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Bachelor Thesis Finance
Economic Freedom and its influence on Foreign Direct Investment - Evidence from
Transition Economies
Annick Verhoeven
S377779
BSc. International Business
Tilburg University
Department of Finance
PO Box 90153, NL 5000 LE Tilburg, The Netherlands
Supervisor:
Mintra Dwarkasing
Abstract:
Recent evidence suggests that the institutional quality significantly influences the level of
foreign direct investment. How does the economic freedom influence the level of inward
foreign direct investment? In this paper we try to answer this question by investigating
fourteen transition economies in Central and Eastern Europe, from 2000 until 2009.
Regression of our panel data shows the relationship between the economic freedom as
measured by the Heritage Index and foreign direct investment taking GDP, inflation
and EU-accession as our control variables. Our main conclusion is that economic
freedom is positively related to foreign direct investment.
Keywords: Foreign Direct Investment, Economic Freedom, Transition Economies
27 Mai 2011
Economic Freedom and its influence on Foreign Direct Investment – Evidence from Transition Economies
Contents
I
Introduction
3
II
Literature Review
5
III
Data and Methodology
11
IV
Results
15
V
Conclusion
18
VI
Literature
19
Appendix – Tables and figures
22
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Economic Freedom and its influence on Foreign Direct Investment – Evidence from Transition Economies
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‘Little else is requisite to carry a state to the highest degree of opulence from the lowest
barbarism but peace, easy taxes, and a tolerable administration of justice.’
(Adam Smith, retrieved from Dugald Stewart, 1858)
I Introduction
Cultural norms and institutions are often believed to explain why certain countries grow rich
and others remain poor (Landes, 1998). An important factor in this regard is economic
freedom. In this paper, we analyze the effect of the institutional environment on the inward
foreign direct investment (FDI).
For most of the world 2009 was a year of economic disaster, but for Poland it was successful,
being the only country in the European Union not to fall into a recession. Moreover, it
continued to attract foreign investors, even though it is more likely they fear emerging
countries. The good performance of Poland is remarkable as, according to de Haas (2001) the
former communist countries in Central- and Eastern Europe are (still) building and
restructuring their financial system and institutions, from a state-planned to a market
economy. Besides the good economic performance, the attraction of FDI is very important to
countries like Poland since Hryniuk (2003) states that FDI contributes substantially to the
transformation process and economic growth in many post-soviet countries. The most
important factors determining FDI inflows are therefore important to know when creating
policies to attract FDI. We focus in our study on fourteen transition economies, using the
economic freedom as measure for the state of the institutional environment1. To understand
the impact of economic freedom on FDI, we must first understand the concepts of FDI and
economic freedom. FDI is defined by the European Bank for Reconstruction and
Development (EBRD) as an investment involving a long-term relationship and reflecting a
lasting interest and control of a resident entity in one economy („parent enterprise‟) or in an
enterprise resident in an economy other than that of the foreign direct investor („foreign
enterprise‟). It has three components: equity capital, reinvested earnings and intra-company
loans or debt transactions. Gwartney et al (1996) state that individuals have economic
freedom when the property they acquire without the use of force, fraud, or theft is protected
1
The transition economies being used are: Estonia, Latvia, Lithuania, Poland, Czech Republic, Slovakia, Hungary, Slovenia,
Bulgaria, Romania, Albania, Bosnia and Herzegovina, Croatia and Macedonia.
Economic Freedom and its influence on Foreign Direct Investment – Evidence from Transition Economies
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from physical invasion by others. Moreover, they must be free to use, exchange, or give their
property to someone else, as long as their actions do not violate the identical rights of the
others. This means that an index of economic freedom should measure the extent to which
property is protected and individuals are free to engage in voluntary transactions (de Haan &
Sturm, 1999). FDI is extremely important for transition economies, since these countries often
have sufficient stocks of human capital but lack the technology and capital needed to
stimulate growth (Aleksynka 2003). Therefore it is believed that cross-border capital flows
(their magnitude as well as composition and stability) are important for the success of
transition (Garibaldi, Mora, Sahay et al 2002). Moreover, it is interesting to study the
countries chosen since the change of the economic system included a significant institutional
change which allows researchers to econometrically test the significance of institutions for
several stages of economic life (Kostevc, Redek and Sušjan, 2007).
To summarize, the aim of this paper is to study the effect of the level of economic freedom on
the FDI inflows in transition economies. The research question can be stated as follows:
How does the level of economic freedom influence inward foreign direct investment?
Data used in this research to measure economic freedom will be obtained from the Index of
Economic Freedom from the Heritage Foundation. This index measures economic freedom
based on ten subdivisions: business, trade, fiscal, monetary, investment, financial and labor
freedom, government spending, property rights and freedom from corruption. Combined, the
variable economic freedom will give a good indication about the state of the institutional
environment of the countries. To analyze the foreign direct investment, the World
Development Indicators published by the World Bank will be used. Control variables consist
of GDP, inflation, and an EU variable. Data for the control variables is also obtained from the
World Development Indicators. The fourteen Central and Eastern European countries
mentioned before are studied from 2000 to 2009, taking an interesting time period in which
ten of these countries have entered the EU. The other four are potential member states. These
countries are added to the model to see the impact of the EU variable, since this variable
shows if the country is a member or not. A regression is performed using panel data. Fixed
effects are included in our regression to account for unobserved country effects.
Economic Freedom and its influence on Foreign Direct Investment – Evidence from Transition Economies
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The remainder of the paper is organized as follows. Section II reviews literature on the
relationship between the institutional environment and FDI. We will look at the theoretical
influence of economic freedom on FDI and we will discuss empirical findings of the theories.
Section III discusses the data of our own empirical research. Section IV discusses the results
of the data of section III. Section V ends by concluding this paper.
II Literature Review
In this section we focus on the theory of foreign direct investment by linking economic
freedom to the level of inward foreign direct investment. First, we review some theories upon
the influence of FDI on economic growth. After that, we discuss economic freedom and its
impact on the level of inward FDI. Then, we will explain what other factors influence FDI
and finally we will look at empirical evidence for changes of the relation between FDI and
economic freedom when the countries have entered the EU.
According to Alguacil, Cuadros and Orts (2010), FDI is one of the most important factors in
globalization and international integration of developing economies. Moreover, Yeyati et al
(2007) state that the developing world has seen an increase in FDI to 60% as a share of
aggregate net resource flows in 2000. In line with these results, Garibaldi, Mora, Sahay et al
(2002) found that the main private capital inflow to the 25 transition economies was FDI,
analyzing the period between 1991 and 1999. This trend in the development of international
capital flows has given rise to a debate about the main factors attracting FDI. When
discussing FDI, one has to understand the function of it in terms of growth. Before looking
into the variables that might influence the level of FDI, we will first shortly describe some
different opinions about the importance of FDI on economic development.
Theories on foreign direct investment and growth
According to the neo-classical models like the Solow model, growth can be explained by
increases in the stock of physical and human capital and the labor force. The impact of FDI on
growth is limited by the diminishing returns of physical capital and therefore it was believed
unable to change the growth rate of output in the long run. Consequently, mainstream
economists did not consider FDI to be a serious driver of growth. Moreover, firm level studies
Economic Freedom and its influence on Foreign Direct Investment – Evidence from Transition Economies
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often find that FDI does not positively influence economic growth (Spratt, 2009). In line with
this theory, the study of Aitken and Harrison (1999) finds no evidence of a positive
technology spillover from foreign firms to domestically owned ones in Venezuela between
1979 and 1989. Lipsey and Sjöholm (2002) state that although some researchers find evidence
of positive spillovers in some industries, country-specific and industry-specific factors seem
so important that the results do not support the overall conclusion that FDI causes significant
spillovers for the entire economy.
The New Theory of Economic Growth however, states that FDI can influence the rate of
growth. Many macroeconomic studies also find a positive relationship between FDI and
growth. Potential advantages of FDI on the host country could be for example: the
introduction of modern management techniques, access to new technologies, stimulation of
investment in R&D and the ability of FDI to finance current account deficits (Bengoa Calvo
& Sanchez-Robles, 2002). The UN (2005:82) states that FDI is regarded as a potential
catalyst for raising productivity in developing countries, transferring technology and
managerial know-how, and facilitating access to international markets.
The impact of economic freedom on inward foreign direct investment
In this paper, our focus is on the influence of economic freedom on FDI in transition
economies. It is possible that FDI inflows also effect the development of economic freedom.
However, we will not take into account this reverse effect, since most papers that describe the
relationship between FDI and economic freedom do not take this reverse effect into account
(Heriot & Theis 2008; Kostevc, Redek, and Sušjan 2007; Garibaldi, Mora, Sahay et al 2002).
Without going further into the discussion about FDI stimulating growth, we will investigate
what variables influence FDI, starting with the economic freedom.
Brenton, Di Mauro and Lücke (1999) found that the stock of FDI in Central and Eastern
Europe (CEE) has grown rapidly since the beginning of systemic transformation in the early
1990s, particularly in the more advanced Central European transition economies. Kostevc,
Redek, and Sušjan (2007) analyzed the relationship between FDI and the quality of the
institutional environment for 24 transition economies during the years 1995-2002. They found
that the quality of the institutional environment significantly influences the level of FDI. This
Economic Freedom and its influence on Foreign Direct Investment – Evidence from Transition Economies
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research also used the Index of Economic Freedom by the Heritage Foundation to measure the
institutional environment. The concept of this measurement was introduced in the late 1980s
to offer a careful analysis of the factors influencing the institutions necessary for economic
growth. After years of performing studies upon the statistical relationship between economic
freedom and economic development they concluded that the countries with the most
economic freedom have higher rates of economic growth and are more prosperous (Index of
Economic Freedom, 2002). After correlation analysis between FDI and the economic freedom
index of the Heritage Foundation, the study of Kostevc, Redek, and Sušjan (2007) illustrated
that regulation, property rights protection, and black market have the strongest impact on FDI.
It clearly indicates that foreign investors move their capital into developing economies once
these economies have established a certain quality of the institutional environment which
increases stability and reduces uncertainty. In their research they showed that the economies
with a Heritage Foundation Index of 3.5 or less had received on average five times the amount
of FDI per capita inflow of the group with a poorer institutional framework. When Brenton,
Di Mauro and Lücke (1999) added the economic freedom index to their model consisting of
income, population and distance to explain bilateral FDI stocks, they found it adding
considerably to the explanatory power of the model, confirming the importance of this
variable for explaining FDI flows. Moreover Glaeser et al. (2001) found, while comparing the
Polish and Czech capital market developments that the quality of regulation has been
important for the development of Polish capital markets. Bevan et al. (2004) extensively
studied the importance of the institutional environment for FDI on the basis of the transitional
indicators by the EBRD. They also found a strong relationship between formal institutional
development and FDI. The former studies mentioned focused on transition economies, but
other studies in different countries find the same relationship between economic freedom and
FDI. For example, Bengoa Calvo and Sanchez-Robles (2002) investigated a sample of 18
Latin American countries for 1970–1999 and found that economic freedom in the host
country is positively related to FDI inflows. Moreover, Bénassy-Quére, Coupet and Mayer
(2007) as well as Grogan and Moers (2001) and Brunetti, Kisunko and Weder (1997)
discovered that a wide range of institutions, including bureaucracy, corruption, information,
the banking sector and legal institutions matter for inward FDI independently of GDP per
capita. The orders of magnitude found in the papers are large, which means that moving from
a low level to a high level of institutional quality could have the same impact as suddenly
becoming a neighbor of a source country. The case of Bulgaria illustrates how important the
Economic Freedom and its influence on Foreign Direct Investment – Evidence from Transition Economies
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institutional environment in transition economies is. According to Glaister and Atanasove
(1998) Bulgaria has adopted a very liberal legal framework for FDI, but because of the
prevalence of white collar crime and high bureaucracy it has resulted in a lagging behind of
this country compared to other Eastern European countries in terms of FDI.
Some critical points can be stated, because not always all elements of economic freedom are
in line with the general positive relationship to FDI. For example, countries like Burundi,
Cameroon and Malawi have relatively high levels of confidence in property rights but
negligible levels of FDI (Spratt, 2009). It can be the case that other factors as the abundance
of natural resources are more important than economic freedom. This will be discussed in the
next section. Another interesting point to investigate is the difference in institutional
environment within the group of transition economies. Murrell (2003) shows that in general,
the institutional quality in transition economies has improved quickly. However, he states that
there is a large difference in the levels of institutional development between the countries.
Kaufmann et al. (2005) draws the same conclusion after finding that countries like Czech
Republic, Slovakia and Poland have institutional quality that is in many aspects comparable to
those of developed countries while other transition countries continue to lag far behind. In
general, when combining all ten elements of the economic freedom index with the results
from multiple studies, we can conclude that economic freedom has a positive influence on
inward FDI. Table IV shows an overview of important papers and their results regarding the
relationship of the institutional environment and FDI. All papers described here also show this
positive relationship.
Other factors influencing FDI
A very broad study with the question „What moves capital to transition economies?‟ was
conducted by Garibaldi, Mora, Sahay et al (2002) for the IMF. They investigate private
capital inflow (FDI and portfolio investment) for 25 transition economies between 1991 and
1999. They conclude that FDI can be explained in terms of macro-economic variables,
whereas portfolio investment can only be explained in terms of financial market infrastructure
and a property-rights indicator. Bevan and Estrin (2004) use regression analysis to investigate
the influence of the variables GDP, unit labor costs, trade freedom, risks interest rates,
distance and EU announcements on the level of FDI. Unit labor costs are negatively
Economic Freedom and its influence on Foreign Direct Investment – Evidence from Transition Economies
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associated with FDI which supports the hypothesis that foreign investors are cost sensitive.
The difference in real unit labor costs is an important determinant of FDI. Moreover, they find
that the distance between the host and home country does matter. The largest FDI flows are
from Germany to Poland, from Austria to Czech Republic and Hungary and from Finland to
Estonia. Kostevc, Redek and Sušjan (2007) state that the quality of the institutional
environment can play a secondary role. Transition economies that have abundance in natural
resources like fossil fuels attract relatively extremely high levels of FDI compared to their
institutional situation. Examples are Kazakhstan, Azerbaijan and Russia: oil-rich countries
with large inflows of FDI but a decreasing level of institutional quality. Other factors, related
to economic policy, also seem to have an influence on the level of FDI. For example, Tung
and Cho (2001) show that tax incentives in particular areas of China have been an important
reason for FDI inflows in the last decade. Moreover, a higher level of volatility of exchange
rates turns out to be harmful for the level of FDI in developing countries (Benassy-Quere,
Fontagne and Lahreche-Revil, 2001).
Another important factor that has been extensively investigated in literature on FDI in
transition economies is the market size. It has been stated that larger economies attract more
FDI (ERBD, 2006). In this respect the Balkan countries have disadvantages compared to the
other countries for different reasons. The region suffers from the syndrome of fragmentation
rather than unification. Long-standing rivalry and instability have created distances among the
countries of the area and thus make cross–border trade and FDI activity more difficult
(Pournarakis & Varsakelis, 2004). Besides this, multiple studies (Kostevc, Redek and Sušjan,
2007; Henisz, 2000; Bevan & Estrin, 2004) find a significant negative relationship between
our control variable inflation and the level of FDI, and a positive significant relationship
between GDP and level of FDI. The first can be explained since price stability is a good
indicator of macroeconomic management by the government. This means that a moderate or
low inflation tells the investors how successful the government is and thus what the
prospective future growth will be. Consequently, the lower the average inflation rate is in the
host country, the more foreign investment will be attracted to the country (Kinoshita &
Campos, 2002). Moreover, Garibaldi, Mora, Sahay et al (2002) already showed that direct
inflows increase with good macroeconomic performance as measured by growth.
Economic Freedom and its influence on Foreign Direct Investment – Evidence from Transition Economies
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Changes in the relationship between FDI and economic freedom with EU membership
Finally, we will examine the influence of the EU membership on the level of FDI. It is
interesting to include this variable since the accession seems the final stage in completing the
transition process and reaching levels of economic performance similar to Western countries.
From the sample we use, ten countries are a member of the European Union. Czech Republic,
Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia and Slovenia entered on the first of
May in 2004 and Bulgaria and Romania entered the first of January in 2007. The other four
countries are part of the Stabilization and Association Process (SAP), which is the framework
for EU negotiations all the way to eventual future accession. It is a long term commitment of
political effort and financial and human resources. From these countries, Croatia and
Macedonia are official candidate countries and Albania is a potential candidate country.
Because of these recent developments, much has been written concerning the benefits and
costs of eastward expansion of the EU on both current and potential members (van Brabant,
1998). If we look at the influence of EU membership and integration with the EU, the
literature review shows that these factors are highly important for the inflow of FDI. Bevan
and Estrin (2004) show that integration with the EU is important for FDI in transition
countries. To test this in their regression analysis they add a „Cologne variable‟. This variable
measures the impact on FDI of announcements about the possibility of the host country to join
the EU. The countries have a dummy value of three when they were told that they had
satisfied the Copenhagen criteria of accession from June 1993 and could begin entry
negotiations. Countries with value two showed good progress and were therefore likely to be
able to start negotiations soon. After regression, Bevan and Estrin (2004) find that the
Cologne variable is positive and significant, concluding that EU announcements about
potential accession have significant independent effects on FDI flows to transition countries
by increasing FDI to countries that are more likely to enter the EU. On the contrary, countries
that are not so successful in implementing the transition process are not given short term EU
entrance approval which will discourage FDI inflows. Claessens, Oks and Polastri (2000)
confirm this by concluding in their research on capital flows to transition economies that the
ten countries that applied for EU membership attracted more private flows and relied less on
official flows. A study on the economic freedom index of the Centro Einaudi in Italy tries to
explain the economic freedom from another viewpoint. They start by looking at the freedom
Economic Freedom and its influence on Foreign Direct Investment – Evidence from Transition Economies
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index in the EU before entrance of the transition economies and compare the results with the
level after entrance of these countries. They find that after entrance; the index of European
Union is not much influenced, meaning that the level of economic freedom in the new
countries does not diverge much from the rest of Europe. Moreover, they observe an
improvement in the institutional quality in the last two years investigated, which can imply
that the unification process will push the countries year by year more similar to the rest of
Europe (Guggiola, 2001). According to the theories stated before, this would be positive for
the inward FDI. Besides that, this study gives reason to conclude that the transition economies
can only enter the EU when their level of economic freedom is sufficiently similar to the
Western countries. In this respect, we expect to find a difference in level of institutional
quality of the countries already entered and the (potential) candidate members.
III Data and Methodology
In this section we describe the data variables that are used in our research. Our data consist of
fourteen Central and Eastern European countries in a time frame of ten years, from 20002009. Within this time frame we study whether economic freedom has an influence on the
level of foreign direct investment. Control variables for this research consist of gross domestic
product per capita (GDP), inflation and the EU-variable.
The main independent variable of our study is the degree of economic freedom. The Index of
Economic Freedom published by the Heritage Foundation and the Wall Street Journal
employs rankings based upon data. A scoring system supports the Heritage/WSJ Index of
Economic Freedom: the ten specific economic freedoms measured in the Index of Economic
Freedom are individually scored on a scale of 0 to 100. Table 12 shows the categories of the
global economic freedom. A country‟s overall economic freedom score is a simple average of
its scores on the ten individual freedoms (Miller & Holmes, 2011). The intuition of the
variable is to measure the impact of institutional quality improvements on economic
development, specifically on foreign direct investment. Regarding the other variables we use,
first of all we have plotted the variables FDI per capita (FDIpc) and GDP per capita (GDPpc)
to see if we need to transform the data. After plotting, we have seen that we must adjust these
2
Tables can be found in the Appendix
Economic Freedom and its influence on Foreign Direct Investment – Evidence from Transition Economies
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variables and use the logarithm of GDPpc and FDIpc for our regression analysis since both
are highly non-linear.
A similar pattern in the FDIpc of all the countries3 (except Estonia) which entered the EU in
2004 can be seen looking at the time series in figure II. First of all, it shows a decrease in the
FDIpc inflow between 2002 and 2003 for Slovenia, Slovakia, Lithuania, Hungary and Czech
Republic and only a small increase for Latvia and Poland. This decline was due to the end of
the privatization process in these countries. Especially the decrease in FDI in Czech Republic
and Slovakia, respectively 76,2 and 86,4 percent, is very large since the „greenfield‟ projects,
which are generally smaller in size and spread over a longer period of time, could not
compensate for the fall in privatization (Kornecki & Rhoades, 2007). A „greenfield‟ project is
a form of foreign direct investment where a multinational company builds and operates a new
facility in a foreign country from scratch. It involves long term employment and the projects
are especially common in the telecommunications and electricity industry, where they account
on average for over 50 percent of projects that involved private participation (Sherif, n.d.).
Secondly, all seven countries show an increase between 2003 and 2004. Poland for example
has an increase of 177,3 percent of FDIpc and for Lithuania this is even higher with 333,8
percent. The reason for the increase is the accession to the European Union in May 2004. In
general, the FDI inflow to transition economies has been developing in accordance to the
development of the political environment and progress in transformation. Looking at the time
series of FDIpc after 2004, we also see a pattern of increasing FDI for the new EU members.
This can be explained by an improved business environment and new policy measures for
liberalizing, promoting and protecting FDI. The governments of those countries have
officially encouraged FDI and have provided substantial incentives for foreign companies,
such as five-ten years tax abatements, infrastructure improvements, tariff exemptions, outright
subsidies and other favorable treatment (Gabor, 2002). Looking at the development of the
economic freedom over these years, a less parallel movement can be found. Countries like
Poland, Estonia and Czech Republic experience a decrease in economic freedom after 2004
and the general movement of the other countries over the rest of the time period is also not
purely positive. It may therefore be concluded that, even though a minimal level of
institutional quality is necessary for EU accession, the membership of the EU does not grant
an improvement of economic freedom.
3
4
These countries are: Slovenia, Latvia, Slovakia, Poland, Lithuania, Hungary and Czech Republic.
These countries are: Slovenia, Latvia, Slovakia, Poland, Lithuania, Hungary and Czech Republic.
Economic Freedom and its influence on Foreign Direct Investment – Evidence from Transition Economies
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Between 2004 and 2005 we see a decrease of FDIpc inflow in Slovenia, Slovakia, Macedonia,
Poland, Albania and Bosnia and Herzegovina. Besides this, there is a relatively weakened
growth in Hungary and almost no growth in Romania. This is the consequence of the slowdown in the Euro-area half of 2004 and early 2005 when FDI, exports and GDP weakened.
The Baltic countries and especially Estonia (with a 205,2 percent growth in FDIpc between
2004 and 2005) diverge from this pattern. This could be explained by the fact that FDI
inflows to these three countries have been channeled mainly from Finland, Sweden, Denmark
and the United States, which (except for Finland) have not adapted the euro. Moreover,
Estonia has always been a leader in development, the FDI inflows per capita and GDP are
among the highest of all transition economies. This growth has continued and in January of
2011 they even have adopted the euro.
Looking at the data and figure I, we can conclude that Hungary is an outlier in terms of level
of FDIpc. The time series of FDIpc of all countries are within the regions -584,5 and 2034,
but Hungary shows levels of 7193.7 and 6315.9 in 2007 and 2008, which is respectively 52,1
and 41 percent of their GDP. This is far above the other countries, which is quite remarkable
since one of the most attractive host countries for FDI is indeed Hungary but also Poland and
Czech Republic, which do not seems to diverge much from the rest of the sample (UNCTAD,
2002). Moreover, one of the largest factors influencing the top position of these three
countries is the geographical proximity to major trading partners as Germany and Austria, but
in this factor Hungary also does not hold a more favorable position than Czech republic or
Poland (Cottarelli, 1998). If we look into some details of Hungary we see that it was the first
country of Central and Eastern Europe to attract foreign capital. Now it gets on average nearly
one third of all foreign direct investment flowing into Central Europe (Kornecki & Rhoades,
2007). Because of the difference between Hungary and the rest of our sample size, we will
include one model omitting Hungary from the sample.
Comparing the levels of FDI over the years while looking at the time series in figure II, we
can see that for ten countries of our sample the levels of FDIpc have decreased after 2007.5
For three countries, the level of FDI has been lower in 2009, compared to 2008. Only Albania
did not see its FDIpc decrease in these years. We believe that the decline can be caused by the
global financial crisis, which started in the summer of 2007 and showed its effects in the
5
These countries are: Bosnia and Herzegovina, Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania,
Macedonia, Poland and Slovakia.
Economic Freedom and its influence on Foreign Direct Investment – Evidence from Transition Economies
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middle of 2007 into 2008. As the UNCTAD in 2009 reports: „Global FDI inflows are likely to
have fallen by more than 20 percent in 2008 and will probably decline further.‟ About
transition economies the UNCTAD states that even though there was a decline in FDI inflows
in 2008 compared to 2007, they most certainly remained positive but it will worsen. That is
also in accordance with our data, as we indeed have no negative inflows in 2008, but in 2009
Slovenia, Slovakia and Hungary do have a negative FDIpc. Since we do not see any evidence
for the levels of economic freedom to be effected by the global crisis, we expect our model to
better explain the relationship between economic freedom and FDI if we omit the years 2008
and 2009. Therefore, we will include a fourth model, performing regression on all countries,
including fixed effects, but only including the first seven years of the sample.
Figure IV is a scatter plot which shows the sample cloud illustrating the dependence of
foreign direct investment per capita on the y-axis on economic freedom on the x-axis. We get
a visual idea of the relationship between the two variables. It differentiates between the
countries, so we can analyze the effect of economic freedom on FDIpc. This enables us to
identify fixed effects on the regression. In general, the overall tendency seems to be towards a
positive relationship. However, Estonia seems to have a very weak relationship between
economic freedom and FDIpc as the same levels of economic freedom show very different
levels of FDIpc. Hungary is again distinct in the picture, showing extremely high levels of
FDIpc for certain levels of economic freedom, compared to the other countries. Also Bosnia
and Herzegovina shows a weak relationship as a significant increase in economic freedom
does not show a significant increase in FDIpc.
The aim of this research is to look at the variable foreign direct investment inflow per capita
and see if it is influenced by economic freedom. The control variables are there to see whether
only this independent variable influences our dependent variable, or that it might be
influenced by other variables as well. The methodology we use is regression analysis with
panel data. The beta coefficients of the different independent variables will be used to look at
the sign and size of the relation between the different independent variables and the dependent
variable. We estimate the following equation to test for the relationship between foreign direct
investment inflow and economic freedom, controlling for GDP, inflation and EU accession:
Economic Freedom and its influence on Foreign Direct Investment – Evidence from Transition Economies
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yit  0  1EcoFrit   2 gdpit  3init   4 EUit  i   it ,
where yit is the dependent variable and defined as the logarithm of foreign direct investment
inflow per capita for a given country i at time t; β0 is the intercept of the regression line;
β1EcoFrit is defined as the level of economic freedom for country i at time t; β2gdpit is defined
as the logarithm of gross domestic product per capita for country i at time t; β3init is defined as
inflation for country i at time t; β4EUit is defined as the dummy variable with values 0 or 1,
where 1 stands for EU membership, for a country i at time t; and εit is the error term. Since
GDP and FDI are highly non-linear, the logarithm of these variables is used. Furthermore, we
include the fixed effects  i to account for fixed effects in the regression. By including the
fixed effects alpha, we control for country specific, unobserved, fixed effects. A summary of
the descriptive statistics of the variables can be found in table III.
IV Results
In this part we will discuss the outcomes of our regression on the data in the previous section.
We have regressed four different models. The first model is not taking into account any fixed
effects, the second model does include fixed effects, the third model omits Hungary from the
sample as a result of diverging values and the last model omits the years 2008 and 2009. We
will also compare the results with findings of other research in this field, to see whether
comparable outcomes are found.
The results of the regression of the four models can be found in the table below. The models
are estimated using ordinary least squares. The dependent variable is the variable foreign
direct investment per capita, transformed in log. The following signs indicate the significance
levels: *** significant at 1 percent, ** significant at 5 percent, * significant at 10 percent,
two-tailed.
Economic Freedom and its influence on Foreign Direct Investment – Evidence from Transition Economies
Model
| 16
1: OLS
2: OLS
3: OLS
4: OLS
Dependent
variable
logFDIpc
logFDIpc
logFDIpc
logFDIpc
Economic Freedom
0.0166*
(1.86)
0.0173
0.0178
(0.93)
0.0087
(0.87)
Log GDPpc
Inflation
EU
(0.46)
0.876***
(6.67)
1.154***
(5.16)
1.1504***
(5.33)
1.514***
0.0115
(1.07)
0.0162
(1.37)
0.0175
(1.55)
0.0067
0.1589
(0.83)
0.1176
(0.58)
0.00197
(0.01)
0.08257
(6.29)
(0.57)
(0.42)
R
2
FE included
0.5130
0.6951
0.694
0.7676
NO
YES
YES
YES
The first model shows a significant positive beta of 0.0166 for the economic freedom on the
dependent variable foreign direct investment per capita. It indicates our predicted positive
relationship between economic freedom and foreign direct investment. In this relationship, the
dependent variable has been log-transformed and the independent variable is in the original
scale. We should therefore interpret the beta of the economic freedom as the percentage
change times 100 for an increase of one in the scale of economic freedom, ceteris paribus.
Looking at the economic significance of this number, we see that an increase of 1 in the
economic freedom scale on average leads to an increase of 0.0166*100, which is 1.66 percent
in foreign direct investment per capita. Looking at the time series of Albania we see this
positive relation clearly. The movements of the lines of economic freedom and foreign direct
investment per capita are both positive and related.
The second model shows a higher correlation coefficient, indicating that more variation in the
foreign direct investment data is explained by this regression model. By including fixed
effects, we controlled for the average differences within the countries in observable or
unobservable predictors. The higher R2 is, the more of the total variation the so called
between group variation is. Including the fixed effects of the countries, it is predictable that
the between group variation will increase, in our case with almost 20 percent points. This is
Economic Freedom and its influence on Foreign Direct Investment – Evidence from Transition Economies
| 17
however logical by construction as R2 increases per definition when adding variables to a
model. The second model shows again a positive relationship between economic freedom and
foreign direct investment, but it is not significant anymore.
The third model omits Hungary, since this country shows levels of FDI diverging extremely
from the mean (see figure I and II). When we look at the results of this model three we see
that it is not much different from the second model. The beta for economic freedom is positive
but not significant, just as in the second model. We may therefore conclude that even though
Hungary shows different values than the rest of the sample, it does not make a significant
difference when investigating the relationship between economic freedom and foreign direct
investment.
The fourth model explains most of the variation in the foreign direct investment, compared
the other three. Model four explains 76,76 per cent of the variation. Again we can see that the
beta for economic freedom is positive but not significant. Hence, when controlling for fixed
effects the significant effect disappears.
Looking at the control variables we can see that in all four models, the GDPpc is highly
significant at one percent. It positively influences the foreign direct investment per capita. The
relationship between independent and dependent log-transformed variables is called elasticity.
In this setting we therefore interpret the beta of GDPpc as the percentage change in the
dependent variable, when the independent variable (the GDPpc) increases by one percent.
The control variables inflation and EU show a positive relationship, but not significant. For
inflation the positive beta is quite remarkable since literature (Rogoff & Reinhart, 2003;
Lipsey & Chrystal, 2006) explains that inflation destroys the value of the currency, which is
negative for the growth and thus negative for FDI inflows. Moreover, Glaister and Atanasova
(1998) described the effect of inflation on employment in Bulgaria. They suggested as well
that inflation can cause different problems, reducing the attractiveness for inward foreign
direct investment. A low inflation environment is desired in countries that try to attract FDI as
source of capital flow. The EU variable has a positive beta in all models, but it is not
significant. The positive relationship was expected and found in other studies as well, but for
example Bevan and Estrin (2004) found significant beta‟s for their Cologne dummy, which
was a measure of EU announcement for potential accession. This difference could be
Economic Freedom and its influence on Foreign Direct Investment – Evidence from Transition Economies
| 18
explained since the majority of our sample countries already joined the EU in 2004, and our
time horizon goes until 2009. Development caused by EU accession was probably of a greater
importance looking at years longer before 2004.
V Conclusion
In this paper we have researched if economic freedom influences the level of foreign direct
investment inflows in transition economies. First, we have reviewed the literature and saw
that many papers find a positive relationship between economic freedom or institutional
quality and foreign direct investment. However, not all of them investigated transition
economies and most of them used data from years far before EU accession. Therefore we
have conducted our own regression analysis in the next section using recent data and
including an EU control variable. We used data from fourteen countries for ten years, starting
with the year 2000. We have found that there is a positive relationship between economic
freedom and foreign direct investment. However, as soon as we include fixed country specific
effects in the model, the beta is not significant anymore. The model that explains the variation
in FDIpc the best is when we exclude 2008 and 2009, due to declining FDI levels caused by
the global financial crisis.
We suggest that further research should be done. First of all, it should include a larger time
span. The influence of two years on the model should not make such a large difference,
therefore it would be better to also include years before 2000. Then the influence of the EU
variable and the economic freedom will be better explained, as differences in values will
probably be larger. Moreover, we could include more countries, as now the majority of our
sample already has a minimal level of economic freedom after entering the EU. In our use of
control variables, we could have added labor costs as many papers suggest this variable also
influences FDI inflows. Also, the distance variable measuring distance between host and
home country can be included. Besides adding more variables, taking into account that there
is a reverse effect of FDI on economic growth possible, as mentioned in our literature review
section, might give us valuable insights too.
Finally, we must be careful when using the economic freedom index. We have adopted this
index because other papers as Kostevc, Redek, and Sušjan (2007) also used the index of the
Economic Freedom and its influence on Foreign Direct Investment – Evidence from Transition Economies
| 19
Heritage Foundation. However, this index generalizes all countries in the world judging them
among the same Western criteria of economic freedom. However, it could be possible that
Western ideas of economic freedom are not fully applicable to historical, cultural, and
political traditions of many transition economies. It could be the case that in some of these
countries collectivism and cooperation works better than complete implementation of for
example property rights and profit maximization (Young, Teodorovic, Koveos, 2002). History
and traditions being closely tied to everyday life in these countries, the truth in this statement
can be seen.
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Economic Freedom and its influence on Foreign Direct Investment – Evidence from Transition Economies
| 22
Appendix - Tables and Figures
Table I. Distribution of the global economic freedom
This table provides the distribution of the economic freedom, using five categories.
100-80
Free
79.9-70
Mostly free
69.9-60
Moderately free
59.9-50
Mostly unfree
49.9-0
Repressed
N/A
Not ranked
Table II. Descriptive statistics
This table summarizes the variables described with complete definitions in units (U),
minimum value (Min), maximum value (Max), mean, and standard deviation (SD). The units
used are: percentage (%), dollars ($), and the scale measure.
Variable
Complete definition
U
Min
Max
Mean
SD
FDIpc (TR)
Foreign direct
investment per
capita in transition
economies
$
-584.49
7193.66
506.3656
870.26571
FDIpc (WE)
Foreign direct
investment per
capita in Western
economies
$
-3601.86
20965.78
1778.1454
2997.89694
EcoFr (TR)
Economic freedom
in transition
economies
Scale
36,60
78
61.4725
7.99775
EcoFr (WE)
Economic freedom
in Western
economies
Scale
57.40
80,40
69.9140
5.59488
GDPpc
Gross Domestic
Product per capita
$
1201.82
26910.67
7880.2280
5429.21935
Inflation
Inflation
%
-2.15
44.25
5.6586
6.24896
Economic Freedom and its influence on Foreign Direct Investment – Evidence from Transition Economies
| 23
Table III. Descriptive statistics per country
This table provides descriptive statistics for the variables per country. Inflation is stated in
percentage, economic freedom on a scale from 0 to 100 (as described in table 1), GDP per
capita and foreign direct investment in US dollars.
Albania
FDIpc
$
133
EcoFr
Scale
59
GDPpc
$
2523
165
47
2920
606
59
3804
Inflation
%
3.5
Bosnia and
Herzegovina
Bulgaria
6.2
6.0
Croatia
587
53
9683
Czech Republic
614
68
12040
Estonia
1044
76
10071
Hungary
1726
65
9910
4.0
2.3
5.0
5.9
Latvia
344
66
7645
Lithuania
278
69
7602
Macedonia
161
47
2932
7.5
3.2
4.3
Poland
306
60
8012
Romania
276
55
4670
Slovakia
425
64
11050
Slovenia
375
60
17461
3.2
19.8
3.9
4.4
Economic Freedom and its influence on Foreign Direct Investment – Evidence from Transition Economies
| 24
Table IV. Review of results from other papers
This table provides an overview of the research conducted by some important other papers.
The sample sizes, used data, the dependent variable and the results are described.
Authors
Samples
Used data
Dependent
variable
Results
Carstensen,
K., Toubal,
F. (2003)
Ten OECD
reporting countries
and seven Eastern
European
destination
countries in the
period 1993-1999
FDI from OECD
International Direct
Investment Statistic
Yearbook, private
market share and the
privatization from
EBRD.
Net annual
outward
bilateral FDI of
the reporting
countryi into
host country.
Not only the level but
also the method of
privatization significantly
affect the flows of FDI.
Garibaldi, P.,
Mora, N.,
Sahay, R.,
Zettelmeyer,
J. (2002).
25 transition
economies
between 1991 and
1999.
FDI from Balance of
Payments Statistics
Yearbook 2000, five
institutional
indicators from the
World Bank and two
from the EBRD.
Natural log of
inward foreign
direct
investment in
millions of
US$.
FDI flows increase with
state of economic
liberalization.
Heriot, K.C.,
Theis, J.
(2008)
121 countries in
the period 20002005
FDI from United
Nations (2006) and
Economic Freedom
from The Fraser
Institute Economic
Freedom Index
Natural log of
foreign direct
investment
average for
the country
from 2000 to
2005.
The relationship
between economic
freedom and FDI shows
a significant statistical
relationship at the 99%
level.
Kostevc, Č.,
Redek, T.,
Sušjan, A.
(2007).
24 transition
economies 19952002.
FDI from the EBRD,
economic freedom
from the Heritage
foundation.
FDI per capita.
Overall institutional
environment had a
significant impact on the
level of FDI. The EU
accession dummy also
had a positive significant
impact.
SanchezRobles, B. &
BengoaCalvo, M.
(2002).
18 Latin-American
countries over the
period 1970-1999
FDI from the
Summers-Heston
data basis,
completed when
necessary with data
from IMF and the
World Bank.
Economic freedom
from the Fraser
Institute Index
FDI inflow as a
percentage of
the GDP.
The index of economic
freedom seems to have
had a positive and very
significant effect as a
means of attracting
capital flows.
Economic Freedom and its influence on Foreign Direct Investment – Evidence from Transition Economies
| 25
Figure I. The FDI per capita in US dollars, per country for the period 2000 until 2009.
Economic Freedom and its influence on Foreign Direct Investment – Evidence from Transition Economies
| 26
Figure II. Time series of FDI per capita in US dollars compared to mean of the sample for the
period 2000 until 2009
Economic Freedom and its influence on Foreign Direct Investment – Evidence from Transition Economies
| 27
Economic Freedom and its influence on Foreign Direct Investment – Evidence from Transition Economies
| 28
Figure III. Time series of economic freedom compared to the mean of the sample for the
period 2000 until 2009
Economic Freedom and its influence on Foreign Direct Investment – Evidence from Transition Economies
| 29
Economic Freedom and its influence on Foreign Direct Investment – Evidence from Transition Economies
| 30
Figure IV. Scatter plot of FDI per capita in US dollars and economic freedom for the period
2000 until 2009.