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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 |2 Economic Freedom and its influence on Foreign Direct Investment – Evidence from Transition Economies |3 ‘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 |4 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 |5 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 |6 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 |7 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 |8 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 |9 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 | 10 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 | 11 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 | 12 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 | 13 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 | 14 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 | 15 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. VI Literature Aitken, B.J., & Harrison, A.E., (1999). Do Domestic Firms Benefit from Direct Foreign Investment? 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Journal of International Money and Finance, 26, 104-130. Young, A.E., Teodorovic, I., Koveos. P. (2002). Economies in transition: conception, status and prospect.Singapore: World Scientific Publishing. 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.