Foreign Direct Investment Into Ukrainian

Foreign Direct Investment Into Ukrainian Banking Sphere

Foreign Direct Investment

Into Ukrainian Banking Sphere

We currently live in a constantly changing and developing world which forces us to become more flexible and adaptable. Changes have become increasingly obvious at all levels of life, including the social, political, economic and more importantly, the technological sides of our every day lives.

The economic changes can be divided into two major categories: business changes and macroeconomic changes. The microeconomic changes refer to the modifications affecting the internal structures and organizational behaviour of companies. Basically, these refer to an attention shift from production to the human resource and the clientele. On a more general context, the macroeconomic changes refer to market liberalization and globalization. The two terms are in fact complex concepts to encompass a wide series of national and international changes which affect the local, national and international side of a business.

Market liberalization and globalization have eased countries' path to a better and stronger economy by allowing them to freely trade with other countries, based on David Ricardo's Theory of Comparative Advantages. But the trade soon expanded to include more than basic commodities. Today, international markets trade human resource, capital and technologies and set the basis for contracts of foreign direct investments.

Foreign direct investments represent situations when a company is being built or purchased by a foreign investor, with the specified intention of improving the quality of the products and services offered by that company, and consequently its revenues and profits. "Foreign direct investment (FDI) plays an extraordinary and growing role in global business. It can provide a firm with new markets and marketing channels, cheaper production facilities, access to new technology, products, skills and financing. For a host country or the foreign firm which receives the investment, it can provide a source of new technologies, capital, processes, products, organizational technologies and management skills, and as such can provide a strong impetus to economic development" (Graham, Spaulding, 2005).

Foreign Direct Investments affect all industry sectors within a country, including the financial one. As such, banks are frequently subjected to abroad financing and manage as such to become stronger and sustain an emerging economy.

2. Ukraine's Economy

Ukraine is the thirtieth largest economy of the globe, measured by the countries' gross domestic product. In 2006, Ukraine registered a purchasing power parity of $364,300,000,000, an estimated growth of 7.1% as compared to 2005, according to the measurements of the American Central Intelligence Agency.

Ukraine used to be the largest and strongest economy in Europe and provided significant supply to neighbours and other European states. However, its independence in 1991 has had numerous negative effects upon the country and its economy.

Shortly after independence was ratified in December 1991, the Ukrainian Government liberalized most prices and erected a legal framework for privatization, but widespread resistance to reform within the government and the legislature soon stalled reform efforts and led to some backtracking. Output by 1999 had fallen to less than 40% of the 1991 level. Loose monetary policies pushed inflation to hyperinflationary levels in late 1993. Ukraine's dependence on Russia for energy supplies and the lack of significant structural reform have made the Ukrainian economy vulnerable to external shocks" (Central Intelligence Agency, 2007).

Today, the largest proportion within the Ukrainian economy is being withheld by the service sector, with 55%. 25% of the total population works in agriculture and 20% works within other industries. The basic agricultural products produced by the Ukrainian population revolve around grain, sunflower seeds, vegetables and sugar beets, alongside with milk and beef. The major industries are coal, electricity, metals, machinery and transportation equipments, chemicals and sugar processing. (CIA, 2007)

In 2006, exports from Ukraine held up a total of $38.95 billion and the imports totalled the sum of $44.14 billion. The country's major export partners are Russia, Turkey, Italy and the United States of America, to which Ukraine exports metals, fuel and petroleum, chemicals, machinery and transportation equipments, alongside with food products. The major import partners are Russia, Germany, Poland, China and Turkmenistan, from which the country imports energy, machinery and equipments and chemicals (CIA, 2007).

During the past years, the country's economy has shown significant signs of improvement. The strengthening of the national economy has been highlighted by the increased standards of living and by a growing gross domestic product. Problems still exist and are most relevantly presented by the uneven distribution of income and the wide gap between the country's wealthy and its poor. In 2003, more than 37% of the total population were living below the poverty line. These problems have also been raised by international organizations to which Ukraine desired to adhere, such as WTO or the European Union. These also posed the problem of difficult legislation, lack of transparency and high taxes, which reduce investors' interest and as such the country's chances to economically develop.

Although the economy is likely to expand in 2007, long-term growth could be threatened by the government's plans to reinstate tax, trade, and customs privileges and to maintain restrictive grain export quotas" (CIA, 2007).

A contemporaneous economic feature of Ukraine is their intense desire to adhere to international organizations which regulate commerce and other vital features of a country's status. However along the years the country has collaborated with international organizations such as the North Atlantic Treaty Organization, Ukraine has yet to become a member.

The organizations to which Ukraine desires to adhere are basically NATO, World Trade Organization and the European Union. In order to succeed in their accession processes, the European country must comply with all the regulations imposed, the most important one being that of nurturing a stable and sustainable economic growth. Alongside monetary and political regulations, sustained economic development can be obtained through significant foreign direct investments.

3. FDI to Ukraine

In 2006, investments in Ukraine summed up to a total of 24% of the country's total gross domestic product. The steady economic growth registered by Ukraine has encouraged investors to penetrate the local market and invest in the country's resources and capabilities. The banking sector was an important target for foreign investors, but the state did little to ease the privatization of banks.

During the recent years, the investments have decreased due to the improper policies implemented by the state government. "Ukrainian economy has performed very well in the last two years, but economic growth is slowing down; foreign direct investment continues to decline" (Segura, 2002).

Looking at the matter from a different angle, other economists disagree. Alexander J. Motyl, professor of political science at Rutgers University, states that the direct foreign investments have yet to decrease. He points out that during the past three years, the country has in fact been faced with reduced growth rates, but at no time did these rates become negative. The table below reveals the actual statistics per quarters of 2003, 2004 and 2005.

Table 1: FDI to Ukraine in 2003, 2004 and 2005

Source: Motyl, a.J., 2005, a Look at the Numbers: Is foreign direct investment into Ukraine Plummeting? The Ukrainian Weekly, Number. 40, Volume 73

As such, the foreign direct investments to Ukraine have not decreased, but have increased at a slower rate. However, the slower growth rate of economic development is a negative incentive and scares foreign investors. There are two major forces which discourage foreign investments. First, there is the constantly growing inflation, which reveals economic instability. Foreign investors are as such faced with high risks of business failure and think twice before entering the Ukrainian market. Secondly, there are the strict state policies and the authorities' resistance to privatizations. While economic stability and regulation of inflation are harder to achieve and demand long-term actions, the privatizations of large state owned enterprises is a handier tool and could retrieve a significant growth of the FDI into Ukraine. "Government can improve FDI statistics only by selling large state companies" (Bryl, 2005).

The World Bank Group has identified four basic reasons why the FDI to Ukraine is endangered. These four reasons also represent the motives for which foreign investments could decrease in the following years and they also stand for the changes which must be made. They encompass the banking system but can easily be expanded to the general industry in Ukraine, as they are all affected by the same regulations. They basically refer to:

The lack of investment instruments - the strong devaluation of the national currency (the ruble), combined with the increased levels of national debt and the illiquidity of the Ukrainian equity instruments discourage foreign direct investments

Lack of adequate corporate governance - Local Ukrainian banks and companies are reluctant to selling the majority of their shares to foreign investors, who actually desire to control the majority of the company in order to retrieve a successful outcome

Complex and high taxes - the tax policies influence greatly investors' decision to enter the Ukrainian market. Since 1991, national and international investors are subjected to the same regulations, with equal rights and obligations. A new tax policy is being developed and it revolves around the reduction of the value added tax from 20% down to 17% and also the reduction of profit taxes from 30 to 25%. However, the development and implementation of the new fiscal regulations could expand throughout numerous years.

Lack of incentives and transparency in the privatization process - the current administration is basically blamed for its refusal to privatize large state owned companies and numerous banks. In addition, the government is also accused that when they do indeed agree to the privatization of a bank or company, their procedures and reasons are not made public. (Wold Bank, 2001)

These issues, alongside with other significant matters have been raised by international organizations and their quick resolve is vital for a balanced economy. While the North Atlantic Treaty Organization places increased emphasis on military strategies and alliances, the European Union places increased interest on all aspects of life. In this order of ideas, the European organization imposed numerous conditions including, amongst others, the reduction of taxation, the implementation of transparency policies and the reduction of political restrictions. Ukraine will fail to accede to the EU until they have resolved these problems.

In all, foreign direct investments represent a major chance for economic growth and stability in Ukraine. However the economic growth and the FDI have not decreased during the recent years, they have increased at a slower rate, discouraging as such investments. Problems have also been posed by a weakening national currency, raising inflation and a series of inadequate government policies and regulations. In addition, investors compare the developments made by Ukraine with other emerging economies, and are rarely satisfied with an inferior rate of growth. Table two shows the foreign direct investments into nine emerging countries, since 1991 up to 1994.

Table 2: FDI to 9 emerging economies

Source: Pietsch, B., 1997, Investment in Ukraine, the OECD Observer, Number 24

As it can easily be observed, Ukraine is far behind other similar economies, a negative point when analyzing the investment opportunities. A particular feature of the foreign direct investments to Ukraine is its linkage to the country's desire to adhere to international organizations, such as the North Atlantic Treaty Organization, the World Trade Organization or the European Union.

4. Particularities of FDI into the Banking Sector of Ukraine

The economic instability and a reduced growth and development rate must be overcome in order to increase the foreign direct investments, so necessary to all industry sectors. "One ingredient Ukraine needs plenty of is foreign direct investment (FDI) to boost capital, improve skills and raise its economic performance generally - just as in other successful transition countries. This goes for almost every sector of the economy, from agriculture to banking." (Ogutcu and Kinach, 2003)

The banking sector in Ukraine is severely affected by the lack of foreign investors. Most banks and financial institutions in Ukraine are owned by local investors. The most common form of foreign banks is the formation of financial institutions by companies from abroad. But these companies are basically Ukrainian companies, founded abroad. In other words, Ukrainian investors use the national capital to create companies outside Ukraine's territory, and then use the newly founded companies to invest into the national banking system. "In turn, residents can be owned by non-residents, such as is the case with Ukrainian banks that are, in large part, owned by non-residents such as offshore companies that are, in reality, Ukrainian companies." (Deloitte Touche Tohmatsu Emerging Markets Ltd., 2003)

Another feature on the Ukrainian banking system is the country's partial acceptance of foreign direct investments. In this order of ideas, foreign investors who desire to purchase stocks at a national bank are only allowed to do this within the limits and boundaries imposed by both state officials and the banks' management. Alfa Bank and Ukrsib are for instance two relevant examples of this situation as they are both partially owned by residents and non-residents. ING on the other hand is one of the few entirely foreign banks. (Deloitte Touche Tohmatsu Emerging Markets Ltd., 2003)

The partial privatization of banks and financial institutions has long been debated by numerous economists, as it presents both advantages and disadvantages for both parties. In this order of ideas, it dissatisfies the investors as it prevents them from holding the entire or the majority package of stocks, preventing them from exercising full control over the bank. On the other hand, a commonly owned institution gives the advantage of shared risks. To the Ukrainian state, a joint ownership of the national banks offers the advantage of reduced costs and increased investments, while offering the possibility to still control the actions of the financial institution.

However the banking sector has yet to develop and reach its maturity to become fully liberalized and free from state interventions, the foreign direct investments of the recent years have set a favourable course for the Ukrainian financial institutions. Table 3 shows the main features of the banking sector throughout six years.

Table 3: Banking Sector

Source: Deloitte Touche Tohmatsu Emerging Markets Ltd., 2003

As compared to the previous decade, the foreign direct investments into the Ukrainian banking sector have increased and are expected to follow their ascendant trend. However, the state officials must improve and clarify the legislature on the field as well as present foreign investors with numerous incentives. The most significant reasons why Ukrainians should place more emphasise on increasing the levels of foreign direct investments into their banking system include: