Irina Guruli is Program Manager at the Economic Policy Research Center.

Foreign Direct Investment (FDI) inflows to Georgia fell significantly from the second quarter of 2012, closing the year 23% down from 2011. After several years of steady recovery, this is a serious concern for policy makers. Georgia’s domestic capital market is still underdeveloped, leaving economic growth substantially dependent on external sources of finance, particularly including FDI. FDI is especially important for long-term growth, as it can be directed towards financing large infrastructural projects that would otherwise be impossible to fund through the domestic banking sector.

Georgia still lacks indigenous engines of economic growth that could potentially absorb capital from banks as well as stimulate saving, and hence more foreign and domestic investment. Unlike remittances, FDI is vulnerable to shocks and economic downturns. The global financial and economic crisis that emanated from the west in 2008 was – according to the majority of international sources – the most severe for over 70 years. Economic growth is one of the most important determinants of external investment – the slowdown of the world economy that proceeded 2008 reduced the attractiveness of crucial markets to foreign investors, which consequently reduced FDI flows.

In 2011, however, the United Nations Conference on Trade and Development (UNCTAD) reported an improvement in global trends: FDI rose by 17%, causing both UNCTAD and other International Economic Organizations (IEOs) to tentatively predict that the end of the global recession was on the horizon. Georgia followed this trend with FDI inflows growing 27% from the previous year. In 2012, however, global FDI inflows fell again by 18%, while the transition economies of Eastern Europe, the Commonwealth of Independent States (CIS) and Georgia suffered a decline in FDI flows of 28%.

Not all sectors of the Georgian economy have been affected equally by the recent drop in FDI inflows. Figure 3 shows a significant increase in the transport and communications, and manufacturing sectors, up 18% and 59% respectively. Manufacturing maintained inflows throughout the post-crisis period, but FDI to the transport and communications sectors in 2012 was at just 35% of the level recorded in 2008. The mining, real estate and consultancy sectors have experienced the most significant drops, with each recording a more than 50% reduction in FDI from 2011 to 2012. Meanwhile, FDI directed towards the real estate sector in 2012 was just 10% of the figure recorded in 2008.

Given the sensitivity of FDI to global shocks and economic downturns, it would thus be easy to conclude that Georgia’s declining FDI is the result of global trends; that, as UNCTAD proposes, as the more developed nations increasingly struggle, the transition economies have simply suffered from weak external demand. One must not forget, however, that throughout the post-crises period, the impact of the downturn has been felt differently in developing, developed, emerging and transition economies. Growth in 2011 was largely universal, but 2012’s FDI decline was unevenly spread. The reduction in global FDI inflows was largely isolated to the United States and those European countries most affected by the Eurozone crisis, which combined were significantly great alone to reduce the global aggregate figures. Meanwhile, and for the first time, the developing world’s share of global FDI inflows exceeded that of the developed, and Georgia’s neighbor, Turkey – the source of a large proportion of total remittances to Georgia – has recorded consistent increases in FDI inflows.

Although the effect of global trends cannot and should not be dismissed, key influences remain unaccounted for: local and regional effects. A decade ago, IEOs including the International Monetary Fund (IMF) reported that despite strengthening its macroeconomic performance, low FDI inflows to Georgia and the Caucasus region reflected a weak investment climate due to a lack of structural reforms. Of particular concern were the region’s demanding tax systems, widespread corruption, unnecessary state intervention, poor regulatory framework, and weak legal structures. According to the World Bank and International Finance Corporation’s (IFC) Ease of Doing Business Index, however, Georgia has made remarkable improvements in all the above over the last ten years. Although Georgia would benefit from further institutional improvements, we must look elsewhere to understand why the economy experienced a drop in FDI during 2012.

While many empirical analyses have established that institutional factors such as those mentioned above greatly influence FDI inflows, less attention has been given to the literature that concentrates on the relationship between political risk and investment decisions. Several of the transition economies of Eastern Europe and the CIS have experienced a great improvement in FDI inflows throughout the past decade. Meanwhile, other countries in the region – specifically those whose democratic evolution has remained unsettled, bringing into doubt the stability and effectiveness of their governments and the prospect of social unrest – have been generally ignored by foreign investors.

All investment, FDI included, is a forward-looking activity, and is founded on investors’ expectations about future returns and the confidence that they can place on those returns. Therefore, the decision to invest in an economy almost always involves an evaluation of the political future of the country in question. Political instability in the host country means that there are two principle risks that an investor will have to factor into their cost-benefit analysis, each of which is particularly important in transition economies. The first is that internal instability or regional conflict may reduce the profitability of operating in an affected country, either because sales and exports are in danger, production is disrupted, or resources are damaged. The second result is that political instability is likely to decrease the value of the affected country’s domestic currency, consequently reducing the value of the assets invested in the country’s economy as well as of any future profits that the investment could be expected to produce.

Thus it can be concluded that alongside the decrease in the availability of FDI stock on the global market, uncertainty regarding Georgia’s political future caused by 2012’s eventful elections and unfriendly relations with Russia, has made potential investors more cautious. The assumption becomes even more accurate if we take into account that the FDI inflow has particularly decreased in the third and fourth quarters of 2012. Given that, according to UNCTAD, international investors are holding back huge sums of cash holdings, it can be assumed that FDI inflows will be gradually restored after October’s presidential election – assuming that further political instability is not provoked, and that investors are given no reason to doubt the competency of the new regime and thus the future strength of the Georgian currency.

The Georgian Ministry of Finance has given a very positive prognosis regarding future FDI inflows into the country; according to the Minister, FDI inflow will equal around 2 billion USD, gradually converging to the level recorded in 2007 – i.e. more than double compared to 2012. Attainment of the pre-crises peak level of FDI will largely depend on how soon the global economy recovers from recession and how successfully Georgia continues its open-door policy towards FDI.