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)
Wednesday 06th February 2019
Jorge Emilio Núñez
Twitter: @London1701
https://drjorge.world 
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