New Institutional Economics and FDI Location in Central and Eastern Europe

Abstract * This paper links the new institutional economics with organizational decision making on foreign direct investment (FDI). We examine the relationship between FDI inflows in Central and Eastern Europe (CEE) and institution building--particularly governments' efforts to create a more favorable FDI environment by reducing uncertainty and, concomitantly, costs associated with long-term capital investments. * By combining institutional constructs with traditional factors that contribute to FDI decision-making and applying them to economies in transition, we extend the new institutional economics. Key Results * We found support for the positive link between institutional variables that reduce uncertainty and costs for MNEs and FDI flows into CEE. Corruption and a measure of political risk were negative and significantly related to inward FDI, while the presence of bilateral investment treaties and the level of restrictions on repatriation of earnings of CEE affiliates were positive and significantly related to inward FDI. * Traditional variables also mattered: the foreign exchange rate was significant and negatively correlated to FDI, while market size was highly significant and positively correlated to FDI. Introduction The goal of this paper is to demonstrate that institutions matter in the context of foreign direct investment (FDI) in the transitional economies of Central and Eastern Europe (CEE). We employ the new institutional economics (NIE) as a theoretical foundation and apply concepts related to it in an examination of FDI activity that may respond to institutional development in CEE. Within this context, FDI is expected to respond to country-level macroeconomic, microeconomic and institutional changes, especially institutional factors that reduce (increase) uncertainty and/or costs related to long-term capital investments. This approach follows Rumelt, Schendel, and Teece (1991) in utilizing tools from both economics and strategic management to facilitate understanding of FDI decision-making. It is well understood that firms entering a new market must adapt their overall strategies to environmental conditions in the host country (Hymer 1976, Kindleberger 1969). Along these same lines, as governments in transitional economies battle for larger shares of global FDI flows, there is increasing evidence that they have adapted their institutional environments (1) in order to attract inward FDI (Meyer 2001). Although institutional hurdles (2) exist in all countries, for emerging markets and economies in transition, the evolution of market-based institutions is a critical hurdle (Clague 1997, Meyer 2001). Economic transition involves replacing one governing framework with another and, in the case of CEE, this transition involved replacing a socialist system with an institutional framework that is consistent with a market economy. And since efficient markets depend on market-based supporting institutions (North 1990), all of the CEE countries have pursued transition strategies from state control toward open markets. Some of the adjustments associated with the installation of a market economy have been implemented more rapidly than anticipated, while others have lagged, partially determined by the manner in which state socialism disintegrated in a given country. (3) Within the broad theoretical framework of institutional theory, normative, cultural-cognitive, and regulative systems have all been identified as being useful approaches. The normative approach specifies how things should be done and normative systems define goals or objectives but also suggest legitimate means by which to pursue them (Scott 2001). The cultural-cognitive approach recognizes that internal interpretive processes are shaped by external cultural frameworks. In fact, it has been proposed that cultural dimensions are the cognitive frameworks in which social interests are defined (Douglas 1982). …