On Determinants of Foreign Direct Investment in Transition Economies

Foreign direct investment (FDI) brings host countries capital, productive facilities and technology transfers, as well as new jobs and management expertise. Thus it is important to understand why in many countries FDI inflow is lower than expected. The goal of this study is to explore some important factors determining flow of FDI into transition countries. In particular, we analyze the legal environment for FDI in some transition economies. Then we model the impact of stability of the economic and legal environment on the pattern of FDI. Our analysis shows that (i) higher variability of basic macroeconomic fundamentals reduces the flow of FDI, (ii) high volatility of fiscal and business regulations makes the inflow of FDI smaller, and (iii) macroeconomic and legal instability leads to adverse selection of the investors. Based on theoretical findings we formulate a clear message to policy makers stating that in order to expect significant flow of long term and non-speculative foreign capital, first of all, a stable economic and institutional environment is needed.