The central and eastern European EU Member States have recorded impressive productivity gains over the past 15 years. Despite this catching-up process, however, a marked gap vis-à-vis the rest of the EU remains. These productivity gains have been accompanied by substantial inflows of FDI, which have been facilitated by supportive government policies.
A key question is thus how important FDI inflows have been for the convergence process in general and for productivity gains in particular. In addition, it is important to understand whether and which economic conditions affect the size of the benefits associated with FDI inflows. Studies on productivity growth have underlined the importance of absorptive capacity, which may enhance the transfer of technology and thereby strengthen the impact of FDI on productivity growth. The emphasis on absorptive capacity is based on the idea that the potentially positive impact of FDI on the receiving economy may fail to materialise if domestic companies lack sufficient abilities to imitate and adopt superior technologies used by foreign firms.
This paper provides empirical evidence of the overall effect of FDI inflows for productivity convergence in central and eastern Europe, using industry-level data from a relatively new and to a large extent still unexploited harmonized database (EU KLEMS). These data have a country, industry and time dimension, covering a wide range of countries and sectors in a consistent way. An important feature of the paper is that it also concentrates on whether the size of benefits associated with FDI depends on the absorptive capacity of the recipient country. The robustness of the empirical results in the paper is checked by relying on two alternative econometric approaches, one exploiting the cross section while the other the time dimension of the data.
The results in this paper point to the following conclusions. First, there is a strong convergence effect in productivity both at the country and at the industry level, i.e. productivity growth depends positively on its gap vis-à-vis the euro area. Second, foreign capital, in the form of FDI inflows, plays an important role in accounting for productivity growth in the central and eastern European region. Third, the impact of FDI on productivity critically depends on the capacity to absorb technology. More specifically, the effect of FDI on productivity seems to be increasing with a declining productivity differential vis-à-vis the euro area. There is also evidence that the level of human capital is positively associated with a larger impact of FDI. The former type of interaction between absorptive capacity and the beneficial impact from FDI seems to be important in manufacturing, whereas the latter is more significant in services.
Overall, this paper provides empirical evidence that FDI and absorptive capacity are key factors for productivity convergence in central and eastern Europe. The policy implication is that creating favourable conditions for FDI is likely to support productivity convergence. More importantly, however, the favourable impact of FDI on productivity is not automatic and can be strengthened by improving the absorptive capacity of the recipient economy.