FDI in Poland

Dan Deluca

Introduction

For many developing economies, Foreign Direct Investment (FDI) is seen as a way to promote economic growth and industrial development. Poland is an example of a country that has been very successful in attracting FDI, and this appears to have propelled a lot of the country’s recent economic growth. Starting from a difficult position in the early 1990’s, Poland’s economy grew strongly during the second half of the decade. At the same time it became the dominant recipient of FDI in Eastern Europe. In 2001, Poland was the fifth largest developing-country recipient of FDI in the world, behind only China, Hong Kong, Brazil, and Mexico.

Like other former Eastern Bloc countries, Poland is no ordinary developing economy. Some economists refer to these former communist countries as “transition economies”, since they are making the transition from an economy with minimal capitalist experience, institutions, and infrastructure to a free-market economy. These countries are seen as having a high level of economic potential in the relatively short term. But they require substantial investment and structural change to realize that potential. And it is often helpful for a poor country to receive that investment from overseas. The success that Poland has had in attracting investment capital may prove instructive to other developing economies. Likewise, Poland’s continuing economic struggles show that FDI is just one component of an economic growth plan, not a quick solution to a country’s problems.

History

Poland is justifiably famous as the first Eastern Bloc country to experience a widespread popular revolt against the communist system, beginning with the unrest in the Gdansk shipyards in 1985. Poland formed the first non-communist government in the Eastern Bloc in 1989, and undertook significant capitalist reforms in 1990 and 1991. There was substantial economic and political instability in these years, as the government and economy adjusted to the new regime.

Poland had experimented with integration with the West in the 70’s and 80’s, with poor results. In the early 80’s, growth was strongly negative, inflation was very high, and foreign debt reached unsustainable levels. Though not as famous as the Mexican default of 1985, Poland’s announcement in 1990 that it could not pay its debts limited the FDI flowing to Poland in the early 1990’s.

But by 1994 the economy had stabilized, and in that year Poland rescheduled its external debt in what was called the Club of London Agreement. After this, FDI in Poland increased dramatically, from $88 million in 1990, to $3.7 billion in 1995, to $10.6 billion in 2000. FDI dipped in 2002 to around $8 billion, as privatization has slowed and some macroeconomic issues have developed. Overall stock of FDI in Poland has expanded from $3 billion in 1992 to $62 billion in 2002.

Much investment in the early and mid-1990’s was related to privatization, as the government sold off assets to foreign investors. In recent years, privatization has slowed, contributing to the decrease in FDI. In March 2002, Poland instituted a new set of incentives for foreign investment, similar to incentives in place in Hungary and the Czech Republic. These incentives, plus a great deal of other information for potential investors, are detailed in the web site of the Polish Agency for Foreign Investment (http://www.paiz.gov.pl/en).

Foreign investors are represented throughout the economy. Manufacturing, telecommunications, and construction have received the most FDI, since investors had to spend large amounts of money to modernize these sectors. The financial sector has also received much FDI, since a thorough revamping of the financial system was required in the transition to capitalism. Key investors include France Telecom, GM, Fiat, Daewoo, Citibank, HVB Group, Gazprom, and Vivendi Universal.

Economic growth was strong for a number of years once Poland began receiving substantial FDI in 1995. The economy grew an average of 4.8% in each year from 1995 to 2001. Gross Domestic Product (GDP) per-capita increased from $3,280 in 1995 to $4,881 in 2002. From 1995 to 2001 exports increased from $23 billion to $36 billion, but imports increased even more, from $29 billion to $50 billion. Growth in both imports and exports were propelled by foreign-owned firms. Also, the nature of exported goods changed dramatically, with manufactured goods comprising a much higher share. This pointed to a shift in manufacturing from basic goods, such as food and steel, to more complex value-added goods, fueled largely by foreign firms.

In the last two years economic growth has slowed to around 1% a year. This is partially related to the economic slowdown in Poland’s key trading partners, first in Russia in 1998, and later in Germany, which takes about a third of Poland’s exports. But other macro-economic factors are also involved. There are still many state enterprises, especially in mining and heavy industries, which are unprofitable, and generally inefficient. In addition, the government has been running a large deficit, currently about 5% of GDP, largely due to generous social welfare programs, many left over from the Communist era.

Unemployment has become a problem, with the overall rate hovering between 15% and 20% since 2000, substantially higher than in Hungary or Czech Republic. There is no evidence that FDI has contributed significantly to overall unemployment, by, for instance, large-scale layoffs by acquired companies. But one factor could be the restrictive and expensive regulations and taxes related to labor. Companies pay very high payroll taxes, and generous benefits are mandated by the government, so there may be some reluctance to take on new employees.

In addition to high unemployment, Poland is also suffering from a growing disparity between people who live in the cities and people who live in the country, with the latter suffering much higher unemployment and lower incomes. This is due in part to structural factors, such as poor rural infrastructure and education. It may also be an unintended effect of the relatively rapid industrial modernization of Poland spurred by FDI. Investment -- both foreign and domestic -- has been concentrated in manufacturing, and a few other industries, whereas agriculture has not received the investment needed to modernize.

Whether current economic difficulties will lead to a further decrease in FDI remains to be seen. FDI to Poland did decrease in 2002, but it was still over $8 billion, and FDI has generally been decreasing globally. What is clear is that the Polish economy has gone through a substantial, though incomplete, economic transformation, and FDI has played a large part in this process.

Lessons Learned

FDI appears to be an important contributor to economic growth.

Although it is impossible to know what would have happened to the Polish economy without the substantial FDI it received starting in 1995, it appears that this investment was an important contributor to Poland’s overall economic growth during the period. Economic growth increased after 1995, at the same time as FDI took off. Increased exports were largely fueled by foreign firms -- their share of exports increased from 21% to 48% between 1994 and 1998. FDI also contributed to an increase in total investment - which, along with productivity improvements, is a key determinant of overall growth. The foreign share of investment increased from 20% to 40% between 1994 and 1997.

A Stable Economic and Regulatory Environment is Important for Attracting FDI

Poland undertook the original “shock treatment” in changing from a communist economy to a capitalist economy in the early 90’s, resulting in substantial economic turbulence from 1990 to 1994. In addition, it had a substantial overhang of public sector external debt, which the state had declared itself unable to pay. As a result, Poland did not attract much FDI in the first half of the 1990’s, with Hungary receiving the bulk of FDI flowing to Eastern Europe. But in 1994, Poland signed the Club of London agreement with its external lenders, which rescheduled its external debt. This was seen as a turning point for Poland and after this FDI increased dramatically, and Poland quickly became and continues to be the dominant recipient of FDI in the region.

A High “Hassle Factor” is a Strong Disincentive for FDI

Poland, Hungary, and the Czech Republic have been much more successful than Russia in attracting FDI. These countries have focused on the needs of investors, and have been very clear and consistent in the incentives, regulations, and taxes that foreign firms face. Russia, on the other hand, has not been able to give foreign companies the type of legal protection and regulatory transparency needed to ensure that investment risk is reasonable. Foreign firms in Russia have frequently found themselves subject to unexpected taxes and regulations, often in a simple attempt at official extortion. Criminal extortion, and other criminal activity, is also much more widespread in Russia than in the Central European countries. These factors have resulted in Poland consistently receiving 3-4 times as much investment as Russia, despite having just one-fourth the population, and the same educated workforce, low costs, and basic infrastructure.

The Effect of FDI on the Balance of Payments Can Be Either Positive or Negative

There are two primary reasons that foreign companies enter a new country. If focused on market opening, the foreign company hopes to establish a local presence and sell locally. If focused on production efficiency, the foreign company hopes to exploit low costs or other resources to produce for export. Market opening investment is more likely to lead to increased imports, since inputs may be imported, but output will be sold locally. Production efficiency investment may have a more beneficial effect on the balance of payments, since output is destined for export. However, such investment can still negatively affect the balance of payments for a while, since such firms may import substantial capital equipment and production inputs for some time. Generally it takes 2-4 years for industrial firms to begin sourcing locally.

In the case of Poland, exports of foreign-owned firms increased dramatically in the late 90’s, but imports by these same firms increased even more. The auto industry in particular appeared to be focused on market opening at first, importing many inputs and selling most output in Poland. Given the state of Polish industry in general, there has been a great deal of import of both inputs and capital equipment, contributing to deterioration of the trade balance. FDI, then, clearly contributed to a negative balance of payments, though this might have been an inevitable by-product of industrial restructuring that FDI was promoting.

The initial stages of FDI, at least in a previously under-served “transition economy”, may be motivated more by market potential than production economies

This means that merely having lower labor costs may not be enough to attract investors to a country. Investors are generally more inclined to set up in a country where they think there is a population that will be willing and able to buy their products. As noted above, auto manufacturers first entered Poland as a way to gain share in a previously under-served market. And it appears that in Poland, and in the other transition economies of Eastern Europe, this was generally the pattern. These countries were particularly under-served in terms of consumer goods and services, so these areas received a lot of initial-stage FDI.

FDI Leads to More FDI

Not surprisingly, foreign direct investment has a “signaling effect”, which lets other investors know that the economy and government are functioning effectively, and the country is worth investing in. Since 1995 Poland has consistently been the largest recipient of FDI in the former Eastern Bloc. Hungary and the Czech Republic have also been consistent recipients of FDI, and the list of developing countries receiving the most FDI each year -- China, Mexico, Brazil, Hong Kong, South Korea, Singapore -- is generally quite consistent.

Nonetheless, developing countries should be wary of the idea of “priming the pump” - i.e. giving very large incentives to attract initial foreign investment -- in the absence of the real economic, legal, and regulatory stability sought by foreign investors. These investors are sophisticated, and so the signaling effect of FDI is not enough to cause them to overlook structural shortcomings. An economy hoping to gain increased FDI would do better to improve the economic and regulatory environment for foreign investors than to focus on giveaways.

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