Foreign direct investments in Europe: are the East-West differences still so noticeable?

• Author: Brahim, Mariem
• Position: Report

1. Introduction

   Ten years after the European Union's enlargement which has included ten new member states among Central and Eastern European countries (CEECs)--which was considered as a major step of European integration and as the promise of an economic catch-up for the new member states -it seems appropriate to question which factors motivate the direct investments realized by multinational firms in the enlarged Union. In particular, this article examines whether investment choices that prevail in the former EU-15 and the new and more heterogeneous EU-28 are driven by the same motivations or not. In other words, if the determinants of FDI in the Eastern part of Europe are similar to those realized in the former EU-15, it can be considered that a kind of convergence has been achieved between the two parts of the enlarged EU.

   Foreign direct investment has often been considered as > (Boillot, 2002). Actually, the debates which occurred before the realization of the EMU as well as the EU enlargement emphasized the thesis of an > convergence across member countries. The model that prevailed at the beginning of the European integration process would continue in a context of a deeper economic integration in the EU. In the early steps of European integration, the countries participating in the EEC then in the EU benefitted from large economic and social outcomes, favored by the transformation of the size and contents of trade flows and the increase in FDI. The latter would be part of a virtuous circle: FDI tend to accelerate the production diversification and to increase trade in goods and services. The less developed countries would therefore catch up with the more advanced ones in their productive structures and their standards of living.

   However, the enlargement process encompassed major uncertainties (Chavance et al., 2004). The enlargement could widen the wealth gaps and increase inequalities across EU member states, as a result of deeper productive globalization on the one hand, trade and financial liberalization on the other hand. While economic integration tends to promote direct investments, especially on an intra-European basis, it also contributed to deepen the existing gaps, fostered social and tax competition enhanced by individual strategies of competitive devaluation, which are no longer about monetary variables but rather about wage, employment and social protection systems. The convergence hypothesis would not hold in such a context and huge differences would be noticed between the former EU-15 countries on one hand and the new member states on the other hand.

   The aim of this work is to analyze whether determinants of FDI in the two parts of the enlarged EU reflect such differences. Some studies based on the analysis of FDI showed huge differences in direct investment choices within the EU with a clear divide between the East and the West (Dupuch, 2004). Before the enlargement, CEECs were considered heterogeneous with large internal gaps. This article intends to reexamine this issue ten years later. Have the FDI choices of European countries changed towards a closer path than the one which prevailed in the former EU-15? From this point of view, can a kind of convergence be observed between the East and the West? Is there a form of FDI normalization in the EU or a persistence of specificities across the new member states?

   The article is structured as follows: the next section will deal with FDI-related literature and its relevance within the enlarged European Union. This is then followed by the presentation of stylized facts on FDI in Europe since 1993 so as to enhance the econometric analysis of their determinants and to bring forward possible differences between Eastern and Western Europe.

2. Literature review

   There are many motivations prompting a firm to expand internationally. They can be classified into four categories according to Berhman's classification (1972) which was resumed by Dunning (1993, 2008) on the mainspring of multinationals: Market seeking, Resource seeking, Efficiency and Strategic Asset seeking. However, in the case examined here, the new international trade theory provides more relevant orientations to our analysis. Thus, the distinction between horizontal and vertical direct investment strategies is privileged.

   A first investment type, called horizontal, meets the target of searching new markets. This type of investment aims at serving the host countries' markets, since the multinationals are setting up subsidiaries and developing local goods and services productions that can replace exports from the home country.

   According to Brainard (1997), the choice of FDI rather than exportation to serve a foreign market can be explained by a firm's trade-off between the advantages linked either to the proximity or to the concentration of activities. The firm's choice will then be determined by the weight of scale economies balanced with the transport costs. The horizontal FDI choice seems an alternative to exportation if the exchange costs exceed those of an abroad establishment. The transport costs and the international exchange obstacles are therefore factors in favour of direct investment strategies.

   Consequently, the direct investment in a foreign country makes it possible to produce a part of domestic production operations in order to reduce distribution costs or even to improve the multinational's position in the target market. The size of the host country's market, its economic growth potential, but also its proximity and the access to the neighboring economies are the main driving forces of these investments (Brenton et al., 1999; Campos and Kinoshita, 2003; Faeth, 2008, Bevan and Estrin (2000), Carstensen and Toubal (2004)). Moreover, the geographic and cultural proximity also seem determinant factors for the direct investments realized by a multinational towards another country (Resmini (1999); Tondel (2001); and Rasciute and Pentecost (2010)). The perspectives of markets growth in the countries of Eastern Europe formed from this point of view a favorable field to the development of the multinationals' activities.

   A second type of investment is about the FDI seeking economic efficiency. The companies are then motivated by the search for low-cost production factors (capital or workforce). These investments are called > and imply movements of productive activities relocation rather than the deployment of production activities similar to those of the home country. Helpman (1984, 1985) then Helpman and Krugman (1985) elaborated a vertical FDI model starting from the differences of factorial endowments. These models are based on the factors proportion theory developed by Hecksher-Ohlin. The vertical FDI is based on the gaps between the countries regarding factorial endowments and can be explained by the technological distance between countries. This explanation can apply in the case of North-South investments. Nevertheless, the vertical FDI develop when the transaction costs between two economies are weak enough for such an operation to be profitable. The weakness of the access costs in the host country is a determinant factor for the foreign subsidiary to be able to import inputs at low costs.

   Regarding the link between international trade and FDI, foreign investment has been considered by economic theory not only as a substitute for international trade but also as its complement. For instance, international trade and FDI flows have dramatically soared in the last decades. Certain market imperfections and mainly the possibility of achieving vertical investment lead to the conclusion that these two variables are closely linked. On the other hand, strong theoretic foundations, either linked to the factors exchange model or to the fundamental trade-off between exports and investment emphasized by the traditional trade theory (Mundell, 1957), support the idea of substitution. Therefore, empirical analysis can contribute to the debate on the role played by multinational firms in international trade. Many econometric studies have closely investigated the impact of FDI on international trade. For example, Fontagne and Pajot(1999) introduced bilateral FDI flows in a gravity equation applied to trade flows between twenty-one OECD countries over the 1980-1995period. They put forward a strong relation of complementarity between the two variables: a 10% increase of FDI towards a foreign country is linked to a 5% growth of exports to that same country.

   In addition, the theory shows a different effect of the geographic distance on horizontal and vertical FDI. Distance from the host country increases the transport costs which will favor horizontal strategies of establishing subsidiaries in the host country rather than exporting from the home country. Conversely, a small geographic distance between two countries can enhance vertical investment strategies towards a given country followed by the re-importation of final goods towards the home country. In this case, low transport costs implied by the proximity between the two countries will favor this type of strategy.

   Again, since the opening of their markets, the CEEC's have shown economic characteristics which made them a favorable destination for the relocation of companies coming from the former EU-15.

   In such a context, looking for lower costs (wages and other costs) can be the main factor. Wage costs are much lower than in the EU-15, so that EU countries are more and more challenged by the competition of goods and services coming from the new Member States. Simultaneously, competitiveness factors can incite firms to increase their presence abroad, both through trade flows and FDI.

   However, the theory according to which the vertical FDI would be justified by the labor costs does not have common agreement. Thus, Kravis and Lipsey (1982) used unitary salary costs in order to explain the relocation place choice of the American...