Why an economy this size should want foreign capital, stated without the slogans

The argument for foreign investment is usually made badly. It is asserted rather than explained, and the assertion invites the obvious objection that foreign owners extract profits.

The stronger version rests on three mechanisms, each of which is specific enough to be argued about.

The cost of capital

A Ukrainian company financing expansion domestically faced borrowing costs far above what an equivalent western European company paid. That gap is not a market failure to be complained about; it is a price reflecting country risk, currency risk and a thin credit market.

The practical consequence is that a project generating a solid return would go ahead in Germany and would not go ahead in Ukraine, because the hurdle rate was higher. Investment that would be economically productive simply did not happen.

Foreign direct investment brings capital priced at the investor's cost of funds rather than the local one. The project that could not clear the domestic hurdle clears the foreign one, and the plant gets built.

That is the core of the argument and it does not depend on any claim about foreign owners being better managers.

Technology and process transfer

The transfer that matters is rarely the machinery. It is the operating system around it: quality control procedures, maintenance regimes, supply chain management, health and safety practice, financial reporting discipline.

This transfers through people. Someone works for five years in a foreign-owned plant, learns how a modern operation runs, and then either takes those practices to a domestic company or starts one. The spillover from foreign investment shows up in the domestic firms staffed by people who trained in foreign ones, and it is a larger effect than the direct output of the foreign plant.

Competitive discipline

The least popular argument and probably the most important.

Domestic incumbents in a protected market have no reason to improve. A foreign entrant with better products, lower costs or better service forces a response — investment, restructuring, price reduction — and the response benefits customers who never buy from the foreign company at all.

This is exactly why incumbents lobby against foreign entry, and the strength of that lobbying is a reasonably good indicator of how much competitive discipline is missing.

The honest counter-arguments

Profit repatriation is real, and a country running a large stock of foreign-owned assets exports a stream of dividends. The question is whether the assets would have existed at all without the foreign capital, and usually the answer is no.

Foreign ownership of banking makes credit supply sensitive to decisions taken abroad, which the region learned in 2008. That is a genuine cost and an argument for a mixed ownership structure rather than against openness.

And foreign investment can be extractive when it is concentrated in resource sectors under weak governance. That is an argument about which sectors and under what rules, not about whether.

The practical conclusion

A middle-income economy with a high cost of capital, an ageing industrial base and weak competitive pressure has more to gain from openness than a wealthy one does, because it is short of exactly the things foreign investment supplies.

The policy question is never whether to be open. It is what regulatory and competition framework makes the openness produce those three effects rather than just the profit stream, and that framework is domestic work that no investor will do for you.

Related in this archive

• Import quality: the reputation problem and the standards system that fixed it
• The neighbourhood beyond one border: five countries that mattered more than expected
• Ukraine and Kazakhstan: two post-Soviet economies that diverged
• Ukraine Annual Review 2010: recovery on two channels

The most valuable thing foreign capital brings is not money but method. I have seen it in my own companies: once you start working with a foreign partner, reporting, maintenance planning and site safety change by themselves, because the other side is not used to anything else. Cheap credit is an advantage; the discipline is what lasts.