Endrit Avdullari What affects the relationship between Foreign Direct Investments and GDP growth: Evidence from

Eastern Europe WHAT AFFECTS THE RELATIONSHIP BETWEEN FOREIGN DIRECT INVESTMENTS AND GDP GROWTH: EVIDENCE FROM EASTERN EUROPE by E Avdullari (Student Number: 10299447) A dissertation submitted for the MSc International Management Programme School of Business & Social Sciences Roehampton University 2011

Endrit Avdullari What affects the relationship between Foreign Direct Investments and GDP growth: Evidence from Eastern Europe Acknowledgements I would like to thank Debbie Pearson, Cindy Ferguson, Paul Bemand and Sarah Gart land for their valuable contribution in this study. This dissertation is dedicated to my family who have supported me immensely thro ughout this process.

Endrit Avdullari What affects the relationship between Foreign Direct Investments and GDP growth: Evidence from Eastern Europe

Endrit Avdullari What affects the relationship between Foreign Direct Investments and GDP growth: Evidence from Eastern Europe List of Abbreviations and Acronyms ABF ALB B&H CEFTA CIA Corr. CRO CZE EC EEC EU FDI FYR GDP HUN INSTAT IMF MAC MNC N NATO POL Rep. ROM R&D Sig. SLO Std. SVK UK UN UNCTAD UNESCO U.S. USD WDI WB W GI Associated British Food Albania Bosnia and Herzegovina The Central European F ree Trade Agreement Central Intelligence Agency (of the United States) Correlati on Croatia Czech Republic European Commission Eastern European Countries Europea n Union Foreign Direct Investments Former Yugoslav Republic Gross Domestic Produ ct Hungary (Albanian) Institute of Statistics International Monetary Fund Macedo nia Multinational Companies Number of values The North Atlantic Treaty Organizat ion Poland Republic Romania Research and Development Significance Slovenia Stand ard Slovak Republic United Kingdom United Nations The United Nations Conference on Trade and Development The United Nations Educational, Scientific and Cultural Organization United States United States Dollar World Development Indicators Wo rld Bank World Governance Indicators

Endrit Avdullari What affects the relationship between Foreign Direct Investments and GDP growth: Evidence from Eastern Europe What affects the relationship between Foreign Direct Investments and GDP growth: Evidence from Eastern Europe 1. Introduction, organisational context and research objectives The relationship between the economic growth and the level of FDI has always bee n a matter of discussion between economists. The theoretical framework explainin g the relationship between FDI and GDP growth derives from two major models. The neoclassical growth model states that FDI cause an increase in investments and their efficiency leading to increases in growth. In the long-run, according to t he endogenous growth model, FDI promote growth, which is considered a function o f technological progress, originating from diffusion and spillover effects (Nair -Reichert and Weinhold 2001; Jones 2002). Nevertheless, a number of studies have proved that FDI are not always correlated with GDP growth and recent research h as concentrated more in identifying the reasons behind these results stressing t he importance of economic and political economy of the countries under considera tion. This study determines which variables are most often correlated to FDI in our sa mple of 11 EEC such establishing which ones are most influential and as a result deserve particular attention from policy makers and entrepreneurs. A linear reg ression model will be built, whenever possible, for each country in order to ide ntify the variables that best explain the variance of FDI. The study will also i nvestigate whether there is any significant pattern or difference between the co untries where the relationship between GDP growth and FDI is strong and the coun tries where it is not. The research tests whether each of the variables is corre lated with FDI and than a model that best explains the variance of FDI as a func tion of these factors is constructed. The results are expected to provide a set of common features of the countries that are able to absorb the advantages comin g from FDI which as a result would then be reflected in the economic growth. The findings will offer advice to policy makers on which issues need to be addresse d with priority. The conclusion will also be helpful to executives of MNC on whi ch countries offer a more positive environment to host their investments and wil l provide information on the markets with future potential. The selected determinants are GDP growth, human capital, market size, economic f reedom, political freedom, openness to trade, tax rate, GDP per capita, R&D, gov ernment spending, real interest rate, accessibility to credit, infrastructure, i nflation and unemployment. The countries under investigation are Albania, Bosnia and Herzegovina, Bulgaria, Croatia, Czech Republic, FYR of Macedonia1, Hungary, Romania, Poland, Slovenia and Slovak Republic. 1 Now on will be referred to simply as Macedonia. 1

Endrit Avdullari What affects the relationship between Foreign Direct Investments and GDP growth: Evidence from Eastern Europe Macroeconomic data series were collected from highly reputable international bod ies. the research is mostly based on the WDI dataset from the WB but data from U NESCO, The World Factbook from CIA, The Wall Street Journal and The Heritage Fou ndation publication on freedom, The UN, The EC for Economic and Financial Affair s as well as other national statistical institutes are also used for an eleven-y ear time frame from 1998 to 2008. After testing the relationship between GDP growth and FDI for each country indiv idually, the results were confronted to other possible factors that have been su ggested by the literature to be influencing FDI. A regression model collecting a ll influential determinants was then created to prioritize the impact of each de terminant on FDI and check whether there was any general pattern that explained the difference between the countries where the correlation between FDI and GDP g rowth was significant and the countries where it was not. This study tested the importance and prioritized previously researched settings affecting the efficiency of FDI in regard to economic growth. Prior research has often concentrated on testing or finding one or few individual influencing vari ables and aimed to either build a model for the whole region or alternatively fo r a single country. This research does not concentrate on one or few but include s a wide range of determinants. The countries are divided into two groups. The f irst group includes those countries where FDI is correlated with GDP growth and the second group includes those where this relationship is not significant. The second group is further divided into subgroups according to their common charact eristics identified by the study. The main findings were collected from research in different regions and/or temporal horizons and were tested in the selected t ime and region. The results helped creating both a national and a regional frame work that describe why some countries are more successful than others in attract ing FDI and where can each of the countries under consideration focus in order t o be more attractive to investors. In this paper, the model will be statisticall y tested among 11 countries of CEE, in order to subsequently be compared with th e conclusions reached by the literature review. Previously offered factors that are believed to determine the significance of the relationship between the GDP g rowth and FDI will be tested in order to identify those more relevant to the cou ntries under investigation. The region has been chosen because CEE is one of the most dynamic regions of the world due to the many political developments that h ave occurred there in a short span of time and although close geographically the re are significant differences between individual countries such offering to thi s research a very diverse sample. All these countries experienced a quick transi tion from being planned economies to adopting a free market economic system with different approaches and inevitably, different results. The contribution of thi s paper on the overall knowledge relays on the fact that there seem to be no pre vious 2

Endrit Avdullari What affects the relationship between Foreign Direct Investments and GDP growth: Evidence from Eastern Europe studies that covered all the allegedly influential factors together, especially not in so many EEC countries altogether. In addition, to the author`s best knowl edge, there is no other study offering both a national and regional insight in t his context. The second part of this paper will cover the literature available u p to date which includes findings of important studies and the evidence that the y presented to support their theses. Starting by offering a general background o n how the theory has evolved, this paper continues by presenting some of the mos t influential suggestions, results and methodology from previously published wor ks. Different views and the arguments on where they are based are included in th is section. In part three, details on how this research was carried out and a cl oser view to the variables and the sample taken into investigations are presente d. Reasons on why this particular approach, data set, data sources and research design were used are also explained in this section together with a closer look to the tests used. Main findings are included in part four together with a selec tion of illustrating graphs and tables to support the analysis. In part five mai n conclusions and recommendations are drawn adding a note regarding this study`s limitations and other implications for future research. Other relevant informat ion such as the bibliography, full statistical results, the data and the variabl es is attached at the end of this paper. 3

Endrit Avdullari What affects the relationship between Foreign Direct Investments and GDP growth: Evidence from Eastern Europe 2. The Literature Review Multinational enterprises expanding their influence in foreign countries in orde r to have control on local assets and production activities has been a growing t rend of the world economy (Mallampally and Sauvant 1999). Starting from the late 1980`s a rapid increase of FDI was experienced almost anywhere in the world. Th is new striking economic feature revitalised the debate on the net resulting eff ect of the costs and benefits that FDI inflows produce on the economy of host co untry and/or vice-versa (Hansen and Rand 2006). 2.1 The relationship between FDI and GDP growth Developing countries, rightly, do not appear to show as much int erest in foreign bank lending and portfolio investment as they do in FDI. The re ason behind this preference is related to the fact that countries are not very m otivated by short-term profits (e.g. portfolio investments) which are volatile a nd do not guarantee a steady income for the economy (Mallampally and Sauvant 199 9). Hence, since the 1990`s, FDI has become the leading source of external finan ce. Long-term prospects for making profits in production activities which are no t as flexible and hence reflect stability motivates this choice. Many countries are inclined to liberalise their policies toward MNC in order to benefit from th e positive influence that the investments are thought to have on a countrys trade and industry. Policy makers have been so eager to attract these investments tha t they even offered special incentives to foreign enterprises like lower or shor t-term brakes in income taxes, import duty exemptions, lowering of entry barrier s, subsidies for infrastructure etc., sometimes even to the point of damaging th e free competition (Aitken and Harrison 1999; Blomstrm and Kokko 2003). Thomas (2 007) has collected many examples where EEC have been competing fiercely using th e above-mentioned incentives as well as providing free or discounted price on la nd or opening agencies to help new foreign businesses reduce bureaucracy, time a nd costs and provide all required information to them. Some countries have even offered free funds coming from newly introduced schemes and investment-supportin g legislation, all to attract as much FDI as possible. The competition has becom e so fierce that some of these schemes are being subject to abuse. Recently, ABF , the British manufacturer of Twining, obtained a fund of 15 million USD coming from the European Regional Development Fund granted to the Polish authorities to attract new investments. The move has drawn criticism from the EC which is revi ewing the situation since ABF is closing its factory in the UK such suggesting t hat is in fact simply relocating its operations to Poland and not expanding its activity as the scheme requires (OMurchu and Cienski 2010). All these efforts hav e leaded to the unavoidable fact that the largest amount of investments from abr oad in developing countries has originated from FDI (Lipsey 1999). 4

Endrit Avdullari What affects the relationship between Foreign Direct Investments and GDP growth: Evidence from Eastern Europe Casson (1990) sees the theory of FDI as a mixture of other existing theories. He argues that it intersects with the theory of international capital markets whic h illustrates the risk-sharing and financing agreements, the theory of the firm which specifies the location, management and utilization of the output and the t rade theory which indicates the location of production and the destination of sa les. MNC are believed to bring new advanced technologies in developing countries such playing an important role in their growth (Borensztein, Gregorio and Lee 1998). Since in developing countries there exists a low efficiency of the capital, FDI inflows can help these economies to increase their capital-worker ratio by intr oducing more productive technologies (Bosworth, Collins and Reinhart 1999). The inflow of FDI was seen as crucial in resolving the issues of EEC related to thei r scarcity of capital and low productivity (Sergi 2004). Investors, especially r isk seeking ones, are interested to expand in developing countries since investm ents in capital-scarce countries are expected to yield a higher return (Asiedu 2 002). There is a general belief that FDI can give valuable help in transforming former communist countries by adding significantly to the low amount of domestic savings directed to investments. In contradiction to the Solow growth model1 wh ere technology is assumed exogenous, the growth literature supports the hypothes is that economic growth depends on the level of domestic technology and its abil ity to adopt and adapt new advanced technologies used by leading countries (Moos a 2002). Enterprises that are part of transnational systems which consist of par ents and affiliates, achieve important advantages being linked to these channels through non-equity arrangements. If the environment is conducive, these feature s can be harnessed successfully by domestic firms of the host country (Mallampal ly and Sauvant 1999). Productivity gains, transfer of advanced technology and pr ocesses, managerial skills, employee training, augmentation of domestic savings and investments, profits from foreign exchange that originate from exports to ot her countries, creation of new markets, capital flows, networks and channels are all positive effects that originate from FDI and support the rationale for the efforts that are made to attract FDI (Alfaro et al. 2004; Ram and Zhang 2002). M any studies (e.g Hansen and Rand 2006; Carkovic and Levine 2005; De Mello 1997) have been conducted to test the relationship between FDI and GDP growth in diffe rent contexts. The results have proven to be rather extreme. Some of these studi es (e.g. Bengoa and Sanchez-Robles 2003; Alfaro et al. 2004) have found a consid erably strong relationship while others (e.g. Borensztein, Gregorio and Lee 1998 ) found no evidence of a significant correlation between the two variables. The views can be grouped into two main categories. 1 The Solow model of growth: Y= AK L-1 where Y= tot l output, A = technology, K= C p it l nd L=L bour. (Solow 1956). 5

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe The first group rgues th t FDI ssist in the tr nsfer of technologic l nd busi ness skills nd underst nding to the host country. In contr st, the second group believes th t FDI will hurt resource lloc tion nd slow growth (C rkovic nd L evine 2005). The effects of FDI on the level, composition nd growth of the outp ut of the host country lso depend to l rge extent on the m croeconomic policy in oper tion in th t country. In gener l, it seems th t FDI c n exert n imp ct on the output of the host country if it is possible to bsorb surplus resources nd/or improve efficiency through ltern tive lloc tions (Moos 2002). In orde r to benefit from technologic l tr nsfer, Xu (2000) h s found th t minimum thr eshold level of hum n c pit l needs to be re ched. As M nsfield nd Romeo (1980) , h ve found in their r ther d ted study, multin tion l comp nies tend to protec t their technologies s long s they c n from domestic firms to strengthen their position in the loc l m rket. Neither they nor Germidis (1977) found ny signif ic nt evidence of technology tr nsfer to loc l competitors. However, recent evid ence suggests th t the technologic l environment h s ch nged completely in the l st three dec des. In the long term, technology diffusion might occur from l bou r turnover by le rning-by-observing or le rning-by-doing s domestic employees m ove from foreign to domestic firms (Alf ro et l. 2004). Altern tively, domestic firms might benefit just from observing the products of these foreign firms (Bl omstrm nd Kokko 1997). B l subr m n y m, S lisu nd S psford (1996) stress th t this process still depends on the bility of the hum n c pit l to dopt nd impl ement these pr ctices. In trying to determine whether FDI c uses n incre se on GDP or vice-vers , H nsen nd R nd (2006) found th t is FDI which c uses growth while GDP h s no l sting imp ct on FDI. This finding is import nt in th t suppor ts the hypothesis th t by tr nsferring know-how skills nd d pting new technologi es FDI c n signific ntly ffect economic growth. The view contr dicts two e rlie r studies one by De Mello (1997) nd the other by C rkovic nd Levine (2005) who concluded th t there w s no positive long-run imp ct to growth c used by FDI. M oos (2002) expl ins the effect of FDI on output by using the multiplier model o f Keynes (1936) which predicts th t most of the income is spent for consumption nd only wh t is left fter this is s ved. This is cyclic l process where e ch time th t the income incre ses, the spending incre ses too by gener ting more i ncome for the businesses which in turn c n hire more people dding further more to the tot l spending. The theory pplies in closed economy so rightly Moos ( 2002) recognises its limit tions in qu ntifying the multiplier in the re l econo my where domestic investment is highly ffected by other f ctors such s imports or t xes. This comes from the f ct th t in ddition to the le k ges coming from domestic investments, FDI h s other le k ges on its own (e.g. remitt nces) whic h dd to the foreign cl ims on the domestic output. To complic te m tters furthe r, FDI m y not gener te extr 6

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe income but inste d be just substitution for imports such expl ining the differ ent findings from rese rchers in this subject. On one h nd, one could rgue th t given ppropri te policies nd b sic level o f development, FDI c n pl y key role in the process of cre ting better econo mic environment. On the other h nd potenti l dr wb cks do exist, including det erior tion of the b l nce of p yments, s profits re rep tri ted h ving neg tiv e imp cts on competition in n tion l m rkets. As in m ny other fields of develop ment economics, there is not univers l greement bout the positive ssoci tion between FDI inflows nd economic growth (H nsen nd R nd 2006). Different develo ping countries h ve been ble to t ke dv nt ge of the presence of FDI in their economies but on ver ge they h ve not been s successful s middle or high-inco me countries which h ve shown notice bly higher r te of success in this proces s (Singh nd Jun 1995). From the m cro point of view FDI m y le d to rise in o utput nd income for the economy. This is p rticul rly true for developing count ries when there is usu lly high r te of unemployment nd the c pit l is sc rce . Being considered s foreign borrowing but which does not h ve to be p id b ck, F DI will h ve positive imp ct on the b l nce of p yments. The net effect on tr de however, will depend on whether FDI substitutes the current imports or whethe r its imp ct f lls on exports. From the micro point of view, new tr nsn tion l comp ny entering the domestic m rket might upset the m rket powers. It might in cre se the competition but it might lso le d the m rket to monopolistic or ol igopolistic environment (Moos 2002). Unfortun tely, n import nt re son why MNC choose to invest in country is often rel ted to wh t is known s the t riff ju mping hypothesis which rgues th t if it is difficult to ccess loc l m rket th rough tr de, firms m y set up loc l ctivities with the simple go l of voiding this restr int (Asiedu 2002) nd not to exp nd their ffili te so th t they c n export to other countries from there (R m nd Zh ng 2002). Another concern with MNC entering the domestic m rket is th t it m y not le d to rise in c pit l c cumul tion since gener ted profits might be rep tri ted in the form of dividends , roy lties etc. inste d of being reinvested in loc l ctivity. When very powerf ul, MNC c n we ken government control over cert in economic policies le ding to unw nted pr ctices like c rtels or pricing tr nsfer such c using dverse effects on the m rket m king it less competitive (L ll nd Streeten 1977). Obviously, b y ffecting c pit l ccumul tion, FDI is seen s m jor pl yer in economic deve lopment nd this f ct is cknowledged by convention l theories of economic growt h. Nevertheless, not ll FDI re founded by c pit l from their home country. The y m y s well borrow from fin nci l institutions of the host country which would neutr lise the positive effect of c pit l ccumul tion (Moos 2002). Undesir bl e effects of FDI th t d m ge domestic tr de nd industry include use of technolo gies th t misuse the host countrys f ctor proportions, d m ging loc l businesses 7

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe through intense competition, concentr ting only in the loc l m rket nd not imi ng to export, s well s d pting nd promoting in ppropri te soci l nd cultur l norms which d m ge the host countrys tr ditions nd inherit nce (R m nd Zh ng 2002). 2.2 The Determin nts Blomstrm, Lipsey nd Zej n (1994) st te th t when c ountry becomes rel tively rich, FDI h ve positive effect on economic growth. T hey me sure the we lth in terms of GDP per c pit . Lower income countries find i t difficult to ttr ct FDI m inly bec use they l ck infr structure f cilities es peci lly in cruci l re s such s tr nsport, communic tions nd inform tion tech nologies (Obwon 2001). The view is lso supported by Binici, Hutchison nd Schi ndler (2010) who suggest th t income levels ffect c pit l flows nd cross-borde r sset holdings. Agreed on principle, the m tter is seen from different persp ective by L ne nd Milesi-Ferretti (2003). They ssoci te country with higher income per c pit with lower risk nd conclude th t since intern tion l investme nts re more risky th n domestic ones, higher level of GDP per c pit le ds to n incre se in intern tion l ssets tr de. In ddition to the import nce of GDP per c pit , rese rch of UNCTAD (1999) h s found th t the GDP growth-FDI rel t ionship depends lso on the levels of other v ri bles including politic l nd fi n nci l environment, educ tion nd tr de of the country under consider tion. Sch neider nd Fry (1985) support the view on politic l environment, h ving found n inverse rel tionship between FDI flows nd politic l risk1 while J spersen, Ant hony nd Knox (2000) nd H usm nn nd Fern ndez-Ari s (2000) did not find ny im port nt evidence on the imp ct of politic l freedom on FDI. When it comes to eco nomic freedom, there is gener l greement th t it f cilit tes FDI (Bengo nd S nchez-Robles 2003). For ex mple, Lipsey (1999) found th t mong ten Asi n countr ies th t he studied, the ones who h d the highest r nked economic indices were lso the ones who h d ttr cted more investments from Americ n firms. Borensztein , Gregorio nd Lee (1998) suggest th t the growth effects of FDI c n be expl ine d by the differences in the bility to bsorb technology hence hum n c pit l nd R&D re cruci l in this process. H nsen nd R nd (2006) bring the point forw rd st ting th t the le st dv nced is the technology, the sm ller is the FDI imp c t on growth. They reject the effects of GDP per c pit , hum n c pit l, tr de nd ccessibility to credit, recognising however the import nce of the economic nd technologic l environment. The uthors further suggest th t once cert in leve l of development s whole is re ched, the country c n h rness the benefits ori gin ting from FDI. Bengo nd S nchez-Robles (2003) h ve found 1 Politic l risk nd politic l inst bility re the opposite of politic l freedom. High politic l freedom me ns low politic l risk nd low politic l inst bility. 8

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe simil r results dding to the discussion the import nce of m rket liber lis tion . Their findings contr dict with those of Blomstrm, Lipsey nd Zej n (1994) who d id not find evidence th t hum n c pit l is critic l nd with the findings of Bru no, Crin nd F lzoni (2004) who st ted th t FDI tend to h ve more positive effe ct on countries th t h ve bund nt unskilled l bour. B l subr m n y m, S lisu n d S psford (1996) point out th t developing countries h ve rel tively less tr in ed hum n c pit l nd s result technologic l progress does not ccount for b ig p rt of growth. Bec use of notice ble g p in levels of hum n c pit l betwee n developed nd developing countries, it becomes very ch llenging for developing countries to undert ke investments in R&D since they would r rely be ble to ge ner te new signific ntly useful knowledge h ving less tr ined hum n c pit l. B eck, Levine nd Lo yz , (2000) support the ide th t developed fin nci l syste m stimul tes growth. M rtin nd Rey (2003) h ve found th t fin nci l integr tion decre ses the cost of c pit l. Borensztein, Gregorio nd Lee (1998) go further st ting th t it is two w y rel tionship: c pit l gener tes FDI nd FDI gener t e per se more c pit l. A very import nt point reg rding the fin nci l environmen t nd the doption of best technologic l pr ctices is m de by Alf ro et l. (200 4) who st te th t if ccess to credit is restricted, FDI c nnot be fully efficie nt since loc l entrepreneurs would not be ble to cquire these new technologies coming from FDI, even if they h ve cquired the know-how, due to fin nci l restr ints. In this kind of environment the m rket would limit the positive extern lit ies of FDI s result pushing investors to move to countries where ccessibilit y to credit is higher. Moore (2010) gives p rticul r ttention to the fin nci l development bec use he considers it s essenti l in deregul ting c pit l m rkets restriction s well s developing fin nci l innov tions which le ds to wider c pit l m rket nd investment opportunities. Furthermore, this cre tes positiv e incentive for foreign b nks which in turn gener tes even more liquidity for th e m rket. Kind (2010) indic tes th t the studies th t h ve investig ted this re l tionship h ve found FDI to be encour ged by fin nci l development. The level o f ddition l t x revenue e rned by the government from MNC nd the mount of fun ds going b ck from the ffili te to the mother comp ny t the home country re t wo import nt counter cting f ctors identified by Feldstein (1994). He believes t h t their influence is decisive on the over ll effect on growth nd finds th t t he t x r te imposed to MNC ffects their decision to invest or not in foreign country only when this r te exceeds or f lls below the existing t x r te on the origin ting country. Wei (2000) gener lises furthermore st ting th t the rel tio nship between FDI nd the t x r te is lw ys neg tive. A wide number of studies h ve investig ted this rel tionship but very few of them h ve found ny evidence showing th t investors re signific ntly influenced by the t x policy. The 9

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe gener l greement seems to be th t t x r te ffects the volume of FDI only when m rket nd politic l f ctors re seldom equ l. Still, the t x r te effect seems to v ry ccording to the firm nd the loc l ch r cteristics of the country (Mori sset nd Pirni 2000). For ex mple, export-oriented comp nies (Gusinger 1986) n d comp nies fin nced by ret ined e rnings re more sensitive to t x dv nt ges ( Feldstein 1994). St rt-up comp nies highly ppreci te incentives th t help them void or postpone initi l expenses (Rolfe et l. 1993). Sm ll countries tend to h ve sm ll corpor te t x r te in order to ttr ct big comp nies (Morisset nd Pirni 2000) etc. Nevertheless, policy m kers still feel th t signific nt differ ences mong neighbours or other countries with which they believe to be competin g with in ttr cting FDI re to be voided whenever possible. The EU is n ex mp le of how countries c n incre se pressure on different members to incre se r tes of cert in t xes which re rel tively lower s for ex mple income t x nd t xes on the self-employed in the c se of Greece (IMF 2009) or the corpor te t x in t he c se of Irel nd (B rber 2010). T x tion policy is decided unil ter lly by n t ion l governments under EU l w but the union pressured these two countries in re turn of b il-out p ck ge when they were experiencing fin nci l difficulties. O ther c ses include pressure on the UK crown dependencies of Isle of M n, Guernse y nd Jersey which h ve been sked to incre se their corpor te t x r te since so me members of the EU h ve expressed concerns th t the policy does not coincide w ith the spirit of the union (Sherwood 2010). B rthel, Busse nd Neum yer (2010) believe th t openness to tr de not only impro ves FDI by incre sing the bility of goods nd services to flow freely but lso reflects positive ttitude tow rd foreigners nd glob lis tion which investors ppreci te. Nevertheless, their rese rch found th t the rel tionship, lthough positive w s not strong. However, on her Afric -b sed study, Asiedu (2002) did f ind th t openness to tr de w s cruci l to every country th t ims to benefit fro m FDI. She lso found th t big m rket size lso promotes FDI while infr structur e h s n import nt effect only on some countries. Kind (2010) lso supports the view th t infr structure problems discour ge FDI especi lly in developing count ries considering its v il bility critic l in running n efficient business. The m rket size is considered s determin nt lso by Bengo nd S nchez-Robles (200 3) bec use in l rge m rkets MNC c n exploit economies of sc le. The view is put in doubt by Endres, Fuest nd Spengel (2010) who rgue th t growing simply in m rket size c n even le d to neg tive effects if the growth comes simply from st rong popul tion growth nd is not reflected in re l per c pit terms. On the oth er h nd, both glob l nd region l m rkets re in continuous integr tion. This h s le d to gre ter tr de liber lis tion which h s reduced the import nce of the m rket size which is still import nt but worth mentioning th t now even sm ll cou ntries, 10

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe given the right incentives Kokko 2003). re provided, c n compete to ttr ct FDI (Blomstrm nd

Anch r z (2002) offers helpful review of the most import nt studies th t h ve tested the import nce of government spending. He h s found th t foreign investor s p y p rticul r ttention to the mount th t the government spends in the host country nd believe th t the size of the government reflects the ttitude of the country tow rds foreign investments. The gener l consensus is th t l rge mou nt of spending by the government is perceived s h rmful to m rkets nd free com petition when it goes beyond cert in optim l level. This conclusion is often r el ted to the f ct th t n investor might h ve to go through long line of bure ucr cy le ding to extr costs nd potenti l inefficiencies including corruption . On this line of logic, l rge government spending is considered s neg tive to FDI. The ltern tive view is th t l rge mount of expenditure by the governmen t m y lso be considered s sign of development nd investment to productive s ectors such s infr structure or tr nsport to provide businesses positive envi ronment to invest efficiently. Levy-Yey ti, P nizz nd Stein (2007) found n inverse rel tionship between inte rest r te cycles nd FDI inflows suggesting th t FDI inflows re expected to inc re se during recession. Moore (2010) t kes more c utious ppro ch st ting th t the imp ct of interest r tes m y v ry ccording to the level of GDP per c pit , technology, l bour qu lity, institution l c p bility nd their bure ucr tic eff iciency of the host country. His econometric results indic te th t in the s mple of 108 countries the rel tionship is neg tive but it loses signific nce when th e m rket re ches cert in st ge of fin l development. The effects of infl tion on FDI re lso m tter of discussion. On one h nd, in fl tion m y be sign of n unst ble m croeconomic environment. Different studie s (Mehl nd Winkler, 2003; V ldovinos, 2003) h ve found th t in countries in tr nsition, infl tion h s neg tive imp ct on growth. It does not stimul te long-t erm contr cts forcing credit institutions to keep liquid portfolios such incre s ing their costs nd decre sing efficiency (Bordo nd Rousse u 2006; Rousse u nd W chtel, 2001; De Mello 1997). It lso h s neg tive imp ct on investors since it reflects irresponsible policies which m y le d to unst ble exch nge r te reg imes, excessive money supply nd poor economic conditions. However, n interesti ng point is m de by C mpos nd Kinoshit (2003) who believe th t in the initi l st ges of tr nsition, positive rel tionship between infl tion nd FDI c n le d to growth (e.g by encour ging investments r ther th n s vings). 11

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe B rros nd C br l (2000) h ve found th t country which h s high unemployment r te is expected to be more ttr ctive to investors. Billington (1999) found th e s me results. He suggests th t unemployment encour ges FDI since the situ tion implies to the investor th t the required l bour will be v il ble in the host country. However, Jones nd Wren (2010) stress th t while unemployment ttr cts FDI, very high r te will m ke the region un ttr ctive suggesting to entreprene urs th t it is depressed. The study will t ke ll of these f ctors into consider tion nd will investig te their imp ct in order to est blish whether there is ny rel tionship between th ese determin nts nd FDI for the countries of the selected s mple. The study wil l lso prioritize these f ctors ccording to their imp ct nd will check for p t terns between the countries where FDI is positively ssoci ted to GDP growth nd the presence or not of signific nt correl tions between cert in v ri bles with FDI in these countries. 12

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe 3. Rese rch Design nd Methods In their efforts to expl in why FDI re ssoci ted with economic growth in some countries nd not in others, previous studies h ve b sed their rese rch on one o r few expl n tory v ri bles nd h ve tested their st tistic l signific nce (Levi ne nd Renelt 1992). This p per t kes n ltern tive ppro ch offering wide vi ew of the v il ble knowledge on the subject so f r nd then tests ll the v ri bles collected in e ch country sep r tely. M croeconomic d t series were collec ted from reput ble intern tion l bodies such s the WB, The WSJ nd The Herit ge Found tion, CIA The World F ctbook, The UN, EC for Economic nd Fin nci l Aff i rs nd other n tion l st tistic l institutes for n eleven-ye r time fr me from 1999 to 2008. The study tested the influence of the following v ri bles on FDI: GDP growth, hu m n c pit l, m rket size, economic freedom, politic l freedom, openness to tr de , t x r te, GDP per c pit , R&D, government spending, re l interest r te, ccess ibility to credit, infr structure, infl tion nd unemployment. Det ils on the v ri bles c n be found in Appendix I. To test the FDI-GDP rel tionship the net FDI inflows nd the GDP growth r te v ri bles h ve been used respectively s sugges ted by Borensztein, Gregorio nd Lee (1998). All the p pers reviewed in this res e rch th t h ve found signific nt rel tionship between the two v ri bles, h ve lso found it to be positive. Both GDP growth nd FDI c n t ke neg tive v lues. GDP growth c n be neg tive when the economy contr cts in ny p rticul r ye r n d FDI c n be less th n zero when the mount of investments le ving the country ( FDI outflows) is gre ter th n the mount of the new investments entering the cou ntry (FDI inflows). The net FDI inflows me sures the net inflows of investment to cquire l sting m n gement interest (10 percent or more of voting stock) in n enterprise oper ting in n economy other th n th t of the investor. It is the sum of equity c pit l, reinvestment of e rnings, other long-term c pit l, nd sh ort-term c pit l s shown in the b l nce of p yments (Alf ro et l. 2004: 94-95). To me sure the hum n c pit l, the number of ye rs spent by m le on second ry sc hooling h s been dopted s used by B rro nd Lee (1994), since they consider it to be the most signific ntly correl ted with growth. Although their methodology h s been used by wide number of other studies with less or no v ri tion (See for ex mple C stell nd Domnech 2002), Liberto, Mur nd Pigli ru (2005) present v lid point when they criticise it for not 13

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe t king into consider tion the qu lity difference between educ tion l institution s. B rro nd Lee (1994) found this correl tion to be positive. B sed on the s me study, to me sure the government spending, the r tio of government consumption (expenditure) to the GDP h s been used. B sed on their findings we will be expec ting FDI to be positively rel ted to hum n c pit l nd to h ve neg tive rel ti onship with the government spending. However, other studies (see for ex mple Anc h r z 2002) h ve expressed ltern tive expl n tions on how the correl tion betwe en FDI inflows nd government size c n lso be positive when investors see it s n effort to provide more positive economic environment so we c n expect both results. The WGI d t on politic l freedom w s collected by different institutes on beh l f of nd published by the WB. It c ptures perceptions from enterprises, citizens nd expert survey respondents s reported by number of survey institutes, thi nk t nks, non-government l org niz tions nd intern tion l org niz tions on the possibility th t the government is overthrown by ny me ns other th n those incl uded in the constitution of the country. These include terrorism nd politic lly -motiv ted violence. The d t r nge within the (-2.5: 2.5) interv l where higher v lues represent more st ble environment (K ufm nn, Kr y nd M struzzi 2010; The World B nk Group 2010). If signific nt, the correl tion with FDI is expecte d to be positive (B rro nd Lee 1994). Thom s (2010) lists l rge number of stu dies nd policy m kers th t h ve used this d t set. In his critic l study on th is d t set he lso list some of the concerns rel ted to it including the comp r bility cross countries over time, bi s in expert polls, nd the question ble i ndependence of the different sources used. K ufm nn, Kr y nd M struzzi cknowl edge th t the govern nce estim tes is ssoci ted with l rge st nd rd errors but still cl im th t the methodology m kes the WGI the most inform tive individu l d t source nd c lcul tes estim ted indic tors s well s m rgin errors. In our c se, since the d t c n be either positive or neg tive we would expect positi ve coefficient if the index is gre ter th n zero nd vice-vers . To me sure the economic freedom d t collected by the WSJ nd The Herit ge Found tion were used since they offer n index which llows us to observe ch nges in the economic cl im te over time. The economic freedom t kes into consider tion freedom to do bus iness, to tr de nd to invest s well s fisc l, monet ry nd fin nci l freedom, level of government spending, property rights, l bour freedom nd freedom from corruption. A gr de is ssigned to e ch of these ten components for e ch country using sc le from 0 (no freedom) to 100 (m ximum freedom) nd then the ver ge of the results is c lcul ted in order to find the over ll economic freedom inde x (The W ll Street Journ l nd The Herit ge Found tion 2010). Using the s me d t set in different time-series for L tin Americ n countries, Bengo nd S nche z-Robles (2003) found positive rel tionship between FDI nd economic freedom. 14

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe We will be expecting simil r results for ll the countries in our s mple where t he rel tionship is signific nt. Although the d t sets of both politic l nd economic freedom re widely used, t here is still much discussion bout their v lidity. Besides the concerns listed in the p r gr ph bove in reg rds to me suring politic l freedom, b sed on the w ork of Thom s (2010), the d t set of economic freedom might in ddition suffer lso from high correl tion between the used indic tors for c lcul tion. As Thom s (2010) st tes, soci l scientists h ve continuously developed qu ntit tive meth ods to me sure bstr ct concepts nd they h ve concerned with the issue of v lid ity. He concludes th t bec use the WGI re n import nt step he d in ttempting to qu ntify the d t , there relies the d nger of prem turely ccepting them s v lid. The d t sets on politic l nd on economic freedom will be used in this s tudy being, to the uthor`s knowledge, the most ccur te yet, but since there is still discussion bout their v lidity, p rticul r c ution will be t ken before re ching ny conclusions in this subject. M rket size is me sured simply by GDP level nd l rge number of studies consider this v ri ble s cruci l in fosteri ng FDI (see for ex mple Asiedu 2002 or Bengo nd S nchezRobles 2003). The rel t ionship between the two v ri bles is expected to be positive. However, in our s mple, ll countries re p rt of either CEFTA or the EU so ccording to Blomstrm nd Kokko (2003) even sm ll countries c n be expected to h ve strong ssoci tio n between FDI nd GDP growth since they c n e sily export within the tr de re which they re p rt of such benefiting from high level of openness to tr de to the common m rket. Another condition is put in by Endres, Fuest nd Spengel (20 10) who believe th t m rket size is import nt only if is supported by wide dis tribution of the we lth. Hence, we might expect more moder te effect of the m rket size in EEC comp red to other countries where we lth is distributed more ev enly or to more integr ted (in terms of freedom to tr de) regions of the world. Different uthors me sure openness to tr de using different ppro ches. It m y b e c lcul ted s exports plus imports rel tive to GDP (C rkovic nd Levine 2005) or me sured by the r tio of exports to GDP (N ir-Reichert nd Weinhold 2001). Th e l tter method w s used for this study since we re interested to test whether sm ll countries th t h ve rel tively sm ll m rket size c n benefit from FDI re g rdless of their m rket size if they h ve high openness to tr de nd from thi s point of view we re interested only in the level of exports. B sed on the v il ble evidence presented, openness to tr de is expected to be positively rel te d to FDI. The development of fin nci l intermedi ries is me sured by the ccessibility to c pit l c lcul ted by the mount of domestic credit th t fin nci l intermedi rie s supply to the priv te 15

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe sector s sh re of the tot l output s used by Beck, Levine, nd Lo yz (2000) . They find th t the imp ct of fin nci l intermedi ries is signific nt nd posit ive. Other studies might h ve not lw ys found the rel tionship to be signific n t (e.g. B rthel, Busse nd Neum yer 2010) but no ltern tive point of view reg r ding the direction of the rel tionship w s found so it is f ir to ssume th t n y signific nt ssoci tion between ccessibility to c pit l nd FDI will be posit ive. The conditions of infr structure in the host country re very import nt to investors since they incre se the productivity of the investment nd s result ttr ct FDI. The liter ture uses the number of telephones per 1000 popul tion t o me sure infr structure nd they re positively correl ted with FDI (Asiedu 200 2). We h ve used d t collected by the WB which simplifies the figure by c lcul ting the figure per 100 people. The ch nge is only for pr ctic l purposes nd im plies no st tistic l difference. Kind (2010) h s lso found th t the infr struc ture is positively ssoci ted with FDI. There is still discussion mong rese rch ers bout which t x r tes need to be considered when trying to build regressio n model. Sever l studies h ve used the nomin l t x r te which c n be misle ding since it does not consider t x reb tes offered continuously to v rious MNC (Mori sset nd Pirni 2000). Devereux nd Griffith (1998) h ve concluded th t the ver ge ggreg te t x r te h s gre ter influence on the decision of investors to w here to exp nd their ctivity. B sed on this conclusion we h ve dopted the tot l ver ge t x r te in this study which ccounts for deductions nd exemptions. W hile different businesses re ttr cted to different t x systems, on n tion l level t x r tes seem to ffect FDI either when there is notice ble difference between the countries th t compete in ttr cting the investment or when there is little or no difference between other economic nd politic l conditions (Feldst ein 1994; Morisset nd Pirni 2000). In these circumst nces its effect is expect ed to be neg tively correl ted to the level of FDI. GDP per c pit is me sured s GDP divided by the popul tion number in the middle of the ye r1. A higher leve l of GDP per c pit is expected to ttr ct more FDI especi lly for middle nd hi gher income countries (Obwon 2001). R&D is c lcul ted s the mount of expendit ure for R&D s sh re of the GDP. The more is spent in developing the technolog y the more likely it is to ttr ct FDI interested in the industry nd dopt the use of these new technologies which in turn will help other domestic comp nies nd will ultim tely incre se growth. As result the rel tion between the two v r i bles is believed to be positive. Re l interest r te is the r te of b nks lendi ng to prime customers fter h ving been djusted for infl tion. Although previou s studies indic te neg tive rel tionship with FDI, Moore (2010) suggests t kin g c utious ppro ch since the business environment of the host country 1 All definitions on this p r gr ph 16 re b sed on the WDI published by the WB.

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe might highly influence the rel tionship. Infl tion represents gener l incre se in the consumer prices index. Most studies h ve found th t the rel tionship bet ween infl tion nd FDI is neg tive but ccording to C mpos nd Kinoshit (2003) it c n lso be positive when ssoci ted with growth during tr nsition period s o we might expect to find positive rel tionship for countries th t h ve h d long tr nsition. Unemployment is the percent ge of the l bour force th t is v i l ble nd looking for work to the tot l l bour force. Its rel tionship with FDI is lso mbiguous. On most c ses, unemployment h s positive rel tionship with FDI bec use it sign ls investors th t l bour is v il ble (B rros nd C br l 200 0) but if cert in high level of unemployment is re ched, it c n reflect poor economic environment nd s result discour ge investors to enter the country Jones nd Wren (2010). 3.1 The Regression Model The multiple regression model will h ve the following l ine r form: (1) = bo+b1x1+ b2x2+b3x3+b4x4+b5x5-b6x6+b7x7+b8x8 b9x9-b10x10+b11x11+b12x12 b13x13+b1 4x14 b15x15 Where: = FDI, b0= const nt, b1-b15 the coefficients of the v ri bles. x1= M rket size; x2= Hum n c pit l; x3=Economic freedom; x4=Politic l freedom x5=Openness to tr de; x6= T x r te; x7= GDP per c pit ; x8=R&D; x9=Government spending; x10= Re l interest r te; x11=Accessibility to credit; x12= Infr structure; x13=Infl t ion; x15=Unemployment. To be noted th t mong ll the determin nts GDP growth, politic l freedom, re l interest r te nd infl tion re the only ones th t c n t ke neg tive v lues. As result, we might expect their coefficients signs to be different from wh t it h s been shown in the bove regression model (1) s long s the over ll v lue of bnxn coincides with the expected sign in the model (i.e. bnxn is positive when the coefficient in the model is positive nd it is neg tive when the coefficient in the model is neg tive). Also, since FDI c n be neg tive too, we c n expect t he s me for the const nt b0. 3.2 The S mple nd the Time Interv l This study is investig ting Alb ni , Bosni nd Herzegovin , Bulg ri , Cro ti , Czech Republic , M cedoni , Hung ry, Rom ni , Pol nd, Slov k Republic nd Sloveni from 1998 to 2008. The time interv l h s been chosen ccording to the d t v il bility. Pri or to 1989 ll of the countries in our s mple were centr lly pl nned economies nd there were b rely ny st tistics reg rding FDI. Before 1995, FDI figures were lmost non existing nd very vol tile for this region (Bev n nd Estrin 2004). D t v il bility for the 1995 1998 time17

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe fr me re still very limited especi lly for Alb ni , B&H nd M cedoni . Studies th t h ve covered this period h d to exclude t le st these three countries. Nev ertheless, the dopted11-ye r period with s mple of 11 countries still llows re ching signific nt conclusions. Other studies1 h ve m n ged to re ch robust re sults working with even shorter periods nd sm ller s mples. The re son why EEC offer useful study context to test FDI determin nts relies on the f ct th t l though these countries h ve common st rting point, i.e. the time when the curr ent economic systems w s dopted, they h ve signific nt differences in economic nd institution l development s well s in size (World B nk 2002). Coming from communist b ckground, ll the countries under investig tion h ve tr nsited to m rket economy in the e rly 90`s f cing simil r ch llenges most of which unknown before. Yet, some were more successful th n others such offering rese rches the opportunity to comp re their individu l fe tures th t le d to these differences nd t ke import nt lessons from them for the future. 3.3 Exclusions nd Missing D t The study ttempted to include ll the countries of the region in the s mp le. Unfortun tely, this w s not possible. Montenegro nd Kosovo decl red their i ndependence respectively in 2006 nd 2008 from Serbi . H ving ll been p rt of S t te Union of Serbi nd Montenegro since 1992, the d t used to be collected fo r ll three entities s one country. Since the sep r tion, e ch of them h s coll ected nd published its own d t thus m king it impossible to include them in th e study since the period of the st tus quo would be too short nd s such insign ific nt. As result, Kosovo, Montenegro nd Serbi were excluded from this rese rch. The d t for our rem ining 11 countries w s not lw ys v il ble. Alb ni does not record the d t for R&D so w s excluded when c lcul ting this p rticul r v ri ble. Also, d t on hum n c pit l for B&H could not be used for correl tio n tests since it w s v il ble for two ye rs only. The d t on hum n c pit l re v il ble only from 1999 nd for t x r te only from 2005 for ll countries. For Cro ti nd B&H, it w s not possible to c rry out correl tion test between th e t x r te nd ny other v ri ble since the t x r te h s been const nt from 2005 to 2008. D t on politic l freedom for 1999 nd 2001 were not v il ble for ny country since t the time, the d t used to be collected bi nnu lly. Det ils on other missing d t c n be found in Appendix I. The correl tion between FDI nd e ch of the other v ri bles w s c lcul ted on p irwise exclusion b sis to de l with the missing d t . 1 See for ex mple Bruno, Crin nd F lzoni (2004) who b sed their study on 3 countri es in 9-ye r time-fr me. Asiedu (2002) focused in the 1996-2003 interv l while Bev n nd Estrin (2004) collected d t from 1994 to 2000. 18

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe 3.4 Multicolline rity Multicolline rity mongst two predicting v ri bles is to b e expected especi lly when using sm ll s mples nd time periods. For ex mple, ec onomic freedom is by definition correl ted with openness to tr de, politic l fre edom nd government spending. M rket size is n tur lly correl ted with governmen t spending, R&D, GDP per c pit nd openness to tr de since they ll re c lcul ted s sh re of GDP. Accessibility to c pit l is highly ffected by the re l i nterest r te which is in turn ffected by infl tion etc. We will check whether m ulticolline rity h s c used ny problems in our correl tion tests by spotting n y odd results in our coefficients in section 4.2. 3.5 Tests The d t will be proce ssed with PASW (former SPSS) St tistics 17TM . The ssoci tion of the determin n ts with FDI will be tested st tistic lly in order to provide fr mework th t c n expl in which f ctors re more strongly rel ted to FDI in e ch country. Initi l hypotheses reg rding the expected sign of the coefficients of e ch signific nt f ctor h ve been constructed b sed on the liter ture review. The results will b e p rticul rly import nt for v ri bles th t c n be both positively nd neg tivel y rel ted to FDI (e.g government spending) ccording to their economic nd polit ic l settings such providing ddition l evidence to the over ll c demic discuss ion. The collected d t were in line with the origin l sources from the uthors th t h ve suggested th t these v ri bles would ffect the FDI such m int ining t he s me methodology th t they h ve used in their study. For ex mple the hum n c pit l w s me sured in the s me w y s in the study of Borensztein, Gregorio nd Lee (1998). 3.6 Procedures A correl tion test w s first run mongst FDI nd ll the other v ri bles for every singly country in order to observe which v ri bles were most often correl ted with FDI. As result we were ble to build list o f most import nt v ri bles which would then be used lso to construct the regres sion models. These models would determine which v ri bles re most import nt for every country sep r tely. Although signific ntly ssoci ted with FDI, not ll o f these v ri bles were included in the respective regression model simply bec us e there could be only one or few determin nts needed to expl in the FDI v ri nce better nd dding n ddition l determin nt would not necess rily improve the m odel, on the contr ry it might c use problems of multicolline rity (See for ex m ple the c se of B&H in Appendix II). Nevertheless, this does not imply th t the v ri bles which re not included in the regression models re not import nt. The model simply prioritizes their import nce ccording to their bility to expl in the v ri nce of FDI. The countries were fterw rds divided into groups 19

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe ccording to the correl tion results between the GDP growth nd the level of FDI iming to observe potenti l differences between the models of the countries whe re the rel tionship w s import nt nd those where it w s not. This en bled us to determine p ttern of fe tures where countries th t h ve strong FDI - GDP gr owth rel tionship differenti te from the other countries under investig tion. Co untries where the FDI- GDP growth rel tionship w s not import nt were further di vided into subgroups ccording to the re sons identified by this study th t even tu lly le d to this rel tionship being insignific nt. As in most crosscountry st udies on growth ccording to Kormendi nd Meguire (1985), the expl n tory v ri b les were entered independently nd line rly. Among other objectives, this study lso imed to c lcul te the correl tion of e ch determin nt with FDI nd build for e ch country regression model th t consi dered FDI the v ri ble which w s dependent from one or more determin nts collect ed from the liter ture with t le st 90% confidence interv l. We did not choos e lower signific nce level due to the limited number of v ri bles nd the shor t time period. However, signific nce h s been noted throughout the results if pr ctitioners re interested in higher level (i.e. 0.05 or 0.01). The def ult me thod for this n lysis is Enter but this would me n th t we would force ll correl ted v ri bles into the equ tion nd most possibly decre se the v ri nce expl in ed by the model. Inste d the Stepwise method w s used in order to enter into the e qu tion only those v ri bles which would signific ntly incre se the import nce o f the model. This me ns th t n extr v ri ble w s dded to the model only if it improved it signific ntly. The Enter method w s used only in the c se of Sloveni nd Czech Rep. where only one v ri ble w s correl ted to FDI nd s result th ere w s only one v ri ble to be dded in the equ tion. The F-test tests our null hypothesis th t there is no signific nt rel tionship between FDI nd the v ri b le in our model. All the models h ve the form: = b0 + b1x1 + b2x2+...+b15x15. Th e coefficients (b1-b15) represent the rel tive import nce of e ch independent v ri ble. Our model form implies th t b0 equ ls the level of FDI which would be re ched independently from the level of the v ri bles included in the equ tion (i. e. if the v ri bles re equ l to 0), while bn shows the degree of ch nge of FDI when xn (the v ri ble included in the regression model) ch nges by one. N mely, ch nge in xn (xn) by one unit will h ve n imp ct of bn xn on FDI. If v ri ble (xn) is not included in the fin l model, it would me n th t its coefficient (bn ) is equ l to 0. 20

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe 4. Findings, n lysis nd ev lu tion The existing liter ture offers number of v ri bles th t re believed to ffect FDI. In our study we selected 15 v ri bles which were most often encountered in previous nd most influenti l studies. The v ri bles t ken into consider tion f or ll the countries were GDP growth, hum n c pit l, m rket size, economic freed om, politic l freedom, openness to tr de, t x r te, GDP per c pit , R&D, governm ent spending, re l interest r te, ccessibility to credit, infr structure, infl tion nd unemployment. 4.1 Correl tion nd Regression results Alb ni The correl tion w s signific nt between FDI nd the following v ri bles: m rket size, econ omic freedom, openness to tr de, GDP per c pit , ccessibility to credit, infr s tructure nd unemployment. The model for Alb ni FDI = 7249333.24 + 2.131E7 * c cessibility to credit R2 =0.9031 Bosni nd Herzegovin The correl tion w s signific nt between FDI nd the follo wing v ri bles: m rket size, economic freedom, openness to tr de, GDP per c pit , R&D, ccessibility to credit, unemployment, re l interest r te# nd infr struc ture#.

The model for B&H FDI= -1.69E9 + 1.11E11* R&D R2 = 0.932 Bulg ri The correl tio n w s signific nt between FDI nd the following v ri bles: GDP growth, hum n c p it l, m rket size, economic freedom, openness to tr de, GDP per c pit , ccessib ility to credit nd unemployment#. # R2 (the coefficient of determin tion) shows how much of the v ri nce of FDI is e xpl ined by the equ tion. Determin nt w s signific nt t 0.1 signific nce leve l. 21

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe The model for Bulg ri FDI= -5.538 + 0.192*openness to tr de R2 = 0.797 Cro ti The correl tion w s signific nt between FDI nd the following v ri bles: hum n c pit l, m rket size, GDP per c pit , re l interest r te, ccessibility to credit , unemployment politic l freedom# nd economic freedom#. The model for Cro ti FDI = - 7.047E9 + 0.365* m rket size R2= 0.682 Czech Repub lic The correl tion w s signific nt only between FDI nd R&D#. The model for Czech Republic FDI= -6.145E9 + 1.011E10*R&D R2= 0.285 Hung ry No v ri bles were signific ntly correl ted to FDI nd s result no reg ression model could be built for the country. Hung ry is the only country in our s mple where the v ri nce of FDI could not be expl ined by ny of the 11 v ri b les. M cedoni The correl tion w s signific nt between FDI nd the following v r i bles: m rket size, openness to tr de, GDP per c pit , re l interest r te, cce ssibility to credit nd infl tion. The model for M cedoni FDI = 1.370E8 + 4.680E7*infl tion R2=0.539 # Determin nt w s signific nt 22 t 0.1 signific nce level.

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe Pol nd The correl tion w s signific nt between FDI nd the following v ri bles: GDP growth, m rket size, openness to tr de, GDP per c pit , ccessibility to cre dit nd unemployment#. The model for Pol nd FDI= 8.275E8 + 1.839E9*GDP growth R2 = 0.592 Rom ni The correl tion w s strong between FDI nd the following v ri bl es: GDP growth, hum n c pit l, m rket size, economic freedom, GDP per c pit , go vernment spending, ccessibility to credit, infr structure nd infl tion. The model for Rom ni FDI= -1.887E10 + 0.527*m rket size R2=0.923 Slov k Republi c The correl tion w s signific nt between FDI nd the following v ri bles: openn ess to tr de, government spending#, economic freedom# nd infl tion#. The model for Slov k Rep. FDI= -4.976E9 + 9.793E7*openness to tr de R2=0.409 Slo veni The correl tion w s signific nt only between FDI nd the t x r te#. The model for Sloveni FDI= 1.17E10 - 2.95E8*t x r te R2= 0.839 We c n notice th t in ll countries, only one determin nt h s been included in t he model. In no c se, would dding second determin nt h ve improved the regres sion model signific ntly (by t le st 0.05). The result comes s surprise, esp eci lly in some of the countries were number of v ri bles were correl ted to F D, since tot l of 15 determin nts # Determin nt w s signific nt 23 t 0.1 signific nce level.

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe were included in the n lysis. As mentioned previously (section 3.4) this m y h ve resulted from the f ct th t m ny determin nts re correl ted to e ch other n d they h ve been excluded from the model due to multicolline rity. Another poten ti l re son is rel ted to our rel tively sm ll s mple. Adding extr v ri bles to the model would h ve incre sed the prob bility th t the rel tionship is signifi ic nt due to ch nce. For ex mple, in the c se of B&H, dding two ddition l v ri bles would h ve incre sed the coefficient of determin tion, but two of the v ri bles h d to be excluded since the model would h ve become insignific nt h d we not done so (See Appendix II). A summ ry of the correl tion results th t show wh ich v ri bles re correl ted to FDI for e ch country c n be seen in T ble 1 nd T ble 1b. ALB GDP growth Hum n c pit l M rket size Economic freedom Politic l Freedom Open ness to tr de T x r te GDP per c pit R&D Government spending Re l interest r te Accessibility to credit Infr structure Infl tion .898** .902** .815** .902** ** B&H BUL .649* .822** .762** .803** CRO .723* .826** .59# .637# CZE HUN MAC POL .77** -.764* .721* -.697* .687* ROM .636* .949** .961** .847** SVK SLO +/+ ++ .816** .712* .653* .787* .610* .623# ++ .640* -.916# .798** ** .893** ** .670* ** .893

.823 .966* .769** .817 .655 .533# * .714* -.576# .955 .946** -.652# .950** .690* .578# .734* ** * # -.697* -.579# + + ++-.705* .705* .811** -.603# .671* .635* .948** .739** -.736** 7 -.577 10 9 + + -.589# 4 1 +Unemployment -.817 -.772 -.569 Tot l 7 9 8 **Sig. 0.1 -.651 8 * 1 0 T ble. 1 . Correl tion results of the v ri bles signific ntly correl ted to FDI. Determin nt^ GDP growth M rket size Countries where the determin nt w s included in the regression model Pol nd Cro ti ; Rom ni Openness to tr de Bulg ri ; Slov k Rep. T x r te Sloveni R&D B&H; Czech Rep. Ac cessibility to credit Alb ni Infl tion M cedoni ^The other determin nts were n ot included in ny of the regression models. T ble 1b. Determin nts included in the regression models. N tur lly, the v ri ble which w s most strongly correl ted with FDI w s lso the one th t best expl ined the v ri nce of FDI. All models re good represent ti on of the v ri nce of FDI (more th n 50%) except for Czech Rep. (28.5%) nd Slov k Rep. (40.9%). 24 t 0.01 *Sig. t 0.05 #Sig.

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe 4.2 The coefficients T ble 1. offers det iled view on the direction of the sig nific nt rel tionships between FDI nd e ch determin nt. There re no surprises in the ssoci tion of FDI with GDP growth, m rket size, openness to tr de, cces sibility to credit nd infr structure which is positive in ll c ses s expected nd neither re there ny controversies with t x r te, re l interest r te nd u nemployment which rel tionship with FDI is neg tive. We were expecting possible mbiguous results on government size, politic l freedom nd infl tion. While n eg tive rel tionship between FDI nd government size is more common, we c n noti ce th t Rom ni h s positive ssoci tion between the two v ri bles. The countr ys government is not mong the highest spenders ( s sh re of the GDP) but it is the one who h d incre sed the spending more th n two times from 1998 to 2008 (s ee Gr ph 1). This spending h s led 30 Alb ni 25 20 15 10 5 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 200 8 Bosni nd Herzegovin Bulg ri Cro ti Czech Republic Hung ry M cedoni Pol n d Rom ni Slov ki Gr ph 1: Gener l government fin l consumption expenditure (% of GDP) 1998-2008. Source: WDI. to better infr structure, better tr ined hum n c pit l, growth in GDP, decre s ed unemployment, more st ble infl tion etc. (see Appendix I for the complete d t set) which h s sent investors sign ls of positive economic environment. As mentioned previously by Anch r z (2002), this situ tion cre tes the conditions for positive correl tion between government spending nd FDI which is lso wh t we h ve found. The positive rel tionship between infl tion nd FDI for M cedon i is nother interesting finding. The country h s been the le st free politic l ly in the region (see Gr ph 2) nd lthough positive steps h ve been m de since 2004, it still suffers from very high r te of unemployment, suggesting th t it s tr nsition period is not completely over yet. As described by C mpos nd Kinos hit (2003) these economic nd politic l settings c n le d to positive rel tio nship between infl tion nd FDI, which coincides with our findings. 25

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe 1.5 Alb ni 1 0.5 0 1998 2000 2002 2003 2004 2005 2006 2007 2008 -0.5 -1 -1.5 Gr ph 2. Politic l st bility nd bsence of violence index 1998-2008. Source: Th e World B nk Group. Bosni nd Herzegovin Bulg ri Rom ni Slov ki Sloveni Cro ti Czech Republic Hung ry M cedoni Pol nd

4.2.1 Wrong signs Since ccording to the theory, the rel tionship between politic l freedom nd FDI is positive, we were expecting the coefficient of politic l fr eedom to be positive for ll countries (if signific nt) except for Alb ni , B&H nd M cedoni for which the d t is neg tive. Hence, neg tive coefficient to i ndic te the positive rel tionship between politic l freedom nd FDI w s predicte d in their c se. Surprisingly, the coefficient w s positive for both Alb ni nd M cedoni . The inverse rel tionship between the economic freedom, R&D nd hum n c pit l with FDI in the c se of Pol nd nd th t of R&D with FDI for Slov k Rep. do lso contr dict the theory nd come s surprise result. Since the predicti ons were b sed on the theory review the controversy h s to be investig ted in th e methodology nd the econometric results. While there is no discussion bout th e methodology used to me sure R&D, the concerns nd critics on the v lidity of t he d t on hum n c pit l, economic freedom nd especi lly politic l freedom prov e to be more serious th n nticip ted. The problem with hum n c pit l nd econom ic freedom rises only once, in the c se of Pol nd which le ds to the ssumption th t for R&D, hum n c pit l nd economic freedom the problem results from the h igh correl tion between the v ri bles nd/or other econometric l problems. Since c rrying out det iled n lysis of the qu lity of institutions in Pol nd comp red to the other EEC nd on the d t of Pol nd in economic freedom in order to t est this ssumption would go beyond the mbitions of this study, we will inste d n lyse the problem st tistic lly in se rch of n expl n tion. On the other h n d, the problem with the politic l freedom indic tor h s been noticed in 2 out of the 4 times th t the indic tor w s correl ted to FDI. Hence, this study 26

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe dds evidence to the concerns presented by different uthors (See Thom s 2010) o n the v lidity of the used methodology in c lcul ting this indic tor. From the s t tistic l point of view, the problem might be noticed when de ling with rel t ively sm ll s mple (in our c se 11 ye rs or even less when there re missing d t ) if the independent v ri ble h s l rge v ri nce nd the determin nts h ve minim l v ri tion especi lly when lso highly correl ted with e ch other (Kenned y 2005; C mpos nd Kinoshit 2003). T ble 2 shows th t in Pol nd, hum n c pit l, economic freedom, R&D nd GDP growth re highly correl ted with e ch other ( s well s with other v rious determin nts). A closer look t the descriptive st ti stics of the v ri bles correl ted with FDI in the c se of Pol nd, Alb ni , M ced oni nd Slov k Rep. offers further expl n tions. We c n see th t FDI being re l tively high figure in ll four countries h s rel tively high v ri nce while the v ri nce of the determin nts under discussion is very sm ll le ding to the wr ong coefficient sign, which s Kennedy (2005) notes, is indeed n indic tor of mu lticolline rity. Economic freedom R&D Hum n c pit l Pe rson Correl tion Sig. (2-t iled) N **. Correl tion is signific nt t the 0.01 level (2-t iled). GDP growth .735 * .844 ** -.722** .028 9 .004 9 .024 9 *. Correl tion is signific nt t the 0.05 level (2-t iled). T ble 2. Results of correl tion tests between hum n c pit l with economic freedom, R&D nd GDP growt h in Pol nd. In T ble 3 we c n see how sm ll is the v ri nce of the three v ri bles th t h ve wrong coefficients. It is interesting how sm ll s mple of 9 v lid c ses for hum n c pit l (two c ses h ve been excluded due to d t un v il bility) h s le d to sm ller v ri nce. Their correl tion to GDP growth, which lso h s sm ll v r i nce, expl ins the surprising result. Note th t politic l freedom h s very sm ll v ri nce too but the f ct th t it is not correl ted with GDP growth h s prote cted it by being ffected from multicolline rity in Pol nd but th t is not the c se for Alb ni nd M cedoni . Another re son th t m y h ve c used this issue wit h politic l freedom is g in linked with the methodology used. The d t r nge is (-2.5: 2.5), too sm ll comp red with the other determin nts nd implying sm l l v ri nce of the indic tor. 27

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe N FDI GDP growth Hum n c pit l M rket size Economic freedom Politic l freedom Op enness to tr de GDP per c pit R&D Accessibility to credit Unemployment 11 11 9 11 11 9 11 11 11 11 11 Std. devi tion 4.154E9 1.7388580333E0 .223763281 2.5930241E10 1.9305 .3049450270 6 6.427150259 697.8691521 .05419925758 7.713724738 4.44524 V ri nce 1.725E19 3.024 .050 6.724E20 3.727 .093 41.308 487021.353 .003 59.502 1 9.760 T ble 3. St nd rd devi tion el ted to FDI in Pol nd nd v ri nce of FDI nd v ri bles signific ntly corr

N FDI Economic freedom R& D Government spending Openness to tr de Infl tion 10 1 1 11 11 11 11 Std. devi tion 1.3393166E9 6.2176143 .1812070 1.500513746 8.7471856 3.1519163658 E0 V ri nce 1.794E18 38.659 .033 2.252 76.513 9.935 T ble 4. St nd rd devi tion nd v ri nce of FDI nd v ri bles signific ntly corr el ted to FDI in Slov k Rep. The s me p ttern c n be noticed in the c se of Slov k Rep. The v ri nce of R&D i n Slov k Rep. is much sm ller th n th t of ny of the other v ri bles th t re c orrel ted with FDI (T ble 4). As T ble 5. shows, the s me pplies in the c se of Slov k Rep. R&D is highly correl ted with ll the v ri bles th t re correl ted with FDI. Economic freedom R& D Pe rson Correl tion Sig. (2-t iled) -.836** .001 Government spending .693* .018 11 Openness to tr de -.913** .000 11 Infl tion .658* .028 11 N 11 *. Correl tion is signific nt t the 0.05 level (2-t iled). **. Correl tion is signific nt t the 0.01 level (2-t iled). T ble 5. Results of correl tion tests between v ri bles signific ntly correl ted to R&D in Slov k Rep. 28

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe Politic l freedom in Alb ni nd M cedoni h s lso very sm ll v ri nce (T ble 6). Missing d t for 1999 nd 2001 h s incre sed the ch nces of multicolline ri ty nd the results in both countries h ve been ffected. This h d led to wrong sign for this indic tor. For the bove re sons, since these correl tions re not genuine but occur due to their ssoci tion with other dependent v ri bles, they will be not considered s signific ntly correl ted with FDI in our n lysis. Our fin l correl tion m trix will be s shown in T ble 7. T ble 6. St nd rd devi tion nd v ri nce of FDI nd v ri bles signific ntly corr el ted to FDI. .Alb ni b. M cedoni N Std. devi tion 249812059.9 800911154.6 3.079433242 V ri nce N Std. devi tion 175523719.8 368859150.9 0.304945027 V ri nce FDI M rket size Economic freedom Politic l freedom Openness to tr de GDP per c p it 11 11 11 6.241E16 6.41459E17 9.482909091 FDI M rket size Politic l freedom Openness to tr de GDP per c pit r te Accessibility to credit Infl tion 11 11 9 3.08086E16 1.36057E17 0.09299147 9 0.298306567 0.088986808 11 5.407232676 29.23816521 11 5.440651211 29.6006856 Re l interest

11 170.3464452 29017.91138 11 246.3238948 60675.46116 11 5.812624718 33.78660612 Accessibility to credit Unemployment 11 11.14056133 124.1121068 11 8.909657377 79.38199457 11 1.793523703 3.216727273 11 2.753952449 7.58425409 29

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe T ble 7. Correl tion coefficients nd signific nce (corrected). ALB GDP growth Hum n c pit l M rket size Economic freedom Politic l freedom Open ness to tr de T x r te GDP per c pit R&D Government spending Re l interest r te Accessibility to credit Infr structure Infl tion Unemployment Tot l -.817 6 ** B&H BUL .649* .822** CRO CZE HUN MAC POL .77** ROM .636* .949 ** SVK SLO Sign + + + Tot l 3 3 7 6 2 6 1 7 2 2 3 7 2 3 5 .723* * .898 .902 ** .816 .712 ** .762** .803** .826** .590 ~ ** .653 *

.721* .961 .847 ** ** * ** .623 # + + .637 .902 ** # .687* .610 * .798** .893** .670* .640 * + -.916 # + + .893 ** .823 .966 ** .769** .817** ** .655 .534 # *

.714* .955 ** * .946 -.652 .950 ** # ** -.579 # +-.705* .705* * -.603* .671 * .690 .578 * .811** .635* .948 .739 ** + + -.589 # # ** .734 -.772 9 * * -.736 -.577 ** +-.569 8 #

-.651* 8 1 0 6 7 9 4 1 30

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe 4.3 Bulg ri , Rom ni nd Pol nd A correl tion between FDI nd GDP growth w s c lcul ted for e ch country. The test found th t the rel tionship between the two v ri bles w s signific nt (Sig < 0.1) only in Pol nd, Bulg ri nd Rom ni . In ll three countries, the rel tionship w s positive nd strong (Pe rson correl tio n > 0.5). Bulg ri 0.649 0.031* Rom ni 0.636 0.035* Pol nd 0.77 0.006** Pe rson correl tion Sig. T ble 8. Correl tion results between FDI Pol nd. nd GDP growth in Bulg ri Rom ni

nd

15 Rom ni Slov k Republic The gr ph shows cle rly th t the three countries where the correl tion between F DI nd GDP growth is strong nd signific nt re mongst those h ving the highest level of FDI. Czech Rep. lso h s high level of FDI but, differently from the countries where FDI is strongly correl ted with number of other determin nts, in Czech Rep., FDI seem to be rel ted only with the mount spend for R&D. A sim il r p ttern c n be seen in the GDP growth ch rt (Gr ph 4). 31

Bulg ri , Pol nd nd Rom ni h ve in common the following v ri bles: m rket size , GDP per c pit nd ccessibility to credit correl ted to FDI. Those re lso t he v ri bles most often correl ted to FDI for the 11 countries in our s mple (T ble 7). Pol nd, Rom ni Hung ry nd Czech Rep. used to ttr ct most of the FDI e ntering the region in 1998 but s shown cle rly in Gr ph 3. Hung ry h s f llen b ehind since 2006 while Bulg ri h s joined the top le ding countries. 20 Alb ni Bosni nd Herzegovin Bulg ri Cro ti 10 Czech Republic Hung ry 5 M cedoni Pol nd 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 -5 Gr ph 3. FDI net inflows (in billion$) 1998-2008. FDI d t in billion USD. Sourc e WDI.

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe

A very interesting p ttern c n be noticed by looking t the GDP per c pit gr ph . The three countries th t h ve strong GDP growth FDI correl tion re r nked c losed to e ch other, n mely 6th, 7th nd 8th. The countries th t re in the bott om of the list, Alb ni , B&H nd M cedoni , lso h ve rel tively l rge number of determin nts correl ted to FDI but the results suggest th t minimum level o f GDP per c pit is needed in order for FDI to be ble to enh nce growth. Our re sult suggests th t the minimum GDP per c pit level should be in the (2177.74USD : 2569.99USD) interv l (i.e. more th n the GDP per c pit of M cedoni r nked 10 th but less th n the s me figure for Bulg ri r nked 6th). At the top of the lis t, we c n see th t Hung ry is r nked 5th but it h s only no v ri ble correl ted to FDI so it does not offer reli ble c se study to re ch conclusion. However Cro ti , r nked 4th, does h ve eight signific nt determin nts but GDP growth is not mongst them. This suggests th t there 1 The correl tions of the determin nts of Slov k Rep. re only moder tely strong ( sm ller th n 0.65) nd only one of them is signific nt t the 0.05 level (the ot her four signific nt t the 0.1 level). 32

Rom ni le ds the w y (in 2008) with Bulg ri nd Pol nd being in the s me r nge with Alb ni , B&H, M cedoni nd Slov k Rep. On one h nd we h ve three countrie s in tr nsition with problems in infr structure (Alb ni ), hum n c pit l (Alb ni nd M cedoni ), very sm ll m rket size, low income per c pit nd limited poli tic l freedom (Alb ni , B&H, M cedoni ) which s result do not look very ttr ctive to investors. On the other h nd we h ve Slov k Rep. which lso h s problem s in infr structure but it m inly l cks very strong nd highly signific nt1 corr el tion with number of v ri bles to FDI.

15 Alb ni Bosni nd Herzegovin 10 Bulg ri Cro ti Czech Republic 5 Hung ry M cedoni Pol nd 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Rom ni Slov k Republic Sloveni -5 Gr ph 4. GDP growth ( nnu l %) 1998-2008. Source WDI.

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe might lso be m ximum level of GDP per c pit for country to be ble to t ke dv nt ge of FDI. This level is t the (6221.68USD; 6796.341USD) interv l (i.e hi gher th n GDP per c pit for Pol nd but lower th n the s me figure for Cro ti ) ccording to our findings. These results seem to suggest th t not only there is minimum level of development for countries in order to t ke dv nt ge of FDI s some studies suggest (e.g. Obwon 2001; Singh nd Jun 1995; Blomstrm, Lipsey n d Zej n 1994; Bengo nd S nchez-Robles 2003 etc.) but there seems to exist lso s tur tion point me ning th t fter re ching cert in level of income per c pi t , countries c nnot keep relying on FDI but h ve to st rt developing their own resources. After ll, GDP per c pit is one of the v ri bles most often correl t ed with FDI (T ble 9). The finding coincides in principle with wh t Blonigen nd W ng (2005) h ve suggested, i.e. FDI incre ses growth in developing n tions but not in industri lised ones. 16000 14000 Alb ni Bosni nd Herzegovin Bulg ri Cro ti 8000 Czech Republic Hung r y 6000 M cedoni , FYR Pol nd 4000 Rom ni Slov k Republic 2000 Sloveni 12000 10000 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Gr ph 5. GDP per c pit (current US$). 1998-2008. Source WDI. Our results lso support the rese rch of Jones nd Wren (2010) who h ve st ted t h t very low unemployment discour ges investors bec use it shows th t there is not much hum n c pit l v il ble nd s result there must be high competiti on to recruit the needed l bour force. On the other h nd, very high unemployme nt is not very desir ble either since it sign ls inst bility. Gr ph 6 shows us h ow ll the three countries where the FDI-GDP 33

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe growth rel tionship w s import nt, h ve n unemployment r te in the [5.5-7.5] r nge for 2008. For B&H nd M cedoni , the high unemployment discour ges the enter ing of FDI nd not surprisingly, the low unemployment r te seems to be c using t he s me effect for Czech Rep. nd Sloveni . 50 45 Alb ni 40 35 30 25 20 15 10 5 0 1998 1999 2000 2001 2002 2003 2004 2005 2 006 2007 2008 Gr ph 6. Unemployment, tot l (% of tot l l bour force) 1998-2008. Source: WDI, I NSTAT, EC for Economic nd Fin nci l Aff irs, The UN, CIA - The World F ctbook. Bosni nd Herzegovin Rom ni Bulg ri Cro ti Czech Republic Hung ry M cedoni Pol nd

4.4 Czech Republic, Hung ry nd Sloveni Czech Rep. nd Hung ry h ve been mongs t the most successful countries in ttr cting investments. Czech Rep. w s t the top of the list in 2003 nd 2005 while Hung ry w s in the top 3 from 1998 to 20 02 (Gr ph 3). However, none of the v ri bles tested w s correl ted with FDI infl ows in the c se of Hung ry nd R&D could expl in only minor p rt of the FDI v ri nce for Czech Rep (27.5%). Kinoshit (2000) found simil r results suggesting th t firms eng ged in R&D in Czech Rep. re the only enterprises where there is evidence of spillovers from FDI. These results lone could expl in why the rel t ionship between FDI nd GDP growth is not strong between these two countries but closer look t the d t gives us further evidence. The GDP growth for both co untries fell sh rply in 2008 re ching (together with Cro ti ) the lowest levels in the region (Gr ph 4). For Hung ry the downf ll st rted lmost simult neously with the decre sing of its level of FDI inflows which h s f llen from the 3rd pl ce in 1998 to 7th in 2008. The l st three ye rs h ve witnessed notice ble f l l in its GDP growth with only 0.6% growth in 2008 which inevit bly h s h rmed th e confidence of the investors in its economy. For Czech Rep. the situ tion seems to be le st severe since 34

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe only 2008 w s n unsuccessful ye r from this point of view (2.46% of GDP growth comp red to 4.71%, the ver ge for the whole region for 2008). Another import nt f ctor seems to be the t x r te policy. Hung ry h d the highest t x r te in the region for the l st two ye rs of the period studied. It t xed on ver ge 57.5% of the ye rly profits in its pe k in 2008, more th n 30% higher th n the r te in Pol nd, the country which ttr cts more FDI in EEC. Next highest in 2008 is Cze ch Rep. which t xes 48.6% of the profit of business, still more th n 10% comp re d to Pol nd for the s me ye r. Since Pol nd, Hung ry nd Czech Rep. h ve simil r levels in most of the other indic tors, we c n ssume th t most investors h ve diverted their ttention to Pol nd moving w y from Hung ry nd Czech Rep. These results confirm the findings of Feldstein (1994) nd Morisset nd Pirni (2000) which suggested th t when other v ri bles re not signific ntly different, lo wer t x r te becomes n import nt incentive for investors. Czech Rep. nd Sloven i h ve the lowest r te of unemployment in the region. As mentioned before, b se d on the evidence nd on wh t Jones nd Wren (2010) h ve found, this f ct is not ttr ctive to investors since they prefer higher (but not too much) r te of u nemployment in order to void competition on hum n c pit l s much s possible. Sloveni `s indic tors re ll very positive. It is the country with the higher i ncome per c pit in our s mple but is the le st ttr ctive when it comes to fore ign investments. From 2005 to 2008 the country h s lost more investments th n it h s ttr cted (FDI is neg tive: Gr ph 3). This confirms wh t Moos (2002) h s p reviously st ted, i.e. th t investors re not very willing to invest in develope d countries where the m rkets re lre dy very competitive preferring inste d mi ddle income countries where they c n benefit from successfully filling existing g ps in efficiency. 4.6 Slov k Rep. nd Cro ti Slov k Rep. nd Cro ti re the two countries where lthough FDI were correl ted with number of determin nts, there w s found no e mpiric l evidence to suggest th t they were ssoci ted with GDP growth. As menti oned previously, their high income per c pit seems to be one of the c uses why FDI nd GDP growth re not signific ntly correl ted. After re ching cert in le vel of income, the countries ppe r to lose their dependency on investments from bro d nd their economy relies more on the perform nce of the intern l ctors. But these two countries h ve their own ch llenges to f ce. Cro ti spends roun d 1% of the GDP in R&D, very high for the region, but on the other h nd does not h ve the right level of hum n c pit l to be ble to h rness the dv nt ges gene r ted from the rese rch coinciding with the findings of B l subr m n y m, S lisu nd S psford (1996). Its economic freedom index st nds on the s me low level s th t of B&H (2006-2008) nd is without doubt n unw nted dr wb ck for potenti l investors. Both the hum n c pit l nd the 35

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe

36

economic freedom v ri bles re signific ntly correl ted with FDI nd hence h ve n import nt imp ct on the results. Together with Czech Rep nd Hung ry, Cro ti nd Slov k Rep. h ve been hit by the glob l recession in 2008 with notice ble decre se in their GDP growth trend. Nevertheless, the re l problem for Slov k R ep. is its poor infr structure, unusu l for country of this income level, but even more import ntly the fluctu tions in infl tion which is inversely correl te d to FDI. 4.5 Alb ni , Bosni nd Herzegovin , M cedoni These three countries h ve the worst figures in most of the v ri bles under consider tion (See Appendix I) but ll three of them re showing signs of signific nt improvement. Alb ni h s better-th n- ver ge economic freedom, st ble economic growth (6.7% ye r on ver ge from 1998 to 2008) nd n incre singly better index of politic l fr eedom. However it still h s to de l with low level of hum n c pit l nd infr s tructure, high re l interest r te, low ccessibility to credit nd very limi ted openness to tr de. These l st two v ri bles deserve p rticul r ttention sin ce they re strongly correl ted to the level of FDI. As Alf ro et l. (2004) h v e found when ccess to credit is restricted, even if there re useful spillovers from foreign investors to the domestic economy, loc l investors find it extreme ly ch llenging to t ke dv nt ge of them unless ccess to funds is gr nted. Moor e (2010) h s stressed th t this t kes ddition l import nce in the e rly st ges of development. M cedoni h s to ddress its deficiencies in hum n c pit l nd R &D but especi lly in unemployment nd politic l freedom. Its low-t x policy (r t es were recently decre sed below 20% nd re more th n 75% lower th n the r tes in Cro ti , the second lowest in the region for 2008) does not seem to h ve chi eved p rticul r results t le st not in the short term. The d t suggests th t p olicy m kers in M cedoni should work h rder to incre se politic l freedom nd d ecre se unemployment s number one priority without forgetting to ddress the difficulty of investors to ccess credit nd control the highly fluctu ting infl tion r te. B&H is perh ps the country th t h s to de l with more ch llenges th n ny other in our s mple. Except for perh ps it`s low re l interest r te, high ccessibility to credit nd good infr structure, ll other indic tors re in ver y low levels. Since government spending nd politic l freedom re not rel ted to FDI, the most problem tic v ri bles seem to be the lmost non existing level of R&D, the high unemployment nd the very low index in economic freedom.

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe 5. Conclusions, implic tions for pr ctice nd policy nd recommend tions 5.1 Conclusions The study identified the countries where the rel tionship w s im port nt, the v ri bles th t were most often correl ted with FDI nd those th t b est expl ined the v ri nce of FDI. A robust line r regression model for FDI w s successfully built for 8 countries. In ddition p tterns of different country se ttings th t expl ined the results were lso identified. The rese rch found th t mong the countries of our s mple there is strong, sig nific nt nd positive ssoci tion between FDI nd GDP growth in Bulg ri , Rom ni nd Pol nd. M rket size, GDP per c pit , nd ccessibility to credit were the three v ri bles which were correl ted more often with FDI (in 7 out of the 11 co untries tested). M rket size, openness to tr de nd R&D were e ch included twice in the regression models, being the determin nts which best expl ined the v ri nce of FDI. The m in objective, identifying p tterns between countries where the rel tionship between GDP growth nd FDI w s strong nd signific nt nd countrie s where it w s not, w s fully chieved s the study succeeded in offering n exp l n tion which w s supported by both the d t nd previous economic theories.

Evidence shows th t the countries th t h ve gre ter number of determin nts cor rel ted signific ntly to FDI nd th t h ve in ddition, high level of FDI infl ows seem to be ble to benefit from stronger rel tionship between FDI nd GDP growth. This finding suggests th t investors seem to feel more comfort ble inves ting in countries where other investors seem to be lso interested. The phenomen on, known s the be uty contest concept1 or the herd beh viour w s first described b y Keynes (1936) to expl in m rket trends. It is situ tion where investors do n ot m ke decisions b sed on wh t they person lly perceive to be the best investme nt option but inste d invest where they expect other investors to invest. Howeve r, the findings from our s mple provide evidence th t investors do not follow th e trend blindly but inste d lso expect m rkets to provide positive economic nd politic l environment. The rese rch found th t countries th t h ve more v ri bles correl ted with FDI tend to h ve better ch nces in t king dv nt ges of FDI by tr nsl ting them into GDP growth. However, this does not pply to low or hig h income countries. Low income countries tend to lso h ve more v ri bles correl ted to FDI but due to lower figures in economic nd/or politic l indic tors, FD I f il in enh ncing growth in their c se. High income countries 1 Keynes (1936) cre ted fiction l situ tion where there would be contest where entr nts would choose the most be utiful f ces from m g zine. Whoever selected the most popul r f ces would win. Keynes suggested th t to m ximise its ch nces of winning inste d of n ively choosing wh t he/she believed to be the most be ut iful f ces, contest nt should choose wh t he/she predicted would be the m jori ty`s perception of wh t be uty is. 37

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe on the other h nd seem to not be ble to h rness signific nt benefits from FDI o nce they h ve re ched cert in level of development. Middle income countries se em to be more dv nt ged in this m tter. In our s mple this c tegory is estim te d to st rt t the (2177.73USD: 2569.99USD) GDP per c pit interv l nd to end wi thin the (6221.68USD; 6796.34USD) GDP per c pit interv l. In our E stern Europe -b sed study, Alb ni , B&H nd M cedoni did not h ve GDP growth correl ted to FDI possibly due to their low income figures nd economic s well s politic l still ongoing ch llenges. Bulg ri , Rom ni nd Pol nd h d over one third of the v ri bles tested correl ted with FDI nd higher income per c pit (over 2500U SD in 2008). The higher income countries did not h ve m ny determin nts ssoci t ed with FDI inflows except for m ybe Cro ti (7 out of 15) nd Slov ki (4 out o f 15) which seemed to be too rich to be benefiting signific ntly from FDI. L st bu t not le st, investors seem to p y p rticul r ttention to the existing level of FDI in the host countries. Bulg ri , Rom ni nd Pol nd were lso mongst the c ountries th t h d the highest level of FDI. In terms of projection, we would expect Cro ti , if it continued to receive n i ncre sing mount of FDI inflows t this r te, to st rt developing stronger rel tionship between FDI nd GDP growth nd perh ps exp nd the interv l set for the G DP per c pit r nge. The s me would be expected from Alb ni but perh ps in mu ch l ter st ge when it re ches higher income per c pit level. Joining NATO in 2009 h s been m jor step forw rd for the country in improving its intern tion l im ge. Accession to the EU would in ddition improve signific ntly the ch nce s of Alb ni , B&H nd M cedoni to ttr ct more foreign investments s they woul d be voiding the m jor restr int of h ving sm ll m rket size, improving their indices of politic l nd economic freedom s well s providing e sier ccess to intern tion l credit m rkets. At some point in the future when these conditions re fulfilled, they will perh ps be seen by investors s n efficient pl tform to b se their ctivity nd export to other countries of the EU.

5.2 Limit tions nd Implic tions for Future Rese rch Even though the present s m ple of 11 countries nd 11 ye rs is rel tively sm ll nd h s c used econometric l problems such s multicolline rity, it still provides import nt insights nd e vidence where policym kers c n b se their policies to ttr ct FDI nd for entrep reneurs who c n use these results s checklist before deciding to t ke on ne w investment bro d. Nevertheless, future rese rch using longer time series n d/or including other countries of the region which h ve simil r ch r cteristics will h ve better possibilities in finding more robust conclusions. A d t set wi th less missing d t would lso m ke n 38

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe import nt contribution to the signific nce nd the ccur cy of ll the regressio n models. The study confirmed some of the concerns rel ted to the methodology us ed to c lcul te the d t on hum n c pit l nd economic freedom. However, even mo re serious problems were experienced with the WGI d t set used to c lcul te poli tic l freedom. The study recommends th t n ltern tive d t set is used for thi s v ri ble or, if not possible, critic l ppro ch is dopted. The study chieved its objective to c lcul te the correl tion coefficients betwe en FDI nd e ch of the other 15 v ri bles tested. Among the 11 countries only on four occ sions (R&D for Alb ni ; hum n c pit l for B&H nd t x r te for Cro ti nd B&H) could the test not be c rried out due to d t un v il bility. In order to meet the requirements implied by the objectives th t this study h d to meet (i.e. time nd length), the study concentr ted on 15 v ri bles which were consid ered s more import nt by the liter ture in determining the FDI. However it f il ed in finding v ri ble signific ntly correl ted with FDI in Hung ry nd the re gression models for Czech Rep. nd Slov k Rep. were not very robust. In the c se of Hung ry none of the v ri bles h d ny import nt correl tion with FDI so no s ignific nt model could be built. In ddition the model for Czech Rep. nd Slov k Rep. w s signific nt but could describe the trend of FDI only in minor sc le (less th n 50%). If ddition l resources re v il ble, future rese rchers c n t ry to exp nd the number of v ri bles correl ted with FDI nd s result perh ps succeed in filling these g ps. 5.3 Recommend tions While Bulg ri , Rom ni nd Pol nd were the only successful countries in our s mple th t h ve been ble to h rness FDI in the 1998-2008 period they c n still improve their perform nce even further. Rom ni needs to m ke signific nt efforts in order to incre se the bi lity of investors to ccess credit since some of them m y h ve so f r seen it s n import nt hurdle. It lso needs to review its tr de policies since it is the le st open country of our s mple in terms of intern tion l tr de (for 2008). Al though policies to control infl tion in Rom ni seem to h ve been successful, th e situ tion will need continuous ttention since its level is still rel tively h igh. The s me c nnot be s id bout Bulg ri whose fluctu tions in prices h ve so mehow been excused by the tr nsition period but needs now to m ke de ling with it priority so th t infl tion does not become problem in the future. While Pol nd shown cle rly by the results nd the indic tors, is perh ps the best pl ced c ountry, n incre se in its economic freedom index would strengthen further its p osition of being the country which ttr cts the most FDI in the region. 39

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe Czech Rep. Hung ry nd Sloveni re notice bly mongst the most successful econo mies in E stern Europe. Our study h s found th t once cert in economic nd polit ic l conditions re fulfilled, investors prefer to exp nd in the country with th e le st income per c pit , lowest t x r te, gre test m rket size nd level of FD I. Czech Rep. nd Hung ry h ve rel tive big m rket size but they re perh ps pe n lised by their high t x r te comp red to Pol nd or Bulg ri . Sloveni on the ot her h nd seems to be less ttr ctive due to its sm ller m rket size nd notice b ly higher level of GDP per c pit . It is f ir to ssume th t these three countri es h ve enjoyed much shorter tr nsition period nd h ving lre dy benefited fr om FDI in their e rly st ges, their economies re now less dependent from FDI. Slov k Rep. nd Cro ti h ve h d rel tively successful tr nsition period but t hey re step behind the bove-mention countries. In order to compete with the highest r nked countries, Cro ti needs to ddress its low index of economic fre edom nd h s to djust its educ tion-R&D r tio by either investing more in hum n c pit l or ltern tively concentr te spending in R&D only in its most productiv e fields where there re possibilities of spillovers. Sloveni on the other h nd , needs to invest more in infr structure nd eng ge more ctively in policies to put infl tion under control. The problems of Alb ni , B&H nd M cedoni re more serious. Since the level of spending by the government of Alb ni is r ther low, the country should incre se its investments in infr structure nd hum n c pit l. Secondly, its centr l b nk should consider lowering the interest r te which is the highest of the region o r perh ps use other supporting policies to e se ccess to credit for investors. M cedoni h s to de l with number of issues. High unemployment nd low politic l freedom need to become top priorities. Low ccessibility to credit nd unst b le infl tion together with the low level of hum n c pit l nd R&D should lso be ddressed s soon s possible. The situ tion in B&H would seem to be the most c h llenging. Since infr structure is in good levels, its government c n consider diverting some of the spending to hum n c pit l nd concentr te more on efforts to improve the economic nd politic l indices which seem to be very d m ging to the im ge of the country. Unemployment is nother m jor issue th t deserves p rt icul r ttention. To summ rise, lthough different businesses m y focus on p rticul r v ri bles, o n n tion l level we c n conclude th t investors choose to invest in countries where they re offered n ccept ble level of number of economic nd politic l indic tors. Furthermore, mongst the countries th t fulfil these conditions the y tend to select the one with the gre test m rket size nd lowest income per c p it so th t they c n t ke dv nt ge of g ps in the 40

Endrit Avdull ri Wh t ffects the rel tionship between Foreign Direct Investments nd GDP growth: Evidence from E stern Europe m rket nd economies of sc le. The t x r te nd the beh viour of other investors re lso essenti l in this process. Assuming th t policy m kers continuously im to m ximise the n tion l income, th ey should lso in help investors ccess credit s e sily nd che ply s possible , e se intern tion l tr de in order to m ximise exports nd incre se the efficie ncy of R&D investments. 41