Foreign direct investment (FDI) comprises investments from outside a country to set up new establishments, expand existing ones or purchase local companies. According to government body UK Trade & Investment, the UK has an estimated stock of over £1 trillion of FDI, and only the United States and China have more. About half of this stock of FDI is from the European Union (EU).
Countries generally welcome FDI as it tends to raise productivity, which increases output and wages (Bloom et al, 2012). FDI brings direct benefits as foreign firms are typically more productive and pay higher wages than domestic firms. But FDI also brings indirect benefits as the new technological and managerial know-how introduced by foreign firms can be adopted by domestic firms, often through being part of multinationals’ supply chains. FDI can also increase competitive pressures, which force managers to improve their performance.
Why might Brexit hit foreign investment?
Why might FDI fall if the UK were to leave the EU? There are at least three reasons:
- First, being fully in the single market makes the UK an attractive export platform for multinationals as they do not face the potentially large costs from tariff and non-tariff barriers when exporting to the rest of the EU.
- Second, multinationals have complex supply chains and many co-ordination costs between their headquarters and local branches. These would become more difficult to manage if the UK left the EU. For example, component parts would be subject to different regulations and costs; and intra-firm staff transfers would become more difficult with tougher migration controls.
- Third, uncertainty over the shape of the future trade arrangements between the UK and EU would also tend to dampen FDI.
A number of factors determine where firms choose to locate and invest. Bigger and richer markets tend to attract more firms, which want to be close to their customers. The UK has strong rule of law, flexible labour markets and a highly educated workforce, all of which make it an attractive FDI location whether or not it is in the EU.
Supporters of Brexit claim the UK could attract more FDI outside the EU as it would be able to strike even better deals over trade and investment.
So what do the data say?
Our research examines bilateral FDI flows across all 34 OECD countries over the last 30 years. We look at how FDI changes when countries join the EU after controlling for a large host of factors such as the size and wealth of the different countries.
The evidence is clear. Being in the EU increases FDI by around 28% (the exact magnitude ranges from a 14 per cent to 38 per cent increase in FDI depending on the statistical method used). These estimates are similar to those in Campos and Coricelli (2015), who find an impact of 25 per cent to 30 per cent using an alternative method that compares the evolution of UK FDI with a comparison group of similar countries.
Being a member of the European Free Trade Association (EFTA) like Switzerland would not restore the FDI benefits of being in the EU. In fact, we find no statistical difference between countries in EFTA compared with those completely outside the EU like the United States or Japan. So striking a comprehensive free trade deal after Brexit is not a good substitute for full EU membership.
Foreign investment increases your income
To get at the nation-wide impact of FDI on output and income, we draw on the work of Alfaro et al (2004), who estimate the effect of changes in FDI on growth rates across 73 countries. We find that the impact of lower FDI following Brexit would be equivalent to a fall in real UK incomes of about 3.4 per cent. This represents a loss of GDP of around £2,200 per household.
Quantifying the relationship between FDI and growth is notoriously difficult so the exact number is subject to considerable uncertainty. But it suggests that falls in FDI following Brexit would matter for living standards in the UK. An income decline of 3.4 per cent is larger than our static estimates of the losses from trade of 2.6 per cent in our pessimistic case (see previous article), which suggests that a significant fraction of the long-run impact of Brexit comes from FDI losses.
Of cars and cash – two UK success stories that stand to lose out
The macroeconomic estimates give a bird’s eye view of the effects of Brexit; but it’s useful to focus on particular industries: cars and financial services.
Cars are a successful part of UK manufacturing. In 2014, the industry contributed around 5.1 per cent to UK exports, 40 per cent of which were to the EU. Head and Mayer (2015) use information on assembly and sales locations (IHS Automotive data) on 1,775 models between 2000 and 2013. In their work, Brexit has two main disadvantages:
- First, as trade costs rise, locating production in the UK is less attractive because it becomes more costly to ship to the rest of Europe.
- Second, there is an increase in the co-ordination costs between headquarters and the local production plants located separately in the UK and the EU – for example, transfers of key staff within the firm may be harder if migration controls are put in place.
Putting both costs together, total UK car production is predicted to fall by 12 per cent – 180,000 cars per year. This is mainly because European car manufacturers such as BMW move some production away from the UK. Prices faced by UK consumers also rise by 2.5 per cent as the cost of imported cars and their components increase.
Financial services have the largest stock of inward FDI in the UK (45 per cent) and constitute 12 per cent of tax receipts. The single market allows a bank based in one member of the EU to set up a branch in another, while being regulated by authorities in the home country. This ‘single passport’ to conduct activities in EU member states is important for UK exports of financial services. ‘Passporting’ means that a UK bank can provide services across the EU from its UK home. It also means that a Swiss or an American bank can do the same from a branch or subsidiary established in the UK.
The UK might be able to negotiate some of these privileges after Brexit. Members of the European Economic Area (EEA) outside the EU enjoy them, but they also have to contribute substantially to the EU budget, accept all EU regulations without a vote on the rules and must allow free labour mobility with the EU. And even for these countries like Norway, which must ‘pay and obey with no say’, there seem to be greater difficulties in doing business than a full EU member. One reason is that the coverage of financial services under the EEA does not keep pace with EU policy changes, so Norwegian banks have a tougher time accessing the EU market.
Staying in the EU also gives the UK the ability to challenge new regulations in the European Court of Justice, a right that was successfully exercised when the European Central Bank wanted to limit clearing-house activities to the Eurozone. If the UK leaves the EU, it would lose its leverage in negotiating and challenging future EU regulations.
In summary: is it worth it?
Overall, Brexit would cut inward FDI – by close to a quarter according to our new estimates. This will damage UK productivity and could lower real incomes by 3.4 per cent. Case studies of cars and finance also show that Brexit would lower EU-related output of goods and services, and erode the UK’s ability to negotiate concessions from regulations on EU- related transactions.
Of course, these costs may be a price that many people are willing to pay to leave the EU. But they are not trivial costs. The UK received about £44 billion of new FDI inflows in 2014, according to UK Trade & Investment. If we conservatively assume that the stock of FDI is unaffected, that still means losing almost £10 billion of annual inflows after Brexit.
- This article is based on Foreign investors love Britain – but Brexit would end the affair in CentrePiece, the magazine of LSE’s Centre for Economic Performance (CEP).
- The post gives the views of its authors, not the position of LSE Business Review or the London School of Economics.
- Featured image credit: DesignRaphael Ltd
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Swati Dhingra is an Assistant Professor at the Department of Economics at LSE. Before joining LSE, Swati completed a PhD at the University of Wisconsin-Madison and was a fellow at Princeton University. Her research interests are international economics, globalisation and industrial policy. Her work has been published in top economic journals including The American Economic Review. She is Associate Editor of the Journal of International Economics, and was awarded the FIW Young Economist Award and the Chair Jacquemin Award by the European Trade Study Group for her work on firms and globalisation. Swati is a member of the Globalisation group at the LSE’s Centre for Economic Performance, and has made regular contributions to work on economic policy.
Gianmarco Ottaviano is Professor of Economics at LSE and an associate at LSE’s Centre for Economic Performance Trade Research Programme. His research interests include international trade, multinationals, economic integration, immigration and economic geography. He holds a PhD in Economics from the Catholic University of Louvain, Belgium.
Thomas Sampson is an Assistant Professor in the Department of Economics at LSE. He holds a PhD in Economics from Harvard University and an MSc in Econometrics and Mathematical Economics (with distinction) from LSE. He has worked as a consultant to the World Bank, a fellow of the Bank of Papua New Guinea and other organisations. He has published papers in a number of leading academic journals. His research interests are in international trade, growth and development.
John Van Reenen is a Professor in the Department of Economics and Director of LSE’s Centre for Economic Performance. He received the European Economic Association’s Yrjö Jahnsson Award In 2009 (jointly with Fabrizio Zilibotti), as the best economist in Europe under the age of 45. In 2011 he was awarded the Arrow Prize for the best paper in the field of health economics. His research focuses on the causes and consequences of innovation, the measurement of management practices and their impact on productivity across firms and countries.