Foreign direct investment and employment in transition economies

The pattern of FDI inflows

FDI inflows to the entire transition region relative to unemployment are shown in the Illustration. FDI responded very slowly to the transition process before experiencing a very sharp increase from around 2003; despite setbacks following the recession in 2008, relatively high FDI continued to flow into the region as a whole. Unemployment rose steadily to 2001 and has since been falling. However, as seen in Figure 1, in 1990–2014, there were sharp differences in FDI inflows between the four regions. FDI increased earlier in the EU membership group and rose to higher levels.

These inflows were significant for growth, representing a large proportion of total domestic investment or gross fixed capital formation (GFCF). For example, among EU members, Slovakia received more than one-third of GFCF via FDI between 2000 and 2007; Bulgaria received more than 50% of GFCF via FDI between 2003 and 2008, with a maximum of 99%! In contrast, FDI to Russia has been modest, given the scale of the host. Even so, FDI represented more than 10% GFCF after 2003, reaching more than 20% in peak years.

The other two regions, FSU and Central Asia, showed a similar pattern to Russia, but at lower rates of FDI, though even these inflows were often large as a share of GFCF, exceeding 50% in many years in Kazakhstan, Uzbekistan, and Azerbaijan.

Direct effects of FDI on output and the labor market

FDI and unemployment

If FDI to the transition economies increases output, one might also expect to see it lead to a reduction in unemployment. However, the theoretical predictions are less clear-cut in this case because FDI is usually associated with enterprise restructuring, which, because firms under socialism were state-owned and had substantial overemployment, is likely to involve substantial reductions in employment [9], [10]. This is especially true if the bulk of FDI came into the transition countries via acquisitions of inefficient former state-owned firms through privatization.

As noted in the Illustration, unemployment rose in the 1990s, presumably due to the impact of enterprise restructuring on labor markets. Figure 3 reports FDI inflows against (average) unemployment for each of the four regional groupings where the picture is rather more uneven. The pattern of inverse correlations between FDI and unemployment seen among the region as a whole broadly holds for the group of EU members; the decline in unemployment starts at the end of a long gradual period of rising FDI, perhaps when the most important employment effects from restructuring are complete. Unemployment is at its lowest levels when FDI reaches its peak, and the rise in unemployment after 2008 closely follows the pattern of decline in FDI. A similar pattern of inverse correlation is seen in Central Asia, where a period of low FDI and high unemployment is followed by one of higher FDI and much reduced unemployment levels.

However, the trend seen in the other former Soviet and Balkan countries, suggests that the process of restructuring takes much longer and is less reliant on FDI than for the EU members [10]. It is difficult to discern any relationship between FDI and unemployment rates in Russia, perhaps because FDI is driven more by the resource cycle. Regression analysis on these data reveals that FDI in one year significantly reduces subsequent levels of unemployment. Thus, it can be concluded that FDI does act to reduce unemployment in the transition economies.

FDI and institutional change

It is often argued that FDI inflows and institutional change will be closely related, though the causality is not necessarily straightforward. The evidence suggests that foreign investors will enter economies with stronger institutional arrangements because their investments will likely be better protected from expropriation or corrupt practices and their ability to earn profits will be enhanced [5]. However, the logic may also run the other way; foreign engagement in the economy may lead to domestic political and economic pressures to improve institutional arrangements. Stronger institutions will also likely be associated with better functioning labor markets [9].

The EBRD has developed a series of indicators of institutional quality for transition economies and data have been collected for the entire transition period. Figure 4 displays the average score for each of the four regional categories from 1991–2014 against FDI inflows.

In aggregate, improvements in transition scores predate the upswing in FDI; institutional improvements in the 1990s laid the foundation for FDI from around 2000. The relationships shown in Figure 3 offer some evidence for this. FDI into EU countries rises sharply some seven years after the transition index stabilized at quite a high level, and FDI into Central Asia and Russia rises steeply some ten years after the increase in transition scores. However, in the FSU, FDI begins to rise quite early, already in 2001, while transition scores remain rather low. It is notable that institutional quality and policy environments are not always tightly related, especially in resource-rich economies like Russia and Central Asian countries.

Regression analysis confirms the above interpretation, showing that FDI responds positively, but with a lag to the transition scores. This suggests that policies to improve the institutional environment covered in the EBRD transition indicators, namely governance—liberalization, privatization, trade and exchange rates regime, and competition policies—had positive effects on FDI, and through that on growth and employment.

Indirect effects of FDI on the labor market

One major survey summarizes the empirical literature on the indirect effects of FDI on the labor market [10]. It finds that privatization to outside owners resulted in 50% more restructuring than privatization to insiders (current managers or workers). Foreign ownership was found to produce significantly more restructuring than privatization to domestic owners, especially for EU members. In the FSU, privatization to foreign owners typically yielded a positive effect, while privatization to domestic owners typically generated a negative one. Turning to employment, the authors identified 17 studies that examined the effect of ownership on employment; they found a marked tendency for privatized firms with foreign owners to increase employment relative to firms with state ownership. As such, FDI via privatizations can be seen as a leading factor generating enterprise restructuring in transition countries, especially amongst the EU members. While FDI via privatization to foreign owners may also have contributed to unemployment in the transition economies initially (as seen in Figure 3), it also enhanced competitiveness in the longer term, probably driving the later rises in output and declines in unemployment.

During the socialist era, the transition economies had become isolated, falling behind the Western world when it came to key technologies, skills, and capabilities. FDI served as an important mechanism for catching up. In particular, recipient economies could be stimulated through spillover effects from FDI, which diffuse more productive methods throughout an economy via access to advanced technology, systems, skills, training, and management, all of which can act to raise firms’ total factor productivity [2], [3]. Furthermore, rising productivity levels may contribute to improved international competitiveness, allowing the host economy to increase exports and improve their balance of payments, potentially alleviating international finance constraints to economic growth and increasing demand for labor [9].

It is usually argued that positive spillover effects from FDI derive from the diffusion of technology and knowledge between foreign entrants and domestic incumbents [2]. Demonstration effects represent an important channel for knowledge diffusion; they occur, for example, when local firms upgrade their technologies or adopt similar organizational practices to mirror more productive foreign companies [3], [8]. Furthermore, domestic entrepreneurs may also recognize the market potential of innovations introduced by foreign firms.

Labor mobility is another important mechanism that enables the diffusion of superior technology, skills, and know-how from foreign to local firms [3]. A local workforce that was previously trained and employed by foreign-owned firms might possess better skills when they accept jobs in local enterprises, or they may choose to exploit these skills through entrepreneurship. Finally, foreign investors can help domestic firms compete better in the global economy. Thus, exposure to FDI can positively influence the export decisions of existing domestic firms or help local entrepreneurs to identify export market opportunities.

However, while there is positive evidence about spillovers for particular countries, notably some EU member states such as the Czech Republic, the overall findings from FDI in transition economies are ambiguous. Of five studies specifically covering the transition region, three reveal positive spillovers, while two others find negative effects [9]. This variation is probably explained by differences in two main factors: integration to the global economy, e.g. EU membership, and the quality of institutions.

The benefits that host economies can gain from spillover effects depend on their ability to absorb the knowledge and skills being generated by foreign investors. The previous studies indicate that the scale and direction of FDI’s impact on the host economy are conditional on factors such as the quality of institutions and the levels of human capital and financial market development [9]. Thus, while the expectation is for positive effects, the host economy and domestic firms may not have the “absorptive capacity” necessary to raise their productivity to the levels attained by their new foreign competitors; the technological gaps may be too large, the incentives too weak, and the availability of human capital too limited for competitive processes to raise domestic performance [3], [8], [11]. The latter problems are characterized by shortages of key skills, including managerial ones, and deficiencies in technical education and training [8]. Thus, for FDI to produce the greatest benefits for national economic performance, institutions must be strong—especially with regard to the rule of law and freedom from corruption—and the level of human capital must be high enough to facilitate the transfer of knowledge.