Export, invest, or both? A Stackelberg game of multinational entry mode and the FDI-trade nexus in emerging economies: evidence from a 70-country bilateral panel

Abstract

Whether inward foreign direct investment (FDI) complements or substitutes for bilateral trade receives contradictory answers in the empirical literature. This article contributes on two fronts. On the theoretical side, we construct a two-stage Stackelberg game. The host-country government (leader) sets a policy vector (tariff τ, FDI incentive s, institutional quality q). The multinational firm (follower) observes this policy and selects its entry mode among four options: pure export (EX), horizontal FDI (H), vertical-platform FDI (V), or combination strategy (C). Backward induction yields four equilibrium regimes and a complementarity frontier Σ, i.e. a frontier in (τ, Δw, q) space of policy, labor cost, and institutional quality parameters, that separates configurations where FDI stimulates trade from those where it crowds trade out. On the empirical side, we test these predictions on a directed bilateral panel of 70 countries (including 45 emerging and developing economies across Africa, Asia, Latin America, and the Middle East) covering 2,415 pairs and 67,023 observations over 1995-2023. A PPML gravity estimator with pair-clustered standard errors shows that bilateral FDI is positively associated with trade on average (+0.025, p < 0.001). Institutional asymmetry between partners, measured by |WGI_A − WGI_B|, amplifies this association (+0.023, p < 0.001), consistent with the vertical-FDI mechanism predicted by the model. Regime classification achieves 74.8% accuracy (Cohen's κ = 0.55, corresponding to moderate agreement on the Landis and Koch (1977) scale). The cross-pair permutation test and bilateral fixed effects confirm the robustness of these results. Results are interpreted as conditional associations rather than causally identified effects. These findings provide emerging-economy policymakers with a diagnostic tool to anticipate whether inward FDI from a given partner will strengthen or weaken the trade balance.

JEL Classification: F12, F21, F23, C72, O24

Paper type: Empirical Research