Emerging Europe: Creating A Friendly Investment Environment

The authorities in emerging Europe now face a more difficult environment than had been anticipated at the year’s outset. The weakening of economic activity in their main export markets and the associated rise in investor risk aversion are likely to complicate macroeconomic management in a number of ways. Output growth is likely to be weaker and budgets should come under some pressure, as governments try to cope with the aftereffects of a global recession. This hardening of the policy environment comes at a particularly critical time in the case of Turkey, still struggling to cope with an unsustainable fiscal position and the consequences – social, political – of a GDP contraction of 7% in 2001. South Africa’s policymakers face an uphill task too, as pressure on the rand complicates macroeconomic management. But it will also pose challenges for the economic teams in the Czech Republic, Hungary, and Poland as governments try to push forward their respective EU accession agendas which, in many cases, involve dismantling entrenched vested interests. Even Russia – the country with the strongest fiscal and external position in the region – is having to worry about the “adjustments” that may have to be made to the 2002 budget if a slump in global demand were to bring about a much weaker oil price.

Against this background, the ability of governments to attract foreign capital acquires added importance. FDI has become a key source of financing in recent years – generating strong growth for those successful in attracting it. The Czech Republic, Hungary and Poland have been particularly successful in this regard – helped by their closer links to the EU, but also by policies which are perceived to have been investor-friendly. We look briefly at the factors that have contributed to the growth of foreign investment in recent years and offer a tentative ranking of the countries in emerging Europe and South Africa.

Overall macroeconomic stability has been shown to be one of the key determinants of investment inflows – with low inflation, steady exchange rates and public finances under control, all supportive of FDI (see Borensztein and de Gregorio, Journal of International Economics, 1997). Location matters too. In the case of countries in central and eastern Europe, for example, the proximity to the EU and prospects of future membership, have acted as a powerful incentive for investors looking for opportunities for on-site production involving economies of scale. In addition, perceptions that future EU membership will enhance political stability and ensure a fairly stable regulatory environment are seen as added factors in explaining the relatively large inflows of investment to countries in the EU’s periphery.

The opposite is true for Turkey and Russia. Reflecting runaway public finances, Turkey has been a high-inflation country during the past two decades. The currency has come under repeated pressures and the country’s growth performance has been highly uneven. Foreign direct investment has been extremely low and the ambivalent attitude of successive governments to foreign participation in domestic economic activity has not helped. Likewise, foreign investment in Russia has been very low, at least in relation to the potential interest of investors, particularly in the country’s huge energy sector. In recent years, Russia has been more successful than Turkey in creating the basic conditions of macroeconomic stability that will reassure investors, although much remains to be done in other areas (see below), seen to be also central to investor decisions as to where to take capital. South Africa has enjoyed broad macro stability but other factors have dampened investor interest, including high levels of crime and an on-going AIDS epidemic and its impact on labor costs. (See “South Africa And Zimbabwe: Neighbourhood Watch”, GWEM, 12 October 2001).

The regulatory environment is another driver of FDI. Because foreign participation in domestic economic activity can sometimes give rise to special concerns – for example, the extent of foreign control of local industry, or the perception that foreign investors have “unfair” advantages over local counterparts – most governments have combined a degree of regulation of foreign investment with incentives designed to attract it.

The regulatory framework is best in the Czech Republic, Hungary and Poland. All three have moved rapidly to eliminate obstacles, including the lifting of previous restrictions on dividend remittances and on majority participation. They have also streamlined authorisation procedures and, more generally, created a regulatory environment characterised by well-defined, simple and stable rules. Russia’s rules are quite liberal on paper, but foreign investment has suffered as a result of the presence of a precarious legal environment, the lack of adequate protection for minority shareholders, and other deficiencies in the rule of law. Although the present government has committed itself to amending these weaknesses swiftly, the damage done during the 1990s will take time to undo. Turkey’s determination to join the EU may be the most important single factor to create a foundation of stability that will begin to attract investment from the current low levels, although it is at the back of the queue of potential new members. In South Africa the authorities have shifted their focus to privatisation as a potential source of FDI, but the approach has at times seemed erratic and unpredictable.

Foreign direct investment inflows

Relatively low labour costs and a skilled labour force are factors that make countries attractive investment locations. This has helped countries in eastern Europe, but it is not a substitute for macro stability and a predictable legal environment. Political stability is also important; wild swings in policies as a result of changes in the domestic political landscape introduce additional risk factors in investment decisions. Other factors that have played a role are: labour market flexibility, levels of education, and the quality of infrastructure.

Without doubt, the Czech Republic, Hungary and Poland are in a category of their own in having created the basic elements of a supportive investment environment. All three governments have opened their borders and set aside undue concerns about foreign ownership of the domestic economy. They have benefited from technology transfers and know-how; although large capital inflows have at times posed problems for exchange rate management, the overall effects on the capital account have been favourable. Russia offers perhaps the greatest potential in terms of future growth, linked to the development of its energy sector. But, so far, investment inflows have been meager, reflecting legitimate concerns about the policy environment. The government will need a longer track-record of prudent macroeconomic management and a commitment to liberal economic policies before inflows swell. Turkey needs first to get its macroeconomic act together. Then, it will have to show that it can do so without large infusions of “bail-out” debt before foreign investors take a serious look at the country as a long-term investment destination. The authorities in South Africa will have to reassure investors that they are serious about dealing with the AIDS crisis; in the short-term their decision to enforce certain exchange controls on non-residents may dampen investor interest (see: Global FX and Local Market Strategies, 18 October).