Recently the Georgian government started a campaign for attracting foreign capital to the country. A whole page ad (pictured above) runs on one of the first pages in the print edition of The Economist for already a month. Capital is a necessary requirement for development. But there are a few types of it. And one of them is especially important. This is venture capital.

Venture capital comprises financial resources that are invested in startups. Startups, by definition, are small enterprises. They have a larger potential for growth, therefore returns, in case of success, are also higher. International experience shows that small, young, innovative firms are major contributors to long-run economic growth. High returns, however, come with high risks: new ventures have a higher likelihood of failure.

Starting up a firm is much easier in a familiar environment. Overwhelming statistical evidence demonstrates that startups are localized not only in a country but also on a city/village level. Similar findings are present with respect to venture capital. And it is quite intuitive: investors need to be well aware of the local environment in order to be able to correctly assess the risks of the venture project.  Due to this reason venture capital rarely crosses sovereign borders.

As ad campaigns are unlikely to attract this vital type of capital from far abroad we should search for alternatives for developing the venture capital industry. This implies active government policies at national and trans-national levels. As European-style venture capital experience shows, banks can play a large and important role in this process. After all banking sector is the link that channels capital through the economy.

The Georgian banking sector has survived the current worldwide economic turmoil very well. This is due to strict regulations from the National Bank of Georgia, but also due to the very conservative stance, the sector takes with respect to the risks. This is apparent from an extremely low share of non-performing loans in the sector. This has clearly benefited the economy during the last three years.

However, Georgian bankers’ conservatism will not be successful if they were to engage in risky, but lucrative, venture capital business. The government will need to introduce sharp and effective incentive schemes to motivate banks to go in the needed direction. But, these incentives have to come with correct regulations to minimize the risks of negative spillovers from a bank’s venture business to its more conventional activities. Singapore, the country to which the Georgian government is said to be aspiring, is a very good example of an effective venture capital incentive-regulation package. Perhaps the Georgian government should start looking at Singapore’s experience with respect to the venture capital markets.

One other thing that can be done is to try to develop the industry within the region rather than within the sovereign borders. Evidence suggests that venture capital that crosses sovereign borders is mostly located within the country’s close neighbors. Regional cooperation should be particularly attractive for Georgia as it can compete for large volumes of capital concentrated in oil-rich Azerbaijan or richer and larger Turkey.

Starting up the business is easy in Georgia. But it is not cheap when compared to Georgian per capita income. Therefore, unless there are institutions/people who can pool the resources and take the risks associated with startups, I am afraid Georgia’s growth is going to run out of steam much earlier than one would expect.

Zakaria Babutsidze is an Assistant Professor at the Economics Department of SKEMA Business School and an Economist at the Department of Innovation and Competition of Observatoire Français des Conjonctures Économiques, Sciences Po. Both institutions are located in Sophia Antipolis, France.

He has degrees in economics from Maastricht University (Ph.D.), Central European University (MA), and Tbilisi State University (BA).