International Workshop“Bridging the gap: the role of trade and FDI in the

Mediterranean”Napoli, Castel dell’Ovo

8-9 Giugno, 2006

FDI Potential and Shortfalls inSouth Mediterranean Countries: Determinants and

Diversion Effects

A. Ferragina (aferragina@unisa.it)F. Pastore (fpastore@unina.it)

22

Outline Outline • FDI in the MED-10 vis-a-vis Central and FDI in the MED-10 vis-a-vis Central and

Eastern Europe: overview of performance Eastern Europe: overview of performance and potential.and potential.

• Determinants of FDI with the help of the Determinants of FDI with the help of the gravity model: the role of institutional and gravity model: the role of institutional and policy variables.policy variables.

• Simulation analysis of the magnitude of Simulation analysis of the magnitude of “normal” value of FDI expected on the “normal” value of FDI expected on the basis of the explanatory variables.basis of the explanatory variables.

• Diversion of FDI from MED to CEECs?Diversion of FDI from MED to CEECs?

33

IntroductionIntroduction

• A worrying stylised fact: Southern A worrying stylised fact: Southern Mediterranean countries (MED so far) Mediterranean countries (MED so far) receive little FDI from most other regions in receive little FDI from most other regions in the world.the world.

• FDI flows into some of them have tended to FDI flows into some of them have tended to grow slowly over the 90s and to decline grow slowly over the 90s and to decline after 2000, while they have been booming in after 2000, while they have been booming in Central and Eastern Europe (CEECs).Central and Eastern Europe (CEECs).

44

World FDI outflows to CEEC10 World FDI outflows to CEEC10 and MED10 and MED10

• Actual dollar values of FDI outflows from 1994 to 2004 Actual dollar values of FDI outflows from 1994 to 2004 from the World to CEEC10 and MED10 million USD and from the World to CEEC10 and MED10 million USD and as percentage of total FDI outflows (Unctad, 2005).as percentage of total FDI outflows (Unctad, 2005).

World FDI outflows to CEEC10 and MED10

0

5000

10000

15000

20000

25000

30000

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Mil

lio

ns U

SD

0

0,5

1

1,5

2

2,5

3

3,5

4

4,5

5

%

Med10 CEEC10 (% of world) Med10 (% of world) CEEC10 (% of world)

55

EU investment are crucialEU investment are crucial

• EU is the main provider of FDI to the South EU is the main provider of FDI to the South Mediterranean. Mediterranean.

• In 2004 the EU provided on average more than In 2004 the EU provided on average more than 70% of the FDI to MED10. 70% of the FDI to MED10.

• The European presence is not equally distributed The European presence is not equally distributed in all the MED but for some countries it is really in all the MED but for some countries it is really striking: Turkey received more than 75% , striking: Turkey received more than 75% , Morocco 73% (more than 95% in 2001), Tunisia Morocco 73% (more than 95% in 2001), Tunisia 65%.65%.

• According to the MIPO database from ANIMA, According to the MIPO database from ANIMA, 59% of the investment projects are coming from 59% of the investment projects are coming from European investors, essentially France, Spain, the European investors, essentially France, Spain, the United Kingdom, and Germany.United Kingdom, and Germany.

66

Things are not going wellThings are not going well

• EU FDI: a slow trend of growth up to 1997 EU FDI: a slow trend of growth up to 1997 • an upsurge between 1997 and 1999 and a an upsurge between 1997 and 1999 and a

good performance up to 2002: overall good performance up to 2002: overall from 5 to 15 billions $ and from less than from 5 to 15 billions $ and from less than 1% to almost 14% of total EU FDI.1% to almost 14% of total EU FDI.

• However, from 2002 to 2004 a strong However, from 2002 to 2004 a strong decline has eroded previous results: a fall decline has eroded previous results: a fall from almost 14 to 4 per cent, from almost 14 to 4 per cent, corresponding to a decrease of more than corresponding to a decrease of more than 10 billions USD (from 15 to 5 billions $). 10 billions USD (from 15 to 5 billions $).

77

EU FDI outflows to CEECs EU FDI outflows to CEECs and MED10and MED10

actual dollar values of EU FDI outflows to CEEC10 and MED10 from 1994 to actual dollar values of EU FDI outflows to CEEC10 and MED10 from 1994 to 2004 as percentage of total EU FDI outflows (2004 as percentage of total EU FDI outflows (Eurostat, Economics and Eurostat, Economics and Finance Statistics) : Finance Statistics) : this cursory evidence might suggest this cursory evidence might suggest investment diversion from MED to CEECsinvestment diversion from MED to CEECs

EU15 FDI outflows in Meds10 and CEECs

0

5

10

15

20

25

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

% o

n t

ota

l

Med10 CEEC

88

EU15 FDI outflows to MED10 (% on total EU15 FDI)

0

2

4

6

8

10

12

14

16

18

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

%

Algeria Tunisia Morocco Jordan Lebanon Syria

Egypt Israel Palestina Turkey Med10

MED10

Source: Eurostat, Economics and Finance Statistics.

99

Perfomance and Potential Perfomance and Potential IndexIndex• two indicators for ranking countries with respect to two indicators for ranking countries with respect to

FDI (UNCTAD, 2004):FDI (UNCTAD, 2004):

• 1) a “performance index” which relates the share of 1) a “performance index” which relates the share of the FDI flows to a country to its share in the world the FDI flows to a country to its share in the world GDP. AnGDP. An index above (below) one indicates that the index above (below) one indicates that the couuntry attract more (less) FDI as a percentage of couuntry attract more (less) FDI as a percentage of its economic dimension its economic dimension

• 2) a “potential index”, which is calculated as simple 2) a “potential index”, which is calculated as simple average of 12 structural variables which average of 12 structural variables which corresponds to the main FDI determinants identified corresponds to the main FDI determinants identified by theoretical and empirical models (market size, by theoretical and empirical models (market size, degree of openness, degree of openness, infrastructures, technologies, infrastructures, technologies, qualified labour force at low cost, natural resources qualified labour force at low cost, natural resources endowment, regulatory framework, busineess endowment, regulatory framework, busineess climate and country risk which influence the degree climate and country risk which influence the degree of confidence of investors).of confidence of investors).

1010

Performance of MED in 2004: Performance of MED in 2004: ranking ranking over 140 countries over 140 countries

(Unctad, 2005)(Unctad, 2005)• UNCTAD ranking of countries according to UNCTAD ranking of countries according to

the inward FDI performance index:the inward FDI performance index: MED lag MED lag behind at the international level: Lybia is at behind at the international level: Lybia is at the bottom of the list (116), followed by the bottom of the list (116), followed by Turkey (111), Egypt (108), Algeria (95), Turkey (111), Egypt (108), Algeria (95), Lebanon (90), Israel (83). Better Tunisia Lebanon (90), Israel (83). Better Tunisia (67), Morocco (65), Jordan (48) and Syria (67), Morocco (65), Jordan (48) and Syria (39). (39).

• CEECs position is far better for most CEECs position is far better for most countries: countries: Bulgaria 12, Estonia 16, Slovak R. Bulgaria 12, Estonia 16, Slovak R. 25, Czech R. 28, Croatia 33, Romania 35, 25, Czech R. 28, Croatia 33, Romania 35, Poland and Albania 42, Hungary 46, Latvia Poland and Albania 42, Hungary 46, Latvia 47, Lithuania 59, Slovenia 60, Macedonia 47, Lithuania 59, Slovenia 60, Macedonia 72.72.

1111

Potential of MED in 2003: Potential of MED in 2003: ranking ranking over 140 countriesover 140 countries

(Unctad, 2005)(Unctad, 2005)

• UNCTAD ranking of countries according to UNCTAD ranking of countries according to the inward FDI potential index in 2003: the inward FDI potential index in 2003: USA (1), China (12), Slovenia (28), while USA (1), China (12), Slovenia (28), while Egypt 75 Morocco 87, Syria 95! Egypt 75 Morocco 87, Syria 95!

• The MED (excluding Israel) all from 60 The MED (excluding Israel) all from 60 downward. downward.

1212

Evolution of Performance Evolution of Performance • Only in few MED changes occurred over Only in few MED changes occurred over

the last decade through economic reforms the last decade through economic reforms and the adoption of more friendly policy and the adoption of more friendly policy towards investors have translated into towards investors have translated into significant improvement.significant improvement.

• This is suggested by the evolution of the This is suggested by the evolution of the performance index over the period 1993-performance index over the period 1993-95 and 2000-2002. 95 and 2000-2002.

• Jordan, Algeria and Lebanon have realised Jordan, Algeria and Lebanon have realised an important increase in the index of an important increase in the index of development of FDI. development of FDI.

• But Tunisia, Egypt, Morocco, Syria, Turkey But Tunisia, Egypt, Morocco, Syria, Turkey show a negative evolution.show a negative evolution.

1313

Evolution of PerformanceEvolution of Performance

France

Malta

Portugal

Spain

AlbaniaBosnia

CroaziaMacedonia

Slovenia

Algeria

Tunisia

Egypt

Israel

Lebanon

Syria

Cyprus

GreeceItaly

Morocco

Turkey

0,00

0,50

1,00

1,50

2,00

2,50

3,00

3,50

4,00

0,00 0,50 1,00 1,50 2,00 2,50 3,00 3,50 4,00

performance index 1993-95

perf

orm

ance in

dex 2

000-2

002

France Italy Malta Portugal SpainAlbania Bosnia Croazia Macedonia Serbia-MontenegroSlovenia Algeria Morocco Tunisia EgyptLybia Jordan Israel Lebanon SyriaCyprus Greece Turkey Jordan

Jordan

1414

Evolution of PotentialEvolution of Potential

• Most of the countries with upsetting Most of the countries with upsetting FDI performance (Turkey, Tunisia, FDI performance (Turkey, Tunisia, Morocco, Egypt, Syria) have had a Morocco, Egypt, Syria) have had a negative or static dynamic also as far negative or static dynamic also as far as the potential index is concerned as the potential index is concerned

• Only Israel shows a big increase in Only Israel shows a big increase in potential from 0,20 to almost 0,40 potential from 0,20 to almost 0,40

1515

Evolution of Potential Evolution of Potential

France

Italy

MaltaPortugal

Albania

Croazia

Slovenia

AlgeriaMorocco

Lybia

Lebanon

Cyprus

Spain

Macedonia

TunisiaEgypt

Jordan

Israel

Syria

Greece

Turkey

0,00

0,05

0,10

0,15

0,20

0,25

0,30

0,35

0,40

0,45

0,50

0,00 0,05 0,10 0,15 0,20 0,25 0,30 0,35 0,40 0,45 0,50

Potential index 1993-95

Pote

ntial in

dex 2

000-2

002

France Italy Malta Portugal Spain

Albania Bosnia Croazia Macedonia Serbia-Montenegro

Slovenia Algeria Morocco Tunisia Egypt

Lybia Jordan Israel Lebanon Palestina

Syria Cyprus Greece Turkey

1616

Perfomance and PotentialPerfomance and Potential• Comparing the Potential Index value with

the Performance Index value gives an indication of how each country performs against its potential.

• Countries in the world can be divided into the following four categories:

• front-runners (countries with high FDI potential and performance);

• above potential (countries with low FDI potential but strong FDI performance);

• below potential (countries with high FDI potential but low FDI performance);

• under-performers (countries with both low FDI potential and performance

1717

Perfomance and PotentialPerfomance and Potential• In the figure below, it is shown the position In the figure below, it is shown the position

of the 10 Mediterranean partners with of the 10 Mediterranean partners with respect to both these two indicators in the respect to both these two indicators in the period 2000-2002. period 2000-2002.

• On the horizontal axis, it is portrayed the On the horizontal axis, it is portrayed the Performance index and on the vertical axis Performance index and on the vertical axis the Potential index. the Potential index.

• For comparison, to measure the distance For comparison, to measure the distance of Mediterranean economies from of Mediterranean economies from international partners, there are also international partners, there are also countries with high and average potentials, countries with high and average potentials, such as USA, China, Poland, Venezuela. such as USA, China, Poland, Venezuela.

• Striking the potential value of China and Striking the potential value of China and Poland, quite close competitors for MED.Poland, quite close competitors for MED.

1818

Perfomance and Potential Perfomance and Potential IndexIndex• Four partitions of the figure:Four partitions of the figure:

• MED with high (low) performance those MED with high (low) performance those which on the horizontal axis intercept value of which on the horizontal axis intercept value of the inward FDI performance index above the inward FDI performance index above (below) one(below) one

• countries with high (low) potential those with countries with high (low) potential those with a potential index above (below) the average a potential index above (below) the average for the Mediterranean area (South and North) for the Mediterranean area (South and North) as a wholeas a whole

1919

Perfomance and Potential Perfomance and Potential IndexIndex

• 1) MED with 1) MED with high performancehigh performance combined with combined with high potential (frontrunners)high potential (frontrunners): only : only IsraelIsrael, close to , close to Spain, France, Slovenia, Portugal and Cyprus.Spain, France, Slovenia, Portugal and Cyprus.

• 2) MED with 2) MED with highhigh performance but low potential performance but low potential (countries “above their potential”)(countries “above their potential”): : Morocco, Morocco, TunisiaTunisia, close to Albania, Croazia, Macedonia., close to Albania, Croazia, Macedonia.

• 3) MED with 3) MED with worrying position both as worrying position both as performance and as potentialperformance and as potential (“(“underperformers”)underperformers”), above all , above all Egypt, Turkey, Egypt, Turkey, Syria, but also Jordan, Algeria, Lebanon.Syria, but also Jordan, Algeria, Lebanon.

2020

FDI index 2000-2002

France

ItalyMalta Portugal

Spain

Algeria MoroccoTunisiaEgypt

Israel

CyprusGreece

Croazia

Macedonia

Slovenia

United States

China

Poland

Venezuela

JordanLebanon

Syria Turkey

Albania

0,00

0,20

0,40

0,60

0,80

1,00

1,20

1,40

0,00 0,50 1,00 1,50 2,00 2,50 3,00 3,50

Performance index

Pote

ntia

l ind

ex

2121

FDI index1988-1990

France

Italy

Malta Portugal

Spain

Algeria Tunisia Egypt

Israel

Lebanon

CyprusGreece

Turkey

United States

China

Poland

Venezuela

Morocco

Lybia

Jordan Syria

0,00

0,20

0,40

0,60

0,80

1,00

1,20

1,40

0,00 0,50 1,00 1,50 2,00 2,50 3,00 3,50

Performance index

Pote

nti

al in

dex

2222

Why so little FDI?Why so little FDI?• Does the current situation with both Does the current situation with both

low performance and low potential and low performance and low potential and with some countries even showing with some countries even showing performance “above their potential” performance “above their potential” suggests that MED have reached an suggests that MED have reached an equilibrium although of low level? equilibrium although of low level?

• What role is played by distortions of an What role is played by distortions of an institutional and policy type that institutional and policy type that economic agents are submitted toeconomic agents are submitted to in in MED? MED?

2323

Determinants of FDIDeterminants of FDI

• pick up the pick up the determinants of FDIdeterminants of FDI flows to a flows to a large sample of host economies: large sample of host economies:

– a gravity model is estimated to this purpose with a gravity model is estimated to this purpose with panel data techniques based on aggregate country-panel data techniques based on aggregate country-level data on level data on bilateral FDI flowsbilateral FDI flows of of fourteen fourteen European countries and two non EU countries European countries and two non EU countries (USA and Japan)(USA and Japan) into a large sample of into a large sample of developed developed and developing partners (84),and developing partners (84), using among the using among the relevant explanatory variables also relevant explanatory variables also institutional institutional and policy factorsand policy factors for the years 1994-2004 for the years 1994-2004

2424

Simulation analysisSimulation analysis• Use these estimates to perform forecasts for FDI flows to both Use these estimates to perform forecasts for FDI flows to both

the single CEECs and Southern Mediterranean countries, the single CEECs and Southern Mediterranean countries, subsequently comparing these estimated flows to actual flows subsequently comparing these estimated flows to actual flows

• For CEECs, the stock adjustment might have already taken place. For CEECs, the stock adjustment might have already taken place. Hence, actual and expected flows should not be strongly Hence, actual and expected flows should not be strongly misaligned.misaligned.

• On the contrary, we would expect that actual capital flows to MED On the contrary, we would expect that actual capital flows to MED are much below the expected flows because the stock adjustment are much below the expected flows because the stock adjustment process still has to take place.process still has to take place.

• However, the current situation although not corresponding to an However, the current situation although not corresponding to an optimum allocation of resources,optimum allocation of resources, might also correspond to an might also correspond to an equilibrium taking into account the distortions of various types that equilibrium taking into account the distortions of various types that economic agents are submitted to in MED (actual flows not below economic agents are submitted to in MED (actual flows not below expected).expected).

2525

Diversion of FDI from MED to Diversion of FDI from MED to CEECs?CEECs?

• Here we use the gravity model to assess Here we use the gravity model to assess whether changes in FDI flows to CEECs whether changes in FDI flows to CEECs which are economically integrating appear which are economically integrating appear to be associated with negative changes in to be associated with negative changes in FDI flows to MED. FDI flows to MED.

• Our methodological approach is based upon Our methodological approach is based upon that of Sapir (1997) who sought to identify that of Sapir (1997) who sought to identify whether a “domino effect” had whether a “domino effect” had characterised the impact of European characterised the impact of European integration upon bilateral trade flows. integration upon bilateral trade flows.

• We experiment by including interaction of We experiment by including interaction of regional dummies with dummy variables for regional dummies with dummy variables for particular sub-periods: 1994-1998 particular sub-periods: 1994-1998 (transition period), 1998-2004 (pre-(transition period), 1998-2004 (pre-accession period) and for years, checking accession period) and for years, checking how regional dummies change.how regional dummies change.

2626

Choice of the model: Choice of the model: underlying theoretical underlying theoretical

reasonsreasons• Why firms produce abroad and face additional costs instead of Why firms produce abroad and face additional costs instead of

simply servicing the markets via exports?simply servicing the markets via exports?• Dunning (1977, 1981), the “Dunning (1977, 1981), the “OLI frameworkOLI framework”, considers FDI ”, considers FDI

as determined by Ownership, Location and Internalisation as determined by Ownership, Location and Internalisation advantages which the MNC holds over the foreign producer. advantages which the MNC holds over the foreign producer.

• The so-called “The so-called “New Theory of FDINew Theory of FDI” takes inspiration from the ” takes inspiration from the OLI approach and refers mainly to the Ownership and OLI approach and refers mainly to the Ownership and Location advantage to introduce MNCs in general equilibrium Location advantage to introduce MNCs in general equilibrium models, where they arise endogenously. models, where they arise endogenously.

• The early literature (Helpman 1984, Helpman and Krugman The early literature (Helpman 1984, Helpman and Krugman 1985) was mainly able to explain ‘vertical FDI’, i.e. 1985) was mainly able to explain ‘vertical FDI’, i.e. investment that takes place in order to take advantage of investment that takes place in order to take advantage of differences in relative factor endowments (hence in factor differences in relative factor endowments (hence in factor prices) across countries.prices) across countries.

2727

Other theoretical Other theoretical explanationsexplanations

• There are also ‘horizontal’ FDI: similar types of production There are also ‘horizontal’ FDI: similar types of production activities, owned by MNCs, taking place in different activities, owned by MNCs, taking place in different countries. This phenomenon is better clarified if countries. This phenomenon is better clarified if multinational activity is not driven by factor endowments multinational activity is not driven by factor endowments differences, but rather by the differences, but rather by the trade-off between proximity trade-off between proximity and concentrationand concentration ( (Brainard 1993; Markusen and Venables , Brainard 1993; Markusen and Venables , 19951995).).

• The The proximity advantageproximity advantage stems from ‘firm-level’ economies stems from ‘firm-level’ economies of scale, whereby R&D activity (or any other type of of scale, whereby R&D activity (or any other type of ‘knowledge capital’) is transferable to affiliates and allows ‘knowledge capital’) is transferable to affiliates and allows MNCs to be closer to the foreign market. MNCs to be closer to the foreign market.

• The The concentration advantageconcentration advantage derives from traditional ‘plant- derives from traditional ‘plant-level’ economies of scale, which make it more profitable to level’ economies of scale, which make it more profitable to concentrate production in one location and then export. concentrate production in one location and then export.

• Whenever the former outweigh the latter, foreign Whenever the former outweigh the latter, foreign investment will take place, and this will be more likely the investment will take place, and this will be more likely the higher are intangible assets relative to fixed costs of higher are intangible assets relative to fixed costs of opening up an affiliate and the higher are transport costs, opening up an affiliate and the higher are transport costs, which are assumed to be positive and an increasing function which are assumed to be positive and an increasing function of geographical distance in this model.of geographical distance in this model.

2828

Gravity modelGravity model• When we get to the empirical analysis, to compare When we get to the empirical analysis, to compare

‘attractiveness’ across countries and explain the geographic ‘attractiveness’ across countries and explain the geographic distribution of FDI we need a model that can pick up all these distribution of FDI we need a model that can pick up all these common determinants.common determinants.

• To synthesise the two approaches discussed above, i.e. To synthesise the two approaches discussed above, i.e. Helpman and Krugman’s treatment of vertical FDI and Helpman and Krugman’s treatment of vertical FDI and Brainard’s of horizontal one, we will include in the model the Brainard’s of horizontal one, we will include in the model the following main variables: following main variables:

• a measure of the ‘economic space’ between the two a measure of the ‘economic space’ between the two countries, given by the sum of the two GDPs and by the two countries, given by the sum of the two GDPs and by the two country’s populations to catch the ‘market-seeking’ aspect of country’s populations to catch the ‘market-seeking’ aspect of FDIFDI

• the relative factor endowments, an index of countries’ the relative factor endowments, an index of countries’ similarity in size measured by their relative GDP. similarity in size measured by their relative GDP.

• additional variables, such as distance, a common language, a additional variables, such as distance, a common language, a common border, or preferential trade agreements, that may common border, or preferential trade agreements, that may reduce the costs (transaction and transportation costs) of reduce the costs (transaction and transportation costs) of locating abroad and which can be introduced via dummy locating abroad and which can be introduced via dummy variables. variables.

• This type of gravity model approach has been already This type of gravity model approach has been already applied to studies of FDI as a means of picking up the applied to studies of FDI as a means of picking up the common determinants of FDI flows across countries (Eaton common determinants of FDI flows across countries (Eaton and Tamura, 1996; Brenton and Di Mauro, 1999). and Tamura, 1996; Brenton and Di Mauro, 1999).

2929

Enlarged gravity modelEnlarged gravity model

• We apply this type of model but we propose a We apply this type of model but we propose a “broad” version:“broad” version:– factors traditionally considered in gravity factors traditionally considered in gravity

models such as proximity and market size models such as proximity and market size should make countries attractive locations for should make countries attractive locations for FDI and should play a decisive role, but …FDI and should play a decisive role, but …

– moving from the consideration that the success moving from the consideration that the success of FDI attractiveness of CEECs was mainly due of FDI attractiveness of CEECs was mainly due to the prospects of EU membership and to the to the prospects of EU membership and to the fact that most CEECs have succeeded in fact that most CEECs have succeeded in attaining both institutional and political stabilityattaining both institutional and political stability

– …….we attempt to explain FDI shortfalls of MED .we attempt to explain FDI shortfalls of MED with a gravity model enlarged to include policy with a gravity model enlarged to include policy and institutional factorsand institutional factors

3030

SpecificationSpecificationln (Bilat FDIijt) = ln (Bilat FDIijt) =

traditional gravity: traditional gravity: ββ0 + 0 + ββ1 ln SUMGDPijt + 1 ln SUMGDPijt + ββ2 ln POPit + 2 ln POPit + ββ3 ln 3 ln POPjt +POPjt +ββ4 lnDiffGDPPCijt +4 lnDiffGDPPCijt +ββ5 ln Distij + 5 ln Distij + ββ6ln Areasij + 6ln Areasij + ββ7 7 LLij+ LLij+ ββ88

Borderij + Borderij + ββ9 Langij + 9 Langij + ββ10 Colonialij + 10 Colonialij +

policy and instit.: + policy and instit.: + ββ11 Regionalijt + 11 Regionalijt + ββ12 ln (IMP/GDP)jt + 12 ln (IMP/GDP)jt + ββ 13 ln (M2/GDP)jt + 13 ln (M2/GDP)jt + ββ 14 ERVijt + 14 ERVijt + ββ 15 CUijt + 15 CUijt + ββ16 Govijt + 16 Govijt + ββ17 FTAijt +17 FTAijt +ββ18 Humcapjt +18 Humcapjt +ββ19 Current + 19 Current + ββ20 Capital + 20 Capital +

regional and time dummies: + regional and time dummies: + ββ21 EUij + 21 EUij + ββ22 MED+ 22 MED+ ββ23 23 CEECs + CEECs + ββ24 YEARDummies 24 YEARDummies

• where: where: i i and and j j denotes donor and host country respectively,denotes donor and host country respectively, t t denotes timedenotes time

• FDIij is the value of the FDI flow from country FDIij is the value of the FDI flow from country i i (home (home country) to country country) to country j j (host country)(host country)

• and the variables are defined as follows: and the variables are defined as follows:

3131

Traditional gravity Traditional gravity variablesvariables

• SUMGDPijtSUMGDPijt is the sum of nominal value of the gross is the sum of nominal value of the gross domestic product in i and j domestic product in i and j

• POPiPOPi and and POPjPOPj, is the population of i and j, is the population of i and j• DiffGDPPCijt DiffGDPPCijt is the absolute difference in per capita is the absolute difference in per capita

income between i and j (a proxy for relative factor income between i and j (a proxy for relative factor endowment)endowment)

• Distij Distij is the Great Circle Distance betweenis the Great Circle Distance between i i and and j j in miles in miles • AreasAreas is the sum of the areas of is the sum of the areas of ii and and jj in square in square

kilometres (hence a proxy for distance within the country kilometres (hence a proxy for distance within the country to the border),to the border),

• LLijLLij is a dummy variable, which is 0 if no countries are is a dummy variable, which is 0 if no countries are landlocked, 1 if one partner is landlockedlandlocked, 1 if one partner is landlocked

• Borderij Borderij is a binary variable, which is 1 if is a binary variable, which is 1 if ii and and jj share a share a border and 0 otherwiseborder and 0 otherwise

• LangijLangij is a binary variable, which is 1 if is a binary variable, which is 1 if ii and and j j share an share an official language and 0 otherwiseofficial language and 0 otherwise

• ColonialijColonialij is a binary variable, which is 1 if is a binary variable, which is 1 if ii colonized colonized jj

3232

Further variablesFurther variables• RegionalijtRegionalijt is a binary variable, which is 1 if is a binary variable, which is 1 if ii and and j j

belong to a Regional Trading Agreement in year belong to a Regional Trading Agreement in year tt • IMP/GDPj IMP/GDPj a proxy for the openness of a country to a proxy for the openness of a country to

foreign tradeforeign trade• ERVijtERVijt is the volatility of the bilateral nominal is the volatility of the bilateral nominal

exchange rate between exchange rate between ii and and jj in period t in period t • CUijtCUijt is a binary variable, which is 1 if is a binary variable, which is 1 if ii and and jj use the use the

same currency at time tsame currency at time t• GovjtGovjt is the sum of six governance indices of is the sum of six governance indices of jj at at tt• FTA FTA is a dummy variable defined as 1 if only one of is a dummy variable defined as 1 if only one of

the countries is in a regional trading agreement (and the countries is in a regional trading agreement (and 0 otherwise) proxi measure of trade diversion 0 otherwise) proxi measure of trade diversion

• Current and CapitalCurrent and Capital are variables coded 1 if host are variables coded 1 if host country has current and capital account restrictions country has current and capital account restrictions respectivelyrespectively

• MEDMED is a dummy variable which is 1 when host is a dummy variable which is 1 when host countries are MED10 countries, countries are MED10 countries, CEECCEEC is a dummy is a dummy variable for belonging to CEEC10, variable for belonging to CEEC10, EUEU is a dummy is a dummy variable for EU membership of i.variable for EU membership of i.

3333

Instability of FDI over timeInstability of FDI over time

• Data on FDI flows at which we are looking here may be considerably biased upward or downward in a particular year

• For instance, a large merger and acquisition deal has taken place or a substantial portion of the domestic corporate sector has been privatized.

• Great instability in the coefficients over time.• Year dummies are introduced to solve this Year dummies are introduced to solve this

problem.problem.

3434

Empirical resultsEmpirical results• Here we present the results of the regression

analysis of bilateral FDI flows by major investing countries over 1994-2004.

• The gravity model introduced is used to define a "normal pattern" of bilateral FDI flows.

• Dummy variables are included for three groups of countries EU, CEECs, MED10 to get a very preliminary test for a possible divergence from this pattern.

• If the corresponding coefficients are significant and negative, we interpret this as evidence that the group has received less FDI than other countries after controlling for all the other factors.

• Therefore, the group concerned can expect to benefit from further large FDI inflows as foreign investors adjust their stocks to the new opportunities created by economic transformation.

• If the dummies are not significant, the future growth of the FDI flows can be expected to be in line with changes in the determinants of FDI.

3535

Determinants IDeterminants I• First focus on few variables at the core of gravity First focus on few variables at the core of gravity

models: sum of GDP (a measure of mass), models: sum of GDP (a measure of mass), Population, Distance (measure of transport and Population, Distance (measure of transport and transaction costs). transaction costs).

• The The “gravity variables”“gravity variables” have all the expected sign: have all the expected sign:• Increased ‘economic space’Increased ‘economic space’ (SUMGDP and (SUMGDP and

Population) have a noticeable impact on FDI. Population) have a noticeable impact on FDI. Elasticity of bilateral FDI with respect to population Elasticity of bilateral FDI with respect to population larger than 1. larger than 1.

• DistanceDistance appears to harm FDI something which is appears to harm FDI something which is more intuitive in the case of exports. However, non more intuitive in the case of exports. However, non linear relationship: squared distance positive. Also linear relationship: squared distance positive. Also ttheory suggests that firms will tend to prefer FDI to exports as trade costs, as proxied by distance, rise. More distant markets will tend to be served by overseas affiliates rather than by exporting.

• Differences in relative factor endowmentsDifferences in relative factor endowments have a have a negative impact on FDI; from the theoretical negative impact on FDI; from the theoretical discussion above one can infer that, on average, EU discussion above one can infer that, on average, EU investors are in general more prone to horizontal investors are in general more prone to horizontal than to vertical FDI. than to vertical FDI.

3636

Regional Dummies:Regional Dummies:

• MED negative and significant at 10%MED negative and significant at 10%

• CEECs positive but not significantCEECs positive but not significant

• EU positive and significant at 1% .EU positive and significant at 1% .

3737

Determinants IDeterminants I

------------------------------------------------------------------------------ ------------------------------------------------------------------------------ Log FDI | Coef. Std. Err. z P>|z| Log FDI | Coef. Std. Err. z P>|z| ---------------------------------------------------------------------------------------------------------------------------------------------------------- Log sum gdp | .1151378 .0075292 -15.29 0.000 Log sum gdp | .1151378 .0075292 -15.29 0.000 Log population host | .8594187 .0551189 15.59 0.000 Log population host | .8594187 .0551189 15.59 0.000

Log population donor | 1.304252 .0645561 20.20 0.000 Log population donor | 1.304252 .0645561 20.20 0.000

Difference of GDP p.c. | -.9031703 .048244 -18.72 0.000 Difference of GDP p.c. | -.9031703 .048244 -18.72 0.000 Distance | -3.99e-07 6.29e-08 -6.35 0.000 Distance | -3.99e-07 6.29e-08 -6.35 0.000 DistanceDistance22 | 2.32e-14 4.06e-15 5.72 0.000 | 2.32e-14 4.06e-15 5.72 0.000 EU | .648041 .1534813 EU | .648041 .1534813 4.22 4.22 0.000 0.000 MED10 | -.5623256 .314175 MED10 | -.5623256 .314175 -1.79-1.79 0.073 0.073 CEEC10 | .0778871 .2526697 CEEC10 | .0778871 .2526697 0.31 0.31 0.758 0.758 _cons | -27.60273 1.496819 -18.44 0.000 _cons | -27.60273 1.496819 -18.44 0.000 ------------------------------------------------------------------------------------------------------------------------------------------------

3838

Determinants II: “enlarged Determinants II: “enlarged gravity”gravity”

• As expected As expected Border, Language, Regional Border, Language, Regional agreement all have positive and significant agreement all have positive and significant effects on FDI levels.effects on FDI levels.

• CU is significant and positive.CU is significant and positive.• FTA not significant effect, indicating that for the FTA not significant effect, indicating that for the

full sample there has been no discernible trade full sample there has been no discernible trade diversion effect of FTAs. diversion effect of FTAs.

• Colonial links not significant too.Colonial links not significant too.• The import on GDP coefficient is also not The import on GDP coefficient is also not

significant.significant.• Volatility of exchange rate is positive and Volatility of exchange rate is positive and

significant:significant: FDI more stable and less risky than FDI more stable and less risky than portfolio and trade activities?portfolio and trade activities?

• Governance is highly significant with positive sign Governance is highly significant with positive sign (very robust variable).(very robust variable).

• Current and capital account restrictions are both Current and capital account restrictions are both negative and highly significant.negative and highly significant.

3939

Regional Dummies:Regional Dummies:• MED no more significant : all the negative MED no more significant : all the negative

difference with respect to other countries difference with respect to other countries seems to be explained by the institutional seems to be explained by the institutional and policy variablesand policy variables

• CEECs after introducing the institutional CEECs after introducing the institutional variables becomes negative and significant: variables becomes negative and significant: the group has received less FDI than other countries after controlling for all other factors..

• EU not significant: EU not significant: the future growth of the FDI flows can be expected to be in line with changes in the determinants of FDI.

4040

Log FDI Coef. Std. Err. z P>z

Log sum GDP .1102201 .0410843 2.68 0.007

Log population host 1.068.686 .0581647 18.37 0.000

Log population donor 1.181.239 .0662389 17.83 0.000

Difference in GDP pc -.3142086 .0527492 -5.96 0.000

Distance -3.24e-07 5.78e-08 -5.60 0.000

Distance squared 1.76e-14 3.69e-15 4.78 0.000

Log area -.2154785 .0396847 -5.43 0.000

Common border .8735025 .3147306 2.78 0.006

Common language .9506041 .3273679 2.90 0.004

Regional integration .293194 .0712112 4.12 0.000

Colonial links .6739344 .4622208 1.46 0.145

Import/GDP .002354 .0017827 1.32 0.187

Exchange rate volatility .223984 .0212081 10.56 0.000

Governance .0687912 .0037609 18.29 0.000

Current account restrictions -.1866332 .0440186 -4.24 0.000

Capital account restrictions -.0811416 .0455017 -1.78 0.075

Currency union .4337308 .0593678 7.31 0.000

FTA .053803 .0513012 1.05 0.294

EU -.1302178 .1475229 -0.88 0.377

MED10 -.306008 .2716849 -1.13 0.260

CEEC10 -.4018635 .218197 -1.84 0.066

_cons -3.325 1.462.512 -22.74 0.000

4141

Simulation Analysis: Simulation Analysis: Actual vs. Expected FDI

• The simulation concerns the expected or The simulation concerns the expected or “normal” FDI flows to each single MED and CEECs “normal” FDI flows to each single MED and CEECs (that would be expected based on the empirical (that would be expected based on the empirical benchmark model described above) compared benchmark model described above) compared with actual FDI flows. with actual FDI flows.

• Our expectation would be that, if the adjustment Our expectation would be that, if the adjustment process was quite fast (slow) FDI flows are above process was quite fast (slow) FDI flows are above (below) the average level of flows expected to (below) the average level of flows expected to countries with comparable attributes.countries with comparable attributes.

• For MED we would expect not to observe a strong For MED we would expect not to observe a strong catching-up effect in the past years in spite of the catching-up effect in the past years in spite of the fact that these economies are underdeveloped as fact that these economies are underdeveloped as compared to average industrialised countries and compared to average industrialised countries and in need to adjust and to catch up too.in need to adjust and to catch up too.

4242

Germany FDI flows to MED: simulated in % of actual

0

50

100

150

200

250

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Morocco Egypt Israel Turkey

4343

Italy FDI flows to MED: simulated in % of actual

0

20

40

60

80

100

120

140

160

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Egypt Israel Morocco Turkey

4444

• The calculations for these four MED The calculations for these four MED indicate that most of them attracted indicate that most of them attracted almost 100% of the total expected FDI almost 100% of the total expected FDI inflows.inflows.

• A downward shift in inflows for Israel A downward shift in inflows for Israel with slight increases for Egypt and with slight increases for Egypt and Morocco. Morocco.

Simulation results by Simulation results by countrycountry

4545

Diversion of FDI from MED Diversion of FDI from MED to CEECs?to CEECs?

• Here we use the gravity model to assess Here we use the gravity model to assess whether changes in FDI flows to CEECs whether changes in FDI flows to CEECs appear to be associated with changes in FDI appear to be associated with changes in FDI flows to MED. flows to MED.

• In particular, we check whether increasing In particular, we check whether increasing CEEC integration over the 1990s, culminating CEEC integration over the 1990s, culminating into the accession for most of them, had any into the accession for most of them, had any noticeable negative impact upon FDI flows noticeable negative impact upon FDI flows from EU countries going to the MED10.from EU countries going to the MED10.

• We experiment by including the We experiment by including the interaction interaction of regional dummies with time dummies of regional dummies with time dummies for for particular sub-periods: 1994-1998 (transition particular sub-periods: 1994-1998 (transition period), 1998-2004 (pre-accession period) period), 1998-2004 (pre-accession period) and for years.and for years.

4646

Results by years:Results by years:• Interaction of regional dummies with Interaction of regional dummies with

time dummies: how they have been time dummies: how they have been changing over two periods (1994-changing over two periods (1994-1998, 1999-2004)? and year by year?1998, 1999-2004)? and year by year?

• Negative and significant dummy for Negative and significant dummy for CEECsCEECs both in 1994-1998 and in both in 1994-1998 and in 1999-2004 (1999-2004 (most years show a most years show a negative and significant dummynegative and significant dummy).).

• For MED negative and significant for For MED negative and significant for the first period the first period but not significant but not significant and positive in the second period (in and positive in the second period (in each year from 1999 to 2003).each year from 1999 to 2003).

4747

coefficient of MED and CEEC dummy interaction with time

-1,20

-1,00

-0,80

-0,60

-0,40

-0,20

0,00

0,20

0,40

0,60

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003MED

CEEC

4848

Diversion of FDI from MED Diversion of FDI from MED to CEECs?to CEECs?

• We find that MED countries in the 1994-1998 We find that MED countries in the 1994-1998 were receiving substantially less FDI than were receiving substantially less FDI than could be expected on the basis of their could be expected on the basis of their incomes and proximity to the EU and to other incomes and proximity to the EU and to other variables. variables.

• However, the magnitude of this However, the magnitude of this ‘underpotential’ weakened in the late 1990s ‘underpotential’ weakened in the late 1990s and in the first half of the 2000s which may and in the first half of the 2000s which may suggest that the enlargement process did not suggest that the enlargement process did not adversely affected the magnitude of inward adversely affected the magnitude of inward FDI from EU countries.FDI from EU countries.

• Hence, our, albeit limited, analysis finds Hence, our, albeit limited, analysis finds no no evidence to suggest that the intensification of evidence to suggest that the intensification of FDI in CEECs, following integration with the FDI in CEECs, following integration with the EU, has had a discernible dampening effect EU, has had a discernible dampening effect on FDI flows going to MED.on FDI flows going to MED.

4949

ConclusionsConclusions The current situation of FDI in MED although does not The current situation of FDI in MED although does not

correspond to an optimum allocation of resources corresponds correspond to an optimum allocation of resources corresponds to an equilibrium taking into account the distortions that to an equilibrium taking into account the distortions that economic agents are submitted to. economic agents are submitted to.

• Rejection of the hypothesis ofRejection of the hypothesis of FDI diversion away from the MED. • FDI in these countries have come down but institutional and institutional and

policy variables the main reason.policy variables the main reason.• It is from the issue of the FDIs that one can best perceive the It is from the issue of the FDIs that one can best perceive the

necessity to modify the business environment and the behaviour necessity to modify the business environment and the behaviour of the enterprises but also the role of anchorage which EU can of the enterprises but also the role of anchorage which EU can play.play.

• During the same period, Eastern Europe offered promising long During the same period, Eastern Europe offered promising long term perspectives on this ground enhanced by the perspective term perspectives on this ground enhanced by the perspective of adhesion which also offered investors a guarantee of of adhesion which also offered investors a guarantee of regulatory and institutional reformsregulatory and institutional reforms

• Industries that faced difficulties (most of the time public ones), Industries that faced difficulties (most of the time public ones), have been privatised and restructured under the impulse and have been privatised and restructured under the impulse and with the help of Europe, a process that did not take place at a with the help of Europe, a process that did not take place at a sufficient scale in the MEDsufficient scale in the MED

• As a result CEECs moved towards a deeper integration not As a result CEECs moved towards a deeper integration not limited to a few tariff evolutions and are progressively adapting limited to a few tariff evolutions and are progressively adapting their legal framework and their practices to international their legal framework and their practices to international standards standards