The Role of FDI in Trade and Financial Services in Transition: What Distinguishes Transition Economies from Developing Economies?

Abstract

Modern commercial sectors create backward linkages that encourage quality and cost effective production, while financial institutions create forward linkages that help to impose efficient governance structures throughout the economy. The latter are also crucial for FDI in other branches of the economy. The so-called banks and commercial organizations created in socialist times are part and parcel of the old system, where they performed mostly mechanical functions and hence lack the know-how, skills and proper incentives needed in a market economy. They therefore hinder, rather than help transition. The large urban sector and the complex production sector in transition economies which is in dire need of its restructuring, require fast development of such services. This is why FDI in these services is potentially so important to the transformation process.

Following a theoretical introduction and the exposition of the main argument, the paper examines the quality of policies and market infrastructure that enhance or create barriers to FDI in general and to financial and commercial sectors in particular, with special emphasis to indicators of law and order. We use indices developed by the EBRD, Transparency International and the International Institute for Management Development (IMD) to quantify these obstacles, and find that some indices provide satisfactory explanations for the structure of FDI.