12 Like all other countries, except for Moldova, Bulgaria was not an outlier. Its governance was in the positive range and its institutional development lagged less than 60 percent behind the level of highly industrialized economies. The net cumulative FDI inflows predictably exceeded US$ 500 per capita putting it well ahead of countries that had negative scores of governance and low EBRD scores. On the other, Moldova attracted less FDI than then the structural index would suggest. The reason is straightforward: the absence of political stability as captured in the value of governance index.

Similarities between the results derived from plotting cumulative FDI inflows and levels of governance and structural reforms come as no surprise. Both indexes are highly correlated, with the value of correlation coefficient of 97 percent (Table 6). Both indices are also similarly strongly and positively correlated with cumulative FDI inflows per capita, with correlation coefficients exceeding 80 percent. It is interesting to note that the variation in values of CPI and FDI inflows is also positively correlated, albeit somehow weaker than the two other indices.

**Table 6:** _Values of correlation coefficients among corruption, governance, reform progress and FDI_

||CPI|Governance|EBRD|
|---|---|---|---|
|Corruption Perception Index (CPI)|1|0.83|0.77|
|Governance aggregate index|0.83|1|0.97|
|EBRD-basedindex|0.77|0.97|1|
|Cumulative net FDI|0.75|0.84|0.82|

Source: See Table 5.

Data for Bulgaria as well as for Romania provide strong support to the link between progress in governance and FDI inflows. The 1990-2003 time profile of FDI flows to Bulgaria per capita also appears to coincide with changes in the values of structural reform index (see Table 4 and Figure 2 above). So does Romania’s time profile. Until 1997 annual FDI inflows to Bulgaria and Romania were very low. There had been little improvement in terms of the structural reform index. Surge in FDI inflows since 1997 has accompanied the implementation of structural reforms. In 2003 FDI per capita in Bulgaria exceeded for the first time the population-weighted average FDI per capita flows to CEEC-8.<sup>6</sup> If structural reforms including large-scale privatization to strategic investors explain most of FDI inflows, then recent progress in Bulgaria augurs well for the future. Indeed, according to the most recent estimates, FDI flows increased 6 percent last year and amounted to 10 percent of the GDP or US $286 per capita. Privatization accounted for 23 percent of total FDI inflows over 1999-2003. The share was 26 percent in 2003. On the other hand, relative ‘stagnation’ in Romania’s structural reforms was also accompanied by stagnant FDI inflows per capita in the period following large privatization in 1998 (Figure 5).

Hence, the progress achieved in building market-supporting institutions combined with the higher quality of governance explains most of the variation in flows of FDI to sixteen transition economies, CEEC10 and SEE-6. Bulgaria’s inward FDI stock, as approximated by cumulative net FDI inflows since the collapse of central planning in 1990, is in line with what one would expect given its record in second generation reforms. This is the case for both indices of governance quality and structural reforms’ progress averaged over 1998-2004.

How does the emphasis on structural reforms match studies pointing to other factors explaining FDI flows? The conclusion about the primacy of institutions appears to contradict other findings on determinants of FDI inflows. Most of them identify unit labor cost, openness to trade, size of the host economy, the proximity to the EU as major factors explaining differences in FDI inflows. Some argue that country-specific risk does not influence FDI inflows (Bevan and Estrin 2004), whereas others have found credit ratings as an important explanatory variable (Janicki and Wunnava 2003). It is also interesting to note that announcement about timetables for admission to the EU has positively influenced FDI flows (Bevan and Estrin 2004).

6 Because of delays in reporting by foreign firms of reinvested earnings, the BCB revised upward in January 2005 its estimate of FDI for 2003 from EUR 1.25bn to EUR 1.85bn.