10 How does Bulgaria compare to other countries in the region? While the index based on EBRD’s scores—for obvious reasons—does not allow for precision in capturing the institutional progress, it nonetheless indicated the direction of changes and achieved progress. Bulgaria has made huge strides especially since 2001 and is much more advanced than Romania and SEE-4 economies, yet its level of institutional maturity remains well below that achieved by CEEC-8 economies. The value of structural reform index is roughly the same as achieved by a median for CEEC-8 countries around 1997-98. Hence, Bulgaria has still some way to go in order catch up with recent EU entrants.

# _B. Impact on FDI inflows_

Better governance and regulatory environment, low ‘hassle’ cost of conducting business, labor force, etc., all increase the probability of receiving higher FDI inflows. Empirical research strongly suggests that progress in second-generation reforms, i.e., with the focus on institutions supporting competitive markets, provides explanation in country variation of FDI inflows. Garibaldi et al. (2002) have shown, that the quality of institutions explains the variation in FDI flows to transition economies. In a similar vein, Broadman et al. (2004, p. 20), plotting the data on FDI per capita and EBRD’s governance and enterprise restructuring indices for all Balkan countries also find a very strong positive association between these two variables. Countries that have made the largest progress in transition to competitive markets have also attracted the largest inflows of FDI, whereas countries with weaker business climate have been less successful in attracting FDI. Ineffective protection of property rights and weaknesses in contract enforcement always discourage foreign investors.<sup>5</sup> In the analysis that follows, we focus, like in the studies mentioned above, on the institutional environment as critical to explaining variation in FDI inflows. In contrast to Broadman et al. (2004), we look at cumulative FDI inflows per capita and use an aggregate EBRD-based indicator measuring the progress in building market-supporting institutions. We take FDI inflows per capita rather than in terms of GDP simply because the latter is positively correlated with higher quality of governance. As discussed earlier, the aggregate indicator is the average of EBRD scores limited to areas not directly associated with first generation reforms. The progress in these areas no longer strongly differentiates among transition economies, as was the case during the initial stages of transition, whereas institution and governance-related domains do. The index is averaged for the 1996-2002 period. The rationale behind averaging over the eight-year period is straightforward: a good climate has to exist for a sufficiently long time to affect investors’ decisions. As a second test, we also plot cumulative net FDI flows per capita and the aggregate indicator of quality of governance. As mentioned earlier, the quality of governance is defined here as an average value of the indicators of political stability, government effectiveness and regulatory quality. These three aspects of the business environment are critical to FDI inflows. The indicators pertain to 1996, 1998, 2000 and 2002 and range from –2.5 (lowest score) and +2.5 (highest score). For the same reason, we take the average over time (Table 5).

The variation in the progress in structural reforms and the quality of governance corresponds very closely to the variation in cumulative FDI net inflows per capita over 1990-2003. Countries whose institutions were below 40 percent of the level in industrialized market economies have failed to exceed US$ 500 dollar worth of cumulative net FDI inflows per capita (Figure 3). So have the countries with the negative values of the aggregate governance indicator (Figure 4).

> 5 There are two exceptions to this general rule: First, investments in natural resource sectors tend to flow as long as the state is firmly in control and can shield an investor from the domestic investment climate. Second, even the best climate may fail to attract investors if a country, for instance, has no viable transportation infrastructure, it suffers from chronic shortages of electricity or is located in the middle of nowhere. As we shall argue later, whereas Bulgaria does not have attractive natural resources (oil or natural gas), its infrastructure remains relatively underdeveloped.