The "Addiction" with FDI and Current Account Balance

The EU new member states (NMS) have been recipients of substantial net capital inflows in the form of FDI. Economic policy makers and development strategists often regard them as the pillar of the development and neglect their potential long run consequences: inevitable deficit in the investment balance. FDI however affects current account balance also indirectly by improving or deteriorating trade balance which might overweigh negative direct effects, moderate them, or add to the deterioration of the current account balance. Capital outflows through the investment account in NMS have been increasing rapidly . Namely, the rates of return on FDI are twice the rates of return on portfolio investments and three times the rates of return on loans. Indirect effects have moderated strong direct effects but could not overweigh structural current account deficit caused by transition. A major problem might arise as a consequence of the “addiction” with FDI. First, the outflows of capital speeded up by the opportunities of multinationals to reallocate production to the countries with even cheaper labor might become larger than new inflows. Second, sudden interruption of FDI inflows could result in an exchange rate crisis.