The Impact of Fdi Inflows on Real GDP in Estonia: Evidence from a Cointegration Approach and Causality Test

By Kisswani, Khalid M.; Kein, Alar et al. | The Journal of Developing Areas, Fall 2015 | Go to article overview

The Impact of Fdi Inflows on Real GDP in Estonia: Evidence from a Cointegration Approach and Causality Test


Kisswani, Khalid M., Kein, Alar, Shetty, Shekar T., The Journal of Developing Areas


(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

In the literature many studies shed light on the effect of FDI on economic growth. In theory it is believed that foreign direct investment (FDI) enhances the productivity of host countries and promotes economic development. This notion comes from the fact that FDI may not only provide direct capital financing, but may also create positive externalities via the adoption of foreign technology and know-how (see DeMello, 1997, 1999). Yet, the empirical evidence on the existence of such positive productivity externalities is still debatable. [1] The macro empirical literature finds weak support for an exogenous positive effect of FDI on economic growth. Findings from this literature indicate that a country's capacity to take advantage of FDI externalities might be limited by local conditions, such as the development of local financial markets or the educational level of the country. In addition, there are studies suggest that the entry of foreign firms could lead to negative effects through a decrease in labor productivity at domestic firms (Lutz and Talavera, 2004). Thus, the evidence on the relationship between FDI and economic growth available up to date is still rather mixed, even for individual countries and does not allow making definite generalizations.

In this paper we focus our attention on the relationship between FDI and economic growth in Estonia. Estonia deserves our attention for the following reasons. First, Estonia is a (former) transition economy. Considering the theory-based expectations and the technological backwardness of the transition countries at the start of transition from command to market economy, we believe that the impact of FDI on economic growth should, first of all, reveal itself in the study of transition economies. Second, Estonia stands out as a country, where the transition from a command to a market economy (that started in the beginning of 1990s) has been one of the most rapid and successful ones in terms of economic growth and institutional changes among former command economies. Within less than two decades Estonia has been able to build functioning market-economy-institutions virtually from scratch and has joined the European Union (EU) and the Euro - zone. In real terms, Estonia's GDP has more than doubled and its GDP per capita (in Euros nominal terms) has increased by roughly 13 times during the past two decades. All this has led to the rather rapid convergence of GDP per capita in Estonia to the EU average levels. [2]

Third, during roughly the same period Estonia has experienced a strong inflow of FDI. FDI has grown from 0.66 billion euros (17.7% of GDP) at the end of 1996 to 14.7 billion euros (84.2% of GDP) by the end of 2012. As a result, the FDI stock per capita (11,000 euros) in Estonia ranks as the highest among the Central and Eastern European countries.[3] Fourth, the FDI in Estonia has relied predominantly on FDI inflows from two high-income Nordic countries: Sweden and Finland, which are characterized by high level of knowledge and technology and, therefore, could potentially contribute to the economic growth in the host country via spillover of knowledge and technology.[4] Fifth, Estonia is an open economy with good education and banking systems, which empirically have turned out to be important factors that determine the role of FDI on economic growth.[5] Finally, regardless of the fast and successful transition from command to market economy, impressive economic growth, openness, high share of FDI and the origin of FDI predominantly from the high income and advanced-technology-countries, the published empirical studies (to the knowledge of authors) haven't provided support for the hypothesis of the impact of FDI on economic growth in Estonia, although, based on the theory and the empirical evidence from many other countries (including from transition economies), expectations of a positive contribution of FDI on economic growth, could arise. …

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