Foreign Direct Investment in European Transition Economies : The Role of Policies

Gravity factors explain a large part of Foreign Direct Investment (FDI) inflows in transition economies, including in Southeastern Europe—a region not comprehensively covered before in econometric studies—but host country policies also matter. Key are policies that affect unit labor costs, the corporate tax burden, infrastructure, and the foreign exchange and trade regime. This paper focuses on non-privatization FDI—a novelty in the literature—and finds evidence of nonlinearities, with the impact of policies on FDI changing above a certain level of income. It also develops the concept of potential FDI for each host country, using its deviation from predicted levels given optimal policies to estimate what governments can realistically expect to achieve in terms of attracting additional FDI