FOREIGN DIRECT INVESTMENT IN AN EMERGING MARKET ECONOMY:
THE CASE OF ROMANIA
by
Stephen P. Ferris
Department of Finance
College of Business and Public Administration
University of Missouri-Columbia
G. Rodney Thompson
Department of Finance
Pamplin College of Business
Virginia Polytechnic Institute and State University
Calin Valsan
Department of Finance
Pamplin College of Business
Virginia Polytechnic Institute and State University
For The University of Pittsburgh, CED
November, 1993
I. INTRODUCTION
The collapse of communism in eastern Europe has left significant economic challenges in its wake. The first challenge facing these newly liberated states is the removal of the centralized economic system that allocates resources by command and sets prices without reference to market forces. The second challenge is more long-term in nature and involves the recapitalization of the national industrial base. It is finding the solution to these short and long run problems that represents the challenges and opportunities present in the transitional economies of eastern Europe. Such solutions are required to assure that economic growth and development proceeds.
The replacement of centralized economic planning with a system of free prices and private ownership of capital is essentially an internal political process. The speed and extent of the dismantling of the structure of government subsidies and the state operation of enterprises must be determined by the resilience of the population. Consequently, the focus of this study will be upon the process of industrial recapitalization in these emerging market economies. More specifically, we will examine the determinants of foreign direct investment which represent a critical component in the revitalization of industry in eastern Europe.
Presently, the rate of capital inflows into the former Soviet bloc is inadequate for meaningful industrial recapitalization. Although foreign investment has increased relative to previous years, the high degree of political uncertainty remains a deterrent to many Western investors. Eastern European governments have attempted to allay these fears through a nearly complete deregulation of the legal framework which controls direct foreign investment. As shown in Table 1, most of the former centrally planned economies now allow 100% foreign ownership and the repatriation of profits. Some of these countries also have instituted significant tax deductions and tax holidays.
Romania, the focus of this study, represents one of the most dramatic cases of transition to a market-based economy.1 Having been both the poorest and most authoritarian among the Soviet bloc nations, Romania will face the greatest challenges in converting to a market-driven economy. To date, the transition strategy of the Romanian government has emphasized four elements: lifting price controls, privatization, institutional reform, and incentives for foreign investment. Attracting foreign capital is of tremendous importance to Romania, yet the government's principal focus has only been on tax incentives. The objective of this study is to examine the determinants of foreign direct investment and thereby assist in the design of policies that will stimulate Western investment in Romania. Although politically unique, this period of economic transition is not so different from that experienced by many Third World nations, especially those of Latin America. Indeed, we use the pattern and nature of foreign direct investment in Latin America to develop a descriptive relationship of foreign investment that will be of use for Romania, and more generally, to all of eastern Europe.
The choice of Latin American economies as our sample for analysis of determined by the relatively large number of observations from an approximately homogenous group of countries. Much like the Eastern European countries under consideration in this paper, many of the Latin American countries in the sample have experienced periods of state intervention and economic regulation interrupted by periods of economic liberalization. The longer run trend in these countries has been toward increasingly free markets, consistent with the current state of the Eastern European economies. Moreover, the general level of income and standard of living in most Latin American countries is similar to that prevailing in Eastern Europe. The similarities between these two groups of countries are also evident in terms of the level of industrial development and national productivity levels.
II. THEORETICAL DISCUSSION
A number of studies have examined the nature and level of foreign direct investment. In this section we will construct a model for foreign direct investment using variables suggested in the literature. The results from this analysis will allow us to better understand the nature of foreign investment in an emerging market such as Romania.
Imports - According to Mundell (1957), foreign direct investment should ultimately flow into those countries that are importing goods from abroad. Because of market imperfections, such as tariffs and quotas, foreign firms will find it attractive to produce locally in order to satisfy domestic demand. This classic concept of "import substitution" has long been a theory used to explain international capital flows. Schmitz and Helmberger (1970) as well as Dunning and Norman (1983) contend that foreign direct investment creates vertically integrated production units and therefore increases the amount of trade. Hymer (1970, 1972), Kindelberger (1970), Vernon (1966), and Caves (1971) argue that given the oligopolistic structure of markets and international integration, imports and the level of foreign direct investment are complementary. Thus, the hypothesized relationship between imports and foreign direct investment is positive.
Exports - As the level of a nation's exports increases, its economy becomes more internationally integrated. This has the effect of altering local labor markets and driving domestic wages towards world levels. This, in turn, makes foreign investment less profitable as the advantage of lower wages evaporates. Based upon these observations, one might hypothesize a negative relationship between exports and foreign direct investment.
There is, however, an alternative possibility. A nation may have higher exports because of some unique access to foreign markets. If, for instance, a country characterized by low wages had access to a trading group, one might expect that country to attract significant levels of foreign direct investment as countries external to the trading group attempted to sell within the group. This targeting of the low wage country by nations outside the trading group could lead to a positive relationship between the level of exports and foreign direct investment.
Infrastructure - Vernon (1966) has suggested that for production to migrate abroad, the host nation must provide an adequate infrastructure. Likewise, Munteanu (1991) has described the essential dilemma of the foreign investor. That is, the multinational corporation desires to operate within a developed nation, possessing a reliable infrastructure since it will result in a more efficient distribution system. Moreover, as noted previously, a less developed nation likely means lower wages with a correspondingly greater profit potential. Based on these observations, ceteris paribus, we hypothesize a positive relationship between foreign direct investment and the level of development of the country's infrastructure.
Gross Domestic Product - Gross domestic product captures the productive capacity of an economy. It reflects both the size of the domestic market as well as the purchasing power of the citizens. A positive relationship between this variable and foreign direct investment would be consistent with Kindleberger who contends that foreign investment requires a sufficiently large host country market to accommodate the increase in local supply.
Population - Population is a measure of the potential market size of the host country. Further, a smaller population will reduce projected profit from foreign investment as potentially low wages will be more rapidly driven to world levels. Culem (1988) reports a positive impact of population upon foreign investment within developed countries. The model to be specified might enter this variable as a direct measure of population, in which case we would expect a positive relationship between population and foreign direct investment. Alternatively, the influence of population may enter the model as a per capita measure of imports, exports or GDP.
Political Risk - The existence of political risk should have a depressing effect on the attractiveness of foreign direct investment. Aharoni (1966, 1973) notes that although managers attempt to avoid risk in their investment decisions, many dimensions of risk are difficult to measure. Thus, the political risk associated with foreign direct investment has a high subjective content. Lucas (1990) considers political risk as one of the major reasons why capital does not flow from wealthy to poor nations as freely as predicted by neo-classical theorists. Why hypothesize a negative relationship between this variable and foreign direct investment, suggesting an inverse relationship between political risk and the level of foreign direct investment.
III. EMPIRICAL METHODOLOGY
A. Model Specification
Based upon the immediately preceding discussion, we specify our model of foreign direct investment as follows:
FORINVj,t = 0 + 1IMPj,t-1 + 2EXPj,t-1 + 3GDPj,t-1 + 4VEHj,t + 5RISKj,t
where:
FORINVj,t = net dollar amount of foreign direct investment in country j at time t;
IMPj,t-1 = dollar amount of imports in country j at time t-1 standardized by the country's population at time 5-1.
EXPj,t-1 = dollar amount of exports for country j a time t-1 standardized by the county's population at time t-1.
GDPj,t-1 = dollar value of country j's gross domestic product at time t-1 standardized by the country's population at time t-1.
VEHj,t = number of commercial vehicles used in country j at time t standardized by the country's population at time t
RISKj,t = the natural log of a published political rights index for country j at time t.
Further elaboration regarding the specification of each of the variables presented above is required. Four of the five independent variables are specified in a per-capita format. These variables are imports, exports, gross domestic product (GDP), and commercial vehicles (our measure of the level of infrastructure development). Further, three of these variables, imports, exports, and GDP are lagged one year because of the possible problems of reaction time as well as a possible problem of endogeneity.2 Capital inflows are not likely to reflect the influence of changes in these variables instantaneously. In terms of the possible endogeneity problem, large foreign investment flows could impact the reported levels of imports, exports, or GDP.
Because infrastructure involves so many different components of a nation's economy, there are a number of possible proxies for its measurement. We elect to use the number of registered commercial vehicles to represent the extent of infrastructure development. As vehicle registration increases, so do the miles of paved roads, fuel stations, and other such measures of infrastructure. Such increases, in turn, should have a favorable influence on commodity distribution and communication networks.
The RISK variable captures the degree of democracy of the political system rather than the political risk of the nation.3 This index, calculated by Freedom House of New York, was selected over other indices such as International Business Communication's International Country Risk Guide or the Political Risk Index produced by the Economist Intelligence Unit because of its availability over a longer time period. Variables reflecting the corporate tax regime and exchange rates are not included in the model's specification for two reasons. The first concerns the extremely limited data availability on corporate tax structures for our sample of developing nations. Secondly, for many of these nations the exchange rate is set by government authority on an administrative basis and does not reflect the true market valuation of its currency.
B. Sample and Data Description
As discussed above, our sample consists of 11 Latin American countries. These nations are Argentina, Bolivia, Brazil, Chile, Columbia, Ecuador, Mexico, Paraguay, Peru, Uruguay, and Venezuela. Our sources of data include the International Monetary Fund's International Statistics, the United Nation's Statistical Yearbook and the Gastil Freedom Index Published by Freedom House. Our period of analysis extends from 1963 to 1985, but because of incomplete data not all countries are included for every year.
IV. EMPIRICAL RESULTS
The results of our regression analysis are contained in Table 2. The results are consistent with previous findings regarding the importance of international trade as a determinant of foreign direct investment. The estimated coefficient of the previous period's imports (IMP) is positive and significant, indicating that the volume of investment inflows is directly related to the volume of foreign imports.4 Culem (1986) and Harvey (1989) have recently provided evidence consistent with this result. The negative and significant estimated coefficient of the previous period's exports (EXP) indicates that with a smaller volume of exports from the developing country, the more likely it is that the country will receive foreign direct investment. This finding is consistent with our expectations, indicating that the policies and strategies of multinational corporations are strongly oriented toward cost reduction. That is, multinational corporations invest in countries with the largest potential for increases in exports. This is also consistent with this result. The negative and significant estimated coefficient of the previous period's exports (EXP) indicates that with a smaller volume of exports from the developing country, the more likely it is that the country will receive foreign direct investment. This finding is consistent with our expectations, indicating that the policies and strategies of multinational corporations are strongly oriented toward cost reduction. That is, multinational corporations invest in countries with the largest potential for increases in exports. This is also consistent with neo-classical theories (e.g. Hecksher and Olin, 1933; 1967) which predict that capital will flow to countries with the highest marginal productivity of capital. In those countries with a relatively low level of exports, the factors of production are not fully competing for price equalization on the international market. Therefore, there are benefits to be exploited as a result of the lower prices of the factors of production. Investing in such a country however, should increase the impossible to examine the relationship between foreign direct investment, trade, and infrastructure using current Romanian data. The time series of the required data is not currently sufficiently developed. Yet it is not unreasonable to believe that our empirical findings using sample of other developing nations are applicable to Romania. We base this contention on three critical considerations.
The first consideration that validates these results for Romania involves the nature of state economic planning. In our sample of countries, the central government had long been the primary economic agent. In Romania the state economic sector had been strong for decades and government intervention in the economy had been extensive. Second, political instability and/or social unrest are common phenomena in many of the countries investigated. The experience of most former Communist countries has been similar since their independence from the Soviet block. Third, Romania, like the nations in our sample, is a developing country. Moreover, the countries in our sample include a wide variation in their level of development, so there should be no particular bias. Given the relevance of these findings for Romania, let us now consider the present state of foreign direct investment in the Romanian economy.
B. Current Foreign Investment In Romania
From March 1990 through September 1991, the number of investment projects involving foreign capital in Romania increased sharply from about a dozen firms to more than 5,900. The total foreign capital invested by these firms was $245 million, an average of $41,600 per project.Table 3 provides a detailed national breakdown of foreign investment in Romania by total capital committed and the number of joint ventures.
Although the amount of foreign investment in Romania has recorded tremendous level of exports and ultimately drive up the price of the factors of production.
The estimated coefficient of the previous period's gross domestic product (GDP) is positive and significant as hypothesized. As the less developed countries of the sample become more wealthy they represent a potentially more profitable market and thus should attract larger amounts of foreign direct investment.
As expected, we found a positive and significant estimated relationship between the number of commercial vehicles in use (VEH) and the level of foreign direct investment. It is important to note that this variable proxies the level of infrastructure development in these economies. Adequate infrastructure permits the minimization of transportation and distribution costs as well as the penetration of new markets.
The political rights variable (RISK) has a positive estimated coefficient that is not significantly different from zero. If one were to attribute information to this point estimate, it would suggest that foreign investors prefer to invest in countries dominated by restrictive political systems. That is, it may be that foreign investors are risk averse and prefer to invest in nations with a high degree of social stability. Though historically dictators do not long endure,their regimes are usually of sufficient duration to be considered a reasonable investment horizon.The truth is that investment in a free, but poor country with significant social problems may be viewed as more risky than that in a totalitarian regime.5 However, it must be emphasized that this discussion is based upon a positive point estimate, not a significant estimated coefficient.
IV. APPLICATION OF FINDINGS TO ROMANIA
A. Relevance to Romania
Because the transition to a market economy in Romania has only recently begun, it is increases since the democratic revolution of 1989, its absolute level continues to be relatively modest compared to the requirements for the Romanian economy. Estimates for the modernization of Romania's energy sector alone approximate $1 billion.
Thus, given Romania's need for foreign capital and the limited amounts currently received, it is critical that both Romanian officials and international investors understand those determinants that make foreign investment attractive. The following discussion will expand upon those factors and illustrate how they might apply to Romania.
C. Determinants Of Investment In Romania
In a recent study, Munteanu evaluates the political and economic determinants that supposedly shape foreign investment decisions in Eastern Europe. He argues that in the case of Romania, overall economic and financial risk is perceived to be higher and more important than political risk for businesses. The behavior of foreign firms in Romania appears to support such a belief as major investors seem to be attempting to avoid uncertainty by entering into joint ventures with the state. Foreign investors will obviously minimize the risks associated with an emerging market economy if their joint ventures are with the government. The extent to which foreign firms are willing to invest in an evolving economy may depend upon the extent to which state is willing to share its monopoly When domestic output declines, as is presently truein Romania, the absolute size of the state monopoly correspondingly shrinks. Therefore the partto be shared becomes smaller, reducing the probability of attracting large foreign investors.Maintaining a monopolistic environment and eliminating investment restrictions combine toprovide attractive investment opportunities, but may deter the emergence of free competition inthe future. There is a clear trade off. If the dismantling of the state monopoly proceeds rapidly,significant long run investment opportunities are created. Alternatively, the political andeconomic instability arising from an excessively rapid dismantling of state monopolies maydiscourage more immediate foreign investment.
The level of both imports and exports are displayed above to be important issues relative to foreign direct investment. In order to reduce its dependence on foreign markets. Romania pursued an import-substitution oriented strategy of development until 1989. This type of inward-oriented policy allows economic growth only through domestic demand and output.6 While drastically reducing imports, the Romanian government imposed draconian measures to increase exports in order to reduce its foreign debt. At the beginning of 1989 the foreign debt had been retired, but the economy was weak with both a stagnant technological base and low productivity.Presently, Romania does not have a coherent trade policy. Export subsidies have been reduced while some import restrictions have been lifted. Yet the government continues to impose other restrictions on exports. Our empirical results suggest that countries that have the potential to increase exports and are relatively dependent on imports are more likely to be the targets of foreign direct investment. In the case of Romania, an export promotion strategy is preferred to an import substitution strategy because it imposes low barriers to international trade and signals that the country is willing to become more internationally integrated. Moreover, the United Nations' World Development Report finds that export-oriented developing countries achieve higher growth performances than those pursuing import substitution.
Physical infrastructure is another critical determinant of foreign direct investment.Romania is an example of the importance of infrastructure in determining the level of economic growth. Presently Romania's economy suffers from inadequate and obsolete highway,communications, and distribution systems. Many of the shortages of 1990 and 1991 were caused by the failure of the distribution and communication facilities, not by the lack of supply. It is reasonable to believe the empirical conclusion that multinational corporations prefer to invest in CouMries with a higher level of infrastructure development. Hence modernization of the Romanian infrastructure is essential for the expansion of foreign investment. Until now. the state has not appeared eager to undertake massive public investment in this sector. The reasons are simple. Tax revenues are not sufficient to support such long-term expenditures and the benefits of such investments are long term in nature. Yet, the costs of failing to make such expenditures will be felt by the economy for many years into the future. Rather than allocating scarce capital for the maintenance and operation of inefficient state owned facilities, Romania needs to increase its spending on infrastructure development.
V. CONCLUSION
The object of this study has been to examine the determinants of foreign direct investment in emerging market economies. We then apply these findings to Romania in an effort to direct public discussion and policy initiatives into meaningful channels. A successful program of foreign investment will permit the modernization of the Romanian economy and perhaps ultimately insure the survival of its recently enacted democratic reforms.
Our findings indicate that a country's participation in international trade has a positive influence on its capital inflows. Both greater levels of imports and export potential enhance a nation’s attractiveness for foreign direct investment. This suggests that Romania abandon the vestiges of its former policy of attempting to locally produce for import substitution and move towards a greater export orientation.
We also discover that the degree of infrastructure development has an overwhelming impact on the process of foreign investment. The existence of adequate distribution and communication networks encourage capital investment by multinational corporations. Romania needs to increase its public funding on infrastructure related projects in order to maximize its return from invested capital.
As with all the newly liberated eastern European countries, Romania will continue to experience tremendous social changes. These changes need to be accompanied by political stability in order to produce an attractive investment environment for multinational corporations. The requirements of balancing democratic change and political stability are a challenge to all emerging market economies of Eastern Europe. It is important to realize that efforts to retard the implementation of democratic changes in order to preserve political and economic stability may ultimately result in a failed conversion to a market economy.
END NOTES
1 Although the former Soviet bloc nations were all characterized by centralized economic planning, there is a diversity among them. Czechoslovakia, Hungary, and Poland are more developed than Bulgaria or Romania. Attempts to reform the Communist economic system were made in Hungary and Poland earlier than in any other communist nation. Czechoslovakia, Romania, and Bulgaria began their reforms only after 1989.
2 In our estimation of the model, we also used lags of two and three years. The results obtained are qualitatively identical to those reported for a one-year lag. Thus we do not present them separately in this study.
3 The possible values of this index range from 2 to 14. A free country in which the citizens enjoy political rights and civil liberties would have an index equal to 2, whereas a country experiencing a total dictatorship would have an index equal to 14.
4 Industrial organization based explanations of foreign direct investment, such as Caves (1966),Vernon (1966), and Kojima (1978), further inquire whether the foreign investment was a substitute for imports, generated by market imperfections and protectionism or a complementary alternative for multinational corporations to minimize production costs.
5 Because of the qualitative nature of the political risk variable, we also estimated our regression analysis excluding this variable. The results were not significantly changed. The estimated coefficients of the remaining variables retained both their sign and significance.
6 Romania was not the only developing country to use an import substitution-type of trade policy. Outside the communist bloc, other developing countries like Argentina, Bolivia, Peru, Ethiopia, and Bangladesh pursued import substitution strategies as well. The alternative to import-substitution is export promotion. In this case, the economy is outward focused and, therefore, significantly dependent on international markets.
Table 1
WESTERN JOINT VENTURES (JVS) IN EASTERN EUROPE
Total Jvs Total JVs
with Wester with U.S. Major
Partners Partners Sectors Legal Conditions
Albania 9 0 NA -Passed first foreign Investment law on 7/31/90
-Allows JVs, does not allow 100% foreign ownership
Bulgaria 100 21 Food Processing -100% repatriation ot domestic
Footwear and foreign profits
Chemicals -100% foreign ownership allowed
Electronics -New law passed 5/17/91
Czech 1000+ 40 Casino -Repatriation for all profits pending
& Slovak Light Industry under internal convertibility and future
Republics Retail Sales BIT
Retail Saies -Allows for 100% ownership
-Jvs have lower tax rate
Hungary 5000 300 Consumer Goods -100% foreign ownership aliowed
Services -No government licenses required
Manufacturing -100% repatriation of domestic and foreign profits
Tourism
Poland 2442 177 Food Processing -100S6 foreign ownership allowed
Construction -100% repatriation of export earnings
Tourism -Access to foreign exchange
-Amendments to joint venture law pending
Romainia 1000+ 50+ Data Processing -100% foreign ownership allowed
Chemical Productio -100% repatriation of hard currency/some soft
Services (trading) -Two to five year tax holiday
Yugoslavia 1000+ 42 Food Processing -100% foreign ownership allowed
Electronics -Repatriation of profits and invested capital guaranteed
Tourism
Source: Eastern Europe Business Info Center
Revised Julv 18, 1991
Table 2
DETERMINANTS OF FOREIGN DIRECT INVESTMENT
FORINVjt = ~0 + ~1IMPj,t-1 + ~2EXPj,t-l + ~3GDPj,t-l + ~4VEHj,t + ~5RISKj,t
VARIABLE COEFFICIENT Prob. Value
INTERCEPT 139.659 0.9596
IMP l2.332 0.0352
EXP -31.513 0.0001
GDP 7.701 0.0001
VEH 2643.767 0.0001
RISK 10.755 0.9929
Adjusted R2 = 0.3836
F = 155.933
Table 3
JOINT VENTURES IN ROMANIA
(March 1990 - September 1991)
Total Capital Number of
Country Invested ($000) Country Joint Ventures
USA 31,746 Germany 918
Germany 27,323 Italy 624
Italy 26,209 Syria 541
England 21,804 Turkey 536
France 16,435 USA 367
Hoiland 16,372 Lebanon 315
Switzerland 11,692 France 275
Spain 11,223 Israel 252
Turkey 8,361 Hungary 188
Austria 7,940 Austria 187
Dominica Rep. 7,553 Greece 170
Syria 6,775 Jordan 156
Israel 6,495 Iraq 130
Canada 6,021 England 109
Lebanon 5,925 Switzerland 106
Ireland 5,122 Holland 102
Egypt 4,105 Iran 101
Greece 3,457 Sweden 87
Soviet Union 2,107 Canada 84
Hungary 2,052 Belgium 81
Cyprus 1,993 Yugoslavia 78
Yugoslavia 1,826 Egypt 53
Sweden 1,693 China 49
Iraq 1,396 Australia 44
Iran 1,323 Cyprus 37
Jordan 1,089 Spain 26
Belgium 995 Un.Arab Emirate 25
Australia 782 Liechtenstein 23
Hong-Kong 744 Soviet Union 22
Moldova Republic 618 Denmark 22
Korea 583 Moldova Republic 21
Un.Arab Emirates 550 Sudan 17
India 309 Libya 17
Cameroon 292 Kuwait 14
Singapore 284 Bulgaria 13
Liechtenstein 282 Yemen 12
Libya 220 Poland 12
Norway 209 India 11
China 182 Norway 10
Japan 162 Ireiand 9
Panama 143 Tunisia 8
Tunisia 108 Singapore 8
Yemen 108 Panama 8
Bulgaria 103 Pakistan 8
Denmark 103 Japan 8
Finland 95 Korea 7
Luxemburg 91 Finland 6
Sudan 88 Algeria 6
San Marino 87 Cluatar 4
Kuwait 79 Luxemburg 4
Source: Romanian Agency for Development