Trade Policy Uncertainty and its Effect on Foreign Direct Investment: Evidence from Mexico

Abstract

This paper investigates whether "trade policy uncertainty" (TPU), even absent changes in actual trade policy, may have an effect on foreign direct investment and export participation decisions. The paper focuses on the case of Mexico, where we observe a plausibly exogenous and sharp increase in TPU vis-à-vis a large trading partner beginning in the second half of 2016. To empirically test this hypothesis we first use data from Google trends to construct a TPU index that is similar in spirit to the economic policy uncertainty index of Baker et al. [2016]. We argue that this index provides a proxy that adequately captures both time series and cross-sectional variation in TPU across states in Mexico. This time-series and cross-sectional variation in exposure to trade policy uncertainty is exploited to identify the effects of increased uncertainty on FDI flows and export market participation decisions. Our main findings indicate that the increase in TPU during the reference period was associated with: i) A negative effect on FDI inflows, with the effect being driven by the negative effect that TPU had on foreign direct investment in states that are more export oriented, and ii) Higher average export probabilities for monthly exports of HS-6-digit products, the effect being driven by higher probabilities of exporting to the United States. The results of a negative effect of an increase in TPU on FDI and positive on export probability are in line with the real options perspective on decision making that points to: (a) a negative investment-uncertainty relationship when adjustment costs make it optimal to postpone investment, and (b) a positive effect of uncertainty about export market entry costs on export probabilities when export status is easily reversible.