Obstacles to Foreign Investment Inflows into Ukraine:

Economic Policy Issues and Recommendations

By Orysia Loutsevych

Sergey Ostapenko

Harvard Institute for International Development

1999

I. Introduction

It is a disappointing reality that Ukraine is significantly lagging behind the majority of the transition economies in its ability to attract foreign investments. The process of transitions poses the ultimate financial task: huge capital requirements for the old state enterprise restructuring and the creation of new businesses. Ukraine officially stated the demand for capital in the amount of $40 billion dollars for the next five years.

There are four main sources of capital at the world financial markets: bonds, private loans, equity investments (foreign direct and portfolio investments), and official aid and lending. In the year of 1998 the total amount of foreign direct investment (FDI) in the world was equal to UDS 640 billion. It is increasingly recognized that FDI has the potential to bring substantial benefits to host economies, in terms of capital inflows, transfer of technology, skills, employment, purchasing power, and linkages to the world economy. In this paper, we will focus on the determinants of the inflow of FDI into Ukraine, look into major economic policies at place and assess their impact on investment climate.

The main body of this paper will be built around specificly addressing the following questions:

  1. What are the major determinants of the FDI inflows into transition economies?
  2. What are some major obstacles posed by presenteconomic policies that create unfavorable business climate for the companies with the foreing capital and undermine further foreign investment inflows in Ukraine?
  3. What changes in the economicpolicies are necessary for theimprovement of investement climate in Ukraine?

Foreign capital inflows are the followers in the process of transition, meaning that capital movement is directed to the countries where GDP is growing and sound economic polices are at place. Therefore, broader set of policies designed to provide long-term stimulation to the economy is a necessary precondition of FDI inflows. FDI alone can hardly promote sustainable level of economic growth. It is the task of policy makers to design sound economic policies that stimulate demand and supply mechanisms within the country. High level of FDI inflows in the economy would then serve as an indicator of sound and sable public policy environment.

The actual inflow of FDI to host countries depends upon decisions taken by Trans-National Corporations (TNC’s) which are determined by a myriad of factors. Understanding these factors is important for policy makers wishing to influence investors’ decisions regarding the location of their foreign production facilities. It is assumed that present macroeconomic polices in Ukraine have negative impact on the business activities of the companies with foreign capital and discourage further investments.

In order to study the impact of Ukrainian economic policies at place on investment climate in the country in Part II we describe the determinants that are traditionally accepted as critical to FDI inflow in transition economies in the economic literature and review the basic components of the country-specific risk. Part III will present empirical results about the determinants of foreign investments and discuss its impact on the investment decision-making process. Part IV discusses the impact of present economic policies on companies with foreign capital based of the survey results of 10 companies with foreign capital in Lviv Oblast. Finally, Part V will focus on the impact of specific marcovariables on FDI in Ukraine and discuss possible policy measures that can be taken by the Ukrainian government in order to provide a climate to promote FDI.

II. Country Risk and FDI

Despite the fact that Ukraine has a strategic geographic location, rich natural resources and relatively cheap skilled labor force, which makes its market an attractive investment environment, the country has not yet achieved the expected potential in attracting foreign capital. To the end of 1998 the country has managed to attract only USD 2.7 billion, or 54 USD per capita. Furthermore, over the first quarter of 1999 foreign direct investments registered a drop of 51.7 % in comparison with the first quarter of 1998 (Ukrainian Economic Trends, August 1999).

The decreasing level of foreign capital inflows into Ukraine is particularly evident on the regional level. The decrease in the level of investment activity in Lviv Oblast was one of the largest in Ukraine. Despite its boarder geographic location, traditional linkages to the thriving market in Western Europe, lower wage cost than in other industrialized regions of Ukraine, abundance of highly skilled labor, less competition for foreign investors, and the existence of free economic zones with substantial tax incentives, the level of foreign capital inflow is rather low and continues to decrease. Figure 1 demonstrates a sharp decrease in the inflow on the foreign capital in the oblast.


Source: Lviv Oblast Administration, 1999

This trend could be partly attributed to the influence August 1998 financial crises, which hit not only Ukraine but also all transition economies and increased risk aversion of foreign investors to transition and emerging markets. Nevertheless, besides the external forces that negatively impact FDI inflows in the whole region, internal economic environment in Ukraine impairs its ability to attract foreign capital because of the country’s inconsistent reform record. Over 1998, Ukraine was unable to attract a single new strategic foreign investor.

The availability of capital is crucial for growth potential of any economy. Therefore, it is the pivotal task of a government to create conditions supportive for both domestic and foreign investors. In Ukraine gross domestic investments (as % of GDP) has been decreasing since the year 1994. By depleting the size of national capital stock the country undermines the foundation for transformation of its economy. High level of capital flight and active shadow economy signals about the reluctance of the capital owners to invest in the national economy. Therefore, the research must be focused on creating proper economic conditions both for foreign and Ukrainian owners of capital to invest in Ukraine. By bringing capital, technology, and management skills foreign investments could significantly improve the supply and demand in foreign trade and money market. However, economic recovery and growth will never be sustainable without thorough public sector reform.

It is hypothesized that public economic policies at place create disincentives for new foreign investors to enter Ukrainian market and generate many obstacles to doing business for the existing projects with the foreign capital. Inability to create the business climate with the minimal state interference with operation of markets, efficient financial system, sound monetary policy, presence of the multiple administrative barriers to business operations, slow progress of privatization, and unfavorable tax system, make Ukraine unattractive to foreign and domestic investors.

Research on the determinants of FDI in Ukraine is still in its infancy since the country is a relatively new participant on the global investment market. Therefore, the studies of the determinants of FDI in other transition markets form the basic platform for any researcher aiming to capture the determinants dimension of FDI.

That the countries of Central and Eastern Europe are thought by investors to be relatively risky is suggested by the rating provided by the Euromoney. The index’s March 1999 ranking of 180 countries gave the Central and East European region a very low average rating of 53 (the average rating for industrialized countries is 91) (Euromoney, 1999). The total Euromoney country risk rating is a composite of political risk, economic performance, debt indicators, credit ratings, access to bank finance, access to short-term finance, access to capital markets and discount on fortfaiting. According to World Markets Research Center, in terms of risk, Ukraine received a “significant risk” rating in 1999, which means that “the overall business environment is acceptable but needs significant improvement...and FDI inflows remain pitifully low” (World Market Research Center, 1999). This does not mean that it is impossible for these countries to attract foreign financing. For instance, As of 1998 Hungary has managed to attract FDI in the amount of USD 25 billion, Poland in the amount of USD 30.7 billion, and Czech Republic in the amount USD 8.5 billion (Business Central Europe, 1999).

Evaluation of the overall riskiness of the country is of particular importance to investors. Each evaluation is a careful judgement by the private sector of a government’s ability to maintain a reliable business environment. The evaluation includes all the potential risks that may affect the future profitability of country investments. The risks that investors take into account could be divided into two categories: commercial risk and risk connected to the overall business climate in the country. Commercial risk includes demand for the products and services, credit wrothiness, behavior of the competitors, export regulations, and remittance of the profits. Investment climate risk includes macroeconomic performance, political stability, and the transparency and reliability of the regulatory framework in any given country.

Regulatory framework is critical for foreign investors when trying to determine whether or not to undertake a specific project. A number of companies in Central and Eastern Europe have encountered impediments that have made it difficult to bring their projects to financial closure. Among these impediments are:

  • Lack of government support: even when the government expresses its commitment to such projects, there are difficulties often at lower levels of bureaucracy, especially within ministries, regional and municipal authorities.
  • High transaction costs and uncertainty: few governments in the region have either developed clear guidelines for attracting investors or established a stable investment climate for FDI. In some sectors it may not be clear whether private entry is permitted, what are the economic goals of the government, will societal stability be preserved, etc. In more general terms, there is high political and economic risk that deters investors to commit their financial resources.
  • Insufficiently developed conditions for market entry and exit: the absence of laws defining concessions, bidding, and arbitration procedures. Part of the reason for Hungary’s success in promoting private investments was the early adoption of a concession law (Carter and Holtedahl, 1996)
  • Weak regulation: uncertainty about the future environment for projects, especially with respect to tariff adjustments, taxes, currency regulations, etc.

Apart from the regulatory framework, the lack of developed input markets and infrastrucural deficiencies in the areas such as banking and communications have also been important deterrents. Surveys show, however, that investors have been most concerned about the high degrees of political and economic instability, uncertainty and consequent risk that they face in most countries of the region (McMillan, 1993).

In evaluating the risk of the country for FDI investors take into account many factors. Macroeconomic policies and general business environment are of crucial importance. Statistics shows that within the Central and Eastern European region, FDI has been concentrated in those countries which have achieved success in the progress of transition as indicated by an average score of at least 3 on the EBRD’s scale of transition indicators (EBRD, 1995). The indicator is a composite rating which includes the evaluation of enterprises (the process of privatization, enterprise restructuring); markets and trade (price liberalization, trade and foreign exchange system, competition policy); and financial institutions (banking reform and securities market) in each country of the region. This pattern is reinforced by the results of the IFC and World Bank survey of 3,951 international companies asking about their investment plans in developing and transition countries. The firms clearly indicated that the main obstacles to doing business in transition countries are unpredictability of judiciary, tax regulations, corruption, financing, and general uncertainty on costs of regulations (Pfeffermann and Kisunko, 1999).

III. Determinants of FDI in the Countries in Transition

The analysis of the determinants of FDI is largely the analysis of the forces that shape decisions to invest and how they interact with market conditions, including conditions within potential host countries. The factors influencing the decisions of companies are often distinguished in terms of those factors specific to the firm, those factors specific to the individual location, and policy factors.

Table 1. Principal determinants of foreign direct investment

  1. Firm-specific determinants:
  • Technological assets, usually measured by R&D intensity
  • Product differentiation and marketing skills, measured by advertising intensity
  • Management skills
  • Production efficiencies (multi-plant operations, scale economies)
  • Size and concentration
  • Ease of internalizing returns from ownership advantages
  • Access to capital

2. Locational determinants:
  • Size of host-country markets
  • Production costs, including labor costs and productivity
  • Transportation costs, exchange rates and trade barriers
  • Natural resource availability

  1. Policy determinants:
  • Efficiency of administrative apparatus
  • Domestic economic stimulation
  • Investment incentives and performance requirements
  • Openness to foreign ownership
  • Repatriation policies
  • Fiscal regime

Source: (Gold, 1991)

Decisions by TNCs as to where to locate their foreign production facilities are governed both by the strengths of TNCs and by conditions and policies in specific locations. Countries that seek to attract FDI can do little about firm specific determinants of FDI, but they can influence policy and some locational determinants in a significant manner.

It is possible to offer some generalizations about the locational and policy advantages of countries most likely to influence different types of TNC activity. Dunning [10] offers several factors that are directly related to the establishing of the production subsidiary by a TNC in a foreign country. These are the following factors:

  • High sales potential;
  • Oligopolistic competition;
  • Low production cost;
  • Restrictive import policies;
  • Liberal investment policies;
  • Dynamic economy;
  • Liberal exchange controls;
  • Exchange rate depreciation;
  • Low political risk.
Explaining FDI motivations

The key factors that influence the decisions of TNC’s fall under three broad categories (according to Dunning): 1) firm-specific (or ownership) advantages, which give a firm competitive advantages in global markets (these include, for example, technological assets, product differentiation, management skills, production efficiencies, size and concentration); b) internalization advantages, which exist when the internalization of cross-border transactions within a firm becomes a more efficient form of servicing markets than arm’s length transactions; c) locational advantages, which occur when the local conditions of potential host countries make them more attractive sites for FDI operations than the home country, taking into account how these conditions combine with the ownership and internalization advantages of the firm. Locational determinants include natural factors (market characteristics, natural resource availability), and finally political determinants comprise of political and economic stability, economic conditions (production costs, transportation costs, and exchange rates) and policy factors (trade barriers, openness to foreign ownership, fiscal regimes, investment incentives). Source: (Dunning, 1993)

Even though the factors affecting the level of FDI in general are well known, the empirical surveys of FDI could hardly identify the ultimate driving force behind investments and the specific characteristics of business climate that are supportive to foreign capital inflows in Central and Eastern Europe. The explanations mainly offered are the different goals and motivations governing the investments: market-oriented investments vs. factor-oriented investments.

In Hungary, for instance, the most important motive for non-export-oriented companies is acquisition of a share in the market, followed by good economic development prospects. Less pronounced are factors related to the quality and cost of labor or services. Basic conditions governing the legal, economic and political stability of investments are highly ranked. As the main constraints to FDI, the companies name inflation, the high level of taxes, social security contributions and bureaucracy (Elteto and Sass, 1997).

In another study, Meyer (1996) distinguished between three types of investments typical for FDI in transition economies of Eastern Europe. These three dominant types of motivations are market orientation, production-cost orientation, and market- and production-cost orientation. His questionnaire survey showed that the investors’ primary motive was to acquire market shares, while in most cases production-cost considerations were not at all important as independent determinants. Investment motives and barriers were further investigated through the selection of the five most important factors out of fifteen that determined investment motivation and barriers to investments. Market-oriented investors ranked the number of inhabitants of the target country highest, while production-cost oriented investors valued cheap labor the most. Both types favored political stability and good pre-investment contacts with local partners. The most important barrier to investment in the region according to the survey results is high economic risk.

The factors that explain aggregate FDI flows to Central and Eastern Europe typically include economic growth rates, relative labor costs, and potential market size (Schwartz and Haggard, 1997). However, the inspection of these variables during the transition period suggests that they have played a subordinate role. Up until 1995, there has been no apparent correlation between domestic labor costs and economic size (measured by GDP) on the one side and FDI inflows on the other side. The most popular FDI sites are countries (Hungary and Czech Republic) with regionally expensive (and rising) labor costs and low populations.

However, the data on Visegrad countries illustrates the significance of privatization to inward FDI inflows. Privatization accounted for over half the FDI in the Czech Republic and Hungary and just over a quarter of FDI in Poland from 1991 to 1995. In general, privatization strategies may encourage more FDI by making the terms of ownership relatively attractive to prospective foreign investors. Voucher privatization and institutional privatization tend to be restrictive while direct sale and public tender privatization approaches tend to be unrestrictive to FDI inflows (Schwartz and Haggard, 1997).