Privatization, Foreign Direct Investment and Export Performance: Evidence from Transition Economies

Privatization, Foreign Direct Investment and Export Performance: Evidence from Transition Economies Empirical examination of exports of Central Europe...
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Privatization, Foreign Direct Investment and Export Performance: Evidence from Transition Economies Empirical examination of exports of Central European EU candidates to EU markets sheds new light on the intricacy of links between the ‘troika’ of privatization, FDI inflows, and integration into international markets. It also provides a strong empirical support against fears that opening to FDI might lead to a catastrophic relocation of domestic industries and erosion of the potential for growth. With liberal trade policies and business environment friendly to both domestic and foreign firms, FDI is a powerful agent of economic development and integration. A wellconceived privatization program may in turn contribute to their inflows. The choice of a method of privatizing large state-owned enterprises (SOEs) as well as government willingness to open the ‘strategic’ sectors to foreign investors appears to have had a profound impact on change in composition of exports. In brief, an active search for outside investors based on following liberal policies pays off in terms of improved competitiveness in higher value-added products. This is a general conclusion that can be drawn from the analysis of three Central European countries—Czech Republic, Hungary and Slovenia. These three countries have a lot in common. Skills of their workforce are comparable. They have all dramatically liberalized their respective economic regimes. They are superbly located, bordering with the EU. The quality of their physical infrastructure is similarly good. They are all signatories of the European Association Agreements with the EU. They are also among countries chosen by the European Commission to be among first-wave of Eastern Enlargement of the EU. Their trade policy towards the EU and other preferential partners bears strong similarity. They have all been moving at a similar pace to dismantle all barriers to trade in industrial products with their European partners by 2001. Yet, there are significant differences in terms of export performance in EU markets. Approaches to privatization varied… Transfer of property rights is the single most important institutional issue faced by former centrally planned or “market socialism” economies. Each has approached it differently. The major differences boil down to the method of privatization of large SOEs and the scope of privatization. The variation has reflected idiosyncratic legacies of central planning and Yugoslav ‘market socialism.’ Hungary, which inherited high external debt and sought foreign exchange to service it, has adopted (a) a very friendly attitude towards foreign investors, (b) sought to sell large SOEs on case-by-case basis to outside investors, and (c) quickly opened services to privatization mainly by foreign firms. Slovenia represents the other extreme vis-à-vis Hungary. Since the external debt was low, there was little, if any pressure to generate extra foreign exchange revenue. The legacy of

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“market socialism” with its diluted ownership structures and politics built around the notion of negotiated consensus has favored the management-employee (insider) method of privatization. In the absence of controls on managers provided in highly developed economies by welldeveloped product and capital markets, insiders tend to keep out the outsiders including foreign investors. In contrast to Hungary, Slovenia has been very reluctant to open its financial and telecommunication services to foreign penetration. Czech Republic had none of legacies peculiar to Hungary and Slovenia. Its foreign debt was low, but unlike Slovenia its economic system was that of non-reformed central planning with strong central controls. Its privatization strategy was two-pronged: around 350 large firms—in which investors, domestic and foreign alike, expressed interest—were sold using conventional case-by-case methods; and the reminder of large and medium firms were privatized through the mass voucher privatization program. For firms privatized through vouchers, the shift to strong corporate governance and thus efficiency gains would depends on effective capital markets. The lack of transparent regulatory framework of capital markets and weak protection of shareholders rights is an obstacle to foreign investment (especially portfolio investment) as well as to restructuring and sound management. These symptoms have been present in the Czech Republic. … and so did FDI inflows Different approaches to privatization have contributed to different FDI inflows. Hungary, which actively searched outside investors, stands out among transition economies in terms of attracting large flows of FDI. The Czech Republic with its two-pronged strategy follows, while insider privatization in Slovenia turned out to a significant barrier. During the early stages of the transition in 1990-93, Hungary absorbed 45 percent of FDI inflows to 25 countries of the former Soviet Union and Central and Eastern Europe. Its share in these flows subsequently fell over 1994-97, once other transition economies have become attractive for foreign investment. But in terms of annual flows in respect to GDP Hungary has remained the top recipient each year over 1990-97. Hungary’s edge over other FDI recipients is even larger when cumulative FDI inflows are assessed against GDP (Table 1). With annual FDI inflows amounting since 1991 on average to around 5 percent of the GDP, their cumulative value is equal to 33% of the GDP, around 2 times more than in Czech Republic.

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Table 1: FDI inflows to Czech Republic, Hungary and Slovenia in terms of value and share in GDP, 199097 and total 1990

1991

1992

1993

Czech Republic

207

400

600

564

Hungary

311

1,462

1,479

Slovenia

0

0

111

1994

1995

1996

1997 Total, 1990-97

762

2,568

1,435

1,300

7,836

2,350

1,144

4,519

1,986

1,785

15,036

113

84

170

178

300

956

(in million of US dollars)

(in terms of share in GDP)

Total in 1997GDP

Czech Republic

0.66

1.64

2.14

1.82

2.12

5.46

2.65

2.62

15.78

Hungary

0.98

4.56

4.11

6.28

2.85

10.54

4.57

3.95

33.30

Slovenia

0.00

0.00

0.90

0.90

0.58

0.90

0.95

1.55

4.92

Source: Global Development Finance 1997, Vol.2, World Bank, Survey of Europe 1997/99, United Nations ECE 1998, and Monthly Bulletin, Bank of Slovenia, various issues

Why has Hungary been more successful than other transition economies in attracting FDI? Structural reforms and sound macroeconomic fundamentals are clearly necessary conditions to attract capital flows. But it appears these general characteristics would fail to explain, for instance, why the Czech Republic or Slovenia has attracted less FDI although they both scored higher than Hungary in terms of inflation (lower) and debt stock (lower). Hungary has succeeded in turning a liability—a huge international debt at the outset of its fullfledged transition to competitive markets—into an asset. It had made a strategic decision not to seek rescheduling. The acute demand for foreign exchange needed to service debt had two implications: First, there was no national debate over alleged dangers of foreign penetration as in Slovenia or the Czech Republic. Second, balance-of-payments considerations have given an extra incentive to establish a relatively transparent legal system and implement privatization policies favoring sales to the highest bidder, no matter whether domestic or foreign. Last but not least, the principle of national treatment was quickly extended to foreign investors even in areas traditionally regarded as strategic (e.g., telecommunication, energy and utilities). Privatization, especially of strategic sectors, has contributed significantly to FDI inflows. These accounted for 43% of FDI in Hungary over 1991-97. Sales of equity in national telecommunications companies were responsible for the 1993 and 1995 peaks in FDI flows to Hungary and the Czech Republic respectively. Privatization of several strategic sectors including energy, public utilities, banking with foreign participation contributed to another Hungarian peak in 1995. The Czech Republic has yet to implement a similar program, while Slovenia has erected legal barriers to foreign ownership. FDI help in integrating into world markets… This conclusion can be drawn from the following: First, the more FDI a country a country has attracted, the faster growth of exports it has experienced. Over 1993-97 exports from the three countries grew at impressive rates—the ranking conforms to that in terms of the value of FDI stock. The same was in exports to the EU. Between 1993 and 1997 the value of Hungarian exports increased by 132%; Czech by 103%; and Slovenian exports by 43%.

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Second, the more FDI a country has attracted, the larger was change in its EU-destined export basket. Although the share of manufactures increased in exports of three countries, by all measures, the largest change occurred in the Hungarian export basket, followed closely by that in the Czech export basket. Given the relatively high quality and degree of scientific education in three countries, one would expect their increasing specialization in sophisticated engineering goods, i.e., technology and human capital intensive products. Indeed, this shift seems to have occurred. All countries expanded their exports of these products faster than of unskilled labor intensive and natural intensive products. But again the fastest growth came from Hungary. The value increased from US $3.1 billion in 1993 to US$ 8.9 billion in 1997, or by 281% (Figure 1). Hungary overtook Czech exporters, while Slovenian exports slightly contracted in terms of value. Figure 1: Exports of technology- and human capital-intensive products to EU, 1993-97 10

(in billion of US dollars)

9 8 7

Slovenia

6 5

Czech Republic Hungary

4 3 2 1 0

1993

1994

1995

1996

1997

Source: Own calculations based on data from the UN COMTRADE database.

FDI seem to have contributed to a significant change in patterns of specialization. Again Hungarian exports have recorded the largest change as captured by the revealed comparative advantage index assessed against EU markets. Although with a lower GDP per capita than the Czech Republic or Slovenia, Hungary’s revealed specialization in these markets is now in both technology and capital intensive products, i.e., the values of revealed comparative advantage index (RCA) are above unity. In defiance of predictions by critics of MNCs, Hungary has also experienced the largest shift away from specializing in unskilled labor intensive products. At the other extreme, Slovenia’s EU-destined exports have undergone the smallest change. It continues to specialize in skilled and unskilled labor intensive products with the former category registering the largest increase (Table 2).

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Table 2: Indices of Revealed Comparative Advantage in 1997, and change between 1993 and 1997 Czech Republic Relative Factor Intensity Group RCA, 1997

Hungary

Slovenia

Change (%) RCA, 1997 Change (%) RCA, 1997 Change (%)

Natural Resource Intensive

0.54

-29

0.50

-44

0.46

0

Unskilled Labor Intensive

1.54

-2

1.08

-39

1.94

-6

Technology Intensive

0.99

57

1.16

55

0.58

14

Human Capital Intensive

2.20

25

1.52

48

2.70

20

Source: Own calculations based on data from the UN COMTRADE database.

Is there a direct link between FDI and export performance? Evidence is abound and compelling. Consider the following. Among medium and large firms in Hungary there are no purely Hungarian-owned private companies. The share of foreign-owned firms in Hungarian exports increased from 37% in 1992 to almost 80% in 1997. Over the same period the value of exports more than doubled, hence the growth came mainly, if not only from firms with foreign capital. Between 1995 and 1997 the value of Czech exports of manufactures increased by 18%. Excluding non-electric and electrical machinery and transportation equipment, there was no increase. All the increase came from new (or revamped) industrial capacities mainly in the automotive sector. This sector absorbed more than 10% of total FDI. Its flagship company, Skoda-Volkswagen, accounted for 7% of Czech exports to the EU. The value of these exports increased over the 1995-97 period of sluggish growth by 127 percent! Moreover, SkodaVolskwagen’s Czech suppliers, having gone through intensive restructuring, are now exporting to other Volkswagen plants through Europe. They have been responsible for the expansion in exports of motor vehicle parts, whose share in total EU-destined exports rose from 1 to 4 percent over 1995-97. … and have several advantages over domestic mode of integrating into world markets The discussed country-studies show that integration through FDI has several obvious advantages. First, it has provided domestic companies with access to top-quality corporate governance, managerial techniques, marketing expertise, and capital. Second, foreign owned firms have been in a good position to develop linkages with their counterparts in the EU and elsewhere. This has had two major advantages: firms could forego expenditure on breaking into foreign markets, which can be sizable; and they realize economies of scale thanks to greater product specialization in differentiated products. Second, FDI has made a crucial contribution to the development of intra-industry trade. Integration based on intra-industry trade, as opposed to inter-industry trade, yields several benefits to a national economy. It is the fastest growing component of international trade thus providing a good base for sustainable growth. It tends to be much less vulnerable to swings in business cycle than inter-industry trade, thus assuring a higher degree of stability. Last but not least, intra-industry trade, in contrast to inter-industry trade, does not produce such significant inequalities in regional development and income distribution. This trade does not involve

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relocation of whole industries. In consequence, specialization in differentiated products associated with inter-industry trade poses fewer adjustment problems than inter-industry trade. Third, although indirect effects related to restructuring and productivity spillovers are difficult to capture, competition from foreign firms and their more stringent quality requirements has resulted in improved performance. FDI contribute to the development of forward (cost) and backward (demand) linkages between firms. Fourth, beyond contributing to the development of forward and backward linkages among firms, MNCs contribute to integration of domestic production capacities into global networks of production and distribution. Last but not least, surveys conducted in these countries show that firms with foreign participation are more profitable and more foreign trade oriented than those solely locally owned. Policy implications While the prospect of EU has been a powerful magnet for FDI, the variation in inflows seems to point policies as explaining it. Hungary’s success has broader implications: §

An active policy to attract FDI pays off in terms of expanding export offer and moving up the value-added spectrum. FDI beget exports, growth and more investment. The policy, however, should not consist in offering special concessions (subsidies) to foreign investors.

§

Liberal foreign trade and investment regimes are the most important condition to attract FDI. Although the three countries have liberal foreign trade regimes (at least for around 80% of their imports, i.e., those coming from preferential trading partners), the differentiating factor is investment regime.

§

Privatization of large SOEs to an outside investor, although more time consuming, is clearly a better method than privatization to insiders.

§

Privatization of strategic sectors including services (banking, insurance, and telecommunications) to outside investors establishes an environment attracting FDI in other sectors and facilitating international trade. This should be carried out quickly and short-term fiscal revenue considerations should not be the major criterion.

This note is based on Bartlomiej Kaminski, “Foreign Trade and FDI in Hungary and Slovenia: Different Paths— Different Outcomes,” Transition, The World Bank and The William Davidson Institute, December 1998. Slovenia. Trade Sector Issues, PREM ECSPE, The World Bank, September 29, 1998

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