Positive And Negative Effects Of Foreign Direct Investment (Fdi) On Post-Communist Economies—The Case Study Of Hungary

After the fall of the Communist regime, Eastern European countries faced the challenge of reconstructing and transforming their heavily centralised economies into functional free-market economies that would place them in line with developed capitalist countries. Thus they engaged in intensive institutional reforms, all following different paths, strategies and instruments. Hungary’s path towards the market economy did not follow the mainstream due to early economic and political changes that were implemented in the pre-democratic era—namely, the introduction of so-called ‘goulash Communism’, which represents a more gradual and organic approach to the capitalist market and was implemented in the late 1970s when a number of competitive measures were introduced. Hungary was one of the most successful cases of economic and democratic transition. However, the high dependence on foreign direct investments (FDI) has had a double effect on the country’s development. This article offers an explanation of the recent economic developments and the economic growth in Hungary. The purpose is to emphasise both the positive and negative impacts of foreign direct investment on the transitional and post-transitional period, as well as its effects on the current macroeconomic situation in Hungary. This qualitative study offers an analytical view of the last few decades, is relevant in terms of economic structure, and helps to explain the placement of Hungary within the global capitalism structure.

The first part of the paper provides a brief description of the socialist period and pre-transitional years in Hungary, emphasising a number of economic reforms that were introduced by the New Economic Mechanism and so-called ‘goulash Communism’

The metaphor of “goulash Communism” refers to the different path that the Communist regime pursued in Hungary after the Hungarian Revolution of 1956, when the Kadar regime imposed economic and social reforms and policies aimed at softening the restrictions of the Communist dogmas and creating high-quality living standards.

Although the Hungarian socialist period shared a great number of characteristics and economic distortions with the other satellite countries, such as a centralised economy, fixed and subsidised prices, soft budget constraints and gosplans or distorted structure of production and lack of comparative advantage, Hungary maintained a different path, both in the management of the economy and in the political sphere. The Communist regime in Hungary was described as the loosest, and the country was also designated as the one with the most favourable living conditions before the fall of the Iron Curtain. After the uprising in 1956, Hungarian political leaders realised that there were well-defined limits to what citizens would and would not tolerate. This realisation led to the implementation of the New Economic Mechanism (NEM) in January 1968, a system that decentralised authority for decision-making to ministries and local councils, introducing competitiveness and incentives for productiveness.

What is most striking is that the introduction of the NEM occurred in the background of the wider intra-Soviet debate that captured the Communist and Marxist thinkers of the 1960s

Other useful references in this context are the chapters on Liberman and “An attempt to economic reform” and Kosygin “Soviet Consumerism” in Daniels (1993) or Gale Stokes’s book “Stalinism to Pluralism: A Documentary History of Eastern Europe Since 1945” that detail the debate on. For a review of the literature on the debate regarding the soviet progressive reformation see Kaser (1965).

Some of the most important reforms ought to be given a special glance in order to highlight the earliness of the transitional start in Hungary. By 1986, 41 percent of the retail goods were already free of price control (by 1988, 63 percent; by December 1990, 90 percent), while in 1987, in order to harden the budget constraints, attempts were made to transform the Magyar National Bank into a two-tier bank system through the transformation of the three main credit departments into commercial banks. In 1988, a new tax system was introduced that was similar to international fiscal practices and included a value-added tax and a personal income tax (Kornaj 1997, Palankai 1997). Before the demise of Communism in Europe, Hungary had already taken bold steps towards market liberalisation, which explains the privileged position of Hungary vis-à-vis the other Central and Eastern European Countries. The way from socialism to capitalism was paved with a high level of indebtedness, although the transition process was designed and led by a strong community of Hungarian economists with international reputations who had the confidence and the knowledge to question the transition policies suggested at the international level. Even though a painful rapid change was considered unjustified and irrelevant, and a gradual systemic change was favoured initially, by 1995, Hungary found itself in need of ‘shock therapy’ policies. The objectives of Hungary at the beginning of the transition period converged with the objectives of all ex-Communist countries—namely in establishing the market economy, leading to higher economic efficiency, economic growth and improved living standards. Broadly speaking, this meant 1) improving allocative efficiency by correcting the distortions of socialism (introducing flexible prices and creating a competitive market environment open to the international trade), 2) stabilising the macroeconomy, an endeavour necessary for the correct functioning of the price system, and 3) creating a healthy entrepreneurial environment by providing incentives to the private sector and corporate governance arrangements to make firms and corporations respond to market signals (privatisation and greenfield enterprises), as well as creating government institutions and laws adequate for the functioning of the market economy.

In this article, we argue that the Hungarian transition was split into two well-defined phases: a) 1990–1995, representing a gradual and passive phase with severe economic implications, and b) 1995–2002, representing a period of economic development and an FDI-based transition with positive effects over the national economic indicators such as know-how transfer or enhanced entrepreneurship but also with severe welfare implication, regional inequality and fast-forward privatisation based on neo-liberal principles that hampered the sustainable development of the Hungarian economy. Post-2002, and especially after the 2008 economic crisis, the FDI saturation effect and the consequences of the economic depression revealed the weaknesses of the FDI intensive dependency approach to transition.

In order to stabilise the macroeconomic situation, Hungary adopted a heterodox approach that combined monetary, fiscal and income policies. In the first years of transition, from 1990 to 1995, although Hungary had previously experienced liberalisation, the country had a three-year transformational recession (mostly due to the loss of the common market represented by the Council of Mutual Economic Assistance countries) in which it saw a drastic fall in the real gross domestic product (by approximately 20 percent) and a rise in the unemployment rate. Increasing imports and decreasing exports posed the problem of a considerable trade deficit (Figure 8). Inflation and currency devaluation increased, and by the end of 1994, the Hungarian macroeconomic situation was clearly not sustainable (Figure 1). As Janos Kornai (1997, 125) underlines, ‘the developments in Hungary had some disquieting features as well’. The socialist system had bequeathed the country a dire macroeconomic heritage and, above all, a very high foreign debt. In this respect, the starting point of the Hungarian economy was worse than for most of the other post-socialist economies. There were many difficult tasks that the government in office in 1990–1994 failed to perform, and the succeeding government, which took office in 1994, vacillated for several months to do so. By 1993, the current account deficit had already reached 9 percent of the GDP. When this recurred in the following year, with a deficit of 9.5 percent, there was a real danger that the external finances of the country would get into serious trouble.… The equilibrium problems caused the rise in external and internal debts to accelerate. The growing costs of servicing this debt raised the current account and budget deficit even more so that further loans had to be raised to cover them’.

Figure 1.

Source: World Development Indicators (WDI) & Global Development Finance (GDF) 2018.

The artificial growth of 2.9 percent in 1994 (Figure 2), timid in comparison with other CEES’s, and the double-digit inflation rate of approximately 20 percent (Figure 1) was burdening the country’s economy even more. The first transitional phase was also marked by a rapid increase in the unemployment rate due to the accumulated structural and efficiency problems, the loss of the Eastern European markets and the closure of enterprises. Unemployment reached a peak in 1993 (Figure 3), while the real wage, pension and income indexes faced a decrease compared to the level of 1989, a trend that continued until 1997 (Figure 10).

Figure 2.

Source: World Development Indicators (WDI) & Global Development Finance (GDF) 2018.

Figure 3.

Source: Hungarian Central Statistical Office 2018.

In March 1995, on the background of a dangerously fragile macroeconomic situation, the Hungarian government, together with Central Bank, announced the implementation of a stabilisation package of laws and regulations to adjust the economy and stop the soft reforms. This is defined by Kornai (1997) as a ‘‘small-scale shock-therapy’’ that brought rapid improvements of certain macroeconomic indicators. The package included measures that were primarily aimed at stabilising the national budget deficit (it included cuts in public expenditure by 15%). These measures had an impact on the reduction in consumption and imports as well as the growth of the volume of exports, thus correcting imbalances and deficits. To the same extent, the reform was aimed at monetary and fiscal tightening (devaluation of currency and a change from a fixed to crawling-peg exchange rate regime). ‘‘The extensive macroeconomic package introduced in 1995, (which included the adoption of a crawling-peg exchange rate regime, an impressive programme of privatization and a substantial fiscal tightening), as well as the deepening of structural reforms implemented earlier, created the conditions for remarkable progress of the Hungarian economy over the past two years’’ (i.e. 1997, 1998) (OECD Economic Surveys Hungary 1999, 9). As noted in the 1997 Economic Survey of Hungary, these measures served to restore the competitiveness of the Hungarian industry and substantially reduce both external trade and government deficits. While domestic demand fell sharply, exports expanded rapidly, and inflation fell from a peak of 31 percent in June 1995 to an average of 23.6 percent in 1996 (Figure 4). At the same time, the extensive privatisation of the economy, and particularly of the banking system, “contributed to the microeconomic restructuring and rapid productivity growth.’’ (OECD Economic Surveys Hungary 1999, 9). The main macroeconomic indicators began to stabilise, and Hungary marked a period of growth due to the positive impact of the measures taken. The improved macroeconomic development and lower labour costs boosted the confidence in the business sector, which led to a significant increase in investments, a decrease in the inflation rate, and an acceleration of the GDP in the following years (Figures 4 and 5). However, as it can be observed in Figure 3, even though the unemployment rate decreased significantly since 1995, the measures had no significant impact on the employment rate

The unemployment rate (U3) is a poor measurement for the labor market strength because it only considers people that are actively involved in looking for a job while statistically dis-considering several important subgroups which have either given up or are in the impossibility to do so (retirees, stay-at-home parents, students) (Funk 2009).

Figure 4.

Source: Trading Economics – Hungarian Central Statistical Office 2018.

Figure 5.

Source: Trading Economics – Hungarian Central Statistical Office 2018.

The intense privatisation through an FDI-based strategy was already present since 1990, but it intensified after 1995, when a considerable amount of capital, gathered especially via FDI inflows, enriched the state budged (Hunya 1997). Janos Kornai emphasises that the ‘FDI in 1995, including sums paid in connection with privatization, came to about US$ 4.6 billion. The scale of the sum can be gauged well from the fact that in 1994, the worst year of external disequilibrium, the deficit of the current account was US$ 3.9 billion’. Even though populist debates over the usage of money suggested and pressured the consumption of the money, ‘the economic common sense prevailed at last and, it was decided to use the proceeds of privatizing the key branches for reducing Hungary’s foreign debt. Given how large common debt was, the saving of interest in this way seems to be the safest, and when all is said and done, the most effective investment. That not to mention that a reduction in Hungary’s indebtedness has numerous favourable external effects on the country’s financial ratings as a stimulant to investment’ (Hunya 1997, 141).

The balance of payment indicators for Hungary suggests substantial FDI inflows in the first half of 1990, most notably in 1993 and 1995 (due to considerable privatisation deals) and in 2001, but a considerable drop in 2002 to 2003 (Sass 2014). We make these developments visible in Figure 7, and we note that the ups and downs of the Hungarian economy closely follow the FDI transfers, whereas the development of the macroeconomy in Hungary, to some extent, coincides with the slowdown in the country’s growth rates prior to EU accession in 2004, and with the start of the reaccumulation of debts in 2002, as visible in Figure 6.

Figure 6.

Source: Trading Economics – Hungarian Central Statistical Office 2018.

Figure 7.

Source: Trading Economics – Hungarian Central Statistical Office 2018.

In reinforcing the earlier statements, we notice that from 1995 onwards, and particularly between 1998 to 2003, Hungary had a period of remarkable growth (average of 4–4.5 percent GDP). This period of economic success and growth is owed to the fact that by 1998, approximately 80 percent of the SOEs were sold to strategic foreign investors (Pogatsa 2009), and in 2003, privatisation process ended altogether. The considerable drop in FDI inflows also corresponded with wage increases by 50 percent in the public sector in 2002, which contributed to the decrease of FDI inflows.

On the one hand, the penetration of foreign firms in Hungary is among the highest in the world, which could imply that an upper limit was reached. The large presence of foreign direct investors in many domestic-market-oriented activities leaves room for other investors only if the economy is growing rapidly for an extended period of time. In Hungary, many investors could not find further scope for profitability extending their activities and, thus, they started to invest in neighboring countries, which from 1997 on even led to a considerable increase in outward FDI. Moreover, cost-reducing, export-oriented projects tend to choose other countries in the region with cheaper and more abundant (unskilled and semi-skilled) labor. On the other hand there are numerous unused resources in the country. For example, besides the low labor force participation rate, the availability of unused pools of skilled labor in many regions of Hungary points at yet unexploited foreign investment opportunities’. (Sass 2004, 65)

The Hungarian economy lacked the key element of diversification of investment mechanisms and channels, both foreign and internal, and it became, slowly but firmly, highly dependent solely on foreign investments. When foreign capital halts or reduces its flows (for example, during an economic crisis or as a consequence of an increase of minimum wage national benchmarks), this is rapidly reflected in the economic indicators of any country that is overdependent on external flows of capital.

Starting in 2003, the budget deficit of Hungary increased (Figure 9), while the government debt to GDP ratio (which had diminished from 1998 to 2002) immediately reversed its trend from 2002 onwards, as showed by Figure 6.

Figure 8.

Source: Trading Economics – Hungarian Central Statistical Office 2018.

Figure 9.

Source: Trading Economics – Eurostat 2018.

After the 2004 EU accession, a new wave of foreign direct investment hit the Hungarian market, paired however with FDI outflows approximately equal to the FDI inflows (Figure 7). This arrangement came to an end once the effects of the financial crisis began to appear: in times of necessity, mother companies retain funds to preserve business survival. In 2010, both inflows and outflows had substantial negative levels that indicated the withdrawal of foreign capital from the Hungarian market and its impact on the country’s economy (Figure 7).

It is undeniable that FDI contributed by default to the development of the country’s economic potential mainly through 1) access to capital, 2) management and transfer of know-how, 3) technical skills leading to higher productivity and higher output, 4) development of permanent new economic activities and sectors that improved the country’s overall competitiveness (for example service sector or car sector), 5) higher exports and financial inflows from investing companies as well as 6) spillovers to local firms. However, ‘companies with foreign participation may form a separate island in the economy, having very limited links to local enterprises. They may preserve the technological backwardness of the host country by transferring the low value-added activities.

And may lead the host countries to overspecialize in a few products (and only in certain sectors), thus exposing it to the business cycle of the world economy’ Sass (2004, 77). At the same time, FDI can increase disparities between regions, both in terms of development and wages, or it can limit the sell market of manufactured products (in Hungary’s case, the main market for its products is EU-28) and once the effects of the crisis affected the purchasing power of all European countries, the Hungarian economy was struck by the recession wave and exports of the country declined drastically). Overall, these trends were visible in Hungary during the transition period and had their contribution to the structural economic dynamics of the country. The most recent crisis showed the problems that overdependency can put on the economy in general, particularly in the case of Hungary, although not restricted to it.

Nevertheless, FDI has had, on average, a positive effect on the economic growth of Hungary, but it had a less positive impact on the welfare and aid aspects of the society, particularity in times of transition. Being the country with the highest stock of FDI, higher than all the other transition countries put together, Hungary’s employment rate over time did not show surprising changes but remained at the average of 50–55 percent, lower than the EU-27 average, over the entire period. This process reached its nadir in 1996, when only a third of Hungarians had a job—1.3 million less than in the period of the regime exchange. At the beginning of the 1990s, the employment rate still exceeded 60 percent, falling to 52 percent by 1996. Following the significant fall in the number of employed people in the first period of the regime change, an increase of 9 percent occurred between 1996 and 2006 among 15–64 year-olds, and the employment rate grew to 57 percent. ‘In 2008 and 2009, in connection with the effect of the world economic crisis on the labour market, employment began to decrease again to reach the level of 10 years earlier (55.4%)’ (Hungary 1989–2009, Central Hungarian Statistical Office). These developments are visible in Figure 3. Real Wages Index experienced a decline until the late 90s but started to increase thereafter and arrived at the 1989 level by 2002 (Figure 10). The increase was relatively steady in the private sector but much more variable in the state sectors. Although the wages increased between 2002 and 2006 by 6-10 percent (except 2004 when they actually declined), in 2006 they were only a fraction of the average wages in EU-15, while in the period after 2006 wages started to decline again and future prospects of an increase were hard to be foreseen in the near future.

Figure 10.

Source: Trading Economics – Hungarian Central Statistical Office 2018.

The importance of FDI for the creation of job opportunities is crucial, therefore it is natural to examine the impact of FDI on the regional distribution of employment and income. The findings speak for themselves since 80 percent of the FDI stock transfers were largely located mainly in Hungary’s most developed regions (Central Hungary and Western Transdanubia) and ‘it is not surprising that FDI has increased regional income and employment differences. … In sum, regional income and employment imbalances increased’ (Sass 2004, 84) and although the government has tried to attract FDI to less developed regions through fiscal incentives or development of infrastructure, the initiative had limited success.

The ratio of research and development (R&D) to GDP expenditures declined in real terms, and their ratio to GDP fell from 2 percent in 1989 to below 1 percent within a few years (from 1994–2000). From the end of the 1990s, the ratio rose from 0.67 percent to 1 percent but has not essentially changed since then. It is, however, encouraging that since the mid-1990s, as a consequence of the FDI, many transnational corporations (TNCs) such as Ericsson, Siemens or Nokia transferred part of their R&D activities to Hungary, a fact that indicates that the country has indeed the capability to attract high-value-added foreign direct investment if such a strategy is pursued. The R&D investments, private or national, nevertheless remain limited and the scores for Extent of Market Dominance and Distortive Effect of Taxes and Subsidies on Competition position Hungary at the very end of the Global Competitiveness Index 2018. Hungary ranks 83 and 122, respectively, out of 141 countries for Business Dynamism and Entrepreneurial Culture as analysed by the Global Competitiveness Index 2019. The report shows that Hungary’s stage of development has been upgraded from a factor-driven economy and is currently transitioning from an efficiency-driven economy to an innovation-driven economy, a fact that reflects the positive features of the country’s development strategies in spite of its pitfalls. Hungary’s position out of the 141 countries analysed is 47, and although the country is not badly positioned, it is extremely interesting to see the differences of indicators (in close relation with FDI inflows and outflows) between the latest report and the ones issued in the previous years (particularly 2012–2016) that reflect the economic shock through which Hungary has passed and the fundamental changes in the economic scene at the beginning of the 2008 economic crisis.

The article aims to present an objective cost-effectiveness analysis of FDI’s effects on post-Communist markets by looking at the revealing case study of the Hungarian market in its transitional and early post-transitional years—namely, the period between 1990–2012, split into two separate periods that are marked by separate development strategies. We discuss both the positive and negative effects of FDI inflows on the economic development post-2012 to the present. The main goal of the article is to contribute to the re-interpretation of the Hungarian growth model based on FDI by highlighting both the stabilising power of the FDI model as well as the associated risks, appropriately backed by the synthetic analysis of the standard macroeconomic indicators analysed in the case of countries under the burden of transition: GDP, inflation, debt and deficit.

The present article goes against the mainstream line of analysis which considers Hungary the success model of transition or a ‘start transition student’ (Pogatsa 2009). In going against the mainstream, we present a set of societal welfare drawbacks (wage index, employment, Research and Development indicators.) that present the social consequences of the Hungarian economic path. Within the general debate on models of transition. The approach of the subject at hand is all the more important since the FDI-based model of transition is still viewed as a guaranteed success and therefore implemented in countries under transition at the moment, whereas the scale and effectiveness of foreign investments are largely presented without also highlighting the weaknesses or risks that are associated with them. In this sense, Hungary provides the best example in terms of both the positive and negative effects of the model, analysed using the appropriate macroeconomic and social welfare indicators. It is certain that Hungary has commenced the long road towards the market economy with the clear competitive advantage of a certain level of liberalisation that began prior to the 1990 benchmark. A few countries, including Hungary, embraced the wave of liberalisation and the debate within the Communist elites regarding the reformation of Communism that took place in the 1960s and 1970s. White (1990) identifies five stages of elections in Eastern Europe: 1) semi–civil war, 2) plebiscitary Stalinism of the 1920s–1950s, 3) the de-Stalinising stage of the 1950s to 1960s, 4) a slow widening of electoral choice between the 1960s to 1980s, and finally, 5) the democratisation and free election phase that started post-1990 (White, 277–80). We highlight that besides the NEM and the liberalisation of the banking system, Hungary has also benefitted from a lighter authority starting in the late sixties; therefore, it is a certainty that the seed of liberalisation, both economic and otherwise, in ‘the happiest barrack in Eastern Europe’ was planted before 1990.

Because of the early structural reforms and liberalization, Hungary had the competitive advantage of the frontrunner. However, during the first 5 years of transition this advantage was lost on the background of delaying reforms which led to economic decline and increasing foreign debt. The Hungarian macroeconomic indicators were artificially boosted by the mini shock therapy represented by the stabilisation package (passed in March 1995), which increased confidence in the private sector and particularly foreign investors (the capital accumulation of indigenous businessmen and businesswomen were scarce to begin with). In the second phase of transition, the artificial boost was maintained by privatisation deals (instead of productivity and technological advancement), a constant inflow of FDI facilitated by the governmental incentives. The transitional years of the Hungarian economy were deeply marked by the FDI component, which was devotedly advocated by the neo-liberal vision of the governments (pertaining to both sides of the political milieu—left and right— equally) that held power after the regime change. The double edge of the FDI-based model of economic growth created an ‘over dependent’ Hungarian economy and materialised in side effects that rendered it unsustainable in the long run and exposed it to systemic risks: geographical differentiation in terms of development and productivity, small effects on real wage and employment rate, insulation of the private sector, increased vulnerability during economic crises, the risk of technological backwardness and a lingering of low-added value market activities, among other factors.

Despite the fact that the country previously underwent liberalisation, a gradualist approach of transition avoiding a full-fledged shock therapy that would have a strong impact on the functioning of the economy, and had the largest proportion of FDI, transition and development in Hungary went smoothly, but dangerously and the growth proved to be unsustainable once the economic depression started to cut the bold verve of the foreign investors. Hungary has respected the axioms of Washington consensus with high precision and success being ranked as the leading country among the other transitional economies, although perhaps with too much zeal and without questioning its means (since it is true that the ten points of the Washington consensus do not make any references to its consequences on employment or social externalities or the social costs incurred by the growth measurement package). The FDI-based path proved to be a two-edged weapon that contributed to the growth and convergence of the country in terms of technology but also in the fragmentation of living conditions and standards. Furthermore, it also created a double dependency: growth based on foreign capital and domestic economic stability based on international stability. The FDI model in the early transition period might represent the proper solution to restart economic activity and grease the wheels of the private sector through infusions of capital, know-how transfer, budget stabilisation and employment; perpetuation of the model in ulterior phases of transition implies risks that may steer the national economy towards dependency rather than competitiveness.