Strengthening the Corporate Securities Market Will Attract More FDI in Georgia

Op-Ed

Like all post-soviet countries, currently one of the most important challenges for Georgia is to ensure its economic prosperity. At different times, many economic strategies have been elaborated, the core substance being to attract and keep stable foreign direct investments (FDI). For this reason, for more than 25 years the central priority of the Georgian economic policy has been to constitute the appropriate interesting circumstances for this.

Enormous budgetary resources are collected for this aim. Georgia has a special governmental agency and joint stock companies (JSC) with 100% governmental ownership. Among the leading missions of these institutions is the promotion of Georgia’s investment image worldwide and the engaging of more FDI.

Georgia has had changeable political, macro-economic and fiscal indicators which adequately reflected the attitude and expectation of existing and potential investors. Undoubtedly, to establish new business entities, installing franchising of nominated brands and moving official representations of foreign companies will play a positive role for the Georgian economy, but reality shows that there are several reasoning preconditions to strengthening the national economy only by attracting FDI. More concretely: Georgia does not always have the charming political and economic climate needed for grabbing the attention of profitable FDIs.

Indeed, these factors play a nominal role, because with the general political and economic atmosphere one of the vital issues for FDIs is the existence of a balanced way to finance the business and/or the source and infrastructure to extend its activity as a stabile investor.

Georgia is in a situation whereby the domestic long-established economic sectors, such as tourism, production and export of wine, mineral water, agricultural products, infrastructural and real estate sectors have yet to dynamically affect the national economy, as seen in many international evaluations and in the country’s high poverty index.

It is essential to take into consideration that Georgian political and macro economical frameworks are changeable; that dependence on various regional factors is unstable; and that the charming transit geographical location of the country maintains its uniqueness in the region.

Each of these circumstances provides conditions to create an improved investment atmosphere.

According to recent studies, both private banks and stock markets promote growth, with stock markets proving the more powerful. Only a well-organized stock market can measure the real value of enterprises: On the one hand, national and non-resident entrepreneurs can evaluate the opportunities and, based on this data, evaluate the best corporate strategies, and on the other hand, all potential investors (especially foreign institutional investors) can determine their different commercial possibilities. This is simple arithmetic, as capital market-oriented financial reporting presents more objective and realistic information for all interested investors.

The current Georgian financial market includes the following components: products of commercial banks, non-banking sector (micro financial organizations, credit lines), brokerage and insurance companies and stock exchange. From these components, capital markets include the state securities market, corporate stocks and corporate bond markets, currency and monetary market, currency forwards and derivatives.

From the initial stages of the formation of domestic private financial institutions, Georgia took a path on behalf of the private banking sector as opposed to the capital markets. Presently, this sector is the most successful not only among the financial institutions, but generally among all domestic industries. In parallel, Georgian financial institutions belonging to the capital market sphere still remain as a nominal source of financing.

Unlike private equity market capitalization, the existing capital market tends to rely on bond issuance with comparatively valuable local liquidity.

The institutions of well–developed capital markets depend on several factors. Considering that the Georgian governmental securities market operates in better conditions, the fundamental cause of under developed capital markets is weak corporate stock and the corporate bond market. Accordingly, the financial instruments belonging to these institutions are not highly in-demand not only among the population, but also with the domestic and foreign investors.

Relative growth of capital is not seen among small and mid-sized companies. Consequently, in order to really positively affect the various economical parameters, Georgia needs more institutional foreign investors, the best way being the creation and operation of JSCs. Large JSCs determine the trends of one or another market and generally the rate of a country’s business indexes. The nature of a JSC is to associate a lot of stable investors (shareholders), where all (in share type and ownership structure) should feel multilaterally stable and secured. The shareholders operate on different liquid stock markets instead of the company’s daily internal matters. Each shareholder is potentially interested in extending the quantity of capital as an institutional investor by buying shares and/or placing shares on the stock exchange. With the equity market, it would be a great motivation for different investors to place corporate bonds.

Georgia, as a small country with a still underdeveloped business climate, is unflavored with a large number of well-developed and profitable JSCs.

Based on the official statistical data, currently in Georgia 236,767 capitalized private entities are registered, of which only 80,330 have active status (33%). Georgia has 234,240 LLCs, of which only 79,423 are active, while 2,527 are JSCs, from which only 907 have an active status.

Considering this, Georgia scores the following position:

1. Proportional rate of registered LLCs from all capitalized companies: 98.89%;

2. Proportional rate of active LLCs from all active capitalized companies: 98.88%;

3. Proportional rate of registered JSCs from all capitalized companies: 1.1%;

4. Proportional rate of active JSCs from all active capitalized companies: 1.13%.

This data indicates that the demand for starting and operating “great businesses,” such as active JSCs, is quite low. Moreover, the existing legal framework does not include the concept of the publicly-owned LLC which would be authorized to issue securities. The cause for this position may be different: the law, macroeconomic indicators, political tension, tiny markets of different services and products, or the flexibility of small-sized legal entities. One of the leading factors remains the underdeveloped corporate securities market.

The cornerstone of my conception includes reforming and strengthening Georgia’s corporate securities market institutions and, in parallel, not letting weaken the existing attempts to attract more FDIs which, from time to time, are transformed into a source of portfolio investment.

There are various specifications determining the attractiveness of FDI, which mainly depend on the type of industry, targeted region/country, and/or the origination of investment. More specifically, the significant factors effecting FDIs are:

1) Favorable geographical location;

2) Internal and external political stability;

3) Low bureaucracy and logical scope of liberation of business from government pressure;

4) Modern infrastructure;

5) Labor skills and wage rates;

6) Macro-economic parameters;

7) Tax rates and the existence of bilateral agreements about concessionary taxation;

8) Exchange rates of national currency;

9) Property rights (basically focused on the intangible meaning of shareholders’ rights);

10) Sophisticated internal regulations balancing fair expropriation;

11) Access to the free trade spaces;

12) Clustering effects and size of economy, which determine the potential of the economic growth.

Some of the enumerated factors have a direct correlation with the potential of the commercial securities market and transect the potential interest of investors. But how do they correlate with the commercial securities market? Internal and external political stability, macro-economic parameters, tax rates and existing bilateral agreements about concessionary taxation, exchange rates of national currency, intangible property rights, clustering effects and size of economy widely effect the FDI climate, although targeting the development of the commercial securities market will affect their meaning and necessity. An interaction of factors will not produce solid results on behalf of the commercial securities market if no step is taken to enlarge this market.

As an intermediate conclusion, we get such a chain: Further work on the improvement of these parameters and the overall FDI environment is needed, in parallel with work on the development of the commercial securities market and a connection of these processes.

Why will an improved commercial securities market attract and preserve more profitable FDIs?

1) A securities market of high quality demonstrates public trust and confidence of the different companies, as the central actors, in this market. Accountable enterprises are obliged to operate wholly transparently, and the neutral self-regulated market rules determine the clear rating and real value of the corporation.

In distinctive jurisdictions, there are many approaches to the bureaucratic scopes imposed on one or another market. There is no doubt that the financial market needs moderately determined bureaucracy. One of the unique characters of capital markets is neutral self-regulation in compliance with the principles of international best practices. Preeminently, authoritative international organizations and consideration of the recent trends of trans-national corporations elaborate these principles. The concept of the “not-anarchical,” and in some regions the “incorporated” rules, of self-regulation in the best way meets Adam Smith’s idea of an “invisible hand”. In all points, the requirements of the corporate securities market benefit from this idea: “self-regulated markets”; “real competition” (along with sober competition among the actors of the financial market); “basic neutral supply-demand mechanism” and the “self-interest” of the corporations, where all decisions are made based on “the best corporate interests”;

2) A financial market where only a well-developed banking sector has the predominant position effects the investors’ subordination to the banking rules, where no-one is motivated to establish a modern corporate governance system and more transparent financial accountable standards. In turn, this will negatively effect minority shareholders’ rights. As we discussed above, only JSCs can determine the trend of one or another market where numerous shareholders are accumulated. As an environment where minority shareholders’ rights are weak, Georgia will not be able to attract durable institutional investors. Consequently, the Georgian financial market will become closer to better anti-monopoly circumstances than in such an environment where only the banking sector is developed;

3) Considering that for a long-term source of financing, it is more flexible to use the capital market platform than the money market, as opposed to a short-term source of financing, one of the main interests of investors is to operate in the long-term. This comes with risks of lost capital. Where different sources of financing are developed is a high probability of continuing an existing activity and/or re-investing capital to other financial instruments by a neutral, self-regulated transparent market. Such possibility gives additional investment opportunities, where investors are interested in allocating additional capital;

4) With the dynamic corporate securities market, one additional space for investment is the allocation and affiliation of capital within an organized investment fund. Particularly, an effective securities market will enhance the formation and operation of venture capital. In a certain time, it will be generated into the defined experience of joint business activity and push the formation of institutional investment funds. Moreover, based on the best practice, for instance, mutual funds can passively track stock and bond market indexes and allow limited investors to buy diversified shares of a number of investment holdings within the fund’s investment objective. Without considering the well-developed securities’ market, it is difficult to have a mature base for investment funds. That is why, as a first step, it is important to ensure better conditions for the commercial securities market, which will push the development of investment funds. This chain will present, for FDIs, additional motivation and the capacity to be involved in diversified investment possibilities by using different methods of capital flow;

5) A well-developed commercial securities market will clearly influence the national macro parameters proportionately to the various international assessments, which, in the long-term perspective, will attract more FDIs. Namely, the macro factors will keep such circumstances that indirectly affect the supply-demand relationship of additional capital, and will be able to raise the national GDP due to its solid connection with the amount of existing capital in the country.

Major reasons obstructing the development of the commercial securities market

Today, the following factors are obstructing the development of the Georgian commercial securities market:

• Legislative failures regulating legal attitudes among the actors of capital markets. One of the least developed actors of the portfolio investment is the private equity market. Therefore, by legislative failures I mean the existing mutually opposed legal norms, a number of unregulated issues and/or not highly-enough qualified regulations. For instance, according to the existing Georgian legislation, it is quite possible to trade securities listed to a stock exchange out of the competitive regime - directly to the shadow, which reveals turbulent circumstances of the prices of traded securities. On-exchange trades are held using the delivery versus payment (DVP) principle. More clearly, buyers do not gain their securities until reimbursement, and sellers do not receive their payment until conveyance. The mentioned scheme negatively affects the stable and protected investors’ rights, especially those of minority investors;

• Unequal circumstances among financial institutions. Particularly, Georgia formally has a bipolar financial market: commercial banks and the actors of the capital markets. The predominant status of commercial banks deteriorates the liquidity of the commercial securities market. This reality founds factual monopolar circumstances among the actors of the financial market;

• Insufficient transparency of the securities issuers, which is shown as low standards of corporate governance. Furthermore, the existence of an ineffective system of creditworthy appraisal of companies;

• Fair access to the same information equals trade in identical conditions. The existing system does not ensure this possibility due to faulty procedures for the effective prevention of insider-influence on the fairness of trading and subsequent adequate reaction to the insiders’ fulfilled dealings;

• The publicity of the capital markets is low throughout the Georgian population, although almost all adult citizens know something of banking products and capital market functions;

• Undeveloped taxable system of capital market participants;

• Absence of flexible organizational requirements for investment firms;

• Absence of legal frameworks for the domestic rating corporations.

Some core principles which should be envisaged

The following basic measures need to be taken into consideration in order to gain a better commercial securities market:

• Institutional reformation of JSCs, as by its nature a JSC should be an entity with many shareholders (as opposed to the so called “family businesses”) and the publicly issuance of their securities and trade on the exchange;

• Creation of real competitive circumstances among the domestic corporate financial institutions by the anti-monopoly agency and the National Bank;

• Considering the core principles of international best practice, the elaboration of a code of corporate governance for existing and all potential future stock exchange(s) and its (their) members. It is important to subordinate the rule of “comply or explain” of the chosen international principles of corporate governance to the National Bank of Georgia instead of the Service for Accounting, Reporting and Auditing Supervision;

• Infrastructural reformation of the stock exchange, by which I mean the further development of the IT system of the stock exchange is also significant;

• Provision of appropriate educational activities for market participants, potential investors, financial professionals and an audience with the high interest of the financial market;

• Adequate reforms of the national legislation. This is not about making technical amendments of the appropriate legislation but elaborating an extensive legal framework for national trust companies and covered bonds or so-called “mortgage bonds”. (In turn, all these amendments should affect the consequences for adopting proper tax treatment);

• Ensuring low transactional cost and a more flexible taxation system. It is essential to tax the net investment revenue instead of certain transactions. The interest incomes of bank deposits are not taxable income, but other financial instruments are under the obligation of taxation. This factor pushes potential investors to use banking instruments instead of securities market instruments;

• Ensuring more transparency of the financial statements of issuers.

Last but not least

Nowhere is there an adapted panacea of “the best model” of one or another system. Multilateral studies, extensive, systematic and informal consultations with the private sector and the various comparative qualified evaluations of all related issues are the fundamental parameters of being closer to “the best model”. There is no reason to stay in a passive and satisfied position; to remain and support the status quo of the existing financial system because of the well-developed commercial banking sector. Bearing in mind the importance of all the above, steps to directly improve the commercial securities market should be taken at the right time.

There are many endeavors to ensure strict compliance with the EU directives in almost all socio-economic sectors. This should be no different with regards the reformation of the Georgian capital market. Unquestionably, this process is positive, but it should not maintain the context of formally requiring EU standards. It is essential to make a broad analysis of the existing system considering all features of the domestic financial market. This approach will provide for the success of Georgian commercial securities market and will generate wealth and a unique national experience of engagement, keeping both FDIs and, in parallel, the different sources of portfolio investment.

Levan Kokaia is a lecturer at the Georgian Institute of Public Affairs (GIPA). He regularly publishes articles concerning Georgian business legislation, mainly focusing on corporate governance issues and the legal regulation of capital markets and investment funds.

BY Levan Kokaia

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