The Impact of a Raw Material Import Ban on Vertical Outward FDI: Theoretical Insights and Quasi-Experimental Evidence

TL;DR

This study investigates how domestic input shocks, exemplified by China's 2017 waste paper import ban, influence firms' decisions to undertake vertical outward FDI, revealing a strategic response to supply disruptions.

Contribution

It provides the first empirical evidence linking supply-side shocks to vertical OFDI using a quasi-experimental approach and firm-level data.

Findings

The import ban increased vertical OFDI probability by 16%.

Firms with higher baseline costs or productivity are more likely to invest abroad.

Supply shocks prompt firms to reallocate production across borders.

Abstract

This paper examines how adverse supply-side shocks in domestic input markets influence firms' vertical outward foreign direct investment (OFDI) decisions. While the theoretical basis for cost-driven OFDI is well established, empirical evidence on the causal mechanisms remains limited. We develop a framework in which input cost shocks raise unit production costs, but firms undertake vertical OFDI only when shocks are sufficiently severe or when baseline costs are already high. Firm heterogeneity leads to a sorting pattern, whereby more productive firms are more likely to invest abroad. To test this mechanism, we exploit China's 2017 waste paper import ban as an exogenous shock and leverage a distinctive feature of the paper product industry's supply chain. Using a difference-in-differences strategy and firm-level data from 2000 to 2023, we find that the policy shock increased the probability of vertical OFDI by approximately 16% in the post-policy period relative to a control group. These results provide robust evidence that firms respond to domestic input shocks by reallocating production across borders, highlighting vertical OFDI as a strategic response to supply-side disruptions. The findings contribute to understanding the micro-foundations of global production decisions in the face of input market volatility.