Does Foreign Direct Investment Have an Effect on Economic Development? The Case of Bulgaria

Blagoy Kitanov

Final Paper

TNCs and National Governments

Does Foreign Direct Investment Have an Effect on Economic Development:
The Case of Bulgaria

Introduction

There is a big amount of literature in the recent decades about the broad effect of foreign direct investment (FDI) on the development of the recipient country. Interestingly, policy-making has come to ignore the ambiguous and inconclusive academic research results in terms of the benefits and costs of FDI. Almost every country nowadays strives to attract foreign investment most probably due to the success stories of some countries that have achieved rapid economic growth after encouraging FDI (China, Ireland, Hungary, Czech Republic). It is beyond doubt that transnational corporations (TNCs) possess much of the world’s stock of technological knowledge and are productively using it. However, it is not so obvious whether the host countries can benefit from that knowledge.

This paper examines the issue of whether FDI has a significant effect on economic development of the recipient country and more specifically whether FDI has an impact on economic transition of post-communist Bulgaria. It will be argued that a general attempt to correlate FDI stock and GDP growth is not as important as assessing which sectors of the economy will be positively affected by foreign investment. The main thesis is that FDI does have an effect on economic development but whether this effect will be significant (positive or negative) depends on the sectors that receive foreign capital. If FDI is attracted to areas where there exist comparative advantages and perspectives for development in the host country, the effect will be beneficial. Otherwise, the technology and capital gains will be insignificant. The widely used concept of “absorption capacity” will be used to explain under which circumstances horizontal and vertical spillovers from FDI are taking place.

In the case of Bulgaria, FDI have played a role in economic development in a much later stage (after 1997) due to inefficient structural reforms, slow privatization, macroeconomic instability and institutional incongruence. Most of the FDI in the country now goes to the real estate sector and to the low-technology labor intensive industries, but there are incipient trends for growing investment in higher technology branches. In any case, Bulgaria is still far away from the development of an export-oriented economy.

A Quick Overview of the Bulgarian Transition Process

Between 1990 and 1997 Bulgarian transition experience has been dismal. The country had been experiencing severe balance of payments problems since the mid-1980s which led to the accumulation of more than $ 9 billion in foreign debt.^[1] After the collapse of the communist block, Bulgarian industries lost main markets, output fell dramatically and the debt-service ratio was rising to unsustainable levels. This forced the government to declare moratorium on debt payments^[2], thus cutting Bulgaria off from Western capital markets in the beginning of transition. Structural reforms were inadequate due to political struggles, shadowy economic interests and, most importantly, due to the communist-inherited behavior of economic agents. State enterprise managers took advantage of the loosening controls and extracted resources from the state for their own benefit. Asset stripping and rent-seeking were widespread and eroded the productivity of the industries. On top of that, privatization hadn’t started until 1995-1996 and was carried out in such a way that excluded foreign firms from participation because it chose the “voucher” method whereby Bulgarian citizens had priority. All in all, by the beginning of 1997 only 20% of the state owned assets were privatized.^[3] Greenfield investment was also low since foreign investors were not interested in setting up a business in unstable macroeconomic and institutional environment.

Accumulation of external and internal debt and insufficient foreign exchange reserves were the main causes of a deep financial crisis in 1996 – 1997. After the introduction of a currency board (that stabilized the currency) and the election of a new government that pursued conservative fiscal policy, completely liberalized capital flows and foreign trade and finally carried out effective privatization, a business environment conducive to FDI was created. Privatization laws were amended so that foreign investors were entitled to invest in Bulgaria under the same terms and conditions available to local persons; license and registration regimes were simplified; tax incentives were designed to attract foreign capital.^[4] FDI prior to the setting up of the currency board were $ 63 million per year (2% of GDP), while afterwards they reached $ 700 million average per year (6% of GDP).^[5]

Impacts of Inward FDI in Transitional Economies: A Theoretical Framework

In this section, I will use a well-established framework in the relevant literature analyzing the effect of FDI on the macroeconomic environment and on the transition process of the host country.

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^[1] Vesselin Dimitrov, Bulgaria : The Uneven Transition (London: Routledge, 2001), p. 69

^[2] Ibid., p. 71

^[3] Ibid., p.74

^[4] Radmila Jovancevic and Zeljko Sevic (ed.), Foreign Direct Investment Policies in South-East Europe (London: Greenwich UP, 2006), p. 254

^[5] Ibid., p. 256