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The Effect of Treaties on Foreign Direct InvestmentBilateral Investment Treaties, Double Taxation Treaties, and Investment Flows$

Karl P. Sauvant and Lisa E. Sachs

Print publication date: 2009

Print ISBN-13: 9780195388534

Published to Oxford Scholarship Online: May 2009

DOI: 10.1093/acprof:oso/9780195388534.001.0001

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New Institutional Economics and FDI Location in Central and Eastern Europe *

New Institutional Economics and FDI Location in Central and Eastern Europe *

The Effect of Treaties on Foreign Direct Investment

Robert Grosse (Contributor Webpage)

Len J. Trevino

Oxford University Press

Abstract and Keywords

This chapter demonstrates that institutions matter in the context of foreign direct investment (FDI) in the transitional economies of Central and Eastern Europe (CEE). It employs the new institutional economics (NIE) as a theoretical foundation and applies related concepts in an examination of FDI activity that may respond to institutional development in CEE. It shows that the flow of FDI into the transitional economies of CEE tends to follow patterns similar to those in other emerging markets, with the added dimension that institutional factors appear to play a larger role than elsewhere. In particular, bilateral investment treaties, the degree of enterprise reform, and repatriation rules tend to stimulate FDI, while political risk and the level of corruption in government tend to constrain FDI into these countries. This outcome provides strong support for this reasoning based on the new institutional economics.

Keywords:   foreign direct investment, institutions, transition economies, CEE, emerging markets


The goal of this chapter is to demonstrate that institutions matter in the context of foreign direct investment (FDI) in the transitional economies of Central and Eastern Europe (CEE). We employ the new institutional economics (NIE) as a theoretical foundation and apply related concepts in an examination of FDI activity that may respond to institutional development in CEE. Within this context, FDI is expected to respond to country-level macroeconomic, microeconomic, and institutional changes, especially institutional factors that reduce (increase) uncertainty and/or costs related to long-term capital investments. This approach follows Rumelt, Schendel, and Teece (1991) in utilizing tools from both economics and strategic management to facilitate understanding of FDI decision-making.

It is well understood that firms entering a new market must adapt their overall strategies to environmental conditions in the host country (Hymer 1976; Kindleberger 1969). Along these same lines, as governments in transitional economies battle for larger shares of global FDI flows, there is increasing evidence that they have adapted their institutional environments1 in order to attract inward FDI (Meyer 2001). Although institutional hurdles2 exist in all countries, for emerging markets and economies in transition, the evolution of market-based institutions is a critical hurdle (Clague 1997; Meyer 2001). Economic transition involves replacing one governing framework with another and, in the case of CEE, this transition involved replacing a socialist system with an institutional framework consistent with a market economy. Since efficient markets depend (p.274) on market-based supporting institutions (North 1990), all of the CEE countries have pursued transition strategies from state control toward open markets. Some of the adjustments associated with the installation of a market economy have been implemented more rapidly than anticipated, while others have lagged, partially determined by the manner in which state socialism disintegrated in a given country.3

Within the broad theoretical framework of institutional theory, normative, cultural-cognitive, and regulatory systems have all been identified as being useful approaches. The normative approach specifies how things should be done, and normative systems define goals or objectives but also suggest legitimate means by which to pursue them (Scott 2001). The cultural-cognitive approach recognizes that internal interpretive processes are shaped by external cultural frameworks. In fact, it has been proposed that cultural dimensions are the cognitive frameworks in which social interests are defined (Douglas 1982). The regulatory framework involves the capacity to establish rules, to determine who has conformed to such rules, and, as necessary, to manipulate sanctions to influence behavior (Scott 2001).

Although each of these three dimensions of institutional theory provides a basis for analysis—the cultural-cognitive dimension from an anthropological perspective, the normative dimension from a sociological perspective, and the regulatory dimension from an economic perspective—we focus on the regulatory environment and use the new institutional economics as a theoretical foundation for our study.

The new institutional economics focuses on the intersection of institutional environments and firms that results from market imperfections (Harris, Hunter, (p.275) and Lewis 1995). North (1990) posited that institutions provide the rules of the game that structure interactions in societies and that organizational action is bound by these rules. A central focus of NIE is the reduction of costs associated with transactions, in this case those related to FDI decision-making and implementation. This perspective emphasizes that firms incur costs when they undertake business transactions, such as the cost of obtaining information and writing and enforcing contracts. According to NIE, firms are a particular form of organization for administering transactions between one party and another, and firms exist because they may be able to reduce the costs of negotiating and enforcing terms and conditions of exchange relative to market transacting (Coase 1937). Under the managerial-choice approach of NIE (Williamson 1975, 1985; Walker and Weber 1984), managers employ a transaction-cost-economizing calculation when making contracting decisions. North (1990) suggests that the efficiency of political institutions may be measured by how closely an actual political market approximates a zero transaction cost result.

In the case of the multinational enterprise (MNE) and FDI decision making, presumably the better the institutional environment is able to approximate zero transaction costs for the foreign investor, the more likely the country is to receive inward FDI flows, ceteris paribus. Thus, one way to understand the intersection of MNE investment strategy and the institutional environment in transitional economies is to analyze the ability of institutions to reduce transaction costs associated with FDI that result from uncertain environments (Hoskisson et al. 2000).4 This requires an investigation of differences in institutional models across countries and their effects on inward FDI flows.

In the case of transitional economies, the cost of establishing FDI is high (Meyer 2001). In fact, Estrin, Hughes, and Todd (1997) found that inefficiencies in developing economies led to substantial extra costs and delays for foreign investment. In addition to the normal costs associated with conducting business in a foreign country, foreign firms entering transition economies may face increased levels of uncertainty resulting from high inflation, opaque regulatory environments, underdeveloped judicial and financial systems, and corruption. All of these elements increase the costs associated with FDI in the host country; and according to Coase (1937), when it is costly to transact, institutions matter.

Although the new institutional economics has been studied widely in developed countries, there is a dearth of theoretical and empirical research using an institutional framework in emerging economies. Furthermore, because the new institutional economics has been applied primarily in developed markets, less is (p.276) known about the institutional environment–FDI decision-making interface in emerging economies (Hoskisson et al. 2000). Due to the degree and abruptness of political and economic change in transitional economies, such environments may provide an excellent framework for advancing the empirical study of the new institutional economics.

We examine the extent to which institutional reform in CEE has resulted in reduced uncertainty and costs associated with long-term capital investment, ultimately impacting FDI inflows in 13 CEE countries. These countries comprise Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Russia, Slovakia, Slovenia, and the Ukraine. The formerly centrally planned economies of CEE provide a particularly noteworthy region for studying institutional reform and its impact on inward FDI. As evidence, between 1990 and 2000, inward global FDI stock increased at an average rate of about 12.8% per annum. During this same period, inward FDI in developing countries increased at an average annual rate of 21.3%. However, since 1990, inward FDI in CEE increased by an average annual rate of 33.0% (UNCTAD 2001).5 Although the FDI stock in CEE has increased 4,063% between 1990 and 2000, there is high variability among host country recipients6 (see Figure 1). The initial surge in FDI into this region was quite volatile, with absolute declines in 1994 and 1999, and with rapid growth often occurring before and after. The pace of both market-seeking and cost-reducing direct investment slacked off noticeably after the Russian financial crisis of 1998, and has not resumed its initial growth path to date (see Figure 2). Abrupt or incremental changes in institutional reform variables, resulting from the shift from state control to open markets, coupled with significant movements in inward FDI flows, provide another rationale for the present study.

A. Literature review and hypotheses

1. New institutional economics and FDI

We argue that, while the new institutional economics is not a unified theory, it does provide the basis for theoretical constructs to demonstrate that “institutions matter.” We have identified five such constructs—corruption, regulation, investment treaties, privatization, and political risk—that demonstrate that governmental institutions matter in FDI (p.277)

                      New Institutional Economics and FDI Location in Central and Eastern Europe                                               *


Source: UNCTAD World Investment Reports

decisions. Evidence that supports these measures of institutional dimensions as affecting FDI decisions will thus support the broader proposition that the new institutional economics offers a useful framework for understanding these decisions, beyond the traditional economic, political, and financial dimensions.


Corruption may be defined as acts in which the power of public office is used for personal gain in a manner that contravenes the rules of the game (Jain 2001); thus, corruption is one element of a country’s institutional environment that may act to deter or attract FDI. The existence of corruption requires three factors to co-exist. First, someone must have discretionary power to design regulations and to administer them. Second, there must be economic rents associated with this power and identifiable groups must be capable of

                      New Institutional Economics and FDI Location in Central and Eastern Europe                                               *


Source: UNCTAD World Investment Reports

(p.278) capturing these rents. Third, the legal/judicial system must offer sufficiently low probability of detection and/or penalty for violation (Jain 2001). Kaufman and Wei (2000) found that there is a positive relationship between the preponderance of bribery in a country and the time that international managers have to spend with bureaucrats. In this context, corruption is analogous to a tax because it raises the cost of doing business (Jain 2001). When corruption is a key factor in the policy environment, these considerations place companies’ FDI at risk or force investors to incur higher costs to reduce this risk. Seen in this light, corruption may affect resource allocation by altering foreign investors’ perception of the host country environment. While corruption is not limited to the formerly communist countries, it has been much more of a factor there than in other settings. Because recent studies have found that increases in host country corruption levels reduce inward FDI (Hines 1995; Wei 2000), we posit that firms will incorporate this variable into their FDI decision-making process, ultimately influencing FDI levels in the host country.

Hypothesis 1: The greater the host country’s success in reducing corruption, the lower the foreign investor’s uncertainty and costs associated with long-term capital investment, resulting in increased inward FDI.


Foreign investment regulations and changes in those regulations are one element of a country’s institutional environment that may influence inward FDI flows by increasing uncertainty and FDI-related costs. In principle, firms seek full ownership of FDI, no restrictions on profit repatriation or capital controls, adequate protection on technology transfer, and well-defined property rights. In CEE, firms face a complex web of legal rules and procedures, all of which have the potential to increase costs. Prior to the demise of the Soviet Union, FDI into these countries was highly regulated, and generally was limited to minority joint ventures and long-term cooperation agreements. Along these lines, Contractor (1990) found that these styles of government-imposed regulations and performance requirements tended to limit certain types of FDI.

Although the degree of controls placed on foreign investors in CEE countries declined significantly during the 1990s, the amount of regulation did differ across countries. We posit that these decreasing regulations may act to reduce uncertainty and costs for foreign investors, ultimately influencing inward FDI flows.

Hypothesis 2: The greater the success in institutional reform in the host country, as proxied by decreased foreign investment regulations, or by increased enterprise reform (European Bank for Reconstruction and Development index of enterprise reform), the lower the foreign investor’s uncertainty and costs associated with long-term capital investment, resulting in increased inward FDI.


The adoption of bilateral investment treaties (BITs) can be considered one of the elements of institutional reform that has helped to foster the perception that the formerly centrally planned economies of CEE (p.279) are moving toward market-based economies. Since World War II, many BITs, under the auspices of the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (World Bank), have been enacted in order to provide protection for foreign direct investors. BITs generally offer investors additional and higher standards of legal protection and guarantees for foreign investments beyond those offered under national laws. In fact, BITs often have provisions for the avoidance of double taxation of income and capital. Thus, from the perspective of the new institutional economics, a BIT may act to signal a favorable investment climate.

During the 1990s, the number of BITs quintupled, rising from 385 at the end of the 1980s to 1,857 at the end of the 1990s (UNCTAD 2000). The number of BITs between developing countries, between developing countries and countries in Central and Eastern Europe, and between Central and Eastern European Countries increased from 63 at the end of the 1980s to 833 by the end of the 1990s. In an investigation of market reform and FDI in Latin America, Trevino et al. (2002) found a significant and positive relationship between the number of host country BITs and inward FDI. In a related study, Heinrich and Konan (2001) found that preferential trade areas with low individual trade costs see increased investment due to a more integrated market. We propose that BITs may act as an instrument for the international protection of foreign investment, thereby reducing uncertainty and FDI-related costs, while at the same time signalling to foreign investors that the host country has undertaken institutional reforms toward building a market economy. This may imply that BITs are playing an increasingly important role in the proliferation of international investment.

Hypothesis 3: The greater the number of host country bilateral investment treaties, the lower the foreign investor’s uncertainty and costs associated with long-term capital investment, resulting in increased inward FDI.


Privatization of state-owned enterprises is considered one of the fundamental elements of institutional reform driving the development of the transitional economies of CEE (Frydman, Hessel and Rapaczynski 1998). Since state-owned enterprises in CEE have operated inefficiently due to a dearth of entrepreneurial and managerial skills and a lack of efficient capital markets (Meyer 1998), a common policy in developing countries, and one emphasized by all governments in CEE, is the sale of state-owned enterprises to private sector investors (Kogut 1996). Whether the privatized firm is wholly- or jointly-owned, the potential for cost reductions by transferring the foreign firm’s technology and management capabilities to the acquired state-owned enterprise is often present.

In related studies of Latin American privatization programs, Devlin and Cominetti (1994) and Hartenek (1995) have concluded that privatization has given foreign companies more opportunities to invest in host Latin American countries (i.e., it has eliminated institutional barriers that constrain FDI). (p.280) In general, privatization programs tend to indicate a government’s willingness to allow the private sector to play a larger role in the economy, thus supporting the entry and growth of foreign MNEs as well as domestic firms. These findings suggest that privatization is a private-sector-friendly policy, which offers the potential for cost reductions by MNEs contemplating investment in the host country.

Hypothesis 4: The greater the reduction in barriers to FDI in the host country, as proxied by higher levels of host country privatization, the lower the foreign investor’s costs associated with long-term capital investment, resulting in increased inward FDI.


Another element of the institutional environment in the host country revolves around its political risk profile. Political risk may be defined as the risk that a sovereign host government will unexpectedly change the institutional environment under which businesses operate (Butler and Castelo Joaquin 1998). The institutional environment adopted creates unique political risks that contribute to FDI-related costs for foreign investors, and the MNE must consider these costs when deciding whether to invest in the host country. From a financial perspective, political risk may alter operating cash flows via discriminatory policies and regulations, leading to unexpected decreases in future cash flows. Because the uncertainty and costs associated with each country’s political risk profile alter the return to the foreign investor (Bailey and Chung 1995), a risk-averse firm, ceteris paribus, will under-allocate capital to host countries in the presence of high political risk.

Hypothesis 5: The greater the success of a country in reducing political risk, the lower the foreign investor’s uncertainty and costs associated with long-term capital investment, resulting in increased inward FDI.

2. New institutional economics and FDI (Control Variables)

Additional factors that should help to explain FDI into CEE countries are those that routinely are found to be important in explaining FDI in most countries around the world. We treat these factors as “control variables” in that they do not differentiate CEE investment from that occurring elsewhere, but they still are expected to play an important role in this region. First, consider the level of macroeconomic instability or risk. With the fragile democracies and market systems of the CEE countries, instability of prices, interest rates, exchange rates, and even unemployment would be expected, in comparison with industrialized economies. We measure two types of macroeconomic risk, namely inflation and exchange rate changes, and recognize that they also mark conditions that characterize emerging markets more broadly.


Inflation generally is caused by excessive growth in the money supply. Under the former socialist regimes of CEE, inflation was often hidden because prices were fixed, and thus did not allow supply and demand to function normally. In CEE countries, studies have shown that economic instability makes FDI particularly challenging for foreign investors (Meyer 2001). A high and/or (p.281) variable rate of inflation is a sign of internal economic instability and of the host government’s inability to maintain consistent monetary policy. When companies face an institutional environment with high inflation, their capital budgeting and long-term planning become more uncertain. As a result, foreign investors’ capital commitment becomes riskier due to increased uncertainty and costs. In the worst case, they respond by avoiding investment in environments with these conditions.

From the MNE’s perspective, high inflation creates uncertainty about the realized net present value stemming from a costly capital commitment. In addition to the uncertain revenues and, by extension, the realized net present value of costly, irreversible (in the short-run) investment in a high-inflation country, inflation also may inhibit export sales from the host country, thus making resource-seeking FDI less attractive. Trevino et al. (2002) found a negative and significant relationship between inflation in Latin American countries and inward FDI flows, while Aspergis and Katrakilidis (1998) found that inflation and inflation uncertainty had a negative and significant effect on FDI flows in Portugal, Spain, and Greece. Central and Eastern Europe has a shorter history of institutional reform than that occurring in either of the aforementioned studies. In addition, there is sufficient cross-country variability in inflation in CEE to justify an examination of its effect on FDI inflows in the region.

Hypothesis 6: The greater the success of government in controlling inflation, the lower the foreign investor’s uncertainty and costs associated with long-term capital investment, resulting in increased inward FDI.


Another potential impediment to FDI is the absence of a stable, well-accepted currency. The possibility of unanticipated depreciation in the host country exchange rate makes long-term planning difficult and increases the risk associated with long-term investment. Currency devaluation and volatility may result from economic or political upheaval, and foreign investors must incur costs to prevent transaction and translation losses when host country currencies depreciate. If they believe that depreciation will continue after they enter the host country, they may conclude that the costs will be too high to justify their investment. Thus, ceteris paribus, foreign investors would be expected to undertake FDI in countries whose currencies are expected to maintain the value of their earnings.

Another argument suggests that currency overvaluation is an example of market disequilibrium, and a currency may be defined as undervalued when, at the prevailing rate of exchange, production costs for tradable goods are on average lower than in other countries. In this case, there is an incentive to locate production of internationally traded commodities in countries with undervalued currencies and to purchase production capacity with overvalued foreign exchange. Thus, the devalued host country currency may attract foreign investors who wish to acquire “inexpensive” local assets. This second line of reasoning is consistent (p.282) with recent literature (Grosse and Trevino 1996; Klein and Rosengren 1994; Froot and Stein 1991) in developed countries. If this argument holds in the transitional economies of CEE, it may be that foreign investors possess the international experience to overcome the increased costs of operating in these markets. Since exchange rate devaluation creates both problems and opportunities for MNEs, requiring them to incur costs to manage the risks inherent in a devaluing currency, but also presenting the opportunity of acquiring host country production facilities with overvalued foreign exchange, we develop this argument as an empirical question.

Hypothesis 7: The greater the depreciation of the host country’s currency, the higher (lower) the host country’s inward FDI.


Since country size or purchasing power has been widely used to explain global patterns of FDI, we employ it as a control variable in our model. Even though gross domestic product often declined by more than 20% per annum during the early transition phase in CEE, Western firms increasingly desire access to local markets in order to expand their businesses. This suggests that more FDI will flow into larger countries, which have higher disposable incomes, and which have greater consumption levels. Evidence from recent studies comparing FDI flows to different emerging economies has been relatively consistent. Several studies in CEE found that market-seeking motives are the principal reasons why investors undertake FDI there (Svetlicic and Rojec 1994; OECD 1994; Marinov and Marinova 1999). Trevino et al. (2002) used gross domestic product (GDP) as a surrogate for market size and found it to be highly significant in explaining FDI into Latin American countries. Similarly, Jermakowicz and Bellas (1997) concluded that inward FDI in CEE countries made to gain access to local markets is positively correlated with the population of the host country and their purchasing power. In a study of FDI in China, Wei (2000) found that GDP growth strongly influenced FDI there. The UN (UNCTAD 1998, 139) found that across all emerging markets, for separate analyses in three five-year periods between 1980 and 1995, nominal GDP was a strong positive factor explaining FDI into those countries. Based on the broad literature on FDI location, we expect that:

Hypothesis 8: The larger the host country market size, as indicated by gross domestic product, the greater the host country inward FDI.7

(p.283) B. Data sources and methodology

Variables used in the modeling are as follows:

FDI = flow of foreign direct investment into the given host country, from the IMF International Financial Statistics CD ROM database (IMF 2001b).

CORINGOV 8 = corruption in government, an index scored from 1 to 6 constructed by Political Risk Services’ International Country Risk Guide (ICRG) database using subjective evaluation of country criteria.

RULELAW 9 = rule of law, an index scored from 1 to 6 constructed by Political Risk Services’ International Country Risk Guide database using subjective evaluation of country criteria.

REPATREQ = repatriation restrictions imposed by the government on overseas funds transfers, from the IMF publication Exchange Arrangements and Exchange Restrictions (various years).

EBRDER 10 = European Bank for Reconstruction and Development (EBRD) index of enterprise reform, scored from 1 to 4, from the annual EBRD publication Transition Report (various years).

(p.284) TREATY 11 = number of bilateral investment treaties, as listed in the United Nations Conference on Trade and Development Bilateral Investment Treaties, 1959–1999 database (UNCTAD 2000).

PRISHARE = private sector share in GDP (in %), from the EBRD Transition Report (various years).

INFL = inflation (change in consumer price index), from IMF International Financial Statistics.

POLRISK 12 = an index of political risk based on 12 weighted variables, scored on a scale from 0 to 100, as measured by Political Risk Services’ International Country Risk Guide database.

EXRATE= nominal exchange rate versus U.S. dollar, from IMF International Financial Statistics.

GDP = gross domestic product (in current U.S. dollars), from IMF International Financial Statistics.

We explored the hypotheses using a standard multiple regression modeling procedure. Given the data set of annual FDI inflows into 13 CEE countries from 1990 to 1999, we used a panel data format for the models, grouping FDI by country and by year as classifying dimensions. Standard OLS models, least-squares dummy variable models, and random-effects GLS models were computed for each specification to explain FDI inflows. Random-effects models proved to utilize the available information most efficiently and produced the most significant model results. The correlation matrix of the variables is presented in Table A1.

Before proceeding to regression estimates, we address some potentially problematic aspects of the time series nature of our data set. First, we were concerned about the potential for little or very slow variation in the independent variables, especially those related to regimes and regime changes. Closer review of the data, (p.285)




















(*) = significant at the .10 level

(**) = significant at the .05 level

(***) = significant at the .01 level

however, indicated that this concern was unwarranted since all of the independent variables exhibited sufficient year-to-year variation to justify their inclusion in the model without adjustment.

Second, we were concerned about the possibility that we were regressing time-varying independent variables on a country-specific and time-invariant dependent variable. Thus, we tested the stationarity of our dependent variables by conducting unit root tests for panel data. The most popular form of unit root tests for panel data is Levin and Lin (Levin and Lin 1993). Results of this Levin-Lin test indicate that both of the dependent variables are stationary in level form (see Table 1). Although many scientific time series are stationary, most time series, especially macroeconomic time series, are trending (Kennedy 1998; Nelson and Plosser 1982). To avoid problems with using non-stationary time series, a Levin-Lin test was conducted on each of the macroeconomic variables, and the results indicate that all of them are stationary in level form (see Table 2). These two tests fail to reject the null hypothesis of stationarity of our data series in every case. Therefore, our model is estimated below in level form.

C. Statistical results

Table 3 shows the main model, in which the regression models explained over half of the variation in aggregate FDI flows into the thirteen countries during the 1990s. Our main interest in the statistical analysis is to demonstrate the importance of institutional (non-traditional) factors in explaining FDI into the formerly communist countries in the early years of their transition to market-based democracies. Two institutional variables proved significant in explaining this investment: the number of bilateral investment treaties entered into by the country, and the level of restrictions on repatriation of earnings of the CEE affiliates. The former may be interpreted as a measure of the country’s willingness to offer (p.286)






















0.75 (2.53)**























–0.02 (–1.30)



0.04 (2.32)**



0.01 (0.31)

–0.01 (–1.41)

















Observations Adjusted R2

54 54

0.59 0.56

54 0.53

t-statistics in parentheses

(*) = significant at the .10 level

(**) = significant at the .05 level

(***) = significant at the .01 level

These are all random effects, GLS regression models.

variable definitions:

CORINGOV = corruption in government [higher value = less corruption]

RULELAW = extent of rule of law in policy application [higher value = less arbitrariness]

REPATREQ = repatriation controls [higher value = more controls on repatriation]

EBRDER = EBRD index of enterprise reform [higher value = greater reform]

TREATY = # of bilateral investment treaties

PRISHARE = private sector share in GDP

INFL = inflation (change in consumer price index)

POLRISK = political risk index [higher value = less risky]

EXRATE = nominal exchange rate versus U.S. dollar

GDP = gross domestic product (in current U.S. dollars)

(p.287) equal treatment to foreign firms as compared to domestic companies. The more the host country has undertaken institution-building via BITs, the greater the amount of FDI that occurred. The latter outcome, repatriation restrictions being positively correlated with FDI, is surprising. This may be a phase in the transition from government-owned economic activity to more fully open economies, such that initial repatriation restrictions may be followed by a move toward greater openness to remittances in the future. Another measure of institutional constraints in these governments is their level of corruption. As expected, higher levels of perceived corruption led to lower levels of FDI. This finding was consistent for other specifications of corruption, such as the extent to which a country was governed by the rule of law rather than by arbitrary policymaking. Host country political risk was significantly and inversely related to FDI, as expected.

Looking next at the new international economics from a macroeconomic perspective, we found that inflation did not add significantly to the explanation of FDI into the CEE countries, but that the other two measures did. This outcome was not totally unexpected, given the weak relationship of inflation to FDI in emerging markets in previous studies. The exchange rate had a significant negative correlation to the flow of FDI in most of the models, supporting the argument that a weaker-currency country attracts less investment. In addition, market size was highly significant in explaining FDI flows into CEE. Apparently, the main attraction of CEE countries for FDI during the 1990s was to serve local markets, as corroborated by the various company surveys cited previously.

D. Discussion

The new institutional economics is employed as a theoretical foundation to better understand the intersection of MNE investment strategy and the institutional environment in the transitional economies of CEE. We test the theory empirically with traditional macroeconomic factors as well as non-traditional environmental and political measures of institutional development, and we attempt to explain the institution-environment framework surrounding FDI decision-making. By applying the new institutional economics to transitional economies, we have responded to the call to explain organizational behavior in developing country settings utilizing this theory (Meyer 2001; Shenkar and von Glinow 1994; Hoskisson et al. 2000).

Our findings confirm that corruption is an element of the institutional environment that increases uncertainty and costs associated with long-term capital investment in CEE. Since corruption forces investors to incur higher costs to reduce this risk, we expected and found that the level of corruption in government constrains inward FDI in CEE. If transitional economies want to attract greater FDI, they will have greater success by providing a business environment that operates under fair, concrete and transparent laws.

The degree of restriction on foreign firms’ profit repatriation was positively related to inward FDI. This finding was surprising because capital account (p.288) restrictions limit companies’ ability to allocate profits optimally on a global basis (for use where returns may be higher or to augment dividends to shareholders). Since foreign operations in the formerly communist economies of CEE are still relatively young, it is possible that retained earnings are needed for expansion in these new operations. Thus, managers may view current repatriation restrictions as unimportant at present, and perhaps likely to change in the future. The policies themselves may be in a transitional phase, with lower repatriation limits on the horizon, and with currently high limits as a false indicator of general policy restrictiveness.

We found that the number of bilateral investment treaties that CEE countries had signed was highly significant in attracting FDI to the region. Our study indicates that foreign investors view BITs that assure equal treatment of foreign and domestic investors as a critical component of institution building. Such equal treatment, we posit, reduces the costs of doing business in CEE. Support for this variable demonstrates that it serves as another useful measure of institutional reform that affects FDI decision-making. This finding should be of considerable interest not only to such non-governmental organizations as UNCTAD and the World Bank, which sold developing countries on the value of BITs, but also to the host countries that eventually adopted them.

As expected, we found a highly significant and positive relationship between the degree of privatization in the host country and inward FDI. This result is consistent with recent studies (Frydman et al. 1998; Meyer 1998) that view privatization as a fundamental element of institutional development. The decision by CEE countries to privatize state-owned enterprises provides two roles in terms of present and future costs for foreign investors in the institutional environment. First, it allows companies to improve operating efficiency and to reduce FDI-related costs when they acquire a state-owned enterprise, because the foreign investor provides managerial and technological capability that can bring the acquired firm up to global standards. Second, privatization sends a message to foreign investors that the government is building an institutional environment that is consistent with market-oriented economies. Although we have shown that privatization correlates positively with FDI, the number of government-owned companies is finite. Thus, governments are limited in their ability to continue to attract FDI from companies investing in previously government-owned firms.

We expected and found an inverse and significant relationship between political risk and FDI. This finding supports our institutional constraint argument, similar to the corruption variable. (In fact, corruption is a form of political risk that we were able to separate out from the overall category.) High political risk increases costs for foreign investors by forcing them to operate under extreme uncertainty. The CEE countries present unique risks, and companies are aware of these and are inclined to invest in those countries where institutional stability is greatest and FDI-related costs (i.e., political risk) are lowest.

(p.289) We hypothesized that lower inflation would correlate with higher inward FDI, yet although we found directional support for the inflation variable, it was not significant in explaining FDI. It is possible that companies have gained so much operating experience in high inflation environments around the world that they no longer perceive high inflation as sufficiently problematic to justify keeping them out of potentially attractive and profitable markets. Just as likely, the relatively low levels of inflation worldwide in the past decade may not constitute a significant barrier to FDI at this time.

By indicating that countries with stronger currencies attracted greater levels of FDI, results for the exchange rate variable supported the macroeconomic institution-building argument and contradicted previous findings related to market disequilibrium in developed countries (Grosse and Trevino 1996; Klein and Rosengen 1994; Froot and Stein 1991). This outcome is consistent with the part of the literature that finds that foreign investors prefer to invest in high-value (high real exchange rate) markets where earnings may be expected to depreciate less frequently and rapidly. That is, firms prefer to obtain assets in countries that demonstrate a greater likelihood of protecting those assets. Therefore, more FDI went into countries where the costs of dealing with depreciating currencies were lower.

Consistent with existing literature in developed and developing country settings, we found that GDP was highly significant in explaining FDI flows into the CEE countries. Our findings indicate that companies are still locating in the largest country markets. This is true in spite of the growth in regional trade agreements and various bilateral agreements that allow companies to more readily gain access to other country markets without a necessary local production presence. The interesting adjustment will occur when the CEE countries are linked sufficiently to the European Union so that firms will have confidence in investing in CEE for serving all of Europe; this may produce a large flow of “offshore assembly” investment as has occurred in Mexico for sales in the U.S. market during the past twenty years.


The flow of FDI into the transitional economies of CEE tends to follow patterns similar to those in other emerging markets, with the added dimension that institutional factors appear to play a larger role than elsewhere.13 In particular, bilateral investment treaties, the degree of enterprise reform, and repatriation (p.290) rules tend to stimulate FDI, while political risk and the level of corruption in government tend to constrain FDI into these countries. This outcome provides strong support for this reasoning based on the new institutional economics. It also implies that country-level efforts to attract FDI in the twenty-first century will require governments with strong institutions that are committed to reducing uncertainty and FDI-related costs for foreign investors, by pursuing lower corruption, more stable political environments, and bilateral investment treaties that help to create an even playing field for foreign and domestic investors.

Greater achievement of the rule of law, of enterprise reform, and of inter-governmental agreements on the treatment of FDI all form a background that is conducive to attracting FDI. CEE governments that want to use FDI as part of their engine of economic growth are clearly instructed about the direction of institutional change that is needed. As in other FDI studies, it has been shown that more comprehensive frameworks for explaining this phenomenon produce more complete understanding of FDI flows. Limiting analysis only to economic factors, or to factors that are readily measurable, may simplify the effort, but the value of adding institutional variables relating to the FDI environment has been clearly demonstrated here. With improvements in the measurement of these variables, our ability to explain and understand FDI has improved significantly.

Even though our analysis is fairly comprehensive from a regulatory perspective, our narrow focus on the new institutional economics is limited in that neither the normative nor the cultural-cognitive dimensions of institutional theory were analyzed in the present study. An additional institutional perspective comparing Anglo-Saxon and German/Scandinavian models of market economies (more “liberal” versus more “coordinated”) could provide further understanding of the process through which the CEE countries are passing.14 Future research could improve upon the present study by measuring and modeling these added dimensions of institutional theory into a more comprehensive explanatory model of the multinational enterprise and investment location.








































































































































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(*) This chapter was reprinted with permission from the Management International Review. The chapter was originally published as New institutional economics and FDI location in central and eastern Europe,” 45 Management International Review 123 (2005).The authors are grateful to Michael A. Hitt and Lorraine Eden for comments and suggestions on an earlier draft of this chapter. In addition, the authors thank Taisa Minto and Sangit Rawlley for their research assistance and Doug Thomas for his statistical help.

(1.) The institutional environment is defined as the set of fundamental political, social, and legal ground rules that establishes the basis for production, exchange, and distribution (Davis and North 1971).

(2.) Meyer (2001) measures institutional reform by a composite index based on the European Bank for Reconstruction and Development transition indices, which reflect an expert evaluation of institutional reforms. In our study, institutional factors are measured independently by several of our independent variables.

(3.) The transition has moved forward more or less toward market-based institutions depending on whether the government has pursued a more “coordinated” or a more “liberal” policy framework (Hall and Soskice 2001). The former framework more closely parallels the German and Scandinavian institutional systems, and the latter is exemplified by the United States and other Anglo-Saxon countries. The “coordinated” structure tends to produce stronger unions and industry associations, as well as greater collaboration between firms and between firms and government; the “liberal” structure tends to produce greater arm’s-length competition, greater labor mobility between firms, and more focus on explicit contracting between parties.

It could easily be argued—but is not pursued here—that the more coordinated policy environment is an easier regime to establish when moving from a communist one, and that moving to a more liberal regime will likely provoke a more difficult initial transition. A reviewer points out that the formerly-communist countries lack a history of developing “associative coordination mechanisms” such as nationwide trade unions and industry associations — and that this lack hinders these countries from moving into the sphere of coordinated market economies. This point ignores, however, the pre-communist historical evolution of countries such as Russia and the Central European nations, which developed much more similarly to Germany and the northern European countries than to the Anglo-Saxon countries. In any event, this is an empirical question.

(4.) Interestingly, Madhok (1997) points out that the decision-making perspective should be to raise firm value, rather than just to decrease costs. Thus, looking at government policies and institutional conditions should emphasize the impacts of this environment in altering transaction costs and in changing revenues and risks. All of these impacts are relevant in the FDI decisions in question here.

(5.) The CEE growth rate is calculated from 1992 to 2000, since a number of the countries were only created in 1991. If we use the available data on FDI into the region for 1990–2000, the growth rate was 103.5% per year.

(6.) Fundamental changes in the structure of the global economy help to explain much of these increases. In addition, market reform, changes in the investment climate, and government policies toward investment offer additional explanation. In the past, host country attractiveness has been positively correlated with the country’s overall size or its natural resource endowment. With the onset of “globalization” and multiple linkages among markets in the 1990s, however, host country competitiveness as a manufacturing site and as an export platform have become additional important determinants of attractiveness.

(7.) Another variable that may help to explain FDI into CEE is the amount of existing trade (imports) between countries in that region and home countries of MNEs. Higher levels of trade may act as another proxy for institutional reform, because it is an indicator of the degree of openness in a given country. Since the end of the cold war, CEE countries have become increasingly interested in integrating with the world economy, because they believe previous policies have fostered and protected inefficient production. Further, industrial countries and international organizations have pressured emerging economies to reduce their import barriers. Therefore, CEE countries have undertaken microeconomic reforms that promote freer movement of international trade. Logically, MNEs need more trade and more open economies for resource-seeking operations, especially as they integrate their global production with vertical and horizontal value-chain linkages. For a country to be an inherent part of this integration, it must allow MNEs to easily import and export. This integration is particularly important when MNEs seek a base to serve regional CEE markets. Because imports and exports were extremely highly correlated with gross domestic product in the host countries, we did not test this hypothesis.

(8.) According to Political Risk Services, “This is an assessment of corruption within the political system. Such corruption is a threat to foreign investment for several reasons: it distorts the economic and financial environment, it reduces the efficiency of government and business by enabling people to assume positions of power through patronage rather than ability, and, last but not least, introduces an inherent instability into the political process.”

(9.) Rule of Law “reflects the degree to which the citizens of a country are willing to accept the established institutions to make and implement laws and adjudicate disputes.” Higher scores indicate: “sound political institutions, a strong court system, and provisions for an orderly succession of power.” Lower scores indicate: “a tradition of depending on physical force or illegal means to settle claims.” Upon changes in government new leaders “may be less likely to accept the obligations of the previous regime.” Definitions from Political Risk Services, Inc.

(10.) This 4-point scaled index was measured as follows, aiming at “enterprise restructuring”:

  1. (1:) soft budget constraints, few other reforms to promote corporate governance

  2. (2:) moderately tight credit and subsidy policy but weak enforcement of bankruptcy legislation and little action to strengthen competition and corporate governance

  3. (3:) significant and sustained actions to harden budget constraints and promote corporate governance effectively

  4. (4:) substantial improvement in corporate governance

  5. (4+:) standards and performance typical of advanced industrial economies.

(11.) Initially BITs were concluded between a developed and a developing country, usually at the initiative of the developed country. The developed country, typically a capital-exporting country, entered into a BIT with a developing country, typically a capital-importing country. This was done in order for the developed country to secure additional and higher standards of legal protection and guarantees for the investments of its firms beyond those offered under national laws. The developing country, on the other hand, would sign a BIT as one of the elements of a favorable climate to attract foreign direct investors.

(12.) “The aim of the political risk rating is to provide a means of assessing the political stability of the countries covered by the International Country Risk Guide on a comparable basis. This is done by assigning risk points to a preset group of factors, termed political risk components. The minimum number of points that can be assigned to each component is zero, while the maximum number of points depends on the fixed weight that component is given in the overall political risk assessment. In every case, the lower the risk point total the higher the risk, and the higher the risk point total the lower the risk.”

(13.) In a statistical context, models that include the political and institutional variables explain more of FDI into the CEE countries than models that only include “traditional” factors that explain FDI in all countries. Re-running the models presented in this chapter with only traditional factors produced about half of the explanatory power of the augmented models.

(14.) As pointed out by one reviewer, “It might be the case that more liberal governmental policies in CEE are attracting more FDI … but such an approach can also go hand in hand with a weakening of labor law and industrial relations and other social welfare state institutions, by favoring mainly a small political and business elite in these countries, as it is the case, for example, in Russia and China. Thus, it is not astonishing that in these countries corruption and political risks are increasing.”