Foreign direct investment in Estonia: a source of productivity spillovers and local industrial development?

Abstract

Foreign direct investment and its effect on host countries have been much discussed topics in both academia and the public policy sphere. They likely will remain on the agenda in the future to come as states continue to compete for capital and knowledge accompanied by increasingly less restrictions on the international transfer of both of them. Likely, potential investors in the future will also be offered incentives by host governments. The results of this study suggest that there may not be sufficient evidence for much special support being put in place to attract FDI. This study exploits a large and detailed panel data set of firms in the Estonian economy to assess the evidence of direct and indirect effects of FDI. The study is conducted through assessing the correlation of foreign ownership at the firm and sectoral level and firm productivity. Additionally, at the sectoral level the evidence for pecuniary externalities is evaluated through a model of domestic firm entry based on foreign investments in a sector. The inflow of foreign direct investment may affect the host country through a large variety of different mechanisms which have been discussed in the literature. Most effects are not unequivocally positive or negative but depend much on case-specific circumstances. This study has assessed three mechanisms through which FDI may affect the host country. These are the direct (own firm) effects, indirect spillover effects and pecuniary externalities of foreign investment. The results are mixed. This study adds to the existing literature through three results based on data for the Estonian economy. First, foreign ownership is found to have a positive correlation with productivity in firms in the host country. While the extent of this effect may vary between sectors, overall there is relatively strong evidence for direct effects of FDI on productivity. Second, the results are more mixed concerning indirect effects of FDI. The study finds horizontal and forward linkages to have a positive correlation with firm productivity while the correlation is negative for backward linkages. The study makes it possible to compare effects in different sector for both direct and indirect effects, thereby providing directions for further research into sector-specific characteristics facilitating spillover effects. As a third finding, the study cannot corroborate the assumption that positive effects of FDI may to a significant extent occur through pecuniary externalities. The simply entry rate model employed in the study does not find a correlation between domestic firm entry and foreign concentration in a sector. The results differ from much of the previous studies given the fact that most studies have found stronger evidence for a positive effect through backward linkages than for other kinds of spillovers. These mixed findings reflect the variety of mechanisms by which FDI affects a host country. The mixed findings point to the direction in which future research should continue. Most studies in the field focus on direct and indirect effects of FDI while the exact mechanisms through which spillovers occur still remain largely a “black box”. This study makes a contribution to other kinds of spillovers through assessing the effect of FDI on one aspect of pecuniary externalities. Further research needs to aim at disentangling more precisely the specific mechanisms at work through which effects on the host country may occur. Given the promising findings concerning indigenous firm development found for mainly Ireland and Poland in the literature, the mechanisms of pecuniary externalities should be a focus of attention. As with other studies in the same field, we need to be cautious with policy conclusions as we are measuring the correlation between two factors but not directly the possible causal link between them. Generally, there is evidence that inflow of FDI is correlated with increased productivity especially when ownership is transferred. This result provides some rationale for countries to actively encourage the inflow of foreign investments. However, policy also needs to incorporate the fact that the specific mechanisms of host country effect are still largely unclear. These two policy implications are already found in the Estonian policy regime towards FDI and their continuation can hence be recommended. Based on the findings of this study, the strength of the regime lies in its focus on creating an overall favourable investment. This is in contrast to very specifically targeting sectors or kinds of investments and providing subsidies for these as has been the case in other countries. The rationale of specific subsidies is not sufficiently corroborated by the empirical literature including this study and hence may only distort investment flows. Estonia has been successful in the attraction of FDI through its policy of non-discrimination between different sources of investments and hence its continuation can be recommended. There is no reason why lessons from the Estonian FDI policy experience may not also be applicable in particular to other transition economies. However, particularly three specific characteristics of the Estonian situation need to be taken into consideration when applying similar measures as these characteristics may affect outcomes. First, Estonia early introduced a clear and consistent FDI policy regime. The small size of the country may have played a role in the quick and consistent implementation. Second, Estonia at the time of its economic liberalization already had a relatively high standard of development when compared to other transition economies. This may have facilitated the development of positive host country effects. Third, the cultural and geographic proximity to the Nordic countries has served as a comparatively easily accessible source of investments. Such an advantage is arguably not available to many other transition economies.