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A blog about economics in the South Caucasus.

Making Sense of FDI Dynamics

Foreign direct investment (FDI) is critical to every developing county, and Georgia is no exception in this regard. Georgia wants to grow out of poverty and catch up with the economically more developed regions of the world – for this to happen, foreign resources are needed, in particular if the domestic savings rate is as low as in Georgia.

Yet FDI is not only about the capital which is made available to the economy but also, and even more importantly, about trust foreigners have into the Georgian economy. It is one thing to make cheerful statements about Georgia’s rosy economic future and a completely different one to put one’s own money at stake. Nobody invests who does not see true opportunities for attractive returns and reasonable chances to get the money back.

Given this crucial role of FDI, it is prominently featured in many political debates, but the concept is not always well understood. The chart shows Georgian FDI from 2009 to the third quarter of 2014. As one can see, FDI reaches a low in the second quarter of 2014 and then soars at the very end of the chart. Does this mean that investor sentiments have declined in early summer but then improved drastically towards the end of last year?

This is indeed how it was understood by many journalists and politicians, who issued alarming statements when the FDI went down in the second quarter. And when it went up in the third quarter, the government interpreted this as foreign appraisal of its economic policy. However, the reasons behind the high intra-year volatility of FDI are much more profane.


DON’T PANIC! AND DON’T PRAISE!

After TBC Bank was listed at the London Stock Exchange, the European Bank for Reconstruction and Development (EBRD) sold a good deal of the TBC shares it held. These shares are now with investors who own less than 10% of TBC shares each. By definition, only financial investments which make up at least 10% of the stock of a company count as FDI, and so EBRD is now no foreign direct investor with TBC anymore. As a consequence, while the proportion of foreign ownership of TBC was not changed, the transaction had a negative impact on FDI. Around the same time, TBC bought 80% of the shares of Constanta Bank from the foreign OikoCredit – as foreign owners were replaced by Georgian ones, also this affected FDI negatively. Neither was capital availability reduced through these events, nor do they indicate a loss of trust in the Georgian economy on part of foreign investors.

Yet also the increase in FDI in the third quarter does not justify triumphant comments. The reason for the dramatic upturn was the construction of residential buildings necessary for the European Youth Olympic Festival (“Tbilisi 2015”), carried out by Chinese investors. This sports event was acquired for Tbilisi still by the old government, so there is no justification for the new government to consider this FDI as foreign support of their economic policies. Moreover, the construction started three years ago, and the third quarter of 2014 was just the period when a big portion of cash flows from the direct investors was received. If this amount would be spread throughout the duration of the whole project, which would be the right thing to do if one is interested in FDI as a measure of economic activity of foreigners in Georgia, we would see slightly higher FDI numbers in all previous quarters and no peak in the third quarter of 2014.

 

Feb-27_2015_500_1


AND DON’T TAKE FDI AT FACE VALUE!

According to the definition of the International Monetary Fund, direct investment is “a category of cross-border investment associated with a resident in one economy having control or a significant degree of influence on the management of an enterprise that is resident in another economy”. In practice, “significant degree” translates into the guideline that an investor must hold more than 10% of the voting power in a company for the investment to count as FDI, causing a discontinuity when a foreign investor increases their investment beyond 10%. This was behind the anomaly we saw in the third quarter of 2014. There are a couple of other catches with FDI – one can easily construct hypothetical examples of increases and decreases of FDI which are not associated with positive or negative economic developments, respectively. Some FDI may even be harmful for an economy (a detailed discussion of these issues can be found in the article “The Two Faces of Foreign Direct Investment” by Nikoloz Pkhakadze, published on the ISET Economist Blog).

All of these considerations are based on the assumption that FDI data is reliable, but obtaining reliable FDI data is not easy. FDI data – disaggregated by countries and sectors – is quarterly compiled and reported by Geostat, and it is based on three sources: data from the National Bank of Georgia about FDI in the financial sector (including commercial banks, microfinance organizations and insurance companies), data from the Ministry of Economy on privatizations (some of which involve foreigners), and, most importantly, questionnaires sent to companies. While the first two sources are very reliable, there are considerable uncertainties regarding the data obtained from questionnaires. This has implications, as through the years 2007 to III-2014 79% of the identified FDI came from the questionnaires (the financial sector and privatizations accounted for 11% and 9%, respectively).

Questionnaires about FDI are sent periodically to about two thousand companies. The list of companies is updated each quarter to include newly founded companies. However, a problem is that companies are not legally obliged to fill out the surveys (though GeoStat says that the majority of companies involved in the survey provide the information requested). Based on recommendations by international organizations, it is planned to make responding obligatory for companies in the near future.

To conclude, politicians and journalists should not take FDI numbers at face value. In a small country like Georgia, even the decisions of single businesses can lead to considerable changes in the FDI, as in the second and third quarters of 2014. Only if it is known how particular FDI movements come about, they can be interpreted economically in terms of capital availability and investor confidence. If such background information on FDI developments is lacking, as it is often the case, it would be better to not refer to FDI numbers if one wants to say something about Georgia’s economic fortunes.

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Guest - Mathias on Friday, 27 February 2015 18:07

Given your analysis, should we for the time being largely ignore FDI data as a relevant indicator for how Georgia is doing?

A few years back I was told that Georgia counted profits generated by foreign-owned companies that were left within Georgia as FDI. Do you know if that is a correct interpretation? It might lead to a significant distortion, because a number of major businesses are technically owned by non-Georgian entities, but those entities often have Georgian beneficial owners.

If one looks at the sources of FDI in Q3 2014, the Nr 3 to 5 investor countries are the Netherlands, Panama and Malta – all three are popular off-shore locations and tax havens. Presumably, a significant share of the funds coming from those countries is, although technically FDI, Georgian money that was parked – or in some cases laundered – in these locations. (http://geostat.ge/index.php?action=page&p_id=140&lang=eng).

Given your analysis, should we for the time being largely ignore FDI data as a relevant indicator for how Georgia is doing? A few years back I was told that Georgia counted profits generated by foreign-owned companies that were left within Georgia as FDI. Do you know if that is a correct interpretation? It might lead to a significant distortion, because a number of major businesses are technically owned by non-Georgian entities, but those entities often have Georgian beneficial owners. If one looks at the sources of FDI in Q3 2014, the Nr 3 to 5 investor countries are the Netherlands, Panama and Malta – all three are popular off-shore locations and tax havens. Presumably, a significant share of the funds coming from those countries is, although technically FDI, Georgian money that was parked – or in some cases laundered – in these locations. (http://geostat.ge/index.php?action=page&p_id=140&lang=eng).
Guest - RT on Monday, 02 March 2015 23:40

> Georgia counted profits generated by foreign-owned companies that were left within Georgia as FDI.

That seems to be the correct way:
"Reinvested earnings represent an important component of foreign direct investment ..." http://unctad.org/en/docs/iteiit20063a2_en.pdf

> Georgia counted profits generated by foreign-owned companies that were left within Georgia as FDI. That seems to be the correct way: "Reinvested earnings represent an important component of foreign direct investment ..." http://unctad.org/en/docs/iteiit20063a2_en.pdf
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