DETERMINING FACTORS AND EFFECTS OF FOREIGN DIRECT INVESTMENT IN AN ECONOMY IN TRANSITION : Evidence from Czech Manufacturing in 1991-97

The paper is based on an econometric model for 15 manufacturing industries. It analyses the causes and the effects of FDI in a small open economy in transition during 199197. The model comprises of panel data with 1050 potential observations (10 variables x 15 industries x 7 years). The hypotheses tested are derived from the theory of investment location for a small open economy where comparative advantages, industrial organisation and market structure form the basic determining factors of the industrial structure of FDI inflows. The experiments with our models indicate that the key variable on the side of determining factors of the industrial structure of FDI was the capital per labour ratio. It is evident that after 1994 the role of capital was overshadowing the role of labour in attracting the FDI. The new FDI ventures into the Czech economy are biased in favour of capital intensive industries. As a variable of minor significance there was observed the role of increasing returns to scale. We cannot confirm that there were other significant “causes” determining the FDI during the whole studied period because a part of them could have been correlated with effects of FDI. On the side of effects of FDI on firms, there were several variables that were statistically significant: the level of profits, total factor productivity and the development in prices measured by producer price index. The latter factor has been universal to all patterns of Czech incoming FDI flows both in time and space (industries). From the very onset, foreign investors into the Czech manufacturing were strongly biased to investments into those industries where the index of inflation was higher than average. This is a classical explanation of location activities built into the foundations of comparative advantages and shared by both the Ricardian and the Stolper-Samuelson models. Natural resources or human capital endowment in industries were not among the factors that influenced significantly the decision-making about FDI. The facts revealed in this paper are of a crucial importance for the policy-making. We have found that there are only very weak causal links in the Czech economy for the attraction and the success of FDI. The majority of phenomena distinguishing the firms (industries) with FDI from indigenous firms can be derived from the effects of FDI. As a consequence, we cannot expect that indigenous firms would enjoy the same natural “comparative advantages”, which were observed to have been developing in firms with FDI. If this trend would continue, the gap between the foreign and the indigenous enterprises would be widening. The benefits of FDI could be then internalised exclusively in recipient enterprises and the indigenous firms would fall out off the competition. Having been singled out as outsiders, they would sink Address of the authors: Charles University, FSV-IES, Opletalova St. 26, CZ-11000 Prague E-mail: benacek@mbox.fsv. cuni.cz down to a group of other indigenous firms competing among themselves at the margin of survival. 1. FDI as an Engine for Survival Czech economic transformation had its ups and downs. In 1990 it commenced in a hind position, with hardly any experience from entrepreneurship under its “reformed” central planning and with households lacking capital for the initiation of large-scale investments. With these adverse endowments being given, betting on FDI would be a very promising strategy for securing the future growth. Nevertheless, Czechoslovak government opted at that time for a very different strategy in the large-scale businesses. By giving priority to the voucher privatisation scheme and the scheme of sales to Czech owners (Mejstrik [1996]) it set forth for a highly unorthodox avenue of self-reliance. The ensuing intransparent ownership and perverse objectives of the quasi-owners had a long-term impact on the performance of firms and the Czech society. Though still accepted as an important means of privatisation, the FDI remained a less-favoured child that was assumed to be strong enough to care for himself. Without doubt, the stress on one’s own capacities was a dire undertaking, which was at first criticised by IMF and the World Bank, but very soon it became the Czech most admired achievement. Unfortunately, in 1996 there were first signals that indigenous Czech firms lagged behind the firms with foreign capital . Czech privatisation strategy was a bet on odds that it could be possible to build capitalism without capital. This was an impossibility theorem, which had to fall down on the new Czech capitalists-to-be. The accumulation of capital was a necessity and the indigenous firms had to act in such a way that instead of concentrating on the restructuring of production, they had to cope with corporate property control, equity transfers and the acquisition of assets under their own management. Many of these acts were illegal 2 and their effects on the firms were negative. The necessity to close the widening trade balance deficit during 1994-97, the government had to proceed with restricting both the monetary and the fiscal policies. That brought the frail Czech firms to a test of survival during 1997-98. In the same period there was a sharp change in the views on ownership. The openness to FDI became the mostfavoured policy for not only all liberal parties, but also for the trade unions and Socialists. Unfortunately, foreign investors became very cautious and the changeover to a new strategy remained to a large extent without practical response. Now it looks evident that those firms that succeeded in attracting FDI were those more lucky ones where the growth of production was combined with high wages and high profits. Since only a minority of firms succeeded in that, the Czech economy was slowly progressing into a system of dual set of firms distinguished by speed. On one hand there are the indigenous firms that press for low wages, government bailout schemes and the soft legislation. On the other hand there are firms with foreign capital that can withstand appreciating exchange rate and still increase its market competitiveness and capital returns. 1 The first studies in this respect were by Benacek, Zemplinerova [1996] and Zemplinerova, Benacek [1996] and [1997]. These studies covered the full sample of firms with employment over 24 employees (altogether over 3000 enterprises) and their conclusion was less optimistic than what was found in the study by Djankov and Hoekman [1998] who used a selected pattern of 513 firms. 2 The word “tunnelling” became a synonym for ingenious schemes of asset stripping and rent-seeking, which have left the majority of indigenous corporations and banks in debts. On top of its inefficient acquisition, the extracted “authentically private” capital was often either sent abroad or spent on imports of consumer goods. Under this “division of roles” in entrepreneurship there is a rising danger that the gap between these two groups will even deepen and thus perpetuate the existing split. Thus in 1999 approximately a half of the firms in the Czech economy were firms able to stand on their own with a prospect for gaining profits. The majority of these were firms with foreign capital. The remaining half (or a third, in the better case) of all firms is now challenged by either pending restructuring or liquidation. Since it is not very likely that the weakened indigenous Czech corporate sector would be able to recover with the help of their own means, there are two alternatives left which may do the job. The first one is the government bailout. Because the Czech propensity to save is extremely high and also the taxes are very high, the means so available are substantial. The present Czech government thinks that there may be a hope for chance. Their problem is only managerial: who are those clerks and entrepreneurs who will administer and use these means productively? With the lack of them one can have doubts there may be anything perspective in this scheme. The other chance left to the ailing indigenous enterprises rests in their association with the foreign capital, either in joint-ventures or by their direct takeovers by foreign firms. Unfortunately we can doubt that the FDI entry into Czechia would change its strategy and, instead of concentrating on green-field investments (as was clearly the situation since 1996), it would return back to acquisitions and mergers. If this would not be the case, the only possibility then remains that the FDI firms, which have now become leaders in the Czech economy, would have positive spillover effects on the rest of the economy. So, at this stage of development, the Czech economy would be helped more by means of externalities spinning off from foreign to indigenous firms than by direct effects on productivity in the firms under foreign control. It is the aim of this study to analyse more closely how the foreign investors behaved in the past, what were the determining factors for their activity, what were the industrial patterns, which attracted their attention and how was it with their effects on the economy. 2. The Data and the Variables Used in this Study This study builds on the experience we developed during our empirical tests from the previous paper (see Benacek and Visek [1998]). The data in the former study were based on a single year 1994 and comprised 91 industries. The problem was that we lacked the time dimension and the picture we have received was generally static. Nevertheless, we have discovered that the industries with a massive presence of FDI behaved to a large extent differently than the industries without that financial support. In this paper we have grouped the manufacturing data into 15 industries classified according to NACE 2-digit nomenclature. We have clustered some industries because we did not have the FDI data for all industries in the required structure. The intensity of FDI in the given industry i (as the