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A blog about economics in the South Caucasus.

The Two Faces of Foreign Direct Investment

Recently, the Georgian media abounded with alarming reports about a slowdown of foreign direct investments (FDI) in Georgia. Indeed, economic figures seem to support the view that there may be a turn in the FDI activity. The graph shows FDI in the first two quarters of each year from 2005 to 2013. There is obviously a huge volatility in the investment activity throughout those years, reflecting economic and political events like the war and the financial crisis in 2008. Yet since 2009, FDI activity was following a slow but steady upward trend.

This trend seems to have come to an end in the current year: the foreign direct investment in the first two quarters of 2013 was below the 2012 companion numbers.

 

fdi1


WHY DO WE CARE ABOUT FDI?

The two Turkish economists Faruk Guersoy and Hueseyin Kalyoncu investigate the connection between FDI and GDP growth in Georgia (“Foreign Direct investment and Growth Relationship in Georgia”, International Journal of Economics and Financial Issues 2, 2012). Their analysis is based on data of the years 1997-2010. In line with most of the research on this issue, they show that FDI inflow and GDP growth are closely related also in our country.

The reasons for the alignment of GDP growth and FDI activity are manifold. A survey article by the economists Prakash Loungani and Assaf Razin summarizes the most important arguments (“How Beneficial Is Foreign Direct Investment for Developing Countries?”, Finance and Development 38, 2001): (1) FDI allows the transfer of technology – particularly in the form of new varieties of capital inputs – that cannot be achieved through financial investments or trade in goods and services. (2) FDI can promote competition in the domestic input market. (3) Recipients of FDI often gain employee training in the course of operating the new businesses, which contributes to human capital development in the host country. (4) Profits generated by FDI contribute to corporate tax revenues in the host country.

Yet while the general view on FDI is positive, the two authors also note that: “Despite the evidence presented in recent studies, other work indicates that developing countries should be cautious about taking too uncritical an attitude toward the benefits of FDI.” Why can FDI also be problematic?


IS FDI ALWAYS DESIRABLE?

Let us consider a hypothetical example. An investor from Russia buys 60% of the shares of a Georgian company for 50 million laris. This operation will increase the FDI by 50 millions. Then he lends to this Georgian company 20 million laris for one year for an interest rate of 10%.  This operation will even more increase the FDI, namely by 22 million laris (the whole amount of money that has to be paid back is counted as FDI). Now assume that the company runs into trouble and cannot pay back its debt after one year. It is common that the credit contract specifies that in this situation the company’s default does not lead to immediate bankruptcy, but to an increase of the interest rate (this is particularly common if the credit was provided by one of the company’s owners). So assume that the company gets penalized with a doubling of the interest rate and has to pay an additional 2 millions of laris as interest. This operation increases the FDI by 2 million laris, even though there was no positive economic activity associated with it. In this example, taking FDI at face value would be deceptive, as there may be economic activities associated with it that are far from being beneficial.

Let us push this example even further. Assume that a Georgian businessman is unhappy about how the Russian investor treats his Georgian employees. Out of concern for his compatriots, he decides to buy back the 60% of the shares. This operation decreases the FDI by 50 million laris, even though the activity was good for the company, its workers, and the Georgian society as a whole.

Obviously, there are investments that are harmful for a country, for example if they cause environmental problems or lead to an exploitation of the local workforce. Yet FDI does not take into account the nature of an investment. It counts everything in the same way.


WHAT SHOULD POLITICIANS DO?

The role of the government in FDI acquisition is exactly to evaluate the economic impacts of an investment. While beneficial investments should be encouraged, investors with questionable intentions should be deterred. In the past, however, this seems not to have worked always very well.

As an example, the Austrian delicatessen company Schirnhofer was planning not only to sell its production in Georgia, but also to produce it here. Schirnhofer intended to build a factory in Mtskheta that would have given work to 600 people. In addition, the company was going to give cattle of a special breed to 3000 local farmers. Yet claiming that the products of Schirnhoffer were of low quality, the financial police confiscated some of its imports in Poti, even though there was not even a laboratory in Georgia which could check the alleged flaws in those products. These artificial barriers made the investor to change his mind about investing in Georgia. Now the factory will be built in Kazakhstan – in Tbilisi, Schirnhofer will just operate a store.

Another example is the city of Zestafoni. Since decades, Zestafoni is home to a huge ferroalloy industry. Also in recent years, ferroalloy held a large share in Georgia’s exports. The factory, founded in 1930’s, is now operated by foreign investors, and one hears a lot of complaints about how the factory is operated. The salaries of local workforce are low, there are air polluting issues, with Zestafoni having the highest cancer rates in Georgia. Last not least, the industrial infrastructure seems still to be the same as in Soviet times. Not surprisingly, the residents of Zestafoni are dissatisfied with the foreign investor, and recently there were two weeks of protests and demonstrations. The investor pays taxes to the government, yet these tax payments would also be paid by any other investor, regardless of domestic or foreign. In this case, the government did not ensure that the investor would bring technology, renew the infrastructure, etc.

Of course, in the last years Georgia often managed to attract FDI of good quality. An instance is the pipeline by British Petroleum which is very profitable for the country. BP built three pipelines that increased the geo-political importance of Georgia, and Georgia collects considerable fees for the transfer of oil and gas through the country. It is also worth mentioning that many BP employees are Georgians.

Another example of constructive investment are the activities of the Italian sweets giant Ferrero in Georgia.  Ferrero employs about 150 people and hundreds of seasonal workers. They also launched a training program, enabling hazelnut farmers in Samegrelo to master advanced cultivation techniques.

Instead of judging the economic development only based on the increase or decrease of FDI, politicians should have a deeper look at the nature of those investments. The FDI numbers alone are not very meaningful.

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Guest - RT on Monday, 07 October 2013 21:12

1. That's an interesting chart, though it may be more interesting to look at these flows in % of GDP (corresponding two quarters). There will be less of a spike in 2005-8, while 2009-2013 may show a more pronounced decline. In nominal numbers, the chart merely shows a broadly flat inflow of FDI in the last three years.

2. You nicely show how FDI is related to future growth. But there may also be a simpler link to current growth. Given low savings in Georgia, investment on the margin is financed by inflows from abroad, including FDI.

3. The example with a Russian investor is strange

1. That's an interesting chart, though it may be more interesting to look at these flows in % of GDP (corresponding two quarters). There will be less of a spike in 2005-8, while 2009-2013 may show a more pronounced decline. In nominal numbers, the chart merely shows a broadly flat inflow of FDI in the last three years. 2. You nicely show how FDI is related to future growth. But there may also be a simpler link to current growth. Given low savings in Georgia, investment on the margin is financed by inflows from abroad, including FDI. 3. The example with a Russian investor is strange
Guest - Eric Livny on Tuesday, 08 October 2013 00:53

Quote from The Telegraph: "Steel-making giant Arcelor Mittal has suffered an extraordinary attack from a French government minister, telling the company it is no longer welcome in his country...". See http://www.telegraph.co.uk/finance/newsbysector/industry/9702604/ArcelorMittal-not-welcome-in-France-anymore-says-minister.html

Now, I don't know much about France, but I applaud Arnaud Montebourg for taking on the world's largest steelmaker. I have observed this company's operations in Temirtau, Kazakhstan and am confident that any country is better off not having the likes of Arcelor Mittal siphoning off its natural resources.

(1) Mittal purchased the Temirtau Steel plant back in 1995-6, yet its "investment" b>involved no transfer of technology. Mittal surely bought the natural resources on which the plant sits, but did not invest anything in its physical capital. The Soviet technology was used for all production processes when I visited the plant in 2005, ten years after the initial investment had been made. It was still operated by the same Ukrainian engineers who came to Kazakhstan in Soviet times.

(2) FDI by Arcelor Mittal did not promote competition in the Kazakh domestic input market. Foreign ownership did not change anything in the plant's way of doing business, including procurement of domestically produced inputs.

(3) Temirtau plant employees received no training other than what was necessary for them to perform their immediate duties. Therefore, foreign ownership had not impact on employees' human capital.

(4) I don't have the data to support this, but I think that Mittal Steel's contribution to the Kazakh budget (as opposed to the ruling clan) was nothing to write home about: payroll taxes on the (low) wages received by local employees and even less in profit taxes given that steel was marketed through Mittal's own daughter companies. Using sufficiently low ("transfer") prices the company could easily make sure that profits were accumulated in tax heavens, not in Kazakhstan. The company's new owners surely made a nice profit, but very little of it went back to the national economy, the small company town, and its employees.

When I visited Temirtau (the town, about 50km from Karaganda) back in 2005, it was lying in ruins.

There must be better ways of making use of a country's natural resources!

Quote from The Telegraph: "Steel-making giant Arcelor Mittal has suffered an extraordinary attack from a French government minister, telling the company it is no longer welcome in his country...". See http://www.telegraph.co.uk/finance/newsbysector/industry/9702604/ArcelorMittal-not-welcome-in-France-anymore-says-minister.html Now, I don't know much about France, but I applaud Arnaud Montebourg for taking on the world's largest steelmaker. I have observed this company's operations in Temirtau, Kazakhstan and am confident that any country is better off not having the likes of Arcelor Mittal siphoning off its natural resources. (1) Mittal purchased the Temirtau Steel plant back in 1995-6, yet its "investment" b>involved no transfer of technology. Mittal surely bought the natural resources on which the plant sits, but did not invest anything in its physical capital. The Soviet technology was used for all production processes when I visited the plant in 2005, ten years after the initial investment had been made. It was still operated by the same Ukrainian engineers who came to Kazakhstan in Soviet times. (2) FDI by Arcelor Mittal did not promote competition in the Kazakh domestic input market. Foreign ownership did not change anything in the plant's way of doing business, including procurement of domestically produced inputs. (3) Temirtau plant employees received no training other than what was necessary for them to perform their immediate duties. Therefore, foreign ownership had not impact on employees' human capital. (4) I don't have the data to support this, but I think that Mittal Steel's contribution to the Kazakh budget (as opposed to the ruling clan) was nothing to write home about: payroll taxes on the (low) wages received by local employees and even less in profit taxes given that steel was marketed through Mittal's own daughter companies. Using sufficiently low ("transfer") prices the company could easily make sure that profits were accumulated in tax heavens, not in Kazakhstan. The company's new owners surely made a nice profit, but very little of it went back to the national economy, the small company town, and its employees. When I visited Temirtau (the town, about 50km from Karaganda) back in 2005, it was lying in ruins. There must be better ways of making use of a country's natural resources!
Guest - Y on Tuesday, 08 October 2013 14:54

FDI can be a powerful instrument in the government's industrial policy toolkit. The idea is to 'direct' FDI in way that facilitates the creation of industry clusters, instead of relying on the spillovers generated by more or less haphazard FDI process.

http://www.eclac.cl/ddpe/noticias/noticias/7/20807/MortimoreEJDR.pdf Here is a link to some case studies done in this area.

The drawback of such approach is of course the danger of interfering too much, hindering the more viable market initiatives. Yet, to the extent that in Georgia industrial development might suffer from the coordination problems, such industrial policy may actually be beneficial.

FDI can be a powerful instrument in the government's industrial policy toolkit. The idea is to 'direct' FDI in way that facilitates the creation of industry clusters, instead of relying on the spillovers generated by more or less haphazard FDI process. http://www.eclac.cl/ddpe/noticias/noticias/7/20807/MortimoreEJDR.pdf Here is a link to some case studies done in this area. The drawback of such approach is of course the danger of interfering too much, hindering the more viable market initiatives. Yet, to the extent that in Georgia industrial development might suffer from the coordination problems, such industrial policy may actually be beneficial.
Guest - Matsatso Tepnadze on Wednesday, 09 October 2013 00:36

Unfortunately, foreign direct investment in Georgia comes at a cost in terms of value added activities at the firm level, ignoring other economic and non economic considerations. I think there is essential need for any principal mechanism to conduct foreign investment reviews in Georgia. For example, in Canada, under the Investment Act, foreign investments are classified into two categories: Investments that are subject to notification and investments that are reviewable. For the latter, an investment project will be approved by the Government of Canada, if it is likely to be of net benefit to Canada and not injurious to national security. Only after having Implemented similar approach, we could judge whether increase of FDI really stimulates economic growth or not.

Unfortunately, foreign direct investment in Georgia comes at a cost in terms of value added activities at the firm level, ignoring other economic and non economic considerations. I think there is essential need for any principal mechanism to conduct foreign investment reviews in Georgia. For example, in Canada, under the Investment Act, foreign investments are classified into two categories: Investments that are subject to notification and investments that are reviewable. For the latter, an investment project will be approved by the Government of Canada, if it is likely to be of net benefit to Canada and not injurious to national security. Only after having Implemented similar approach, we could judge whether increase of FDI really stimulates economic growth or not.
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