The “Proximity-Concentration” Tradeoff in a Risky Environment∗ [Preliminary]

This paper analyzes the impact of country specific risk on a firm’s choice between serving a foreign market through exports or affiliates sales. We find that country pairs with less correlated business cycles trade more, relative to multinational production. Moreover, the stochastic properties of world output fluctuations affect the cross country patterns of trade flows and foreign affiliate sales. Using U.S. data on trade and affiliate sales, we find empirical support for the predictions of the model. Our estimates suggest that, if the business cycles of New Zealand and the United States were perfectly synchronized, New Zealand’s exports would drop by 2 percent, relative to the sales of its affiliates in the United States. This drop is equivalent to a reduction of more than 4 percent in the distance between New Zealand and the United States. ∗We are thankful for helpful comments from participants at the 2009 Society for Economic Dynamics Annual Meeting, and the Brown Bag Seminar at the Minneapolis FRB. We would also like to thank Raymond Mataloni, Stephen Yeaple, William Zeile for their help with the multinational affiliate data. Ruhl thanks the National Science Foundation for support under grant SES-0536970. †E-mail: [email protected] ‡E-mail: [email protected] §E-mail: [email protected]