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Review of Economics & Finance Submitted on 14/Sept./2010 Article ID: 1923-7529-2011-01-19-12 Lucyna Kornecki and Vedapuri Raghavan ~ 19 ~

Inward FDI Stock and Growth in

Central and Eastern Europe

Lucyna Kornecki, Vedapuri Raghavan

Department of Economics, Finance, and Information System College of Business

Embry-Riddle Aeronautical University (ERAU)

600 S. Clyde Morris Blvd. Daytona Beach, FL 32114, U.S.A., Tel: +1-386- 226-4963, fax:+1-383-226-6696, Tel: +1-386- 226-6246, fax: +1-383-226-6696

Abstract: This article analyses the foreign direct investment (FDI) in Central and Eastern Europe (CEE) during the post communist era and tests the hypothesis that FDI contributes to the economic growth of the CEE countries. It reflects macroeconomic changes in post communist CEE and estimates the impact of the FDI stock on economic growth in the CEE using model based on the production function. This paper finds a positive association between FDI and economic growth in the CEE and a tremendous impact of FDI stock on GDP growth.

JEL Classification: P50, P51, O52, O47, P20

Keywords: Foreign direct investment (FDI), Economic growth, Central and Eastern Europe (CEE)


1. Introduction

The FDI inflow in the CEE economies has been a vital factor in the first stage of the privatization process during the transition period. Currently, the main reasons to pursue FDI are to boost productivity, encourage employment, stimulate innovation and technology transfer, and enhance economic growth (Mueller & Goic, 2002). The CEE countries have identified the positive effects of FDI on the transformation process of their economies. FDI has increased in the past twenty years to become the most common type of capital flow for the reconstruction and stabilization of the CEE economies.

After the collapse of communism, central planned economies started to receive official assistance aimed primarily to support market reforms and private capital flows. Official assistance has been provided by Organization for Economic Cooperation and Development (OECD) in the form of foreign aids, grants, and loans. The private flows including foreign direct investment (FDI) and international portfolio investment (IPI) were dominated by FDI. International portfolio based enterprises are controlled domestically by local managers, as investors own a small shares of stock and have little or no influence on the management of the enterprises (Zoltan, 2002).

The inflow of FDI into the CEE countries has had an upward trend since 1990 with some minor variation. In 2003 there was a major dip in the inward FDI (USD 9,648 million). However by 2004 inward FDI had recovered and was on an upward trend reaching USD 26,764 million. The official development assistance and official aid has been quite stable across the years. The only noticeable anomalies were in 1991 (USD 3,479 million) and 1995 (USD 3,841 million). Both these years saw a sudden spike in the inflow of official development assistance and official aid. ISSNs: 1923-7529; 1923-8401 © 2011 Academic Research Centre of Canada ~ 20 ~

In recent years, there has been an increased interest in the new investment called the Greenfield investment in the CEE. For example, nearly 60 percent of Polish FDI inflows during 2006 was attributed to Greenfield investments. Poland is currently competing for Greenfield investments on export to the EU markets in the manufacturing sector (automotive, chemical, and metal investments) and in the services sector when in the past foreign investments in Poland were focused on the domestic market.

The CEE countries have increased their participation in the world economy since the fall of communism, particularly over the last few years. They accepted the challenge of trade openness and attracted significant foreign direct investment. Going global has helped them to grow faster (Cernat & Vranceanu, 2002).

Comparison of the CEE Inward FDI Performance Index against the World Performance Index between 1988 and 2005 indicates that the Inward FDI Performance Index of CEE transitioning economies was above the world average performance index. The Inward FDI Performance Index ranks 141 countries by the inward FDI relative to the economic size of the country. The Performance Index represents the ratio of a country’s share of global FDI inflows to its share in global GDP and it showed that the CEE countries received more FDI than its relative economic size.

The CEE countries increased their percentage share in the total EU trade. Between 1996 and 2003, the share of analyzed countries in the total EU trade increased from 4.5% to 7.5%. The CEE share in the world GDP increased between 1996 and 2006 from 0.4% to 1.6%.

This paper reviews the experiences of the CEE countries transforming from a central planning to market oriented economies, analyzes the basic economic growth trends, and the link between increasing FDI stock and the growth of real GDP. The following countries will be examined in this article: Poland, the Czech Republic, Hungary, Slovakia and Slovenia. All these countries became members of the European Union (EU) on May 1, 2004. The EU membership has shaped major aspects of economic policies and legislation in CEE (Sohinger, 2005).

The largest economy among the countries that will be analyzed is Poland, with the population of 38.1 million. This compares to 10.4 million in the Czech Republic, 10 million in Hungary, 5.4 million in Slovak Republic, and 2 million in Slovenia

This research utilizes 1960-2006 archival data from the United Nations Conference on Trade and Development (UNCAD), United Nations Economic Commission for Europe (UNECE), World Investment Reports, as well as other selected databases.


2. GDP and FDI in the CEE

“The purpose of economic activity is to increase the well-being of individuals, and economic structures that are able to do so are more desirable than those that do not” (Stiglitz, 2002). There is a variety of indicators assessing transition outcomes in the CEE transforming economies. The GDP per capita constitutes a very important economic index used in the international comparisons, which shows a change in the standard of living. Increasing GDP per capita during the transformation period between 1990 and 2006 indicates rising standard of living in the CEE countries (Figure1). Since 1990, GDP per capita in all analyzed CEE countries has been increasing. In 2005, the relatively high GDP per capita has been found in Slovenia (USD 22.632) and the Czech Republic (USD 20.417), in comparison with Hungary (USD 16.994), Slovakia (USD 15.214) and Poland (USD13.791). Review of Economics & Finance ~ 21 ~ 05,00010,00015,00020,00025,00019901992199419961998200020022004YearsGDP per Capita, US Dollars Czech RepublicHungaryPolandSlovakiaSlovenia

There are different patterns of economic growth and differences in output performance of various CEE countries, during transition period. However, all of the transition CEE countries have been building the new macroeconomic structure via deregulation of prices, liberalization of trade, privatization, external assistance and capital market development (Paliwod, Thomas & Farfus, 1998).

Figure 1. Real GDP per Capita in the CEE Countries

Source: UNECE Statistical Database, Economic Statistics:

Foreign direct investment has increased in the past twenty years to become the most common type of capital flow during transition period in the CEE. The most important economic reason for attracting FDI at the beginning of the transformation process was to facilitate the privatization and restructuring of the central planning economies (Heimann, 2003). At present as the privatization and reconstructing processes come to an end, the main reason to pursue FDI is to enhance sustained economic growth (Gao, 2005).

The volume of FDI inflows has grown rapidly, as the Governments of the CEE countries have been officially encouraging FDI and developing a formal FDI promotion programs providing substantial incentives for the foreign companies. The size and increasing FDI inflows to transitioning CEE countries has been impressive. Poland, Hungary, and the Czech Republic have become the most attractive destination for foreign investments.

Important factor influencing business environment in the CEE countries is their membership in the EU. The EU policies and the national incentive based FDI policies are two driving forces influencing business environment in the CEE countries. During the preparation period of CEE countries to become members of the EU (2003-2004) the FDI inflows in the Czech Republic increased by 186.3% (from USD 1.863 to 3.596 million), in Hungary by 176.3% (from USD 1.909 to 3.365 million), in Poland by 133.7% (from USD 3.660 to 4.892 million), in Slovakia 142.1% (from USD 636 to 904 million) and in Slovenia by 141.1% (from USD 299 to 422 million).

Recent inflows can be attributed to the positive impact of the EU enlargement in May of 2004. For example the value of FDI located in Poland in 2006 (USD 22. 123 million) was higher by 81.9% when compared to the previous year (USD 12. 162 million). The greatest amount of FDI inflow in 2006 was invested in real estate and other business activities (USD 7. 197 million), manufacturing (USD 5.241 million), trade and repairs (USD 3.150 million), financial intermediation (USD 2.448 million), and buying and selling of real estate by nonresidents (USD 1.336 million, (

The percentage share of the FDI in the CEE with regards to the countries origin indicates that the private investment from the EU countries represents the highest share of productive capacity owned by foreigners in this region. For example in Poland, the EU countries hold 74% of ISSNs: 1923-7529; 1923-8401 © 2011 Academic Research Centre of Canada ~ 22 ~

productive capacity, while the private investment originated from USA constitutes 13%, in comparison with international corporations representing 6% of the foreign productive capacity (Kornecki, 2006).

New EU countries have improved the business environment and introduced policy measures aimed at liberalizing their economies. The EU reshaped conditions of doing business in the new Member States and shaped major aspects of economic policy and legislation. The statistical data on inward FDI confirm the positive reaction of FDI flow to the EU membership. The implementation of the EU policies changed the following: trade policy, competition policy, consumer protection policy, environmental policy, public procurement policy, policy towards small and medium enterprises, social policy, transport policy and socio-economic cohesion policy (Witkowska, 2000).

The EU policy towards enterprises aims to promote entrepreneurship, encourage innovation, improve competitiveness of firms, create a financial climate encouraging business activities, promotion of cooperation between enterprises. The firms can also receive assistance from the EU structural funds. Between 2007 and 2015 Poland will receive over 67 billion EUR from the EU’s budget. Poland will be the largest recipient of EU funding in the coming years. The EU grants may be allocated to projects from virtually all sectors of the economy and intend to raise the economic competitiveness, among others, through transport infrastructure reform. The country’s Eastern regions and the rural areas are the priority of the modernization policy for the near future (Witkowska, 2007).

Table 1. Inward FDI flow as a % of GDP, 1990-2005 Year / Country Czech Republic Hungary Poland Slovakia Slovenia
1990 0.20 0.14
1991 2.01 9.04 0.36
1992 3.31 8.12 0.76 0.80
1993 1.84 12.98 1.90 1.33
1994 2.08 5.64 1.80 1.75
1995 4.62 11.12 2.63 1.32 0.74
1996 2.39 7.11 2.87 1.76 0.85
1997 2.31 8.87 3.12 1.08 1.69
1998 6.10 6.90 3.68 3.16 1.02
1999 10.73 6.71 4.33 2.08 0.49
2000 9.05 5.76 5.45 9.42 0.70
2001 9.42 7.40 3.00 7.51 1.87
2002 11.87 4.52 2.09 16.69 7.34
2003 2.31 2.54 2.12 2.25 1.19
2004 4.51 4.57 5.14 3.00 2.59
2005 8.49 6.01 2.65 4.21 1.44

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