By Michael Faul

Ways To Invest in a Foreign Market Foreign Direct Investment - When a firm directly invests in production or other facilities in a foreign country, and maintains effective control of said investment Foreign Portfolio Investment – Investing in securities sold by a foreign firm or government

Advantages of Bringing in FDI Technology Transfers Inflows of foreign stable capital into the country Helps in the transition to privatization (when state owned firms are sold to foreign investors) Improves the countries’ infrastructures Brings foreign executives into the country with sufficient knowledge of macroeconomic global and local situations

The Asian Crisis Causes: High levels of short-term dept vs. GDP led to a financial Panic – Large inflows of Foreign Portfolio Investment led to huge amounts of short-term dept that was feared to never be repaid – Investors began pulling out their funds from solvent but illiquid banks at the same time in 1997

Short-Term Debt and Reserves

Debt-to-GDP Ratio

Financial Results of the Asian Crisis

FDI and Stable Capital The capital investments that are made through FDI are long-term investments that are illiquid assets, and thus speculation cannot cause a “mass pull-out” of this capital Had the investments in Asia been of the direct rather than portfolio nature, the crisis may have been avoided

Factors Influencing FDI Inflows

Traditional Variables in Determining Whether to Invest FDI in an Economy: Plant/Firm Level Efficiency: – Are labor costs low in this country – Is there enough skilled labor in this country, so that there exists a relatively low productivity-adjusted labor cost – Are there government policies, such as low corporate tax rates that could reduce production costs Transportation Costs: – Is there an existing infrastructure that will allow for the flow of both the inputs/outputs of a given investment – Are there local suppliers in this economy, or is it necessary to look abroad for necessary inputs – Are there tariffs or import/export quotas that prevent a multinational firm from maximizing the effectiveness of its foreign investment

Traditional Variables in Determining Whether to Invest FDI in an Economy (Cont.): Market Size: – Once the multinational firm decides send FDI into a country is there going to be sufficient demand in their particular market – Is this particular market already filled with competitors, or is it an untouched market that is ready to be exploited – Is there a market potential in any of the neighboring countries

FDI Influencing Factors That Arise in Transition Economies Country Risk: – The risk of non-payment or non-servicing of payments for goods or services, as well as loans and other finance tools – The chance of repatriation of capital by the host government – The possible loss of rights due to inadequate laws to protect intellectual property (i.e. patents, trademarks, processes, etc.) The Level/Method of Privatization: – How much has this country actually advanced towards a market economy (How high a share of the GDP is possessed by private businesses) – How stable is the market that has been created in this country

Types of FDI Horizontal FDI - A multinational firm (MNE) enters a foreign country to produce the same type of products that it produces at home Vertical FDI - a multinational firm enters a foreign market to produce intermediate goods to be used in their final products

Vertical vs. Horizontal Horizontal FDI - Often the case when there exists high barriers to trade (i.e. tariffs, transportation costs, import quotas) Vertical FDI - More likely when there are few trade barriers and the different production factors exist at various prices in different economies

Locations of Transition Countries Poland, The Czech Republic, and Hungary compose the more centrally located transition economies Romania and Bulgaria are a part of the south eastern countries in transition

The Distribution of FDI in Transition Economies Was Not an Equal Distribution In general, transition economies have not received large amounts of FDI (less than 1% before transition, and only up to 5% of world FDI by 1995) The majority of this FDI inflow is located in the CEECs with only a small amount in the SE European countries Within these regions, a few countries have attracted the majority of the investment (Cumulatively, Hungary, the Czech Republic, and Poland have attracted 84% of all the FDI in Eastern Europe and Russia has attracted 85% of the FDI in the CIS region)

The Distribution of FDI in Transition Economies Was Not an Equal Distribution (Cont.) The FDI inflows in the Balkan Region between 1989 and 2000 were insignificant, at less than 20 billion USD$ in those 11 years – This number (the combined total FDI inflow of 8 countries over 11 years) does not even amount to that of one year of German or British FDI outflow

FDI Inflows To CEECs In China from , the Per Capita (Millions of US$) FDI was $ , far higher than in any of these countries

FDI Inflows To CEECs

FDI Inflows To China and India

China’s Employment Structure

All of the determinants that a Multinational Enterprise (MNE) considers are important in deciding whether or not to invest directly in an economy, however, the level of privatization and the method of which it is reached is the foremost important measure that is considered This can explain why Bulgaria and Romania always performed relatively poorly in terms of FDI, despite their large markets and relatively low costs Reasons For FDI Inflow Inequalities

By the Numbers:

Reasons For FDI Inflow Inequalities (Cont.) Stability can be quoted as the reason that Poland, the Czech Republic, and Hungary attract so much of the CEECs FDI: – They were the first countries to enter into the Central European Free Trade Area (CEFTA) and thus investment in one of these countries guarantees trade amongst all the nations, and the EU as well – They also are characterized by low risk of repatriation as private market shares compose large proportions of the GDPs, upwards of 80% – Large Markets, Stable Environments, and advanced trade situations lead to good performance in FDI

Reasons For FDI Inflow Inequalities (Cont.) It is not necessary for a country to be a large country in order to attract a decent amount of FDI: – Slovenia- a stable county which is perceived to have little risk attracts sufficient amounts of FDI – Slovak Republic- which has about 75% of its GDP privatized also is successful in attracting FDI inflows

Reasons For FDI Inflow Inequalities (Cont.) In Bulgaria and Hungary, the process towards privatization has taken far longer than in the countries that are favorably attracting FDI inflows and are thus lagging behind in that regards I will use the case of Bulgaria to explain how FDI flows into these less open economies

Incentives for FDI in Bulgaria

Obstacles To FDI in Bulgaria

Regression Equation The factors presented in the aforementioned survey can be used to create a regression equation that is able to calculate the approximate FDI levels in a transition economy Although such a calculation is too complex for this course, independent economists as well as World Bank consultants have worked towards creating equations that can perform these estimations (this is where the importance of these surveys truly lies)

Bulgarian FDI Inflows The 2001 numbers do not represent an entire year

Explanation These type of determinants were common in the SE European transition economies, and explain why the largest European direct investor into Bulgaria was Greece – The history of trade between these two nations (which had occurred before Bulgaria had switched to a planned economy) fostered less fear of country risk than other investors felt – The close geographic proximity also contributed to the fact that the largest FDI in Bulgaria by a EU country came from Greece (this proximity provides them with lower transportation costs than any other EU country) – Cultural closeness also provided for an easy transition of Greek investors into the once closed Bulgarian market

Conclusion and Question FDI flows to the countries that best fit the needs of the firms and provide them with the best chance for profit with the most limited risk As the transition economies move closer and closer to free markets, they still compose only a small percentage of the world’s FDI inflows. Is there anything that these countries can do with their macroeconomic policies to entice more direct investment inflow, or are the traditions and policies of the developed market economies holding them back?