For Msc in Finance and International Business

THESIS

For MSc in Finance and International Business

Foreign direct investments in Ukraine: progress and perspectives

Author:

Oksana KIFYAK

Academic Adviser:

Erik Strøjer MADSEN

Associate Professor

Department of Economics

Aarhus, Denmark

2009

Acknowledgements

First of all I am grateful to our God, that He inspired me for making “a journey” through my land, and gave me strength for completing the paper. I want to thank my supervisor, Erik Strøjer Madsen, for his guiding and help throughout the process of writing the thesis.

My sincere gratitude is to my mother - for comments, to my husband - for support, to my sister in law - for suggestions and to my friend, Viktoriya Fedulova – for her help. My special acknowledgement goes to my little daughter, Josephina, who gave me the opportunity to write this paper.

Abstract

Nowadays, we can observe fast developing of East European economies. To develop, economy needs some platform, or capital. Here, the question of foreign investments arises. The Foreign Direct Investment topic will always be important due to its big impact on economies development. However, it is not always very easy to invest in particular country due to existing barriers.

This paper presents Ukrainian FDI progress and perspectives to a reader. It describes investing climate, reveals barriers and outlines future trends. Ukraine is compared with the closest neighbors from the investment point of view. Being neighbors, countries however, have different transitional paths.

In this work present-day investment position of Ukraine is revealed. Current state of different branches of Ukrainian industry along with market forecast is presented in the paper. This thesis also includes recommendations for foreign investors.

Paper is built on analytical researches and includes the cases of foreign companies-investors.

Key words: FDI, Ukraine, CIS, EEC, crisis, forecast

Table of Contents

Acknowledgements 1

Abstract 2

Introduction 1

CHAPTER 1. Theoretical framework of Foreign Direct Investment 2

1.1. FDI introduction, theories and models 2

1.2 Determinants of Foreign direct Investment 7

1.3. Should countries promote Foreign Direct Investment? 18

CHAPTER 2. Country analysis 20

2.1. Ukraine and development path 20

2.2. Investment and Business Climate analysis 21

2.3. Investment barriers assessment 23

CHAPTER 3. Ukrainian Foreign Direct Investment Analysis 37

3.1. Level of FDI to Ukraine 37

3.2. Comparing of the neighbors 41

3.3. Analysis of the structure of Ukrainian FDI by branches 47

CHAPTER 4. Recommendations to investors 60

Bibliography 65

Appendixes 72

Table of Figures

Tables

Table 1.Foreign Direct Investment Theories 4

Table 2. Determinants of FDI 9

Table 3.Ukraine Ratings 2003-2008 21

Table 4.Countries Sovereign Credit Ratings 2008 21

Table 5. Comparing of Countries Ratings 22

Table 6. Index of economic freedom, selective country rankings 22

Table 7. Interest rates, percent, US dollars 25

Table 8. Export and import requirements in Ukraine 31

Table 9. Trade Balance of Ukraine, 2001-2008, billions of US Dollars 32

Table 10. The degree of openness of the Ukrainian economy 2001-2008 33

Table 11. Interdependence between FDI determinants and FDI level in Ukraine 35

Table 12. Investment attractiveness of Ukrainian regions - 2008 41

Table 13. The transition path of selected countries 42

Table 14. FDI in the chosen countries by activity types 46

Table 15. FDI in the chosen countries by investors 46

Table 16. The branches of Ukrainian industry, their development and forecast. 62

Figures

Figure 1. Multiplication effect of FDI 3

Figure 2. Ukrainian GDP per capita, nominal, US Dollars 23

Figure 3 Annual GDP Growth, selected countries, percent 24

Figure 4 Budget proficit (deficit), percent of GDP 24

Figure 5.Ukrainian nominal Exchange rate (1996-2009), UAH 25

Figure 6.Ukrainian real exchange rate (2000-2007), percent 26

Figure 7.Inflation, end of period, consumer prices, percent 26

Figure 8. Legal System 30

Figure 9. Current Account of Ukraine, billions of US Dollars 32

Figure 10. Unemployment, percent 33

Figure 11. Nominal average salary in Ukraine, US Dollars 34

Figure 12 Herfindahl-Hirschman Index 2005 35

Figure 13. FDI as a percent of GDP 38

Figure 14. FDI Stock in Ukraine, billions of USD 39

Figure 15. FDI inflow to Ukraine, billions, USD 39

Figure 16. FDI inflow to Ukraine in 2008 by countries, percent 40

Figure 17. FDI Flow per capita, by country, billions, USD 44

Figure 18. FDI Stock, billions of USD 44

Figure 19. FDI to Ukraine in 2008 by activity types 48

Figure 20. Structure of M&A in Ukraine in 2007, percent 60

Figure 21. Volume of M&A in Ukraine, billions of USD 60

1

Introduction

Foreign direct investment plays an important role in international business and in the development of different economies. Many governments have liberalized their policies to attract investors. Foreign capital is filling the budget, reduces unemployment, promotes technology and knowledge transfer. It’s impossible to imagine modern society without FDI. Nowadays, we can observe fast developing of East European economies. To develop, economy needs some platform, or capital. It is possible to take it from your ”own pocket” or to ask someone else. Here, the question about foreign investments arises. The FDI topic will always be significant due to enormous demand on investments.

Ukraine is the biggest country in the Central-Eastern Europe. Its possession of land, capital and labour resources creates perennial interest from foreign investors. During 18 years of independence, Ukraine passed the long way of political and economical reforms. One of the most important steps was liberalization of markets, creating the conditions for direct investments. There are still many risks and barriers for international investors. Along with that investments, made into Ukrainian economy, brought enormous yields, which are not accessible for developed economies investors. Recent years stability of macroeconomic figures brought big inflow of investment to the country, however financial crisis shook the growth tendency.

This paper gives an overview of Ukrainian Foreign Direct Investment since Independence, its transitional path, modern situation and attempts to make a forecast of attractive areas for investor in future. The paper consists of four chapters. The first describes theoretical background, refers to the main FDI theories, summaries them and points out on the determinants of FDI. Second chapter introduces Ukraine to a reader, reveals its investment position and business climate. Here the barriers for FDI are examined. Chapter three describes the level of FDI to Ukraine in general and tries to concentrate on specific branches, which attracted the biggest amount of investments. This part also deals with comparing FDI performance of our closest neighbors- Hungary, Poland, Romania, Russia and Belarus. The fourth block reveals the perspectives of FDI and points to the future areas, which can be very interesting to investors. This part contains forecast of Ukrainian development and suggests possible FDI trends.

CHAPTER 1. Theoretical framework of Foreign Direct Investment

1.1. FDI introduction, theories and models

The economy of every country has the question of FDI among top-important ones. FDI appears to be one of the most studied, but still not fully researched topics in international business area.

Foreign direct investment implies, that a company from one country makes a physical investment in another country. It is the establishment of an enterprise by a foreigner. FDI imply investments, made to acquire lasting interest in enterprises operating outside of the economy of the investor. “Lasting Interest” implies the existence of long-term relationship between the direct investor and the enterprise and a significant degree of influence by the direct investor on the management of the direct investment enterprise. Direct investment involves both the initial transaction between the two entities and all subsequent capital transactions between them and among affiliated enterprises; both incorporated and unincorporated (OECD). The FDI pair consists of a parent enterprise and a foreign affiliate, which form a multinational corporation. The investment becomes FDI when it affords the parent enterprise control over its foreign affiliate (Wikipedia). The IMF defines control in this case as owning 10% or more of the ordinary shares or voting power of an incorporated firm or its equivalent for an unincorporated firm; lower ownership shares are known as portfolio investment (IMF, 1993). Foreign Direct Investment is one of the three components of international capital flows. FDI itself has three components: equity capital, reinvested earnings and intra-company loans (Vavilov, 2005).

There is traditional thought, that investment activity and the cyclical processes create economical progress in every economy. What is the impact of foreign capital on domestic economy? Foreign capital fills the internal sources of the country. Capital inflow reduces tension in the credit sphere; its influence on interest rate and banking credits serves as additional stimuli for further investments. FDI is able to increase production effectiveness, widen the distribution markets due to higher technological level and better equipment. The rise of productivity level in the sector with foreign investor presence involves suppliers and related industries development as well. The development of economy, which follows after, creates demand in qualified labor force: engineers and economists. Moreover, export-oriented MNC rise export profits of the country.

Figure 1 Multiplication effect of FDI

Source: Dirko A.A.,2004,The impact of FDI on economical development of the recipient country

Foreign capital serves as a major resource of growth and technology diffusion in the transition economies of CEE countries. MNC’s increase country’s compatibility on international arena and attract even more investment (Dirko, 2004).

The main theories of FDI try to explain its nature, types and internationalization process. Main theoriesare – theory of industrial organization, theory of the firm, trade theory and theory of location (Table 1).

Theory of industrial organization suggests why firms, which have the resources to operate internationally achieve technical and organizational advantages over domestic firms via FDI. Let’s say Hymer (1960) in his Industrial Organization model argues that some firms achieve advantages that allow them to obtain rents in foreign markets. Foreign investor is in less favorable situation than the local one. Due to this fact, international investor must possess monopolistic advantage to receive higher profits.

Theory of the firm tries to answer the question in which way can the MNC expand its activity in host country. (Vernon, 1966) has introduced Product Life Cycle model. Products have a finite economic life and go through 3 phases: new product, maturity and standardization. FDI occurs when in the maturity phase the innovator shifts production in developing countries due to lower factor cost advantages.

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Table 1 Foreign Direct Investment Theories

Macro theories / Micro theories
Theory/hypothesis / Authors / Theory/hypothesis / Authors
Theories of Industrial Organization
Theories of Industrial organization / Hymer (1960, 1968, 1976) Caves (1971, 1974) Teece (1981, 1992) McCullough (1991)
Theories of the Firm
Product cycle / Vernon (1966), Hirsch (1967), Vernon (1979), Buckley and Casson(1976) / Transaction Related / Coase (1937) Buckley and Casson (1976) Williamson (1975, 1979) Rugman (1981) Hennart (1982, 2000) Hill and Kim (1988) Prahalad and Doz (1987) Bartlett and Ghoshal (1989)Doz, Awakawa, Santos and Williamson (1997)
Internationalization process / Johanson and Vahlne(1977, 1990), Eriksson, et al. (1997) / Resource based/Raw materials / Penrose (1958) Wenerfelt (1984) Nelson and Winter (1982) Cantwell (1989, 1994) Teece, Pissano and Shuen (1997)
Strategy related (and Oligopolistic production) / Vernon (1966) Knickerbocker (1973) Graham (1975) Flowers (1976) Vernon (1982) Hostman and Markusen (1987) Graham (1990, 1998)
Option theory / Kogut and Kulatilaka 1994) Rivoli and Solaria 1996) Casson (2000)
Internalisation / Buckley and Casson (1976)
Theories of Trade
Macro (country oriented) / Kojima (1973 to 1982) Helpman (1984, 1985) Markusen and Venables (1998) / Micro (firm oriented) / Vernon (1966), Hirsch (1976), Ethier (1986), Batra and Ramachandran (1980), Gray (1982, 1999), Markusen (1984, 1995, 1998)
Theories of Location
Theory of location
(General) / Vernon (1966), Vernon (1974), Hirsch (1967), Dunning (1972), Root and Ahmed (1979), Davidson (1980), Lipsay and Kravis (1982), Krugman (1991, 1993) / Clustering and agglomeration / Enright (1991, 1998), Porter (1998), Audretsch (1998), Chen and Chen (1998), Head, Ries, and Swenson (1995), Markusen and Venables (2000)
Internationalization / Johanson and Vahlne (1977, 1990), Schneider and Frey (1985), Welch and Luostarinen (1988) / Knowledge enchasing / Cohen and Levinthal (1990), Levinthal (1990), Kogut and Zander (1992, 1994), Nonaka (1994), Porter (1994, 1998), Dunning (1995, 1997), Kuemmerle (1999)
Market size / Stevens (1969), Kwack (1972), Schwartz (1976) / Output / Stevens (1969), Kwack (1972), Schwartz (1976)
Exchange rate /currency area / Aliber (1971), Cushman (1985), Culem (1988), Froot and Stein (1991), Rangan (1998) / Spatial transaction cost / Florida (1995), Scott (1996), Storper and Scott (1995)
Taxes, subsidies and/or tariffs and incentives / Hines (1996), Devereux and Griffith (1996), Haufler and Wooton (1999), Glass and Saggi (2000)
Cheap labour / Riedel (1975), Donges (1976, 1980) Juhl (1979)

Source: Adapted from Jordaan, J. 2004. Foreign direct investment and neighboring influences. University of Pretoria

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Ten years later, Buckley & Casson (1976) introduce Internalization model. They’ve pointed out five advantages of internalized transaction over the market. Internalization increases ability to control and plan, gives the opportunity for discriminatory pricing. It avoids bilateral monopoly, reduces uncertainty and avoids government intervention.

Trade Theory explains that location of international production is based on specific advantages. It reveals why is it better to invest in another country rather than trade. Traditional trade theory suggest that trade should be greatest between countries that are not similar.

Theory of Location is a framework that determines location of FDI as the key-point for the future activities. The host countries possess some location advantages, otherwise the firm would simply operate in a single location. This theory operates with protectionism, transportation cost, cooperation with downstream firms, and acquisition of existing distribution networks. This theory uncovers the reasons that determine the choice of the overseas investment.

As a part of Location Theory, very important were findings of Dunning (1972). Here he identifies four main types of foreign production, according to their motive for going abroad: 1) resource-seeking, 2) market-seeking, 3) efficiency-seeking, and 4) strategic asset or capabilities seeking (Pawlik, 2005).