Foreign direct investments and their institutional quality factors in Romania and Bulgaria.

AuthorRadulescu, Magdalena
PositionReport

Introduction

There is a wide range of factors which attract foreign direct investments (FDI). The first category includes traditional financial and economic factors, such as tax rates, monetary conditions, market size of the host country, growth potential, purchasing power, cost of production, geographic location and natural resources. The second category includes factors that are related to the political, social and cultural environment of the host countries. While the macroeconomic determinants of FDI have been analyzed to a considerable extent in past empirical work, the role of the institutional factors such as protection of property rights, political stability, educational levels and efficiency of the legal system has been underexplored (Gwenhamo, 2011).

The impact of taxation of FDI has been widely studied, and the results have varied. A series of studies elaborated for the European countries suggests that taxation has a relatively low impact on FDIs as a result of a reduced influence of taxes on relocation costs (Edmiston, Mudd, and Valev, 2003). Leibrecht and Bellak (2005) or Bellak, Damijan and Leibrecht (2009) in their studies elaborated for the Central and Eastern European countries concluded that corporate income tax is a key factor in location decisions of foreign companies and it is as important as the labor cost factor or as the infrastructure. Benassy-Quere, Fontagne, and Lahreche-Revil (2001) studied the sensitivity of FDI to the tax rates for 11 OECD countries over the period 1984-2000, and they concluded that tax rates play a significant role in investment location for FDIs.

In Romania and Bulgaria, the peak of FDI inflows was reached in 2007-2008. Once the crisis erupted, these two countries were faced with large outflows, even if the fiscal environment remained very friendly (see more on various fiscal policy measures during the current economic crisis in Duma, 2015). Bulgaria has the lowest corporate income tax (10%) in the entire European Union (EU), while Romania has the second lowest corporate income tax of 16% among the EU countries. Even after overcoming the crisis and regaining their positive economic growth rates, they were unable to attract large FDI inflows anymore. Therefore, lowering the tax was not a successful strategy in the long-run for both countries mentioned above. That is why we believe it is important to study the impact of non-traditional quality factors on FDI inflows in those two countries

However, we must state that the entire EU was severely hit during the crisis in terms of FDI inflows. Compared with the record peaks reached in 2007, inward flows decreased eight-fold in the entire EU during 2008-2010 (Eurostat, 2011), so Romania and Bulgaria are no exceptions. FDI inflows increased in the EU in 2011, then they dropped again in 2012, and only in 2013 the FDI inflows went up slowly, by 12 % (Eurostat 2014). In the Central and Eastern European region, only Hungary and the Czech Republic regained substantial FDI inflows after 2011, while Romania and especially Bulgaria could not attract large FDI anymore (Eurostat 2014).

Even though Bulgaria has adopted a very liberal legal framework for FDI, the organized crime in business and the bureaucracy have resulted in Bulgaria "lagging behind" when compared to the other Central and Eastern European (CEE) countries in terms of FDI (Glaister and Atanasova, 1998). An extensive discussion on bureaucracy and reforming the civil sector can be found in Abashidze & Selimashvili's recent study (2015).

As origins of the institution-based view, Richard Scott (1995) defined institutions as "regulative, normative, and cognitive structures and activities that provide stability and meaning to social behavior." In this framework, economists have mostly focused on formal laws, rules and regulations (La Porta, Lopez-de-Silanes and Shleifer, 2008 cited in Peng et al., 2009).

The profound differences in institutional frameworks between emerging economies and developed economies force economists to pay more attention to these differences (Li and Peng, 2008; Zacharakis, McMullen and Shepherd, 2007). Recent research shows that, in developed economies, firm-specific effects are more critical in explaining the variation in foreign subsidiary performance (just like in the classical view of the economic literature) and, in emerging economies, country effects are more important (just like in the institutions-based view) (Makino, Isobe and Chan, 2004).

The aim of this paper is to stress mainly the influence and impact of the political institutional quality determinants on FDI (political stability, rule of law, governance effectiveness, regulatory quality, control of corruption, property rights), and also the influence of infrastructure index, share of educated work force of total population and the share of the research and developments expenditure of GDP on FDI. The infrastructure quality index is an economic institutional quality determinant of FDI. The study was elaborated for Bulgaria and Romania with a dataset of 1999-2014 values. We elaborated regressions to underline the impact and the influence of each factor mentioned above on FDI inflows in Bulgaria and Romania. The results are important for shaping some policy recommendations in the conclusions section.

Section 2 presents some literature findings regarding this issue of this paper, section 3 presents the methodology elaborated for measuring the impact of these factors on FDI and the results and section 4 concludes the paper.

Literature review

There is an increasing appreciation that formal and informal institutions significantly shape the strategy and performance of firms in emerging economies (Wright, Filatotchev, Hoskisson, & Peng, 2005--cited in Peng et al., 2008). If the institutional nature of the determinants shaping the framework where the corporations act is not fully understood in emerging economies, the corporate governance reform policies may become irrelevant. An institution-based view can help firms in the emerging economies enhance their competitiveness. The companies need to know more about the framework and the rules abroad (Peng et al., 2008).

It is clear that developments in the institutional framework have been essential in reducing the uncertainties for firms. These innovations support institutions that promote cooperative activity (through the legal enforcement of contracts), institutions that provide incentives for investment in human capital and institutions that increase the incentives for innovation (patents). The incentives that determine people to cooperate include both formal incentives set by management, and informal norms and values (Dunning and Lundan, 2008a; 2008b).

Various factors shaping FDI have been analyzed in the academic literature. For the impact of the political stability on FDI inflows, Jaspersan et al. (2000) and Hausmann and Fernandez-Arias (2000) found no relationship between FDI and political stability. Schneider and Frey (1985) found an inverse relationship. Loree and Guinsinger (1995) found that political risk had different effects in USA in different years. Busse and Hefeker (2007) show that government stability, absence of internal conflict, and basic democratic rights are significant determinants of FDI inflows.

Infrastructure quality is positively related to FDI flows as many authors showed (Wheeler and Moody, 1992; Kumar, 1994; Loree and Guinsinger, 1995). Asiedu (2002) studied the impact of the infrastructure quality for African countries. There is no impact in Sub-Saharan Countries, whereas the impact is positively related in Non-Sub-Saharan Countries. Bellak et. al (2009) showed on a panel on eight CEE countries (data 1995-2004) that a good infrastructure may compensate for high corporate income tax.

Wheeler and Mody (1992) elaborated an early study of foreign investment determinants, and found that infrastructure quality is an important determinant, while fiscal taxes are not significant for FDI, but many other researches argued that taxation is as important for FDI as the economic and political institutional factors (Bellak et al., 2009; Williams, 1997).

From a policy perspective, it would appear that the right approach by governments concerned with attracting foreign direct investment is to lower corruption and keep taxes low but to maintain investment in infrastructure rather than using revenue for consumption expenditures. Infrastructure improvements, corruption, and taxes display a similar significance (Goodspeed et al., 2006).

Assiotis and Sylwester (2010) found that the effects of controlling corruption are much better in authoritarian regimes than in democracies, on a panel of 119 political regimes (1984-2007). Corporate governance practices, together with business integrity and governmental anti-corruption efforts, can counter-balance the commercial and political corruption over time (Boubaker and Nguye, 2014). The impact of corruption experience on the anti-corruption trust has been studied by Babos (2015), who found that it varies across countries with different cultural backgrounds. The impact of corruption has also been studied by Wei (2000a, 2000b); Wei finds significant negative effects of corruption. Because corruption acts as a tax on enterprises, it raises costs and reduces incentives to invest. The same results were achieved by Mathur and Singh in 2013 when they pointed out that for Asian host countries (except for China) a rise in corruption acted the same as a rise of the income tax. They stressed that foreign investors care about economic freedoms (property rights index), rather than political freedoms (regulatory quality index and the rule of law index) in Asian countries such China and Singapore. The control of corruption has no perceptible effect on trade and FDI flows, when the other political institutional variables are included; when included separately it has a positive significant effect...

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