Many see foreign direct investment as a key prerequisite for an economic breakthrough in Ukraine. Yet, as this Financial Times article reports, political and security problems in Ukraine prevent FDI from climbing back to its pre-war levels. With the onset of the conflict with Russia, FDI flows to Ukraine experienced an unprecedented decline, falling from $8.5bn in 2012 and $4.5bn in 2013 to just $410m in 2014. Despite a certain rebound, driven by the recapitalisation of foreign-owned banks, FDI has so far failed to return to previous levels.
It is important to note, though, that foreign investment in Ukraine has often served as a veil for local (and sometimes Russian) big business, which uses special purpose entities in Cyprus and other tax havens to secure special legal treatment, conceal the ownership of assets and minimise taxes.
Cyprus has traditionally been the largest source of such investment, accounting for 24 per cent of FDI stock as of October 2016 (33 per cent as of January 2014). In 2012, the last year before the current crisis, Cyprus and the British Virgin Islands accounted for as much as 71 per cent of net FDI inflows.
The next largest investors, Germany and the Netherlands, are each responsible for roughly 12-13 per cent of the FDI stock in Ukraine. Yet most German FDI came in one instalment in 2005 from India’s ArcelorMittal, which controls a steel plant in Ukraine through its German subsidiary. The recent growth of FDI from the Netherlands, a popular tax haven, as well as from Switzerland, has mostly disguised the reinvestment of Ukrainian or Russian capital. For instance, in February 2016, a Dutch-registered subsidiary of Rinat Akhmetov’s DTEK built up its share in the largest private gas producer in Ukraine to 55 per cent.
Observers and policymakers should not limit themselves to discussing formal FDI numbers, as is often the case, but should look more closely at the origin of investment in Ukraine. The focus should not be on how to reach pre-war FDI levels, but on how to attract genuine FDI.
This distinction underlines the fundamental importance of reform in Ukraine. It may also prevent observers from falling prey to a statistical illusion, should a rise in FDI be fuelled by investment of local origin. This would signal a failure to remove long-existing obstacles to foreign capital, and a failure to create a safer environment for local investors. It is therefore worrying when high-ranking officials in Ukraine’s government seem to overlook this.
Just how big a hurdle is the ongoing military conflict in Donbass likely to be to genuine FDI?
On average, the eruption of warfare causes greenfield FDI to drop by about 90 per cent. In countries with simmering conflicts, investors remain sensitive to the level of violence. Though the conflict in Ukraine is restricted to about 7 per cent of the country’s territory, uncertainty over Russia’s next stept affects the political risk of investing in Ukraine and thus continues to limit FDI inflows. Due to the widespread coverage of the conflict by international media, no clear distinction is often made between the few regions caught in warfare and all the others that have not experienced its effects directly.
Higher returns can partially make up for the perceived danger. FDI in conflict-affected countries yields on average 50 per cent more than that in countries with comparable income levels. This, as well as the large potential of certain industries, explains why the crisis in Ukraine has not discouraged some (genuinely) foreign investors. For instance, agriculture has attracted investment from US-based Cargill and China’s Cofco. France’s Nexans and Japan’s Fujikura have started export-oriented production in the western region of Lviv, seizing on such advantages as an educated and low-cost workforce, as well as proximity to the EU market.
According to a survey by the EBA and Dragon Capital, investors who are actively looking for opportunities in Ukraine are more concerned with widespread corruption and lack of trust in the judiciary than with the conflict with Russia. A volatile currency and an unstable financial system, as well as restrictive capital controls and complicated tax administration, are also more important than security threats. Investors in other conflict-affected countries have also been shown to worry more about unexpected and arbitrary changes in government policy than about security issues.
Unfortunately, despite notable progress in some areas, evidenced for example by the clean-up of the banking system and the overhaul of state procurement, reforms in Ukraine have not been comprehensive. Attempts at reform have become particularly half-hearted in the recent months, as VoxUkraine’s Index for Monitoring Reforms shows. The improvements we have seen so far are certainly not enough to compensate for the negative impact that Russia’s aggression has had on investment.
Yet the ongoing conflict does not necessarily rule out FDI growth in Ukraine. Many of the key obstacles to FDI were there long before the warfare began. Addressing such long-term problems, while challenging, presents an opportunity for the Ukrainian government. If successful, far-reaching reforms could counteract the uncertainty that stems from the conflict and help attract genuine foreign direct investment into the country.
Rostyslav Averchuk is a guest editor at VoxUkraine, an independent analytical platform.