Josef Brada, Ali M. Kutan, and Taner Yigit * Arizona State University

The Effects of Transition and Political Instability on Foreign Direct Investment Inflows: Central Europe and the Balkans Josef Brada*, Ali M. Kutan**, and Taner Yigit*** * Arizona State University ** Southern Illinois University Edwardsville, WDI and ZEI. ***Bilkent University, Turkey

Objective • This paper examines how transition policy, and conflict and political instability affect foreign direct investment flows. • Focus is on Central European and the Balkan economies. • It does so with a unique methodology. • First, it estimates a model of FDI inflows into non-transition European countries. • Second, it uses this model to predict FDI inflows for seven transition economies, now EU member states. By comparing the actual and predicted FDI inflows, it draws conclusions regarding the effectiveness of these countries’ transitional policies on FDI. • Third, it models how economic variables predict the ratio of actual to predicted FDI inflows. It then uses this latter model along with the first model on European nations to predict FDI in seven Balkan states. Again, it uses the difference between actual and predicted FDI to draw conclusions regarding the effects of conflict and instability on FDI inflows.

Motivation • Limited studies on FDI inflows, especially for the Balkan region and regarding the impact of external political stability on FDI inflows. • Available studies are unable to answer the question of whether or not the observed FDI flows to transition economies in Central Europe and the Balkan region have been abnormally different relative to flows experienced by non-transition European economies of similar economic characteristics because of transition factors or political instability. • Because many Balkan economies have faced a different type of political risk, such as actual or potential warfare, as well as foreign economic and military interventions, separating such risks from the “normal” political uncertainty requires modeling strategies that reflect the unique situation of the countries.

FDI flows to Transition Countries • FDI inflows into the Balkan region are lower than those to the Central European countries • There are greater inter-country differences in the volume of FDI inflows

FDI flows to Transition Countries (Cont.) • Overall, the data clearly reveal what can reasonably be termed a shortfall in FDI for the Balkan countries.

Some causes of the Balkan FDI shortfall • Lower levels of economic development • Many are small and on the periphery of the European Union • Many have been unable to implement or sustain cohesive reform strategies • Problems in privatizing firms • Political instability, both among countries of the region and within many of the countries themselves

Visible examples of political instability in the Balkan region • The early and partly violent breakup of the Republic of Yugoslavia and the continued fragmentation of what remained as Yugoslavia, culminating in the NATO intervention • Macedonia has suffered from inter-ethnic strife, as a blockade by Greece, as well as from the enforcement of the blockade against Serbia • Albania has experienced tensions with both Macedonia and Greece • Croatia has had continuing conflicts with Serbia in addition to its involvement in Bosnia • Domestic instabilities such as inter-ethnic tensions or assassinations of political figures, failures in regime changes, and ineffective governments to deal with domestic violence

Methodology • We do not use a traditional approach to estimate FDI inflows • We instead use an indirect approach to make inferences on the impact of transitional policies and external political instability on FDI inflows because of: • lack of data (short sample period) and too many parameters to be estimated • Lack of reliable data on external political stability

Our Indirect Approach • Step 1. Establish the relationship between FDI inflows and country characteristics for core European economies that are not undertaking transition and not subject to serious political stability • Countries: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Norway, Spain, Sweden and Switzerland • Sample period: 1980-2001 • To do so, we estimate the following FDI regression:

Equation 1 where the prefix L indicates the log operator and: FDIi,t= foreign direct investment inflow into country i in year t in billions of current US$ GDPPPi,t = GDP of country i in year t in billions of US $ in 1995 PPP US$ GDPPCi,t = per capita GDP of country i in year t in billions of 1995 PPP US$ TRADEi,t = ratio of the trade of country i to its GDP in year t SECONDi,t = secondary enrollment (% gross school enrollment) of country i in year t LANDi,t = land area of country i in year t in square kilometers CITYi,t = population of the largest city of country i in year t

Estimation method • The estimations are carried out using feasible GLS pooled-panel regression. • We avoid the introduction of any fixed/random effects or lagged terms or using dynamic panel data estimation to formulate a more “universal” model of FDI because the introduction of these variables makes the projection of estimated parameters on another set of countries much more difficult, either due to different inertia or strength of instruments. Instead we used country-specific and almost constant variables like land or population to proxy for the fixed effects.

Table 1: Parameter Estimates for Equation 1 (Dependent variable: Log FDI)

Step 2: Benchmark Estimates of the Effects of Transition on FDI Inflows • To estimate the effects of transition on inflows of FDI, we use the parameters of Equation 1, which gives the expected FDI level for non-transition, politically stable European market economies, to estimate the expected levels of FDI for a sample of transition economies that are experiencing less political instability than are the Balkan countries. • The sample countries are the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland and the Slovak Republic, and we estimate their expected levels of FDI for the period 1993 to 2001.

Step 2: Benchmark Estimates of the Effects of Transition on FDI Inflows (Cont.) • We then define the transition shortfall (or excess) in FDI for these transition economiesin year t as: where Expected FDIi,t is calculated using the parameters of Equation 1 and the economic characteristics of country i in year t.

Table 2: Predicted and Actual FDI Inflows in Transition Economies (billion US $)

Table 2: Predicted and Actual FDI Inflows in Transition Economies (billion US $)(contd)

Step 3: Benchmark Estimates of the Effects of Political Instability on FDI Inflows • To estimate the effects of external political instability on inflows of FDI, we regress the ratio of actual to predicted FDI inflows against economic variables. We then use this latter model along with the first model on European nations to predict FDI in seven Balkan states. Again, we use the difference between actual and predicted FDI to draw conclusions regarding the effects of conflict and instability on FDI inflows. • The sample countries are Albania, Bosnia, Bulgaria, Croatia, FYROM, Romania and Slovenia, and we estimate their expected levels of FDI for the period 1993 to 2001. • We estimate the following FDI model:

Equation 6 where L is the log and D is the difference operator and INITLINFi = cumulative inflation in country i between 1990-93 INITDLGDPi = cumulative GDP decline in country i between 1990-93 INITLPRIVi = share of private sector in GDP of country i in 1993[1] LINFRAi,t = EBRD index of infrastructure reform of country i in year t SPREADi,t = lending minus deposit rates for country i in year t BUDGBALi,t = overall budget balance (% of GDP) of country i in year t DCURRACCi,t = change in current account (% of GDP) of country i in year t DUNEMPi,t = change in unemployment rate of country i in year t DLPRIVi,t = change in share of private sector in GDP in country i in year t [1].

Table 3: Parameter Estimates for Equation 6 (Dependent variable: Log R)

Inferring the Effects of Transition and Political Instability on FDI in the Balkans • With the parameters for Equations 1 and 6 at hand, we next estimate the effects of political instability on FDI inflows to Balkan countries • We first use the parameters of Equation 1 to estimate the FDI inflows into the Balkans that would be expected if they were normal European countries, undergoing no transition and experiencing no exceptional political instability. These estimated values of FDI are reported in the first row of each country’s entry in Table 4.

Table 4: Predicted and Actual FDI Inflows in Balkan Transition Economies (billion US $)

Table 4: Predicted and Actual FDI Inflows in Balkan Transition Economies (billion US $)(contd)

The Effects of Transition and Political Instability on FDI in the Balkans(Cont.) • The second row for each country reports the expected FDI based on Equation 6, that is the country’s expected FDI inflow if it were a transition economy such as the ones used to estimate the parameters for Equation 6. • The difference between the FDI projected by Equation 1 and Equation 6 is thus a measure of the loss or gain experienced by these countries because of the quality of their transition policies. • The loss of FDI due to regional political instability is given by the difference between FDI a projected by Equation 6 and the actual FDI that a country received.

Conclusions • Transition status allowed Central European and Baltic countries to receive higher than expected FDI inflows. • Much of the shortfall in FDI inflows to Balkan countries is attributable to political instability of these countries, not their lack of transition reforms. • The literature on the beneficial effects of FDI on growth implies that the costs of political instability can be much higher than our measurements.

Josef Brada, Ali M. Kutan, and Taner Yigit * Arizona State University