Explaining Foreign Direct Investment in Central and Eastern Europe: an Extended Gravitiy Approach

In this paper, we question whether there is a catch-up effect or announcement effectin Foreign Direct Investment (FDI) from the European Union (EU) to the ten EU accession countries. We study FDI outflows from the Netherlands, a small open economy with few historical ties to Eastern Europe, and compare FDI in the transition countries in Central and Eastern Europe to FDI in other regions - most notably to transition countries in Central Asia. In our analysis we try to impose as little structure as possible on the data and allow for heterogeneity within the different regions. In an effort to improve on past studies in the same area, we use a very broad sample of countries, we present country-specific results and test how robust regional dummies are, we check for omitted variable bias and we try to correct for possible non-linearity in the gravity relationships. We find that many of the differences in results of previous studies can be attributed to these specification problems. There is no evidence that an overall catch-up effect or announcement effect exists. Rather,economic fundamentals explain differences in inward investment in the region. FDI and trade are mostly complementary and there is no evidence that there is crowding out between regions.