Foreign direct investment (FDI) has stimulated economic growth in Central, East and Southeastern Europe (CESEE) over the past 30 years, helping convergence with Western Europe, but some forms of FDI have been much more beneficial than others, according to econometric research by the Vienna Institute for International Economic Studies (wiiw) published on November 30.

At a press conference, speakers from the wiiw and the German Eastern Business Association (which commissioned the report) insisted that despite a slowdown in FDI flows since the Global Financial Crisis, foreign investment would continue to have a vital role to play in the region’s development, particularly now that international companies are rethinking their supply chains.

Phillipp Haussmann of the German Eastern Business Association admitted that the German economy had benefited more than almost any other from the opening of markets and the lower production costs in Eastern Europe since 1989.

At €360bn, German trade with the CESEE region was now one fifth of Germany’s total trade, bigger than that with the US and China combined. “Our close economic ties with the region made a decisive contribution to Germany’s global competitiveness,” he said.

But he added that the investment and trade relationship between Germany and Eastern Europe had benefited both sides and was not a “one-way street”.

The report, entitled “Economic and Social Impacts of FDI in Central, East and Southeast Europe”, in fact showed that German and Austrian FDI had the most impact on the region in terms of growth, creating jobs, raising wages, as well as reducing poverty and not widening inequality, largely because it was concentrated in the sectors such as manufacturing, and via means such as retained earnings, that had the biggest effects.

Haussmann added that the efforts by some states to weaken these investment links were therefore misguided.  “Efforts to disadvantage foreign investors or to force them out of strategic sectors are a loss for both sides,” he warned. Viktor Orban’s regime in Hungary has regularly launched such campaigns against foreign investors.

The report dismisses populist arguments against FDI, such as that it crowds out domestic investment, arguing that the weak linkages between domestic and foreign companies in the region meant that FDI had had no effect on domestic investment either way.

Tremendous opportunities

The panellists also pointed out that there would also still be great opportunities for CESEE countries from planned nearshoring or “friendshoring”, as multinationals seek supplies from nearer countries or those that share Western values following the disruption to supply chains caused by the COVID-19 pandemic in China, as well as the Ukraine war and sanctions on Russia.

“Right now, German companies are reorganising their international supply chains against the backdrop of global upheavals,” Haussmann said. “The shortening and regionalisation of supply chains play an important role in this. There are tremendous opportunities for Central and Eastern Europe if the framework conditions are right.”

Gunter Deuber, chief economist of Raiffeisen Bank, one of the biggest banks in the region, added: “A lot of companies are currently looking at projects,” though he said the new investment cycle would start in two to three years.

The European Bank for Reconstruction and Development’s 2022/23 Transition Report published last week included a survey showing that three quarters of German manufacturing companies in global supply chains have implemented at least one measure to improve the resilience of their supply chains and that Central European suppliers were seen as much more reliable than Chinese or other Asian ones. Already in Hungary and Slovakia more than 35% of output comes from work for global supply chains.

However, the panellists said that the rule of law – currently a serious problem in Poland and Hungary – and labour shortages were big obstacles to a new FDI wave. Haussmann warned: “The shortage of qualified labour is becoming more and more a problem. That is the biggest problem – as long as the rule of law is guaranteed.”

According to the report, since the collapse of communism, CESEE countries have had a wave of FDI that has completely transformed their economies. Between 1993 and 2020 the world as a whole has been receiving annual FDI inflows of around 2.5% of global GDP, while foreign investment in the 17 countries in CESEE has averaged 4.4% of GDP (the report excludes post-Soviet countries apart from the Baltic states).

After an early focus on Central Europe and the Baltic states, over the past decade investment has been moving into the Western Balkans.

Average annual flows of FDI into individual CESEE countries as a percentage of GDP over 2011-20

In relation to GDP, the highest stock of FDI is in Montenegro at 110% of GDP, followed by Estonia at 100% and Serbia at 90%; the lowest were in Slovenia, Romania and Bosnia & Herzergovina, at around 40%.

In the four main states of Central Europe, Czechia has the highest stock of FDI as a percentage of GDP, followed by Hungary, Slovakia and then Poland – by far the largest economy – bringing up the rear.

Most of these inflows into CESEE – around 60% of the total – have come from the nearby EU15 countries, with Germany focussing most on Central Europe, while Austria has carved out a niche in the Western Balkans, and the Nordic countries in the Baltic states. By contrast, Russia, China, Turkey and companies registered in Switzerland have been big players in the Western Balkans.

According to the report, FDI inflows representing 1 percentage point (pp) of GDP are associated with 0.19 pp higher GDP growth, indicating a causal link between FDI and GDP growth via increased household consumption and higher exports.

For FDI from Germany and Austria, this effect is five times higher – FDI inflows of 1 pp of GDP have led to 0.9 pp higher GDP growth. Germany had invested some €190bn in the region by the end of 2020, while Austria had contributed €76bn.

FDI has also lowered unemployment, though normally after a two-year lag, and has also increased wages.

Investment into manufacturing and services has had more impact on economic growth than investment into the primary sector (agriculture and mining), and FDI via equity injections or retained earnings has been more beneficial than investment via debt instruments (such as loans to affiliates), the research found.

“FDI in debt instruments or FDI in the primary sector does not have the same effect on GDP growth, and sometimes it has negative effects,” Branimir Jovanovic, one of the authors of the report, told the press conference.

This would indicate that equity investments by German carmakers into greenfield plants in Central Europe have helped convergence much more than investments through loans in Southeastern European countries such as Montenegro, Serbia and Bulgaria, a path often followed by Chinese companies.

Targeting investment

The report admits that overall, FDI has had no significant impact on inequality and poverty, but adds that FDI from European countries has been found to reduce both inequality and poverty, likely because it has benefitted mainly lower-income persons. By contrast investment through loans or into primary industries such as mining have had much less impact.

“CESEE economies should not give up on their efforts to attract more FDI, but also their endeavours should be more targeted, focusing on investments that have greater economic and social impacts,” the report recommends.

The report argues that foreign investment should not be criticised for widening inequality, or the fact that the region has the highest poverty rates in Europe, but instead, the causes of this should be sought in domestic factors.

“Our results indicate that the reasons for the perhaps unsatisfactory economic and social outcomes in the CESEE countries – such as the limited economic growth and the significant level of social disparities – should not be attributed to the foreign investment,” the report says. “Instead, one should look at domestic factors, such as weak support for domestic private investment, insufficient public investment in infrastructure, a modest level of spending on public services and the limited scope of government redistribution.”

At a press conference, Doris Hanzl-Weiss, one of the authors of the report, concluded that, “FDI is still important for the growth model of the region. We don’t see any big alternative growth model for the region without FDI as a cornerstone.”

Maria Holzner, executive director of wiiw, also insisted that FDI still had a big part to play in the region’s development. “Foreign direct investment continues to be the basis of the growth model in Central and Eastern Europe,” he said. “Those countries in the region that have the highest incomes are also closely integrated into the Central European industrial cluster through high levels of foreign direct investment. A good example is the direct investments of the German automotive industry, which have created tens of thousands of jobs for qualified skilled workers who were particularly hard hit by the collapse of large state-owned industrial enterprises in the course of the economic transformation after 1989.”