1. Introduction
Foreign direct investment (FDI) is a versatile concept based on the fact that it plays an important role in a country’s development, and there are many aspects related to this issue that need to be carefully examined.
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unemployment can increase based on the fact that foreign companies using new and modern technologies will need less employees compared to similar domestic companies (
Forte and Moura 2010;
Žilinskė 2010) and that they are looking to use local cheap resources (
Žilinskė 2010);
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and that knowledge transfer from multinational enterprises is usually directed to local suppliers or customers, and prevention of technology leak to local competitors is achieved usually through intellectual property protection (
Smarzynska Javorcik 2004;
Gerschewski 2013).
Secondly, even though there is evidence that FDI positively influences economic growth, there is no clear evidence regarding who benefits more (host countries or home countries) (
Lipsey 2002).
Thirdly, there is a lack of studies that investigate categories of countries that attract the highest values of FDI (developed countries vs developing countries). Diaconu
Maxim (
2015) pointed out that for a long period of time, developed countries attracted increasing flows of FDI compared to developing countries; however, the situation changed after the 2008 global financial crisis. Obviously, besides global crises, there are other factors that can change FDI inflows from one country or region to another.
It is also very important to analyze and understand which factors are the major determinants of FDI. The numerous empirical studies that have been conducted to reveal the economic, social, and cultural determinants of FDI have generally focused on economic size and growth, inflation, openness, financial development, tax rates, physical infrastructure, institutional development, economic freedom, religion, distance between countries, and common culture (e.g., see
Bayar and Ozel 2014;
Saini and Singhania 2018). However, a few studies have focused on the interplay between finance and FDI. In this context, authorities play a major role in developing and implementing strategies that can create an appropriate and favorable environment for FDI.
There are many other aspects that need to be clarified related to issues of FDI. In this study, we focus mainly on the interaction between FDI inflows and financial sector development considering the gap in the related literature, as well as the fact that many studies have investigated the factors mentioned above. In recent years, financial sector development has become a significant economic growth factor together with the acceleration of financial liberalization and the considerable expansion of the global financial sector through the efficient allocation of funds achieved by the easing of risk management, allocation of resources, monitoring managers, mobilizing savings, and easing of output transfers (
Levine 1997). In this context, many theoretical and empirical papers have focused on the discovery of factors underlying the development of the financial sector. The conclusions of these studies revealed that institutions, trade openness, legal traditions, and political economy are major factors which promote financial sector development (
Law and Habibullah 2009;
Huang 2011;
Voghouei et al. 2011;
Popescu 2014;
Cherif and Dreger 2016). Furthermore, globalization processes have led to considerable increases in the flows of FDI and transnational portfolio investments. As a result, global FDI flows reached
$1.76 trillion in 2015 after a substantial contraction due to recent crises in the world (
UNCTAD 2016). In addition, global portfolio equity was approximately
$1.116 trillion in 2014 (
World Bank 2016a). Therefore, both FDI and portfolio inflows have become important sources of finance, especially for countries with insufficient capital. However, the increasing frequency and severity of the crises associated with globalization processes have caused significant decreases in foreign capital flows, and interruptions in international capital flows may damage the development of economies.
Consequently, researchers have focused on the finance-growth nexus and the FDI-growth nexus in parallel with these transformations, and they revealed that both financial sector development and FDI inflows have made significant contributions to economic growth through various channels (
Adeniyi et al. 2015;
Nwaogu and Ryan 2015;
Chowdhury 2016;
Pradhan et al. 2016). Based on data from eight European developing countries (i.e., Albania, Belarus, Croatia, Latvia, Lithuania, Poland, Romania, and Turkey),
Mahmoodi and Mahmoodi (
2016) concluded that economic growth can be stimulated by FDI inflows.
Simionescu (
2016) reached the same conclusion that FDI had a positive impact on economic development using data from EU-28 countries, during the years from 2008–2014.
However, a limited number of studies have been implemented to investigate the interaction between financial sector development and FDI inflows, despite these two variables having the potential to theoretically affect each other. In this context, FDI inflows may affect the development of financial sectors positively by increasing funds in a financial system, but it can also have no influence or a negative impact on the development of a financial sector, as FDI inflows are also an alternative financing instrument, or in other words, a competitor for domestic financial markets (
Levine 1997;
Desbordes and Wei 2014). Furthermore, a more developed financial system causes a country to experience FDI inflows by providing external finances under better economic conditions for the attraction of FDI inflows (
Desbordes and Wei 2014). On the other hand, foreign portfolio investments can contribute to the development of financial sectors by providing funds for financial markets through purchases of financial instruments, but considerable withdrawals in the foreign portfolio inflows have the potential to damage financial institutions. However, an improved financial sector can lead to increases in foreign equity flows by providing more financial instruments (
Desbordes and Wei 2014). Based on an analysis that focused on Brazil, Russia, India, China, and South Africa,
Kaur et al. (
2013) reach the conclusion that stock market capitalization and the size of banking sector positively influenced FDI, and they additionally specified that “more domestic credit by the banking sector negatively influences FDI inflows.” On the contrary, another study conducted by
Aqeel et al. (
2004) found that FDI inflows in Pakistan were significantly influenced by the size of domestic credit to the private sector. Consequently, the interaction among FDI inflows, foreign portfolio inflows, and financial development remained ambiguous in theoretical terms.
The main objective of this paper is to analyze the short- and long-run interactions between financial development and FDI inflows using data from a panel of 11 Central and Eastern European Union (CEEU) countries, consisting of Slovenia, Slovak Republic, Romania, Poland, Lithuania, Latvia, Hungary, Estonia, Czech Republic, Croatia, and Bulgaria between the period from 1996–2015. The CEEU countries have transited from closed or relatively closed economies (
Estrin 1991;
Uvalic 2018) to open market ones as a result of the late 1980s collapse of the Communist Bloc and pursued integration within the European Union (EU).
Decades of communism put their mark on each economic sector and the process of transition from communism to capitalism was a long-term process that involved systemic reforms. Obviously, at the beginning of the 1990s each country had its own level of economic development and adopted different reforms during the transition period which attracted different levels of FDI.
Dãian (
2012) and
Gorbunova et al. (
2012) stipulate that starting with the 1990s, European countries in transition faced massive inflows of FDI. This is not surprising taking into consideration that multinational enterprises found a well-educated and cheap labor force there, as well as good infrastructure (
Noble et al. 2011). The study conducted by
Gorbunova et al. (
2012) on 26 former socialist European countries also concluded that FDI inflows were mainly influenced by “specific market and institutional factors”, and therefore, in order to attract FDI inflows it was necessary to focus more on institutional factors rather than economic ones. So institutional variables have become relatively more important than economic factors in this sample of countries due to the transformation process.
Integration with the EU, another important stage in CEEU countries’ evolution, also forced them to make structural reforms for EU membership. Therefore, CEEU countries have attracted FDI inflows and foreign portfolio investments from developed EU member countries and also from other countries as a result of economic and institutional transformations.
This paper is one of the initial studies on the finance-FDI nexus and is structured as follows.
Section 2 is a literature review which provides a brief review of some of the previous representative studies related to this subject.
Section 3 provides the data and econometric methodology, and gives an explanation of the data and methods used in this research.
Section 4 is an empirical analysis which indicates the empirical results based on selected tests. Finally, the last section presents the main conclusions of this research.
2. Literature Review
It is well known that an abundance of FDI in a country generates economic growth (
Kurtishi-Kastrati 2013). There are many benefits associated with FDI, including environmental and social improvement, knowledge transfer, employment opportunities, new technologies, and innovations (
De Mello 1997;
Basu and Guariglia 2007;
Kurtishi-Kastrati 2013), and the generation of state budget income (
Nistor and Păun 2013). Even these benefits differ from one country to another based on their ability to attract FDI, and it is very important for all countries to see FDI as a source of economic development and modernization.
Considerable expansion in both foreign capital inflows (i.e., FDI inflows and foreign portfolio investments) and financial sectors have led researchers to discover possible macroeconomic effects of foreign capital inflows and financial development. Empirical studies have generally focused on the FDI and portfolio inflow–growth nexus and the financial development–growth nexus (
Eschenbach 2004;
Acaravci et al. 2009;
Wan 2010;
Almfraji and Almsafir 2014;
Ahmad et al. 2016). Furthermore, some authors have studied the influence of financial development on the FDI–growth interaction and discovered financial development was a prerequisite for the positive interaction between FDI inflows and growth (
Alfaro et al. 2004;
Adjasi et al. 2012). However, a limited number of papers have analyzed the interaction between FDI inflows and financial development, although they revealed that financial development was a significant factor that lead to FDI (
Al Nasser and Gomez 2009;
Korgaonkar 2012;
Desbordes and Wei 2014;
Bayar and Ozel 2014;
Fauzel 2016;
Enisan 2017). On the contrary, a limited number of papers showed that FDI inflows have made significant contributions to the development of financial sectors (
Abzari et al. 2011;
Sahin and Ege 2015;
Gebrehiwot et al. 2016). The relevant literature has generally focused on the impact of financial sector development on FDI inflows. This study investigates the impact of FDI inflows and portfolio inflows on the development of financial sectors as distinct from the existing literature.
In the related literature, there have been no studies which investigate the impact of FDI inflows on the development of financial sectors in the total sample of CEEU countries. However, some studies included several countries from the CEEU sample, and these studies generally revealed a significant relationship from financial development to FDI inflows (e.g., see
Korgaonkar 2012;
Desbordes and Wei 2014;
Bayar and Ozel 2014).
Korgaonkar (
2012) also analyzed the interaction between financial development and FDI inflows in 78 countries over the period from 1980–2009 utilizing a data mining approach and discovered financial development was an important prerequisite for the attraction of FDI inflows.
Desbordes and Wei (
2014) researched the relationship between FDI flows and financial development of both source and destination countries in 83 source countries with 3919 parent companies and 125 destination countries with 13 broad manufacturing sectors over the 2003–2006 period, employing panel regression and revealing that improvements in financial sectors of source and destination countries had positive impact on FDI flows.
Furthermore,
Bayar and Ozel (
2014) also explored the determinants of FDI inflows in seven EU transition economies during 1997–2011 and concluded that financial development positively affected FDI inflows. In another study,
Sahin and Ege (
2015) also examined the causal interaction between FDI inflows and financial development in Turkey, Macedonia, Greece and Bulgaria over the period from 1996–2012 using bootstrap causality tests and revealed a unilateral causality from FDI inflows to financial development in Bulgaria and Greece, but a two-way causality in Turkey.
Some papers researched the interplay between finance-FDI for different countries and country groups. In one of the initial studies,
Al Nasser and Gomez (
2009) studied the interplay among FDI inflows, banking, and capital market development in 15 countries from Latin America between 1978 and 2003 with panel regression and revealed a positive interaction among FDI inflows, banking sector, and capital market development. Furthermore,
Anyanwu (
2011) revealed that financial development affected FDI inflows negatively in the study about factors behind FDI inflows to Africa. In a similar way,
Abzari et al. (
2011) analyzed the causality between financial development and FDI inflows in eight developing countries between 1976–2005 using a Vector Autoregressive (VAR) model and reached a contrary one-way causality from FDI inflows to financial development.
Gebrehiwot et al. (
2016) analyzed the connection between financial development and FDI in eight African countries between 1991–2013 employing Granger causality tests and panel regression and revealed a two-way causality between the variables.
Bayar and Ozturk (
2016) also examined the causal interaction between financial development and FDI inflows in Turkey over the 1974–2015 period with the bootstrap Granger causality tests of
Hacker and Hatemi-J. (
2006) and determined a one-way causality from the development of financial sectors to foreign direct investment inflows.
Fauzel (
2016) also analyzed the relation between FDI and financial development in a small island developing states during the 1990–2013 period, using a panel vector autoregressive model and found a bi-causal relationship. Therefore, foreign investments contribute to countries’ financial development, but that it also attracts and encourages foreign investment.
Enisan (
2017) investigated the major determinants underlying FDI inflows in Nigeria employing the Markov regime-switching approach and revealed that the development level of a financial sector is one of the main determinants for FDI attraction.