The Effect of Human Capital on Inwards FDI: Evidence from European transition economies

A country’s human capital has been neglected as a potential determinant of inwards foreign direct investment (FDI), both in theory and empirical research. When human capital has been included in models of the determinants of FDI, it appears simply as a control variable or one of the variables in a “kitchen sink” approach, usually without any theoretical rationale for its inclusion or critical discussion of the measures used. The mis-specification that may result from this is advanced as one of the potential explanations for the very diverse findings in previous literature and the failure of the meta-regression analysis (MRA) reported in this thesis to find an ‘authentic’ effect of human capital on inwards FDI. Accordingly, this research seeks to fill this gap, by identifying the mechanisms through which human capital is expected to attract FDI to European transition economies and drawing conclusions about the most appropriate measures of human capital given the characteristics of the former communist (education) system. The ‘productivity-enhancing’ skills and traits that (foreign) investors are likely to value in such economies are identified and the manner in which these skills are developed is analysed. In the light of this analysis the conventional human capital measures used in empirical analyses are critically assessed. These contributions are used to develop an empirical model for estimating the effect of human capital on inwards FDI at country-, sector- and industry-level in 12 European transition economies during the period 1995-2008. Consistent with the results of previous studies, as suggested by the MRA, no significant effect of traditional volume measures of human capital on FDI inflows/stocks is found. However, some evidence is presented in this thesis indicating that the quality dimension of human capital as measured by cognitive skills proxies may affect inwards FDI in the manufacturing sector. Accordingly, several potential explanations for the findings and some of their implications for future macro-level research focusing on the effects of human capital are explored.