vertical fragmentation. This paper uses the ASEAN-China Free Trade Agreement (ACFTA) as a case study and detect its two effects through a sector-level examination of FDI in China’s manufacturing industry. Both effects are found with ACFTA. The finding suggests that the market expansion effect can assist sectors with international competitiveness in attracting more market-seeking FDI, while the vertical fragmentation effect can promote vertical FDI to sectors with intense trade in intermediate goods. A policy insight from this study is that the selection of FTA partners is important in the effect of FTA on FDI. Forming FTAs with big markets would bring market-seeking FDI, while forming FTAs with countries on the same production value chain can bring vertical FDI.