“Ukraine is Europe’s last untapped manufacturing destination.” So says Dušan Kulka, a regional competitiveness planning adviser with Ukraine's Local Investment and Competitiveness (Linc) project, which is funded by the United States Agency for International Development (USAid). And the evidence seems to support his statement.

The largest country wholly in Europe, Ukraine shares a border with several EU countries to its west and borders Russia to its east. Its existing rail network connects the Black and Baltic Seas. And culturally the country is even closer to London than the two-hour time difference suggests. 

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Its large and highly educated workforce has already made IT outsourcing a $1bn industry in Ukraine and has the potential to do the same for other sectors. While the fact that wages are lower in Ukraine than across its western borders makes it likely that as China’s appeal is lessened by increasingly higher wages and logistics costs, Ukraine’s will rise.

Yet Ukraine's potential still goes largely unnoticed, with political furor and low global business rankings dominating headlines instead. However, behind the politics and league tables, a challenging yet rewarding investment environment is developing in Ukraine.

The Ukrainian government has tried to focus its investment promotion efforts, with president Viktor Yanukovych bringing the country’s various inward investment offices under one roof. The State Agency for Investment and National Projects issues tenders for feasibility studies and manages a variety of public-private partnerships (PPPs) with both domestic and foreign investors. It also oversees the InvestUkraine website and serves as a one-stop shop for incoming investors. 

Flying low

For many years, Ukraine was primarily known for its aerospace industry. It is still one of the few countries in the world to contain companies working on every stage of aircraft manufacturing, from design to building to maintenance. Yet despite the country's long history in the field, many of its largest and most established companies are flailing.

When Ukraine gained independence in 1991, the scattered assets from Ukrainian aircraft manufacturer Antonov and Russian aerospace and defence company Tupolev were brought together under the Antonov name, making one of the largest aerospace companies in Ukraine. But the company was oriented toward military production, and although it has tried to move into the commercial space, it has had limited success.

According to a 2011 Organisation for Economic Co-operation and Development (OECD) sector competitiveness review, Antonov delivered fewer than 10 commercial aircraft in 2009. One reason for the company's low production is that it is starved of finance for research and development as well as for funding client sales. Closer ties with Russian counterparts have brought little more than piecework for its production units.

Antonov is also in need of capital to strengthen its outward FDI flows into its markets to maintain its market share. India, a long-term client of Antonov, received not only six aircraft from US-based Lockheed-Martin in 2011, but also a commitment from the company to plough almost $285m of the $960m contract back into India’s defence industry. This is the sort of deal that Antonov will have to compete with if it is to stay in the market.

Herd mentality

The ailing aircraft production industry is a legacy from Ukraine’s Soviet past, but its agriculture sector shows more promise for the economic future of the country, and provides Ukraine’s current and would-be investors with many more opportunities. One such opportunity is being provided by the State Agency for Investment and National Projects, which is developing a public-private partnership (PPP) package aimed at rebuilding the country’s cattle population.

Ukraine's cattle numbers dropped steadily between 1990 and 2011 and calls to remedy the situation have been longstanding but futile, as cattle ownership remains fragmented throughout the country. The government's move to tackle the problem is natural, but there is more to the equation, says Linc's Mr Kulka. “Dealing with agriculture is often a matter of sentiment. There is the desire to ‘feed the nation’,” he says. But there is also a whole supply chain to deal with, as steers require feeding and the shrinking herds have not created a business need for high-capacity modern processing plants. This means that infrastructure will need to be considered as well as headcounts.

Moreover, the very need to rebuild the country's cattle herd has been called into question. Jim Davis, an independent agriculture sector analyst living in Kiev, the capital of Ukraine, is sceptical about the project. “The market in Ukraine has decided for itself what the cattle herd size should be. Bringing government in to the picture will only create problems and distortions. Also, it takes six weeks to see a return on chickens, about six months on pork. Cattle takes two years, and that is a long time around here.”

The long-term nature of such an investment is compounded by the government’s record of interfering in the agriculture market. For example, when there was a poor harvest in 2010, the government introduced grain export quotas. The move, which kept grain within the country and forced traders to sell locally, kept bread prices stable domestically, but exacerbated wheat price rises elsewhere and severely dented the country’s reputation abroad. Meanwhile, grain that had been intended for export piled up on the Black Sea, without storage facilities.

Infrastructure needs

The lack of storage facilities in Ukraine is one example of a basic problem that can be solved with FDI. Indeed, many of Ukraine's infrastructure and logistics problems could easily be fixed with foreign investment and expertise. But this is sorely lacking.

Fedor Arbuzov, head of the industrial and logistics property department at property services company DTZ Ukraine, says that the development of the country's real estate segment came to an abrupt halt with the onset of the global economic downturn. He says that foreign developers were the first to pull out, with most leaving the market altogether.

“When rents halved in 2008, local developers could cut corners. Some work was put on ice and stayed that way until late 2010. Other projects, where the land had been purchased, were scrapped,” he says.

The economic downturn did much to delay the modernisation of Ukraine's infrastructure. Whereas 80% of logistics construction in Europe adopts a build to order (BTO) approach, Ukraine’s first BTO logistics projects were in the planning stages in 2008 and thus cut. The first BTO project was not opened in Ukraine until 2011.

Other projects fell victim to the global financial crisis and still have not been realised. A project aimed at increasing international airfreight into the Kiev area with the development of new facility was cancelled, as were plans to build specialised storage facilities.

Green gridlock

It is not just Ukraine's infrastructure development that has suffered setbacks; many of the its policies are in urgent need of reform. In recent years, the State Agency for Investment and National Projects has placed particular emphasis on green energy, describing it as one of the agency's primary focuses. In many countries, investors in renewable energy have to contend with special interest energy lobbies and layers of bureaucracy. Then there is the issue of the government’s willingness to give price incentives or tax breaks. In Ukraine, these problems exist, but on a much greater scale.

The government said that it was going to tackle the problem, but Konstantin Yakunenko, a PhD researcher at Ukraine’s Kiev Mohyla Academy, says that the government’s plans to liberalise the energy sector, which were laid out in 2010, have effectively stalled.

“The only change in the past two years is that the nominally neutral market regulator issued an order forbidding itself from following the law regarding anti-monopoly measures. It did also raise the market capture that the company could have, though,” he says.

There are those that believe the country is making progress in this area, however. Green tariffs were introduced in 2009 and now form an important part of the business plan of Activ Solar, an Austrian-owned company with production facilities in Ukraine. In 2011, Activ Solar installed Europe’s largest solar energy farm, a 100-megawatt (MW) station in Crimea, in the south of Ukraine. Activ Solar plans to install a further 200MW of capacity in 2012.

Power-generating companies in Ukraine are owned outright by members of parliament, and Activ Solar itself might be no different: Ukraine’s press reports that the company is held through intermediaries by MP Serhiy Klyuyev. There are some that view these close relationships sceptically.

“Investors have to recognise that there are three arrangements for close ties with the government, especially regarding power: when it is useful to the investor, when it is detrimental, and when it is unavoidable. With energy in Ukraine, it is unavoidable,” says Mr Yakunenko. As it stands, electricity prices are set by governmental order and market input is minimal.

Igor Zhovkva, director of the department for national projects at the State Agency for Investment and National Projects, insists that the agency’s tenders are designed with transparency in mind. Given the specific environment that a renewable energy investor would be working in, a PPP arrangement with the state agency may ease access to the corridors of power, especially for newcomers to Ukraine.

Hot topic

Electricity generated by the wind and sun are not the only green initiatives in Ukraine's energy sector. Heat generators running on biomass, either fuelled by wood or rubbish, are also being built across the country, with 68MW of biomass-fired capacity already online. There is room for growth, and the OECD's sector competitiveness strategy for Ukraine points out that the country boasts “abundant agricultural and forestry waste”.

Getting this wealth of fuel to the furnace is a problem, however, and the OECD also notes that biomass is usually only economical when the fuel is transported less than 80 kilometres. When biomass is looked at as an agricultural sector product instead of as waste, then the factors that dog agriculture in Ukraine reappear. The processing, transport and storage of material that once might have been dumped locally, and the machinery to go with it, all need to be invested in. And there is other issue: how much energy does Ukraine really need?

Bil Tucker, chief of party at the USAid-funded municipal heating reform programme in Ukraine, says that merely adding capacity is not the way forward. Installing automatic controls and metering, insulating walls and other demand-side measures is necessary, if only to know the amount of heat actually needed in order to make sure that the rest of the infrastructure can be determined.

“Then intelligent cost-effective decisions can be made regarding whether to renovate or resize existing plants or to build completely new plants. Also, depending on size and location of these heating plants, better decisions can be made about the type of fuel – coal, gas, renewable, bio-fuel – and type of production facility to build or renovate – heat boiler plant or combined electricity-heat co-generation plant, for example,“ says Mr Tucker. 

Encouraging energy conservation is more complicated in a country where the true cost of fuel is not an issue for the end-user. In Ukraine, rates paid by end-users of municipal heat are heavily subsidised. Mr Tucker says that there is more to paying full tariffs for heat and electricity than encouraging energy conservation.

“Full tariffs send a signal to utility companies and banks that they can count on recovering their investments in repairs, maintenance, system expansion, and new energy efficiency and operational equipment and technologies.“

Local politics

While the municipal heating reform programme has found investors such as US-based Contour Global that are willing to work with municipalities and the PPP model, Mr Tucker says that the instability of the country's regulatory, financial and political institutions deters many from investing.

Moreover, while local governments are interested in investing in energy savings and are willing to take on municipal debt, the state, concerned about denting sovereign ratings and having experienced municipal defaults since independence, is reluctant to allow partnerships that could pose such a risk. Mayors are often keen to bring investors into their municipality, as it is one of the few ways to raise revenue. The state collects 97% of the revenue that a municipality draws in, but one of the few exceptions is payroll tax paid by companies registered in that town.

There is a difference in volatility between Ukraine's state and municipalities, and this is something that investors need to keep in mind. While Ukraine's municipalities rarely experience sudden and unpredictable upheavals, its state administration experienced several shake-ups as the current administration sought its footing. The country's current ministry of regional development, construction, housing and communal services is in its third incarnation since 2009, and its current minister is the fifth in that period.

Location, location, location

Each of Ukraine's municipalities offers investors different things, and opinion is divided over where best to invest in the country. Linc's chief of party, Howard Ockman, says: “Cities with between 100,000 and 250,000 residents work well because there is some useful infrastructure in place as well as a trained workforce.”

Mr Kulka says that the presence of major universities such as Kiev Polytechnic University in the capital should not stop would-be investors from looking elsewhere, especially if the company will be exporting to other parts of Europe. “There are highly skilled research institutes throughout Ukraine, especially in the oblasts that now border the EU.” Kharkiv near the Russian border, Lviv near the Polish border, and Odessa on the Black Sea all host renowned technical universities, and are quickly becoming world-class software development centres.

On the other hand, DTZ Investment's department head Natalia Stelmakh warns that “the level of professionalism tends to be higher in Kiev, where there is a greater awareness of a business’ needs”.

Skills base

While Ukraine has long boasted a highly capable technical workforce, the country sorely lacked managers and client-facing specialists with the soft skills necessary to lead teams and customers. While the pool of talented managers still remains small, it is growing. Ukraine's IT outsourcing sector was a $1bn industry in 2011, and analysts claim that the figure could hit $10bn by 2020. But raising talent will remain a concern, especially for the North American and Scandinavian companies that have set up shop in the country.

SoftServe, a leading IT outsourcing company with its European headquarters in Lviv, recognised early on that it would need to develop managers for its business in Ukraine. To do this it created an in-house education programme.

“The graduates coming from our universities have good technical skills, but they can lack the skills needed to work in teams," says Taras Vervega, the company's president of business development for Europe, the Middle East and Africa. "We put them through SoftServe university, and after three or four months, they have learned to work with specific programmes as well as the organisational and basic people skills [needed] to collaborate. We hire the best, and the others may or may not enter the industry elsewhere,” says Taras Vervega, the company's president of business development for Europe, the Middle East and Africa.

When it comes to developing expertise in other areas, Ukraine is reliant upon domestic organisations. Mr Kulka says that Linc has trained more than 200 specialists “in landing foreign direct investment, and the training throughout the project has been intensive. This means being able to differentiate between types of investors and understanding their impact. But also, it means being able to say to a mayor, ‘What happens if we’re nice to this guy?’”.

Making progress

There are still many issues that blight Ukraine's business environment, not least its tax system. The World Bank's Doing Business report places Ukraine second to last in its world tax burden rankings. Everything from the number of taxes to the length of time spent on them – more than 650 working hours per year, according to the World Bank – consumes effort. But changes are being made, and more importantly they are being felt by the business community.

At one time, Ukraine’s state tax authority had a reputation for favouritism. “For several years,” says one Kiev businessman who spoke on condition of anonymity, “whenever there was a budget crunch or cash-flow was a problem, the local tax assessor would call and actually ask if the company could prepay its corporate tax. And this being Kiev, one would often go along with it, especially if the end of the month was around the corner.”

Nowadays, the calls still exist, but business owners, both foreign and domestic, report that the questions are gone. Also, companies that report a loss or zero profit will simply not have their tax statements accepted at the local tax authority office. Continuing such improvements are essential if Ukraine is to attract the investment that it needs to transform its economy.