REGIONAL DETERMINANTS OF FOREIGN DIRECT INVESTMENTS IN CROATIA.

• Author: Kersan-Skabic, Ines

1. Introduction

   Financial globalization is characterized by capital movements that in the last thirty years have become increasingly liberalized (especially among developed countries and European transition countries) and which in 2012 reached $1.35 trillion despite the turmoil in the global economy (UNCTAD, 2013). In the group of developing countries which represents half of the total Foreign Direct Investments (FDI) are the countries of Central and Eastern Europe and of Southeast Europe. These countries are competing with each other in attracting FDI, and their successes are dependent on a number of economic and political factors.

   There are a number of different types of location-specific advantages that characterize motifs for FDI: resource-seeking, market-seeking, efficiency-seeking or strategic asset-seeking. Efficiency-seeking FDI implies a production movement to places where there are lower input costs. In this way a firm can improve its competitive position. Market-seeking investment aims at achieving foreign market proximity and it determines whether it is better to export to a particular market (that incurs transportation costs) or to move production to this market and in this way supply this market.

   In the literature relating to FDI, there is a lot of research on the determinants of FDI inflows and such analyses were done mainly at the country level or groups of countries. These studies explain the dependency of FDI on market size, market growth, barriers to trade, wages, production, transportation and other costs, political stability, psychic distance, the host government's trade and taxation regulations affected the location decisions (Dunning, 1992; Dunning, 1993; Kinoshita and Campos, 2002; Markusen, 1998; Markusen and Venables, 1998; Brainard, 1997; Blonigen, 2005).

   Far less research relating to the determinants of the attractiveness within a particular country has been carried out. Every country has areas/regions that are lagging behind the average level of economic development and all such regions aim to create conditions for economic growth and employment that could result in convergence to the most developed parts of their countries. To reach this goal it is crucial that regions open their economies and connect with foreign partners, as this is the only way they can access new technologies, knowledge, and a wider market which are preconditions for their future development (Balasubramanyam, Salisu and Sapsford, 1996). At the same time it is important to point out that while FDI cannot solve the problems of a region, it can serve as a supplement to other measures to stimulate the economy.

   Why are some regions more attractive than others within the same macroeconomic, institutional and legal framework? Regions differ from each other in many characteristics, such as: size (area and population), economic development, and the sectors (industries) that dominate in their economies. In the case of small countries, foreign investors are probably not drawn to the market of individual regions but the countries and geographic areas to which a certain country belongs. Wage levels can vary slightly among regions within a country. Economic development and the effectiveness of institutions are usually monitored at the country level although there are differences in the functioning of institutions within a country. The legal framework is often preferential (tax exemptions or reduced tax rates) for investments in less attractive and less developed areas, but in the main this does not result in greater investment. The capital city effect can also be observed, where the high concentration of population and activities are attractive to foreign investors.

   Croatia, as a small Southeast European country needs foreign investments in the expectation that they will act as a push-factor to the domestic economy. According to data from Croatian National Bank (2014), Croatia received 24.2 billion euros in the period from 1993 till the end of 2012, which is a very large amount of FDI in per capita terms--6,049 euros. About 90% of total investments in Croatia come from the EU-27. In the group of Central and East European countries only three countries: Estonia, the Czech Republic, and Hungary have received a greater amount of FDI per capita.

   The aim of the empirical study in this paper is to identify the determinants of FDI in Croatian NUTS 3 regions (1) that could be of interest in attracting FDI on a regional level in Croatia in the future, looking from the side of foreign investors in the EU and abroad, as well as from the perspective of Croatian national and regional policy makers.

   FDI in Croatia is mostly directed towards the service sector, with a predominance of the financial sector (banking and non-banking) with 34% of the total investment which together with the insurance and tourism sector represent the biggest share of FDI. There is also evidence of unequal distribution of FDI among Croatian regions. A huge proportion of FDI is located in City of Zagreb (72% of total FDI), followed by Primorje-Gorski Kotar county (6.5%) and Split-Dalmatia county (5%) (Croatian National Bank, 2013). It should also be pointed out that FDI in Croatia is prevailingly brownfield investments with only a modest amount of greenfield investments.

   In Croatia there is a uniform law for the promotion of foreign investment that provides greater benefits for investors in less developed counties (tax benefits) and the benefits depend on the amount of investment and the number of new jobs created. Incentive measures are regulated by the Act on Investment Promotion and Enhancement of the Investment Environment (Official Gazette of Republic of Croatia, no. 111/12 and 28/13). In the framework of regional development it is useful to consider the incentives that are connected with the county's development. The first incentive concerns the county unemployment rate: if the unemployment rate is 10-20% (over 20%) the incentive for capital expenses is a cash grant in the amount of 10% (20%) of the eligible costs of investment for: construction of a new factory, production facility or tourist facility and the purchase of new machines, i.e. production equipment. (2) The second regional incentive concerns the City of Vukovar and areas of special state concern and they are focused on the implementation of reduced profit taxation. (3)

   The hypothesis of this paper is that there are many factors, such as workforce characteristics (level of education, labor costs), the geographical position of the region (close to the EU market), and the development of the region that affect the attractiveness of the Croatian regions to foreign investors.

   Therefore, this paper aims to contribute to the existing literature in several ways. At the beginning of our study, we found two papers that explore the regional determinants of FDI inflows in Croatia (Skuflic and Botric, 2009; Derado, Skudar and Rakusic, 2011). Skuflic and Botric (2009) applied econometric analysis, where the analysis was performed in the period up to 2007, however, Croatia recorded the highest FDI inflows in 2008 (over 4 billion EUR). We will show what determined the total foreign investments in Croatian regions in the period 2000 to 2010 and we will make several models where we will use different panel data estimators. We will apply panel data analysis to find out which of the variables have a significant positive or negative influence on FDI flows among Croatian regions. Static and dynamic analysis will be carried out. The analysis will include relevant and accessible information in a way that the obtained models will give the best possible explanation of FDI determinants in the Croatian regions.

   The paper is organized as follows: the following section presents the literature review, the third section describes the data, the methodology of analysis and presents the results and the final section gives the concluding remarks.

2. Literature review

   Location determinants are very broad concepts and they include traditional factors such as natural resources availability (prices, infrastructure), the size of the market (living standards, wages, production costs), the macroeconomic environment (inflation, unemployment, interest rates, GDP growth rates) and institutional factors (property rights, FDI incentives, bilateral trade/investment agreements, taxes, etc.). A comprehensive framework of FDI attractiveness has been made by Dunning (1992) who introduced the eclectic paradigm (also known as the OLI paradigm). Jordaan (2005) points out that modern theory includes macro and microeconomics determinants in seeking to give a complete picture of the location of FDI. The type of FDI is connected with the development stage of the host country. This explains why most FDI inflow in developing countries is resource (natural resources, raw materials, or low-cost inputs such as labor) and market-seeking. Manea and Pearce (2001) highlight the importance of knowledge-seeking as a motive for FDI.

   Furthermore, some authors (Kinoshita and Campos, 2002; Menghinello, De Propris and Driffield, 2010, Pelegrin and Bolance, 2008) emphasize the agglomeration effect of existing FDI--the self-reinforcing effect of FDI stock. FDI is found to agglomerate more often than regular financial investment partly because FDI is a long-term capital investment that is irreversible in the short term.

   Institutional development is also important in the attractiveness framework (North, 1991; Globerman and Shapiro, 2002; Pournarakis and Varsakelis, 2004; Bevan and Estrin, 2004; Rodrik, Subramanian and Trebbi, 2004). Institutional weaknesses, frequent changes in laws and inefficiency of public administration, may cause a weak inflow or the absence of FDI inflows. The inclusion of institutions in relation to FDI inflows is particularly important for developing countries, because developed countries have strong institutional frameworks conducive...