FDI in the Eastern Europe and EAEU: too little and from the wrong places?

Peter Havlik, Senior Economist, wiiw, Senior Guest Researcher, IIASA. Vienna, 28 November 2017.

Foreign direct investments (FDI) have been the main driver of restructuring and modernisation. In countries from Central and Eastern Europe (EU CEE), FDI have been instrumental in both privatisations of state-owned enterprises and in launching new investment projects. FDI flows in manufacturing have created modern competitive export-oriented industries and generated export revenues whereas FDI flowing into services sectors (including finance, insurance but especially retail trade and real estate) have been more controversial since they boost import demand rather than create new export capacities.

Global FDI flows have been highly volatile and there is no straightforward explanation for such fluctuations. In 2016, FDI to Russia went up sharply, not least owing to a single large transaction related to Rosneft; inflows to Kazakhstan recovered as well. FDI inflow into Ukraine also increased in 2016, primarily due to bank recapitalisations and the privatisation of some companies with the participation of institutional investors such as the EBRD. FDI inflows to Georgia have been relatively high during the whole 2014-2016 period, presumably thanks to the implementation of DCFTA with the EU. A similar trend, albeit at a much smaller scale, has been observed in Moldova.

DCFTA countries have been laggards with respect to attracting FDI, largely due to ‘frozen’ conflicts and the poor investment climate in general. Moreover, FDI in the DCFTA countries (similar to Russia) have a skewed geographic origin: in Ukraine, for example, more than 30% of FDI stocks originate from Cyprus; the share of FDI from Western Europe was just 36% of total FDI stocks in 2016. The extremely high shares of Cyprus and other offshore destinations indicate that this kind of FDI most likely represent just a recycling of domestic flight capital, and possibly also tax evasion. One can probably safely assume that this kind of FDI is also not particularly conducive to an upgrading and modernisation of the economy. Progress in institutional reforms in general should thus rather result in diminishing the shares of offshore-originating FDI.

The experience of the EU CEE countries indicates that FDI inflows have significantly contributed to the modernisation and restructuring of these economies (about 80% of FDI there originates from Western Europe). Especially FDI in the manufacturing industry, business services such as IT, software development and logistics, have been beneficial. Such investments have been particularly welcome as they help to establish competitive export-oriented industries (the successful German-CEE automotive cluster is a case in point). After EU accession foreign investors have to be treated as domestic ones (equal treatment). Most recently, though, a renewed economic nationalism resulted in selective treatment of investors by activities, in some countries de facto restricting foreign investment in banking, trade, etc. (e.g. in Hungary and Poland).

However, it is not just the volume of registered FDI per se and its origin, but also its sectoral composition, investors’ motives and other FDI structural and ‘quality’ characteristics that matter. In EU CEEs, the bulk of FDI has been concentrated in manufacturing, trade, and financial services: each of these three broader sectors account for about 20-30% of total FDI stocks. In this respect, the DCFTA countries have not been much different from Hungary, Poland, Romania or Slovakia. As far as EAEU countries are concerned, most FDI has been concentrated in energy and mining sectors (especially in Kazakhstan and Russia). In Moldova, Ukraine and Romania, there are some (small) foreign investments in agriculture. Energy sector is an important FDI target in Georgia, Moldova and Romania (there are no comparable data for Belarus).

How to explain the huge differences in various FDI structural characteristics across individual transition countries? A number of factors definitely play a role: geography, size of the country, resource endowments, costs and skills of labour, government FDI policies and the investment climate in general. According to the latest World Bank Ease of Doing Business survey for 2018 (published on 31 October 2017 and registering big shifts in ranking scores), the EAEU and DCFTA countries received the following ranking (out of 190 countries surveyed): Georgia (9), Poland (27), Russian Federation (35), Kazakhstan (36), Belarus (38), Slovakia (39), Moldova (44), Romania (45), Armenia (47), Hungary (48), Azerbaijan (57), Ukraine (76) and Kyrgyzstan (77). Russian Federation, Kazakhstan, Belarus and Georgia were among the top 10 countries which managed to improve their ranking recently.

In conclusion, the analysis implies that EAEU and DCFTA countries have not been particularly attractive for foreign investors: taking out round tripping inflows from offshore destinations the accumulated FDI would there be even lower. This explains a lot why restructuring in the region stalls. This pattern can change only with marked improvements in domestic regulatory environment and investment climate. FDI inflows should also be promoted by pro-active government policies (in big countries such as Kazakhstan, Russia and Ukraine also at the regional level) which focus mainly on attracting FDI in manufacturing and business services in order to assist restructuring and modernization.

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