European Integration as a Determinant of Foreign Direct Investment in Central and Eastern Europe, 1995-2013

By Domagoj Babic. Princeton University.

When companies choose to undertake foreign direct investments (FDI) in emerging countries (such as those in Central and Eastern Europe) rather than their home countries or developed ones, they are usually attracted by lower wages and a lucrative entrance to a new and un(der)utilized market (Walsh and Yu, 2010). At the same time, investors have to trade off exchange rate and inflation stability, highly educated workforce and well-regulated markets of countries in the EU-15, for instance, and face poorer legal frameworks and corruption. However, with CEE countries having the prospect of joining the European Union and converging to the institutional framework of the developed countries, thus providing the investors with the best of both worlds, it was reasonable to expect increasing flow of FDI into these countries after they started their European integration process. Kaminski (2000) suggests that the legal and political climate rather than macroeconomic fundamentals shaped FDI to these transitional economies.

Since the beginning of political and economic transition towards democracy and market economy in the early 1990s, Central and Eastern European Countries (CEECs) have seen a significant increase of incoming foreign investments, espe- cially from Western Europe. Public commitment by old EU member-states to the EU enlargement at the Essen European Council in 1994 further pronounced this trend (Bevan, Estrin, Grabbe 2001). These flows greatly increased in volume and became significantly less volatile after the EU decided to open membership negotiation processes in 1997 with the so- called Luxembourg Group2, and especially after waves of enlargement in 2004, 2007 and 2013. The underlying reasons for such changes include investors anticipation of removal of capital controls, privatizations and improved business environment during the negotiation process, while increased legal security and compatibility with Western European norms have increased investors’ confidence. Accordingly, traditional literature on FDI determinants puts a strong emphasis on the importance of legal protection (Blonigen, 390). Countries joining the European Monetary Union and accepting the Euro as their currency had to rein in inflation and excess exchange rate volatility, which made them more attractive for FDI, as investors shun the prospect of host currencys exchange rate uncertainty. Capital ”has moved downhill”, (Mody et al., 2008) eastbound, where it was greatly needed and where many opportunities for greater returns existed.

This course of events provides motivation for this paper, as it poses an inevitable question
of what models for attracting foreign investments should be engaged in the future and how the EU integration process should be used by accessing countries to attract desirable FDI inflows. This study intends to examine the effect of progress of eleven CEE EU member- states on their path to European integration political, eco- nomic and monetary on the inflow of FDI. By closing the gaps in the existing literature and bringing together different successful approaches to the issue of the EU integrations effect on FDI inflows, this study will provide important lessons for policy-makers in EU, CEE, and other non-EU countries alike.

This study is organized as follows. In the next section a brief literature review on determinants of FDI inflows in CEE countries with an emphasis on the factor of European inte- gration is provided. At the same time this study is positioned in the literature and its importance is shown. Then the data used in the empirical analysis is analyzed and the choice of determinants is discussed, with a special emphasis on the European integration. Concise description of the model adopted and discussion of empirical results are presented next. The last section contains the main conclusions.

Read the full paper here.

Advertisements