Foreign direct investment in Ukraine since transition

Foreign direct investment in Ukraine since transition

Communist and Post-Communist Studies 32 (1999) 91–109 Foreign direct investment in Ukraine since transition Mohammed Ishaq* Centre for Economic Refor...

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Communist and Post-Communist Studies 32 (1999) 91–109

Foreign direct investment in Ukraine since transition Mohammed Ishaq* Centre for Economic Reform and Transformation, Heriot-Watt University, Edinburgh, UK Received for publication 15 December 1998

Abstract Since independence Ukraine has attracted very little foreign direct investment, both in absolute terms, and relative to other transition economies. This is the case when we analyse the ratio of FDI to GDP and exports, and the amount of FDI per capita. This paper examines the causes of the low level of FDI, and offers some policy prescriptions which may help to reverse this unfavourable trend.  1999 The Regents of the University of California. Published by Elsevier Science Ltd. All rights reserved. Keywords: Capital movements; Financial flows; Foreign investment; Direct investment; Transition; Economic reform

Introduction By direct investment is meant an investment in a foreign country where the investing party (corporation, firm) usually retains control over the investment, although it can include taking a minority stake. A direct investment typically takes the form of a foreign firm starting a subsidiary or taking over control of an existing firm in the country in question. Although not a direct pillar of economic reform in the transformation from central planning to market economies in the former Soviet bloc, foreign direct investment (FDI) has been viewed as an important component of the overall process of tran* E-mail: [email protected]

0967-067X/99/$19.00  1999 The Regents of the University of California. Published by Elsevier Science Ltd. All rights reser PII: S 0 9 6 7 - 0 6 7 X ( 9 8 ) 0 0 0 2 4 - 5

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sition.1 This is because FDI can bring many advantages to the host nation. These include: 앫 The scarcity of domestic investment funds in the transition countries have been partly offset by an inflow of foreign capital, and in particular by FDI. 앫 The presence of a strategic foreign investor has positive side effects, such as better corporate governance, managerial expertise and skills, actual or potential access to new markets and distribution networks. 앫 In the short run, the host country will under normal conditions improve its balance of payments and possibly also its terms of trade. This paper is going to concentrate on the issue of FDI in Ukraine. It would be both unrealistic and difficult to make a precise judgement as to what would be an adequate level of FDI for Ukraine, given the enormity of the task of economic transition. Only Ukrainian policymakers and advisors from the international, particularly Western, community can really judge the scale of FDI that would be required. Various sectors of the economy are making their own estimation as to how much is required. But these are purely subjective soundings, rather than any concrete appraisal of investment. There is no doubt that significant levels of FDI would be encouraged by a stable political and economic environment. Unfortunately, Ukraine’s actual situation differs from this, as will be demonstrated in this paper. Following on from this introductory section, Section 2 will provide a general review of developments since independence, that is, the overall picture in Ukraine by looking at the role played by FDI in the economy, and its role in the overall strategy of reform. Section 3 will place FDI in Ukraine in a comparative perspective and examine the extent to which the argument or proposition that Ukraine has been unable to attract significant levels of FDI is a fair assessment. The fourth section will investigate the various impediments such as legal, institutional, and political, which have up until now discouraged further foreign investments, and the outlook for the future, in particular what conditions or criteria need to be met in order to boost FDI in Ukraine in the coming years. Section 5 will offer some concluding remarks.

Review of developments since independence and the role of FDI in the Ukrainian transition process The necessity and role of FDI in the Ukrainian transition process At the beginning of transition it was recognised by the Ukrainian government and Western economists that a sustained inflow of private foreign capital would be essential in order to modernise and restructure Ukrainian industry. What was required was

1

See Meyer (1995) for more on the role of FDI in economic transition.

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not only foreign capital, but also technology, management skills, and know-how, which is precisely what FDI would bring. It was envisaged by Ukrainian policymakers and Western economists that in addition to the benefits mentioned in the Introduction, the role of FDI would be the following: FDI is attractive as a non-debt creating source of current account finance, and more broadly as an indicator of growing international confidence in the sustainability of the entire process of reform. A steady flow of FDI is an important sign of confidence, since the world’s major credit rating agencies include it among their indicators of international creditworthiness; the operation of foreign firms within the host economy would contribute to the development of management skills essential for efficient enterprise behaviour in the market economy, and can also help to build a new business ethic; FDI could also contribute to the process of privatisation financially. A great deal of private savings in Ukraine have been eroded by inflation, and would in any event have been inadequate given the enormity of the privatisation task. Foreign financing can help to breach the savings gap. Legislative basis for FDI in Ukraine2 In recognising the positive impact that FDI could make on the Ukrainian economy, various laws have been passed since 1991 to facilitate its role. The first law was passed on 12 March 1992, offering at least on the surface a highly favourable investment regime. This was the Law on Foreign Investment which included protection against future nationalisation, participation in the privatisation programme, 5 year tax holidays, and the promise of profit repatriation in hard currency (after the deduction of a 15% withholding tax). In May 1993 this law was replaced by the Decree on the Foreign Investment Regime deemed by many as more hard-line towards foreign investors, since it increased the amount of investment required to qualify for tax concessions (from as little as US$16 to US$10 000). Nevertheless, the decree continued to guarantee that all foreign investors, after payment of taxes, can freely and immediately transfer abroad the income profits and other foreign currency assets that were obtained in connection with their investments. On 11 February 1994, the government published the Government Programme for Encouraging Foreign Investment in Ukraine, which officially came into effect on 1 March 1994. The Programme’s most notable objectives included among others: to secure foreign financing for various industrial sectors; to increase technological know-how and the quality of production; and to limit energy and raw material waste. The most recent major legislation in this area is the Law on Foreign Investment Status passed on 20 March 1996. According to this, enterprises with foreign capital, which participate in state programmes will be granted tax privileges for the first 3 years of their activity. One such programme has included the state programme for energy sector development, e.g. oil exploration in Crimea. Foreign investments cannot be nationalised or requisitioned.

2

For a guide to the legal and regulatory framework for investment in Ukraine see OECD (1993).

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Currently, the legal framework in Ukraine can be characterised in the following terms as far as FDI is concerned: 앫 There are certain rights guaranteed to foreign investors which include: participation in the management of companies with foreign capital; share of profits in proportion to investment; share in the value of the assets of the company after termination and repatriation; the laws in force at the time when the investment agreement was signed are applicable; less favourable new regulations may not be later imposed on foreign investors. 앫 All industries are open to foreign investors except strategic ones, e.g. defence and sectors involved in the mining of precious materials like gold and platinum. 앫 There are three ways of investing in Ukraine: (1) Through joint ventures with a local partner or wholly foreign owned entity. (2) By adding to the capital of the existing local company and/or by acquiring a share of an existing local company. (3) By setting up a new wholly foreign owned company. 앫 All foreign investors have to go through the process of registration with the Ministry of Finance, which registers between 3 and 21 days the contract in conformity with Ukrainian legislation. After registration, the foreign investor has the legal authority to conduct business. 앫 With a 30% profit tax rate Ukraine has one of the highest tax burdens. Other taxes which apply to business include VAT, and social pensions funds to which employers have to make a contribution. 앫 Laws guarantee the free transfer of profit. Foreign subsidiaries are entitled to free and unrestricted transfer of their profits abroad in foreign currency. 앫 Investment is classified as foreign investment if it is not less than 20% of an enterprise’s charter capital and is no less than US$50 000 (US$10 000 for banks and other financial institutions), provided that the investment is in the form of movable or immovable property. If the investment is in the form of convertible currency, the minimum required is increased to US$500 000 or US$1 million for banks and financial institutions. Despite the various rights assigned to foreign investors, and aimed at facilitating foreign investment, in practice, foreign investors have had to endure various difficulties, not all legal, which we will analyse in Section 3. Some of these are related to the legislation already discussed, some to other legislation which has offset or contradicted the beneficial aspects of the original legislation. Review of inflows of FDI in Ukraine since independence At the beginning of transition, Ukraine was seen as a potentially attractive country for making foreign investments for the following reasons: considerable potential in the market for selling commodities and services; availability of a highly skilled labour force with relatively low wage levels; diverse raw material potential; and a favourable geographical potential. However, in reality, Ukraine has had great difficulty in gaining access to markets. According to Vladimir Konovalov of the Department of Anti-Dumping and Unfair

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Trading Practices at the Ministry of Foreign Economic Relations,3 Ukrainian goods face discrimination in international markets. Furthermore, he pointed out that there is a lot of dumping of goods on Ukrainian markets by developing countries such as Brazil, Mexico and Indonesia, which, he claims, is destroying Ukraine’s potential competitiveness. Table 1 shows both the cumulative and individual annual flows of FDI in Ukraine since 1992. The annual net flow of FDI has fluctuated since 1992. In 1992 Ukraine attracted US$200 million of FDI. But this figure had fallen to only US$151 million in 1994, and the same amount was attracted in 1995. However, there were signs in 1996 that the country was capable of attracting much greater inflows of FDI. By the end of 1996, Ukraine had attracted US$526 million of FDI a figure greater than 1994, 1995 and 1996 put together. This upward trend was reflected in the cumulative level of FDI inflows into Ukraine between 1992 and 1996 shown in Table 1. The increase in the cumulative level of FDI inflows from 1995 to 1996 was particularly great, with an increase of 75% witnessed in comparison to an increase from 1994 to 1995 of 27%. However, latest figures show that the positive signs of 1996 have given way to a lack of confidence in the country due to the stalemate in reform and the lack of political will to tackle corruption and organised crime. By the end of 1997, the inflow of FDI had actually fallen, with only US$516 million attracted in comparison to US$526 million in 1996. It was estimated at the start of transition that Ukraine would require some US$40 billion of FDI,4 although according to Konovalov5 this was a wild estimate made by various industries and sectors based on their calculations of how much they would require for modernisation and restructuring. In other words, some enterprises and ministries declare their demand for what they think is required in terms of FDI, figures which are unrealistic and incorrect. Konovalov believes that it is difficult to make any precise estimation as to what would be a good level of FDI for Ukraine. Table 1 Cumulative and annual flows of net FDI in Ukraine, 1992–1997 (in millions of US dollars) Year 1992 1993 1994 1995 1996 1997

Cumulative 200 398 549 700 1226 1742

Per year 200 198 151 151 526 516

Source: Economic Survey of Europe, 1998.

3 Interview with Vladimir Konovalov, Chief of the Department of Anti-Dumping and Unfair Trading Practices, Ministry of Foreign Economic Relations, May 1997. 4 This was according to the Ukrainian Ministry of Economy’s projections. 5 Interview with Konovalov, Ministry of Foreign Economic Relations, May 1997.

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Table 2 FDI inflows as a % of GDP, exports and per capita 1992–1997 FDI→

As % of GDP

As % exports

Per capita(US dollars)

1992 1993 1994 1995 1996 1997

– 1.4 1.6 1.6 1.2 1.4

1.8 1.8 1.5 1.3 3.1 2.7

3.9 3.9 3 3 10 10

Source: Derived from EBRD (1998) and Economic Survey of Europe (1998).

Only when the national economic structure is integrated into the international economy can we begin to assess how much is required. Therefore, despite the recent progress in attracting FDI, Ukraine has a long way to go before it will be able to meet this target, even if it were to be regarded as a sound estimate, and, in any case, there is no guarantee that the estimated figure will not have been revised upward as transition continues. Looking at Table 2, it can be seen that as a percentage of GDP the flow of FDI has changed little since independence. In 1993, FDI inflows accounted for 1.4% of GDP. After minor fluctuations between 1994 and 1996, in 1997 FDI inflows once again accounted for 1.4% of GDP. FDI inflows as a percentage of the country’s exports (see Table 2) had been falling since 1992 from 1.8% in 1992 to 1.3% in 1995. But in 1996 the level of FDI as a percentage of exports increased to 3.1%, the highest figure since independence, and a reflection largely of the increased level of FDI attracted by Ukraine in 1996. However, the downturn in 1997 was reflected in the level of FDI as a percentage of exports which fell to 2.7%. In the case of FDI inflows per capita (see Table 2), which were around US$4 at the start of independence and which rose in 1996 to represent US$10 per head, this figure remained the same in 1997. This is a very small amount for such a big country. A noticeable feature of FDI in Ukraine has been its uneven regional distribution. The bulk of it has gone to the most economically advanced regions. Table 3 shows Table 3 Regional distribution of FDI as of January 1996a (% share, on an accumulation basis) Kiev Odessa Donetsk Dnipropetrovsk Lvivska Rivenska Vinnitska Volynska

35 17 13 10 10 0.5 0.3 0.5

Source: Ministry of Finance. a The table aims to show the most popular and least popular areas for FDI; therefore some intermediate areas have been deliberately omitted, explaining why the figures do not add up to 100%.

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that Kiev, Odessa and Donetsk have benefited from the lion’s share of FDI. The less attractive regions include Rivenska, Vinnitska and Volynska, and they have gained much less FDI. Of course, investors base their decision on what regions to invest in by taking into account a number of factors. The following are some of the most important: 앫 Location of enterprise. 앫 Density of economic industry. 앫 Quality of city: level of economic development; availability of resources; infrastructure; environment; quality of life; potential market and potential for attracting tourists etc., all add to the quality of a city and make it an attractive target for investment. 앫 Assessment of local perceptions towards foreign partners, enterprises, and exporters. This means that regions perceived as less attractive end up losing out as foreign investors opt for what they perceive as the most attractive regions. This in turn, of course, has a detrimental effect on the regions that lose out as their economic development is hampered. In order to avoid serious regional disparities, it is important that much-needed large scale investment, some of which is likely to come from foreign sources, is evenly distributed. This, of course, would be difficult to achieve in practice unless potential investors are offered considerable financial incentives to set up in less attractive regions. The main sources of FDI have been Western Europe, Russia and the US (Frausum, 1996). As of July 1996, the US led the way with about 19% of all FDI in Ukraine since independence, followed closely by Germany with around 16.1%. Other significant contributions include 7.9% from Russia and 6.8% from Great Britain. Together these four nations accounted for about 50% of the total level of FDI in Ukraine. Other unlikely sources have included Cyprus (this is due to Cypriot laws on company registration) and Switzerland (Ukrainian Legal and Economic Bulletin, 1997). Not all the principal donor nations invest in the same sectors. There is a degree of diversity involved. The following is a breakdown of the sectors in which the major donors invested (Ukrainian Legal and Economic Bulletin, 1997): America’s sectoral distribution of investment saw 19.5% going to financial credit and insurance services, 17.2% to internal trade, and 13% to machine-building. German investment saw 27.8% go to internal trade, 20.2% to machine building/metal works, and 19.4% to food processing. In contrast, British investment was concentrated in the industrial sector, which received 67.6% of all investment by Britain, while Russia invested 44.2% in the public health sector and 19.3% in insurance. The overall sectoral distribution of FDI in Ukraine illustrates that the bulk of it has gone into the trade sector (both domestic and foreign) followed, but some way behind, by the food-processing sector. Table 4 highlights the sectoral share of FDI at the end of 1996. At the beginning of transition, the areas that were selected for priority investment6 included food processing, metallurgy, light industry, and trans6 For a full list of investments labelled as priority areas see the Ukrainian Legal and Economic Bulletin (1996a).

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Table 4 FDI in selected sectors of the Ukrainian economy 1992–1996 (in millions of US dollars) Trade (domestic and foreign) Food processing Metallurgy Light industry Chemical industry Transport

230 105.6 37.2 29.8 29.0 28.0

Source: Figures supplied by the Institute of World Economy and International Affairs, Kiev.

port. Table 4 shows that to a large degree most of the designated priority areas have received FDI. The exercise of selectivity by foreign countries as to what sector to invest in is also detrimental to Ukraine’s economic development. There is no secret that much of Ukrainian industry is in need of capital investment. While it is true that investment is usually profit-driven and not by a country’s needs, in the case of Ukrainian the need is urgent if the country is to be successful in its economic transition. According to the Ministry of Economy,7 the metallurgy industry requires capital investment of US$7 billion; the chemical and oil industry US$3.3 billion; machine building US$5.1 billion; and transport US$3.6 billion. However, the basis on which these projections have been made is not clear. There is a long way to go before such projections— assuming that they are correct—are met. Thus, it follows that most investment in Ukraine will have to be funded from domestic sources even if the climate for FDI improves. Investors can invest in a variety of ways.8 They may invest directly in the enterprises of different industries by setting up joint ventures on the basis of agreements (contracts) on productive co-operation. They may also participate in the privatisation of state owned assets but, as we will see in Section 3, they face problems in this highly bureaucratic and complex process. Some of the foreign direct investors in Ukraine since independence have included Pepsi Co. of the US, Bundespost Telecom of Germany, and BAT Industries of the UK. Joint ventures are a common form of FDI in Ukraine. In the Lviv region alone there are some 400 registered joint ventures. Much American interest in joint ventures in Ukraine was originally based on concerns about Ukraine’s nuclear arsenal. The United States’ concern centred around the following: the danger that nuclear weapons may fall into the hands of extremist and anti-Western elements in Ukraine; concern that Ukraine may wish to keep its nuclear arsenal, thus altering the balance of East–West forces, and therefore jeopardising American–Russian prospects for nuclear arms reductions; and the possibility that Ukraine may be tempted to sell its nuclear arsenal to other countries for financial gain. In January 1995, the world’s 7

Figures provided by the Ministry of Economy, Kiev. For more on the methods and forms of foreign investment see the Ukrainian Legal and Economic Bulletin (1995). 8

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first plant dedicated to converting conventional weapons into peaceful by-products, the Alliant Kyyiv, opened. This is a joint venture between US armaments and defence electronics manufacturer Alliant Techsystems, the UK trading company Rapierbase, and Ukraine’s Ministry of Defence. A comparative perspective on Ukrainian FDI It has often been argued that the flow of FDI in Ukraine has been rather miserly. To what extent is this true? One useful yardstick for measurement would be to compare Ukraine’s ability to attract FDI with that of other transition economies.9 This will be done in the following way: 1. 2. 3. 4.

A A A A

comparison comparison comparison comparison

of of of of

cumulative inflows of FDI. FDI inflows per capita. FDI inflows as a ratio of GDP. FDI inflows as a ratio of exports.

Comparative cumulative inflows of FDI This section looks at the cumulative level of FDI in Ukraine in order to show whether, in comparison to other transition economies, the country represents an attractive target for foreign investors. If we compare Ukraine’s cumulative level of FDI since 1989 with other former Soviet Republics (Table 5), Ukraine comes fourth. Although this appears on the face Table 5 Cumulative level of FDI inflows in the former Soviet Republics 1989–1997 (in millions of US dollars) Armenia Azerbaijan Belarus Estonia Georgia Kazakhstan Kyrgystan Latvia Lithuania Moldova Russia Tajikistan Turkmenistan Ukraine Uzbekistan

70 1993 267 809 104 4267 247 1287 612 249 9743 86 652 1623 216

Source: EBRD (1998).

9 For a comparative analysis of foreign investment in all transition economies see Economic Survey of Europe (1998).

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a commendable position out of 15, especially considering that two of the three above it, Russia and Kazakhstan, are large republics in terms of area, it is less so if one considers that Ukraine lags considerably behind Russia and Kazakhstan. Russia has attracted over six times more FDI than Ukraine, while Kazakhstan has attracted more than twice the amount of FDI. So Ukraine lags well behind these two, a poor performance given its large population (second largest former republic in population terms), and its large profile (at the time of independence, it was a member of the club of nuclear states, and was viewed by the West as having great potential for economic success. The republic of Ukraine was very important economically to the former Soviet Union). If we compare Ukraine’s FDI performance with the non-FSU states the story is even more depressing. In the list of non-FSU countries shown in Table 6, Ukraine comes third to last, a poor performance considering that it is larger in size and more populated than each of the selected countries. Hungary for example has attracted a staggering nine times more, the Czech Republic four times more, and Poland five times more. Although, in fairness, both Poland and Hungary were considerably advanced in their level of economic reforms and development well before Ukraine gained independence, and well before Ukraine embarked upon economic transition. Yet in Ukraine’s defence, the same cannot be said of Romania and Azerbaijan, nor of Russia and Kazakhstan. So why then is Ukraine lagging behind Russia, Kazakhstan, Azerbaijan, and virtually all of the non-FSU in attracting FDI? We will analyse this question in some detail in the final section, but it may be worth noting at this point that the countries which have attracted the most FDI are also those which have been ranked in the category of advanced reformers.10 Comparative cumulative inflows of FDI per capita Table 7 shows that Ukraine has the six lowest cumulative inflows of FDI per capita in all of the former Soviet Union, registering US$41 per head or per person, even behind some of the smallest (Moldova) and less developed or less advanced republics. When compared with the non-FSU countries it actually comes at the botTable 6 Cumulative level of FDI in selected East European states 1989–1997 (in millions of US dollars) Bulgaria Czech Republic Hungary Poland Romania Slovak Republic Source: EBRD (1998).

10

This ranking is based on a report in World Bank (1995).

1000 7473 15 403 8442 2389 912

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Table 7 Comparison of cumulative FDI inflows per capita 1989–1997 (in US dollars) Armenia Azerbaijan Belarus Georgia Kazakhstan Kyrgystan Moldova Russia Tajikistan Turkmenistan Ukraine Uzbekistan Estonia Latvia Lithuania Poland Hungary Czech Republic Bulgaria

19 262 26 19 272 54 58 66 14 139 41 9 557 515 165 218 1519 726 121

Source: EBRD (1998).

tom of the list, by staggering amounts if we compare it with Hungary which had US$1519 per capita and the Czech Republic with US$726 per capita.11 Comparative inflows of FDI as a ratio of GDP If we look at FDI inflows as a percentage of the total gross domestic product in 1997 (see Table 8), Ukraine’s FDI inflows constituted only 1.4% of its GDP. This was greater than Russia, Georgia, Belarus, and Uzbekistan, but was lower than every other former Soviet republic, and the rest of Eastern Europe. Azerbaijan led the way with FDI inflows constituting 24.4% of GDP. Comparative inflows of FDI as a ratio of exports Table 9 shows that Ukraine’s inflows of FDI as a proportion of its total exports in 1997 amounted to only 2.7%. In comparison, other former Soviet republics such as Kazakhstan and Latvia were well ahead. As a proportion of its exports, Hungary’s inflows of FDI in 1997 constituted a staggering 40% of its exports. This is hardly surprising given that, in 1997, Hungary was the third largest recipient of FDI in the former Soviet Union and Eastern Europe. Overall, since 1989 Hungary has been the single largest recipient of FDI in the former Soviet Union and Eastern Europe.

11

See EBRD (1998).

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Table 8 FDI inflows as a % of GDP in 1997 Armenia Azerbaijan Belarus Georgia Kazakhstan Kyrgystan Moldova Russia Tajikistan Turkmenistan Ukraine Uzbekistan Estonia Latvia Lithuania Poland Hungary Czech Republic Bulgaria

1.6 24.4 0.7 1.3 5.7 3.1 3.4 0.8 1.8 4.7 1.4 0.4 2.8 7.6 3.6 2.3 4.7 2.4 5.6

Source: EBRD (1998).

Table 9 FDI inflows as a % of exports in selected transition economies in 1997 Country

FDI % exports

Ukraine Latvia Hungary Czech Rep. Romania Kazakhstan

2.7 23.8 40 15 11.7 16.2

Source: Derived from EBRD (1998); Direction of Trade Statistics 1998.

The basic point derived from this comparison is that in relation to population, GDP or any other indicator, Ukraine has so far attracted very little FDI.

Current obstacles and future prospects This section will examine why Ukraine’s performance has been so disappointing, and what it can do to boost future prospects. The analysis in this section will also allow us to isolate the existing environment and what impact it has on attracting FDI. The problems which foreign investors have had to confront can be divided into legal, institutional, economic, and political.

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Legal and administrative barriers One of the most critical problems which foreign investors confront are the legal impediments.12 Specific problem areas include: the lack of clear legislation; erratic implementation of laws and decrees; and the lack of confidence in Ukrainian legislation. One area which highlights the magnitude of the problem is the issue of taxation. There have been reported situations where local tax authorities make interpretations which conflict with official laws and decrees, e.g. regarding tax holidays. There have also been instances where decrees passed are then blatantly cancelled. One such example of this can be seen in the case where on 20 May 1993, a decree on the foreign investment regime generously granted 5 year tax holidays for companies with foreign investment which had a qualified in-kind investment of US$50 000. But later, the 5 year holidays for all companies with foreign investment after 1 January 1995 were cancelled. Foreign investors saw this as wholly unfair and an indication of Ukraine’s economic instability. In another example, the Ukrainian authorities failed to execute the law regarding investments when they abolished the VAT privileges for goods produced by enterprises with foreign investment. This came despite the fact that according to the Cabinet of Ministers of Ukraine’s decree On the Regime of Foreign Investment (May 1995) enterprises with foreign investment are exempt from all types of taxes for 5 years. There have been complaints against tax inspectorates that they are not familiar with existing legislation, and even less aware of developments in legislation, leading to inappropriate audits of companies assessed taxes and fines. The failure of tax inspectorates to meet with company representatives to address unclear areas of law and how a company should proceed, lead to problems later as companies operate as they see fit, often to be later penalised for misinterpretation of legislation. Lack of confidence in Ukrainian legislation and laws related to investment is illustrated by the fact that private parties generally believe that courts would not recognise and enforce their rights against state parties. Laws are not always drafted by legally trained personnel. In a recent EBRD classification system for transition indicators on laws fostering investment,13 Ukraine was ranked in category 3 in the area of extensiveness of legal rules on investment, where a score of 3 was classified as: “Legal rules do not impose major obstacles to creating investment vehicles and security or to repatriation of profits. However they are in need of considerable improvements”. In the area of the effectiveness of legal rules on investment, Ukraine was placed in the second category where a score of 2 was defined as: “Legal rules are usually unclear and sometimes contradictory. Legal advice is often difficult to obtain. The administration and judicial support of the law is rudimentary”. None of this is surprising and simply gives credence to the well known concerns about Ukrainian laws in general.

12 Some of the legal problems are highlighted in the following: Ukrainian Legal and Economic Bulletin (1996b) and the Ukrainian Economic Monitor (1995). 13 EBRD Transition reports 1996 and 1997.

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Economic barriers related to reforms and transition Privatisation and competition policy In Ukraine the privatisation process has on the whole been vague and complex, and has tended to exclude foreigners.14 Privatisation in general has been slow to get underway and the low rate of privatisation has limited the number of enterprises or potential partners for foreign investors. On a large part there has been a determination to keep the country’s assets in Ukrainian hands. This has led to preference for worker buy-outs as the vehicle to private ownership. Related to this has been the fact that foreign investors have not always had equal access to the auctions which have formed part of the privatisation process. Many Ukrainian officials still hold traditional, communist views about ownership, some even fearing a foreign take-over.15 They even viewed privatisation as a conspiracy by foreigners to take over Ukrainian firms. Many who do not understand the privatisation process believe that it had been set up for the benefit of foreign capitalists who were going to take over Ukraine. Problems associated with privatisation include the fact that most Ukrainian enterprises are unprofitable. This is hardly surprising given the lack of demand, and high labour costs. They need large direct investment in the production sector, although even large investment will not automatically improve profitability. When privatising a state enterprise, the question of whether the investor must also solve its social problems depends on the specific nature of the agreement between the investor and the state. Generally speaking, all social spheres of the enterprise are under the control of local authorities. It is clear that the substantial increase in costs to privatise state enterprises made privatisation unattractive for investors, which is why foreign investment began to flow into Ukraine through other means, e.g. through the creation of foreign and joint ventures. If we look at the laws governing competition policy (Pittman, 1996), we find that the environment in this area has not exactly been conducive to attracting foreign investment.16 Despite the fact that a Ukrainian law on the promotion of competition was passed in early 1992, coming into effect in 1993, and the establishment of an Anti-Monopoly Committee (AMC) with broad powers such as: to prepare anti-monopoly legislation; to protect the interests of enterprises and consumers; to promote honest and fair competition in markets; and responsibility for liquidation of barriers to entry, stimulation of entry and the liquidation of state monopoly units, problems still remain in this area because the AMC has not as yet used its powers very extensively. The result of this has been that there still exists a large number of monopolies able to charge high prices, stifling competition; hardly an ideal environment for encouraging foreign investment. An official from the Ukrainian Ministry of Foreign Economic Relations denied 14 For a brief exposition of the privatisation process in Ukraine, including its problems, see Hare et al. (1998). 15 A view noted during interviews and meetings with Ukrainian officials in Kiev, 1995 and 1996. 16 See Hare et al. (1998, pp. 195–198) for more on competition policy and the Anti-Monopoly Committee.

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the existence of many monopolies.17 Instead he remarked that there existed only a few what he called “Ukrainian type” (presumably he was referring to the typical large-scale types of plants reminiscent of the days of communism) monopolies characterised by large plants and production. In other words, he was indicating that they were largely natural monopolies. However, this does not appear to be a very convincing answer. He went further and pointed out that no enterprise in Ukraine today had control of more than 50% of the market. Perceptions of economic reform Another major barrier to FDI in Ukraine is the general perception of economic reform. In a World Bank survey, Ukraine was ranked in the category of weak reformers (see World Bank, 1995), and its general economic performance has been poor even though signs of improvement and recovery have been noted in the past year, particularly with regard to inflation and GDP. But Ukraine’s commitment to economic reform is seen as erratic, and economic stability has still not been achieved. In other words, a wholesale commitment to economic reform, and credible market policies, do not exist on a scale that would attract or encourage greater foreign investment. Many foreign investors have preferred to adopt a wait-and-see attitude. The country is still perceived as a high-risk country to do business with. The country is dogged by a crisis mentality where there is low confidence among the people and the perception that things are not likely to get better. This hinders the ability of the Ukrainian economy to attract foreign investment while demand is rising. The net result is an unfavourable business environment in Ukraine. Lack of incentives Income tax, which is high, acts as a disincentive. This refers to both personal and company income tax. According to Anatoly Baluch of the Ministry of Economy, there is a double tax system covering both personal and company tax. At the moment the government is working to reduce personal income tax. At present there is a progressive tax system in place which is of an incredible nature. Marginal rates on personal income tax can range from 10% to as much as 50%. Taxation on enterprises is on the verge of being reduced: 30% is viewed as far too much by officials who argue that it acts as an obstacle to further FDI. According to officials, 20–25% would be a more realistic figure. In other words, currently there is a burdensome and uncompetitive tax regime, which means that there is a lack of both fiscal and financial incentives Political hurdles Political factors, specifically the question of political stability, also influenced the decision—making process of potential foreign investors. Since independence Ukraine has had to endure political instability, characterised by clashes between various polit-

17

Interview with Anatoly Baluch, Ministry of Economy, May 1997.

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ical institutions such as the Parliament and Prime Minister, and the Prime Minister and President over such things as the direction and pace of economic reforms. This in turn has created a climate of uncertainty for foreign investors. In addition, the presence of opposing political factions within Parliament, some in favour and some strongly opposed to the process of reform, have not helped. Policy-making is still unpredictable, highly complex and bureaucratic, and confused, so that any advances made are reversible. Crime Since the break up of the Soviet Union there has been a proliferation of crime, not just common crime (murder, burglary, rape), but also economic crime.18 This type of crime has included bribery, extortion, black market activities. It is also well documented that there has been the development of a shadow or unofficial economy, not only in Ukraine but in fact in all transition economies (see Kaufmann and Kaliberda, 1996). However, the problem in Ukraine in this respect has been extremely severe (Kaufmann, 1994). According to Western sources, Ukraine has one of the largest unofficial economies in Central and Eastern Europe, estimated to be in the region of 20–30% of GDP (EBRD, 1998). However, according to Ukrainian officials and academics, the West may be underestimating the size of the shadow economy and they claim that a more realistic figure is a staggering 50–55% of GDP. Why has there been an increase in crime? The disappearance of many former central control systems (such as Gosplan), the creation of novel property arrangements (such as privatisation) and the now virtually unlimited and unregulated access to retail markets have greatly expanded the opportunities for economic crime. Specific types of economic crime have included: exploiting opportunities to collect illegal rents, and to convert public property into private profit. Recent cases have also seen Western businessmen the target of assassinations by organised criminal groups. While there does exist legislation, criminal laws, particularly those relating to the protection of property and the prohibition of money laundering and corrupt practices, are viewed as insufficiently developed and insufficiently policed. Crime has become a problem for Ukraine because it inhibits foreign confidence in the economy and therefore represents a cost to the Ukrainian economy. Furthermore, it diverts financial and labour resources away from some of the more important tasks associated with transition, and can act as an unnecessary distraction to the government in its pursuit of economic reform. Infrastructure Poor development of infrastructure, particularly the quality of roads is a problem. Although the road network is large—a total of 273 700 km of highway, and roads 18 For a review of the emergence of organised economic crime in the former Soviet Union as illustrated in the Russian case see Millar (1996).

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are regarded as sound enough—it is their maintenance which is a major concern, caused by bad workmanship and low quality materials used in construction. In addition, the telephone system is inadequate both for business and for personal use: about 8 million telephone circuits serve about 52 million people (CIA, 1996).

Future outlook So, what can Ukraine do in order to reverse its so far dismal record on FDI? The policy solution or answer is short: It will have to eliminate most if not all of the barriers mentioned in Section 3. But unfortunately execution of this policy solution is likely to be a long process, and is easier said than done. This section will suggest briefly some policy prescriptions, not dwelling too long on each area as some of the problems related with each solution have already been discussed in previous sections. 1. The state must create more favourable business conditions by liberalising economic laws and remove legal inconsistencies, and must create a beneficial tax environment. 2. The state must also speed up the process of privatisation, and clarify rules about private property ownership. 3. Many Ukrainians are still set in their ways, and a change in attitudes may be necessary toward foreign investors and foreign capital. Ukrainian people have to realise that foreign investment, especially in the form of multinationals, can benefit them by providing local employment, and boosting job opportunities. According to Ukrainian officials,19 this is less of a problem today compared to a few years ago, as Ukrainian people are more open and friendly towards foreign businesses today. However, how far this is actually the case is debatable. 4. Economy-wide improvement or progress in the economic climate: macroeconomic stabilisation and lowering of the budget deficit in order to meet IMF benchmarks are important. One useful indicator for potential investors is whether Ukraine is attracting assistance and loans from international bodies like the World Bank, since these organisations often stipulate conditions which a country must meet in order to qualify for assistance. In other words, if assistance is given by these organisations, it can be a sign of confidence in the country’s performance and policies. Potential investors and creditors are likely to regard a strong commitment to sound stabilisation and to structural adjustment policies as essential. Once a country has successfully raised funds in the investment capital markets it is in a better position to attract FDI and repatriate flight capital. It is estimated that as a result of undercapitalised banks there was capital flight of between US$10 billion and US$12 billion from Ukraine since independence. 5. System of civil law—Contracts and company laws would not only have to be established, but respected and adhered to in order to allow private firms to operate 19 Interview with Konovalov, Ministry of Foreign Economic Relations, Kiev, May 1997; and Baluch, Ministry of Economy, Kiev, May 1997.

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effectively in a market environment. Currently there is still an element of uncertainty involved in this area. In an index of economic freedom20 measuring how well countries score on a list of ten economic factors, Ukraine achieved the following scores on those factors which are likely to have a bearing on foreign investment. In the foreign investment category, a score of 4 designated relatively high barriers to foreign investment; a score of 4 on property rights indicated a low level of protection of private property, as has already been mentioned. Similarly, as noted before, a score of 4.5 for taxation policy coincides with high tax rates, including corporate income tax, while a score of 4 for regulation indicates that the country imposes numerous regulations on businesses. Overall, Ukraine was ranked 135th out of 150, finishing below most of the former countries of the Soviet bloc. The results are not surprising and help to explain why foreign investment has not realised its full potential in Ukraine up until now. At present the government is considering measures that would stimulate more foreign investment in Ukraine. Less than a year ago two new bodies, the State Credit and Investment Company and the Agency for Technical Assistance Co-ordination were established with the task of attracting foreign investment. A new foreign investment law has been under preparation for some time, aimed at counteracting criticism of the present legislative framework for foreign investors. More specifically the government in Kiev is keen to centralise the administration of foreign investment rather than continue with the present system which is characterised by deals between potential foreign investors and local authorities. Other key areas for resolution before the new legislation is passed include the question of the future provision of tax holidays for foreign investors, and on whether foreign and domestic enterprises should both receive equal treatment.

Conclusions In Ukraine a combination of political, ideological, institutional, and legislative obstacles have failed to generate the necessary or desired level of FDI. Although the performance in 1996 was encouraging, 1997 was disappointing. In 1995 Ukraine’s stock of FDI was US$0.56 billion. In 1996 there was a small increase to US$0.6 billion. In 1997 there was another small increase to Us$0.65 billion. A more stable political process and climate where the various political institutions such as the executive and legislative are able to work in harmony or in tandem, and are able to resolve their differences amicably, a strong commitment to economic reform even in the face of tough public opposition and outcry, will be essential, and would generate a more credible environment for attracting FDI.21

20

For full comprehensive coverage of the Index see Johnson and Sheehy (1996). On regular updates of business, finance, and investment in Ukraine see Business Ukraine, Economist Intelligence Unit. 21

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Acknowledgements This paper has been prepared with the support of ESRC Research Grant No. R000/23/5650 for which the author is grateful. Some of the information in this paper is drawn from meetings and interviews with officials at the Ukrainian Ministry of Economy and Ukrainian Ministry of Foreign Economic Relations in May 1997.

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