Foreign direct investment in Central and Eastern European countries: a dynamic panel analysis

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Abstract

This paper uses dynamic panel data methods to examine the determinants of foreign direct investment (FDI) into Central and Eastern European countries (CEECs). Our empirical model shows that the traditional determinants, such as market potential, low relative unit labor costs, a skilled workforce and relative endowments, have significant and plausible effects. In addition, transition-specific factors, such as the level and method of privatization and the country risk, play important roles in determining the flows of FDI into the CEECs and help to explain the differing attractiveness of the individual countries to foreign investors. Journal of Comparative Economics 32 (1) (2004) 3–22.

Introduction

This paper examines the determinants of foreign direct investment (FDI) into Central and Eastern European countries (CEECs) during their transition towards a market economy. The last decade has seen a remarkable growth of European but also US outward direct investments in CEECs. This growth is often thought to be driven by the process of integration of CEECs into the European Union and the associated elimination of the barriers to FDI and by the acceleration of the transition process in those economies. However, the CEECs are far from homogeneous and both the level and growth of FDI differ across countries. While the Central European countries, i.e., Czech Republic, Hungary, Poland, Slovak Republic, and Slovenia, have attracted substantial foreign capital, the South Eastern European countries, i.e., Bulgaria and Romania, lag far behind. We argue that this discrepancy cannot be explained fully by traditional FDI determinants because transition-specific factors play an important role in the investment decision of a multinational company in so far as they reflect the actual state of the transition process, the overall policy stance, or even future prospects.

To focus on the transition process, we supplement the traditional determinants, e.g., market potential and trade costs, derived from endowment-based theories of the multinational firm with transition-specific factors, e.g., the level and method of privatization. By using both traditional and transition-specific variables, we extend the work of Lansbury et al., 1996, Holland and Pain, 1998; these authors focus on the business environment and the privatization process as primary determinants of FDI in CEECs. The impacts of these variables are estimated within a dynamic panel data framework using an appropriate generalized method of moments (GMM) estimation technique.1 By employing a dynamic panel data approach, we incorporate all available information in the cross section and time series dimensions and also distinguish between the short-run and long-term evolution of FDI in CEECs. Only a few studies of FDI have used panel data at all, and these estimated static models only (Bevan and Estrin, 2000). By stressing the dynamic nature of FDI, we make the analysis of FDI in Eastern Europe more realistic.

The structure of this paper is as follows. Section 2 contains some relevant stylized facts to motivate the subsequent analysis and a review of the theoretical literature, from which we derive factors having a potential impact on FDI in Eastern Europe. The econometric specification and estimation strategy are presented in Section 3. Section 4 reports and discusses the empirical results, while Section 5 concludes with a policy discussion and some suggestions for extensions.

Section snippets

Some stylized facts and a literature review

Table 1 shows the evolution of FDI inflows as a share of GDP into several regions of the world.2 The transition to market economies in Central and Eastern European countries has been accompanied by a surge of FDI inflows. CEECs attracted more FDI than the low-income countries from 1993 onward and outperformed lower-middle-income countries in 1999, which may have been affected by the Asian

Empirical specification

Based on the theoretical literature, we identify a set of traditional determinants of FDI, namely, market size, trade costs, plant and firm specific costs, and relative factor endowments. A second set of explanatory variables introduces transition-specific determinants, namely, the share of private businesses, the method of privatization, and the risk associated with each host country, that may influence the decision to invest in CEECs. The motivation for our choice of variables follows; the

Estimation results

To examine the impact of adding more explanatory variables and also to assess the robustness of our model, we use five empirical specifications in Table 4 to estimate short-term effects and in Table 5 to estimate long-term effects. The baseline specifications, namely (S1) and (S2), are designed to include the effects of the traditional determinants for FDI inflows but exclude the determinants specific to the CEE host countries. The only difference between (S1) and (S2) is that we use the skill

Concluding remarks

In a dynamic panel model, we identify the factors that encourage and impede FDI flows from OECD countries to seven transition countries in Central and Eastern Europe. Both traditional variables suggested by theory and transition-specific variables have significant and plausible effects on FDI. Among the traditional variables, we find a robust and positive impact of market potential on FDI. However, market access explains only partly the motivation of multinationals that invest in CEECs.

Acknowledgements

This paper has benefited substantially from the comments of Johannes Bröcker, Claudia Buch, Gerd Hansen, Jörn Kleinert, Horst Raff, two unknown referees and, in particular, the Editor. We also wish to thank the seminar participants at Kiel and the ETSG meeting 2002 for their helpful comments. We are of course responsible for any remaining errors.

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