A Tentative Exploration of the Effects of Brexit on Foreign Direct Investment Vis-À-Vis the United Kingdom
Abstract: European Union (EU) integration has boosted inward EU foreign direct investment (FDI) into the United Kingdom (UK). Within the EU, the UK has a relatively significant stock of inward FDI, having reached 61% of its Gross Domestic Product (GDP) in 2017 and risen strongly since 2005. The exit of the UK from the EU and the Single Market will probably result in reduced FDI amongst both investment destinations. The aim of this study is to look at the “real-time” effects of the Brexit June 2016 referendum outcome and its aftermath on UK-related FDI activity. Although FDI flows are notably volatile and biased by periodic non-systematic outliers, and despite some caveats on data sources and availability of time series data, we find tentative evidence of a post-referendum slowdown in gross FDI flows between the UK and the EU, notably involving the big EU economies and Ireland. Regarding a very favoured form of FDI, greenfield FDI, we document a post-referendum fall in announced projects and capital expenditures into the UK by both other EU countries as well as one of the most important non-EU partners, the United States. A different approach is also used to analyse the Brexit effect on FDI activity, based on estimating the effect of two successive stages in the European integration process – EU membership and the Euro area launch – and considering Brexit effects as the reversal of the UK integration into the EU. By using a fixed-effect gravity model to estimate the effects of these integration processes on bilateral FDI activity with the UK, the empirical results suggest that, on the one hand, this country played a role as a gateway for a set of international investor countries outside the Euro area to enter European markets and, on the other, it acted as a hub that reallocated these inflows and those coming from Euro countries across the Euro area itself. Thus the disconnection of the UK from the EU may have further implications for FAI than just reverting the effect of EU membership. Larger trade barriers and lower integration between the UK and the Euro area countries’ markets will likely have a negative impact on FDI activity in the UK and might have, in the short run, a negative effect in the Euro area.
Summary (2 min read)
1 Introduction and relevance
- It is well established that foreign direct investment (FDI) is a source of economic growth and jobs.
- FDI provides a means for creating direct, stable and long-lasting links between economies.
- Since 2009, the UK looks more attractive for FDI than the EU, although both have approached their positions as investment destinations more recently .
2 Analysis and recent trends of FDI flows vis-à-vis the UK
- The authors main goal is to check whether the Brexit vote at the end of 2016Q2 materially affected FDI fl ows in the UK.
- Interestingly, a Brexit effect seems 6 Data source for this section: ECB.
- The authors make use of the FDI Markets database, a service by the Financial Times which is the leading standard regarding greenfield FDI trends.9 Regarding European flows to the UK, they observe a decline in announced greenfield FDI projects and capital expenditure post-referendum.
- The relative share of the UK as a destination of US greenfield FDI capital expenditure into the EU fell from 46% pre-referendum (2015) to 32% post-referendum (2017).
3.1 Estimating the Brexit effect on FDI
- As noted above, the formation of the EU coincided with increased FDI activity, while (the anticipation of) Brexit seems to reduce it.
- Indeed, Brexit effects may be viewed as the reversal of the consequences of the UK integration into the EU.
- On the other hand, lower barriers to capital mobility and reduced transaction costs can increase vertical FDI.13 Nonetheless, empirical studies tend to fi nd that EU membership and Monetary Union increased FDI infl ows.
- Empirical studies using this model generally follow two types of econometric methodology: the most traditional one, which includes size and distance variables, and the most recent one, based on the inclusion of fi xed effects to control for unobserved heterogeneity and mitigate biased estimates due to omitted variables.
- To estimate the “Brexit effect” on FDI fl ows, the authors use a fi xed-effect gravity model in line with Head and Mayer (2014) and UNCTAD and WTO (2016).
3.2 Empirical strategy and data
- These are usually time-invariant characteristics that may be correlated with the likelihood of forming an FTA and if some of them were omitted in the specifi cation, estimates of β1 could be biased.
- The use of logs poses the problem that only positive data can be used in the estimation what may lead to a selection bias.
- Data used covers 34 OECD countries between 1986 and 2013 which are the reporting countries.
- In their analysis the authors use both because the impact of a trade agreement may be short-lived or more persistent what may give rise to different effects in fl ows and stocks.
3.3 Estimation results
- The results of estimating equation (3) for both inward fl ows and stocks are presented in Table 1 (fi rst and third columns) while second and fourth column also present the results for outward fl ows and stocks.
- Dummy variable which is equal to 1 if both reporting and partner countries are members of a free trade agreement, also known as FTA.
- Dummy variable equal to 1 (since 1999) if the reporting country was an EMU member in 1999 and the partner country is out of EMU (11 countries which are the largest investors in UK), also known as out_EMU_r.
- Most of the previous estimations results are also obtained with this new procedure that, in general, yields higher values for most of the signifi cant coeffi cients, thus suggesting a negative bias in the previous estimates.
- UK leaving the EU and the Single Market will likely result in reduced FDI activity between the EU and the UK.
- The gravity equations also point to an extended market effect which increased FDI into the UK from a set of countries outside the Euro area that are global investors.
- Methodological and compilation issues concerning the measurement of FDI Data on Foreign Direct Investment are compiled and statistics are made available by several international organisations, including amongst other the OECD, the IMF, the European Commission/Eurostat and the ECB, also known as ANNEX.
- The Benchmark Defi nition recommends that FDI data be presented in two ways: on a straightforward asset/liability basis (i.e. under the asset/liability principle) and refl ecting the direction of direct investment infl uence (i.e. under the directional principle).
- There may also be fl ows in the reverse direction (when the direct investment enterprise invests or lends funds to its direct investor, but owing less than 10% of its equity, which are then equivalent to the withdrawal of investment) and between fellow enterprises.
Did you find this useful? Give us your feedback