THE INFLUENCE OF FOREIGN DIRECT INVESTMENT ON DOMESTIC INVESTMENT PROCESSES IN LATVIA

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1 Transpor and Telecommunicaion Vol.7, No 1, 2006 THE INFLUENCE OF FOREIGN DIRECT INVESTMENT ON DOMESTIC INVESTMENT PROCESSES IN LATVIA Deniss Tiarenko Transpor and Telecommunicaion Insiue Lomonosov Sr. 1, Riga, LV-1019, Lavia Ph: (+371) The primary aim of he paper is o esimae he exen of FDI influence on domesic invesmen processes in Lavia. Auhor analyses he heoreical issues of FDI effec on capial formaion process in he hos economy. The resuls of economeric analysis of he oal invesmen model presened in his paper show he evidence of crowding ou long-erm effec of FDI on invesmen in Lavia. Keywords: foreign direc invesmen, economeric analysis of he oal invesmen model, crowding in/ou effec 1. INTRODUCTION Recen heoreical and empirical sudies show ha foreign invesmens as a par of inernaional capial movemen play a crucial role in susainable developmen of hos economies. Nowadays-free capial flows across naional borders allow capial o seek ou he highes rae of reurn. Inernaional flows of capial reduce he risk faced by owners of capial by allowing hem o diversify heir lending and invesmen. In economic lieraure, inernaional invesmens usually are idenified as long-erm inernaional movemens, which are divided ino porfolio and direc invesmen. Inernaional invesmen in he form of porfolio invesmen is he purchase of a sock or bond issued in a foreign currency. Porfolio invesmen includes invesmen whose primary purpose is o ge fuure income, bu no o acquire conrol in a firm. The economic lieraure sresses ha his is he essenial disincion beween porfolio and direc invesmen. [5; 303] Capial flows are ypically designaed as foreign direc invesmen (FDI) when a foreigner owns 25% or more of a firm (in he US 10% or more), regardless of weaher he capial flows are used o purchase new plan and equipmen or o buy an ownership posiion in an exising firm. [9; 462] FDI may ake a number of differen forms including: he esablishmen of a new enerprise in an oher counry eiher as a branch or as a subsidiary; he expansion of an exising overseas branch or subsidiary; he acquisiion of an overseas business enerprise or is asses. [2; 110] The significan role in he supply of foreign capial plays mulinaional enerprises (MNEs). MNEs as he firms wih significan FDI asses are characerized by heir abiliy o derive and ransfer capial resources worldwide and o operae faciliies of producion and penerae markes in more han one counry, usually on a global scale. Significan par of he MNEs asses deployed ino he hos economies is inangible asses. They include echnology, managemen skills, channels for markeing producs inernaionally, produc design, qualiy characerisics, brand names, ec. The gains o hos counries from FDI can ake several forms. Firs of all FDI provides capial inflows ha finance curren accoun defici and compensae for insufficien capial formaion of he local firms. Furhermore FDI allows he ransfer of echnology paricularly in he form of new varieies of capial inpus ha canno be achieved hrough financial invesmens or rade in goods and services. FDI can also promoe compeiion in he domesic inpu marke, o improvemen of knowledge and managerial skills and o oher imporan inpus for he enrepreneurial capaciy expansion. Recipiens of FDI ofen gain employee raining in he course of operaing he new businesses, which conribues o human capial developmen in he hos counry. Also profis generaed by FDI conribue o corporae ax revenues in he hos counry. Thus FDI 76

2 Proceedings of he 5 h Inernaional Conference RelSa 05 Par 1 improve he inernaional compeiiveness of he local firms and he overall economic performance and simulae hos economy inegraion ino inernaional markes, disribuion and producion neworks. In evaluaing he impac of FDI on developmen, however, a key quesion is wheher MNEs crowd in domesic invesmens (as, for example, when heir presence simulaes new downsream or upsream invesmens ha would no have aken place in heir absence), or wheher hey have he opposie effec of displacing domesic producers or pre-emping heir invesmen opporuniies. A comprehensive sudy by Bosworh and Collins (1999) provides evidence on he effec of capial inflows on domesic invesmen for 58 developing counries during The auhors disinguish among hree ypes of capial inflows: FDI, porfolio invesmen, and oher financial flows (primarily bank loans). Bosworh and Collins find ha an increase of a dollar in capial inflows is associaed wih an increase in domesic invesmen of abou 50 cens. (Boh capial inflows and domesic invesmen are expressed as percenages of GDP.) The resuls of his analysis also show he significan differences among ypes of inflow. FDI appears o bring abou a one-for-one increase in domesic invesmen; here is virually no discernible relaionship beween porfolio inflows and invesmen (lile or no impac); and he impac of loans falls beween hose of he oher wo. These resuls hold boh for he 58-counry sample and for a subse of 18 emerging markes. (See he Char 1.) [5] Char 1. The Influence of Differen Types of Capial Inflows on Domesic Invesmen [5] In consideraion of such significance of FDI (as shown above) he esimaion of FDI influence on domesic invesmen processes is a raher imporan issue. In recen heoreical and empirical work, invesmen has been idenified as a key variable deermining economic growh. Thus, if FDI crowds ou domesic invesmen or fails o conribue o capial formaion, here would be good reasons o quesion is benefis for he developmen of recipien economies. This paper addresses he quesion of wheher FDI causes crowding in (CI) or crowding ou (CO) of domesic invesmen in Lavia. 2. THE THEORETICAL ISSUES OF FDI INFLUENCE ON DOMESTIC INVESTMENT FDI conribues direcly o overall invesmen, because i is par of i. We can presen he oal gross invesmen (I) in he simple form as real domesic invesmen (I d ) plus real foreign invesmens (I f ): I I d + I. (1) [1] f Foreign invesmens I f can be hough of as being a funcion of FDI. A very imporan quesion as regards he developmen influence of FDI is he exen o which i affecs invesmen by domesic firms (I d ). If i has no effec whasoever, any increase in FDI ough o 1 The sample covers nearly all counries of Lain America and Asia and many counries in Africa. 77

3 Transpor and Telecommunicaion Vol.7, No 1, 2006 be refleced in a la-for-la increase in oal invesmen. If FDI crowds ou (CO effec) invesmen by domesic firms, he increase in I ough o be smaller han he increase in FDI. Finally, if here is crowding in (CI effec), I ough o increase by more han he increase in FDI. The effecs of FDI on invesmen of course may vary from counry o counry, depending on domesic policy, he kinds of FDI ha a counry receives, and he srengh of domesic enerprises. I is possible, however, o specify condiions for CI or CO effec. The foreign invesmens, which inroduce goods, and services ha are new o he domesic economy are more likely o have favourable effecs on capial formaion han foreign invesmens in areas where here already exis domesic producers. In he former case, he effecs on capial formaion will be posiive because domesic producers do no have he knowledge required o underake hese aciviies and, herefore, foreign invesors do no displace domesic invesors. If FDI eners he economy in secors where here are compeing domesic firms, foreign invesmen may ake away invesmen opporuniies ha were open o domesic enrepreneurs prior o he foreign invesmens. The conribuion o oal capial formaion of such FDI is likely o be less han he FDI flow iself. This leads o a conclusion ha he secoral disribuion of FDI can be significan facor ha deermines he influence of FDI on capial formaion process. When he secoral disribuion of FDI is subsanially differen from he disribuion of he exising capial sock or of producion, he conribuion of FDI o capial formaion will be more posiive han when he disribuion of FDI follows roughly he exising secoral disribuion of he capial sock. In oher words, he relaionship beween FDI and domesic invesmen is likely o be complemenary when invesmen is in an undeveloped secor of he economy (owing o echnological facors or o he lack of knowledge of foreign markes). In developing counries he aemps of domesic enrepreneurship o expand in he new undeveloped secor of economy usually are very cosly, especially in high echnology secors where he financial and echnological requiremens run oo far ahead of domesic capabiliies. On he oher hand, FDI is more likely o subsiue for domesic invesmen when i akes place in secors where here exis pleny of domesic firms. The same may occur where domesic firms already have access o he echnology ha he MNEs bring ino he counry. I could be argued ha FDI can lead o invesmens by domesic firms in order o become more compeiive. However, given he vas echnological superioriy of MNEs, heir invesmens are more likely o displace domesic firms, and even cause heir bankrupcy, han o induce domesic firms o inves. Also i should be noed ha mergers and acquisiions migh no lead o increase in he physical capial of a hos counry. In some cases, he acquisiion of a domesic firm is almos akin o a porfolio invesmen, wih foreign invesor doing nohing o improve he operaion of he domesic firm. The main conclusion, which emerges from he shor heoreical analysis given above, is ha he posiive influence of FDI on domesic invesmen is no assured. The exen of FDI influence on domesic invesmen of course is an empirical quesion, and undoubedly he siuaion will vary from counry o counry. In order o es he FDI for CI or CO effec in Lavia he auhor will analyse he model of oal invesmen presened in he hird par of he paper. 3. FOREIGN DIRECT INVESTMENT DYNAMICS IN LATVIA A he end of 2004 he foreign direc invesmen sock in Lavia amouned o million LVL or 31.5% of GDP and he volume of he FDI inflow in he las four years equalled on average o 17% of fixed invesmen. [12; 64] In 2004 he amoun of he FDI inflow in Lavia reached million LVL, which was wice more han in [12; 64] The dynamics of inensiy 2 of invesmen processes in Lavia are presened in Char 2. 2 Gross capial formaion inensiy was calculaed as gross capial formaion and GDP raio. FDI inensiy was calculaed as FDI and GDP raio. All daa is in average 2000-year prices. Calculaions based on daa from annual saisical daabase of Cenral Saisical Bureau of Lavia hp://daa.csb.lv/en/dialog/safile1.asp?xu=&yp=&lang=1 78

4 Proceedings of he 5 h Inernaional Conference RelSa 05 Par % 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% Gross capial formaion as per cen of GDP FDI recieved as per cen of GDP Char 2. The Inensiy of Gross Capial Formaion and FDI in Lavia (% of GDP) As we see from Char 2, he highes FDI inensiy during he overview period was in 1997 wha can be associaed wih large-scale privaisaion process in Lavia. During he nex 4 years FDI inensiy is falling and only for he las 3 years again shows moderae growing endency wha can be associaed wih he influence of EU enlargemen process. Significan fall of FDI inensiy in Lavia in 2001 was caused by Hansabank group reorganizaion, when all Hansa Capial owned subsidiaries in Lavia and Lihuania were sold o Hansabank Group owned banks in hese counries (he approximae value of his arrangemen in Lavia was abou 100 mln. LVL). The main conclusion ha emerges from he analysis of daa presened in char 1 is ha over he las 10 years he inensiy of oal invesmen (gross capial formaion) shows considerable growing endency while he inensiy of FDI during his period is relaively low and does no show significan growh endency. In spie of posiive FDI dynamics during he las 3 years is should be sressed ha a he end of 2004 FDI amouned o 1002 LVL per capia, which is one of he lowes indicaors among he new EU member saes. [12, 63] According o daa of he Bank of Lavia, he bigges amouns of invesmen have been received from Germany, Sweden, Denmark, Finland, USA, Norway, Esonia and Russia, conribuing o almos 80% of all FDI sock in Lavia. [12, 64] Majoriy of hese counries are also he bigges rade parners of Lavia. The secoral composiion of FDI in Lavia in 2004 is presened in Char 3. Commercial services 20% Oher aciviies 7% Manufacuring indusry 15% Energeics 8% Financial inermediaion 17% Communicaion 8% Transpor 8% Trade 17% Char 3. FDI Sock by Kind of Aciviy in Lavia (%, 2004) [12; 65] 79

5 Transpor and Telecommunicaion Vol.7, No 1, 2006 As we see from Char 3, he highes share in he oal srucure of FDI sock belongs o he commercial services secor. The main aciviy of foreign invesors is concenraed in 4 economy secors - commercial services, financial inermediaion, ranspor and communicaion and rade. The oal share of hese secors amouns o 70% of FDI sock in Lavia. Such disribuion of FDI prey precisely corresponds o he secoral disribuion of oal invesmen and secoral srucure of GDP in Lavia. I should be noed ha FDI in producion of goods during he las years grew almos wice faser han in services, bu only a few he so-called Greenfield projecs, involving inroducion of new and modern echnologies by foreign invesors, have been implemened. 4. TESTING OF THE TOTAL INVESTMENT MODEL FOR FDI CROWDING IN OR CROWDING OUT EFFECT A model of oal invesmen was esimaed for a quarerly daa for Lavian economy over he period Following he approach described in Agosin and Mayer (2000) he iniial invesmen equaion used for esing for CI or CO effecs was of he following form: I = α + β F + β F + β F + β F + β F β 10 G 1 + β 11 G 2 + β 12 G 3 + β 13 G 4 + ε, (2) where I is invesmen/gdp raio; F is FDI/GDP raio; G is growh of GDP; α is fixed counry effec and ε is a serially uncorrelaed random error. The invesmen equaion (2) represens he oal invesmen as he sum of domesic invesmen and FDI (based on equaion (1)). The resources ha cross he exchanges as FDI are ofen no used a once o finance real invesmen. There is a lag beween FDI and real invesmen so he lagged explanaory variables of invesmen equaion were used. The growh rae (G) was used as he explanaory variable of desired level of capial sock of domesic firms. Equaion (2) is a version of oal invesmen model wih adapive expecaions wih respec o he growh rae 3. The daa of recen research (Sikus (2003, 2004)) shows, ha he difference beween acual oupu and full-capaciy oupu during he las years in Lavia is relaively small. So he oupu gap as explanaory variable was no used. The source daa for he model is daa provided by Bank of Lavia and he Cenral Saisical Bureau of Lavia. All series are in 2000-year prices. For he esimaion of he invesmen funcion, he mehod employed was ha of Leas Squares (LS). As i was menioned above he significan fall of FDI happened in To eliminae he influence of his shock, he value of Hansabank group arrangemen (approximaely 100 million LVL) was no aken ino accoun in FDI daa for invesmen model (2) esimaion. Afer he esimaion of he model and removing all saisically insignifican variables he final invesmen model equaion can be represened as follows: I = α + β F + β F + β G + β G + dummy + ε. (3) Also he dummy variable for he period of firs and second quarer of 2004 was inroduced o he model o eliminae he shock influence of EU enlargemen process on invesmen in Lavia. The resuls of regression equaion (3) for Lavia are shown in Table 1. 3 e where he expeced growh G = η 1G 1 + η2g2 + η3g3 + η4g. 4 80

6 Proceedings of he 5 h Inernaional Conference RelSa 05 Par 1 Table 1. Esimaes of he oal invesmen model Dependen Variable: oal invesmen, I Mehod: Leas Squares Sample(adjused): 1996:2 2004:4 Included observaions: 35 afer adjusing endpoins Variable Coefficien Sd. Error -Saisic Prob. α F F I I G G Dummy variable Adjused R-squared S.E. of regression Durbin-Wason sa As we see from Table 1 presened equaion (3) explains a high percenage of he variaion in invesmen and all coefficiens are reasonable and saisically significan (a leas a 10 per cen level). The coefficien for long-erm CI or CO effec esing is: 2 ˆ β j ˆ j= 1 β =. (4) LT 4 1 ˆ β j= 3 j The crieria used o deermine he CO/CI effec is he value and significance of coefficien βˆ LT. There are hree possibiliies: 1. Wih a Wald es i is no possible o rejec he hypohesis ha βˆ LT = 1. This means ha in he long run an increase in FDI of one la (or, more precisely, of one percenage poin of GDP) becomes one la of addiional oal invesmen (or invesmen amouning o one percenage poin of GDP). 2. Consider now he case in which he null βˆ LT = 1 is rejeced and βˆ LT > 1. This is evidence of CI: in he long run, one addiional la of FDI becomes more han one addiional la of oal invesmen. 3. If he null βˆ LT = 1 is rejeced and βˆ LT < 1, here is long-run CO: one addiional la of FDI leads o less han a one-la increase in oal invesmen. In oher words, here is displacemen of domesic invesmen by FDI. [1] How o inerpre a resul in which βˆ LT 1? If he equaliy holds, invesmen by MNEs simply adds one-o-one o invesmen by domesic firms, and here are no macroeconomic exernaliies semming from FDI. If he long-erm effec of FDI is o produce CI, long-erm macroeconomic exernaliies are posiive. And evidence for CO implies ha FDI has negaive long-erm exernaliies on invesmen. [1] The Wald es resuls of βˆ LT coefficien for our regression model are showed in Table 2. 81

7 Transpor and Telecommunicaion Vol.7, No 1, 2006 Table 2. Wald es resuls for βˆ LT coefficien Tes Saisic Value Df Probabiliy F-saisic (1, 27) Chi-square Null Hypohesis Summary: Normalized Resricion (= 0) Value Sd. Err β + β ) /(1 ( β + ) ( β 4 As we see from Table 2 βˆ LT coefficien is significanly differen from one. The coefficien value is negaive (-2.051) wha is he evidence of CO long-erm effec of FDI on invesmen in Lavia. I is very imporan o noe, ha he analysis of FDI CI/CO effec using oal invesmen model (1.2) is crucially dependen on FDI being exogenous o he variables deermining invesmen (here, he growh rae of GDP wih respecive ime lags). In order o es for he exogeneiy of FDI, he regression wih FDI as he dependen variable and he growh rae wih one-, wo-, hree- and fourquarer lags as he explanaory variables was esed. The wo equaions esimaed were as follows: = 1G 1 2G2 3G3 4G4 F δ + u, (5) = δ 1G 1 2G2 3G3 4G4 5F 1 6F 2 7F 3 8F 4 F + u. (6) These wo models were esimaed wih daa for using LS mehod. The resuls of esimaion are presened in Table 3. Table 3. Regression esimaions wih FDI as a dependen variable and lagged growh as explanaory variable P-values of coefficiens in equaion P-values of coefficiens in equaion Variable (5) (6) G G G G Adjused R As we can see from Table 3, he esimaed coefficiens of G 1, G 2, G 3 and G 4 are no saisically significan. Adjused R squares of esimaed equaions are low. So i is possible o conclude ha he variables explaining domesic invesmen (pas growh) do no explain FDI in Lavia. Therefore including of FDI as an exogenous variable in he equaions for oal invesmen is jusified. 5. CONCLUSIONS The economeric analysis of he oal invesmen funcion for he period conduced in his paper demonsraes he evidence of he crowding ou (CO) influence of FDI on domesic invesmen in Lavia. CO effec means ha FDI displace domesic invesmen in Lavia i.e. one addiional la of FDI inflow in Lavian economy leads o less han a one-la increase in oal invesmen. However i should be noed ha due o he relaively shor imes series daa available he values of oal invesmen funcion coefficiens for Lavia esimaed in his paper should be inerpreed carefully. 82

8 Proceedings of he 5 h Inernaional Conference RelSa 05 Par 1 One of he reasons of CO effec can be he relaively low FDI inensiy in Lavia over he las 10 years. I should be obvious ha low FDI inflows canno ensure any significan CI effec. The second reason of CO effec can be he peculiariies of FDI disribuion in Lavia, which, as i was menioned above, prey precisely corresponds o he secoral disribuion of oal invesmen. The FDI inflows in Lavia are oriened generally o he mos dynamic secors of he naional economy. Some of hese secors de jure or de faco are monopolized or are oligopolies (gas supply, elecommunicaion, reail sale of fuel, meal indusry and ohers). In oher secors of foreign invesor ineres operae pleny of domesic firms (banking and insurance secor, real esae, wholesale rade and oher services). And in many cases he firms wih foreign capial simply displace or ake over he domesic firms, which are no enough compeiive. This is especially relevan for Lavian economy joining he EU. Thus FDI inflow in Lavia rarely simulaes he domesic firms o inves more o increase heir compeiiveness. In some cases acquisiions, when foreign invesor acquires conrol in a domesic firm o ener he local marke and does nohing o improve is capaciy, do no lead o significan increase in physical capial. Foreign invesors are no acive in less developed secors of Lavian economy where FDI inflow could be a significan incenive for growh and can ensure he crowding in effec on invesmen of domesic firms. The main conclusion from he analysis underaken in his paper is ha he posiive influence of FDI on domesic invesmen processes in Lavia is no assured. The quesion of maximizaion of FDI conribuion o oal invesmen is a policy quesion. The naional invesmen policy should focus on improving he invesmen climae for all kinds of capial, domesic as well as foreign. Today he primary aim is o find he new incenives for FDI inflow in he less developed indusrial secors of Lavian economy where he foreign invesors can conribue new echnologies inroduce new producs and simulae he aciviy of domesic firms ensuring he CI invesmen effec. References [1] Agosin M.R., Mayer R. Foreign Invesmen in Developing Counries: does I Crowd in Domesic Invesmen? In: Unied Naions (UN) Conference on Trade and Developmen (UNCTAD), hp:// [2] Buckley A. Inernaional Invesmen: value creaion and appraisal, a real opions approach. Firs ediion. Handshojskolens Forlag. Copenhagen, 1998 [3] Bosworh B. P., Collins S.M. Capial Flows o Developing Economies: Implicaions for Saving and Invesmen. Brookings Papers on Economic Aciviy: 1. Brookings Insiuion, 1999, pp [4] Desai M.A., Foley C.F., Hines Jr. J.R. Foreign Direc Invesmen and Domesic Economic Aciviy. November [5] Ehier W. J. Modern Inernaional Economics. Second ediion. New York: WW Noron and Company, [6] Hech Y., Razin A., Shinar N.G. Ineracions beween capial inflows and domesic invesmen: Israel and developing counries. [7] Loungani P., Razin A. How Beneficial Is Foreign Direc Invesmen for Developing Counries? Finance and Developmen, Vol.38, No 2, June A quarerly magazine of he Inernaional Moneary Fund - hp:// [8] Schaffer R. Inernaional Business Law and Is Environmen. Third ediion. Minneapolis:Wes Publishing company, [9] Soberson B. and Reed G. Inernaional Economics. Third ediion. London: Macmillan, [10] Sikus D. Lavia`s Poenial Oupu Using Producion Funcion and HP-filer. In: Aca Universiais Laviensis.. Economics and Managemen. Riga: Universiy of Lavia, Vol. 677, 2004, pp [11] Sikus D. Measuring Oupu GAP in Lavia. Bank of Lavia. Working Paper 2/2003. hp:// [12] Ziņojums par Lavijas ausaimniecības aīsību. Lavijas Republikas Ekonomikas minisrija gada jūnijs. 83