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FOREIGN DIRECT INVESTMENT IN TRANSITION ECONOMIES
AND EUROPEAN UNION MEMBERSHIP:
THE CASE OF HUNGARY AND POLAND

Kristin K. Howell
Associate Professor

Department of Economics and Finance
University of North Carolina at Wilmington

601 South College Road
Wilmington, NC 28403

(910) 962-3606

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ABSTRACT

FOREIGN DIRECT INVESTMENT IN TRANSITION ECONOMIES
AND EUROPEAN UNION MEMBERSHIP:
THE CASE OF HUNGARY AND POLAND

Inflows of foreign direct investment (FDI) to the Transition Economies in Central and
Eastern Europe and the Baltics have been relatively low since the fall of the iron curtain.  This
variable is considered one of the most important to international technology transfers and, thus,
economic growth.  Along with other crucial characteristics of a country, such as monetary stability
and open trade policies, a Ahealthy@ growth rate of real GDP per capita is a prerequisite to
membership in the European Union.

There is now somewhat of an uneasy relationship and even resistence to expansion between
the European Union and the Transition Economies.  They have been unofficially categorized into
several tiers according to their readiness for membership, with the Czech Republic, Estonia,
Hungary, Poland, and Slovenia leading the pack.  Some already have special agreements in place. 
Most of these countries have borrowed heavily in the past from the Bank for International
Settlements, the World Bank, the IMF, and bilateral and private sources.  In theory, these loans were
meant to promote monetary and economic stability and eventually, access to private international
capital markets and growth.

There is some disagreement in the literature as to the effects of bilateral and multilateral aid
on foreign direct investment.  The goal of this study is to compare the effectiveness of the use these
countries, specifically Hungary and Poland, made of their short and long-term loans from a variety
of sources.  Impacts on FDI will be examined in order to judge the progress that has been made
towards free markets, economic recovery, and European Union membership.  The conclusions are
of interest to lenders and policy makers.

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FOREIGN DIRECT INVESTMENT IN TRANSITION ECONOMIES

AND EUROPEAN UNION MEMBERSHIP:

THE CASE OF HUNGARY AND POLAND

INTRODUCTION

There have been unprecedented developments in Eastern Europe and the Baltics since the

late 1980's and there are now several tiers of transition economies, defined according to their

potential as future European Union (EU) members.  To qualify, they must, as candidates have in the

past, meet certain criteria concerning appropriate and stable inflation rates, budget deficits,

government debt, interest rates, and exchange rates.  The five countries that seem the most likely to

have their EU membership applications accepted within two years are the Czech Republic, Estonia,

Hungary, Poland, and Slovenia (see Table 1).  Although they are the most economically advanced,

many problems remain, such as the slow pace of privatization, inflation, currency devaluations, and

low per capita income levels.  These countries have also borrowed to varying degrees from

multilateral (International Monetary Fund (IMF) and World Bank (WB)), bilateral, and private

sources, especially after 1989.  Flows of aid, among other variables, have been found to positively

affect inflows of foreign direct investment (FDI) to some degree, which is one of the stimuli of

economic growth and, thus, future EU membership.

OBJECTIVES

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The future success of the EU depends in part on continued and expanded access to capital

markets, which hinges on existing debt of members.  Official and private loans to EU membership

applicants over the years were meant to promote monetary and economic stability and the ability

to attract international capital and, thus, to support smooth flows of trade and finance.  This study

considers the potential effects of transition economy borrowing from a variety of sources on foreign

direct investment inflows, an indicator of technology transfers, competitive strength, and confidence

in a country=s future development and success.  Other variables that reflect the ability of the

countries to enter and benefit the EU, such as interest rates, exchange rates, real GNP per capita,

export volume, inflation (CPI), and total debt service, were also included.

The Human Development Index (HDI), developed by the United Nations, measures the level

of poverty of a nation, or its economic well-being.  It includes real growth (per capita GDP),

education, and longevity and is also considered when making judgements about a country=s

prospects as an EU member.  The results of the overall study varied, as expected, due to the unique

nature of these nations, the use each made of the funds, and the soundness of domestic policy.

LITERATURE REVIEW

Much has recently been written concerning the benefits and costs of eastward expansion of

the EU on both current and potential members (van Brabant, 1998).  Future membership of

transition economies depends on the resolution of a variety of economic and political problems (Neal

and Barbezat, 1998).  Some authors have also questioned whether there are any real prospects of

integrating these countries into the EU, due to the possible negative effects on the latter=s average

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income and growth performance (Baldwin, Francois and Portes, 1997).

Aid (with appropriate conditionality) is frequently discussed as exerting a positive effect on

liberalization, stability, foreign direct investment, and thus, growth (Tsikata, 1998).  Adherence to

IMF programs, for example, may reflect lower investment risks and inspire confidence in the

sustainability of economic policies, often opening the door to other private and public loans (Fischer,

1997).  Positive spillovers of increased FDI may also include increased exports, which improve the

ability of the country to repay debts and lower its total external debt (World Bank, 1999).

External financing has also been viewed though, as a constraint on growth and development,

due to increased ability to import (Bird and Rowlands, 1997).  Thus, the importance of appropriate

conditionality leading to sound domestic economic policies make lender adjustment program reforms

an ever more critical issue.  If aid can promote FDI, which can successfully be channeled to

contribute to competition and international technology transfers that the recipient country can adopt,

positive economic effects are possible (Gastanaga, Nugent, and Pashamova, 1998 and Olofsdotter,

1998).  This success depends on the ability of transition economies to overcome, in many cases,

political resentment against foreign investment and slowed privatization efforts and, thus, encourage

confidence in host country policies (Sinn and Weichenrieder, 1997).

THE MODEL

The empirical work in this paper involves Afirst tier@ potential EU members chosen based

on the availability of consistent data (1980-1997), namely Hungary and Poland.  FDI was chosen

as the dependent variable because it is widely regarded as an economic indicator of technology

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inflows, investment confidence, and thus, growth potential, given Aappropriate@ domestic policies.

 FDI is defined by the WB as Ainvestment that is made to acquire a lasting management interest

(usually ten percent of voting stock) in an enterprise operating in a country other than that of the

investor (by residency), the investor=s purpose being an effective voice in the management of the

enterprise.  It is the sum of equity capital, reinvestment of earnings, other long-term capital, and

short-term capital as shown in the balance of payments.@  The independent variables included

multilateral lending (IMF and WB) with conditions to reform, bilateral loans between the

governments, and private sources of funds (usually commercial banks without adjustment programs).

 Other variables were real GNP per capita, exports, exchange rates, interest rates, prices (CPI),

population, and the total debt service to exports ratio.

All debt represents external obligations of the public sector or private debt that is guaranteed

by the public entity.  It is in the form of millions of dollar flows or disbursements, or the amount of

aid a country received in a given year.  IMF credit represents repurchase obligations with respect to

all uses of IMF resources, excluding those resulting from drawings in the reserve tranche.  Bilateral

lending represents loans from governments, including from central banks and direct loans from official

export credit agencies.  Debt from private creditors includes bonds and commercial bank lending, as

well as credits from manufacturers, exporters, and other suppliers of goods with no related domestic

economic restructuring programs.  All data used was from The World Bank Debt Tables and IMF

International Statistics.

The coefficients in the following equation were originally estimated for each country using

Time Series Processor (TSP) for ordinary least squares (OLS) regression analysis:

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RFDIt = _0 + _1IMFt-1 + _2WBt-1 + _3BILATt-1 + _4PRIVt-1

_5XGSt-1 + _6 ER + _7 INT + _8 CPI + _9POP + _10TDS

_11RGPCt + _t

where RFDI = real foreign direct investment, IMF = IMF lending, WB = World Bank lending,

BILAT = bilateral lending, PRIV = private lending, XGS = real annual export volume in millions, of

dollars, ER = the exchange rate (foreign currency per dollar/period average), INT = annual demand

deposit interest rate, CPI = consumer price index, period average, POP = mid-year population

estimate in millions, TDS = total debt service to exports ratio (debt service ratio), RGPC = real GNP

per capita, and _ = randomly distributed white noise error term.

Lending variables were initially lagged one year because IMF and WB agreements usually

take at least a year to negotiate, implement, and exhibit results, while other variables may impact the

economy more quickly.

The null hypothesis is that there is no significant relationship between the different flows

of lending, the other domestic variables, and real foreign direct investment.  It was expected that

various forms of lending, coupled with Aappropriate@ conditionality and domestic reforms would,

over an intermediate time period (one to three years), promote capital inflows and, thus, economic

strength.

A test for autocorrelation properties (error terms not randomly distributed) revealed a

nonstationarity problem and the need for first differencing of the dependent variable.  These results

indicated autoregressive components in the series and, thus, the need for AR terms in the least

squares equation to account for the autocorrelation (correct for serial correlation of disturbances)

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found in the models and to provide efficient estimates.  First differencing is also a method for dealing

with multicollinearity (explanatory variables related).

RESULTS

The regression results (with computed t-statistics in parentheses below the estimated

coefficients and the number of lags for each variable in parentheses beside the estimate) are presented

in Table II.  The calculated Durbin Watson statistic was compared to the Durbin=s h statistic

(required when any form of the dependent variable (AR) is used as an independent) and was found

to be nonsignificant at the .05 level, reflecting freedom of the residuals from first order serial

correlation.

IMF lending had a significant and positive effect on real foreign direct investment in

Hungary.  Apparently, during this test period (1980-1997) Hungary was able to take advantage of

IMF funds, which increased dramatically between 1991 and 1995, and adjustment programs within

a very short time and improve its prospects for development.  For Poland these results were

negative, probably due in part to the fact that Poland only borrowed from the IMF between 1990

and 1994.  It may also be that the one period lag was not enough time for Poland to use these funds

appropriately or that the amount or the conditionality were inappropriate.

WB lending showed mixed results, with positive impacts in Poland (loans began only in

1990).  The WB effect was nonsignificant in Hungary, despite many years of consistent borrowing.

 Bilateral lending also reflected mixed effects (positive in Hungary and negative in Poland) on real

FDI by the first year.  Private sources of credit proved to have positive effects in Hungary and

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nonsignificant impacts in Poland.  Nonsignificance may indicate inadequate  amounts of funds, large

debt ratios, and appreciation pressures of increasing inflows of foreign investment on the currency

value.  The funds may have been channeled into areas other than export promotion and reflect the

overregulation of the government of the private sector.

Other variables showed mixed results depending on the level of development and domestic

economic and political policies.

CONCLUSIONS

It may be concluded that development financing through the IMF, the WB, and bilateral and

private sources has affected the growth potential of these central European countries in most cases.

 In Hungary, IMF, bilateral, and private lending had positive effects on FDI, an important indicator

of the success of aid and the stage of development. Only loans from the WB during this period did

not impact FDI flows significantly.  Much of the literature has found positive links between IMF

stabilization programs, investment flows, and growth.  The positive results for bilateral loans may

have been due to the small volume of the funds needed, domestic stability, and open trading policies

already in existence.  The confidence that aid inspired in the private capital markets apparently led

to international investment inflows that contribute to technology, competition, and growth.  After

years of negative or slow growth, Hungary showed strong GDP growth of 5.2% in 2000, although

absolute GDP was still below its 1989 level.  Its debt service ratio has been dramatically higher than

Poland=s for many years, although reduced quite a bit in 1999 (26.6%).  In the last few years,

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Hungary has managed to attract more foreign direct investment than any other East European

country, due mostly to privatization advances and other economic reforms.

In Poland, only WB loans produced a positive link to FDI inflows, while IMF and bilateral

lending actually made negative impacts.  The WB focus is usually on structural reforms and on

reducing an inward orientation to trade.  Positive results may reflect that the resources were used

efficiently in terms of amounts, timing and for the Aappropriate@ development projects, given the

country=s state of development.  Negative IMF results suggest too Aharsh@ conditionality or

negative spillover effects.  The negative impact of bilateral lending may support criticisms of bilateral

loans lacking any enforcement of domestic reforms and for having political motivations.  Despite the

negative IMF relation to FDI, Poland was attracting a larger volume of FDI than Hungary by 1999.

 This may be due to great strides in privatization, a relatively stable currency, low debt service, and

 GDP growth (4% in 2000) encouraging confidence in an open investment climate.  Poland=s HDI

rank (38 out of 174 countries in 1999) is somewhat higher than that of Hungary and rose more

rapidly in comparison to Hungary=s level of improvement (standard of living).

Other explanatory variables also yielded mixed, and often surprising, results, probably due

to the extremely divergent economic and political conditions in the countries.

It is therefore not possible, as usual, to conclude that all aid contributes positively to FDI

and growth.  Development impacts of loans and adjustment depend on socio-economic structure and

the nature of the stabilization program.  The recipient government must be willing and able to put

the funds to efficient use and overcome resentment towards foreign direct investment, which slows

privatization.  Varying maturities, timing of disbursements, realistic exchange rates, and types of

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exports also play a role.  It must also be kept in mind that real FDI alone is not an adequate predictor

of the country=s progress and success potential as an EU member.

In general though, the Central and Eastern European countries, especially Hungary and

Poland, have shown dynamic progress with potential for continued growth.  Membership in the EU

should prove beneficial to these nations by reducing investment risks and raising real incomes.  Much

of their progress so far has been driven by the prospect of joining and thus, the need to adhere to the

EU=s requirements.  Criteria for joining the EU have been objective and strict, most recently

including budget deficits, government debt, inflation rates, long-term interest rates, and exchange rates

to be held to specific maximums or margins.

It is important to continue efforts to cooperate internationally to achieve long-term reforms,

such as those related to open trade policies, export development, debt service reduction, and

increased flows of technological know-how.  Improved financial market access and consistent private

investment growth, often linked to multilateral loans, are important for successful transitions to

market economies and EU membership.  Decisions of policy makers and official and private lenders

that result in efficient and humane use of funds depend on understanding these effects.

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T
A

B
L

E
 I – B

A
S

IC
 C

O
U

N
T

R
Y

 F
A

C
T

S
 – 1997 &

 1999

H
U

N
G

A
R

Y
1999    1997

P
O

L
A

N
D

1999   1997
C

Z
E

C
H

 R
.

1999   1997
E

S
T

O
N

IA
1999   1997

S
L

O
V

E
N

IA
1999   1997

H
D

I R
A

N
K

*
36

47
38

44
33

36
44

54
29

33
G

N
P

 per cap
(U

S
$)

11,430
2,372

8,450
1,926

13.018
3,329

8,355
2,984

15,977
4,350

D
E

B
T

 S
E

R
V

IC
E

R
A

T
IO

*
*

26.6
29.7

20.4
6.1

10.3
14.1

13.2
1.4

5.8
3.9

U
N

E
M

P
L

O
Y

M
E

N
T

R
A

T
E

7.1
8.7

13.9
11.5

8.8
4.7

12.3
10.0

9.2
7.1

E
X

P
O

R
T

S
(%

 O
F

 G
D

P
)

53.0
45.0

26.0
26.0

64.0
58.0

77.0
77.0

53.0
57.0

N
E

T
 F

D
I

(m
il. O

f $) as %
 G

D
P

4
4.7

9.6
5.8

.9

*
U

.N
. H

um
an D

evelopm
ent Index (H

D
I) rank out of 174 countries – all im

provem
ents over

previous years
**  D

E
B

T
 S

E
R

V
IC

E
 R

A
T

IO
 (debt service as %

 of exports of goods and services)

S
O

U
R

C
E

S
:    U

.N
. H

um
an D

evelopm
ent R

eport 2001

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TABLE II - OLS REGRESSION RESULTS
dependent variable: real FDI, 1980-1997

INDEP. VAR. HUNGARY POLAND

CONSTANT -45.49
(-8.01)

13.05
  (3.52)

IMF    .11
        (2.17)**

-1.38(-1)
(-2.68)**

WB NA         1.58(-1)
    (1.58)*

BILAT       .24
          (4.92)***

           -.003(-1)
       (-3.65)***

PRIV         .05(-1)
          (5.61)***

NA

XGS NA       .005
        (3.58)***

ER NA      -.001
       (-2.83)***

INT     1.33
          (8.06)***

NA

GNP NA            -.001(-1)
       (-2.60)***

AR (1)
MA(1)

    -.85
    -.94

   -.68

R2       .88     .68

F  18.67   5.64

t stats:    *** = signif. at 1%,   ** = at 5%,   * = at 10%
NA = nonsignificant variable

22



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