How to attract FDI to Ukraine after stabilisation?

17 August 2015

wiiw Research Economist Gabor Hunya assesses the current and potential role of FDI and puts forward a coherent policy mix for Ukraine to attract more and better FDI.

No stability, no FDI

Attracting foreign direct investment (FDI) has been among the primary goals of most Central, East and Southeast European (CESEE) governments. Many of them have achieved remarkable foreign investment inflows in efficiency-seeking, export-oriented projects underpinning economic growth, institutional transformation and technological upgrading. But in several countries including Ukraine high FDI could not be attained due to unstable institutions, uncoordinated policies and inadequate business conditions.

We think that FDI can become a more important source of financial stability and support to competitiveness and structural change if conditions of doing business improve in post-crisis Ukraine.

As of recently, however, circumstances for FDI have worsened in Ukraine. First, the country is considered being at war and close to financial default which deters investments, both foreign and domestic. Second, there are signs of an institutional vacuum and new structures are still to emerge. At the moment, more pressing issues seem to be in the focus of policy-makers than a revamp of FDI policy. It is not the current desperate situation but one with resumed basic political and economic stability when FDI can be re-started. We build recommendations based on past achievements which, combined with lessons of best practice of other countries, may foster higher direct capital inflows in the future.

FDI performance so far

So far, the main target of FDI in Ukraine has been the financial sector, while the share of manufacturing was smaller than in comparable countries like Poland or Romania. This means that even more than in other countries, foreign investors targeted the domestic market rather than export-oriented, efficiency-seeking FDI projects. Within manufacturing, FDI targeted first of all the two main sectors of the Ukrainian economy: the production of basic metals and of food.

Flextronics' Singapore headquarters (photo: Flextronics)

However, some supplier firms in the automotive and ICT industries are present and most probably produce for exports including Flextronics (Singapore), Leopold Kostal (Germany), Gumi (Japan) and Team International (United States). These projects, mostly established between 2012 and 2014, are all located either in the capital city or in the western part of the country. They are rather small projects as of now but may expand based on competitive wages if business conditions improve.

The presence of automotive and IT suppliers indicates that low wages do attract investments into Ukraine in labour-intensive activities and the country has chances to become a component production and service provider platform. It may even attract relocating projects from new EU members such as Poland based on significantly lower wages, provided political and economic consolidation is achieved.

FDI regime to be revamped

Previous governments put in place institutions and frameworks to foster and promote FDI in Ukraine. With a view to improving the investment climate, Ukraine adopted an ‘Investment reform’ in 2011 which targeted the preparation and promotion of strategic investment proposals. It created a ‘one-stop shop’ investment promotion department called InvestUkraine (launched in January 2012) in the State Agency for Investment and National Projects of Ukraine. The investment incentive regime was on the whole attractive as corporate income tax and dividend tax were reduced.  It was most probably not because of the lack of incentives why greenfield investors largely avoided the country but the generally poor business conditions including red-tape and corruption.

FDI policy options

FDI inflows – indispensable for economic restructuring and growth – have so far been meagre in Ukraine, when controlling for round-tripping Ukrainian capital. This puts forward the challenge of designing a business environment as well as specific FDI policies which are conducive towards these goals. Such policies can be based on revamping previous initiatives and regulations as well as on existing recommendations by OECD and other international institutions. Beyond improving the framework conditions which would make the country a less risky place for genuine investors, four main lines of action need to be implemented as a coherent package to attract more and better FDI:

  • Industrial/business parks can act as an incentive for attracting (foreign) investors, as they enable to start operations within a rather short period of time and under good infrastructure and operational conditions. Parks must provide clear ownership rights, good transport connections, abundant and reliable energy and water supply, and need the full backing of the local/regional administration. In particular, the unutilised industrial land of state-owned enterprises could be used in this way. Provinces (oblasts) and municipalities must have the legal authority and financial means to foster the establishment of such parks. A specific form of business parks, special economic zones have been highly attractive in Poland. The government should initiate establishing such zones in border regions with the aim to attract export-processing investments.
  • Granting a transparent contractual regime by the government to the investors in large projects can provide individually tailored packages of incentives. Contracts should guarantee investors’ access to fair or even priority treatment by authorities in a transparent way.
  • Promotion of FDI spillovers is necessary to upgrade the absorption capacity of the local economy. Foreign-owned companies need support to create linkages with local companies, and local companies need support to meet the standards to become suppliers to foreign multinationals. Support may not necessarily mean a lot of money but care and communication on the part of authorities in fostering cluster development.
  • It is also necessary to revitalise the FDI agency InvestUkraine, preferably as an independent agency reporting to the prime minister. There are several successful investment promotion agencies in the new EU Member States, especially PAIiIZ in Poland and Czech Invest in the Czech Republic, which may serve as examples and give support to the Ukrainian agency. Regional investment agencies in territorial-administrative units are necessary to help investors find the proper locations. This is another reason why the competencies and autonomy of oblasts and municipalities need to be upgraded.