The Interrelationship of FDI and GDP in European Transition Countries

Theory states that the foreign direct investments (FDI) have multiple positive effects on a country’s economy. Evidence can be sought from Central and Eastern European countries where FDI is seen as one of the main contributors to GDP growth. This paper examines the relationship between FDI and GDP growth rate in Croatia and other chosen European transition countries using bivariate VAR models. Based on the research conducted, it was found that FDI Granger causes GDP growth in most countries. This is especially true in Poland, Czech Republic and Hungary which have attracted a significant amount of FDI starting from 1990. The estimated VAR models for Latvia and Slovenia provide evidence that GDP causes FDI, corroborating the theory that investor are prone to stable macroeconomic conditions. This paper tries to make a comparative analysis of FDI-GDP link in New EU member states. Further research should certainly include other aspects such as the quality of the legislative system, labor productivity and labor costs, access to capital markets, etc.

markets, foreign investors were attracted by the gravitational factors and low labor costs and FDI had positive effect on the economy of these countries. The purpose of this paper is, therefore, to explore and show that FDI played a significant role in promoting economic growth of selected European transition countries. FDI had a positive effect on employment, domestic production and exports which eventually resulted GDP growth. As structure of this paper concerned, it first provides a review of previous studies.
Secondly, methodology and data used in the paper are listed, followed by the results of empirical analysis.
Finally some closing thoughts are provided.

Literature review
In the last twenty years, FDI and its impact on economic growth have been at the center of interest of many scientists. Longitudinal research by Blomström, Lipsey & Zejan (1992) considering period from 1960 to 1985 shows that FDI causes economic growth, and not vice versa. The results indicate that FDI inflows can encourage GDP growth only in those countries that have crossed a certain threshold of development those which are ready to absorb new technology and use it successfully. Borensztein, De Gregorio & Lee (1995) have examined the impact of FDI on economic growth of industrial countries and developing countries for the period from 1979 to 1989. The results show that the higher the levels of human capital in a country, the more pronounced is the positive impact of FDI on GDP. Namely, human capital is required to accept the technology and ultimately leads to an increase in productivity.
Furthermore, FDI has the effect of increasing total investments in a country by more than one-for-one, providing an encouragement for investments. Mencinger (2003) explores the relationship between FDI and economic growth in eight transition countries for the period from 1994 to 2001. He found FDI to have a negative impact on economic growth. The explanation is that company takeovers have predominated the FDI structure in comparison to greenfield investments. Likewise, cash receipts from the sale of companies during the privatization have been used for consumption and imports, instead of for increasing the productive capital. Bačić, Račić & Ahec -Šonje (2004) investigated the impact of FDI on economic growth of eleven transitional countries for the period from 1994 to 2002. They concluded that FDI has a positive effect on economic growth in small countries like Slovenia, Slovakia and Lithuania and it also has a significant impact on international trade of these countries. However, the impact of FDI on the productivity increase was found as 43 ISSN 1849-5664 (online) http://researchleap.com/category/international-journal-of-management-science-and-business-administration ISSN 1849-5419 (print) International Journal of Management Science And Business Administration Vol 1. No 4. March 2015., pp. 41-58 a characteristic of more developed countries. Asteriou, Dassiou & Glycopantis (2005) analyze the impact of FDI on economic growth of ten European transition countries for the period from 1990 to 2003. Their empirical study confirmed the positive correlation between FDI and economic growth, but also a negative correlation between portfolio investments and growth. The results can be explained by the fact that the capital markets are not fully developed in transition countries, while, on the other hand, they are quite attractive for FDI because of the relatively cheap labor force. Katircioglu (2009)  According to the obtained results, an impulse in foreign investments decreases only the employment, but not GDP. Therefore it can be concluded that the entry of foreign capital into the country increases the marginal product of labor, and this creates a space for increasing profits, but also, for a long-term increase in real wages. Although the effect of foreign capital now seems negative, it could have a positive impact in the general well-being for the near future. The results can be explained by the fact that most of FDI has arrived in Croatia in large waves of privatization, while there was a shortage of investment in new production. The results indicate the necessity to change the policies of attracting FDI and directing them in sectors with higher added value.
Curwin & Mahutga (2014), on the other hand, revisit the classic sociological debate on the growth effects of FDI. They conclude that FDI penetration reduces economic growth in the short and long run in post-socialist transition countries. The authors explain their finding by weak institutional environment which allowed foreign capital to overwhelm domestic markets too quickly. There are also papers based on which one can conclude that economic growth encourages FDI inflows. Franc (2008) analyzed the FDI determinants for Croatia and twelve EU members, confirming that, inter alia, the determinants of FDI include lower labor costs, GDP growth rate, labor productivity, foreign trade, legal system and legislation. Mačkić, Škrabić Perić & Sorić (2014) analyze the systemic competitiveness of post-socialist and capitalist economies. Their research pinpoints several other variables which are relevant to FDI-GDP growth relation such as a country's credit rating, tax evasion, access to capital markets, SMEs, labor regulation flexibility, finance and banking regulation.
According to this study, all of the above mentioned variables are relevant competitiveness factors which affect GDP, and might, in turn, have a significant effect on FDI inflows.
The above literature review suggests that FDI by itself cannot positively affect economic growth. The final net effect depends on the level of development of the country itself, the level of human capital, the level of technological development, policies for attracting FDI, etc. The aim of the empirical part of the paper is to use econometric methods and models to examine the relationship between FDI and GDP growth rates in Croatia and selected European transition countries.

Methodology and data
Several different tests will be used in the research, including the unit root test, the Granger causality test and the bivariate vector autoregressive (VAR) model. 1 The empirical analysis is carried out on a total of ten European transition countries (Bulgaria, Czech Republic, Estonia, Croatia, Latvia, Lithuania, Hungary, Poland, Romania and Slovenia). It should be noted that the covered time series for each country is different. Quarterly GDP data (in millions of EUR) were obtained from the Eurostat database. After retrieval, data have been seasonally adjusted by the Census X12 method. Finally, log-differencing of data was used to approximate the quarterly growth rates of GDP. The FDI data are taken in the form of the total accumulated value of assets in foreign ownership at the end of each quarter (FDI Stocks, in millions of EUR). These were gathered from the databases of Central Banks of the observed countries. FDI data is also log-differenced, producing quarterly growth rates of FDI (FDI hereinforth).

Stationarity
In this study the existence of a unit root will be examined using the ADF test (Dickey, Fuller, 1981). The model is specified in a way that it involves both deterministic components, constant and trend yet, if they were not shown to be statistically significant, they were left out from the model.
The ADF test results for the observed time series are given in Table 4

Granger causality
Having tested the stationarity of the observed series, the analysis is continued through Granger causality However, prior to the analysis of causality it is necessary to determine the optimal number of lags in the model. The value of the optimal number of lags can be determined based on the information criteria of the 46 ISSN 1849-5664 (online) http://researchleap.com/category/international-journal-of-management-science-and-business-administration ISSN 1849-5419 (print) International Journal of Management Science And Business Administration Vol 1. No 4. March 2015., pp. 41-58 model quality, AIC (Akaike), SC (Schwarz) and HQ (Hannan-Quinn). However, in this paper a minimum number of lags that fulfills the initial assumptions and the stability of the VAR model has been used. The optimal number of lags is given in Table 4

VAR model
Finally, the relationship between the FDI and GDP growth rates will be analyzed using the VAR model. In any VAR analysis, the estimated parameters themselves are not so important. The same information, but presented in a form suitable for interpretation and conclusions, are given by the results of the innovation analysis consisting of the variance decomposition analysis and the impulse response functions.

.3.1 Va rian ce dec omp o sit ion
The results of the variance decomposition analysis for the prognostic period of 16 quarters is presented in           The conducted analysis leads to the conclusion that the variance decomposition gives the same information about the cause-effect relationship between FDI and GDP in the observed countries as the Granger causality test.

.3.2 Imp ulse r e sp o nse s
The following part of the analysis is devoted to the reaction of certain variables on the unit shock in other variables.        It is observed that the shock of one standard deviation in GDP_HR has a slight positive, almost neutral effect on FDI_HR. On the other hand, there is a positive impact of shock in FDI_HR on GDP_HR during the first two quarters, after which it starts to disappear.        The shock of one standard deviation in GDP_HU has an almost neutral effect on FDI_HU. On the other hand, there is a positive impact of shock in FDI_HU on GDP_HU during the first two quarters, after which it starts to disappear.    The shock of one standard deviation in GDP_SL has a positive effect on FDI_SL in the first two quarters, after which the effect begins to fade away. Also, there is a positive impact of shock in FDI_SL on GDP_SL during the second quarter, after which it starts to disappear.
Finally, the analysis of adequacy of the VAR model was also conducted. An overview of diagnostic test results is given in Table 4

Discussion
Empirical analysis has led to the conclusion that in most countries FDI is an important determinant of economic growth. This is especially true in Poland, Czech Republic and Hungary, which have, to a large extent, taken advantage of joining the European Union. By creating a favorable investment climate, including the relatively low cost of labor, they have attracted a large number of investors from developed countries of the European Union, who brought with them new technologies, management knowledge and skills. Increased efficiency of production and operation of all the sectors have had a positive impact on economic growth.
These results concur with the common belief that FDI has a positive effect on GDP growth and are in accordance with the recent literature on the subject of FDI-GDP growth relation (Blomström, Lipsey & Zejan, 1992;Bačić, Račić & Ahec -Šonje, 2004;Asteriou, Dassiou & Glycopantis, 2005;etc.) Also, it is noted that in Croatia, FDI is an important factor that can greatly promote higher rates of economic growth. However, investments in Croatia are in decline due to the lack of industrial development plan, high labor costs, high administrative barriers and other obstacles in comparison with other transition countries.
Therefore, if Croatia wants to encourage the growth of the economy, then it has to create a stable business environment that will attract foreign as well as domestic investors. Results show that in some countries, such as Latvia and Slovenia, economic growth plays an important role in attracting the FDI. Foreign investors are prone to come countries with a stable macroeconomic environment, which implies positive growth rates of GDP. This is in accordance with the results provided by Franc (2008), indicating that FDI inflow is determined by lower labor cost, GDP growth rate etc. It is important to note that FDI-GDP growth relation is surely determined by other variables which are not included in this analysis thus, opening room for further research.
Competitiveness, for example, surely affects GDP growth through foreign trade which, in turn, directly affects FDI inflows and thus, affects FDI-GDP growth relationship. Competitiveness is further determined by factors such as credit rating, tax evasion, access to capital markets, SMEs, labor regulation flexibility, finance and banking regulation (Mačkić, Škrabić Perić & Sorić, 2014).

Conclusion
Every country seeks to encourage its economic growth yet, it is impossible to do so without an important factor -capital. Therefore, a country lacking in savings has to resort to importing capital. FDI represents the most significant and propulsive way of international capital flow and it is a prerequisite of technological and economic development for many countries (especially the transition ones). Various empirical studies, which also include non-transition countries provide different results but the common conclusion is that FDI, by itself, does not necessarily have an independent and positive impact on GDP growth as it depends on other economic and social conditions as human capital, financial system development, etc. Empirical analysis done in this paper has led to the conclusion that FDI has a positive impact on GDP growth rate in most of the analyzed countries, especially, in Poland, Czech Republic and Hungary. These countries have attracted a 58 ISSN 1849-5664 (online) http://researchleap.com/category/international-journal-of-management-science-and-business-administration ISSN 1849-5419 (print) International Journal of Management Science And Business Administration Vol 1. No 4. March 2015., pp. 41-58 significant amount of FDI through which encouraged the growth of their economies. The research has also shown that there is reverse link; i.e. GDP growth rates are important in attracting FDI.