The Impact of Policy Uncertainty on Foreign Direct Investment in Services: Evidence From Affiliate‐Level Data and the Role of Regional Trade Agreements

Abstract

This study examined how foreign direct investment (FDI) in services is affected by regional trade agreement (RTA)‐induced policy uncertainty (i.e., second‐moment uncertainty shocks), which is separated from first‐moment shocks. Policy uncertainty is elicited by examining two different types of reservations regarding certain RTA obligations: current and future reservations. Examining these reservations allowed us to capture the different magnitudes and timing of shocks. Using affiliate‐level data, we evaluated how the activities of foreign affiliates of Japanese multinational enterprises are affected by Japan's RTAs with host country‐sector‐reservation level commitments such as market access (MA), national treatment (NT) and the most favoured nation (MFN) signed by Japan from 1995 to 2018. We found that a reduction in PU regarding the current reservation of MA increases the ownership ratio of parent firms. We also found that a reduction in PU regarding the current and future reservation in MFN, together with MA, encourages the establishment of foreign affiliates. Consistent with our conceptual framework, our results show that the magnitude of PU in future reservations is considerably larger for affiliate entry than that in current reservations. Our results also highlight the difference in timing between current and future reservations.