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Trade, Foreign Direct Investment, and Growth: Evidence from Transition Economies

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Abstract

Using a fixed effects panel data approach, this paper empirically examines the effects of trade and foreign direct investment (FDI) on growth of per capita real GDP in 13 transition economies of Central and Eastern Europe, and the Baltic region from 1991 to 2005. A significant positive effect of trade on growth is a robust result for transition economies of this region. In addition, domestic investment appears to be an important determinant of growth. In general, FDI does not have any significant impact on growth in these transition economies. However, when we control for the effects of domestic investment and trade on FDI, it appears to be a significant determinant of growth for the period after 1995.

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Notes

  1. These countries are Albania, Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Macedonia FYR, Poland, Romania, Slovak Republic, and Slovenia. Ideally one would like to include all transition economies in this investigation. But for some of the countries in the former Soviet Union, reliable data are not available for a significant part of the sample period considered in this paper.

  2. The numbers discussed and reported in this paragraph and the next are based on the author's calculation.

  3. To our knowledge, Islam (1995) is the first study to implement panel data approach to cross-country growth data.

  4. In a related study, drawing on the insights provided by a production function with a low elasticity of substitution between capital and labour, for short-run growth dynamics in the transition economies, Lee and Tcha (2004) empirically show that the marginal contribution of FDI to growth is greater than that of domestic investment. In another study, Sohinger (2005) shows, in a less formal way, that FDI, with its growth-enhancing effects, has played a significant role in setting the transition economies in the CEEB region onto the path of convergence with their more affluent neighbours.

  5. See Grossman and Helpman (1992) for a comprehensive discussion of a class of such models.

  6. In the literature, the role of FDI in transferring technology has received much attention and spurred intense debate. For a recent survey, see Saggi (2002).

  7. FDI inflows in the recipient economy ‘comprise capital provided (either directly or through other related enterprises) by a foreign direct investor to an enterprise resident in the economy. FDI flows are recorded on a net basis (capital account credits less debits between direct investors and their foreign affiliates) in a particular year’ (UNCTAD).

  8. Although transition began in 1989 in most countries, data are either not available or too noisy for this initial year of the process. When we calculate growth rates of per capita real GDP, we lose one year's data. Therefore, we use the sample period 1991–2005 in our estimation.

  9. There have been studies that use per capita real GDP, mostly in logarithms, as the dependent variable. For example, see Berg et al. (1999) and Cernat and Vranceanu (2002). Polanec (2004) argues in favour of using growth rate of average labour productivity. There are others (eg Fischer et al., 1996a, 1996b; Sachs, 1996; de Melo et al., 1997) who use the growth rate of aggregate real GDP as the dependent variable. There are some concerns, however, about the use of the growth rate of per capita real GDP measured in 1990 constant USD. For example, the differences in the movements of exchange rates over time across countries may introduce some systematic bias in the estimation of the coefficients in our regression model when we use the growth rate of per capita real GDP measured in constant USD instead of constant national currency as the dependent variable. Furthermore, because of the differences in domestic prices across countries, there may have been important differences even with growth rate of per capita real GDP measured in international purchasing power parity (PPP) dollar. Ideally, one would like to use per capita real GDP in PPP dollar, but data for all relevant variables measured in PPP dollars and for the sample period considered are not readily available. To have a sense of the extent of possible biases, we examine growth of per capita real GDP in 1990 constant national currency and growth of per capita real GDP in international PPP dollar. We observe that growth rates of per capita real GDP in both US dollars and in national currency track each other very closely, and for most countries they are perfectly correlated. The correlation coefficient is the lowest with a value of 0.98 for Bulgaria. Thus, the bias introduced by differences in movements of exchange rate should be negligible. We further obtain growth rates of per capita real GDP measured in PPP dollar from Heston et al. (2006) for 1991–2004 (for some countries data are not available for all the years), plot them alongside growth rates of per capita real GDP in 1990 USD, and calculate the correlation coefficients. The correlation ranges between 0.825 (for Bulgaria) and 0.992 (for Croatia). For Albania, Bulgaria, Hungary, and Lithuania the correlation coefficients are less than 0.90. Most of the deviations in these two sets of growth rates are in the early years of transition. Interested readers can obtain the data and graphs from the author. As mentioned above, these deviations are likely to introduce some biases in coefficient estimates. However, the results do not seem to change qualitatively. The growth rates of per capita real GDP are almost perfectly correlated with the growth rates of aggregate real GDP for all countries.

  10. Data on other variables that may affect growth are also reported in the Transition Reports. They are not included in our set of potentially relevant variables for one of two reasons: (i) incomplete data with data missing for a significant part of our sample period; (ii) they represent the same aspects of the economy as the ones that are included.

  11. However, they have argued that the effects of these initial conditions taper off as time passes. This is another reason why they may be excluded in investigating growth over an extended period of time.

  12. For a discussion on exchange rate regime, stabilisation, and growth in transition economies, see Fischer et al. (1996a).

  13. Intuitively some of the variables are expected to affect one another and, therefore, to be correlated. Our general-to-specific approach of model selection should eliminate the possible collinearity among the variables.

  14. Grogan and Moers (2001) present a cross-section analysis of 25 transition economies to show that institutions are important for growth and FDI.

  15. Note that we do not apply the general-to-specific approach to our variables of interest. Therefore, even in the most parsimonious specification, a multicollinearity problem may arise if two or more of these variables are collinear.

  16. From the data description in the Appendix, it is clear that we have missing data for some variables used in this study. That is, we have to use an unbalanced sample. In the case of missing values for the variables, we use the largest sample possible in each cross-section. An observation will be excluded from the estimation of our regression model if any of the explanatory or dependent variables for that cross-section are unavailable in that period.

  17. There is some evidence of mutual relationship among GDI, FDI, and TRADE. For example, Campos and Kinoshita (2003) find that trade has a positive effect on FDI in transition economies. Kutan and Vuksic (2007) further investigate the effects of FDI on the export performance of 12 CEE countries and find that while FDI has increased exports by increasing supply capacity through augmentation of the physical capital stock in all countries in their sample, it has helped exports through FDI-specific effects such as technology transfer, higher productivity, and information about export markets, only among the new members of the European Union.

  18. See Baltagi (2002 pp. 129–30) for a discussion. Many alternatives for getting around the problems associated with dynamic specification of fixed effects model have been suggested. Notable works include Anderson and Hsiao (1981), Arellano (1989), and Arellano and Bond (1991).

  19. Except for initial per capita real GDP, for other initial condition variables we use the same acronyms as de Melo et al. (1997).

  20. An experiment with the sample period 1991–1995 reveals that IC_cluster1 has significant negative, IC_cluster2 has significant positive, and IC_cluster has significant negative effects on growth. Although the result for IC_cluster1 accords well with de Melo et al. (1997), the result for IC_cluster2 does not seem to conform to these results. This may be due to some important interactions the IC-cluster2 may have with the control variables included in our regression model. The result for the IC_cluster, on the other hand, accords well with the result of Polanec (2004) for the period 1990–1994. The estimated coefficient of Y1990 is negative and statistically significant under all specifications and estimation methods. We do not report the results to save space. Interested readers can obtain the results of this experiment, and also the one-stage estimation results for specifications in Table 6 from the author.

  21. Under the assumption that the regressors are strictly exogenous. See Baltagi (2002, pp. 139).

  22. We do conduct some additional experiments, the results of which are not reported. For example, although we choose our model based on formal tests for exclusion of control variables, some of the included variables may intuitively affect each other or may affect one of our variables of interest. For example, real money growth may have an effect on real lending rate through its effects in the money market. Similarly, tariff that reflects trade liberalisation policy may have an impact on the trade variable. Gross reserves may also affect trade by alleviating the foreign exchange constraint. Size of the government may have a negative impact on fiscal balance. Finally, infrastructure may have a positive impact on FDI and trade. Therefore, in a series of experiments, we exclude one control variable at a time from the benchmark equation and re-estimate the model. The main conclusions are that GDI and TRADE are significant determinants of growth. Under none of these alternative specifications, the estimated coefficient for FDI turns out to be significant when full sample is used. Because the main results do not change, we do not report the results, and thereby save space.

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Acknowledgements

Earlier versions of this paper were presented at the 51st Annual North American Meetings of the Regional Science Association International in Seattle, 11–13 November 2004 and at the 80th Annual Conference of the Western Economic Association International in San Francisco, 4–8 July 2005. I thank Josef Brada, Don Bumpass, Don Freeman, Ioan Voicu, and two anonymous referees for their insightful comments, and to Gabi Eissa, Dhrubajyoti Nath, and Rhitwik Patowary for their excellent research assistance. Usual disclaimer applies.

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APPENDIX: DESCRIPTION OF THE VARIABLES AND DATA

APPENDIX: DESCRIPTION OF THE VARIABLES AND DATA

Table A1

Table a1 Factor loadings of the first two principal components of 11 initial conditions and of the first principal component of eight initial conditions

GROWTH: Growth rate of per capita real GDP. Calculated as 100 times first log differences of per capita real GDP (1990 USD), available from UN Statistical Database. Available for the entire period 1991–2005 for all countries.

GDI: Real gross domestic investment as a percentage of real GDP. Data on real gross fixed capital formation are obtained from the UN Statistical Database and real net FDI inflows are subtracted and the percentage shares in GDP are calculated. Data are available for all years: 1991–2005 for all countries.

FDI: Real foreign direct investment as a percentage of real GDP. Data on net FDI inflows at current USD are obtained from the UNCTAD. They are converted into constant dollars by applying an implicit deflator for gross fixed investment. Percentage shares in real GDP are then calculated. Data are available since 1992 for Albania, Croatia, Estonia, Latvia, Lithuania, Macedonia, and Slovenia. For Czech Republic and Slovak Republic, data are available only since 1993.

INF: CPI inflation. Percentage change in annual average consumer price index (CPI). Available from the EBRD's Transition Reports. For Estonia, Latvia, Lithuania, and Macedonia, data are available only from 1992.

FBAL: Fiscal balance. Government budget balance as a percentage of GDP. Available from the EBRD's Transition Reports. For Estonia and Latvia, data are available only from 1994; for Lithuania from 1993; and for Macedonia, Romania, and Slovak Republic from 1992.

GOV: Size of the government. Real government consumption expenditures as a percentage share in real GDP (1990 USD). Calculated from the data obtained from the UN Statistical Database. Data are available for all years: 1991–2005 for all countries.

X: Nominal exchange rate. Natural log of nominal exchange rate as reported by the EBRD's Transition Reports. Data are available for all years: 1991–2005 for all countries.

EMP: Employment growth. Percentage growth of employment as reported in the EBRD's Transition Reports. Data are available for Estonia, Latvia, Lithuania, and Macedonia since 1992.

MONEY: Real money growth. Percentage changes in broad measures of money (M2) are available from the EBRD's Transition reports. The real money growth rate is calculated by subtracting CPI inflation. Data are available for Bulgaria, Lithuania, and Slovenia from 1992; for Albania, Czech republic, and Slovak republic from 1993; for Croatia, Estonia, and Latvia from 1994; and for Macedonia from 1996.

DOMCREDIT: Real domestic credit growth. Percentage changes in outstanding bank credits available from the EBRD's Transition Reports. Data are available for Bulgaria and Slovenia from 1992; for Croatia, Czech republic, Latvia, Macedonia, and Slovak Republic from 1994; for Estonia from 1995; and for Lithuania from 1996.

LRATE: Real lending rate. Data on nominal lending rates (per annum) are available from the EBRD's Transition Reports. We subtract CPI inflation to obtain real lending rates. Data are available for Croatia, Czech republic, Lithuania, Macedonia, and Slovenia from 1992; for Latvia, Romania, and Slovak Republic from 1993; and for Estonia from 1994.

RES: Gross foreign exchange reserves as a percentage share of GDP. Gross foreign exchange reserves excluding gold as a percentage of GDP are available from the EBRD's Transition Reports. Data are available for Croatia and Lithuania from 1992; for Estonia, Latvia, Romania, and Slovak Republic from 1993; and for Macedonia from 1995.

PVT: Share of private sector in GDP. Private sector value-added as a percentage of GDP, available from the EBRD's Transition Reports. Available for all countries for the entire period: 1991–2005.

TARIFF: Tariff revenue as a percentage of total imports. All revenues from international trade as a percentage of value of imports of merchandise goods. Reported in the EBRD's Transition Reports. Data are available for Albania, Poland, and Slovak republic from 1992; and for Czech Republic, Estonia, Latvia, and Lithuania from 1993.

SUB: Budgetary subsidies and current transfers as a percentage share of GDP. Budgetary transfers to enterprises and households, excluding social transfers. Reported in EBRD's Transition Reports. Data are available for Albania and Slovak republic from 1992; for the Czech Republic and Lithuania from 1993; for Estonia and Latvia from 1994; for Croatia from 1996; and for Macedonia from 1997.

INDEMP: Percentage share of industry in total employment. Share of employment in electricity, power, manufacturing, mining and water in total employment in the economy. Reported in the EBRD's Transition Reports. Data are available for Latvia, Lithuania, and Macedonia from 1992; for Slovenia from 1993; and for Albania from 1994.

INFRA: Infrastructure reform index. EBRD index of infrastructure reform that covers electric power, railways, roads, telecommunications, and water, and waste water reforms. Reported in the EBRD's Transition Reports. Available for the entire period 1991–2005 for all countries.

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Nath, H. Trade, Foreign Direct Investment, and Growth: Evidence from Transition Economies. Comp Econ Stud 51, 20–50 (2009). https://doi.org/10.1057/ces.2008.20

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