EU Monitor July 13, 2005

14 Economics
Foreign direct investment accounts
for three-quarters of economic
growth in the CEECs
Greenfield investments boost output
and deliver technological progress
Foreign direct investment: The growth
engine in Central and Eastern Europe
Foreign direct investment (FDI) has been a widely discussed topic in
the description of the successful transition process of many Central
and Eastern European countries (CEECs) into market economies.
Foreign direct investment in the CEECs
1
rose almost tenfold
between 1994 and 2003 from USD 20 bn to USD 197 bn. In terms
of FDI in relation to GDP, there was an impressive increase from
6.9% to 33.2%.
There is broad consensus that foreign direct investment has a
favourable effect on the transition process and especially on
economic growth. Against this background the surge in foreign
capital investment has prompted a raft of analyses dealing with
economic and political factors which either favour or hamper foreign
direct investment in the CEECs. The analyses focus on why some
countries have been more attractive for foreign direct investment
than others, and go on to draw conclusions about the success of the
transition process. It was tacitly assumed that higher foreign direct
investment pushes up economic growth. These studies provide no
compelling evidence for this, however. Recent research now
confirms that foreign direct investment was the engine of growth in
Central and Eastern Europe in the last 10 years. It contributed 2.3
percentage points to economic growth of 3.5% on average (i.e.
74%). Furthermore, the results of the analyses show the growth
contributions of FDI in each individual country of Central and
Eastern Europe and how quickly foreign investment has been
absorbed.
2
With these findings, the impact of foreign direct
investment gets a quantitative dimension and underscores its
enormous importance for the economic upswing in Central and
Eastern Europe as a region and also in each individual country. For
the future, this means that foreign investors will shift their focus from
the more advanced countries to the next EU candidate countries.
Positive contributor to economic growth in many
ways
Foreign direct investment has various effects on economic growth in
the recipient country. As many foreign companies are producers of
consumer and capital goods, their business activities lead to an
increase in output and have positive effects on employment. While
consumer goods production mainly enhances the product range in
many emerging markets, the production of capital goods plays a key
role with regard to the diffusion of technological progress. As many
multinationals have the technological lead in their market segments,
the capital goods produced are of very high quality and thus boost
the efficiency of the production process also for the domestic end-
producers.
3
Besides direct production, i.e. greenfield investments,
foreign participations are of major importance. These participations
have a long-term horizon and exercise significant influence on local
management. Direct investments of this kind are thus different from
portfolio investments, which tend to have a short-term horizon and

1
The countries analysed are Albania, Bulgaria, Estonia, Croatia, Latvia, Lithuania,
Macedonia, Poland, Romania, Slovakia, Slovenia, the Czech Republic and Hungary.
The European CIS states have not been taken into account due to insufficient data;
the same applies to Serbia and Montenegro and Bosnia and-Hercegovina.
2
Neuhaus, Marco: The Impact of Foreign Direct Investment on Economic Growth: An
Analysis for the Transition Countries of Central and Eastern Europe. Inaugural
dissertation, Mannheim University, May 2005 (due to be published in autumn 2005).
3
The impact of FDI on technological progress and economic growth is similar to that of
imports of high-quality capital goods.
0
20
40
60
80
100
120
140
160
180
200
220
240
94 95 96 97 98 99 00 01 02 03
0
5
10
15
20
25
30
35
40
45
50
55
60
FDI stock, USD bn (left)
FDI stock as % of GDP (right)
Steady inflow of foreign direct
investment to CEECs
1
USD bn % of GDP
Source: UNCTAD
July 13, 2005 EU Monitor
Economics 15
Foreign affiliates provide production
know-how and management
expertise
Presence of foreign firms generates
positive spillovers
Improvements in the institutional
environment
Estimate calculated using dynamic
panel method
for 13 Central and Eastern
European countries
mostly do not involve any management influence. Typically a foreign
investor needs to acquire a stake of at least 10% of the share capital
in order for this to be classified as a direct investment. Mergers and
full takeovers also count as direct investments. The outcome of such
transactions is a permanent transfer of manufacturing know-how
and management expertise from the foreign company that steadily
boost the efficiency and output of local affiliates.
But also the mere presence of foreign companies can result in
positive external effects (known as knowledge spillovers), where
local companies benefit from the transfer of knowledge and
independently develop new products and technologies. Further-
more, foreign direct investment conceivably generates numerous
other benefits. If foreign firms, for example, train their local staff
locally, this also increases the human capital available in the
recipient country.
Another benefit is created by a reciprocal improvement in the
institutional environment in the target country. It is the goal of
economic policy makers to permanently improve the investment
climate in order to attract more foreign companies and stimulate
growth via capital accumulation and technological progress. This
includes infrastructure improvements, comprehensive privatisation
and deregulation efforts as well as an increase in general legal
certainty. In turn, foreign companies lobby for the further bolstering
of company law, greater protection for private property and the
acceptance of international accounting standards.
So there are many factors that make FDI especially because of its
long-term horizon an important growth driver and a guarantor of
greater political and economic stability.
Major growth driver in Central and Eastern Europe
as well
Up until now it has been difficult to prove that foreign direct
investment boosts growth in Central and Eastern Europe. Both the
small number of countries and the short observation period for
which data is available have hitherto prevented serious empirical
analysis. Only recently developed new econometric models and
their application in growth analyses now enable the transition
countries to be assessed. Using the pooled mean group procedure,
a dynamic panel method, enables the rate of per-capita GDP growth
to be estimated for a group of countries across several time periods.
The dynamic aspect of the method is that it assumes a long-term
stable equilibrium between per-capita GDP and its determinants,
towards which the countries converge over time. The special
characteristic of pooled mean group estimation is that unlike in
conventional dynamic fixed effects estimation every country with a
differing speed tends towards this long-term equilibrium. The pooled
mean group method is far superior to the conventional cross-
sectional and time-series analyses thanks to its considerably higher
number of degrees of freedom (made possible by the panel data
structure) and thereby makes its application to Central and Eastern
European countries possible at all. In addition, it is considerably
more flexible than conventional panel methods as it allows a greater
heterogeneity of the estimated coefficients between the countries.
Its dynamic character allows the description of a transition into long-
term equilibrium for every country, which very faithfully reflects the
91 92 93 94 95 96 97 98 99 00 01 02
-16%
-12%
-8%
-4%
0%
4%
8%
12%
Actual GDP per capita
(15-64)
Model result
Romania: Growth modell & reality
Source: Neuhaus (2005)
EU Monitor July 13, 2005
16 Economics
economic developments in Central and Eastern Europe.
4
See the
box on the next page for details about the method, the selected
variables and the estimates.
The results of pooled mean group estimation are highly significant
and show for the first time the positive impact of foreign direct
investment on economic growth in Central and Eastern Europe. But
domestic investment also plays an important role in explaining
economic growth. The fact that the regression coefficient for
domestic investment is three times as high as for foreign
investment, does not actually say anything about the relative
importance of either type of investment for economic growth. The
volume of the changes in investment also plays a part and this was
much higher for foreign investment than for its domestic counterpart,
as illustrated by the growth contributions.
A look at the convergence coefficients shows that on average it
takes almost 3 years for each country to reach the halfway point in
boosting per-capita income from its current level to its long-term
fundamentally justified level (half-life). This high speed of
convergence illustrates that Central and Eastern European countries
remain in a rapid transition process that is continually pushing up
the long-term fundamental equilibrium level. In all, 50% of the
variance in per-capita GDP growth is accounted for, which is high for
growth analyses. For most countries the growth model provides a
good representation of the actual development of GDP per capita
(see charts for Romania and Hungary).

4
Pooled mean group estimation has already been applied by Deutsche Bank Research
to growth regressions. For more details about the method see S. Bergheim et. al
(2005). Global growth centres 2020: Formel-G for 34 economies. Deutsche Bank
Research, Current Issues No. 313, Frankfurt am Main.
91 92 93 94 95 96 97 98 99 00 01 02
-14%
-12%
-10%
-8%
-6%
-4%
-2%
0%
2%
4%
6%
Actual GDP per capita
(15-64)
Model result
Hungary: Growth model &
reality
Source: Neuhaus (2005)
July 13, 2005 EU Monitor
Economics 17
Pooled mean group estimation for Central and Eastern Europe
The pooled mean group procedure is used to estimate the impact of FDI on economic growth for thirteen countries
in Central and Eastern Europe.
5
The sample includes data for Albania, Bulgaria, Croatia, the Czech Republic,
Estonia, Hungary, Latvia, Lithuania, Macedonia, Poland, Romania, Slovakia and Slovenia and covers the period
1991 to 2002. The underlying econometric model is based on the standard neoclassical production function. Output
is produced by a combination of capital and labour.
6
Labour input is measured as the total population of working age
(15-64 years). For capital input we distinguish between investment by foreigners and investment by local residents
to account for the two different types of capital accumulation. Estimates are calculated using the following dynamic
equation:
( ) [ ]
t i
A
t i
H
t i i t i i t i
i i y y
, , 2 , 1 , 0 1 , ,
ln ln ln ln e b b b f + + + - - = D
-
y
i,t
is real GDP per capita of the working-age population, i
A
i,t
is the inward FDI stock as a percentage of GDP, and i
H
i,t
is domestic investment (measured as gross capital formation minus net FDI inflows) as a percentage of GDP. The
intercept of the regression is denoted by b
0,i
, while the error term is given by e
i,t
. The equation runs over all periods t
= 1991, , 2002 and countries i = Albania, , Slovenia. The term in round brackets describes the long-run level of
per capita income as defined by the present levels of foreign and domestic capital accumulation. We compare this
long-run value with the per capita income level of the previous period. If the implied long-run value is higher than the
value of the previous period, then we expect positive growth of per capita income. This growth continues as long as
the long-run equilibrium value increases or, more generally, as long as the countrys GDP per capita has not fully
converged with its long-run value. The speed of convergence is given by parameter f
i
, which we allow to differ from
country to country. The slope coefficients b
1
and b
2
describe how a change in the two types of investment affect the
long-run level of per capita income. We will assume that the long-run effects unlike the convergence speed are
the same for all countries. This restriction is necessary to gain sufficient degrees of freedom to ensure significant
regression results.
7
But at the same time, the restriction is also economically plausible: why should a one-percent
increase in FDI stocks have a different impact on per capita income in the long run in one country than the same
increase in another country? However, the focal point of interest is: will the slope coefficients be significant? In other
words, does FDI have a positive impact on long-run per capita income and thus generate economic growth?

Variables in the model
GDP per capita (15-64): The logarithmic change (growth rate)
in real GDP per capita of the working-age population (15-64
years) measured in 1995 US dollar purchasing power parities.
Foreign direct investment: The logarithm of inward FDI stock
as a percentage of GDP multiplied by 100.
Domestic Investment: The logarithm of the difference between
gross capital formation and net FDI inflows (as a percentage of
GDP and multiplied by 100).

---------------------------------------------
5
See Neuhaus (2005), Chapter 4.
6
Neuhaus augments the basic analysis by introducing additional policy variables into the model (trade openness, budget deficit, government
consumption, and volatility of inflation). However, the estimation results for the partial effect of FDI on economic growth remain largely
unaffected by the inclusion of other variables.
7
If we lift the homogeneity restriction on the slope coefficients, i.e. all countries can show individual effects of a one-percent change in FDI on
the long-run per capita income level, we would have to estimate 6(!) parameters for each country. Given the small number of time-series
observations (max. 13 periods for each country) the unrestricted model would probably deliver insignificant results for many of the sample
countries.

Regression results for the CEE countries
Coefficient t-Statistics
Common coefficients
FDI 0.10 14.0
Domestic investment 0.33 9.8
Country-specific coefficients (mean)
Convergence -0.23 6.2
Intercept 0.19 6.4
Explanatory power
Average R
2
0.50
Source: Neuhaus (2005)
EU Monitor July 13, 2005
18 Economics
Big differences between FDIs growth contributions
One would expect that typically the countries that have generated
the highest economic growth due to FDI would also have booked
the largest capital inflows from abroad during the period under
review. These would be Latvia, the Czech Republic and Estonia with
average annual inflows of well over 5% of GDP. The strategy of
foreign investors has been clear: direct investment primarily in those
countries that were the most developed at the beginning of the
transformation process, offered the best economic environment at
an early stage and were the first candidates for EU accession.
Whether these countries have, however, really experienced the
highest growth contributions depends not only of the size of the
inflows but also the speed at which they are absorbed represented
in the model by the convergence parameter. Countries that quickly
absorb an increase in domestic or foreign investment also
experience a bigger short-term impact on economic growth.
However, these tend to be countries that were less developed at the
beginning of the transition. An increase in FDI seems to feed
through to growth very quickly in these countries. Besides the
inflows and the speed of absorption the dispersion of the inflows
over time plays a part. Rapid changes in the stock at the beginning
of the period under review which are also quickly absorbed are the
biggest growth drivers.
The table below presents the average growth contributions of
increases in the working-age population, foreign direct investment,
domestic investment and other sources for each of the 13 CEECs.
The impact of FDI is outstanding. Foreign investors contributed 2.3
percentage points to the average economic growth figure of 3.5%.
Domestic investment, by contrast, had barely any impact on growth.
The average growth contribution of 0.4 of a percentage point even
fell to zero following the exclusion of Albania, which showed by far
the biggest contribution. It was a similar story with changes in the
working-age population on average they barely made any
contribution to growth. Ultimately, 0.8 of a percentage point, i.e.
almost one-quarter of total average growth, is attributable to other
factors. Overall one can thus say that capital accumulation due to
foreign direct investment has played an instrumental role in the
growth process in Central and Eastern Europe. This applies not only
to the whole region on average, but also to most of the 13 countries.
1.9
2.5
2.9
2.9
3.5
3.6
3.9
4.1
4.5
5.0
6.5
7.0
8.3
0 2 4 6 8 10
SI
RO
AL
MK
PO
LT
BG
HR
HU
SK
EE
CZ
LV
Annual FDI inflows
% of GDP
Average
1994-2002
Source: UNCTAD (2004)
Absorption rate
Half-life
Convergence
parameter
Lithuania 1.2 -0.45
Latvia 1.3 -0.42
Romania 1.4 -0.40
Poland 1.9 -0.31
Albania 2.0 -0.29
Bulgaria 2.4 -0.25
Croatia 2.5 -0.24
Macedonia 3.5 -0.18
Hungary 3.5 -0.18
Czech Rep. 5.0 -0.13
Slovakia 8.3 -0.08
Estonia 13.5 -0.05
Slovenia 13.5 -0.05
Average 2.7 -0.23
Source: Neuhaus (2005)
Average annual contributions to growth, 1994-2002
GDP growth Working-age
population
FDI Domestic
investment
Other
Romania 1.5 0.1 6.6 -1.6 -3.7
Poland 4.5 0.7 3.5 0.5 -0.3
Lithuania 3.1 -0.3 2.9 0.1 0.2
Bulgaria 1.1 -0.3 2.7 -1.6 0.2
Croatia 4.3 -0.7 2.4 0.7 1.8
Latvia 4.5 -0.6 2.4 0.3 2.2
Macedonia 0.9 0.8 2.3 -0.6 -1.6
Hungary 3.5 0.1 2.0 1.2 0.1
Albania 7.6 0.2 1.6 5.9 0.0
Estonia 4.4 -0.7 1.0 -0.2 4.1
Slovakia 4.3 0.8 0.9 -0.1 2.6
Czech Republic 2.2 0.4 0.8 -0.4 1.4
Slovenia 4.1 0.1 0.3 0.4 3.2
Average 3.5 0.1 2.3 0.4 0.8
Source: Neuhaus (2005)
July 13, 2005 EU Monitor
Economics 19
The growth contribution is thus between 1.5 and 3 percentage points
in most cases. Romania is a positive outlier with a growth
contribution of 6.6 percentage points. Exponential growth in its
foreign capital stock and swift absorption ability have made the
biggest contribution to economic growth. The picture is similar for
Bulgaria and Croatia. In the three countries the stock has, on
average, grown twice as fast as that in the Czech Republic, Slovakia
and Slovenia. The lower growth rate of direct investment
combined with the comparatively weaker absorption rate has led
to the relatively low growth contributions in the three relatively highly
developed countries. On top of this, the Czech Republic posted
significantly under-par economic growth rates during the transition
period due to the severe recession in the late 1990s. In Slovenia
and Slovakia there appear to be some special factors (other than
capital accumulation and labour input) that have had an impact
more than half of the growth cannot be explained.
If the average growth contributions of domestic and foreign investors
are compared for all 13 countries, no clear correlation is discernible.
Some countries with large contributions from foreign direct
investment report contributions from domestic investment that are
low whereas others are high; the same applies to countries with low
contributions from foreign direct investment. In other words, the
panel data provides no indication of whether FDI crowds out
domestic investment or complements it (via knowledge spillovers).
Within individual countries the sequence of events does, however,
suggest that foreign direct investment has led to crowding out. There
is a negative correlation between the domestic investment rate and
annual FDI inflows (average 0.4) in ten countries. In the Czech
Republic there is an almost perfect negative correlation between
domestic investment and foreign investment, whereas the positive
correlation in Albania and Poland is the exception. Although it is
certainly conceivable that FDI has a negative impact on domestic
investment demand, the conclusion cannot necessarily be drawn
from the correlation that there is a causal link. Further analyses are
required in this regard. In all there are six countries with negative
growth contributions from domestic investments. Romania had a
declining domestic investment ratio for several years in the second
half of the 1990s. In Bulgaria the ratio was very volatile for the whole
period and is slowly approaching its early 1990s levels. The Czech
Republic recorded highly negative growth contributions particularly
due to the recession.
On average there was barely any stimulus from changes in the
working-age population. Within Central and Eastern Europe,
however, there are stark variations. A huge decline in the working-
age population in the Baltic countries dampened growth
considerably. Without this decline Latvia and Estonia would even
have posted average growth rates of over 5%. In the long term the
demographic trend will in any case work against the CEECs. With
an average birth rate at present of under 1.3 (EU-15: 1.5) the
working-age population should continue to trend down and result in
negative growth contributions.
EU accession candidates under the microscope
The analysis has shown that foreign direct investment has been the
main growth driver in the transition process in the CEECs to date.
With a growth contribution averaging nearly 2 percentage points,
FDI provided all the stimuli that failed to come from domestic
sources. This process will continue in future. Expanding markets,
low unit wage costs and skilled employees as well as an
increasingly stable economic and political environment (particularly
0
10
20
30
40
50
60
94 95 96 97 98 99 00 01 02 03
FDI stock: Bulgaria, Romania &
Croatia
Romania
Croatia
Bulgaria
Source: UNCTAD (2005)
% of GDP
Correlation
coefficient
Albania 0.6
Poland 0.6
Bulgaria 0.0
Lithuania -0.4
Croatia -0.4
Latvia -0.4
Estonia -0.7
Slovakia -0.8
Hungary -0.8
Slovenia -0.8
Romania -0.9
Macedonia -0.9
Czech Rep. -1.0
Average -0.4
Source: UNCTAD (2004), Neuhaus (2005)
Correlation of domestic investment
and FDI, 1994-2002
0
5
10
15
20
25
30
35
94 95 96 97 98 99 00 01 02
Negative correlation between the
two types of investments in
Czech Republic
% of GDP
Domestic
investment
Foreign
investment
Sources: UNCTAD (2004), Neuhaus (2005)
EU Monitor July 13, 2005
20 Economics
in the new EU candidate countries) continue to tempt foreign
investors to transfer their capital to Central and Eastern Europe.
The focus will, however, shift from the previous group of candidate
countries such as the Czech Republic, Hungary and the Baltic
states to the current EU accession candidates. They do not yet have
such a large FDI stock, which means there is still further growth
potential. They also boast even lower wage costs than in the
developed CEECs. This is confirmed by the latest figures from the
WIIW. There were very high inflows to Bulgaria in 2004 (around
EUR 2 bn, or 10.9% of BIP), as in 2003, and inflows to Romania no
less than doubled (from about EUR 1.9 bn to EUR 4.1 bn, or 7% of
GDP). Croatia has received major inflows constantly since 2000.
However, after the record year of 2003 they did halve in 2004 (to
almost EUR 1 bn, or 3.3% of GDP). The remaining Balkan states
are the lowest-ranking CEECs. The FDI stock is low and it is
growing sluggishly (Macedonia 2.8%, Slovenia 1.6%, Albania n.a.).
The prospect of entering the EU in the near future should attract
continued high levels of FDI to Bulgaria, Romania and Croatia and
in combination with a rapid absorption ability lead to large growth
contributions.
For countries whose stock of foreign capital is still small the
economic policy recommendation has to be to recognise the
importance of foreign direct investment for the growth and transition
process and to do everything to enhance the investment climate.
The most developed nations like the Czech Republic and Hungary
with currently high stocks of foreign capital need to stimulate
domestic investment. This will help ensure sustainable economic
development in an era of intense global competition between
different locations for foreign investors.
Marco Neuhaus, +49 69 910-31519 (marco.neuhaus@db.com)
15.6
18.1
22.1
23.4
24.9
27.2
29.1
31.5
35.1
48.0
49.6
51.8
77.6
0 20 40 60 80 100
SI
AL
MK
RO
PL
LT
BG
SK
LV
CZ
HR
HU
EE
FDI stock in 2003
% of GDP
Source: UNCTAD (2005)
2004 2003
Bulgaria 10.9 10.5
Romania 7.0 3.8
Hungary 4.2 2.6
Czech Republic 4.2 2.3
Croatia 3.3 7.0
Macedonia 2.8 2.0
Slovakia 2.7 1.7
Poland 2.5 2.0
Slovenia 1.6 1.2
Estonia k.A. 10.8
Latvia k.A. 3.5
Albania k.A. 2.9
Lithuania k.A. 1.0
New EU members 3.0 3.1
EU candidates 7.1 7.1
Other 2.8 2.5
FDI inflows (% of GDP)
Sources: WIIW (2005), data for the Baltic states from
UNCTAD (2005)