Central, Eastern European Economies Benefit from 'Boomerang Investing'

August 17, 2005

When the communist regimes in Central and Eastern Europe (CEE) came tumbling down in the late '80s and early '90s, Western business people stood poised to make a killing on foreign direct investments (FDI) in this huge, hitherto untapped market. Now, some 15 years after the gold rush, the locals are no longer prepared to just play host to the fat cats. They can do FDI too.


Economics Professor Josef Brada of the W. P. Carey School of Business and Zdanek Drabek of the World Trade Organization examined what motivates this curious phenomenon: the urge among businesses spawned by the chaos of the post-communist period to invest in countries other than the homeland where the profits were made. Their paper, "Corruption and Money Laundering as Drivers of FDI: the Case of the Transition Economies," yields clues about the reasons for the itchy feet -- or itchy money -- in the ex-communist countries of CEE.


Westerners who descended on Central Europe in the '90s calculated that the rewards of investment would be greater than the sometimes uncomfortable sacrifices. And they have largely been proven right. Local business people, however, often had to endure a grimmer reality. Constant interference from the authorities and heavy tax burdens meant that the only way indigenous businesses could reward the labor involved in doing business was to shift their capital abroad. Certain countries welcomed them with open arms. Cyprus was one.


"The fact that one of the biggest investors in Russia is Cyprus says a lot," said Olga Trofimenko, senior lecturer at the Department of World Economy at St. Petersburg State University. In Russia, a company based in foreign country is considered a "legal person" in that country, Brada explained, so that when the company re-invests in Russia it is seen as foreign investment -- no matter that the shareholders are Russian. "This is Russian money with changed nationality -- somehow it got back to Russia," Trofimenko remarked. "Companies go to other countries and they change nationality because it is easier to be a foreign investor in Russia."  


Brada said that this trend is playing out in a number of the CEE "transition" economies. Stretching the definition of FDI somewhat, this phenomenon might be described as "boomerang" investing instead. While the need to avoid corrupt practices appeared to drive the efforts to shelter money on foreign shores, Brada sought to determine whether this type of FDI might be the result of legitimate forces as well. Capital flight and money laundering from some of the former communist would seem more significant motivators for outward FDI.


When to be a stranger at home


"There are a lot of places to park capital: the Caribbean and the Seychelles as well as Cyprus," said Professor Brada. "You certainly see capital going to these countries and in some cases it flows back to the transition economies. People understand that there is some  uncertainty regarding property rights for local owners and that the footing is a bit firmer for foreign ownership -- so what you want to do is ship your money overseas and then bring it back, looking like a foreign owner."


The case of Mikhail Khodorkovsky has thrown into sharp relief one of the key motivating factors in capital flight from transition economies. Khodorkovsky, the erstwhile head of the Russian oil concern Yukos, was sentenced to a nine-year prison sentence in May 2005 on charges of fraud, tax evasion and embezzlement in Moscow. The  trial and sentence was viewed by the Western business community as a contrivance to neuter the tycoon's political ambitions. Brada suggested that it is natural for a successful businessman to aspire to public influence -- though there are clear risks should a Vladimir Putin choose to clip the wings of certain members of the rich elite. Pre-emptive and widespread capital flight in the form of FDI is hardly a surprising phenomenon in such circumstances, Brada said, because the property of other tycoons could be seized by the state through similar trials.


The threat of official retribution for political involvement is strong motivation to move money out of the country, Brada said. "If someone says 'This guy's meddling in politics -- we're going to put him on him on trial,' you're going to want to get out of the country and have a few million dollars stashed away somewhere else. In that case, once the amount of money  you want to move out of the country gets big enough, FDI becomes a very cost effective way of doing it," he added.


Transparency vs. taxes


This scenario does not apply equally to all so-called "transition" economies, however.


"If you look at official statistics regarding Poland, the Czech Republic and Hungary, you will see that most of them are net capital importers," said Trofimenko. "But if you look at the figures concerning Russia, you will see that it is a net capital exporter. The amount of capital that leaves Russia is several times higher than what comes in."


Countries such as Poland, the Czech Republic, Slovakia and Hungary, have recently joined the European Union, where transparency in politics and business is a prerequisite for membership. Data suggest that businesspeople in these countries feel less inclined to take their money elsewhere to invest. Here, perhaps, Khodorkovsky would still be a free man.


Still, there are areas of gray in those countries. Business people in the Central European EU member states -- including many who earned their wealth in similar fashion to the oligarchs in Russia -- can operate relatively unencumbered by the arbitrary decisions of the state. They still face enough concerns to take their companies to greener grass, however.


"Many from the local rich groups gained their wealth by being near those in power," said Richard Mbewe, chief economist of the Warsaw Investment Group, of the situation in Central Europe. "They were given a right to do their business without any disturbance, so there was not much capital flight from these countries. What you could see, on the other hand, was people moving their headquarters to tax havens, because taxation, especially in Poland, was and is quite high. So you see Zygmunt Solorz-Zak, [head of TV station Telewizja Polsat], for example, setting up his HQ in Holland, where taxes are lower."


But matters in Central Europe can get murkier than this, as Brada and Drabek have shown in their paper. At one point in their study, they focus on the motivators for FDI in the Czech Republic, ostensibly one of the most transparent of all the transition economies. They reveal that outward investment from this country is largely dominated by the sectors of trade and repairs, financial institutions, hotels and restaurants. The latter three, they add, "...lend themselves to money laundering."


Most Czech FDI finds its way to neighboring countries, particularly Slovakia, which is part of a trend affecting most of the transition economies, according to the authors. But a strikingly high percentage of this money also turns up in Liechtenstein and the British Virgin Islands -- two parts of the world which would seem to have few, if any, cultural or geographical links with the Czech Republic.


Brada and Drabek charted Liechtenstein's changing relationship with the Financial Action Task Force (FATF), which was established by the G7 nations to eradicate money laundering. Liechtenstein, which at one time was listed as "non-cooperative" by the FATF, reformed its banking policies in 2000 to comply with FATF standards, ending Czech FDI to the country, according to the authors. The British Virgin Islands, however, maintained their presence on the FATF blacklist.


"It's hard to imagine the market potential for Czech goods, or specific advantages for Czech firms in operating resorts and casinos on tropical islands, as the drivers of Czech FDI to the Caribbean," Brada and Drabek commented. "This is compelling evidence that even countries that have, by regional standards, low levels of corruption and relatively well-developed market institutions, may find that capital flight and money laundering are important drivers of FDI."


This example proves is that despite joining the ranks of the European Union, where above-board business practices are assumed, much of what goes on in Central Europe can still be viewed as "transitional." Observers estimate that it could take more than 15 years to purge these economies of the nepotism and underhandedness -- arguably by products of the previous regimes -- that have tarnished business activity in the region since the fall of communism.


"In a sense it's true that joining the EU has probably strengthened the confidence of capital owners that they're not going to be expropriated in the way that Yukos was by Mr. Putin," said Brada. "But on the other hand I think money laundering continues, and I don't think that joining the EU per se reduces the level of corruption." 


Another example of this has been the investigation into Poland's foremost oil company PKN Orlen, in which high-level politicians and businessmen have been accused of engaging in clandestine deals to sell crucial fuel assets to Russian concerns. More recently, first lady Jolanta Kwasniewski was subpoenaed to testify before the commission and a senior policeman was arrested, under suspicion that he had close links with the country's "fuel mafia." The story then took an even more troubling turn when it was revealed that other policemen, secret service operatives and prosecutors were all connected to the crime organization. EU membership has yet to clean up Poland's act, it seems clear.


FDI as business expansion


It would be wrong to assume that all business in the region is tainted by association with the underworld, however. And now that locally-bred companies have established strong niches in their domestic markets, many are seeking out other countries in which to set up shop. Russia's wealth in natural resources, for example, means that its fuel companies are increasingly searching for ways to distribute their products without having to rely on foreign partners.


"FDI [for these companies] is driven by efforts to gain distribution outlets," said Brada. "Russia obviously has a lot of energy resources and rather than simply sell them to someone in the West to distribute, these firms want to be able to control and participate in this process. The simple reason is that there's profit in these downstream activities. That's why Western oil firms like Shell and Exxon are vertically integrated."


The other, smaller countries in the CEE region have fewer natural resources than their huge neighbor, which has meant that FDI by legitimate means has evolved rather more cautiously and with more limited ambitions. With a few exceptions -- some firms are apparently keen on investigating what China has to offer -- CEE companies will tend to expand into adjacent territories.


"For this country [Poland] the sectors of the economy that might seek out new markets would be those producing goods such as textiles, machinery and food products," said Richard Mbewe. "Polish labor costs are also not as attractive compared to Ukraine and even Slovakia, so you find that some firms are looking to manufacture there."


The whiff of corruption may linger in countries such as Poland, but its eventual emergence as a largely transparent place in which to conduct business, as well as the saturation of many of its markets, will encourage home grown companies to look for opportunities outside its borders -- especially in neighboring economies which are still some distance from joining the European Union. As acceptance of the rule of law in business gains currency, companies from the new EU member states will be aiming to profit from the untapped markets, where many farther west fear to tread, just as a few enterprising Westerners did back in the "gold rush" of the early '90s.


"Poland has to use the potential that it has as a member of the EU," said Mbewe. "It is still learning about living in a united Europe, and because at the same time it used to be a communist state, it understands the mentality of the Belorussians and the Ukrainians, so it can become a bridge to these countries. But whether it becomes a bridge to those with dirty money or those with clean money is another question altogether."