Gunter Merdzan
BSF Report 2
IDEFE Publications, 2026
64 pp.
ISBN: ISBN: 978-608-4944-35-5
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Introduction
The question of whether foreign direct investment represents an additional source of capital that stimulates domestic investment activity, or a mechanism through which foreign companies crowd out domestic firms from the market, is one of the central questions in the literature on international business, development economics and economies in transition. This question is particularly important for the countries of Central, Eastern and Southeastern Europe, since their economic development in the last three decades has been closely linked to the processes of liberalization, privatization, institutional transformation and integration into European and global production chains. In these economies, foreign direct investment has most often been treated as an instrument for overcoming the shortage of domestic capital, modernization of production capacities, transfer of technology and improvement of export competitiveness. However, their impact on domestic investment is not unambiguous, as it depends on the form of entry, sectoral structure, the degree of connection with domestic firms, the development of financial markets, the quality of institutions and the absorptive capacity of the host country.
In theoretical terms, foreign direct investment differs from portfolio investment in that it implies permanent participation, control and managerial influence of the foreign investor in the host economy. Unlike short-term capital inflows, FDI usually involves investment in production facilities, technologies, organizational practices, marketing networks and access to foreign markets. In the classic literature on multinational companies, Hymer (1976) lays the foundation for understanding FDI through the idea that firms invest abroad not only because of differences in capital returns, but because they possess specific firm advantages that enable them to compete in foreign markets. These advantages can be related to technology, brand, managerial knowledge, organizational capabilities or access to financial resources. Buckley and Casson (1976) through the theory of internalization, further explain that multinational companies choose a direct presence abroad when it is more efficient than licensing, exporting or market transactions, especially when there are market imperfections and the risk of losing control over technology and knowledge. Dunning (1980, 1988) through the eclectic OLI paradigm, synthesizes this logic through three conditions for the emergence of FDI: firm ownership advantages, host country locational advantages, and internalization advantages.
These theories are particularly relevant for the countries of Central, Eastern, and Southeastern Europe, since their attractiveness to foreign investors resulted from a combination of locational factors: relatively lower labor costs, geographical proximity to Western European markets, the process of European integration, privatization of state-owned enterprises, and gradual improvement of the institutional framework. In the early stages of the transition, a significant part of FDI was associated with privatization, banking, telecommunications, energy, and takeovers of existing enterprises. In the later stages, especially after the enlargement of the European Union, foreign investment increasingly focused on manufacturing sectors, the automotive industry, electronics, parts and components, services linked to global value chains, and export-oriented capacities. Therefore, in these countries, FDI should not be analyzed only as a financial inflow, but as part of a broader process of restructuring production and integration into the European economic area.
The theoretical relationship between FDI and domestic investment is most often analyzed through two opposing hypotheses: the crowding-in effect and the crowding-out effect. According to the first hypothesis, FDI can increase domestic investment activity through several channels. First, foreign companies can create demand for domestic suppliers, logistics, construction services, parts, maintenance, and business services, which stimulates investment by local firms. Second, through the transfer of technology, managerial practices, and quality standards, FDI can increase the productivity of domestic enterprises and encourage them to invest in new equipment, human capital, and organizational improvement. Third, foreign companies can increase the export potential of the economy, which creates a larger market for domestic firms and reduces dependence on limited domestic demand. In this sense, FDI is seen as a catalyst for domestic capital accumulation and as a source of long-term structural transformation.
On the other hand, the crowding-out hypothesis suggests that foreign investors can have a negative impact on domestic investment if they crowd out local firms. Multinational companies often have better access to finance, more advanced technology, higher productivity, developed distribution channels and a stronger brand, which can reduce the competitiveness of domestic companies. In conditions of limited financial markets, foreign companies can indirectly increase the pressure on local sources of financing, especially if domestic firms are dependent on bank loans. In addition, foreign companies can attract skilled labor from domestic firms, thereby increasing labor costs and limiting the capacity of local enterprises to expand. Therefore, the positive effect of FDI on domestic investment is not automatic, but depends on whether foreign investments create links with the domestic economy or remain isolated production islands.
The empirical literature shows that the impact of FDI on domestic investment is heterogeneous and depends on the development level and institutional context of the host country. Borensztein, De Gregorio and Lee (1998) show that FDI can be an important channel for technology transfer and contribute to economic growth, but its effect is conditional on the level of human capital in the host country. de Mello (1999) analyses the role of FDI in capital accumulation, output growth and productivity, stressing that the effects differ between developed and less developed economies. Agosin and Mayer (2000) directly ask the question of whether foreign investment stimulates or displaces domestic investment and show that the results depend on the region, the structure of investment and the ability of the domestic economy to absorb the benefits of foreign capital. This literature lays the foundation for an empirical analysis in which FDI is not treated as universally positive or negative, but as a conditional development factor.
In the context of transition countries, Mišun and Tomšík (2002) show that the effects of FDI on domestic investment vary even among relatively similar economies, identifying positive effects in Hungary and the Czech Republic, but negative effects in Poland over the period analyzed. Jude (2019) further develops this debate by arguing that FDI can crowd out domestic investment in the short term, but generate additional effects in the long term through creative destruction, production linkages, and technological learning. This approach is particularly relevant for CEE, as these economies have gone through different phases: initial transition and privatization, a period of strong capital inflows before the global financial crisis, post-crisis adjustment, and a new phase of nearshoring and regional positioning following disruptions in global supply chains.
The characteristics of the sample countries further justify the need for a separate analysis. The sample includes Albania, Bosnia and Herzegovina, Bulgaria, Croatia, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, North Macedonia, Poland, Romania, Serbia, Slovakia and Slovenia. Although all of these countries are part of the broader post-socialist and European development space, they differ in terms of income level, depth of financial markets, degree of integration into the European Union, industrial structure, institutional quality and the ability of domestic firms to connect with multinational companies. More advanced economies from Central Europe, such as the Czech Republic, Slovakia, Slovenia, Poland and Hungary, integrated into European production networks relatively earlier and have deeper domestic financial and industrial capacities. In contrast, economies from the Western Balkans and parts of South-Eastern Europe have long faced weaker institutional capacity, limited domestic savings, a smaller market, higher political uncertainty and weaker connections of domestic small and medium-sized enterprises with foreign investors.
The Republic of North Macedonia is a particularly significant case in this analysis. As a small, open and landlocked economy, the country faced limited domestic capital accumulation, a narrow industrial base and high dependence on external sources of growth. In the early years after independence, economic transformation was hampered by the break-up of the Yugoslav market, regional instability, the Greek blockade and the 2001 conflict. Later, policies to attract FDI, particularly through the “Invest in Macedonia” campaign and the establishment of technological and industrial development zones, contributed to the entry of foreign companies into the automotive and export-oriented industries. These investments played an important role in modernising the industrial structure, increasing exports and introducing new production standards. However, the question remains whether these investments have sufficiently stimulated domestic investment or whether their effect has been limited by weak links with local suppliers, limited technological absorption and structural weaknesses in domestic SMEs.
The theoretical background of this report is therefore based on the view that FDI should not be assessed solely by its volume, but by its ability to create complementarity with domestic investment activity. For the countries of Central, Eastern and South-Eastern Europe, the essential question is not only whether foreign capital enters the economy, but whether it creates production linkages, technological learning, domestic supply networks and long-term growth of private investment. In this sense, the analysis of the relationship between FDI and gross fixed capital formation allows for an assessment of whether foreign capital reinforces domestic capital accumulation or displaces it. The special focus on North Macedonia allows this issue to be considered in a specific institutional and development context, in which FDI has been an important instrument of industrial policy, but its long-term effect depends on the ability of the domestic economy to move from passively attracting foreign investors to actively building domestic investment and production capacity.
The empirical analysis in this report is conducted on the case of selected countries from Central, Eastern and South-Eastern Europe. In the descriptive part of the report, the broader regional overview includes 15 countries: Albania, Bosnia and Herzegovina, Bulgaria, Croatia, Czechia, Estonia, Hungary, Latvia, Lithuania, North Macedonia, Poland, Romania, Serbia, Slovakia and Slovenia. This broader descriptive coverage is retained in order to present the general movement of FDI inflows and gross fixed capital formation across the region. However, after the preliminary data screening, Hungary is excluded from the main econometric analysis because its FDI series contains several extreme and highly volatile observations, including large negative values, which could disproportionately affect the estimated relationship between FDI and domestic investment. Therefore, the regression analysis is based on an unbalanced panel of 14 countries over the period 1997–2024. The countries included in the econometric sample are Albania, Bosnia and Herzegovina, Bulgaria, Croatia, Czechia, Estonia, Latvia, Lithuania, North Macedonia, Poland, Romania, Serbia, Slovakia and Slovenia. This distinction between the descriptive sample and the econometric sample is maintained consistently throughout the report.
The remainder of the report is structured as follows. Section 2 presents the relevant literature on the relationship between foreign direct investment and domestic investment, with particular attention to the crowding-in and crowding-out effects. Section 3 provides a descriptive overview of FDI inflows and gross fixed capital formation in the selected CESEE countries and in North Macedonia. Section 4 explains the data, variables and empirical methodology used in the analysis. Section 5 presents and discusses the econometric results for the CESEE countries and North Macedonia, while Section 6 summarises the main findings and provides policy recommendations.
Does Foreign Direct Investment Boost Domestic Investment? Evidence from Cesee Countries and North Macedonia
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