One of the key issues in the referendum campaign has been the extent to which a Brexit would affect the UK’s economy. While much of this discussion has focused on trade, the role of investments in the UK from other EU countries is also important. The UK is a major recipient of investment, with only the United States and China receiving more foreign direct investment (FDI) than the UK. And of this investment in the UK (which has an estimated stock value of over £1 trillion) about half has come from other EU countries.
How would FDI be affected if the UK were to leave the European Union?
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 it is in the EU or not. But since EU membership reduces trade and investment costs, it is likely to have an impact even after controlling for these other factors. There are at least three reasons why FDI might fall if the UK left the EU:
- First, being fully in the single market makes the UK an attractive export platform for multinationals as they do not bear 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 the EU would also tend to dampen FDI.
On the other hand, 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 does the data say?
Using an analysis of 34 OECD countries from 1985 to 2013, we can assess how much more FDI comes in when a country joins the EU, once we control for a whole host of determinants of FDI. This calculation shows that EU membership increases inward FDI flows by 14% to 38%, depending on the exact statistical method. On average then Brexit is likely to reduce FDI inflows to the UK by about 22%.
Being a member of the European Free Trade Association (EFTA) like Switzerland does not restore the FDI benefits of being in the EU. In fact, there isn’t much difference between being in EFTA compared with being 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.
How do changes in FDI affect UK incomes?
There is much evidence that FDI brings benefits in terms of enhanced productivity. For example, previous studies have found that multinationals boost productivity in UK establishments through enhanced technologies and management practices. But to get at the nation-wide impact of FDI on output, we need to factor in the many complex ways in which FDI affects people and firms in multiple parts of the economy.
This is a tricky task, but fortunately we can draw on prior research by Laura Alfaro and others which estimates the effect of changes in FDI on growth rates across 73 countries. They find that increases in FDI have a large positive impact on GDP growth, especially for countries like the UK that have a highly developed financial sector.
To be very conservative, we assume a scenario where the Brexit-induced fall in FDI lasts only for 10 years and then reverts to its current level. Combining the estimated drop in FDI inflows from Brexit with Alfaro and her co-authors’ estimated decline in growth implies a fall in real income of about 3.4% after Brexit. This is equivalent to a loss of GDP of around £2,200 per household.
Two case studies: Cars and cash
This is the bigger picture, but what about specific examples? Cars and financial services offer two interesting cases. Cars are a successful part of UK manufacturing. In 2014, the car industry contributed around 5.1% to UK exports, and about 40% of its car exports were to the EU. In a survey of its members in 2014, the Society for Motor Manufacturers and Traders found that 70% of its member firms expect Brexit to have a negative medium to long-term impact on their business.
A previous study by Head and Mayer uses information on assembly and sales locations on 1,775 car models across 184 brands. 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 – 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% – 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 2.55% as the cost of imported cars and their components increase.
Financial services have the largest stock of inward FDI in the UK (45%) and constitute 8% of GDP and 12% of tax receipts. The single market allows a bank based in one member state of the EU to set up a branch in another, while being regulated by authorities in the home country. This ‘single passport’ 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. But just like Norway, these will come at the cost of greater difficulties in doing business with the EU, and with the UK having to accept most EU regulations without a vote on the rules. Staying in the EU gives the UK the ability to challenge new regulations in the European Court of Justice, a right that it successfully exercised when the European Central Bank wanted to limit clearing house activities to the euro area.
Is it worth it?
The firm-level analysis confirms the macroeconomic and survey evidence that Brexit would cut inward FDI. This will damage UK productivity and could lower real incomes by 3.4%. 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.
Swati Dhingra is a Lecturer in Economics at the London School of Economics and Political Science. This article is based on joint research conducted with Thomas Sampson, John Van Reenen and Gianmarco Ottaviano.
The views expressed in this analysis post are those of the authors and not necessarily those of the UK in a Changing Europe initiative.