Foreign Direct Investment in Central Europe and Differences in Transition between post- communist Central European Economies

MA-Thesis / Master von Jan Angenendt

Introduction:

The transition process from a centrally planned to a market economy followed a very different path in East Germany compared to all other former communist countries. The German Democratic Republic acceded the Federal Republic of Germany in 1990, while other former socialist countries in Central and Eastern Europe (CEE) had to start from square one after becoming independent from the USSR. In contrast to other post-soviet countries, East Germany subsequently received massive transfers from the Western part of the country. A significant part of these transfers was invested into infrastructure improvement, while a larger share was spent for consumption, raising the purchasing power in the East of Germany, allowing it to sustain a higher wage level and living standard than would have been economically possible without aid from the West.

Twenty years after the breakdown of the iron curtain and the reunification of Germany, the infrastructure in the Eastern part of the country is en par with the West. The East German wage level remains only slightly lower than the Western level (as does productivity), but is significantly higher than in neighbouring post-communist CEE-countries. Because of these differences in economic transition, it can be expected that East Germany attracts a different kind of foreign direct investment compared to other CEE-countries. The objective of this dissertation is to empirically identify the factors affecting foreign direct investment into the region and to discuss the implications of the empirical findings for regional and national economic policy. The ‘region” is represented in this paper by East Germany and three of its Central-European neighbour-countries, the Czech Republic, Poland and Hungary.

The present study is organised as follows: A brief historical overview of the four economies’ transition processes will be given in chapter 2. The theoretical background, the methodology and the dataset used are being discussed in section 3. Hypotheses derived from the region’s history, economic theory and previous literature on foreign direct investment will be presented in section 4. In section 5 they will be tested and the econometric results identifying the factors affecting foreign investors’ investment decisions in Central Europe will be discussed. Finally, the main empirical findings and their political implications will be summarised in the concluding chapter 6.

Contents:

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Chapter 6.1, General findings:

It appears that the 40 regions could be diverging as investment locations, despite the regional convergence process in terms of wealth. Investors see the regions included in the dataset not as substitutes, but are affected by country-specific factors. This might be due to unobservable influencing variables, such as cultural factors or quality of institutions. From investors’ perspective, the Czech regions seem to be the closest, but still non-perfect substitutes to East German regions. Service and manufacturing sector firms’ location decisions tend to be based on different factors, for example, economic diversity matters for manufacturing and education of the workforce is more important to the service sector, while differences between smaller and larger firms are less significant. Both small and large firms prefer regions offering access to larger markets and thus to more potential customers. The factors affecting European and Non-European investors’ location decisions are largely similar, however Non-European investors appear to be less market-seeking than European investors.

In general, inter-industry linkages seem to play a surprisingly low role for investors, while regional specialisation and agglomeration economies appear to be dominant factors. Fiscal policy affects location decisions as expected, though it appears to become less important as the regions converge. A striking fact throughout all analyses is the significance of the education variable (lnenrol), which is highly significant in nearly all specifications of the models.

Concerning the state of affairs in East German economic development and despite the policy recommendations demonstrating room for improvement, it cannot be said that the results of this analysis indicate that the case of East German recovery is hopeless. The very different transition-path East Germany had to take indeed equipped it with pull-factors, such as a modern infrastructure, and its geographical proximity to the large European markets is an asset. Furthermore, its higher wage level seems to be offset by (unobserved) pull-factors, such as high productivity, and unit labour costs in East Germany finally fell below West German level in 2000. And even the higher German corporate tax level seems to be not necessarily a deterrent to investment – at least not for manufacturing companies and possibly for investors from all sectors in more recent years.