Central and Eastern Europe – the failure of FDI fueled growth

In 1989, more than three decades ago, the Iron Curtain fell, ending Communist rule in Central and Eastern Europe, followed by the collapse and dissolution of the Soviet Union. At that time, the peoples of the region looked to the future with optimism: it was a widely accepted idea that freedom from oppression would also bring prosperity, a way of life similar to that of people living west of the continent. . Then, joining the European Union after 2004 propelled those dreams forward, as joining one of the most developed blocs in the world was to bring economic convergence with the West.

The results are somewhat bittersweet. All of these countries in the region succeeded in partially closing the wealth gap with the West, but this convergence was not at all homogeneous. Moreover, it has also been slower than expected: even after 30 years, none of the post-communist countries has reached the average level of development of the EU.

Due to the relative lack of capital and advanced technologies, which characterized post-communist countries at the time of transition, they chose to rely heavily on foreign direct investment (FDI), i.e. long-term investment, factories and subsidiaries of foreign companies, mainly from the West to achieve convergence. These FDI projects were supposed to be a remedy for all these problems: they promised the region substantial capital inflows as well as advanced production and management processes that would propel long-term economic growth. The FDI model was also encouraged by the European Union accession process – privatization and facilitation of FDI inflows were important aspects of what the EU was considering to assess Bloc membership. Thus, all countries in the region have focused on attracting as much FDI as possible.

In the 2010s, however, it became increasingly clear that the post-transition growth model was not delivering the results everyone had hoped for. Foreign companies locating in the region operate mostly as enclaves, integrating themselves little or not at all into the local supply chain ecosystem, but instead using their own well-established relationships with their suppliers. They generally import their raw materials and also export their finished products abroad. Thus, the trickle-down effects – whether in terms of know-how, capital or even business relationships – of these Western companies are very limited and can positively affect local companies. Consequently, a dual economic system has developed in which efficient foreign firms coexist with much less efficient local firms. In other words, the economic development of these countries does not currently depend on the degree of innovation and efficiency of their companies, but rather on the number of jobs and relatively low added value that they can attract from foreigner.

A huge amount of studies have been devoted to possible solutions to the above situation. There seems to be a broad consensus around the assertion that a competitiveness strategy giving priority to the development of the quality of institutions could be the solution to the problem of the “middle income trap”. Estonia is a positive example that has managed to create high quality institutions which, in turn, propel growth generated by local businesses instead of FDI. For example, the country has put a lot of emphasis on modernizing its government administrative services, a huge project called e-Estonia: since 2002, every citizen has had a digital ID that allows them to do almost everything online, from payment of taxes to vote. This is only one of the pillars but a good tangible example of institutional reforms.

The overall processes above are very useful to understand when considering investing in businesses in the region. The basic situation of the region is positive: it is part of the European Union, some countries have the euro and it has an educated and relatively cheap labor force. Monitoring the evolution of the governance situation in the various countries of the region could be of benefit to long-term investors. In the event that a series of positive reforms are formulated in a country, local businesses may merit further consideration.

Disclaimer: This article was posted by Tamas Jozsa, Research Analyst at Calamatta Cuschieri. For more information visit,www.cc.com.mt. The information, views, and opinions provided in this article are provided for educational and informational purposes only and should not be construed as investment advice, advice regarding particular investments or investment decisions, or tax advice. or legal.

Mary I. Bruner