POLITECNICO DI MILANO

Dipartimento di Ingegneria Gestionale

POLO TERRITORIALE DI COMO

Master of Science in Management Engineering

THE IMPACT OF INSTITUTIONAL FACTORS ON

ATTRACTING FOREIGN DIRECT INVESTMENT
FLOWS

Candidate
Gohar Babayan
Student ID number 818228

Thesis Supervisor
Prof. Lucia Tajoli

Academic Year 2014/2015

 ABSTRACT

Intensification of international capital flows is one of the most prominent motors of

economic globalization. Recently multinational companies prefer to internalize their production
through flows of FDI for increasing efficiency by geographic expansion of their operations and
strengthening their position in the world market. The current stage of economic development in the
world, in turn, shows that foreign direct investment (FDI) is one of the main factors for sustainable,
high-quality and well-balanced economic growth. The need to attract FDI is especially high for
developing and transition countries, as this type of investment promotes structural changes of the
economy, allows to ensure sustainable economic grows as well as allows the recipient-country to
effectively integrate into the process of globalization. In this regard, it is not surprising that
nowadays there is a fierce competition between countries for attracting foreign investments,
particularly foreign direct investments.
The purpose of this thesis is to examine the role of institutional environment on inflows of
foreign direct investments in order to identify the most critical institutional factors for attracting
FDI.
For this purpose, regression analysis was conducted between different indicators of
institutional quality and FDI net inflow. The result of the analysis has shown that institutional
climate, among other indicators, has an important influence on FDI inflows. Furthermore, it was
shown that institutional quality is important not only for FDI attraction, but most importantly, for
obtaining possible benefits associated with inward FDI. The final part of the thesis is focused on the
analysis of institutional and investment environment in transitional South Caucasus, and especially
in Armenia. The choice of the country is based on the following facts: small domestic market of 3
million people and economic blockades, imposed by two neighbor countries, make landlocked
Armenia, to some extent, less attractive for certain foreign investors. Whereas factors such as
geopolitical situation, size of inner market, abundance of natural recourses (which are undoubtedly
having major influence on investment decision-making process) cannot be changed in a short-term
period, the importance of high-quality institutional environment and favourable business climate is
becoming much more critical for Armenia’s investment attractiveness.
The study has been conducted using both general scientific analysis methods and specific
economic and mathematical methods – benchmarking study, graph method, various mechanisms of
econometric and statistical analysis.
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 CONTENTS

INTRODUCTION……………………………………………………………………………….……..….….7

CHAPTER 1 THEORETICAL BASIS OF FDI AND INSTITUTIONAL FACTORS FOR THEIR

ATTRACTION ………………………………………………………………………………………….……9
1.1. The essence of foreign direct investment (FDI)……………………………………….……...……….9
1.2. The role of FDI in economic development of a country………………………………..….…….……9
1.3. Prerequisites for FDI implementation……………………………………………………..……….…13
1.4. Key factors, influencing investment decisions of foreign investors…………………........................14
1.5. Theoretical basis of the institutional environment as a mechanism for attracting FDI…….......……15
1.5.1. Main political regimes and their characteristics…………………………………...…17

1.5.2. Legal Systems………………………………………………………………………..….18

1.5.3. Institution of Property Rights………………………………………………………...….19
1.5.4. Judicial System……………………………………………………………………….….20
1.5.5. Institution of Contract Enforcement………………………………………………..…21

1.5.6. Corruption as a main factor, distorting institutional environment…………………22

CHAPTER 2. RECENT TRENDS IN FDI FLOWS & MACROECONOMIC AND INSTITUTIONAL

MECHANISMS FOR THEIR ATTRACTION………………………………………………………..….24

2.1. International tendency in FDI flows before and after the global financial crisis……………….….…24

2.2. Market size as a key factor influencing FDI inflow…………………………………………….….…34

2.3. Cross-country analysis of the impact of institutional factors on inward FDI flows………….…...…36

CHAPTER 3. ANALYSIS OF FDI FLOWS AND INSTITUTIONAL ENVIRONMENT IN SOUTH

CAUCASUS (WITH A FOCUS ON ARMENIA) ……………………………………………………...…45

3.1. Armenia as a recipient of foreign direct investment in the international capital market………..….…45

3.2. Analysis of the institutional climate in South Caucasus with a focus on Armenia……………..…….54

CONCLUSION………………………………………………………………………………… ……..….…71

BIBLIOGRAPHY…………………………………………………………………………………..…….…74

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 LIST OF FIGURES

Figure 2.1.1 Growth rates of World Trade Turnover and Global FDI flows, 1991-2014………………...…24

Figure 2.1.2 Inflow of FDI by Region, 2000-2014 ………………………………………………………….26

Figure 2.1.3 Nominal FDI inflow and annual average growth rate of GDP in the world

and main economic regions, 1995-2014…………………………………………………………………..….28

Figure 2.1.4 FDI Inflows by main group of countries, 1990-2014 …………………………………….……29

Figure 2.1.5 FDI flows to CIS and Russian Federation………………………………………………….…. 30

Figure 2.1.6 FDI flows to the EU, 2000-2014 ……………………………………………………………... 31

Figure 2.1.7 Main FDI recipients and Donors in the EU, 2013-2014 …………………………..……….…..32

Figure 2.1.8 10 largest FDI recipients in the world in 2014 ……………………………………….…….….33

Figure 2.1.9. 10 largest FDI investors in the world in 2014 ………………………………………….….….34

Figure 2.2.1 The relationship between nominal Gross Domestic Product and FDI net inflow ………….….35

Figure 2.3.1 The relationship between Political Stability and FDI net inflow ………………………….…..38

Figure 2.3.2 Ranking of the main investment climate constraints according to 26000 firms in 53 developing
countries (per cent of firms reporting) ……………………………………………………………………….39

Figure 2.3.3 The relationship between Government Effectiveness Index and FDI net inflow ……….……..40

Figure 2.3.4 The relationship between Control of Corruption and FDI net inflow …………………………41

Figure 2.3.5 The relationship between Rule of Law and Control of Corruption ………………………..…..42

Figure 2.3.6 The relationship between Rule of Law and FDI net inflow ……………………………….…..43

Figure 2.3.7 The relationship between Protection of Property Rights and FDI net inflow …………………43

Figure 3.1.1 Analysis of GDP nominal, GDP growth, GDP per cap., GDP per cap. growth in Armenia .….46

Figure 3.1.2 FDI stock nominal and % of GDP in CIS countries and Georgia in 2014 …….………………48

Figure 3.1.3 Armenian inward FDI (nominal and % of GDP), 1997-2014 ………………………..………..49

Figure 3.1.4 Main sectors, attracting FDI in Armenia in 2013 and during 1988-2013 …………….……….51
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Figure 3.2.1 Political Stability in South Caucasus, 2004-2014 ……………………………………...………55

Figure 3.2.2 Political Stability percentile ranking for countries of South Caucasus in 2014 ………………56

Figure 3.2.3 Government Effectiveness in South Caucasus, 2004-2014 ……………………………...…….57

Figure 3.2.4 Regulatory Quality in South Caucasus, 2004-2014 ……………………………………………58

Figure 3.2.5 Rule of Law in South Caucasus, 2004-2014 …………………………………………..………59

Figure 3.2.6 Control of Corruption in South Caucasus, 2004-2014 ………………………………..……….61

Figure 3.2.7 The quality of governance indicators in South Caucasus, 2014 ……………………….………63

Figure 3.2.8 Estimation of three components of International Property Rights Index (IPRI), 2015 …….….64

Figure 3.2.9 Overall IPRI estimation for South Caucasus, 2015 ……………………………………………64

Figure 3.2.10 Estimation of 10 components of Index of Economic Freedom (IEF) for Armenia, 2015….…65

Figure 3.2.11 Overall score of IEF for Georgia, Armenia and Azerbaijan, 2015 ……………………..…….65

Figure 3.2.12 Value of Judicial Independence, 2015 ……………………………………………………..…67

Figure 3.2.13 Position in Judicial Independence overall ranking ………………………………………...…67

Figure 3.2.14 2016 Ease of Doing Business ranking for Armenia, Georgia and Azerbaijan …………...…..69

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 LIST OF TABLES

Table 3.1.1 Quick facts about main macroeconomic indicators of South Caucasus in 2014 ………....…….45

Table 3.1.2 Main Foreign Direct Investors in Armenia, 2008-2013 ………………………………...………50

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 INTRODUCTION

The current stage of economic development in the world shows that foreign direct
investment (FDI) has a significant impact on sustainable, high quality and well-balanced economic
growth in the recipient country. Hence, any country, which is engaged in the process of economic
globalization, tries to develop favourable business climate in the country, for attracting more
foreign investments. It is therefore necessary to investigate the key determinants that have greatest
impact on FDI inflows and volatility of these flows. As notes in the number of studies on flows of
international capital, historically the fundamental motivations for making exactly foreign direct
investments are the advantage of possession, the advantage of location and the advantage of
internationalization. Therefore, it ought to be noted that presence of such determinants, as
favourable geopolitical location, considerable size of the market, abundance of natural resourced
have a significant impact on a country’s investment attractiveness. However, in nowadays fierce
competition for attracting FDI the above-mentioned determinants are becoming insufficient for a
country being competitive in the global capital market. Whereas the quality of institutional
environment in a country is increasing its importance as a determinant for FDI attraction.
Developed institutional environment in a country significantly decrease transactional cost of
investors, makes doing business easier and, above-all, gives guarantees and protects foreign
investors. Furthermore, it ought to be mentioned that high institutional quality is a necessary factor
for not only attracting FDI but also for obtaining possible benefits, associated with FDI attraction.
Thesis Statement
In this work of thesis, we set up a hypothesis that countries with higher institutional quality
are more successful in attracting foreign direct investments.
Objectives / tasks of the thesis
The purpose of this thesis is to examine the role of institutional environment on a country's
ability to attract foreign direct investment. For this purpose, the following tasks were conducted in
the scope of the thesis:
Ø Study of the essence and conception of FDI and investment climate.
Ø Identification of possible positive and negative consequences for a recipient party after
attracting FDI.
Ø Identification and presentation of the most significant institutional factors, affecting
country’s investment attractiveness.
Ø Analysis of global FDI flows before and after financial crisis.

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 Ø Analysis of South Caucasus (with a focus of Armenia) as a recipient of FDI. Disclosure of
major institutional problems in Armenian institutional and investment environment (in the
context of South Caucasus).
Ø Development of recommendations and formulation of mechanisms for increasing
investment attractiveness of Armenia by improving the quality of existing institutions.
Structure of the thesis
The thesis is structured in the following way:
st
The 1 Chapter of the thesis presents the review of the existing economic literature on
foreign direct investment and institutional quality.
• The first part of the chapter discusses the essence of FDI for economic development
in the recipient country, describes four channels for economic growth and
development as a result of FDI inflow as well as introduces the fundamental
motivations for making exactly foreign direct investments.
• The second part of the chapter covers the theoretical basis of institutional
environment and introduce the main qualitative indicators of institutional
development, which, in turn, are used for econometric analysis.
nd
The 2 Chapter of the thesis consists of three parts.
• The first part presents in-depth analysis of global FDI flows before and after
financial crisis.
• The second and third part, in turn, presents cross-country econometric analysis for
identifying relationship between market size, institutional factors and inward FDI
flows. GDP nominal was used for characterizing market size in the respective
regression analysis. The following institutional indicators were used for conducting
regression analysis: Political Stability, Government Effectiveness, Regulatory
Quality, Control of Corruption, Rule of Law, Property Rights Protection, and

• transitional South Caucasus (Armenia, Georgia and Azerbaijan); provides analysis of

main macroeconomic indicators of the countries and presents in-depth analysis of
Armenia as a recipient of FDI.
• In the second part of the chapter we analyse the institutional environment in South
Caucasus (with a focus on Armenia), we try to identify the main institutional
weaknesses of Armenia and provide recommendations.
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 CHAPTER 1. THEORETICAL BASIS OF FDI AND INSTITUTIONAL
FACTORS FOR THEIR ATTRACTION

1.1. The essence of foreign direct investment (FDI)

The current stage of world economic development shows that foreign direct investment
(FDI) is one of the main factors for sustainable, high-quality and well-balanced economic
development. The need to attract FDI is especially significant for developing and transition
economy countries, as this type of investment promotes structural changes of the economy, allows
to ensure sustainable economic grows as well as allows the recipient-country to effectively integrate
into the process of globalization. Accordingly, in the modern conditions of globalization and the
intensification of capital flows in the world economy, there is fierce competition for attracting
foreign investments, particularly foreign direct investments.
According to OECD, foreign direct investment is defined as a category of cross-border
investment made by a resident in one economy (the direct investor) with the objective of
establishing a lasting interest in an enterprise (the direct investment enterprise) that is resident in an
economy other than that of the direct investor. The “lasting interest” is evidenced when the direct
investor owns at least 10% of the voting power of the direct investment enterprise. An effective
voice in the management, as evidenced by an ownership of at least 10 per cent, implies that the
direct investor is able to influence or participate in the management of an enterprise; it does not
require absolute control by the foreign investor.

1.2. The role of FDI in economic development of a country

Over the last decade, numerous studies have been conducted with respect to foreign direct
investment, which are presenting different (sometimes contradictory) views on the international
financial integration of the country and the results that can be gained from that integration.
In this context one interesting research is the study of de Mello (de Mello, 1999), where the
author identifies two channels through which foreign direct investment can contribute to the
economic growth of a country. Firstly, as a result of the capital-flow, FDI promotes the adaptation
of new technologies in the production process. Secondly, foreign direct investments provide a
transfer of knowledge, both in terms of labor training and accumulation of skills, as well as through
the introduction of alternative, high-quality methods of management and more efficient
organizational structures.
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 A study conducted by the OECD confirms the results of scientific observation by de Mello,
as well as claims that investments contribute to the increase in efficiency of factors of production
and income of the country. However, it should be noted that both studies emphasize a key idea: the
effects from FDI inflow depend on the economic and technological conditions in the recipient
country. So the studies described above claim that developing countries should reach a certain level
of economic development in order to obtain the potential benefits from FDI inflow.
In the study by Robert Lensink (Lensink et al., 2000) the author describes four channels for
economic growth and development as a result of FDI inflow into the country.
Ø The first is the "channel of competition": increased competition in the market helps to
increase efficiency and productivity, as well as investments in human and physical capital.
Furthermore, increased competition may encourage positive changes in the structure of
industrial production towards export-oriented sectors.
Ø The second channel is the “transfer of knowledge” through training of local employees, as
well as through introduction of effective management practices and quality control systems.
Ø The third channel of development is “technology-transfer” as a result of transactions with
foreign companies.
Ø The fourth canal in this study is called "demonstrative channel": as a result of FDI-inflow
and the introduction of new technologies in the production process, local companies are
trying to copy the advanced technology and management methods (used in companies with
foreign capital) which, of course, encourages economic development of the country.

In the research conducted by Borensztein (Borensztein et al., 1998), which aims to study
the relationship between the FDI-inflow and the spread of new technologies in the country, the
author uses data on FDI flows from OECD countries to developing world. The choice of data set is
not a coincidence: with this approach there is a significant technological gap between the donor and
recipient countries. The results of this scientific research shows that FDI from developed world can
be an effective channel for the dissemination of new technologies in those developing countries,
which have appropriate level of human capital.
Another interesting study was conducted by Campos and Kinoshita (Campos and
Kinoshita, 2002). The authors examine the impact of FDI-inflow, and the results of the research
shows that FDI is an important factor for encouraging economic growth in transition countries.
Hence, in the studies presented above, which examine the effects of FDI-inflow from developed
countries to developing ones, a positive correlation between FDI inflows and economic growth of
the recipient country is revealed.
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 Van Pottelsberghe (Pottelsberghe, 2011) in his study uses data on FDI flows exceptionally
among developed countries and reveals that as a result of FDI inflow the beneficiary is the donor
country rather than the receiving party. The results of this study are mainly related to the well-
known practice of multinational corporations, when the latters outsource their complex technical
processes in the more developed countries, in order to use «know how» of those countries.
All these three studies described above, use datasets focused on a specific group of countries,
while in the study by Carkovic and Levine (Carkovic and Levine, 2002) the authors use data on
FDI flows between seventy-two developed and developing countries, from US to Rwanda. As a
result of this particular scientific analysis the authors did not identify a relationship between the
inflow of foreign direct investment and economic growth of a country.
In its turn, Isaak Townsend (Isaak Townsend, 2003) in his study emphasizes that the approach
used in the research by Carkovic and Levine (Carkovic and Levine, 2002) could not give any
informative results. The reason for this is evident from the three researches described above, which
analyze datasets focused on defined group of countries. In particular, research on the impact of
international financial integration of developing countries, showed a positive correlation between
FDI inflow and economic growth of the recipient country. However, the studies that use data on
exclusively developed world, revealed that the FDI inflow contributes to economic growth of the
donor country rather than the host country. Therefore, the result of scientific research by Carkovic
and Levine (Carkovic and Levine, 2002), which uses data from developed and developing
countries, combines the opposite effects of foreign direct investment, hence, did not reveal a
positive correlation between FDI inflows and economic growth.
Another interesting study is conducted by Miao Wang and Sunny Wong (Miao Wang and
Sunny Wong, 2009), in which the authors examined the effect of foreign investment from zero
cycle (greenfield investment) separately from cross-border mergers and acquisitions (M&As), since
these two forms of foreign direct investments are different from each other by nature and, therefore,
can have dissimilar correlation with economic growth of a recipient country. The results of this
research revealed that it is investment from zero cycle that contributes to the economic development
of the country. Furthermore, according to the study, cross-border mergers and acquisitions (M&As),
can positively correlate with economic growth only if recipient country has the necessary level of
human capital. Thus, the authors believe that the use of general FDI figures while studying the
impact of foreign direct investment on economic growth is incorrect and leads to dual (multiple-
valued) results.
An important issue is also the necessity to identify the factors that allow to obtain many benefits
from the inflow of foreign direct investment. In particular, Blomström (Blomström et al., 1994) in
11
his study argues that FDI has a positive impact on growth only in countries with high income per
capita. Whereas Balasubramanyam (Balasubramanyam et al., 1996) emphasizes the openness of
international trade as a fundamental factor for obtaining a positive effect from FDI inflow. As a
result of scientific analysis, Borenztein (Borenztein et al., 1998) reveals that FDI inflows correlate
positively with economic growth exclusively in countries with a highly skilled workforce. In its
turn, in the study by Alfaro (Alfaro et al., 2004) the author reveals that FDI inflow promotes
economic development only in countries with sufficiently developed financial markets.
Thus, summing up of the main theoretical and empirical studies on the impact of FDI inflow on
a country's economic development, we can draw the following conclusions:
Ø The inflow of foreign direct investments from developed countries to developing ones has many
positive effects on the recipient country. As a result of capital-flow, FDI promotes the
introduction of new technologies in the production process. Foreign direct investments provide
the transfer of knowledge, both in terms of labor training and accumulation of skills, as well as
through the introduction of alternative, high-quality methods of management and more efficient
organizational structures. Furthermore, FDI inflow has a positive impact on competition: The
forthcoming of new foreign companies in the national market breaks the existing balance in the
market. As a result, domestic firms have to increase their efficiency and productivity in order to
be able to meet the increased competition and do not lose their market share. Increased
competition may also encourage positive changes in the structure of industrial production
towards export-oriented sectors. Moreover, in the event of cooperation, domestic firms can get
direct support from foreign companies for modernization of fixed-capital assets and applied
technology, which will increase the productivity of domestic firms, therefore, ensuring overall
economic development of a country.
Ø FDI inflow can also have some negative effects. In particular, FDI may have a negative
impact on the external balance sheet, as repatriation of profit may negatively affect capital
transactions account. Moreover, in the case of overdependence on foreign financing,
countries may loose their economic independence. Another negative effect of FDI inflow is
the threat that because of higher salaries in foreign companies, domestic companies may
loose their intellectual potential and become less competitive.
Ø Numerous scientific studies suggest that developing countries that have achieved a certain
level of development can get more potential benefits of FDI inflow. The fundamental factors
for obtaining positive effects from FDI are high income per capita; highly skilled workforce;
openness of international trade and sufficiently developed financial markets
12
 Thus, FDI is an important factor for the economic development of the country. In its turn,
the alleged negative factors can be neutralized through proper state regulation of FDI and creation
of required conditions for obtaining maximum benefits from this kind of recourse. So a government
should try to maximize the benefits from international financial integration and minimize the risks
of financial instability.
1.3. Prerequisites for FDI implementation.

Impressive dynamic of foreign direct investment since the second half of XX century
brought in many hypotheses, which explain the prerequisites for FDI implementation. One of the
most famous works in this area is "eclectic paradigm" by John Dunning (Dunning, 1993), also
known as the concept of OLI. This theory is called "eclectic" because, as a result of synthesis of the
key factors of international production as a whole, the paradigm reveals fundamental motivations
for making exactly foreign direct investments.
The concept of OLI emphasizes three fundamental prerequisites for FDI to occur:
§ The advantage of possession. The companies, which intend to transfer their business
activities outside of their country, should obtain benefits or advantages of possession, in
relation to other companies that serve specific market. Such advantages may be obtained
from possessing a particular production process or product that have some market power
and advantage in a foreign market. In the role of such advantages can act material resources,
applied new technologies, goodwill, trademarks, corporate identification, patents and many
other tangible and intangible assets.
§ The advantage of location. Together with the advantage of possession, the company must
still have additional arguments for operation in a foreign country, as doing business in a
foreign country is always associated with additional cost. The additional costs may occur
from the lack of knowledge about local market's condition and performance, as well as
because of legal, institutional and cultural differences. Hence, a foreign investor must make
a good estimation of opportunities provided by a foreign government and compare them
with the characteristics and capabilities of native economy. The advantage of location can be
divided into economic, political, social and cultural. The economic benefits include:
qualitative and quantitative measures of production-factors; lower cost of transport and
communication; cheap workforce, the size of domestic market and etc. The political benefits
primarily include political stability, liberal legislation on foreign investment, as well as
taxation policy that encourages investments. And finally, social and cultural benefits include

13
 a low-level of crime in the country, high living standards, professional qualities and business
ethics of local entrepreneurs, positive attitudes to foreign companies and etc.
§ The advantage of internationalization. The company must have a reason to use the
benefits of ownership and location on its own authority. Otherwise, the company may
externalize operation by licensing manufacturing of their products to other companies.

John Dunning (Dunning, 1993) argues in his theory that each of these benefits is equally
important for making an investment decision. That is why they can be compared with a three-
legged chair, as each of them can be considered as the most important for maintaining the balance
of the tripod. Thus, according to the "eclectic paradigm", the company will invest abroad in the
event of simultaneous presence of all three of the advantages described in the concept of OLI.

1.4. Key factors, influencing investment decisions of foreign investors

John Dunning (Dunning, 1993) also highlights some of the key factors that influence
investment decisions of foreign investors:
ü Market-size, which in this case is usually characterized by real GDP or population.
Large internal market is associated with the “advantage of location”. Numerous
studies have revealed that most companies make foreign direct investments in the
search for new market opportunities. That is why the size of the market is a very
important factor influencing the investment decision.
ü The growth rate of gross domestic product (GDP). Numerous scientific studies claim
that countries with a quick rate of GDP growth are more attractive for foreign
investors. In particular, in the scientific research by Culem (Culem, 1988) the author
provides empirical evidence that especially fast-growing markets attract foreign
investors.
ü Openness to international trade. The liberalization of the trade regime and export
availability for foreign investors are fundamental factors for increasing investment
attractiveness of a country.
ü High-quality institutions for policy implementation. One of the most important
factors influencing the investment decision is the quality of institutional environment
in the recipient country. Effective institutions allow foreign investors to conduct their
business in an environment based on clearly-defines and set (unbreakable) rules.
High-quality institutions reduce uncertainty and risks of investing in a foreign
country, thus, giving investors confidence for the future.
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 ü Macroeconomic situation of a country. John Dunning notes mainly inflation and
terms of trade (the ratio of import and export price). It is believed that the
government's ability to control inflation will reduce the investment risks, which in its
turn, will encourage the FDI inflow into the country. Also favorable terms of trade
have a positive impact on the FDI inflow. In its turn, the terms of trade are
considered to be favorable if the prices of exported goods increase compared with
the prices of imported goods. However, the causes of such change in prices should be
identified.
Summing up, investment decisions of foreign investors are based on the following strategic
factors.
The search for a new market, exemplified by US automobile firms that have
outsourced their production to Europe for local consumption.
The search for new resources of raw materials. If a company cannot satisfy its need
in any kinds of raw materials by import, it can try to penetrate the markets of the
countries where these resources are available.
Search for opportunities to increase production-efficiency. Companies prefer to place
the production in countries with relatively cheap workforce in order to increase cost-
effectiveness.
The search for new information. In this case we are talking about finding a direct
access to the new technological ideas, «know how» as well as to modern
management practices.
The concept by John Dunning (John Dunning, 1977, 1993), which was formulated over 30
years ago, still remains fundamental for understanding the nature of foreign direct investments.
Also it is worth mention that in the study by Aharoni (Aharoni, 1966) the author argues that
the psychological motives also have a great influence on the investment decision. Among the main
psychological motives author highlights the fear of losing highly promising market, as well as
national competitors’ successful experience of doing business in a foreign markets.

1.5. Theoretical basis of the institutional environment as a mechanism for attracting

foreign direct investment

Impressive dynamics of FDI global flows over the past decade and strong worldwide
competition for attracting this type of resource is because of the fact that the inflow of FDI is one of
the key factors for intensification of economic growth in a recipient country. However, a decisive
15
condition for obtaining possible benefits of international financial integration is high-quality
institutional environment in a recipient country. Hence, it is very important to identify key
institutional factors, which encourage the process of financial globalization of a country, and to
identify the relationship between the quality of these institutions and FDI inflow. However, before
discussing the mail qualitative indicators of institutional environment and their impact on FDI
flows, we should first understand what are institutions.
For a long time, economic theory was underestimating the role of institutions as a factor for
increasing potential benefits from cooperation between economic agents. Down to recent times,
Ronald Coase's famous essay (Coase, 1960) "Problem of Social Cost", did not find its own level in
economic science. In his work Coase has suggested the idea of fundamental importance, which
requires a review of economic theory. The author showed that economic growth and development in
the country largely depends on the type of its current government, if the costs of transactions in the
economic and political spheres are zero. However, when transaction costs are positive, the
distribution of power within the country and the institutional structure of its rule-making agencies
become very important factors for country’s development.
Douglass North (North, 1990) defines institutions as a human-created restrictive framework
that organizes the relationship between people, setting the structure of motives in human
interactions – whether it be in political, economic or social spheres. In modern economic theory,
institutions are defined as the rules of "the game" or "role-mechanism", which defines the
respective roles of the participants, allowing them to coordinate actions and to reduce uncertainty.
Thus, institutions are a special economic resource for society. Below we will focus on those
institutions that are most important in terms of this work.
The primary institution of modern society and economy is the institution of the state. The
state is a constitutive subject, as this institution creates a system of laws, which, in its turn, is an
essential part of the institutional system. The nature of institution of state is determined by citizens,
delegating part of their rights to the government. Such delegation of rights happens due to the fact
that the market itself is not able to effectively perform the functions of the government. From
institutional point of view, among the main functions of the state, we would like to highlight the
contract enforcement, specification and protection of property rights, as well as protection of
fundamental human rights. Effective implementation of these functions may significantly encourage
the rational development of a country in a long term.

16
 1.5.1. Main political regimes and their characteristics
Political system is a foundation for the efficient functioning of any state, and, as a
consequence, for rational development of the market-driven economy. Politic system is a set of
institutions; groups with common interests (political parties, public organizations, etc.); set of
established norms and rules that define the constitutional status of the government. Political system
operates in accordance with the particular system of governing - political regime, which is a
complex of different methods of implementing political power. In this part of the work we will
discuss the main methods of governing – the main political regimes.
Totalitarian political regime - a system of strictly centralized administration, in which the
government is involved in all spheres of society, including daily life of citizens. This political
regime can be characterized by the following features:
• Presence of ideology that encompasses all aspects of life for achieving the ultimate
goal.
• Presence of a single party, led by a dictator.
• Monopolization of the whole state system by the single party.
• Systematic suppression of dissent, through the implementation of physical and
psychological terror.

Authoritarian political regime is a system of governing, characterized by strong

concentration of political power in the hands of the governing authority, which is not responsible to
the citizens. This political regime can be characterized by the following features:
• The power is personified and concentrated in the hands of one person or a small
group of people.
• A low level of social mobilization and no possibility for citizens to participation in
the political system.
• Absence of "rule of law".
• Failure to respect the civil rights and a low level of tolerance for oppositional
activities.
• No electoral competition and the use of the method of co-option for choosing the
composition of governing bodies.
• Limited intervention of the government in non-political spheres.

Democratic political system - a system of government in which the supreme power is resides
in the people and implemented by governing bodies elected by the people. Democracy is not
synonymous with freedom: it is the institutionalization of freedom. The democratic regime - is not

17
just a set of specific governmental institutions: primarily it is based on the fundamental values that
are expressed in different ways in different societies. This political regime includes the following
main features:
• Separation of state power into three branches - legislative, executive and judicial.
• Decentralization of management functions.
• Protection of fundamental human rights such as freedom of speech and religion;
right to equal protection by the law, as well as availability for citizens to fully
participate in political, economic and cultural life of society.
• Regularly hold free and fair elections for citizens of voting age. In a democratic
society citizens have not only a right but also a duty to participate in the political
system, which, in turn, is designed to protect their rights and freedoms.
• Constitutionalism and the rule of law.

Democratic regime with a strong institutional environment can be called a liberal

democracy. Under liberal democracy government especially ensure strict fulfillment of the terms of
contracts between economic agents, guarantees property rights of citizens as well as legal and fair
trial. Therefore, countries with democratic political regime appear to be most attractive to foreign
investors, as this system of governing minimizes uncertainty and gives confidence in the future for
investors.
1.5.2. Legal Systems

Democracy also encourages strengthening and development of the legal system, which is the
fundamental institution for regulating relations between members of society and between economic
actors. The leading authority of a country functions in a society with the help of legal system, which
is a set of coordinated, interrelated and coherent legal means. The legal system forms the legal
framework and judicial system, which ensures fulfillment of terms of contracts and agreements
between economic agents. The three major legal systems worldwide are based on French or civil
law system), English or common law system and German law, which is close to the Scandinavian
law system.
• Civil law system is based on a comprehensive and precisely structured system of laws,
which are summarized in the Code. These codes are the foundation for doing business.
• Common law system, which is also referred to as "case law", is based on previous
adjudications from similar cases. However, if the court decides that the considered dispute is
fundamentally different from all previous cases, judges must pass legislation that will be a
18
 precedent for future courts in similar cases. Thus, courts play an important role in the law-
interpretation in common law.
• The Austro-German system is different from other legal systems because of especially high
degree of property rights protection: many of the buildings in the cities of Germany, Austria
or Switzerland are owned by the same family for centuries. Effective institutional
environment for protecting property rights is one of the most important factors ensuring
intensive economic development of the German legal system.
1.5.3. Institution of Property Rights

From an institutional point of view, the core of any effective market economy is private
property and the consequent property rights, as well as the institute for protecting these rights. In its
turn, property rights protection is guaranteed by the judicial system because it is the court that
settles disputes arising from the violation of property rights.
Institution of property rights is a key factor for economic development. The effective
operation of this institution is fundamental for improving the investment climate, because high
degree of property rights’ protection reduces the uncertainty and risks for foreign investors, giving
them confidence in the future. In its turn, the economic significance of the degree of property rights’
protection has been a research -subject for many theoretical and empirical studies.
In the study by Harold Demsetz (Demsetz, 1967) the author defines property rights as a
special instrument of society, which helps us to form expectations about our dealings with others.
The author claims that improvement of efficiency of resource exploitation mainly depends on the
level of property rights protection over those resources and the fruits of their use. With law level of
property right protection there are no incentives to increase efficiency, as the results obtained from
the exploitation of resources and the resources themselves can be assigned to other individuals
without appropriate compensation. Thus, specification of property rights strengthens the
relationship between the actions of economic agents and their level of well-being, which in turn,
encourages efficiency of doing business.
As a result of analyzing a wide range of cross-country, data Jacob Svensson (Svensson,
1998) reveals a strong positive correlation between the level of property rights protection and
economic growth. This relationship was also revealed in the works by Robert Barro (Barro, 1997);
Stephen Knack (Knack et al., 1997) and others. Later, Daniel Kaufman (Kaufmann et al., 1999)
conducted an analysis of more detailed and adjusted data and confirmed the findings of above-
mentioned researches about the significance of property rights protection in economic development
of a country. Another interesting study is the researched by Demirguc-Kunt (Demirguc-Kunt et
19
al., 1998), in which the author reveals a positive correlation between a high degree of property
rights protection and the growth of investments in physical and financial assets.
Hence, the results of researches considered above show that one of the key factors for
sustainable economic development as a whole and for creation of a favorable investment climate in
particular, is the high degree of property rights protection. Therefore, the primary task now is a
clear definition of property rights protection and the identification of effective methods for
improving the reliability of this institution.
Institute of property rights is mainly characterized by a degree of exclusivity, understood as
excluding the possibility for other actors to interfere in any actions on the use of property item. The
degree of property rights protection is characterized by a number of existing obstacles for
implementing any actions by one entity regarding the property owned by another entity. The
definition of such obstacles is carried out in the process of specification of property rights. There is
also a phenomenon opposite to the specification, which is called the erosion of property rights. The
process of "erosion" is a deliberate distortion of various components of the specified property rights
by introducing numerous inconsistencies. Both the function of the specifications and the process of
erosion is carried out by the mass guarantor of property rights protection - the government. There
are numerous historical examples of property rights erosion, the causes of which are investigated in
the work of Douglass North (North, 1990). According to the author, the governors introduced
numerous inconsistencies in the specification of property rights in order to protect influential voters’
interests.
Erosion of property rights is a convenient way for government budget replenishment, but
only in the short term. The low level of property rights protection increases the risks of doing
business and increases the degree of uncertainty for economic agents, thereby reducing the
incentives for investment activities, which, in its turn, is reflected in the state's ability to replenish
its budgetary resources in the future. Thus, the most difficult task is to ensure the protection of
property rights from violations by the state, as this constitutive party can issue laws, in reference to
which it is possible to legalize the seizure of private property. However, the erosion of property
rights may be conducted not only in the interests of the state as a whole, but also on the part of
some government officials who are willing to use their rank and duty position for improving their
financial well-being.

1.5.4. Judicial System

Independent Judicial System is an essential condition for the effectiveness and fairness of
judicial decisions, hence the most effective mean to ensure the protection of property rights against 20
unauthorized actions on the part of the State or by individuals or groups, which have a certain
influence. Given the fact, that property rights may be violated by representatives of executive and
legislative branches of government, it is independent and effective judicial system that can
effectively perform the functions of property rights protection. However, with the increase in the
degree of independence of judicial system it is also required to strengthen the accountability of
judges before the law and society as a whole.
As a result of analyzing a wide range of cross-country data, Stefan Voigt (Voigt, 2005)
revealed a positive correlation between accountability of judicial system and economic growth in
the country. This relationship has been also revealed in the scientific study by Wolfgang Köhling
(Köhling, 2000). Based on the results of empirical analysis described above, we can conclude that
increasing the level of independence of judicial system and strengthening the accountability of
judges is in the best interest of the state. The reason is that it contributes to economic growth of a
country, which means an increase in tax revenues and as a result state budget revenue. However,
this conclusion is valid only if the increase in tax revenues resulted from increasing the efficiency
of the judicial system would exceed the benefits of rent-seeking by public officials as a result of
dependence of judiciary system from executive branch
1.5.5. Institution of Contract Enforcement

Government's ability to assure contract enforcement is one of the main institutional factors
that contribute to the economic development by stimulating investment activity. Within the scope of
scientific research by Andrew Stone (Stone et al, 1992) the author has carried out a survey among
the citizens of Brazil, in which respondents indicated ineffective contract enforcement as one of the
main factors undermining the incentives for creation and expansion of businesses in the country.
Douglass North (North, 1990) in his work argues that the inability of societies to develop effective
contract enforcement with low-cost over the observance of the contract is the most important factor
for stagnation in the past and one of the main reasons for low level of development in modern
“third-world” countries. Thus, effective contract enforcement is a key element of ensuring
sustainable economic development: the effectiveness of this institution reduces the risks of doing
business in a country and, therefore, contributes to creation of a favorable investment climate.
Low level of development of above-mentioned institutions leads to increased transaction
costs, which in its turn causes the spread of corruption. Corruption is one of the major factors that
have a disastrous influence on the quality of investment climate, as it increases the costs and risks
of doing business.

21
 1.5.6. Corruption as a main factor, distorting institutional environment.

In the study by Bergan (Bardhan, 1997), the author considers the additional costs of foreign
investors in the form of bribes to obtain licenses or permits for investment, as a tax on profits, as
these costs reduce the expected return on investment. The author also mentions that corruption
increases the uncertainty and risk for foreign investors, because the conditions of corruption
agreement have no coercive power by the law. The results of research conducted by OSCE have
shown that doing business in corrupted environments can cost investors about 4 percent of their
total costs, and four per cent is a significant factor that can affect investment decision.
In the study by Ali Al-Sadiq (Al-Sadig, 2009), as a result of analyzing a wide range of
cross-country data the author reveals a negative correlation between the level of corruption and the
FDI inflow in a country: corruption-increase by 1 unit leads to reduction in FDI inflows per capita
by 11 percent. Thus, corruption leads to distortion of market relations. Meanwhile, these distortions
lead to a situation in which any attempts to implement economic reforms (for increasing economic
efficiency of a country) become destructive and negatively effect the economic development and
welfare of the population. Hence, a major step towards the creation of a favorable investment
climate and, as a consequence, the rational development of the economy is improving the quality of
the institutional environment and eradicating corruption, which is a "rust", interfering effective
performance of institutes.
For identifying the relationship between the quality of the institutional environment and FDI
inflow into the country, the central task is the correct assessment of quality of considered
institutions. During the empirical analysis it is very important to take into account the close
relationship between the various indicators of institutional quality and endogenous nature of
institutions.
Qualitative assessment of institutional environment is quite subjective and chiefly based on
judgments, as it is quite impossible to objectively calculate such institutional indicators as the level
of corruption; the degree of property rights protection and etc. Furthermore, the error in qualitative
assessment of the main institutional indicators, distort the real picture of their impact on the studied
variables. Thus, to ensure the correctness of the results of our empirical analysis, we use various
sets of institutional quality indicators. This approach also allows setting a degree of sensitivity of
the results to the considered indicators.
To assess the level of development of legal institutions, as well as to assess the level of
corruption we will use figures presented in the studies by Kaufmann (Kaufmann et al., 2005); La
Porta (La Porta et al., 1998), as well as indicators presented in the "Index of Economic Freedom".
For assessing the quality of regulatory institutions we will use of the most recognized investment 22
ratings - the report of the World Bank and the International Finance Corporation (IFC) “Doing
Business”, which conducts comparative analysis of legal acts, promoting or prohibiting economic
activities in a county.
The main qualitative indicators of institutional development
Indicators, considered in the research by Kaufmann

Measures the probability of destabilization or overthrow of the

Political Stability and
national government by unconstitutional means, as well as
Absence of Violence
through the use of violence (including terrorism)

The index is calculated based on the quality of public services;

effectiveness of the state apparatus; the degree of independence
Government
of the civil service from political pressures, and the
Effectiveness
trustworthiness of government policy
Captures perceptions of state's ability to formulate and apply
sound policies and regulations that encourage private sector
Regulatory Quality development. Captures the perception of
property rights protection, quality of contract enforcement, police
and courts as well as the likelihood of crime and violence in the
country.
Rule of Law
Control of Corruption (CC) – measures the extent to which
public power is used for personal advantage, including both petty
and grand forms of corruption, as well as "capture" of the state by
Control of Corruption
elites and private interests.
Indicators, considered in the research by La Porta

It determines the degree of legal protection of private property

Property Rights Protection
Index
Index of Business Regulation
and the possibility of expropriation of private property by the
government. Specifies the complexity of
starting and doing business in as country, and the effectiveness of
government in the process of business regulation.

It measures the degree of perception of corruption in the public

Corruption Perception Index
sector

By analyzing the main institutional factors that are of the most interest from the point of
view of this work, we obtained theoretical proof that the quality of institutional environment
influences the country's ability to attract FDI. In the next chapter we will try to find out a practical
confirmation of our hypothesis.

23
 CHAPTER 2. RECENT TRENDS IN FDI FLOWS &
MACROECONOMIC AND INSTITUTIONAL MECHANISMS FOR
THEIR ATTRACTION

2.1. International tendency in FDI flows before and after the global financial crisis

From the second half of 20th century world community entered a new era – era of globalization.
One of the most conspicuous manifestations of globalization process is economic globalization, which
refers to an increasing interdependence of world economies and presents a new qualitative level of
forming an integrated economic space. Escalation of economic globalization in the last decade was
mainly due to a significant advancement of science and technology, which has notably decreased
communication and transportation costs, hence, reducing the cost of foreign trade and investment and,
as a result, making it possible to organize global production.
Figure 2.1.1 Growth rates of World Trade Turnover and Global FDI
flows, 1991-2014 (per cent)
80%

60%

40%

20%

0%
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

-20%

-40%

-60%
Growth Rate of WTT Growth Rate of FDI flows

Source: Calculations are done by the author, based on the initial data from
UNCTAD <www.unctad.org>

The most prominent motors of economic globalization are intensification of international

trade and growth of international capital flow, which can be viewed as two inseparable sides of the
coin. Moreover, even though international trade has a major role in the global market, it is worth
mentioning that recently multinational companies have mainly internalized their production through
flows of FDI: the latter has higher growth rate than the expansion of global trade in the last decade
(see Figure 2.1.1). High rates of FDI growth are mainly linked to the companies’ desire to increase
efficiency by geographic expansion of their operations and strengthening their position in the world
market.
24
 The first sharp decline in FDI flows over the last score occurred in 2001: as a result of drop
of inward FDI by 51 per cent and outward FDI by 55 per cent, nominal FDI inflow and outflow
amounted in $684 billion and $584 billion respectively. This fall of capital flows reflects
deterioration of the global economy, resulted mainly from a significant decline in economic activity
of major industrial economies and falling stock markets (three largest economies in the world fell
into recession in 2011). Event on 9/11 have worsened already existing economic slowdown.
Furthermore, global flows of FDI continued to decline for the next two years. Reasons for this
falling trend were not only above-mentioned macro-economical factors but also institutional
factors, such as winding down of the privatization process in many developing countries as well as
wave of big corporate scandals and demise of some major corporations, resulting in loss of trust by
foreign investors. Developed world bore the brunt of investment slow-down: inflow of FDI in EU
decreased by 64 per cent, FDI inflows to Developed America – by 50 per cent, while in Africa there
was a notable increase in FDI attraction. The sharp decrease in global FDI flows during 2001
mainly reverberates a slow-down in cross-border M&As, which is, in turn, conditional to economic
recession and reduced profits in developed world.
After a three-year continual downturn in global capital flows, in 2004 world FDI inflow and
outflow increased by 24 per cent ($ 682 billion) and 67 per cent ($ 887 billion) respectively, mainly
due to a notable increase in inward FDI flows to developing countries. Since 2004, the number of
companies from emerging market economies in the total number of cross-border corporations began
to grow rapidly.
After 3 successive years of increase, global FDI flows reached their historical high in 2007,
when inward FDI amounted to $1,871 billion, increasing by 34 per cent and outward FDI - $2,129
billion, increasing by 58 per cent. It is worth mentioning that nominal inward FDI was surpassing
the previous record of global FDI inflow set in 2000 by some $500 billion. As a matter of fact
global financial crisis did not affect FDI flows in 2007, since all the three major geographical
regions – developed economies, developing economies and transition economies – registered
historical high of both inflows and outflows. However developed world was the major recipient of
FDI, with $1,254 billion inward FDI in virtue of increase by 34 per cent. As a result the share of
developing economies in global FDI inflows decreased from 29 per cent to 27 per cent.
Notable increase in FDI flows was mainly due to high economic growth and intensification
of corporative activities in many regions. Reinvested earnings amounted to one third of global FDI
inflows, which was associated with a significant increase in profits of overseas affiliates (accounted
for more than $1,000 billion), operating in developing countries. Although historical high level of
global FDI to a certain degree is related to the depreciation of the dollar against other major
25
currencies (the difference was especially noticeable in EU, as in 2007 dollar was at a historical low
against euro), the increase in FDI during that year is still a record even measured in local currencies.
However it is worth mentioning that as a result of dollar-depreciation and thereby reduced investment
costs in the US, United States became more attractive for the European investors. Dollar-depreciation
made exporting to the US less economically advantageous because of sales-slowdown; hence some
large export oriented companies extended local production in the USA.
Intensification of cross-border merges and acquisitions also significantly contributed to the
rapid increase in global FDI flows in 2007: the value of global cross border M&As exceeded the
record level of 2000 by 21% and accounted for more than $ 1.600 billion, while their number was
10,145. During the second half of 2007 some major agreements were signed, including the $98
billion purchase of ABNAMRO Holding NV by the consortium of Royal Bank of Scotland, Fortis
and Santander (which is considered as a biggest deal in banking history), as well as purchase of
1
Alcan (Canada) by Rio Tinto (United Kingdom).
Figure 2.1.2 Inflow of FDI by Region, 2000-2014 (Million of dollars)
900000
Million
800000

700000

600000

500000

400000

300000

200000

100000

0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

EU Developed America Developing Asia South America Africa

Source: UNCTAD <www.unctad.org>

If in 2007 global financial crisis (which began with the subprime mortgage crisis in the
USA) had a limited influence on FDI, then during the next year, global investment market suffered
significant deterioration. Economic recession combined with the reduction of credits and notable
decrease in revenues of TNCs in developing countries, caused a drop in global FDI flows in 2008:
both inward and outward FDI fall by some 20 per cent, amounting to $1,489 billion and $ 1,693
billion respectively. The global financial crisis has also influenced the geographical distribution of

1 United Nations Conference on Trade and Development: World Investment Report 2008/ Transitional Corporations
and the Infrastructure Challenge, United Nations, New York and Geneva, 2008
26
foreign direct investment. As expected developed world has borne the brunt of FDI decrease, as the
global financial crisis started in developed economies: inward FDI to developed countries fall by 37
per cent, as a conscience of significant reduction in FDI inflow to the UK, France, Germany and
Italy (see Figure 2.1.2.). In the first half of 2008 crisis had a limited negative influence on
developing countries, which can be associated with the fact that financial system in developing
world in relatively less connected with the US and European banking system. However in the
second half of the year financial crisis penetrated also those countries, resulting in 30 per cent
decrease in overall FDI inflow in 2008.
The influence of financial crisis on global FDI flows continued also in 2009: the inward FDI
fall by 20% and outward FDI – by 34. This decline was mainly associated with 34 per cent fall in
cross-border M&As. Another interesting fact is that in 2009 FDI inflow to Africa declined by 19%
after a decade of continual growth. This decline was mainly because of a noticeable drop in
commodity prices. Global FDI flows started to recover in 2010. Inward FDI increased by 12%
accounting for $1,328 billion, however it was still well below the pre-crisis level. Meanwhile, the
increase in outward FDI was by 24 per cent, amounting to $ 1,366 billion.
In 2011 global FDI flows registered significant increase, regardless the continued slowdown
in global economy and ongoing debt crises, and surpassed the average level in pre-crisis period.
FDI inflows increased by 17 per cent amounting to $ 1564 billion, and the outflows rose by 16 per
cent accounting for $1587 billion. However global FDI flows were still significantly below their
historical high, registered in 2007.
In 2011 there was an increase in global FDI flows around all major country-groups:
developed, developing and transition. FDI inflow to developed world increased by 29 per cent and
amounted to $ 828 billion, however the recorded level of inward FDI was still significantly below
the late pre-crisis average. Developing countries had a 10 per cent increase in inward FDI ($ 639
billion). The highest growth was recorded in transition countries: FDI inflows rose by 23 per cent
accounting for $ 97 billion. These rise of FDI in developing and transition world in conditions of
economic slowdown shows that the role of those countries in global economy is becoming stronger
and more dynamic. FDI flows to Africa continued to decline also during that year.
The upward trend in global FDI flows during 2011 is mainly associated with increased
incomes of TNCs, cross-border M&As and comparatively higher economic growth in developing
world. As a result of 50 per cent increase, resulted from a significant upturn in the number of
megadeals, the value of cross border M&As overpassed $500 billion. This favorable picture is

27
 mainly associated with the growth of assets’ value in the stock market and increased financial
means of buyers. 2
However, the upward trend of FDI flows did not last for long: in the following year 2012
FDI flows fell significantly: inward FDI dropped by 10 per cent ($ 1403 billion), outward FDI – by
19 per cent ($ 1283 billion). Even though the situation improved in 2013, nevertheless the rise in
FDI flows was still very limited: 4.5 per cent and 1,7 percent increase in inward and outward FDI
respectively.
Figure 2.1.3 Nominal FDI inflow and annual average growth rate of GDP in the world and main economic regions, 1995-2014
(Millions of dollars and percentage)
Million World % Million Developed countries %
1400000 5
2000000 5
1200000 4
1800000 4
1600000 3
3
1000000 2
2 800000 1
1400000

1200000

1000000 1 0
600000
800000 0 -1
600000 -1 400000 -2
400000 200000 -3
200000 -2 -4
0 -3 0 -5
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

FDI inflow GDP growth rate FDI inflow GDP growth rate

Million Transi3on countries % Million Developing countries %

140000 10 800000 9
120000 8 700000 8

100000 6 7
600000
4 6
500000
80000 2 5
400000
60000 0 4
300000
40000 -2 3
200000
-4
20000 2

-6 100000 1

0 -8 0 0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

FDI inflow GDP growth rate FDI inflow GDP growth rate

Source: UNCTAD <www.unctad.org>

The overall picture of global FDI flows in 2014 was the following: outward FDI had a
modest increase by 3,7 per cent ($ 1354 billion), while inward FDI decreased by 16 per cent and
accounted for $1,226 billion. This was mainly associated with the weakness of the world economy,
increased policy uncertainly for doing business abroad as well as increased geopolitical risks for
foreign investors.

2 United Nations Conference on Trade and Development: World Investment Report 2012/ Towards a New Generation
of Investment Policies, United Nations, New York and Geneva, 2012
28
 Although global FDI flows were in unchanging positive relationship with global GDP
growth rate for a long term, however in 2014 inward FDI fell contrary to average GDP growth by
2,4 per cent. Nevertheless, the relationship between foreign direct investment and economic growth
is not identical in all main economic-groups. The relationship is positive in developed world, but
not that stable in developing economies (see Figure 2.1.3). The reason for this variation is that
economic cycle spread more rapidly across developed world. In transition countries the relationship
between these indicators is even more diverse. As we can see from the figure, unlike dynamic of
GDP growth, trend of FDI flows to transition countries was mainly upturn since the start of
liberalization in early 90th until global economic crisis. This is mainly associated with the fact that
those countries were out of global FDI flows for very long period and, as a matter of fact, after
liberalization they had to “catch up”.
Figure 2.1.4 FDI Inflows by main group of countries, 1990-2014 (Million of dollars)

2000000
Million 1800000
1600000
1400000
1200000
1000000
800000
600000
400000
200000
0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Developed countries Developing Countries Transi?on Countries

Source: UNCTAD <www.unctad.org>

The global FDI trend in 2014 varies in different regions of the world. FDI inflow to
developed countries dropped by 28 per cent and amounted to $498 billion. The decline in developed
world was in contrast to rise in cross-border M&As and was mainly reflecting single large-scale
divestment from The USA.3 However the biggest decline was recorded in transition economies –
inward FDI to this region fall by 51 per cent and accounted for $ 48 billion. Downturn trend in FDI
flows to transition economies was mainly because of geopolitical conflicts in the region and
sanction, which significantly discouraged new foreign investors. Thus,

3 United Nations Conference on Trade and Development: World Investment Report 2015/ Reforming International
Investment Governance, United Nations, New York and Geneva, 2015
29
FDI flows to the Russian Federation dropped by 70 per cent and amounted to $ 20 billion (this fall can
be partially viewed as a correction from Rosneft –BP mega transaction in 2013) (see Figure 2.1.5).
Meanwhile FDI inflow to developing world overpass the record level of 2013 by 1,5 per cent and
registered new historical high level for the region. Therefore, by virtue of regional variation of capital
flows, FDI flows to developed world for the first time amounted to 55 per cent of the
global total in 2014 (see Figure 2.1.4).
Figure 2.1.5 FDI flows to CIS and Russian During 2014 a drop by 14 per cent was
Federation registered in FDI flows to Latin America.
Million
120000
However, Central America has borne the
100000 brunt of this decline – FDI flaws fall by 35
80000
per cent amounting to $40 billion. This
60000

40000 significant drop can be viewed as a return to

20000
average values of inward FDI after
0
uncommonly high level reached in the
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014

CIS Russian Federa<on

previous year, resulted from a cross-border
mega deal in Mexico. South America also
Source: UNCTAD <www.unctad.org
registered a drop in FDI flows, which was
comparably small – 4 per cent. Five main FDI recipient countries of the region were Brazil, Chile,
Mexico Colombia and Peru: except Chile, all the other 4 registered a decline in inward FDI in 2014.
Although Brazil remains the main target for foreign investors in Latin America, inflows to the
country declined by 2, 3 per cent and accounted for $ 62,5 billion. Drop in FDI flows was mainly
associated with a 57 per cent decrease in primary sector and very limited increase in manufacturing
(5 per cent) and service (18 per cent) sectors. Main FDI recipient sectors were commerce,
telecommunication, oil and gas extraction and motor vehicles. The second main FDI recipient
country in the region was Chile, with an increase by 38,4 per cent, FDI inflows to the country
amounted to $23 billion. As mentioned above, this increase was in contrary to the FDI fall in other
main host economies in the region, and was mainly a reflection of thrice increase in cross-border
M&A sales. Chile also became the main donor of FDI: foreign direct investment outflow increased
by 71 per cent (due to a strong rise in intracompany loans) and amounted to $13 billion.
Against the background of decreasing FDI in Latin America, FDI flows to Africa remained
relatively flat in 2014, amounting to $ 54 billion. This trend is resulted from 15 per cent decrease in
FDI flows to North Africa, and 5 per cent increase in Sub-Saharan Africa. The main recipient
countries in the region were South Africa, Congo, Mozambique, Egypt and Nigeria. The highest
percentage increase was in Congo - 88 per cent to 5,5 billion. Another top host country, which
30
registered increase was Egypt: inward FDI to the country increased by 14 per cent and amounted to
4,8 billion. This was mainly a reflection of increased investments in oil and construction projects.
Ebola, regional conflicts and prices on raw material negatively affected FDI flows to West Africa:
the region registered a drop in investment flows by 10 per cent. There were also several cases when
companies freeze their business activities and operation in the countries which were worst affected
by Ebola: Africa Minerals closed a flagship mine Tonkolili in Sierra Leone, ArcelorMittal
postponed expansion. The main investors to Africa in 2014 were China and India.
FDI flows to East and South-East Asia increased by 9,6 percent, making it the main
recipient region of FDI in the world. Furthermore, it is ought to be mention that this happened
against the background of economic slowdown in the region. The top recipient countries in asia
were China, Hon Kong, Singapore, Thailand and Indonesia. China was also the largest FDI
recipient in the whole world, surpassing The USA. The country recorded increase in inward FDI by
3,7 per cent to $128,5 billion, which was mainly a reflection of increased FDI in service sector.
However FDI dropped in manufacturing service, as a result of increase in labor cost. During 2014
China started receiving 30 per cent more investments from the Republic of Korea and EU, however
there was a drop of 40 per cent in investments from Japan and drop of 20 per cent in investments
from United States.
Figure 2.1.6 FDI flows to the EU, 2000-2014 (Million of dollars and per cent)
Growth Rate of FDI in the EU % Million Flows of Nominal FDI in the EU
2014 -2 1400000
-23
2013 -10 1200000
2012 -39 -9
-18 1000000
2011 13
24
2010 -8 30 800000
-53
2009 27 600000
2008 -37
-61 400000
2007 49 81
23 200000
2006
19 53
2005 128 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
-100 -50 0 50 100 150

FDI ou@low FDI inflow FDI inflow FDI ouAlow

Source: UNCTAD <www.unctad.org>

The downward trend (negative dynamic) of FDI flows to developed countries, especially to
the European Union is contrasting against the background of a steady increase in FDI flows to
developing world. Thus, inward foreign direct investments in the EU fall by 23% while outward
FDI remained relatively flat, amounting to $257 billion and $269 billion respectively (see Figure
2.1.6). Majority of the EU countries registered a significant drop in inward FDI. The drop was
31
especially prominent for the largest FDI recipients of 2013, namely Belgium (-121%), Ireland (-
79%), and France (-64%). Furthermore, worth of mentioning is that some of the top FDI home
economies in 2014 were those that registered negative value of inward FDI in the previous year,
namely Finland and Switzerland.
United Kingdom was the number one destination for FDI inflows in the EU during 2014
(see Figure 2.1.7). The country has supported a record-breaking number of 1988 Foreign Direct
Investment projects resulted from an increase of 12 per cent. As a result UK created more jobs
through FDI than any other country in Europe (almost 85,000 new jobs were created by FDI
projects recorded in 2014/15)4. The inward FDI stock in UK amounted to $1662 billion making the
country a leader in Europe. According to United Nations Conference on Trade and Development
(UNCTAD), FDI inflows to UK have increased by 51 percent during 2014, against the background
of 16 per cent decrease in the value of global inward FDI.
Figure 2.1.7 Main FDI recipients and Donors in the EU, 2013-2014 (Million of dollars)

Main FDI recipients in the EU Main FDI donors in the EU

Germany
United
Kingdom
Netherlands France
Spain Netherlands

Finland Ireland

Frnace Spain

Poland Italy

Italy Sweden

Sweden Denmark

Malta Belgium

Portugal Million Austria Million

0 50000 100000 150000

-20000 0 20000 40000 60000 80000
2014 2013 2014 2013

Source: UNCTAD <www.unctad.org>

Thus, in 2014 there was a decline in global FDI flows, and the figure was well below the
pre-crisis level. Against the background of a steady increase in foreign direct investment flows to
emerging market economies, the negative dynamic of FDI flows to developed world and transition

4UK Trade & Investment: UKTI Inward Investment Report 2014 to 2015 (Online Viewing), 2015
32
countries is highlighted by contrast. After China opened its doors to foreign trade and foreign
investment in 1978, the country became the largest recipient of FDI among developing countries.
And in 2014 China also became the largest recipient of foreign direct investment in the world,
outstripping The USA, which, in turn, registered a 40 per cent drop in inward FDI ($92 billion) (see
Figure 2.1.8). This notable downturn was mostly a reflection of Vodafone’s $130 billion divestment
of its Verizon Wireless stake. Inward FDI flows to China has grown by 3,7 per cent, amounting to
$128,5 billion. This situation reflects an increase in service sector, which now has a share of 55 per
cent, superseding the share of all time leader - manufacturing sector. In 2014 country’s main
investment partners were Republic of Korea, European Union, Japan and the United States,
however inflow from the 2 latter ones declined by 39 per cent and 20 per cent respectively. The
second largest recipient of FDI in 2014 was Hong Kong, with an increased by 39 per cent.
Singapore and mainland China had a significant contribution in this notable growth: Singapore’s
Temasek Holding purchased 25 per cent stake in A.S Watson Co. at $5.7billion, OCBC Bank from
Singapore purchased Wing Hang Bank at $4,8 billion, COFCO Corporation from China purchased
5
51 per cent stake in Noble Agri Limited at $4 billion.
Figure 2.1.8 10 largest FDI recipients in the world in 2014 (Million of dollars & per cent)
Million
%
140000 40
120000 35

100000 30
25
80000
20
60000
15
40000
10
20000 5

0 0

China China, United United Brazil Canada Australia India

Hong Kong States Kingdom Singapore Netherlands
SAR
... FDI inflow in Developing Countries FDI inflow in Developed Countries FDI inflow as a % of GDP

Source: UNCTAD <www.unctad.org

The Unites States remained the main FDI investor country in 2014. The value of outward FDI
from the country increased by 2,7 per cent and amounted to $337 billion. Outflows from developed
world are mainly reinvested earning, when more than 50 per cent of outward investment from emerging
economies were in equity. Four out of 10 largest FDI home countries were emerging economies: Hong
Kong, China, the Russian Federation and Singapore (see Figure 2.1.9). The

5 United Nations Conference on Trade and Development: World Investment Report 2015/ Reforming International
Investment Governance, United Nations, New York and Geneva, 2015
33
growth of FDI outflows from China has an impressive speed: a positive trend of growth was not
affected even by the global economic crisis. This impressive dynamic of FDI outflows is mostly
associated with a shortage of natural resources, particularly oil, iron ore and aluminum. As a result,
China must establish trade relations with such countries as Australia, the Russia Federation, Brazil,
etc. to ensure continuous supply of raw materials.
Figure 2.1.9. 10 largest FDI investors in the world in 2014 (Million of dollars & per cent)
Million
%
400000 25
350000
20
300000

250000
15
200000 10
150000

100000
5
50000

0 0

United China, China Japan Russian Canada France Ireland

States Hong Kong Germany Federa<on Netherlands Singapore
SAR
... FDI ouDlow in Developing Countries FDI ouDlow in Developed Countries FDI ouDlow as a % of GDP

Source: UNCTAD <www.unctad.org

Further dynamics of global flows of foreign direct investment is conjugated to a variety of

uncertainties. Global FDI flows are expected to grow due to economic recovery in the USA,
demand-stimulation (resulted from decreased oil prices) as well as favorable monetary policy and
ongoing liberalization of investment policy in various countries. Nevertheless, expected recovery of
the global investment market may be prevented by a number of economical and political risks, such
as continuing uncertainties in the EU, potential spillovers from geopolitical tensions, and persistent
vulnerabilities in emerging economies.

2.2 Market size as a key factor influencing FDI inflow

According to John Dunning (Dunning, 1993) one of the key factors, influencing foreign
investors’ investment decision is market size, since most companies make foreign direct
investments in the search for new market opportunities (market seeking investments). In this case a
company’s investment purpose is to exploit the possibilities granted by greater dimensions of the
market. However, in addition to a market size, market seeking investor should also have some other
motivations for making a foreign investment instead of simply exporting produced goods to a
certain market. Some of those motivations are: to follow suppliers or customers that have built
34
foreign production facilities, to adapt goods to local needs or tastes and to save the cost of serving a
market from distance. Nowadays it is also significant to have a physical presence in the serving
market, for inhibiting other competitors from dominating that market.
In the score of this thesis a regression analysis was conducted to identify the relationship
between FDI net inflow and market size. We chose nominal GDP for characterizing market size.
Our dependent variable – FDI net inflow, and independent variable – Nominal GDP are presented in
billion $. For the econometric analysis we have used the average value of these indicators from
2011-2013, in order to reduce the volatility present in the data for each year and for each country.
The results of the analysis are presented below (see figure 2.2.1)
Figure 2.2.1 The relationship between nominal Gross Domestic Product (GDP) and FDI net inflow
(FDI_NET)
300
FDI_NET = 0,0164 GDP + 2,6668
y = 0,0164x + 2,6668
250
R² = 0,88688 Main indicators of Regression
FDI Net Inflow / Billion USD

200
R-squared 0.886

Adjusted R-squared 0.886

150
P-value 0.000
100
Included observations 161
50

0 2000 4000 6000 8000 10000 12000 14000 16000 18000

Gross Domestic Product / Billion USD

The result of conducted simple linear regression analysis with the use of least squares
method has shown that the relationship between nominal Gross Domestic Product (GDP) and FDI
net inflow (FDI_NET) is very strong. R squared is 0,886, which means that 88,6 % of variation in
the dependent variable FDI_NET can be explained by the independent variable - nominal GDP.
According to the regression model a change in nominal GDP by 1 unit will change the FDI_NET by
0,0164 units (FDI and GDP are presented in billion USD). The regression is done with a
significance level of 5% (Confidence level 95%). The p-value of independent variable nominal
GDP is 3,83001E-77, which is smaller than 0.05, hence the independent variable is significant for
the regression results.

35
 2.3 Cross-country analysis of the impact of institutional factors on inward FDI flows

In this section of the thesis we conducted empirical study, which demonstrates the
relationship between the quality of an institutional environment and a country's ability to attract
foreign direct investment. In particular, a cross-country econometric analysis was carried out for
identifying the relationship between institutional factors and FDI flows based on data from the last
few years (average data for the years 2011,2012,2013) on about 150 countries.
The description of the most popular and highly apprised indicators of institutional
development (all of them were used to characterize the quality of institutional environment in South
Caucasus in the third Chapter) is presented below. Majority of this indicators are used in the
econometric analysis conducted in this section of the thesis.
I. Worldwide Governance Indicators - WGI, are calculated from1996 based on studies
conducted by the World Bank and the Brookings Institution. Development of these
indicators was mainly initiated by Daniel Kaufmann, who defines governance as the
traditions and institutions by which authority in a country is exercised for the common
6
good. Within the scope of WGI the authors present six different aspects of public
administration, which are reflected in six aggregate indicators. This section examines five
WGI indicators, which are of greatest interest from the perspective of this thesis:
1. Political stability and absence of violence;
2. Government Effectiveness;
3. Regulatory Quality;
4. Rule of Law;
5. Control of Corruption.
Calculation of above-presented aggregate indicators for measuring the quality of governance
is based on a broad set of input data and represents a statistical generalization of survey
results of individuals, businesses, non-governmental organizations and etc. It will be
observed that WGI indicators take on a value approximately in the interval of -2.5 to 2.5:

the higher the value of the indicator, the higher the quality of public administration.7
II. Index of Economic Freedom is calculated and published from 1995 by an American
research and educational institution “The Heritage Foundation” in cooperation with Wall
Street Journal. This composite indicator consists of 10 components that are estimating
accomplishments and progress of 184 countries in various spheres of economy.

6
Kaufmann, D. “Myths and Realities of Governance and Corruption”, World bank, 2005
7
The Worldwide Governance Indicators (WGI) project <info.worldbank.org>
36
 Econometric analysis was conducted in reliance on the four following indicators of
economic freedom, which are of most interest from the perspective of this thesis:
1. Business Freedom;
2. Investment Freedom;
3. Property Rights;
4. Freedom from Corruption.
Initial data for calculating different indicators of economic freedom are various dummy
variables, such as the presence or absence of a specific law, official statistical data as well as
expert estimation by various organizations. All indicators of Economic Freedom take on a
value in the interval of (0 – 100), with 100 being the highest score (0-repressed; 100-free).
III. Corruption Perception Index - CPI has been published since 1995 by the international
research center “Transparency International”, covering 174 countries in the framework of
the "Global Corruption Report". The index is compiled on the basis of summarized survey
results of different groups of respondents: entrepreneurs who are resident in the considered
country; entrepreneurs who are not residents of the considered country; as well as groups of
experts - non-residents. CPI score takes on a value in the interval of (0-100), where 0
presents the highest degree of corruption, and 100 - the virtual absence of corruption.
IV. International Property Rights Index - IPRI is a special project of “Property Rights
Alliance” in cooperation with Americans for Tax Reform Foundation, covering 129
countries. The aggregated property rights index is based on the evaluation of three different
aspects of property rights: legal and political environment; protection of physical property;
protection of intellectual property. IPRI takes on a value in the interval from 0 to 10: the
higher the index value is, the higher is the level of property rights protection.
V. Indicators presented in the study “Doing Business”, which has been elaborated by the
World Bank and the International Finance Corporation (IFC) since 2003, and represents the
costs and risks associated with business activities, based on an analysis of a country’s
current legislation. Within the scope of “Doing Business” countries are ranked from 1 to 189
(with first place being the best) according to the degree of favor of regulatory environment
to business operations. Higher rank means that the regulatory environment in the country is
conducive to business activities.
VI. Judicial Independence is calculated and published by the World Economic Forum for
around 120 countries within the scope of annual report “The Global Competitiveness
Report”. This index shows how independent is the judicial system of a country from
37
 influences of the government, individuals, or companies and takes a value on a scale from 1 to 7,
where 7 represents entirely independent judicial system, and 1 – not independent at all.
Furthermore, for cross-country analysis we used statistical data on FDI flows, published by the
World Bank (World Development Indicators). In particular, for conducting regressing analysis
we have used net inflows of foreign direct investment, calculated in billion USD (FDI, net inflow).
This indicator is very useful for distinguishing the ability of a particular economy to attract more
FDI than it generates. For the econometric analysis we have used the average value of considered
variables for 2011-2013, in order to reduce the volatility present in the data for each year and for
each country. It is not possible to add more than one institutional variable to the regression because
of the presence of multicollinearity between institutional indicators.
Political Stability
As mentioned in the first chapter of this thesis the fundamental institutional component for
the efficient functioning of any state is a form of political system, which, in turn, is a set of
institutions; groups with common interests (political parties, public organizations, etc.); set of
established norms and rules that define the constitutional status of the government. One of the main
characteristics of political system is stability, which enables political system to function effectively
and progress under the influence of various exogenous and endogenous factors, while retaining its
structure and ability to control the processes of social change. This indicator can be measured by
Political Stability Index, which measures the probability of destabilization or overthrow of the
national government by unconstitutional means, as well as through the use of violence (including
terrorism).
Figure 2.3.1 The relationship between Political Stability (POL_STAB) and FDI net inflow
(FDI_NET)
90 FDI_NET = 3,5914 POL_STAB + 8,3481
y = 3,5914x + 8,3481 80

R² = 0,04207
70
Main indicators of Regression
60 R-squared 0.042
FDI Net
Inflow 50 Adjusted R-squared 0.034
40 P-value 0.02
30 Included observations 125
20

10

-3 -2,5 -2 -1,5 -1 -0,5 0 0,5 1 1,5 2

-10
Political Stability

38
 The result of conducted regression analysis with the use of least squares method has shown
that the relationship between Political Stability Index (POL_STAB) and FDI net inflow (FDI_NET)
is small in importance (see figure 2.3.1). Nevertheless, the results of the regression analysis were, to
some extent, expected, since indicator of political stability is a poorly predictable category. This is
also evidenced by the events of recent years, when a wave of "The Arab Spring" in a few months
has changes political leadership of several Islamic countries, which were considered politically
stable.
However, here I would like to present an alternative point of view, in particular, an
interesting study by The World Bank, which was conducted in 53 countries in order to identify the
main investment climate constraints for 26000 firm operating in developing world (see Figure
2.3.2). Survey results have shown that one of the key factors affecting a country’s investment
attractiveness is political stability: if a foreign company is not confident in the safety of their
employees and their property, it will not believe in the safety of their investments.
Figure 2.3.2 Ranking of the main investment climate constraints according to 26000 firms in
53 developing countries (per cent of firms reporting)

Poli%cal Uncertainty
Macroeconomic Instability

Tax Rate

Corrup%on

Cost and Access to Finance

Crime

Tax Administra%on

Skills %
0 10 20 30 40 50 60 70 80 90

Severe Obstacle Major Obstacle Moderate Obstacle Minor Obstacle

Source: World Bank Investment Climate Survey

Government Effectiveness
For a more in-depth analysis it is necessary to consider other indicators, characterizing the
system of government, in particular, its quality. Government Effectiveness Index is calculated
based on the quality of public services; effectiveness of the state apparatus; the degree of
independence of the civil service from political pressures, and the degree of credibility to the state
policy.
39
 The regression analysis in figure 2.3.3 shows that there is a fairly stable relationship
between the indicator of Government Effectiveness (GOV_EFF) and FDI inflows (R squared =
0.65; P-value =0.00). In addition, the best-fit curve for this case is polynomial. The relationship
between considered dependent variable and independent variable is presented by the following

polynomial equation: y=6,5586*x2 + 6,9873*x + 1,88. This indicator is one of the key factors
influencing the investment decision, as it is the quality of the public services and efficiency of the
state apparatus that mostly influence the size of the burden of foreign investors’ transaction costs in
the context of consuming public services as a public good.
Figure 2.3.3: The relationship between Government Effectiveness Index (GOV_EFF) and FDI net
inflow (FDI_NET)
60
y = 6,5586x2 + 6,9873x + 1,88
R² = 0,65007 50 2
FDI_NET = 6,5586*Gov_Ef +6,9873*Gov_Ef+1,88
FDI Net Inflow / Billion USD

40 Main indicators of Regression

30 R squared 0.650

Adjusted R squared 0.643

20 P- value (x) 0.000
10
P-value (x2) 0,000
Included observations 110
0
-2 -1,5 -1 -0,5 0 0,5 1 1,5 2 2,5
Govenrment Efectiveness

Regulatory Quality
Another indicator, characterizing the efficiency of public administration in a country is the
Regulatory Quality Index, which describes the degree of state intervention in the financial system,
amount of control of foreign trade, as well as the complexity of creating and doing business.

Results of Multiple Regression For identifying the influence of Regulatory Quality on FDI
Multiple R 0,964 net inflow, we conducted a multivariable regression analysis,
R-Square 0,910 between the dependant variable FDI net inflow and 2
Adjusted R-Square 0,908
independent variable, which are GDP nominal – x1 (as GDP
P-value (x1) 0,00
has the strongest influence on the FDI inflow) and
P-value (x2) 0,00
Exponential of Regulatory quality – x2 (initially conducted
Intercept -0,561
pair regression analysis between dependant FDI and
Coefficient (x1) 0,0156
independent Regulatory Quality has shown that the best
Coefficient (x2) 2,2564
relationship between these variables is obtained using the
Observations 126
exponential of the independent variable). We cannot add
40
 more institutional variables to the analysis, as there is a muticollinearity between the variables. As
we can see from the table of conducted multiple regression results, there is a fairy strong
relationship between variables as R-Square and adjusted R-Square are high: all the independent
variables in the equation together (GDP and Regulatory Quality) explain the variance in the values
of dependant variable FDI by 90 per cent (Adjusted R-square = 0,90). In the table of regression

results, we can see that both independent variable x1 (GDP) and independent variable x2
(Regulatory Quality) are significant because both of their values are 0.000 (<0.05). The regression
formula is the following:

y = -0,561 + 0,015*GDP + 2,256*EXP (Regulatory Quality)

FDI is affected in a linear way by GDP, by a factor of 0.015. That means that by a change of 1
billion in the GDP, the FDI will be increased by 0.015 billion USD, while holding other predictor in
the model constant. Analysing the second part of the regression model, there is an exponential
relationship between FDI and the regulatory quality measurement. The increase in FDI can be
represented by 2.25 times the exponential of the regulatory quality value.
Control of Corruption
Another indicator for describing the effectiveness of public administration and the quality of
management of the economy is Control of Corruption Index, which captures perceptions of the
extent to which public power is exercised for private gain, including both petty and grand forms of
corruption, as well as "capture" of the state by elites and private interests. As other governance
indicators, Control of Corruption takes values from approximately -2.5 to 2.5, with higher values
corresponding to better governance (in this case, better control of corruption).
Figure 2.3.4 The relationship between Control of Corruption (C_CORR) and FDI net inflow
(FDI_NET)
80 2
y = 7,4818x + 9,9487x + 4,3024
2
70 R² = 0,83672 FDI_NET = 7,4818*C_Corr +9,9487*C_Corr+4,3024
FDI Net Inflow / Billion USD

60
Main indicators of regression
50

40
R squared 0.836
30
Adjusted R squared 0.833
20
P-value (x) 0.000
10
P-value (x2) 0.000
0
Included observations 110
-2 -1,5 -1 -0,5 0 0,5 1 1,5 2 2,5
Control of Corruption

41
 As shown in figure 2.3.4, there is a strong (R Squared=0,836) and statistically significant (P
value < 0,05) polynomial relationship between Control of Corruption index (C_CORR) and FDI net

inflows, presented by the formula y = 7,4818*x2 + 9,9487*x + 4,3024. According to the coefficients
of the regression, Control of Corruption has a stronger influence on FDI than Governance
effectiveness (the regression formula for the latter is presented above).
Rule of Law
High level of political corruption also means that there is a high risk of failure of existing
rules and laws or premeditated action or omission by government officials for personal (group)
gain. This can be reflected by Rule of Law, which, in turn, is an integrated indicator that combines
the degree of property rights protection; independence of the judiciary, and the government's ability
to assure contract enforcement.
Another conducted econometric analysis has shown that there is a high correlation between
the Rule of Law (ROLL) and Control of Corruption indexes (C_CORR) - the higher Corruption
Control is, the better is Rule of Law (see figure 2.3.5).
Figure 2.3.5 The relationship between Rule of Law (ROL) and Control of
Corruption (C_CORR)
2,5
2
y = 0,9235x + 0,0187
R² = 0,91214 ROL = 0,9235 C_CORR + 0,0187
1,5

1
Rule Main indicators of regression
of 0,5
R squared 0.912
Law
0
-2
Adjusted R squared 0.911
-1,5 -1 -0,5 0 0,5 1 1,5 2 2,5 3
-0,5
P-value 0.000
-1
Included observations 121
-1,5
-2

Control of Corruption

In turn, the results of regression analysis between FDI net inflow and rule of Law (see figure
2
2.3.6) have shown that Rule of Law also has a fairy important for attracting FDI: R =50%, which
means that 50 % of variation in the dependent variable FDI_NET can be explained by the
independent variable – Rule of Law. The p – value is 0.00, hence the independent variable ROL is
statistically significant.

42
 Figure 2.3.6 The relationship between Rule of Law (ROL) and FDI net inflow (FDI_NET)

80
70 FDI_NET = 10,854*ROL + 7,956
y = 10,854x + 7,956
R² = 0,50174 60
FDI Main indicators of regression
50
Net
40
R squared 0.501
Inflow
/ 30 Adjusted R squared 0.496
Billion P-value 0.000
20
USD
10 Included observations 115
0

-2 -1,5 -1 -0,5 0 0,5 1 1,5 2 2,5

-10
-20

Rule of Law

Property Rights Protection

Another aspect that characterizes the development of institutional environment in a country
is property rights protection.
Figure 2.3.7 The relationship between Protection of Property Rights (PPR) and FDI net inflow
(FDI_NET)
80
70 y = 10,078x - 31,996 FDI_NET = 10,078*PPR - 31,996
60 R² = 0,43493
FDI Net Inflow / Billion USD

50
40

30
Main indicators of regression
20
R squared 0.434
10

0 1 2 3 4 5 6
Adjusted R squared 0.429
0 7
-10
-20
P-value 0.000
Protection of Property Rights Included observations 111

Foreign investors always consider the likelihood of partial or full expropriation of property
(business), since weak property rights protection by a government significantly increases the
uncertainty and risks of investing, hence, undermining the incentives for making a positive
investment decision. In turn, the level of property rights protection for various countries can be
measured with a component of Global Competitiveness Index - Property Rights, which takes a
value in the scale from 1 to 7, where 1 – property rights are poorly defined and not protected, 7 –
are clearly defined and well protected by law. The results of our analysis have shown that Protection
2
of Property Rights has a fairy important for attracting FDI: R =43%, which means that
43
43 % of variation in the dependent variable FDI_NET can be explained by the independent variable
– Protection of Property Rights, and 43% is fairy high for a single institutional factor. The p – value
is 0.00, hence the independent variable PPR is significant (see figure 2.3.7)

Judicial Independence
For identifying the influence of Judicial on FDI net inflow, we conducted a multivariable
regression analysis, between the dependant variable FDI net inflow and 2 independent variables,
which are again GDP nominal – x1 (as GDP has the strongest influence on the FDI inflow) and

Judicial independence8 – x2, As we can see from the table of conducted multiple regression results,
R-Square and adjusted R-Square are fairy high: all the independent variables in the equation
together (GDP and Judicial Independence) explain the variance in the values of dependant variable
FDI by 89 per cent (Adjusted R-square = 0,89). In the table of regression results, we can see that
both independent variable x1 (GDP) and independent variable x2 (Judicial Independence) are
significant because both of their values are 0.000 (<0.05). The regression formula is the following:
y = -4,273 + 0,015*GDP + 1,941* Jud_Independence

Results of Multiple Regression FDI is affected in a linear way by GDP, by a factor of 0.015.
Multiple R 0,948 That means that by a change of 1 billion in the GDP, the FDI
R-Square 0,899
will be increased by 0.015 billion USD, while holding other
Adjusted R-Square 0,898
predictor in the model constant. Analysing the second part of
P-value (x1) 0,00
0,00
the regression model, there is a linear relationship between
P-value (x2)
Intercept -4,273 FDI and the Judicial Independence. The increase in FDI can

0,0159 be represented by 1,94 times the Judicial Independence value.

Coefficient (x1)

Coefficient (x2) 1,9410 Summing up, it can be observed that indicators,

Observations 126 characterizing the quality of institutional environment, among

other factors, have a significant impact on the fundamental

mechanisms and areas for attracting foreign direct investment.

In the next chapter we will review the main characteristics of FDI flows to South Caucasus,
with a focus on Armenia, analyze the institutional environment in the region and present feasible
directions for improving the quality of fundamental institutional determinants of the investment
climate of Armenia.

8 Is the judiciary in your country independent from political influences of members of government, citizens, or firms? (1
= no, heavily influenced, 7 = yes, entirely independent)
44
 CHAPTER 3. ANALYSIS OF FDI FLOWS AND INSTITUTIONAL
ENVIRONMENT IN SOUTH CAUCASUS (WITH A FOCUS ON ARMENIA)

3.1. Armenia as a recipient of foreign direct investment in the international capital market.

South Caucasus (Armenia, Georgia, Azerbaijan) can be considered as a strategic crossroad

and natural bridge between Europe and Asia, because of its geopolitical and geo-economical
position as an energy transport corridor from the East to the West, surrounded by three regional
powers: Russia, Iran and Turkey. Against the background of weakening political stability in Russia,
the geopolitical importance of South Caucasus is increasing. Some quick facts about the main
macroeconomic indicators in the region during year 2014 are presented below (see table 3.1.1).

Table 3.1.1 Quick facts about main macroeconomic indicators of South Caucasus in 2014

•Population -3 mln •Population - 4,5 mln •Population - 9,5 mln

•GDP - $ 10,8 bln •GDP
PPP - $ 24,2 bln •GDP per
cap.(PPP) - $ 8077 •GDP
growth - 3,4%
•Unemployment - 16,2%
•Inflation (CPI)- 3%
•FDI inflow - $404 mln
•GDP - $ 16,5 bln
•GDP PPP - $ 34,1 bln
•GDP per cap.(PPP) - $ 7582
•GDP growth - 4,8%
•Unemployment - 14,3%
•Inflation (CPI) - 3,1%
•FDI inflow - $ 1.273 mln
•GDP - $75,1 bln
•GDP PPP - $ 167 bln
•GDP per cap.(PPP) - $ 17515
•GDP growth - 2%
•Unemployment- 5,5%
•Inflation (CPI) - 1,4%
•FDI inflow - $ 4.430 mln

Armenia Georgia Azerbaijan

Source: The World Bank <http://data.worldbank.org >

The region of South Caucasus is afflicted by some unsolved territorial conflicts such as
Nagorno-Karabakh conflict between Armenia and Azerbaijan and Abkhazia conflict in Georgia.
Nagorno-Karabakh war, started after the collapse of USSR until May 1994, was the most serious
conflict in the region in terms of human loss. And although there has been no major armed
encounter in South Caucasus since 1994, none of the above-mentioned territorial conflicts have
found or are close to finding a long-term solution. Meanwhile, the high risk of renewed violent 45
conflict in South Caucasus is significantly weakening political stability in the region making it less
attractive for foreign investors.
Republic of Armenia is the smallest country in South Caucasus. One of the main constraints
for Armenian economic growth is unfavorable geopolitical situation: because of Nagorno-Karabakh
conflict landlocked Armenia is in unilateral economic blockades imposed by two neighbor countries
- Turkey and Azerbaijan. After the Soviet Union collapse in 1991, Armenia became an independent
entity and faced severe complications of transitional economies. Nevertheless, as a result of
structural transformations and economic reforms, Armenian economy started recovering from the
middle of 90’s.
Small domestic market of 3 million people (see table
3.1.1) and economic blockades, imposed by two
neighbor countries, make landlocked Armenia, to
some extent, less attractive for certain foreign
investors, especially export-oriented investors, as they
are limited in access to a big part of regional market
with a population of about 83 million people
(population of Azerbaijan and Turkey). Hence, factors such as geopolitical situation, size of inner
market, abundance of natural recourses (which are undoubtedly having major influence on
investment decision-making process) cannot be changed in a short-term period, the importance of
high-quality institutional environment and favorable business climate is becoming much more
critical for Armenia in order to be competitive with neighbor countries in terms of attracting FDI.
Thus, in this section of the thesis we will try to analyze Armenia as a recipient of FDI and Armenian
legislation in the area of foreign investment.
Figure 3.1.1 Analysis of GDP nominal, GDP growth, GDP per cap., GDP per cap. growth in Armenia
Billion of $ % US$ %
14 20 9000 20
8000 15
12 15
7000
10 10 10
5 6000
8 5
5000
0 0
6 4000
-5 -5
4 3000
-10 2000 -10
2 -15 -15
1000
0 -20
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 0 -20
GDP nominal (Billion of dollars) GDP growth rate (annual %) 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
GDP per capita (S$) GDP per capita, PPP ( $) GDP per capita growth (annual %)

Source: The World Bank <http://data.worldbank.org >

46
 In 2008 Armenia reached the peak of its GDP growth together with reduction of external debt
and balanced budget. However, global financial crisis had a severe influence on the Armenian
economy. After almost a decade (from 1998 to 2008) of double-digit GDP growth, during 2009 the
country registered the highest GDP fall (14,1%) in the South Caucasus. GDP per capita decreased
by 13,8%. The dramatic drop of nominal GDP in 2009 was mainly a reflection of:

Ø Reduction in the private foreign transfers by about one third (from 2.2 Billion US$ in 2008
to 1.5 Billion US$ in 2009.
Ø 40% drop in FDI
Ø Reduction in foreign trade, especially in exports by 32.8%.
Nevertheless, after dramatic fall in 2009 Armenian economy started to recover, registering 3,4 per
cent growth in nominal GDP value - $10,8 billion. The primary driver of economic growth was
agricultural sector, which registered a double – digit growth of 15,5 percent. However economic
growth has a very limited influence on the high level of unemployment in the country – 16,2
percent in 2014 (see table 3.1.1). Continuously shrinking workforce (resulted from increasing
emigration), old-fashioned work skills and presence of a big informal sector significantly disrupt
further economic growth in Armenia. This problem, in turn, needs a complex approach. As
currently the majority of unemployed workers is taking root in outmoded work skills, better –
targeted educational programs and training (reforms in educational system) are needed for ensuring
that academic and training courses are matching the needs of labor market. The government should
promote the development of private sector for creating high-quality jobs and reducing
unemployment rate. However one of the most critical factors for boosting employment in Armenia
is improvement in investment and business climate for increasing inward FDI flows , which, among
with another positive benefits, will create many new job.
After independence, Armenia became a player in the global economy opening its doors for
international trade and capital flows. At the current stage of economic development Armenia is
facing a challenging task of entering a new level of competitive development, driven by global
economic trends and, in particular, by intensification of global capital flows. At this stage, the speed
and efficiency of further economic transformation in Armenia is mainly depending on the country’s
ability to attract more foreign capital in competitive sectors of national economy. Foreign direct
investment, in turn, is the top priority source of such capital, due to the positive benefits of FDI on a
recipient country’s national economy: FDI is not only financial inflow as it also promotes the
introduction of new technologies in the production process. Foreign direct investments provide the
transfer of knowledge, both in terms of labour training and accumulation of skills, as well as
through the introduction of alternative, high-quality methods of management and more efficient 47
organizational structures.
Intensification of inward FDI flows to Armenia means better access to new markets,
production of unique and high-demand products, creating of new jobs, as well as increase in
government revenues. Furthermore, FDI inflow has a positive impact on competition: the
forthcoming of new foreign companies in the national market breaks the existing balance in the
market. As a result, domestic firms have to increase their efficiency and productivity in order to be
able to meet the increased competition and do not lose their market share (see Chapter 1 – 1.1).
Thus, the intensification of FDI inflows is a key factor for long term development of
Armenian economy, primarily through the modernization of production systems, which, in turn,
will lead to reduction of inappropriate high imports and improvements of BoP. Determination of
main direction improving and adjusting current FDI policy in Armenia required in-depth analysis.
Thus, taking into account the above-mentioned, in this section we analyze the dynamics, the
structure and the nature of FDI inflows to Armenian economy, as well as we analyze Armenian
legislation in the area of foreign direct investments.
Figure 3.1.2 FDI stock nominal and % of GDP in CIS countries and Georgia in 2014

mill. $ %
400000 80
350000 70

300000 60

250000 50

200000 40

150000 30

100000 20

50000 10

0 0

Armenia Azerbaijan BelarusGeorgia Kazakhstan Kyrgyzstan Moldova RussiaTajikistan Turkmenistan Ukraine Uzbekistan
Inward FDI Stock (mill. $) Inward FDI Stock (% of GDP)

Source: UNCTAD <www.unctad.org

Armenia has accumulated $ 5,8 Billion of FDI stock until 2014. This makes it the 9th among 11
member countries of The Commonwealth of Independent States (CIS) and Georgia (see Figure 3.1.2).
The leader among the CIS countries, obviously are such large and well-resourced countries like the
Russian Federation, Kazakhstan and Ukraine: the volume of accumulated foreign direct investments of
these three countries in 2014 accounted for 85% of the overall FDI stock value in the CIS and Georgia.
Considering the FDI stock as a percentage of GDP, Armenia stands in a relatively good position trailing
just 2 CIS member countries (Turkmenistan and Kazakhstan) and Georgia.
48
The FDI stock as a percentage of GDP in Armenia increased from 52,22 % in 2013 to 53,60 % in
2014.
As Figure 3.1.3 shows, the first significant increase in FDI inflow to Armenia took place in
1998 when the national telephone company “ARMENTEL” was acquired by the Greek company
“OTE” and “Yerevan Brandy Company”(YBC) was purchased by the French company “Pernod
Ricard”. Also, in 1998 a maximum value of FDI inflow as a percentage of GDP was recorded
(11.7%) for the entire period of observation. Regarding privatization of YBC it is worth mentioning
that despite some difficulties encountered the deal was very successful for the country as business
relationships between farmers and the agricultural products buyers flourished: Farmers started
receiving considerable amount of money for grown grapes on time. Furthermore, this privatization
provides world-class knowledge transfer and accumulation of skills in cultivation and harvesting of
grapes leading to producing the best quality cognac.
Figure 3.1.3 Armenian inward FDI (nominal and % of GDP), 1997-2014

Million of $ %
1000 14
900 12
800
10
700
600 8
500
6
400
300 4
200 2
100
0 0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Inward FDI (million of dollars) Inward FDI (% of GDP)

Source: UNCTAD <www.unctad.org

Armenia joined WTO in 2003, which had a very favorable impact on the country’s
investment climate: before 2003 the tariff for Armenian good in transit through Georgia was 50 per
cent higher than the tariff for Azerbaijan, and WTO membership ended the discrimination toward
Armenia. The privatization process in 2002-2003 also considerable encouraged improvement of
investment climate in Armenia: by July 2003 7178 small and 1789 medium-sized and large
enterprises were privatized. As a result, Armenian inward FDI flows registered 57% growth during
2004. However recently there is a significant slowdown in the privatization process, mainly due to
the unattractiveness of the remaining assets.
49
 The historical high of inward FDI flows to Armenian was registered in 2008, amounting to
$935 million, and was mainly directed to the energy sector (Russia), telecommunication (France
and Russia) and transport (Argentina). However global economic crisis has a very negative
influence on FDI flows to the country: after the record level in 2008 the inward FDI flows were
continuously decreasing, amounting to $ 370 million in 2013 and $ 382 million in 2014.
In this part of the thesis I would firstly like to mention that the last available year in the
database of National Statistics Service of the Republic of Armenia (ARMSTAT) is 2013, hence the
analysis of the main foreign investors in Armenia as well as the analysis FDI flows by groups of
economic activities is conducted by the year 2013. Although foreign direct investments from France
fell by 56 per cent in 2013, the country remained as the largest foreign investor in Armenia - $ 99,1
million (32% of total FDI). French investments were mainly in telecommunications and beverage
industries. The second largest foreign investor was the Russian Federation: as a result of 20 per cent
decrease FDI inflows from Russia accounted to $72,4 million (23,7 % of total FDI). Russian
investments were mainly in energy and gas sector, telecommunications, sport and recreation
services. Table 3.1.2 shows that inward FDI flows from all the main investors notable fell in 2013:
flows from Argentina fell by 75 % and were entirely directed to the sphere of air transport, in
particular in the reconstruction of the International Airport “Zvartnots”. Investments from Germany
fell by 43,6 % and were mainly in mining industry.
Table 3.1.2 Main Foreign Direct Investors in Armenia, 2008-2013 (Million of dollars)

Total FDI 2008 2009 2010 2011 2012 2013

1 118 828 535 703 598 304,4
Russian Federation 735 399 201 357 90 72,4
France 84 197 146 115 230 99,1
Germany 24 19 22 25 50 28,2
United States 23 22 17 24 4 2,6
Cyprus 64 18 31 16 5 4,7
United Kingdom 1 - 4 11 14 10,5
Argentina 88 48 29 9 51 12,6
Luxembourg 7 2 5 5 3 1,4
Switzerland 4 9 12 8 44 10,2

The most attractive sector in Armenian economy for foreign investors is the sector of
telecommunications: 37% of inward FDI in 2013 was in telecommunications – $ 113 million. The
second most attractive field was Real Estate activity, which attracted 15% of inward FDI in 2013-in
absolute terms $ 45,9 million. A dramatic decline of 74% was recorded in the sector of electricity
and gas, which is also a reason of sharp decrease in overall FDI from Russia in 2013 (see Table 50
3.1.1): only $ 7,3million was invested in that sector which is just 2% of inward FDI in 2013 (see
Figure 3.1.4).
Summing up, FDI flows to Armenian economy have declined considerably during recent
years, mainly because of the global economic downturn. The graph in figure 3.1.4, which analyses
the main sectors, attracting FDI during 1988-2013, shows that the major sectors in Armenia are
either natural monopolies (electricity and gas – 21 % of total FDI stock) or oligopolistic markets
(telecommunications – 23 % of total FDI stock) or are connected with extraction and exploitation of
natural recourses (mining and quarrying – 9% of total FDI stock). The dynamics of FDI flows to
Armenia, in turn, depend on the policy pursued by Armenian government on foreign direct
investments. Thus, sustainable development of Armenian economy, in the context of balancing
financial inflows and outflows, mainly depends on the efficiency of foreign investment policy and
overall quality of institutional environment in Armenia.
Figure 3.1.4 Main sectors, attracting FDI in Armenia in 2013 and during 1988-2013
Mining and qarrying Mining and qarrying
2013 1988-2013
Mining support service 15% 9% Manuf-ing of beverages
9% 10%
3% 5% Manuf-ing of basic metal
Manuf-ing of beverages
15% 2%
9% Electricity, gas, steam 5% Electricity, gas, steam

Land transport Land transport

2%
4% 11% 21% Air transport
11% TelecommunicaEon
TelecommunicaFon

Financial service acEviEe Financial service acFviFes

Real estate acEviEes

6% Real estate acFviFes
37% 23% 3%
Other Other

Source: National Statistics Service of RA <www.armstat.am>

For identifying main trends in FDI regulation in Armenia, it is necessary to analyze the
current legislation in this area, since the weaknesses of legal system can significantly deprive the
country from possible FDI flows.
Armenian economy is largely dependent on foreign trade. Therefore, the Armenian
government (GOA) is targeting to effective interaction with the outside world and officially
welcomes foreign investments. Armenian investment and trade policy is relatively liberal: Armenia
has announced policy of “Open Doors” since 1994. The American Bar Association (ABA)
describes the law "On Foreign Investments" in Armenia as one of the most liberal in the transition
world. According to law “on foreign investment” foreign companies, operation in Armenia shall
have the same treatment as Armenian companies (the principle of national treatment).
Furthermore, foreign investors may have additional benefits conditional upon investing in key areas
51
of social and economic development of the country. Foreign companies can invest in any sector of
national economy and in various forms. So foreign investors may invest in Armenia through
creation of enterprises with 100 percent foreign participation; through the purchase of existing
enterprises or shares of the operating companies, as well as through the establishment of joint
ventures. Moreover, foreign investors, in cooperation with state-owned companies, can be engaged
in exploitation of mineral deposits in the case of execution of concession contract. Another
important fact is that foreign investments in the Republic of Armenia cannot be a subject to
nationalization. Also inapplicable is confiscation of foreign investments by the public authorities,
however confiscation can take place in some emergency conditions established by the legislation of
the Republic of Armenia or by a court decision and with full compensation. Profit of foreign
investors remains under their disposal after paying the taxes and other fees established by
legislation of Armenia. Foreign investors and foreign employees have every right and guarantees to
freely export their property, profits (revenue) and other means obtained as a result of investment
9
activities or as a payment for work performed or as a compensation discussed above.
In order to encourage FDI flows to Armenia, the republic's legislation provides certain
privileges and guarantees for foreign investors, including those described below:
v Foreign investors are protected from any changes (concerning business activity) in the
legislation of the Republic of Armenia for five years. So, in case of change in the area of
regulation of foreign investments, upon the request of a foreign investor, the legislation that
was the time of making investment should be administrated during 5 years.
v Foreign investors may benefit from "tax holidays", depending on the size of the
investments. This privilege is granted by the Law "On income tax" of the Republic of
Armenia. According to this law all foreign investments (made after 1998) amounting to
more that $1 million, are fully exempt from income tax for the first 2 years. Another
privileges for foreign investors is deferred payment or value added tax (VAT) for 1-3 years
for certain types of imported goods (used in the production process) amounting to more than
300 million AMD (this privilege is also for local investors).
v Foreign investors may also have a number of customs privileges. The property imported by
foreign investors as an authorized fund, raw materials, complementary parts, semi-finished
products and other means used for implementation of production process are exempt from
customs duties. The property of a foreign investor, imported to the territory of Armenia for
personal use of investor (or enterprise with foreign capital) is also exempt from custom
duties.
9The Law of the Republic of Armenia on foreign Investments, 1994

52
 Another important aspect of the legislation in terms of investment attractiveness of the
country is the procedure for the settlement of disputes. According to the Law of the RA "On
Foreign Investments" all disputes related to foreign investments, arising between foreign investors
and the Republic of Armenia should be resolved within the courts of the Republic of Armenia.
However, foreign investors from countries with which Armenia has signed bilateral agreements on
the protection and promotion of investment, have a right to use the international mechanisms for the
settlement of investment disputes. It ought to be noted that in 1992 Armenia became a member of
the International Center for Settlement of Investment Disputes (ICSID), which provides assistance
to member countries for arbitration proceedings.
However, along with a number of positive legislative aspects, there are factors that adversely
affect FDI inflows into the country. In particular, according to Article 31 of the Armenian
Constitution, foreign citizens don’t have a right of land ownership. This means that foreign
investors are de jure not the owners of the land on which their company operates and in which they
conduct their business. Even though there were no cases of expropriation of land from foreign
investor, impossibility of obtaining full ownership of the land, makes investment projects in
Armenia riskier for certain foreign investors.
In 1998 Armenian Development Agency (ADA) was created by GOA, in order to create
incentive mechanisms for FDI and export promotion. ADA operates according to the so-called
principle of "single window" for investors and exporters. The agency provides assistance to foreign
investors for implementation of investment projects and commercial activities in Armenia. ADA
also acts as an intermediary between foreign investors and the Government of the Republic of
Armenia, by providing the necessary information on investment opportunities in country and
legislation in the field of foreign investment.
Summing up, I would like to say that, undoubtedly, it is impossible to create a favorable
investment climate for foreign investors without having an adequate legislation on foreign
investment. However, liberal legislation is not yet sufficient for making an investment decision in
favor of a country: what matters more is the real application of this legislation in practice. In order
to be competitive with neighbor countries in terms of attracting FDI, Armenia should create more
favorable business climate than the neighbors have, which is not only liberal legislation but also
transparency and stability of the legal base. However, at the current stage Weak Rule of Law
undermines the credibility of Armenia, making country less attractive for foreign investors.
Furthermore, doing business in Armenia is becoming harder under the burdensome pressure of
excessive bureaucracy and a legal system that cannot quickly and fairly resolve disputes. Thus, the
government of the Republic of Armenia should create not only liberal legislation for foreign
53
investors, but also implement fundamental reforms for creating a favorable business environment
and developing high-quality institutional climate. The detailed analysis of the latter is conducted in
the next (final) part of the thesis.

3.2. Analysis of the institutional climate in South Caucasus with a focus on Armenia

The current stage of economic development in the world shows that foreign direct
investment (FDI) is one of the main factors for sustainable, high-quality and well-balanced
economic growth. The need to attract FDI is especially high for developing and transition countries,
as this type of investment promotes structural changes of the economy, allows to ensure sustainable
economic grows as well as allows the recipient-country to effectively integrate into the process of
globalization.
In this part of the thesis we will conduct in-depth analysis of institutional climate in
transitional region - South Caucasus, with a focus on Armenia, as Armenia’s investment climate
poses a number of fundamental challenges: small domestic market of 3 million people; landlocked
country, with a relative geographical isolation after blockades, imposed by neighbour Turkey and
Azerbaijan; lowest GDP per capita in the region of South Caucasus– $ 3619. These negative factors
of Armenian investment climate, obviously, undermine investment attractiveness of the country.
Hence, development of high-quality institutional environment in Armenia can become the country’s
very important competitive advantage in the region for FDI attraction.
It is ought to be mentioned that as a result of blockade almost 80 percent of the length of
Armenia’s borders is closed. Armenia has a small but significant border with Iran, however even more
important is the border with Georgia, since the main trade routes, connecting Armenia with the outside
world, pass through Georgia - more than 70 percent of Armenia’s foreign trade turnover. Iran cannot be
considered as a full-fledged alternative, because of insufficiently developed transport infrastructure, in
particular, undeveloped highways, absence of railway line and etc.
However economic blockade and other above-mentioned negative factors are, to some
extend, predestined and cannot be changed in a short-term or even long-term period. Nevertheless,
there are many other determinants of investment climate, which can be improved and, as a result,
can encourage intensification of FDI flows to the country. In particular, the Armenian government
should focus not only on development of adequate legal system, but most importantly, on ensuring
transparency and stability of that legal system. Foreign investors are responding not only to the
54
official policy, but above all, on the actual implementation of the policy, as absence of rule of law
can significantly increase transaction costs and risk of doing business in a country.
Therefor, in matter of Armenia's investment climate improvement, the factors analysed in
the first and second chapters of the thesis become paramount, namely: government effectiveness;
transparency and stability of legislation; "rule of law" reinforcement; contract enforcement,
property rights protection; reducing of bureaucratic acrimony (time consuming bureaucracy);
independence of judicial system; problem of corruption and etc. Fundamental improvement of these
factors can encourage Armenian investment attractiveness to a great extent.
With reference to the above mentioned, in this section of the thesis we will try to identify the
main problems of Armenia's institutional environment (in the context of South Caucasus), as well as
analyse the dynamics of institutional development in the region. For said purpose we use a wide
range of indicators of institutional quality assessment for having a holistic and internally conformal
picture of the institutional environment in Armenia and in other countries of South Caucasus. This
approach allows to adequately define the place of Armenia in the South Caucasus.
Political Stability & Absence of Violence
According to the World Bank estimates, the region of South Caucasus has relatively week
political stability. Armenia is the most politically stable country in the region, ranking 133rd out of
215 countries (see figure 3.2.1 and figure 3.2.2).
Figure 3.2.1 Political Stability in South Caucasus, 2004-2014

0.4
Weak ..............................
0.2
................Strong
0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
-0.2

-0.4

-0.6

-0.8

-1

-1.2

Armenia Georgia Azerbaijan

Source: Worldwide Governance Indicators <info.worldbank.org>

This means that the probability of destabilization or overthrow of the national government
by unconstitutional means, as well as through the use of violence (including terrorism) in Armenia
is considerably smaller than in other 2 neighbour-countries. However, it ought to be mentioned that
Armenia has significantly aggravated its position in comparison with the previous year: from a
55
positive estimation of 0.06 in 2014 to a negative -0,20. The most politically unstable country in the
region is Azerbaijan -152nd out of 215.
Figure 3.2.2 Political Stability percentile ranking10 for countries of South Caucasus (Armenia,
Georgia, Azerbaijan) in 2014
100- Strong

Armenia
37,86

Georgia
35,92

Political Stability
Azerbaijan
in South Caucasus 29,13

0-Weak

Source: Worldwide Governance Indicators <info.worldbank.org>

However, as noted in the section 2.2, political stability is a poorly predictable category. This
is evidenced by the events of recent years, when a wave of "The Arab Spring" in a few months has
changes political leadership of several Islamic countries, which were considered politically stable.
Another evidence is Ukraine: historically the country was considered relatively stable, however in

2014 Ukraine became one of the most politically unstable countries in the world, ranking 201 st out
of 215. Therefore, the impression of political stability in countries with low political competition
(or its absence) and with insufficiently developed democratic institutions is highly deceptive, and,
to a certain extent, stays outside the scope of this evaluation and our analysis.
Government Effectiveness
According to government effectiveness indicator, Armenia fell into 115th place in the overall
th
rankings among 215 countries, significantly yielding the positions of Georgia -60 place. As figure
3.2.3 demonstrates, until 2006 Armenian government was the most effective in the region but after 2006
the overall picture has been changed significantly. This situation is mainly a reflection of

10 Percentile ranks indicate the percentage of countries worldwide that rank lower than the indicated country,
so that higher values indicate better governance scores.
56
two facts: first, a practical brakeage and, to some extent, even a “reverse” in reformation of political
system and government in Armenia; second, acceleration of reforms in public sector in Georgia
after “the Revolution of Roses”, which significantly increased government effectiveness in the
country. As a result, Georgia took the palm of victory in the region for government effectiveness.

Figure 3.2.3 Government Effectiveness in South Caucasus, 2004-2014

0.8
Weak............................
0.6
..................Strong
0.4
0.2
0

-0.2 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

-0.4
-0.6
-0.8
-1

Armenia Georgia Azerbaijan

Source: Worldwide Governance Indicators <info.worldbank.org>

The legal and regulatory framework in Armenia is not sufficiently transparent. Largest
economic sectors in Armenia are controlled by a small amount of businessmen who have market
dominance and are protected by the state, hence, repressing free competition. The government of
the Republic of Armenia is using tax audits, financial investigations and various official mechanism
to retaliate against those businessmen who are on the side of political opposition. Therewith, the
government rewards political loyalism by political-protection and guarantees. Unequal taxation,
unequal application of customs and other unequal treatment from the government, in turn,
discourages investment initiatives and add uncertainly and risks for less politically-connected
businessmen. Hence, Armenia’s legislation and mandate of its competition authority are not
compatible with international standards. Furthermore, the legislation does not clearly define
11
violations of fair competition, dominant role, or prevention of competition violations.
During the last decade the estimation of government effectiveness in Armenia remain
constantly negative (except year 2013), indicating the low quality of public services; insufficient
effectiveness of the state apparatus; high degree of dependence of civil service from political
pressure (see figure 3.2.3). The negative estimation of government effectiveness in Armenia also

11Investment Climate Statement - Armenia, U.S. Department of State, BUREAU OF ECONOMIC AND BUSINESS
AFFAIRS, may 2015
57
demonstrates weak trustworthiness for government policy, regarding obligations for implementation
of government programs. This situation obviously creates distrust among foreign investors and
undermines incentives to invest in the country.
However, recently there has been a shift in understanding the importance of state
management improvement by the Government of the Republic of Armenia (GOA). In particular, in
recent years there has been a reduction of bureaucratization of the state apparatus, through
introducing elements of electronic government (e-Government). In 2010 Armenian government
introduced electronic document management system, which allows reducing paper work and time
spending significantly as well as improves the process of monitoring of different government
departments. Also from January 2012 an electronic system of state purchases was introduced, which
should encourage transparency in the government. Nevertheless, fundamental reforms are needed
for increasing government effectiveness in the country.
Regulatory Quality
The trend of Regulatory Quality indicator demonstrates that until 2007 Armenia had the
highest regulatory quality in the regions, significantly overpassing two neighboring countries.
However, starting from 2008 Georgia took the lead in the region. As a result, in 2014 Georgia has
th
the highest position in the overall ranking – 44 out of 215, Armenia ranks 86 and Azerbaijan is
121st, with estimations of 0,92; 0,21; -0,29 respectively (see figure 3.2.4).
Figure 3.2.4 Regulatory Quality in South Caucasus, 2004-2014

1.2
Weak...............................
1
...............Strong
0.8
0.6
0.4
0.2
0

-0.2 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
-0.4
-0.6
-0.8

Armenia Georgia Azerbaijan

Source: Worldwide Governance Indicators <info.worldbank.org>

Regardless the fact that over the last decade, Armenia has managed to improve Regulatory
Quality to some extent, the ability of GOA to fulfill some fundamental principles and norms of state
policy that will encourage the private sector development is yet weak. In turn, an active political
58
dialogue with the private sector, in particular, with foreign investors, will enables the government of the
country to understand and establish the procedure for the necessary reforms as well as to present the
progress of established policy implementation to the private sector and, as a result, establish
trustworthiness in the society. Thus, the cooperation of the government with the private sector is an
important factor for improving investment attractiveness of the country. However, there is still a need to
introduce the culture and realization of equal partnership of private and public sectors.
Rule of Law
Rule of Law is a fundamental component of a democratic society. For the UN, the
Secretary-General defines the rule of law as “a principle of governance in which all persons,
institutions and entities, public and private, including the State itself, are accountable to laws that
are publicly promulgated, equally enforced and independently adjudicated, and which are
consistent with international human rights norms and standards. It requires, as well, measures to
ensure adherence to the principles of supremacy of law, equality before the law, accountability to
the law, fairness in the application of the law, separation of powers, participation in decision-

making, legal certainty, avoidance of arbitrariness and procedural and legal transparency." 12
Figure 3.2.5 Rule of Law in South Caucasus, 2004-2014

0.4
Weak .................................
0.2
............Strong
0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
-0.2

-0.4

-0.6

-0.8

-1

Armenia Georgia Azerbaijan

Source: Worldwide Governance Indicators <info.worldbank.org>

According to the Rule of Law estimations by World Bank, in 2014 Armenia ranked 121
(with an estimation of - 0,32) among 215 countries, overpassing Azerbaijan (149/215) in the region.

And again Georgia has the best position in the region: 76 th in the overall ranking. The trend of Rule
of Law in Georgia is very impressing. This and other high ranks for institutional quality in Georgia
are due to fundamental institutional reforms, conducted in the country.
12 Report of the UN Secretary –General: The rule of law and transitional justice in conflict and post-

conflict societies.

59
 During the last decades, the rule of law in Armenia remains low, indicating a low degree of
trust and confidence in the practical implementation of existing laws, weak contract enforcement by
the government; "erosion" of property rights; low efficiency and high level of dependence of the
judicial system; a high probability of infringement of the rule of law and etc. Concerning is the fact
that recently Armenia was constantly worsening its positions in the rankings, however during 2013
and 2014 Armenia, to some extent, strengthened Rule of Law. In turn, «Rule of law» is one of the
most important factors affecting the investment climate, as it induces foreign investors about the
business environment, on the inviolability of "rules of the game", and finally it is rule of law that
gives investors confidence for the future.
Regarding the quality of policy implementation in Armenia, I would like to mention the
negative experience of an international gold mining company «Global Gold Corporation» (GGC),
which faced with great difficulties while doing business in Armenia. In 2003, a subsidiary Sha LLC
wholly owned by GGC received a license for gold mines exploitation in Hankavan and Marjan,
valid until 2017. However, after some time the Ministry of Environmental Protection of Armenia
had withdrawn the license for the development of two mines without any obvious reason. Gold
mining company, in turn, accused the Ministry of extortion and bribery and for expropriation of
acquired rights. This situation, in fact, significantly undermined the credibility of Armenia for
foreign investors.
Corruption
According to Corruption Control index in 2014 Armenia ranked 128th in the overall ranking
of 215 countries. At the beginning of observed period, Armenia and Georgia had approximately the
same level of corruption. However, dramatic reforms in Georgia resulted in significant decrease in

the level of corruption, making the country the leader in the region – 52 nd out of 215 countries in
the overall ranking (see figure 3.2.6).
Corruption is one of the most destructive factors hindering economic development and
creation of a favorable investment climate, as doing business in a corrupt environment significantly
increases investors’ both financial and time costs. Result of research carried out by the OSCE have
shown that doing business in a corrupt environment may cost investors 4 per cent of their total
costs, and this number is a big enough to affect investment decision.
Lack of transparency and high level of corruption in both public and commercial spheres
remain the main problems in Armenia’s institutional environment. Although some reforms were
introduced during recent years, such as reduction of bureaucracy through simplification of licensing
60
procedures, reforms in public administration, introduction of new criminal procedure code and anti-
corruption laws, however the progress in reduction of corruption remain very modest. According to Law
on Civil Service (2002), government officials cannot be involved in commercial activities. Nevertheless,
powerful government officials manage to avoid that law and have an indirect participation in private
sector (for example through close relatives). Furthermore, currently there are no criminal penalties for
noncompliance or filing of false declarations of ownership by government officials. As a result, largest
economic sectors in Armenia are controlled by a small amount of businessmen who have market
dominance and are protected by the state, hence, repressing free competition. This strong
interconnectivity between political and economic spheres encourages the creation of monopolies and
oligopolies and has a significant negative affect on Armenia investment attractiveness. Thus, high rates
of sustainable economic growth in Armenia cannot be possible without radical institutional reforms for
reducing corruption and market oligarchization.
Figure 3.2.6 Control of Corruption in South Caucasus, 2004-2014

Weak ............................
0.5
......Strong

0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

-0.5

-1

-1.5

Armenia Georgia Azerbaijan

Source: Worldwide Governance Indicators <info.worldbank.org>

Azerbaijan has a highest level of corruption in the region of South Caucasus. Results of
survey, conducted by 2013 Global Corruption Barometer have shown that 50 per cent of survey
respondents in Azerbaijan have provided a bride to at least for one out of the nine following public
services mention in the survey (during the 12 preceding month): Education, Judiciary, services
related with land, medical service, the police, registry and permit service, tax authorities and
13
utilities.
Dramatic policy and institutional reforms in Georgia after the Rose Revolution in 2003 has
resulted in very low-level of corruption in the country. During the leadership of president
Saakashvilli anti-corruption efforts resulted in the numerous arrests of government officials, a
13 The Global Corruption Barometer 2013, Transparancy International.

61
significant reduction of bureaucracy in public administration and etc. These positive changes
resulted in an increase of the state revenues by 250 per cent in 2004. The government of Georgia
transformed citizens’ service agencies into Public Service Halls, where various government services
are provided in one building. Bribery is criminalized in Georgia (Article 332-342). Penalties for
accepting a bride start from six years in prison and can lengthen to 15 years varying on the case.
Penalties for giving a bribe can include a fine, a minimum term of imprisonment of two years, or
both. According to results of 2015 Public Opinion Poll in Georgia, only 2 percent of the population
reported that they had to pay a bribe during the preceding year to receive a government service or
decision, which is a very high result for the region.
It ought to be mentioned that the trend of corruption control estimation for observed
countries is very similar with the trends of Rule of Law (see figure 3.2.5 and 3.2.6), evidencing
once again that there is a strong interrelation between these two key characteristics of institutional
quality.
According to Transparency International, which presents corruption perception index, the
th th th
ranking of Armenia, Georgia and Azerbaijan was respectively 94 , 50 and 126 in the overall
ranking among 175 countries for the year 2014. So Armenia and Azerbaijan are in the category of
highly corrupted countries, while Georgia has a much better position. Sector of Education and the
judiciary were considered as the most corrupted sectors in Armenia.
Below I would like to present some recommendations and mechanisms to fight corruption
from international experience, which can work in Armenia as well as in other two neighboring
countries:
Simplification of administrative procedures:
It is well known that excessive bureaucratization is a breeding ground for corruption, since
both bureaucrat and businessman/investor can have corruption temptation and intention if there are
delays or rejections concerning investment projects.
Establishment of an independent Judiciary
Establishment of an independent, well-paid and qualified judiciary is very critical for
ensuring the rule of law in a country. According to United Nations independent expert Gabriela
Knaul “The pervasiveness of corruption in the judiciary and the legal profession, whether one off or
endemic, is very worrying because it directly undermines the rule of law and the ability of the
judiciary to guarantee the protection of human rights. A judiciary that is not independent can easily
be corrupted or co-opted by interests other than those of applying the law in a fair and impartial
manner. Strengthening the judiciary from within, as well as providing all the safeguards for its
62
independence vis-à-vis other public officials and private actors, is essential in combating and
preventing instances of judicial corruption”.14
Increasing wages and professionalism of government officials
Government officials’ wages should be sufficiently high, so that they can resist the
temptation of corruption. The situation when government officials cannot achieve an adequate
standard of living with their wages almost inevitably leads to corruption. Nevertheless, increase in
wages is necessary but not sufficient condition for rooting out corruption. For this purpose,
government should also create an effective and transparent monitoring system. Another important
condition is inevitability of punishment in case of corruption schemes.
Figure 3.2.7 The quality of governance indicators in South Caucasus, 2014

Control of Corrup3on
1
0.8
0.6
0.4
0.2
0
Rule of Law -0.2 Government
-0.4 Efec3veness
-0.6
-0.8
-1

Regulatory Quality Poli3cal Stability

Armenia Georgia Azerbaijan

Source: Worldwide Governance Indicators <info.worldbank.org>

In order to evaluate the overall picture of the governance quality in South Caucasus, we
present 2014 estimation of all the above-discussed indicators compounded together (see figure
3.2.7). As we can see, Georgia is surpassing Armenia and Azerbaijan for almost all the indicators.
Azerbaijan, in turn, has the lowest governance quality in the region. Political Stability is the only
indicator by which Armenia is shooting ahead Georgia. Furthermore, the biggest gap between the
estimations for Armenia and Georgia is for Corruption Control, which once again shows that
institutional reforms in Georgia have resulted in almost rooting out the corruption. Weak Rule of
Law and Control of Corruption are the main problems of Armenian institutional quality, resulting in
undermining of country’s institutional attractiveness. Thus, the government of the Republic of

14 Gabriela Knaul, United Nations independent expert

63
Armenia should take actions for ensuring practical implementation of official policy of the
government as well as initiate serious measures for decreasing widespread corruption in the
country.
Property Rights Protection
Another important characteristic of institutional quality is the degree of property rights protection.
Strong institution of property rights is a valuable element for social and economic development in a
country. The American Convention on Human Rights states:
Everyone has the right to the use and enjoyment of his property. The law may subordinate
such use and enjoyment to the interest of society.
No one shall be deprived of his property except upon payment of just compensation, for
reasons of public utility or social interest, and in the cases and according to the forms
established by law.
Usury and any other form of exploitation of man by man shall be prohibited by law.

According to International Property Rights Index 2015, which takes on a value in the interval (0
weak-10 strong), countries of South Caucasus are characterized by a low degree of property rights
protection (see figure 3.2.9). Low level of property Rights protection, in turn, significantly increases
uncertainties and risk of doing business in the region, hence, negatively affecting investment
decisions. Although Armenia has relatively better position in the overall ranking than two
neighboring countries, the estimation of IPRI is still quite low.
Figure 3.2.8 Estimation of three components of International Figure 3.2.9 Overall IPRI estimation
Property Rights Index (IPRI), 2015 for South Caucasus, 2015
Azerbaijan 3.7 5.8 2.8

Georgia 4.9 5.7 2.2

Armenia 4.2 5.8 2.7

0 2 4 6 8 10 12 14

Legan and Poli;cal Environment

Physical Property Rights Protec;on

Intellectual Property Rights Protec;on

Source: International Property Rights Index 2015 <www.internationalpropertyrightsindex.org>

An egregious example of poor property rights protection in Armenia is an actual deprivation

of people's houses in "Northern Avenue" without adequate compensation (Northern Avenue is in
64
the center of Yerevan, and prices for wrecked houses were much higher that the compensation from
the government), for constructing new building in the same areas. Although the seizure of private
property by the government is one of the fundamental sovereign rights of the government, the aim
of deprivation of property should be obviously targeted to ensure the real interest of public, rather
than the narrow group interest of some oligarchs and government officials. Such a dismissive
attitude from the state towards property rights protection destroys the foundation of effective market
economy.
Economic Freedom
Another important factor that influence investment attractiveness of a country is economic
freedom, because in economically free society a foreign investor may freely perform business
processes and feel legally protected. According to the “Index of Economic Freedom”, published by
nd
the “Heritage Foundation” and “The Wall Street Journal”, Georgia is the 22 freest economy
among 178 countries with a score 73,0 (see Figure 3.2.11). Georgia’s overall economic freedom
score has increased by 0,4 point from the previous year, mainly as a result of improvement in
freedom from corruption, monetary freedom and the management of government spending that
outweigh a significant drop in labor freedom. Georgia’s score is well above the Europe region
average.
Figure 3.2.10 Estimation of 10 components of Index Figure 3.2.11 Overall score of IEF for
of Economic Freedom (IEF) for Armenia, 2015 Georgia, Armenia and Azerbaijan,
2015
Property
Rights
90 Freedom
Financial 80
from
Freedom 70
Corrup4on
60
50
Investment 40 Fiscal
30
Freedom 20 Freedom
10
00
Trade Gov't

Freedom Spending
Monetary Business

Freedom Freedom

Labor
Freedom

Source: Index of Economic Freedom 2015 <www.heritage.org>

nd rd
The position of Armenia in overall ranking is 52 and 23 out of 43 countries in the Europe
th
region. Armenia’s overall score has decreased by 1,8 points (the 8 largest decline in 2015 Index) since
previous year, which is mainly resulted from deterioration in property rights, labor freedom
65
and monetary freedom. And finally the position of Azerbaijan in the overall ranking is 85 th, making
Azerbaijan the least economically free country in the region of South Caucasus. There was a
significant decline in the management of public finance, investment freedom and trade freedom that
outweigh improvements in freedom from corruption and regulatory efficiency.
Due to a liberal regulatory framework, Armenia has a high ranking for many components of
2015 Index of Economic Freedom (Figure 3.2.10). Competitive taxation rates and simplification of
procedures related to business activities complement the impressively high level of fiscal freedom
and Business Freedom (see figure 3.2.10). The Armenian financial sector remains heavily
dominated by the banking sector, which comprises 21 private and one development bank,
15
accounting for 92 percent of financial sector assets. The banking sector in Armenia is very well
regulated. Another component of IEF where Armenia has a relatively high ranking is investment
freedom, which is based on an analysis of the legislative framework in the field of investment. The
only significant restriction toward foreign investors is that according to Article 31 of the Armenian
Constitution, foreign citizens don’t have a right of land ownership. However, the informal sector of
Armenian economy continued to grow. Thus, according to National Statistics Service of the
Republic of Armenia, organizations participating in the informal sector are accounting for 37, 8% of
the total number of operating organizations. And the share of employment in the informal sector is
52.1%, which is equivalent to 621.7 thousand informal jobs.
In recent years, the Government of the Republic of Armenia has implemented a number of
business reforms; in particular, the requirement for minimum amount of authorized capital for
starting a business has been canceled; licensing requirements has been significantly reduced as well
as bankruptcy procedure has been modernized.
Despite the fact that Armenia is well positioned in a number of areas, high levels of
corruption and weak property rights protection significantly undermine dynamic and sustainable
development of Armenian economy (see figure 3.2.10). The judicial system is quite week,
vulnerable to political interference and corrupted. Another concerning fact is that despite the
relatively law taxation rates, the number of tax evasion is increasing. Thus, the combination of a
weak property right protection and high level of corruption in Armenia undermine the ability of
country to take the full advantage of high level of investment and business freedom.
Summing up, improvement of economic freedom in the future will depend on the ability of
Armenia to carry out fundamental institutional reforms for rooting out corruption as well as
strengthen the judiciary and property rights protection. In turn, for improving property rights
protection it is not a sufficient measure to just legally define the purpose of property expropriation
15 Country Program Snapshot. World Bank Group – Armenian Partnership April 2015, World Bank Group.

66
by the government. The fact is that although the RA Law "On Alienation of property for public and
state needs," states that the confiscation of private property can only be justified by public needs,
the government of Armenia has serious problems in defining and establishing the boundaries of the
concept of "public needs".
Judicial Independence
The most effective means for ensuring property rights protection against unauthorized actions on
the part of the government, individuals or groups of individuals is development of independent
judiciary, as an essential condition for the effectiveness and fairness of court decisions.
Nevertheless, together with increasing the degree of judicial independence it is necessary to take
measures for strengthening the accountability of judges before the law and society as a whole.
Figure 3.2.12 Value of Judicial Independence, 2015 Figure 3.2.13 Position in Judicial
Independence overall ranking

4.14

2.96 3.16

Armenia Georgia Azerbaijan

Source: The Global Competitiveness Report 2015-2016 < gcr.weforum.org >

According to the Global Competitiveness Report 2015-2016, one of the main institutional
problems in Armenia is a weak judicial system. Armenia has the worst value in the region for
th
Judicial Independence, falling in 106 place in the overall ranking among 144 countries with a
value of 2.96 (see figures 3.2.12 and 3.2.13). A striking example of distrust towards Armenian
judicial system is the fact that foreign investors always highlighting the point of dispute resolution
in international arbitrations, when setting up a contract with local companies.
However, this approach cannot be a sufficient guarantee for property rights protection, as
many companies, which are registered in the Republic of Armenia, don’t have international offices,
or any foreign assets (to which legal sanctions could be applies), thus, a decision of international
court can basically become a “worthless piece of paper”.
Thus, creation of an independent and effective judicial system is a fundamental factor for
improving the investment climate in a country, as independent and effective judicial system can
67
effectively perform the functions of property rights protection from infringement by the executive
and legislative branches of government, which are often active violators of property rights,
especially in transitional countries. However, together with increasing the degree of judicial
independence it is necessary to take measures for strengthening the accountability of judges before
the law and society as a whole.
Monopolization
The current market situation in Armenia is characterized by a high concentration of
ownership and a high level of monopolization. This is a reflection of post Soviet economic
transformation, when competition is neglected as a key factor of economic and institutional
development. The privatization of state-owned assets in the early stages of the transition economy,
the breakup of the Soviet Union in which organizations were mainly interdependent, and the
absence of any legal framework for regulating competition, significantly influenced the
establishment and progression of Armenia’s competitive environment after becoming independent.
Market monopolization, in turn, limits price competition and free access to a certain production
sectors which are monopolized, hardens wealth polarization in society, negatively influencing both
the society and public production effectiveness.
According to the research conducted by the State Commission for the Protection of
Economic Competition, many markets in Armenia have a high level of concentration and only few
markets in different years had an average level of concentration. For example, the sugar market in
Armenia is almost 100 percent monopolized. Another example of monopolization in Armenia is
“ArmenTel” When the company was the only operator in the field of telecommunications, prices for
mobile phone cards and phone calls were extremely expensive. Furthermore, the quality of service
provided by the monopolist “ArmenTel” was very low. However, with an entrance of new operators
in the field of telecommunication, the priced sharply declined and the quality of
telecommunications improved significantly.
High level of monopolization in Armenia is a striking example of the fact that entwinement
of economic and political interests helps to keep monopolists’ status quo. In turn, unequal
conditions for market players, in other words, rules of game that don’t apply the all the players,
undermines incentives of foreign investors to invest in competitive sectors of Armenian economy.
However, analyzing the impact of monopolization of FDI attraction, we should also consider the
other side on the coin. Basically in certain cases the monopolization of the market may become a
sufficiently attractive prospect for some foreign investors. However, it ought to be mentioned that when
foreign investors invest in monopoly projects, they do not have any incentives for introducing effective
technologies in business operations and management, thus, the recipient country will not
68
have possible benefits from these kind of FDIs, as in such cases inflow of foreign direct investments
will not mean transfer of knowledge, technology and etc. A striking example is foreign investment in
natural monopolies, such as high-voltage network, gas and electricity, transport, and others.
Thus, ensuring a competitive environment for foreign companies is one of the most
important conditions for obtaining benefits from FDI inflow.
Ease of Doing Business
One of the most important factors for creating a favorable investment climate is fundamental
improvement of condition for opening and running a business.
According to Doing Business 2016 report (in which data are current as of June 2015),
Armenia ranked 35th among 189 countries, improving by 3 positions from the previous year. Once
again Georgia has the best position in the ranking in the region of South Caucasus: the country is

24th in the overall ranking. Whereas doing business in Azerbaijan is relatively difficult – 63th
position in the overall ranking. (see figure 3.2.14).
Figure 3.2.14 2016 Ease of Doing Business ranking for Armenia, Georgia and Azerbaijan
(overall ranking from 1 (easy) - 189 (difficult))

20

40

60

80

100

120

Armenia Georgia Azerbaijan

Source: Doing Business 2016: Measuring regulatory Quality and

Efficiency < www.doingbusiness.org>

According to Doing Business 2016, Armenia registered improvement in 3 areas: dealing

with construction permits (+10); trading across border (+29) and enforcing contracts (+8). This
radical improvement in trading across border is resulted from joining Eurasian Economic Union
69
(EEU), as EEU countries significantly simplified procedures between the members of the Union.
Hence, Armenia reduced time and financial costs for border procedures and documentation. The
required time for customs clearance reduced from 50 hours to 3 hours.
Armenia has the lowest position in the region of South Caucasus for 2 indicators of Doing
Business: Protecting Minority Investors and Paying Taxes. Thus, according to Doing Business
2016, the number of hours required for the preparation and submission of tax returns as well as the
number of hours needed to calculate tax payments (VAT, corporate income, social contributions and
etc.) is amounted to 313 hours per year. The same indicator in Azerbaijan, for example, is
accounting for 195 hours per year. In turn, a lot of time needed for preparation and submission of
tax returns can significantly reduce the productivity of employees and result in increase of staff,
hence increasing the overall cost of doing business.
The highest deterioration in Armenia was registered for the indicator “Getting Credits”,
which explores two sets of issues—the strength of credit reporting systems and the effectiveness of
collateral and bankruptcy laws in facilitating lending. (-6 positions). According to the 2016 Doing
Business report, Armenia's ranking for this indicator is 42, Azerbaijan -109 and Georgia – 7.
Nevertheless, it ought to be mentioned that despite relatively high position for many
indicators, Doing Business ranking, to a certain extent, is based on the analysis of legislative
framework. Consequently, the actual implementation of legislation is evaluated in a lesser degree.
So the fact that Armenia is ranked 5th for the indicator “starting a business” is only referring to
required legislative and regulatory procedures and not to the actual cost and duration of the process.
The legislation in a particular area may be very favourable for foreign investors, but in practice,
informal relations may be more important, and the entrance to the market can be equipped by
informal barriers, caused by a widespread corruption and political factors.

70
 CONCLUSION

As a result of analysis conducted in the scope of this thesis the following conclusion have
been drawn and the following recommendations made.
Ø FDI is one of the main factors for sustainable, high-quality and well-balanced economic
growth. The study of the main theoretical and empirical researches on the impact of FDI
inflow on a country's economic development has shown that the inflow of foreign direct
investments from developed countries to developing ones has many positive effects on
the recipient country. As a result of capital-flow, FDI promotes the introduction of new
technologies in the production process. Foreign direct investments provide the transfer
of knowledge, both in terms of labor training and accumulation of skills, as well as
through the introduction of alternative, high-quality methods of management and more
efficient organizational structures. Furthermore, FDI inflow has a positive impact on
competition.
Ø According to John Dunning the key factors that influence investment decisions of
foreign investors are: Market-size, which in this case is usually characterized by real
GDP or population; The growth rate of gross domestic product (GDP); Openness to
international trade; High-quality institutions for policy implementation;
Macroeconomic situation of a country.
Ø On the basis of theoretical framework, the following political and regulatory institutions
were identified to be significant for creating a favorable investment environment as well
as crucial for obtaining possible benefits from FDI attraction: political stability,
government effectiveness, regulatory quality, rule of law, property rights protection,
judicial independence, contract enforcement, ease of doing business, as well as
corruption and monopolization as the main factor distorting institutional environment.
Ø Analysis of global FDI flows has shown that currently the main international capital
centers are Developed Asia, Europe and Developed America. Global financial crisis has
significantly affected the geographical distribution of FDI. Therefore, by virtue of
regional variation of capital flows, FDI flows to developed world in 2014 for the first
time amounted to 55 per cent of the global total. Although global FDI flows were in
unchanging positive relationship with global GDP growth rate for a long time, however
in 2014 inward FDI fell contrary to average GDP growth by 2,4 per cent. Five among ten
largest FDI recipient countries in 2014 were developing. The number of developing
71
 countries among 10 largest FDI investors in 2014 accounted for 4. This one more times
shows the increasing importance of developing world in the global economy.
Ø The results of cross-country econometric analysis of selected indicators, characterizing
the development of institutions in around 150 countries, have shown that the indicators
of institutional quality, among other factors have a significant impact on the basic
mechanisms and areas of FDI attraction. In particular, the most influential institutional
factors for attracting FDI are Government Effectives, Rule of Law and Control of
Corruption. Furthermore, overall quality of institutional environment is important for
both attracting FDI and obtaining the benefits associated with FDI inflow. However,
considering also economic factors, the results of conducted regression analysis once
more proved that level of GDP has a critical importance for FDI attraction.
Ø Republic of Armenia is the smallest country in South Caucasus. Small domestic market
of 3 million people and economic blockades, imposed by two neighbor countries, make
landlocked Armenia, to some extent, less attractive for certain foreign investors,
especially export-oriented investors, as they are limited in access to a big part of regional
market with a population of about 83 million people (population of Azerbaijan and
Turkey). This makes the importance of high-quality institutional environment and
favorable business climate much more critical for Armenia in order to be competitive
with neighbor countries in terms of attracting FDI.
Ø Global financial crisis had a severe influence on the Armenian economy: after the record
level in 2008 the inward FDI flows were continuously decreasing, amounting to $ 370
million in 2013 and $ 382 million in 2014. The major FDI attracting sectors in Armenia
are either natural monopolies (electricity and gas – 21 % of total FDI stock) or
oligopolistic markets (telecommunications – 23 % of total FDI stock) or are connected
with extraction and exploitation of natural recourses (mining and quarrying – 9% of total
FDI stock). These kind of FDI, in turn, does not necessary imply all the possible benefits
associated with foreign direct investments.
Ø Analysis of Armenia’s institutional environment has shown that the country has
relatively good estimations and ranking for those indicators of institutional quality which
are to a greater extend based on the analysis of legislative framework. Consequently, the
actual implementation of legislation is evaluated in a lesser degree. Nevertheless, it
ought to be mentioned that the legislation in a particular area may be very favorable for
foreign investors, but in practice, informal relations may be more important, and the
72
 entrance to the market can be equipped by informal barriers, caused by a widespread
corruption and political factors.
Ø Summing up, I would like to mention that the imitation of various institutions has
become common practice for many transitional countries, including Armenia. The legal
and regulatory framework in Armenia is not sufficiently transparent. Largest economic
sectors in Armenia are controlled by a small amount of businessmen who have market
dominance and are protected by the state, hence, repressing free competition High level
of monopolization in Armenia, in turn, is a striking example of the fact that entwinement
of economic and political interests helps to keep monopolists’ status quo. Unequal
taxation, unequal application of customs and other unequal treatment from the
government (in other words, rules of game that don’t apply to all market players), in
turn, discourages initiative to invest in competitive sectors of economy and add
uncertainly and risks for less politically-connected businessmen. Thus in order to
improve investment attractiveness Armenian government should implement fundamental
reforms in the following areas:
o protection of contractual rights
o assurance of the inviolability of private property rights and
intellectual property.
o Assurance of judicial independence
o Assurance of de-monopolization of the internal market and
improvement of the current anti-monopoly legislation.
o Reduction of corruption and oligarchization of the economy
o Strengthening of contract enforcement institution
o assurance the implementation of human rights and freedoms
and the rule of law
Ø However, implementation of such reforms can be initiated either by the political elite,
which at this stage is not interested in carrying out radical reforms, or by civil society
and the business elite, however, the interests of the latter are intertwined with those of
the political elite, and the first (society) does not have enough influence and cohesion.
Ø However, against the background of the depleting internal sources, assurance of a
long-term economic development in Armenia is not possible without attracting major
foreign investments. In particular, the development based on innovations and capital-
intensive technologies in Armenia is determined by the favorable investment climate
in general, and the quality of the institutional environment in particular.
73
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II.Statistical Sources

1. Database of EUROSTAT < epp.eurostat.ec.europa.eu >

2. Database of The World Bank < data.worldbank.org >
3. Database of UNCTAD < www.unctad.org/statistics>
4. International Property Rights Index <www.internationalpropertyrightsindex.org>
5. Interstate statistical committee of the Commonwealth of Independent States
<www.cisstat.com >
6. National Statistics Service of the Republic of Armenia <www.armstat.am>
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 7. State Commission for the Protection of Economic Competition of the Republic of Armenia
<www.competition.am>
8. The Heritage Foundation: Index of Economic Freedom 2015 < www.heritage.org>
9. Transparency International: Corruption Perception Index <www.transparency.org>
10. World Economic Forum: The Global Competitiveness Report < http://www.weforum.org >
11. Worldwide Governance Indicators <info.worldbank.org>

III.Laws and Regulations

1. The Constitution of the Republic of Armenia

2. The Law of the Republic of Armenia on “Alienation of Property for the Need of the Society
and the State”
3. The Law of the Republic of Armenia on “Foreign Investments”, 1994

4. The Law of the Republic of Armenian on “Income Tax”, 1997

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