INTRODUCTION

Interdependence among countries has increased substantially since the end of World War II. The main force behind this growing interdependence is international trade. Indeed, it is the rapid expansion in world trade, resulting largely from liberalization of manufacturing trade, that has led to substantial growth of the world economy. In recent years, however, foreign direct investment (FDI) has become a major contributor to deepening interdependence among countries. Between 1980 and 1996, world FDI grew at an annual average rate of 12.6 percent, significantly higher than the corresponding growth rate of 6.5 percent for world trade (both in nominal terms).

Rapid FDI expansion has given rise to an important and interesting question regarding the relationship between FDI and international trade. Does international trade promote or discourage FDI? Does FDI facilitate or restrict international trade? These questions concern whether FDI and trade are complements or substitutes (i.e., whether they exert positive or negative influences on each other).

Theoretically, FDI and trade can be either complements or substitutes. Within the framework of the Heckscher-Ohlin (H-O) model, Mundell (1957) showed that FDI and trade are perfect substitutes; in other words, trade reduces incentives for FDI and vice versa. In contrast, by relaxing the assumptions used in the H-O model, Markusen (1983) obtained a case where FDI and trade can be complements. Specifically, he demonstrated that FDI expands trade when trade is induced by non-H-O factors, such as differences in technologies between trading partners. A crucial determinant of this relationship is whether FDI is undertaken in an export industry or import-competing industry in the host country.