Territorial disputes: Brexit (3) [Post 203]

Brexit and foreign investment in the UK

The blog series centers today on a paper exploring the likely effect of Brexit on inward foreign direct investment (FDI) through its possible effect on the benchmark variables that characterize the macroeconomy.Since the outcome on the UK’s exit (‘Brexit’) from the European Union (EU) referendum there has been much comment on the likely nature of the UK’s trading relationship with the EU and the rest of the world. However, despite its importance to the UK economy, the effect on inward foreign direct investment (FDI) received little comment during the referendum debate, and only more recently have the positions of, for example, the Japanese car makers in the UK been the focus of attention. This is despite the fact that the UK has been for 40 years not merely open to inward investment but has actively sought foreign investment across all sectors. Many UK and non‐UK firms have taken the opportunity to develop supply chains that cross into and out of the UK several times. The position of these firms, and the capacity for the UK to continue to attract inward FDI, is potentially one of the most important economic aspects of the UK’s leaving the EU.In many sectors, more than 50% of the value added in the UK is generated by foreign‐owned firms, and overall more than 50% of the private sector research and development in the UK is foreign owned. Because of this, supply chains in many high value sectors are dominated by foreign firms and, by extension, many of the UK’s regions are reliant on inward investment for economic development.This paper seeks to make two contributions. First, it explores why there is a lacuna between the theoretical literature which predicts an inverse relationship between host country exchange rate appreciation and FDI flows, and the empirical literature which at best finds only a weak relationship that is relatively unstable over time.Second, in terms of the UK’s potential Brexit, the documen presents the findings that are informative on two levels. Firstly, there is a high degree of uncertainty over Brexit and what the effects on the UK economy will be. Although the advocates of the UK’s leaving the EU changed their position through 2017, and are adamant that they now wish the UK to leave the customs union, there is a high degree of uncertainty around the effects of withdrawing from many of the institutions that support and manage the free‐trade area. At the time of writing (September 2018) this appears to be the dominant position of the Conservative Party, but they are facing opposition, not just from the political opposition, who seem to favour staying in the customs union, but also from within their own party, and from bodies such as the Confederation of British Industry and the Institute of Directors. As many business leaders and political commentators are arguing, this may lead to a period of instability, following the referendum and the period afterwards while the terms of exit (and re‐entry into the free‐trade area) are negotiated, although it is quite unclear about whether, how and to what extent this instability will manifest itself in the macrovariables.Perhaps the greatest effect of Brexit in terms of its effect on inward FDI is not Brexit itself, but what it implies. Compared with other forms of capital inflow, it is clear that foreign disinvestment will be slower than other forms of capital outflow. Nevertheless, although it is doubtlessly true that these other forms of capital outflow will have a faster detrimental effect on the UK economy, to understand the significance of FDI flows, we need to understand the nature of foreign investment decisions.Foreign investment into the UK occurs with a 2–3‐year lag between the decision’s being taken and the investment. This holds for expansion or reinvestment as well as for new investment. For example, decisions regarding the location of new production lines in the automobile sector for 2021 have already been taken, and decisions for 2024 are due by 2020. As such, the lack of new investment is similar in effect to exit, as it implies de facto a relocation away from the UK. It is also likely to cause a move of supporting sectors and supply chains away from the UK, and an increase in imports.It is reasonable to assume, for example, that on the basis of the present direction of travel of the UK Government, and its so‐called neo‐liberal agenda, there will be an increase in the types of policies that are designed to improve UK cost competitiveness. This means, for example, further increases in labour market flexibility, reductions in employment protection and greater trade with low cost locations such as Asia although it is still a matter of some debate, even within the governing party.At the same time, however, it is palpable that Brexit already puts and will continue to put pressure on UK exchange rates. One hitherto unexplored relationship concerns the interaction between uncertainty and currency depreciation. In times of uncertainty, devaluation of currency deters new investment, irrespective of the fact that it makes the investment ‘cheaper’ in a firm’s home currency.The results suggest that, to remain competitive in attracting inward investment, the incentives that are offered will need to be sizable and may contravene the trade relationships that the UK will seek to form with the EU. There has been some speculation that reduced tax rates may offset some of the negative effects of Brexit, though at the same time tax competition may alienate the EU even further. Irrespectively therefore of what precise institutional arrangements the UK agrees with the EU, the authors expect inward investment to fall in the medium term, though some trade‐offs may be possible as sector level agreements develop.Paper by Royal Statistical Society (complete document)https://rss.onlinelibrary.wiley.com/doi/full/10.1111/rssa.12417

 Wednesday 06th February 2019Jorge Emilio NúñezTwitter: @London1701


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