Central and Eastern Europe (CEE), Global Recession and Foreign Direct Investment (FDI)

The oncoming global recession is unlikely to adversely affect FDI flows into Eastern Europe.

Part I. The Republic of Macedonia – A Case Study (2007)

Ever since its reluctant declaration of independence in 1991,Guest Posting Macedonia occupied the bottom of the list of countries in transition from Communism, as far as absolute dollar figures of FDI go. At 80.6 million USD, FDI in 2003 barely budged from previous years. In 2004, FDI reached 139.5 million USD, only to shrink to 116.2 million USD in 2005. Discounting the sale of ESM, the electricity utility, FDI remained static in 2006 (total FDI was 350.7 million USD or 124.7 million USD, without ESM).

Yet, this is a misleading picture. Macedonia was and is no worse off than other countries in Eastern Europe.

According to UNCTAD’s World Investment Report 2007, FDI in Macedonia, as a percentage of gross fixed capital formation, shot up from 9.7% in the decade of the 1990s to 32.4% in 2006 (compared to 36.4%, the southeast European average; 20.8% the average of all countries in transition; and 12.6% the global average figure).

Macedonia’s FDI stock reached 2.437 billion USD, or 39% of GDP (compared to 42.2% as the southeast European average; 25.3% the average of all countries in transition; and 24.8% the global average figure).

Macedonia’s Inward FDI Performance Index, based on 12 economic and policy variables, climbed from the 86th to the 64th place out of 141 economies surveyed. Its Inward FDI Potential Index also improved from 115 to 106.

Throughout this period, foreign enterprises, profitable overall, consistently hired new employees and wages in the sector stabilized at c. twice the average salaries in local businesses.

Thus, as far as FDI goes, Macedonia’s performance, though far from stellar, was and is above the regional and global averages. The World Bank put it succinctly, as it summarized the period PRIOR to the assumption of power by the new government:

“Macedonia’s rankings either improved or stayed steady for all available scored rankings, and it tracked closely with the regional averages for all rankings. According to the World Economic Forum’s Global Competitiveness Report for 2006-07, the three most problematic factors for doing business are inefficient government bureaucracy, access to financing, and corruption. Macedonia was one of the top 10 Doing Business reformers, jumping up 21 places. The most significant improvements were in the following indicators: Starting a Business (where the paid-in minimum capital requirements were dropped from 111% to 0% of GNI per capita), Dealing with Licenses, and Trading Across Borders.”Other indicators lead to the same conclusion: while Macedonia’s image and perception as a business destination and the business climate have improved considerably under Gruevski’s government, in reality, not much else has changed.

Consider the following numbers, pertaining to Macedonia:

Control of Corruption Indicator, published by the World Bank: 113 (2006) vs. 111 (2007)

Country Credit Rating, published by Institutional investor: 85 (2006) vs. 84 (2007)

Index of Economic Freedom, published by The Heritage Foundation and the Wall Street Journal: 75 (2006) vs. 71 (2007)

Quality of National Business Environment Ranking, issued by the World Economic Forum in its Global Competitiveness Report: 87 out of 121 countries.

Only the World Bank’s Doing Business Ranking jumped from 96 (2006) to 75 (2007). Yet, even this indicator hides some unpalatable truths: Macedonia has deteriorated in certain respects. It is more difficult and cumbersome to hire workers, to register property, to obtain credit, to protect investor rights, and to enforce contracts. In any case, this indicator has more to do with public relations, expectations, and psychology, rather than with the hard facts on the ground.

And the hard facts are:

Macedonia is not ready to absorb and accommodate foreign investors and their capital. It still has a long way to go. This government has put the cart before the horses;

The youthful, populist, and inexperienced administration is overwhelmed and ill-equipped to deal with its obligations towards and promises to foreign investors. Decision-making bottlenecks (especially in the office of Vice-Premier Zoran Stavreski) conspire with red tape and blatant favoritism to render nightmarish both greenfield and brownfield ventures.

In a long-running arbitration, the country was slapped with multimillion dollar damages payable to the Greek investors in Okta. This did not deter the government from conflicting vocally and publicly with Macedonia’s other large investor, the Austrian EVN, owner of the electricity utility;

To its credit, the government has reformed the tax system, introduced a flat tax, and reduced the tax rates, all laudable. But it is still illegal for foreigners to own land and real estate (as individuals) and all but impossible to trade in the local stock exchange. The government has only now resorted to tackling these archaic limitations;

The country is dysfunctional. No institution works properly: the cadastre, the courts, law enforcement agencies, the civil service are all in chaotic disarray. Even the banking system, despite a decade of FDI, is rudimentary. Infrastructure of all sorts is dismal, though improving. The government’s anti-corruption drive is much lauded but highly politicized and one-sided, aimed as it is exclusively at the hapless politicians of the opposition. Macedonia’s laws are not geared to welcome and assimilate foreign investment, foreigner businessmen, and foreign workers;

Macedonia lacks skilled manpower. The education deficit is pervasive. More than half the adult population has eight years of schooling or less. A multi-generational brain drain saps the country’s vitality and prospects in the global information economy of the 21st century. Contrary to the government’s claims in its “Invest in Macedonia” campaign, costs and taxes associated with wages are among the highest in the world.

The country suffers from other problems: a huge informal economy, skyrocketing consumer and enterprise indebtedness, ominous asset bubbles in both the stock exchange and the real estate market, a crippled middle class and crippling poverty and unemployment rates, an unmanageable and increasing trade deficit (c. 20% of GDP), and a whopping current account deficit offset only by remittances from Macedonian workers abroad. The global credit crunch constitutes a major threat to polities with such precarious finances.

Geopolitical instability (in Kosovo) is exacerbated by the current Macedonian regime’s jingoism, its overt and manipulative religiosity, and greenhorn fickleness. Within the last year, Macedonia has considerably retarded its chances to enter NATO and the European Union (EU), having clashed unnecessarily and spectacularly with Greece, Serbia, Bulgaria, and the Albanian minority at home.

Despite a slew of expensive PR and advertising campaigns; the appointments of two ministers and the formation of a special agency to deal with FDI; incessant trips abroad by every functionary, from the prime minister down; and innovative marketing initiatives – FDI figures for 2007, at c. 180 million USD (c. 3% of GDP), are a major disappointment. Moreover, a sizable part of Macedonia’s FDI is in construction, retail, financial services, and trade, economic sectors with minimal contribution to future growth.

In comparison, FDI doubled in decrepit, post-bellum Serbia, to 4.5 billion USD in 2006. Croatia garnered 3.6 billion USD (2.7 billion euro) – twice the 2005 figure. Even strife-torn Bosnia-Herzegovina, under a EU peacekeeping mission, attracted 2.9 billion USD (2 billion euros). Bulgaria absorbed 6.5 billion USD. FDI amounted to 10% of Balkan GDP in 2006.

The conclusion is inescapable: Macedonia has failed in its bid to attract FDI. This is not the first time that Macedonian politicians and their downtrodden and destitute people prefer the fantasy of foreign saviors to the hard slog of painful and much-needed reforms at home. The current prime minister, Gruevski, served in the government of Ljubco Georgievski, whose nostrum and panacea to Macedonia’s economic woes was dollops of money, supposed to be funneled via illusive Taiwanese investors. The person most identified with this policy, Vasil Tupurkovski, now faces criminal charges.

Gruevski can learn many lessons from the debacles wrought by his predecessors. It is not too late to get his priorities straight: reforms, education, domestic investment, and employment first, and only then an open invitation to foreigners to come and invest in Macedonia.

II. Foreign Direct Investment FDI 2000-2003 in Eastern and Central Europe

How will the credit crunch of 2007 affect foreign direct investment in Central and Eastern Europe? What if it develops into a full scale recession in the West and especially in the USA?

It is instructive to study the effects on the region of a previous recession at the beginning of the decade (2000-2002).

The brief global recession of the early years of this decade – which was neither prolonged, nor trenchant and all-pervasive, as widely predicted – had little effect on Central and Eastern Europe’s traditional export markets.

The region were spared the first phase of financial gloom which affected mainly mergers, acquisitions and initial public offerings. Few multinationals scrapped projects, scaled back overseas expansion and cancelled long-planned investments.

According to a 2003 report by the Vienna Institute of Economic Studies, FDI flows to the countries of central Europe were halved in the first quarter of 2002, despite their looming membership in the European Union (realized in May 2004). During 1999-2003 export transactions were frequently delayed and privatizations attracted scant interest.Net FDI flows in 2003, says the EBRD, came to a mere 7.2 billion euros, compared to 22.6 billion euros in the preceding year.

The Vienna Institute erroneously predicted a particularly bleak year for Poland and a Czech economy redeemed only by sales of state assets in the energy sector. Yet its statistics failed to cover reinvested profits. These amounted to $1.5-2 billion in Hungary alone – equal to its average annual FDI.

In reality, the picture was mixed. Forecasts prepared in November 2002 by the United Nations Conference for Trade and Development (UNCTAD) showed marked declines in FDI in Moldova, Estonia, Hungary, Poland, Slovakia, Macedonia and Ukraine. Flows rose in Albania, Bulgaria, the Czech Republic, Latvia, Lithuania and Slovenia, and remained unchanged in Bosnia and Herzegovina, Croatia, Romania and Russia, said UNCTAD.

Foreign direct investment (FDI) in Lithuania grew by at least 15 percent in 2003. Its FDI stock – accumulated in its decade of independence – exceeded c. $4 billion, or c. $1000 per capita, as early as end-2002. Pace has picked up dramatically in the past six years in many second-tier investment destinations in central and east Europe, including Slovakia, and formerly war-torn Macedonia and Armenia. Of the latter’s $600 million in post-communist foreign inflows – two thirds have been placed since 1999.

Prime investment locales, like the Czech Republic, or Hungary, are still attracting enthusiastic fund managers, multinationals and bankers from all over the world. In a startling inversion of roles, Russia became a net exporter of FDI. According to official figures – which are thought to under-report the facts by half – Russia invested abroad more than $3 billion every single year since 2000. This is double the figure in 1999 and translates into $300-500 million in annual net outflows of foreign direct investment.

Moreover, the bulk of Russian capital spending abroad is directed at rich, industrialized countries. The republics of the former Soviet Union see very little of it, though Russian stakes there have been growing by 25 percent annually ever since the 1998 meltdown. Russia’s energy behemoths compete, for instance, with western mineral and oil extraction companies in Kazakhstan and Azerbaijan.

Levels of worldwide FDI declined by more than 50 percent – to c. $730 billion – between 2000 and 2001. Yet, astoundingly, the major downturn in emerging markets’ FDI in 1999-2002 had largely bypassed the region. Net private capital flows – both FDI and portfolio investment – shot up six-fold from $1 billion in 2000 to $6 billion a year later. Most of the surge occurred in the Balkans and the Commonwealth of Independent States (CIS).

According to the European Bank for Reconstruction and Development (EBRD) in its Transition Report Updates, the region grew by 4.3 percent in 2001 and by 3.3 percent p.a. the years after. In 2006 alone, eastern Europe’s GDP shot up by 6.2% and FDI flows amounted to $50 billion. This performance as projected to have been repeated in 2007. This is way more than most developed and emerging markets managed. Eight countries in central and east Europe drew rating upgrades, only two (Moldova and Poland) were downgraded.

Some countries fared better than others. Slovakia sold, in March 2002, 49 percent of its gas transport company for $2.7 billion. Slovenia booked yet another record year in 2002 due to the long-deferred privatization of its banking sector and to the sale to foreign investors of assets originally privatized to cronies, insiders and communist-era managers. The Slovenian Business Weekly correctly expected the country to draw in more than $600 million in 2002 – up 50 percent on 2001.

In the western Balkans, only Croatia stood out as an inviting and modernization-bent prospect. Yugoslavia (Serbia and Montenegro) reawakened, too. It has privatized cement companies and rationalized the banking sector with a view to becoming a preferred FDI destination. In the first 6 months of 2002, it garnered $100 million in realized deals and another $60 million in commitments.

Ironically, during the brief global recession, Romania and Bulgaria (both of which joined the European Union – EU – in 2007) were laggards, though intermittent privatization in both countries was counterbalanced by cheap and skilled workforces in their growing and labor-intensive economies. Macedonia spent those years futilely reviewing, with a view to annulling, at least 30 suspect privatization deals. This did not endear its kleptocracy to anyhow reluctant multinationals.

Per capita, FDI stock is highest in the Czech Republic ($3000), Estonia ($2600) and Hungary ($2400). These are followed by Slovenia ($2000), Slovakia ($1800), Croatia ($1700) and Poland ($1200). All, with the curious exception of Croatia, have joined the EU in 2004.

The total realized FDI in 2000-2002 in central Europe amounted to more than $50 billion, with Poland and the much smaller Czech Republic attracting the most ($14 billion each), followed by the Slovak Republic ($7 billion) and Hungary ($5 billion). The regional FDI stock comes to a respectable $100 billion.

Southeastern Europe (the politically correct name for the Balkans), excluding Greece and Turkey, attracted rather less – c. $12 billion in realized FDI in 2000-2. Croatia topped the list with $3.8 billion, followed by Romania ($3.3 billion), Bulgaria ($2.3 billion), Macedonia ($1.1 billion), Yugoslavia ($0.7 billion) and Albania and Bosnia-Herzegovina ($0.5 billion each).

Yet, the Balkans, impoverished and war-scarred as it is, accumulated a surprising $22 billion in FDI stock. According to the 2003 Investment Guide for Southeast Europe, published by the Bulgarian Industrial Forum, the share of FDI per GDP is much higher in the Balkans than it is, for example, in Russia. In 2001, the ratio was c. 5 percent in Bulgaria, 7.5 percent in Croatia and about 12 percent in Macedonia.

The former USSR as a whole enjoyed $57 billion in FDI between 1991-2002. The bulk of it went to Russia ($23 billion) and the Baltic states ($8 billion). In 1999-2002, Ukraine absorbed $1.9 billion in FDI flows – one half the receipts of the puny Baltic trio: Lithuania, Latvia and Estonia. Belarus and Moldova scarcely registered, each of them with barely above three fifths the FDI in Albania, or ravaged and precariously balanced Bosnia-Herzegovina.

The weight of FDI in the local economies cannot be overstated. Two fifths of the exports of countries as disparate as the Czech Republic and Romania are produced by foreign affiliates. In some countries – like Romania – 40 percent of all sales are generated by foreign-owned subsidiaries. The banking sectors of many – including Bulgaria, Croatia, the Czech Republic and Macedonia – are mostly owned by outside financial institutions.

Foreigners bring access to global markets, knowledge and management skills and techniques. They often transfer technology and train a cadre of local executives to take over once the expats are gone. And, of course, they provide capital – their own, or gleaned from foreign banks and investors, both private and through the capital markets in the west.

Initially, foreign investors provoked paranoid xenophobia almost everywhere in these formerly hermetically sealed polities. Deficient legal and regulatory frameworks, rapacious insiders, venal politicians, militant workers, opaque and politically compromised institutions, disadvantageous tax regimes and a hostile press obstructed their work during the first half of the 1990s.

Yet, gradually, the denizens of these countries came to realize the advantages of FDI. Workers noticed the higher wages paid by foreign-owned plants and offices. The emergent class of shareholders, invariably members of the powerful nomenclature, having sucked their firms dry, sought to pass the carcasses to willing overseas investors. Currently – with a few notable exceptions, such as Belarus – multinationals and money managers are actively courted by eager governments and keen indigenous firms.

Proofs of this grassroots turnaround in sentiment and priorities abound.

FDI is a good proxy for a country’s integration with the global economy. It is an important component in A.T. Kearney and Foreign Policy Magazine’s Globalization Index. The Czech Republic made it in 2002 to the 15th place (of 62 countries), higher than New Zealand, Germany, Malaysia, Israel and Spain, for instance.

Croatia in 22nd rung and Hungary in the 23rd slot compare to Australia (21) and outflanked the likes of Italy (24), Greece (26) and Korea (28). Slovenia was not far behind (25), followed by Slovakia (27), Poland (32) and Romania (40). Even hidebound Ukraine made it to the 42nd place, ahead of Sri Lanka (44), Thailand (47), Argentina (48) and Mexico (49). Russia lagged the rest at the 45th location.

A.T. Kearney’s Global Business Policy Council – a select group of corporate leaders from the world’s largest 1000 corporations – publishes the FDI Confidence Index. It tracks FDI intentions and preferences. Its September 2002 edition ranked 60 countries which, together, account for nine tenths of global FDI flows. The companies interviewed were responsible for $18 trillion in sales and seven out of every ten FDI dollars.

Revealingly, central and east European countries made it to the first 25 places. Poland, right after Australia, preceded Japan, Brazil, India and Hong-Kong, for instance. The Czech Republic, Hungary and Russia – closely grouped together – were found more alluring than Hong-Kong, the Netherlands, Thailand, South Korea, Singapore, Belgium, Taiwan and Austria. Russia – whose economy improved dramatically since 1998 – leaped from beyond the pale (i.e., below the top 25) to 17th place. Hungary moved from 21 to 16.

The report concludes with these incredible projections:

“Russia … could well be a target for almost as many first-time investments as the United States … China, Russia, Mexico and Poland combined … are expected to accumulate about one quarter of all proposed new investment commitments.”

This is part of a more comprehensive trend:

“Europe has become the most attractive destination for first time investments. More than one third of global executives are expected to commit investments for the first time in Europe over the next three years 2003-6 (especially in) Russia, Poland and the Czech Republic.”

A relatively new phenomenon is cross-border investments by one country in transition in another’s economy and enterprises. At four percent of Slovene FDI stock, the Czech Republic has invested in Slovenia as much as the United States, or the United Kingdom. Slovenes and Bulgarians have ploughed capital into the banking, industrial and food processing sectors in Macedonia. Hungarians in Serbia, Czechs in Romania, Croats in Slovenia – are common sights.

Traditional FDI destinations feel threatened by the surging reputation of central and, to a lesser extent, east Europe. In a series of articles he published on radio Free Europe/Radio Liberty prior to the EU’s enlargement eastwards, Breffni O’Rourke summed up Irish anxieties expressed by his interviewees thus:

“There’s a certain unease developing in Ireland as the 10 Central and Eastern European candidate countries move toward full membership in the European Union. The Irish are not unaware that the Czechs are heirs to a fine tradition of precision manufacturing; that the Poles are considered quick-thinking and innovative; that Bulgarians have a way with computers; that the Baltic nations have powerful Scandinavian supporters; and that Romania has extraordinarily low costs to offer investors. In fact, rising costs – in comparison to the Eastern candidate nations – are one of Ireland’s main worries. The question troubling the Irish is: Could incoming Eastern member states prove so attractive for foreign investment that the country would find itself eclipsed?”

According to UNCTAD, global FDI flows amounted to a record 1.5 trillion USD in 2007. Southeast Europe and the CIS (Commonwealth of Independent States) enjoyed robust, record-setting inflows, the seventh year in a row (up 41% on 2006 to a new record of 98 billion USD), emanating mainly from transnational corporations. Capital went to both extraction industries and privatization deals.

But 2007 appears to have been the swan song of FDI. Cross-border M&A (Mergers and Acquisitions) activity – the locomotive of FDI – virtually collapsed in the last quarter of 2007. Increasing risk aversion throughout the global financial system may result in the drying up of credit. Inflation – or, rather, stagflation – is again rearing its ugly head. Wildly fluctuating exchange rate won’t help, either.

Nikola Gruevski’s Way Out

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