Ebook Foreign direct investment financing of capital formation in central and eastern Europe
The positive impact of foreign direct investments (FDI) on transition economies has been widely acknowledged. First, FDI is an important source of financing for transition economies as it helps to cover the current account deficit, fiscal deficit (in case of privatisation-related FDI), and supplements inadequate domestic resources to finance both ownership change and capital formation. Second, compared with other financing options FDI also facilitates transfer of technology, know-how and skills, and helps local enterprises to expand into foreign markets.
This paper addresses the following question: how important is FDI in financing capital formation in transition countries, relative to the other forms of enterprise financing (domestic and foreign credit, capital market financing, and state subsidies)? The potential importance of FDI for capital formation in transition countries is highlighted by the need to replace large amounts of obsolete capital accumulated during years of central planning in the environment lacking an efficient financial sector. (See Section 2 for a brief survey of the literature looking at other features of FDI in transition countries, including analyses of determinants of FDI and the general impact of FDI on the economy.)
The role of FDI in financing capital formation is not clear-cut. The definition of foreign direct investment is focused on the source of capital with little regard to its use (Graham, 1995). Indeed, Lipsey (2000) finds little evidence of FDI having an impact on capital formation in developed countries and shows that the most important aspect of FDI in the selected sample of countries is related to ownership change.
The observation about the unclear relation between FDI and capital formation may also hold in the transition countries. The take-over of an enterprise, particularly through privatisation, may lead to a strong FDI inflow but the proceeds may not be used for enterprise investment purposes. There are, however, cases of take-overs where a part of associated FDI inflows is used for capital formation, e.g., partial privatisation through a capital increase or privatisation with a capital formation component of the sale contract.
Greenfield investments have usually a strong link between FDI and capital formation, although even in this case there is not a one-to-one relation. Lastly, privatisation revenues may have an impact on the country's gross fixed capital formation through state capital expenditures, e.g., in infrastructure projects or state owned enterprises, without a direct link to the enterprise originally subject to FDI flows.
There is also a lagged effect which concerns the capital formation in enterprises already benefiting from the presence of a foreign investor without direct involvement of funds from this investor. Besides providing own funds, foreign investors may implicitly or explicitly increase the credit ratings of the company and enable it to access previously unavailable external financing sources. Most enterprises in transition countries face a credit constraint as they lack a track record of operating in a market economy and the presence of a strategic investor may change this situation.
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