THE EFFECT OF FOREIGN DIRECT INVESTMENT ON LABOUR PRODUCTIVITY: EVIDENCE FROM ESTONIA AND SLOVENIA

University of Tartu
Faculty of Economics and Business
Administration





THE EFFECT OF FOREIGN
DIRECT INVESTMENT ON
LABOUR PRODUCTIVITY:
EVIDENCE FROM ESTONIA
AND SLOVENIA

Priit Vahter












Tartu 2004

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ISSN 1406–5967
ISBN 9985–4–0413–0
Tartu University Press
www.tyk.ut.ee
Order No. 527

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THE EFFECT OF FOREIGN DIRECT
INVESTMENT ON LABOUR
PRODUCTIVITY: EVIDENCE FROM
ESTONIA AND SLOVENIA
Priit Vahter1
Abstract
This paper studies the effects of foreign direct investment on
labour productivity in manufacturing industries of two
transition countries, Estonia and Slovenia. The emphasis is on
the dimension of export/local market orientation. The study is
based on firm-level panel data. It is shown that in Estonia the
export oriented foreign investment enterprises have on average

1 PhD student, Faculty of Economics and Business Administration,
University of Tartu, Narva 4–A214, 51009 Tartu, Estonia; Tel. +372
737 6116; E-mail: pvahter@mtk.ut.ee or Priit.Vahter@epbe.ee Help-
ful comments and suggestions by Urmas Varblane, Jaan Masso, Kars-
ten Staehr and Andres Võrk from the University of Tartu, Ari Kokko
from Stockholm School of Economics, Andrei Kuznetsov from
Manchester Metropolitan University and Martti Randveer from the
Bank of Estonia are gratefully acknowledged. I wish to thank Jože P.
Damijan from Ljubljana University for help with obtaining the panel-
data of Slovenia. Preliminary versions of this study have been
presented at the conference EU Integration and the Prospects for
Catch-Up Development in CEECs––The Determinants of the Produc-
tivity Gap, Budapest, 28–30 May, 2004; workshop Transition and
Enterprise Restructuring in Eastern Europe, Copenhagen, 26–28
August, 2004. This paper has also benefited from comments by
seminar participants at the Faculty of Economics and Business
Administration of the University of Tartu and at the Halle Institute for
Economic Research. Any remaining errors are the responsibility of the
author.

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4
The effect of foreign direct investment on labour productivity
much lower labour productivity level than the domestic market
oriented foreign affiliates. In Slovenia, on the contrary, the
export orientation of a foreign affiliate is not correlated with
lower labour productivity. No horizontal spillovers of foreign
direct investment to domestic firms are detected in Estonia. In
Slovenia, however, positive spillovers to domestic firms are
found but there is no indication of spillovers to other foreign
affiliates. The findings show that different types of foreign
direct investment can have different effects on the host country
and that the existence of positive spillovers may depend on the
level of economic development of the host country.

Keywords: foreign direct investment, productivity, spillovers,
export oriented FDI
JEL Classification: F10, F21, F23

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CONTENTS

1. Introduction 7
2. Theoretical Background.................................................. 9
3. Previous Empirical Literature.......................................... 15
4. Data and Descriptive Statistics for Estonia and Slovenia.... 17
5. General Model and Econometric Concerns ........................ 30
6. Estimation Results .............................................................. 35
7. Conclusions ........................................................................ 42
References .............................................................................. 45
Kokkuvõte ............................................................................... 50

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1. Introduction
Foreign direct investments (FDI) have had a significant role in
enterprise restructuring of transition countries in Central and
Eastern Europe (CEE). Governments in CEE also provide a lot
of incentives for FDI. Justifications for these special incentives
are traditionally the possible beneficial effects caused by the
transfer of technology from the parent company to its local
affiliate and the related positive spillover effects to the domestic
owned firms of the host country. However, empirical literature
on spillovers (e.g. Aitken and Harrison on Venezuela in 1999,
Djankov and Hoekman on the Czech Republic in 2000,
Smarzynska on Lithuania in 2002) shows that there is not much
conclusive evidence to support this view.
The aim of this paper is to study the effects of FDI on labour
productivity in Estonia and Slovenia in the sector of
manufacturing. By using data for Estonia and Slovenia we can
study the effect of FDI on labour productivity in these two
countries that have had different stages of development, i.e.
implying also substantially different effects of FDI. Slovenia
has the highest gross domestic product (GDP) per capita among
the CEE transition economies. In Estonia the level of GDP per
capita is lower, the inward FDI penetration rates have been far
higher. In Estonia also the attitude, the government policies and
the privatisation methods have been more FDI friendly. Hence,
the reasons why investors choose the host country are different
for Slovenia and Estonia.
The research is based on firm-level panel data of the manu-
facturing industries of Estonia and Slovenia from the second
part of 1990s until 2001. We study the correlation between
foreign equity participation in the firm and the firm’s own
productivity, i.e. “own firm” effect—in the terminological tra-
dition of Aitken and Harrison (1999). We endeavour to investi-

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8
The effect of foreign direct investment on labour productivity
gate whether there exist intra-industry (within the same sector)
spillovers from foreign affiliates to the firms with no FDI and to
other foreign affiliates.
We also focus on the issue whether the “own firm” productivity
effects are dependent on the type of FDI. More specifically: is
there a difference in “own firm” effects between the export
oriented and the domestic market oriented FDI? The
exporting/local market orientation dimension is usually (except
e.g. Kokko et al. 2001, Sgard 2001 or Harris, Robinson 2001)
discarded in the analysis of effects of FDI on productivity. The
effects of these two types of FDI on the host economy may be
fairly different. This distinction is also relevant for the debate
on how should governments design their policies to attract FDI
and if the export oriented FDI is preferable for the host
economy as the policy literature sometimes assumes (e.g. World
Investment Report 2002).
Employing panel data techniques we account for the firm-
specific time-invariant effects and also for the sample selection
bias. Another important issue mentioned by several authors is
the non-random selection of FDI recipients. In the case the most
productive local firms receive FDI and unless we account for
this, the positive productivity effects of FDI might be overes-
timated. To account for this possibility, in addition to the usual
methods of econometrics of panel data, we also employ a two-
step procedure to correct for the sample selection bias.
This study of the “own firm” and horizontal spillover effects of
FDI on productivity endeavours to contribute to the rapidly
growing literature, it has the benefits of adding the export/local
market orientation dimension to the analysis and using
enterprise-level panel data for two different CEE countries. One
interesting finding in this paper is that in Estonia the export
oriented foreign investment enterprises have on average much
lower labour productivity level than the domestic market
oriented foreign affiliates. In Slovenia, however, the faculty of
export orientation of a foreign affiliate is not correlated with
lower labour productivity. We detect no horizontal spillovers of

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Priit Vahter
9
FDI to domestic firms in Estonia. In the case of Slovenia
positive spillovers to domestic firms were found, nevertheless
no spillovers to other foreign affiliates were detected. The
remainder of the paper is organised as follows: Section 2
discusses briefly the theoretical relations between FDI and
productivity; Section 3 surveys the most relevant findings of
empirical literature in this field; Section 4 gives the data
overview and studies the average characteristics of different
types of foreign affiliates and domestic firms; Section 5 pre-
sents the general model estimated and discusses various econo-
metric problems of estimation; Section 6 gives the estimation
results of the regression analysis; Section 7 concludes.


2. Theoretical Background
In order for the FDI to materialise, the multinational enterprises
(MNEs) must possess some firm-specific competitive advan-
tages that allow them to compete successfully in the foreign
environment. These advantages—the firm-specific assets—can
constitute of production technologies, but they may also be
related to special skills in management, distribution, product
design, marketing, and other links in the value chain, or be
made up of brand names and trademarks (Caves 1996; Kokko et
al. 2001). One can argue that, in the case of export oriented
FDI, a significant part of the firm-specific advantages of a
foreign firm is made up of networks, relations or other export
related know-how. The theory of FDI stresses the positive links
between firm-specific knowledge based assets and the decision
to invest abroad (e.g. Dunning: 1988: 1–5; Blomström, Kokko
1996: 2; Harris, Robinson 2001: 3). These firm-specific assets
have some characteristics of a public good and can be
transferred at low cost between the subsidiary of the MNE and
its parent company.
Technology transfer by FDI could result in “own firm” and
spillover effects on host economies:

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10 The effect of foreign direct investment on labour productivity
1) the “own firm” effect, i.e. the average performance cha-
racteristics of foreign enterprises differ from those of the
domestic enterprises (DE) in the host country (are presu-
mably better than these of the DEs);
2) various spillover effects from the presence of foreign firms
affect the performance of domestic firms (and other foreign
affiliates active in the host country, spillovers are also
usually presumed to be positive, at least for the DEs)
(Aitken, Harrison 1999: 605–608; Blomström, Kokko 1996:
7, Smarzynska 2002: 1–5).
The extent of technology transfer to a local affiliate depends on
the reasons why FDI was made into the country (host country
advantages), what role and probably also what extent of
autonomy the local foreign investment enterprises (FIE) have in
MNEs value added channel. If the main reasons for investment
were the low cost level of the host economy, including
cheapness of labour or other factors of production, then it is less
likely that higher value-adding activities would be transferred to
a local FIE. Thus the “own firm” or “own-plant” effect of FDI
depends on the international competitive advantage of the host
country and the reasons why FDI was undertaken by this
particular MNE. Higher value creating activities (e.g. R&D) are
more likely to be allocated to local FIE in case there exists high
enough level of absorptive capacity in the local firm and/or host
economy as a whole (Damijan et al. 2003: 18).
The advantages of FDI that presumably result in better
performance (incl. productivity) of FDI affiliates, if compared
to domestic enterprises, are well documented in literature (see
e.g. Aitken, Harrison 1999; Blomström, Kokko 2003; Smar-
zynska 2002, Görg, Strobl 2001). The well-known paper by
Aitken and Harrison (1999) summarises the most important
reasons why economists usually assume that foreign owned
firms will have higher productivity than the rest (Aitken, Harri-
son, 1999: 605). Firstly—superior (and possibly newer) pro-
duction equipment can be transferred from the parent company
to its FDI affiliate. Secondly, the foreign affiliate also receives
an inflow of non-tangible assets from its parent—in the form of

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