Foreign investors love Britain, but Brexit would kill the vibe. According to new research colleagues and I have conducted at the Centre for Economic Performance, leaving the European Union could lead to a fall in inward foreign direct investment into the UK of close to a quarter. This would damage productivity and could lower people’s real incomes by more than 3 per cent.
Case studies of cars and financial services – two UK success stories – show that Brexit would also lower EU-related output of goods and services, and erode the UK’s ability to negotiate concessions from regulations on EU-related transactions. According to government body UK Trade and Investment, the UK has an estimated stock of over £1tn of foreign direct investment (FDI), about half of which is from the EU. Only the United States and China receive more investment than this.
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 also has a strong rule of law, flexible labour markets and a highly educated workforce, all of which make it an attractive location for foreign direct investment whether or not it is in the EU.
But 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. 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 staff transfers within companies would become more difficult with tougher migration controls. Plus, uncertainty over the shape of the future trade arrangements between the UK and EU also tends to dampen FDI.
Supporters of Brexit claim the UK could attract more foriegn investment outside the EU as it would be able to strike even better deals over trade and investment. But what do the data say?
We looked at investment flows across all 34 OECD countries over the last 30 years and analysed how investment 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 results showed that being in the EU increases investment by around 28 per cent (the exact magnitude ranges from a 14 per cent to 38 percent increase depending on the statistical method used). These figures are similar to previous estimates, which have found an impact of 25 per cent to 30 per cent using an alternative method which 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 being in EFTA compared with being completely outside the EU like the US or Japan. So striking a comprehensive free trade deal after Brexit is not a good substitute for full EU membership.
We also found that the impact of lower investment 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 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, 2.6 per cent in our pessimistic case, but smaller than the long-run dynamic losses from trade of over 6.3 per cent.
The macroeconomic estimates give a bird’s eye look at the effects but it’s useful to hone in on particular industries. Two success stories of the UK economy are set to suffer as a result of the decrease: 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, and about 40 per cent of its exports were to the EU. The work of economists Keith Head and Thierry Mayer, based on assembly and sales locations, shows the main disadvantages of Brexit.
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. Courtesy – The Independent