## _pdp05

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---

### I. Introduction: role of FDI in the CIS countries
- FDI fills the gap between domestic savings and high levels of investment needed to support economic growth in the Commonwealth of Independent States (CIS) countries over the medium term.
- FDI often provides external financing in the form of equity rather than debt and is frequently in the export or import–competing sectors, contributing to an improved external position.
- The literature stresses FDI as a source of technology and management expertise.
- De novo firms are particularly important for growth in transition countries; creation of de novo firms in the CIS countries has been low, reflecting entry barriers.
- Aggregate investment in the CIS countries contracted sharply following the breakup of the Soviet Union.
- FDI generally has fallen dramatically short of levels needed to offset low domestic investment rates, with notable exceptions including Azerbaijan, Kazakhstan, and Uzbekistan.
- There is a large gap between cumulative net FDI inflows per capita into some transition economies of Central and Eastern Europe and the Baltic states (CEB) and those into the CIS countries; average annual net FDI inflows relative to GDP also fall short of CEB levels, though the shortfall is smaller.

### II. Trends, composition, and drivers of FDI (including Box 2 summary)
- Net FDI inflows into the CIS countries were low prior to the Russian crisis in August 1998 and generally fell further following the 1998 crisis.
- Economic recovery starting especially in 2000 did not produce a significant upturn in FDI inflows for 1999–2001.
- Total net private capital inflows into CIS countries consisted mainly of direct investment.
- Cross-country variation:
  - Some CIS countries were more successful in attracting FDI, largely due to investment in resource extraction or energy transportation infrastructure.
  - Other spikes in FDI accompanied large privatization transactions or settlement of energy debts.
- Definitions and data quality:
  - Net FDI inflows are defined as the difference between inward FDI (a positive number) and FDI abroad (a negative number); inward FDI and FDI abroad are themselves net data concepts.
  - This section focuses on inward FDI flows (unless specially noted), based on data provided by national authorities.
  - The poor quality of balance of payments data in many countries introduces some noise into measured FDI flows.

- Country groupings used for analysis:
  - Group A: energy exporters — Azerbaijan, Kazakhstan, Russia, and Turkmenistan.
  - Group B: energy importers pursuing market-oriented reforms — Armenia, Georgia, the Kyrgyz Republic, Moldova, Tajikistan, and Ukraine.
  - Group C: other energy importers (not pursuing market-oriented reforms) — Belarus and Uzbekistan.

- A. Energy Exporting Countries — summary findings and key figures
  - General: Foreign direct investment into Group A has generally been limited to the energy sector, with the notable exception of Russia.
  - Drivers: Energy sector projects driven by size, quality, and location of energy reserves; petroleum sector often subject to separate tax regimes; multinationals experienced in dealing with poor governance.
  - Azerbaijan:
    - Inward FDI flows averaged about $900 million per year during 1997–2001 (equivalent to about 20 percent of average annual GDP).
    - Inward FDI flows accounted for about 70 percent of gross capital formation during 1997–2001.
    - Net FDI inflows in Azerbaijan were 26 percent of GDP in 2002 and are expected to rise further in 2003.
    - Recent projects: Baku–Tbilisi–Ceyhan (BTC) pipeline; first phase full field development of Azeri–Chirag–Guneshi (ACG); Shah Deniz gas field and South Caucasus Gas Pipeline expected investment in 2003 and 2004.
  - Kazakhstan:
    - Highest cumulative net FDI inflows per capita during 1989–2001 of any CIS country.
    - In 1999–2001, three quarters of inward FDI flows went into the oil and gas sectors.
    - Petroleum output has grown at around 15 percent per year and now accounts for roughly 25 percent of GDP.
    - Major privatization/transactions cited: Tengiz field stakes (Chevron 1993; additional 5 percent share in 2000 for $450 million; 25 percent stake to Mobil in 1998 for $1.1 billion); Kashagan stake sales in 1998 ($500 million).
    - Kazakhstan attracted minimum investment grade level from international rating agencies in 2002–2003.
  - Russia:
    - Inward FDI flows: $2.1 billion in 1995; $4.8 billion in 1997; $2.5 billion in 1998 (Russian crisis); roughly $3 billion in 1999–2001.
    - In 1999–2001, inward FDI flows accounted for less than 10 percent of gross fixed investment.
    - On a per capita basis, cumulative inward FDI flows in 1999–2001 amounted to about $20 per person.
    - On a stock basis, cumulative inward FDI flows in 1995–2001 were $19.6 billion (bulk from Germany, the United States, and the United Kingdom; Cyprus a leading source but likely reflects Russian offshore companies operating in Cyprus).
    - Sector distribution: food processing largest share of inward FDI flows; oil extraction second largest. More than half of inward FDI flows in oil and gas ($1.5 billion) invested in Sakhalin I and II projects.
    - Deal example: BP announced plan to acquire 50 percent share in a company formed with TNK International for $6.15 billion (reportedly $2.4 billion cash on completion, and three annual tranches of $1.25 billion in BP shares).
  - Turkmenistan:
    - Inward FDI flows averaged around $125 million during 1999–2001.
    - Inward FDI flows dropped from $108 million in 1997 to $62 million in 1998, then rebounded to $125 million per annum in 1999 and 2000 and $133 million in 2001.
    - Inflows mainly in the form of production sharing arrangements (PSAs) in oil sector and modest joint ventures in non–oil sector; levels below those needed to meet government annual production targets.

- B. Reforming Energy Importers — summary findings and key figures
  - General: Group B countries are diverse; common themes include energy sector privatization or large projects accounting for the majority of inward FDI; some countries reliant on one large resource project.
  - Armenia:
    - Inward FDI flows equivalent to nearly 7 percent of GDP on average during 1998–2001 (tailed off following privatization progress).
    - Main sectors: energy, telecommunications, and food.
    - 2002 debt/equity swap: cancellation of $94 million in debt for 100 percent of equity in Hrazdan thermal power plant, Mars control systems plant, and three research institutes.
  - Georgia:
    - Inward FDI flows fluctuated between $80–236 million in 1997–2001 (on average about 4½ percent of annual GDP).
    - High inflows in 1997–1998 attributable to Baku–Supsa pipeline and terminal in Supsa; sale of 75 percent stake in Telasi to AES; AES purchase in 2000 of part of Gardabani thermal power station.
  - Moldova:
    - Inward FDI flows fell from $76–78 million per annum in 1997–1998 to $39 million in 1999, then rose to $128 million in 2000 and $149 million in 2001.
    - About half of recent inward FDI flows in electricity, gas, and water sectors.
    - Foreign direct equity investments relative to total fixed capital formation: 17 percent in 1999; 45 percent in 2000; 44 percent in 2001.
    - Major source countries since 1995: Russia, the United States, Spain, United Kingdom, and France (three fourths of inward FDI flows).
  - Kyrgyz Republic:
    - Inward FDI flows about 7 percent of GDP on average in 1996–2001; net FDI inflows only 3 percent of GDP on average in 1996–2001.
    - Major investments: Cameco’s Kumtor gold mine; U.S. investment in Hyatt Regency Hotel; Reemtsma investment in Bishkek tobacco factory.
  - Tajikistan:
    - Inward FDI flows accounted for less than 2 percent of GDP on average during 1998–2001; majority from a British company investing in a gold mine.
  - Ukraine:
    - Inward FDI flows accounted for 4 percent of domestic fixed capital investment, or about 2½ percent of GDP, in 2001.
    - Inward FDI flows: $267 million in 1995; peak $743 million in 1998; $496 million in 1999 (33 percent drop); $595 million in 2000; $792 million in 2001.
    - Leading sectors: food and processing of agricultural products and domestic trade.
    - Leading source countries (accounting for three fourths of inward FDI stock at end–June 2002): United States, Cyprus, United Kingdom, Netherlands, Russia, British Virgin Islands, Germany, Switzerland, and Austria.
    - Bulk of inward FDI stock from Cyprus and other offshore centers likely reflects domestic and Russian investors.

- C. Other Energy Importers — summary findings and key figures
  - Belarus and Uzbekistan have not implemented fundamental market-oriented reforms; inward FDI flows extremely limited except for specific projects.
  - Belarus:
    - Notable investment related to construction of the Yamal pipeline owned by Gazprom (pipeline started operating, not yet at full planned capacity).
    - 2001 IFC regulatory cost assessment: excessive state involvement and regulatory environment are major obstacles; businesses face much higher regulatory compliance costs than neighbors.
  - Uzbekistan:
    - Net FDI inflows accounted for around 1 percent of GDP in 2001 (balance of payments data).
    - Constraints: discretionary implementation of pervasive regulations; non–transparent system of privileges and tax exemptions; multiple exchange rates imposed in 1997 with foreign currency rationing and constraints on repatriation of profits; delays in liberalization of foreign exchange market scheduled for end–2000.

- D. Motivation for FDI — investor motives and implications
  - Predominant motives:
    - "Resource seeking" FDI has dominated in CIS countries (especially for energy and mining).
    - More advanced transition economies attract "efficiency seeking" FDI oriented toward export processing based on low (productivity–adjusted) labor costs.
    - Market-seeking FDI may be possible in large domestic markets (e.g., Russia, Ukraine) but requires significant improvements in the investment climate.
  - Regional considerations:
    - Investors view smaller countries in a regional context for market-seeking investment; lowering trade and transport impediments within the region could stimulate investor interest by increasing effective market size.
    - Regional efforts to remove trade and transport impediments are underway in the context of the CIS–7 Initiative.

### III. Investment climate — main impediments and country-specific observations
- Main obstacles identified (from IMF country teams and investor surveys):
  - burdensome taxation;
  - widespread corruption and poor governance;
  - weak legal and regulatory frameworks, including property rights violations;
  - pervasive state involvement in the economy;
  - the need to follow through with (or initiate) structural reform programs.
- Underlying the weak investment climate is the need to build institutions appropriate to a market economy.
- Cross-cutting impediments:
  - Extensive government regulation (licensing, inspections, certification) combined with low civil service salaries and weak public administration incentivize rent-seeking.
  - Barriers to entry, impediments to competition, ineffective bankruptcy procedures, and weak corporate governance allow inefficient incumbents to persist.
  - Financial intermediation limited by underdeveloped banking systems and capital markets, constraining SME finance.
  - Weak property rights, contract enforcement, and bankruptcy procedures hinder bank strengthening.
  - Pricing of key inputs (energy, water, rail) acts as implicit subsidy to energy–intensive firms.
- Country-specific highlights (selected):
  - Azerbaijan: transparent and efficient oil sector under PSAs; weak and poorly enforced environment in non–oil sectors; reforms cut businesses requiring licenses by about 85 percent and extended license validity up to 5 years.
  - Kazakhstan: corruption in basic government services; overlapping and excessive regulation and inspection; investment law limiting appeal to international arbitration; transfer pricing law; rigid foreign employee quota; domestic content requirements; government campaign for contract renegotiation.
  - Russia: unstable tax environment, regulation, legal vulnerability, lack of level playing field, crime, unreliable supply, and corruption; tax reforms improved outlook; other reforms at early stage.
  - Georgia: liberal foreign investment policy and WTO membership positive; concerns about arbitrary court decisions, unstable border, kidnapping of foreign businessmen, perceived inadequate anti-corruption measures, poor infrastructure (electricity disruptions); Georgia extracts nearly 3 percent of annual company revenue in bribes (nearly twice as high as in Russia).
  - Moldova: benefits from WTO membership, open trade regime, and effective banking supervision; legal and judicial implementation lagging; new insolvency, pledge and collateral laws, and civil code passed but need effective implementation.
  - Uzbekistan: discretionary regulation implementation; non-transparent privileges and tax exemptions; multiple exchange rates and foreign currency rationing; constraints on repatriation of profits.

- Comparison with other regions — ranking of investment impediments:
  - IMF country teams counted occurrences of impediments across 12 CIS countries in eight areas: (1) corruption; (2) crime and theft; (3) regulation; (4) taxes; (5) financing; (6) inflation; (7) policy instability; and (8) poor infrastructure.
  - Frequency among 12 CIS countries:
    - Corruption cited in 10 countries.
    - Regulation cited in 10 countries.
    - Crime and theft cited in 5 countries.
    - Financing cited in 5 countries.
    - Policy instability cited in 5 countries.
    - Taxes cited in 3 countries.
    - Poor infrastructure cited in 3 countries.
    - Inflation cited in 0 countries.
  - Correlations between IMF country team rankings and World Bank (1997) regional rankings (rank correlation coefficients and test statistics):
    - Sub–Saharan Africa: Rank Correlation Coefficient -0.33; Test Statistic -0.87
    - Latin America and Caribbean: Rank Correlation Coefficient 0.15; Test Statistic 0.37
    - East and South Asia: Rank Correlation Coefficient -0.52; Test Statistic -1.48
    - Middle East and Africa: Rank Correlation Coefficient -0.17; Test Statistic -0.43
    - CIS: Rank Correlation Coefficient 0.01; Test Statistic 0.03
    - CEE (Central and Eastern Europe): Rank Correlation Coefficient -0.36; Test Statistic -0.94
    - High–Income OECD: Rank Correlation Coefficient 0.06; Test Statistic 0.14
  - Interpretation:
    - Obstacles associated with property rights protection (corruption, crime and theft, regulation) ranked among the top three both in CIS and non-CIS countries (except high–income OECD).
    - Tackling corruption is of first–order importance in improving the investment climate.
  - Effect of corruption on FDI:
    - Presence of corruption may reduce quality of FDI; firms with valuable technology and knowledge capital less likely to invest in countries with governance problems, and if they do, they tend to avoid joint ventures. Export–oriented investment is less bound to location and thus more sensitive to governance problems.

### IV. Box 1 — The Role of Privatization
- Link between privatization and FDI:
  - Levels of FDI inflows into transition economies are closely related to the size of privatization receipts.
  - EBRD (2002a) found that privatization in the CIS countries generally has not yielded large–scale foreign investment.
  - In contrast, FDI into the CEB countries was motivated to some degree by their proximity to the EU and the prospect of EU accession.
- Meta-analysis evidence on enterprise performance (Djankov and Murrell (2002)):
  - Privatization was strongly associated with improved enterprise performance for the transition economies as a whole but this effect was not statistically significant for the CIS countries.
  - Explanations include higher share of less effective owner categories in the CIS (workers and diffuse individual ownership) and poor corporate governance institutions.
  - In the CIS countries, bank and concentrated individual ownership were significantly more effective than in the non–CIS countries, while workers and outsiders (including foreign investors) were significantly less effective.
- Need for supporting reforms:
  - Havrylyshyn and McGettigan (2000): importance of accommodating market environment to support privatization, including macroeconomic stability, enforcement of hard budget constraints, and functioning property rights.
  - Zinnes and others (2001): need to strengthen legal, regulatory, and institutional environment as a complement to privatization.
  - Krishnaswamy and Stuggins (2003): suggested focusing initially on legal, tariff, and regulatory reform, and commercialization of operations, prior to unbundling, competition introduction, and privatization in electricity sector.
  - Vandycke (2003): growth of private sector activity in CIS–7 mainly reflected transfer of state assets having little economic value and with weak management and poor governance.
- EBRD assessment of CIS privatization progress:
  - The EBRD indicated that the process of privatization in the CIS countries is largely over but had not attracted large-scale foreign investment or knowledge.
  - The EBRD’s indicator of progress in large–scale privatization ranges from 1 to 3+ (out of a possible 4+) in the CIS countries with a median of 3.

### V. Conclusions and policy implications
- Summary conclusions:
  - Private capital inflows into the CIS countries consisted mainly of direct investment and were concentrated in a few energy–abundant countries.
  - Cumulative net FDI inflows per capita in the CIS countries accounted for only a small fraction of inflows received by the CEB countries.
  - Net FDI inflows fell drastically short of levels needed to support high, sustainable growth.
  - Inflows were generally related to natural resource extraction, energy transportation infrastructure projects, large privatization transactions, and debt/equity swaps to pay for energy supplies.
- Main impediments identified:
  - Weak investment climate owing to incomplete structural reforms.
  - Burdensome tax systems, widespread corruption, extensive state intervention, weak legal and regulatory frameworks, and incomplete structural reforms (banking, civil service, energy).
  - Lack of property rights protection (corruption, crime, excessive regulation) cited most frequently as significant investment impediment.
- Policy implications and recommendations:
  - Further institution building is needed to underpin structural reform efforts.
  - Measures to improve the investment climate should be carefully sequenced:
    - Privatization may not succeed without appropriate legal and regulatory frameworks and a competitive environment in place.
    - Legal and regulatory improvements and competition policy would help lower entry barriers for de novo firms.
  - Natural resource abundance, institutional quality, and prospects for EU accession play significant roles in levels of FDI attracted.
  - Smaller, poorer CIS countries with limited domestic markets and distant from the EU may not reap near- or medium-term net FDI gains from policy improvements; international community support will be needed for countries making best efforts to implement good policies.
  - For larger or energy–diversified countries (e.g., Russia, Ukraine), improved macroeconomic performance provides opportunity to implement structural reforms; investor responses may follow but reforms risk stalling (e.g., around elections).
  - Regional cooperation to remove trade and transport impediments could increase attractiveness of smaller CIS markets for market-seeking investment.
  - Strategies to increase labor productivity, coupled with competitive labor costs, could help attract more efficiency–seeking FDI oriented toward exports.

*Source: _pdp05 - References; Box 1; Box 2 (IMF staff analysis).*

### References      ........................................................................................................

### _pdp05 - References

### I. Introduction: role of FDI in the CIS countries
- FDI fills the gap between domestic savings and high levels of investment needed to support economic growth in the Commonwealth of Independent States (CIS) countries over the medium term.
- FDI often provides external financing in the form of equity rather than debt and is frequently in the export or import–competing sectors, contributing to an improved external position.
- The literature stresses FDI as a source of technology and management expertise.
- De novo firms are particularly important for growth in transition countries; creation of de novo firms in the CIS countries has been low, reflecting entry barriers.
- Aggregate investment in the CIS countries contracted sharply following the breakup of the Soviet Union.
- FDI generally has fallen dramatically short of levels needed to offset low domestic investment rates, with notable exceptions including Azerbaijan, Kazakhstan, and Uzbekistan.
- There is a large gap between cumulative net FDI inflows per capita into some transition economies of Central and Eastern Europe and the Baltic states (CEB) and those into the CIS countries; average annual net FDI inflows relative to GDP also fall short of CEB levels, though the shortfall is smaller.

### CIS country coverage
- The CIS country grouping considered comprises: Armenia, Azerbaijan, Belarus, Georgia, Kazakhstan, the Kyrgyz Republic, Moldova, Russia, Tajikistan, Turkmenistan, Ukraine, and Uzbekistan.
- The EBRD’s CEB country grouping includes: Croatia, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, the Slovak Republic, and Slovenia.

### II. Trends, composition, and drivers of FDI
- Net FDI inflows into the CIS countries were low prior to the Russian crisis in August 1998 and generally fell further following the 1998 crisis.
- Economic recovery starting especially in 2000 did not produce a significant upturn in FDI inflows for 1999–2001.
- Total net private capital inflows into CIS countries consisted mainly of direct investment.
- Cross-country variation:
  - Some CIS countries were more successful in attracting FDI, largely due to investment in resource extraction or energy transportation infrastructure.
  - Other spikes in FDI accompanied large privatization transactions or settlement of energy debts.
- The paper analyzes inward FDI flows (except where specially noted), their sectoral composition, and source country composition, and forms country groupings to highlight common themes, including a focus on foreign direct investment into energy-exporting countries.

### III. Main obstacles to improving the investment climate
- IMF country teams were asked to identify factors influencing each country’s investment climate, guided by investor surveys when available.
- Identified obstacles include:
  - burdensome taxation;
  - widespread corruption and poor governance;
  - weak legal and regulatory frameworks, including property rights violations;
  - pervasive state involvement in the economy;
  - the need to follow through with (or initiate) structural reform programs.
- Underlying the weak investment climate is the need to build institutions appropriate to a market economy.

### IV. Surveys and measures of the business environment
- EBRD/World Bank Business Environment and Enterprise Performance Surveys (BEEPS) in 1999 and 2002 provide qualitative and quantitative indicators summarizing the quality of the business environment.
- BEEPS asked firms to assess the state’s functioning in seven areas: (i) access to financing; (ii) quality of infrastructure; (iii) taxes; (iv) regulation; (v) quality of judiciary; (vi) crime; and (vii) corruption.
- Firms rated how problematic these factors were on a four–point scale and provided quantitative indicators such as underreporting of sales for tax purposes, average time spent by managers dealing with public officials, and payment of bribes.
- BEEPS indicators show an overall improvement, on average, in the quality of the business environment in the CIS countries, even after controlling for improved macroeconomic performance; however, pinning down country-specific weaknesses using BEEPS indicators can be difficult.
- The present paper attempts to identify specific obstacles to a more supportive investment environment in each CIS country and provides stylized case studies of government and incumbent firm actions affecting the investment climate.

### V. Organization of the paper (content structure)
- Section II: analyzes the level and composition of inward FDI flows into the CIS countries over the last decade, including the role of privatization and FDI in energy–abundant CIS countries.
- Section III: evaluates the investment climate.
- Section IV: offers conclusions and policy implications.

*Source: _pdp05 - References (IMF PDF chapter).*

### Box 2 describes trends in net capital flows into the CIS countries, including net FDI

### Box 2 describes trends in net capital flows into the CIS countries, including net FDI inflows

### Definitions and data quality
- Net FDI inflows in this paper are defined (following presentation in the IMF Balance of Payments Statistics Yearbook) as the difference between inward FDI (a positive number) and FDI abroad (a negative number). Inward FDI and FDI abroad are themselves net data concepts.
- This section focuses on inward FDI flows (unless specially noted), based on data provided by national authorities.
- The poor quality of balance of payments data in many countries introduces some noise into measured FDI flows.

### Country groupings used for analysis
- Group A: energy exporters — Azerbaijan, Kazakhstan, Russia, and Turkmenistan.
- Group B: energy importers pursuing market-oriented reforms — Armenia, Georgia, the Kyrgyz Republic, Moldova, Tajikistan, and Ukraine.
- Group C: other energy importers (not pursuing market-oriented reforms) — Belarus and Uzbekistan.
- Note: groupings are for expositional purposes (footnote notes potential alternative groupings such as adding the Kyrgyz Republic and Tajikistan to Group A for gold mining).

### A. Energy Exporting Countries — summary findings and key figures
- General: Foreign direct investment into Group A has generally been limited to the energy sector, with the notable exception of Russia.
- Drivers: Energy sector projects driven by size, quality, and location of energy reserves; petroleum sector often subject to separate tax regimes; multinationals experienced in dealing with poor governance.
- Azerbaijan:
  - Inward FDI flows averaged about $900 million per year during 1997–2001 (equivalent to about 20 percent of average annual GDP).
  - Inward FDI flows accounted for about 70 percent of gross capital formation during 1997–2001.
  - Net FDI inflows in Azerbaijan were 26 percent of GDP in 2002 and are expected to rise further in 2003.
  - Recent projects: Baku–Tbilisi–Ceyhan (BTC) pipeline; first phase full field development of Azeri–Chirag–Guneshi (ACG); Shah Deniz gas field and South Caucasus Gas Pipeline expected investment in 2003 and 2004.
- Kazakhstan:
  - Highest cumulative net FDI inflows per capita during 1989–2001 of any CIS country.
  - In 1999–2001, three quarters of inward FDI flows went into the oil and gas sectors.
  - Petroleum output has grown at around 15 percent per year and now accounts for roughly 25 percent of GDP.
  - Major privatization/transactions cited: Tengiz field stakes (Chevron 1993; additional 5 percent share in 2000 for $450 million; 25 percent stake to Mobil in 1998 for $1.1 billion); Kashagan stake sales in 1998 ($500 million).
  - Kazakhstan attracted minimum investment grade level from international rating agencies in 2002–2003.
- Russia:
  - Inward FDI flows: $2.1 billion in 1995; $4.8 billion in 1997; $2.5 billion in 1998 (Russian crisis); roughly $3 billion in 1999–2001.
  - In 1999–2001, inward FDI flows accounted for less than 10 percent of gross fixed investment.
  - On a per capita basis, cumulative inward FDI flows in 1999–2001 amounted to about $20 per person.
  - On a stock basis, cumulative inward FDI flows in 1995–2001 were $19.6 billion (bulk from Germany, the United States, and the United Kingdom; Cyprus a leading source but likely reflects Russian offshore companies operating in Cyprus).
  - Sector distribution: food processing largest share of inward FDI flows; oil extraction second largest. More than half of inward FDI flows in oil and gas ($1.5 billion) invested in Sakhalin I and II projects.
  - Deal example: BP announced plan to acquire 50 percent share in a company formed with TNK International for $6.15 billion (reportedly $2.4 billion cash on completion, and three annual tranches of $1.25 billion in BP shares).
- Turkmenistan:
  - Inward FDI flows averaged around $125 million during 1999–2001.
  - Inward FDI flows dropped from $108 million in 1997 to $62 million in 1998, then rebounded to $125 million per annum in 1999 and 2000 and $133 million in 2001.
  - Inflows mainly in the form of production sharing arrangements (PSAs) in oil sector and modest joint ventures in non–oil sector; levels below those needed to meet government annual production targets.

### B. Reforming Energy Importers — summary findings and key figures
- General: Group B countries are diverse; common themes include energy sector privatization or large projects accounting for the majority of inward FDI; some countries reliant on one large resource project.
- Armenia:
  - Inward FDI flows equivalent to nearly 7 percent of GDP on average during 1998–2001 (tailed off following privatization progress).
  - Main sectors: energy, telecommunications, and food.
  - 2002 debt/equity swap: cancellation of $94 million in debt for 100 percent of equity in Hrazdan thermal power plant, Mars control systems plant, and three research institutes.
- Georgia:
  - Inward FDI flows fluctuated between $80–236 million in 1997–2001 (on average about 4½ percent of annual GDP).
  - High inflows in 1997–1998 attributable to Baku–Supsa pipeline and terminal in Supsa; sale of 75 percent stake in Telasi to AES; AES purchase in 2000 of part of Gardabani thermal power station.
- Moldova:
  - Inward FDI flows fell from $76–78 million per annum in 1997–1998 to $39 million in 1999, then rose to $128 million in 2000 and $149 million in 2001.
  - About half of recent inward FDI flows in electricity, gas, and water sectors.
  - Foreign direct equity investments relative to total fixed capital formation: 17 percent in 1999; 45 percent in 2000; 44 percent in 2001.
  - Major source countries since 1995: Russia, the United States, Spain, United Kingdom, and France (three fourths of inward FDI flows).
- Kyrgyz Republic:
  - Inward FDI flows about 7 percent of GDP on average in 1996–2001; net FDI inflows only 3 percent of GDP on average in 1996–2001.
  - Major investments: Cameco’s Kumtor gold mine; U.S. investment in Hyatt Regency Hotel; Reemtsma investment in Bishkek tobacco factory.
- Tajikistan:
  - Inward FDI flows accounted for less than 2 percent of GDP on average during 1998–2001; majority from a British company investing in a gold mine.
- Ukraine:
  - Inward FDI flows accounted for 4 percent of domestic fixed capital investment, or about 2½ percent of GDP, in 2001.
  - Inward FDI flows: $267 million in 1995; peak $743 million in 1998; $496 million in 1999 (33 percent drop); $595 million in 2000; $792 million in 2001.
  - Leading sectors: food and processing of agricultural products and domestic trade.
  - Leading source countries (accounting for three fourths of inward FDI stock at end–June 2002): United States, Cyprus, United Kingdom, Netherlands, Russia, British Virgin Islands, Germany, Switzerland, and Austria.
  - Bulk of inward FDI stock from Cyprus and other offshore centers likely reflects domestic and Russian investors.

### C. Other Energy Importers — summary findings and key figures
- Belarus and Uzbekistan have not implemented fundamental market-oriented reforms; inward FDI flows extremely limited except for specific projects.
- Belarus:
  - Notable investment related to construction of the Yamal pipeline owned by Gazprom (pipeline started operating, not yet at full planned capacity).
  - 2001 IFC regulatory cost assessment: excessive state involvement and regulatory environment are major obstacles; businesses face much higher regulatory compliance costs than neighbors.
- Uzbekistan:
  - Net FDI inflows accounted for around 1 percent of GDP in 2001 (balance of payments data).
  - Constraints: discretionary implementation of pervasive regulations; non–transparent system of privileges and tax exemptions; multiple exchange rates imposed in 1997 with foreign currency rationing and constraints on repatriation of profits; delays in liberalization of foreign exchange market scheduled for end–2000.

### D. Motivation for FDI — investor motives and implications
- Predominant motives:
  - "Resource seeking" FDI has dominated in CIS countries (especially for energy and mining).
  - More advanced transition economies attract "efficiency seeking" FDI oriented toward export processing based on low (productivity–adjusted) labor costs.
  - Market-seeking FDI may be possible in large domestic markets (e.g., Russia, Ukraine) but requires significant improvements in the investment climate.
- Regional considerations:
  - Investors view smaller countries in a regional context for market-seeking investment; lowering trade and transport impediments within the region could stimulate investor interest by increasing effective market size.
  - Regional efforts to remove trade and transport impediments are underway in the context of the CIS–7 Initiative.

### III. Investment climate — main impediments and country-specific observations
- General impediments across CIS countries:
  - Extensive government regulation (licensing, inspections, certification) combined with low civil service salaries and weak public administration incentivize rent-seeking.
  - Barriers to entry, impediments to competition, ineffective bankruptcy procedures, and weak corporate governance allow inefficient incumbents to persist.
  - Financial intermediation limited by underdeveloped banking systems and capital markets, constraining SME finance.
  - Weak property rights, contract enforcement, and bankruptcy procedures hinder bank strengthening.
  - Pricing of key inputs (energy, water, rail) acts as implicit subsidy to energy–intensive firms.
- Country-specific highlights:
  - Azerbaijan: dual environment — transparent and efficient oil sector regulated by PSAs; weak and poorly enforced environment in non–oil sectors. Reforms included cutting businesses requiring licenses by about 85 percent and extending license validity up to 5 years.
  - Kazakhstan: surveys cite corruption in basic government services; overlapping and excessive regulation and inspection; policy initiatives complicating investment climate (investment law limiting appeal to international arbitration; transfer pricing law; rigid foreign employee quota; domestic content requirements; government campaign for contract renegotiation).
  - Russia: surveys (FIAS 2001) cite unstable tax environment, regulation, legal vulnerability, lack of level playing field, crime, unreliable supply, and corruption. Tax reforms have improved outlook; other reforms (civil service, banking, judicial, energy, WTO accession) at early stage.
  - Turkmenistan: legal and regulatory environment inadequate; unclear laws without implementing regulations; burdensome business regulations; non-implementation of international accounting standards; slow privatization progress.
  - Armenia: impediments include small domestic market, weak governance, legal system deficiencies; enterprise surveys (1996–1999) identified taxes, policy uncertainty, lack of financing, anti-competitive practices, corruption, crime, infrastructure, and judiciary functioning as main impediments.
  - Georgia: liberal foreign investment policy and WTO membership positive; concerns include inadequate investor rights protection (arbitrary court decisions), unstable border, kidnapping of foreign businessmen, perceived inadequate anti-corruption measures, poor infrastructure (electricity disruptions). Georgia extracts nearly 3 percent of annual company revenue in bribes (nearly twice as high as in Russia).
  - Kyrgyz Republic: main limitations are excessive red tape and perceived corruption; post-1998 WTO accession amendments made investment laws more investor friendly, but licensing remains problematic; Free Economic Zones mixed performance.
  - Moldova: benefits from WTO membership, open trade regime, and effective banking supervision; lagging in legal system implementation; new insolvency, pledge and collateral laws, and civil code passed but need effective implementation; conflict of interest and corruption perceived as key impediments.
  - Tajikistan: investor feedback indicates frustration with informal legal environment, political interference, and lack of payments discipline.
  - Ukraine: deterrents to FDI include instability and complexity of government regulations; ambiguity of legal system; uncertainty in economic environment; corruption (particularly local level); high tax burden; issues with VAT refunds and impossibility of land pledges. Surveys: 2000 International Center for Policy Studies (95 percent of foreign companies believed proper privatization policies could significantly improve business climate); 2002 American Chamber of Commerce survey obtained similar results.
  - Belarus: 2001 IFC survey showed regulatory environment and excessive state involvement are major obstacles.
  - Uzbekistan: discretionary implementation of pervasive regulations, non-transparent privileges and tax exemptions, multiple exchange rates and foreign currency rationing, and repatriation constraints have discouraged investment.

### Comparison with other regions — ranking of investment impediments
- IMF country teams counted occurrences of impediments across 12 CIS countries in eight areas: (1) corruption; (2) crime and theft; (3) regulation; (4) taxes; (5) financing; (6) inflation; (7) policy instability; and (8) poor infrastructure.
- Frequency among 12 CIS countries:
  - Corruption cited in 10 countries.
  - Regulation cited in 10 countries.
  - Crime and theft cited in 5 countries.
  - Financing cited in 5 countries.
  - Policy instability cited in 5 countries.
  - Taxes cited in 3 countries.
  - Poor infrastructure cited in 3 countries.
  - Inflation cited in 0 countries.
- Correlations between IMF country team rankings and World Bank (1997) regional rankings (rank correlation coefficients and test statistics):
  - Sub–Saharan Africa: Rank Correlation Coefficient -0.33; Test Statistic -0.87
  - Latin America and Caribbean: Rank Correlation Coefficient 0.15; Test Statistic 0.37
  - East and South Asia: Rank Correlation Coefficient -0.52; Test Statistic -1.48
  - Middle East and Africa: Rank Correlation Coefficient -0.17; Test Statistic -0.43
  - CIS: Rank Correlation Coefficient 0.01; Test Statistic 0.03
  - CEE (Central and Eastern Europe): Rank Correlation Coefficient -0.36; Test Statistic -0.94
  - High–Income OECD: Rank Correlation Coefficient 0.06; Test Statistic 0.14
- Interpretation:
  - Obstacles associated with property rights protection (corruption, crime and theft, regulation) ranked among the top three both in CIS and non-CIS countries (except high–income OECD).
  - Tackling corruption is of first–order importance in improving the investment climate.
- Effect of corruption on FDI:
  - Presence of corruption may reduce quality of FDI; firms with valuable technology and knowledge capital less likely to invest in countries with governance problems, and if they do, they tend to avoid joint ventures. Export–oriented investment is less bound to location and thus more sensitive to governance problems.

### IV. Conclusions and policy implications — key conclusions and recommendations
- Summary conclusions:
  - Private capital inflows into the CIS countries consisted mainly of direct investment and were concentrated in a few energy–abundant countries.
  - Cumulative net FDI inflows per capita in the CIS countries accounted for only a small fraction of inflows received by the CEB countries.
  - Net FDI inflows fell drastically short of levels needed to support high, sustainable growth.
  - Inflows were generally related to natural resource extraction, energy transportation infrastructure projects, large privatization transactions, and debt/equity swaps to pay for energy supplies.
- Main impediments identified:
  - Weak investment climate owing to incomplete structural reforms.
  - Burdensome tax systems, widespread corruption, extensive state intervention, weak legal and regulatory frameworks, and incomplete structural reforms (banking, civil service, energy).
  - Lack of property rights protection (corruption, crime, excessive regulation) cited most frequently as significant investment impediment.
- Policy implications and recommendations:
  - Further institution building is needed to underpin structural reform efforts.
  - Measures to improve the investment climate should be carefully sequenced.
    - Privatization may not succeed without appropriate legal and regulatory frameworks and a competitive environment in place.
    - Legal and regulatory improvements and competition policy would help lower entry barriers for de novo firms.
  - Natural resource abundance, institutional quality, and prospects for EU accession play significant roles in levels of FDI attracted.
  - Smaller, poorer CIS countries with limited domestic markets and distant from the EU may not reap near- or medium-term net FDI gains from policy improvements; international community support will be needed for countries making best efforts to implement good policies.
  - For larger or energy–diversified countries (e.g., Russia, Ukraine), improved macroeconomic performance provides opportunity to implement structural reforms; investor responses may follow but reforms risk stalling (e.g., around elections).
  - Regional cooperation to remove trade and transport impediments could increase attractiveness of smaller CIS markets for market-seeking investment.
  - Strategies to increase labor productivity, coupled with competitive labor costs, could help attract more efficiency–seeking FDI oriented toward exports.

*Source: IMF staff analysis in Box 2 and Sections II–IV of the referenced IMF paper on capital flows and investment climate in the CIS countries.*

### Box 1. The Role of Privatization

### Box 1. The Role of Privatization

### Link between privatization and FDI
- Levels of FDI inflows into transition economies are closely related to the size of privatization receipts (EBRD (2000), Chart 4.5, p. 84).
- EBRD (2002a) found that privatization in the CIS countries generally has not yielded large–scale foreign investment.
- In contrast, FDI into the CEB countries was motivated to some degree by their proximity to the EU and the prospect of EU accession.

### Meta-analysis evidence on enterprise performance (Djankov and Murrell (2002))
- Privatization was strongly associated with improved enterprise performance for the transition economies as a whole but this effect was not statistically significant for the CIS countries.
- Explanations and detailed findings:
  - The finding was attributed to the higher share of less effective categories of owners (in particular, owners in the “worker” and “diffuse individual ownership” categories were more prevalent) in the CIS countries than in transition countries as a whole.
  - The owners most effective in improving enterprise performance were foreign investors in results which aggregate CIS and non–CIS transition countries, although there were some significant regional differences.
  - In the CIS countries, bank and concentrated individual ownership were significantly more effective than in the non–CIS countries, while workers and outsiders (including foreign investors) were significantly less effective in the CIS countries.
  - This latter finding was at least partly due to poor corporate governance institutions in the CIS countries.

### Need for supporting reforms
- Havrylyshyn and McGettigan (2000) highlighted the importance of ensuring that an accommodating market environment is in place to support privatization, including macroeconomic stability, enforcement of hard budget constraints, and a properly functioning system of property rights.
- Zinnes and others (2001) stressed the need to implement policies to strengthen a country’s legal, regulatory, and institutional environment as a complement to privatization.
- Krishnaswamy and Stuggins (2003), which studied privatization of the electricity sector in the Europe and Central Asia (ECA) region, suggested that it would have been better to focus initially on legal, tariff, and regulatory reform, and commercialization of operations, prior to unbundling, the introduction of competition, and privatization.
- Vandycke (2003) described how the growth of private sector activity in the CIS–7 countries mainly reflected transfer of state assets having little economic value and with weak management and poor governance, a form of privatization that is unlikely to induce the emergence of a dynamic, efficient private sector.

### EBRD assessment of CIS privatization progress
- The EBRD indicated that the process of privatization in the CIS countries is largely over but had not attracted large-scale foreign investment or knowledge (EBRD (2002a), Box 1.3, p. 15).
- The EBRD’s indicator of progress in large–scale privatization ranges from 1 to 3+ (out of a possible 4+) in the CIS countries with a median of 3, suggesting an intermediate level of progress with large-scale privatization.

*Source: _pdp05 - Box 1. The Role of Privatization*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/pdp/2003/_pdp05.pdf_