1. PhD defense June 16th 2004 Helga Kristjánsdóttir
Determinants of Exports and Foreign Direct Investment in a Small Open Economy
PhD defense June 16th 2004
Helga Kristjánsdóttir

2. Background
Following World War II, the production capacity of industrialized countries increased substantially
In 1960s large Japanese car manufacturers had to choose between exporting and investing in United States
Multinational entity (MNE), or a multinational, is a firm with multinational activities

3. Background
In 1980s, general-equilibrium and partial-equilibrium trade theories were combined in New Trade Theory
Vertical FDI – Production located to gain access to abundant factors (Helpman, 1984)
Horizontal FDI – Production located to overcome trade costs and gain market access (Markusen, 1984)

4. Background
Most FDI among developed countries, i.e., East and West, rather than North and South
Small open economies particularly dependent on exports and FDI
Export ratio of Iceland is comparatively small, or 34% in 1999
Scandinavian countries’ export ratios ranged from 37-44%
Japan and US had export ratios below 12%

5. Trade in 1940s and 1950s

6. Trade in 1960s and 1970s
Iceland joined EFTA in 1970

7. Trade in 1980s and 1990s

8. Research Objective Extend existing knowledge in the field
Emphasize criteria used for selecting certain theories for application to Icelandic data
Gravity, as in physics, and knowledge
Interpret implications of empirical results for Iceland in an international perspective

9. Overview The dissertation chapters are:
A Gravity Model for Exports From Iceland
Determinants of Foreign Direct Investment in Iceland
The Knowledge-Capital Model and Small Countries
What Drives Sector Allocation of Foreign Direct Investment in Iceland?

10. Data Used in this Research
The data used in the research is unique:
Data on Exports From Iceland
Statistics Iceland
Panel data: 17 countries, 4 sectors,11 years, Trade blocs EFTA, EU, NAFTA and NON-bloc
Data on Foreign Direct Investment in Iceland
Central Bank of Iceland
Panel data, with the data dimension being: 17 countries, 4 sectors and 11 years

11. Ch. 1: Determinants of Exports
Krugman (1991) observes Iceland’s export ratio to be smaller than expected
Gylfason (1999) finds it to be only 2/3 of its expected value
Gravity model
Trade-theoretic intuition:
Export volume explained by market size and geographical location

12. Ch. 1: Determinants of Exports
Bergstrand 1985 specification:
Yi is GDP of exporting country
Yj is GDP of recipient country
Dij is distance between economic centers of source and host countries
Aij reflects factors that aid or restrict trade between country i and j
 log-normally distributed error term,E(lnij) = 0

13. Ch. 1: Determinants of Exports
The specifications applied here include
Sector and trade bloc fixed effects, both individually and simultaneously
Fishing, Manufacturing, Power, Other
EFTA, EU, NAFTA, NON-bloc
Correcting for small size of Iceland
Also test some marine product subsamples

14. Ch. 1: Determinants of Exports
Distance is found to be a barrier to exports
As in Krugman (1991)
Unlike Krugman
Market size and wealth of recipient country more important than size and wealth of exporting country, Iceland
Even when corrected for small size

15. Ch. 2: Determinants of FDI
Trade literature: Foreign direct investment (FDI) viewed as form of trade
Trade in financial capital
FDI: Foreign ownership of controlling stock in a particular firm (generally 10% or more)
Inward FDI sectors in Iceland
Power, Com & Fin, Tel & Trans, Other
Study if FDI in Iceland can be explained by location, market size, and several other factors

16. Ch. 2.: Determinants of FDI
Trade literature: Gravity models increasingly popular for estimating FDI
Brainard (1997); Mody, Razin and Sadka (2003)
Fixed country and sector effects
Jeon and Stone (1999) and di Mauro (2000) used countries and sectors
Here also trade bloc effects

17. Ch. 2.: Determinants of FDI
Gravity model useful in predicting FDI levels
Consistent with previous literature
Unlike earlier findings, wealth more important than market size
Effects of market size variables (GDP, POP) often close to being equal and opposite in sign
Distance negatively affects FDI, and FDI appears to be driven more by wealth effects than by market size effects

18. Ch. 3.: Knowledge-Capital Model
Trade and investment relations of Iceland viewed in global perspective, incorporating factor endowments
Knowledge-Capital (KK) model by Carr, Markusen and Maskus (CMM 2001) applied to small country case, using Icelandic data
KK model incorporates both horizontal and vertical incentives for FDI

19. Edgeworth Box Origin for Host Country = Oh Unskilled host country
skill(i)-skill(j)>0
Small host country
Y(i)-Y(j)>0
Location
of Iceland
Ydiff=0
Sdiff=0
Skilled Labor
RELATIVE
SIZE
RELATIVE
ENDOWMENTS
Skilled host
country
skill(i)-skill(j)<0
Large host country
Y(i)-Y(j)<0
Os = Origin for
Source Country
Unskilled Labor

20. Ch. 3.: Knowledge-Capital Model
Blonigen, Davies, and Head (2003)
Horizontal model cannot be rejected in favor of the KK model
Davies (2003)
Finds support for KK model
Braconier, Norbäck, and Urban (2003)
Find support for CMM specification

21. Ch. 3.: Knowledge-Capital Model
Basic KK specification and modification
Thoroughly analyze knowledge effects
Specification restrictions, enlarged sample, outlier omission
Blonigen, Davies, and Head (2003)
Davies (2003)
Also proxy by education and per capita wealth
Squared and cubed skill level and subsamples

22. Ch. 3.: Knowledge-Capital Model
Driving forces for FDI in Iceland appear to be different from those in large countries
Potential data difficulties when there are large differences in GDPs or population
Alternatively, omission of important factor endowments such as energy or fish stock

23. Ch. 4.: Sector Allocation of FDI
Skilled and unskilled labor may not be right endowment approach for Iceland
Inward FDI
Sector decomposition, resource endowments
Power, Com & Fin., Tel & Transport, Other
Waldkirch (2003)
Also natural resources, infrastructure, pollution quotas and government stability

24. Ch. 4.: Sector Allocation of FDI
FDI sector shares and levels
FDI shares reflect relative size of each sector within a particular year of investment
Brainard (1997)
Inward and outward FDI share proxies separately as share of affiliate sales in total exp
Slaughter (2000)
FDI proxied by investment share (measured as majority-owned affiliates) in overall MNE investment

25. Threshold Cost and FDI
FDI
Market Size

26. Ch. 4.: Sector Allocation of FDI
FDI theories assume certain threshold costs
Generally not dealt with in FDI empirical models
Markusen (2002): fixed cost that MNEs need to consider when undertaking FDI
Heckman's (1979) two-step model to control for whether sample selection is driving results
KK model seems to explain fixed costs but not the level of investment (marginal change)
However, gravity model provides information on both

27. Levels FDI Heckman GM, 1st step

28. Levels FDI Heckman GM, 2nd step

29. Ch. 4.: Sector Allocation of FDI
Results different from what was anticipated since KK model still does not perform very well for Iceland
Heckman procedure application to gravity rather than KK model, since this gives better indication of how host-country characteristics affect FDI
However, endowment inclusion in gravity model can be credited to KK literature

30. Conclusions I
Geographic approach to trade theory applied to small open economies like Iceland
With incorporation of gravity models
Gravity forces appear to describe Iceland's exports
Distance hampers trade whereas size of trade partners encourages trade
Distance effect apparent not only for export
Also important for FDI in Iceland

31. Conclusions II Reasons to prefer gravity model for FDI
Also find support for the intuition behind KK model, i.e., that endowments matter
Use more endowment proxies than merely the knowledge-endowment proxies
Employ proxies for endowments that are crucial to Icelandic economy
Useful both for explaining levels of investment and fixed costs typical of FDI models