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%.
Case studies of cars and financial services – two UK success stories – show, that if Britain left Europe it 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 £1 trillion of foreign direct investment (FDI), about half of which is from the EU. Only the United States and China receive more FDI than this.
FDI brings a number of benefits. It tends to raise productivity, which increases output and wages. It brings direct benefits as foreign firms are typically more productive and pay higher wages than domestic firms. And it brings indirect benefits as the new technological and managerial know-how introduced by foreign firms can be adopted by domestic firms, often through being part of multinationals’ supply chains. FDI can also increase competitive pressure, which forces managers to improve their performance.
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.
Those that support British exit from the EU claim the UK could attract more FDI outside the EU as it would be able to strike even better deals over trade and investment. But what does the data say?
We looked at bilateral FDI flows across all 34 OECD countries over the last 30 years and analysed how FDI 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 FDI by around 28% - the exact magnitude ranges from a 14% to 38% increase in FDI depending on the statistical method used. These estimates are similar to previous estimates, which have found an impact of 25% to 30% 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 an EU exit is not a good substitute for full EU membership.
We also found that the impact of lower FDI following an EU exit would be equivalent to a fall in real UK incomes of about 3.4%. 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 an EU exit would matter for living standards in the UK. An income decline of 3.4% is larger than our static estimates of the losses from trade, 2.6% in our pessimistic case, but smaller than the long-run dynamic losses from trade of over 6.3%.
Cars and cash
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 this FDI decrease – cars and financial services.
Cars are a successful part of UK manufacturing. In 2014, the industry contributed around 5.1% to UK exports, and about 40% 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 leaving the EU.
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% – or 180,000 cars a year. This is mainly because European car manufacturers such as BMW will move some production away from the UK. Prices faced by UK consumers will also rise by 2.5% 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 12% of tax receipts. The single market allows a bank based in one member of the EU to set up a branch in another, while being regulated by authorities in the home country. This “single passport” to conduct activities in EU member states is important for UK exports of financial services. Passporting 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 an EU exit. Members of the European Economic Area outside the EU enjoy them, but they also have to contribute substantially to the EU budget, accept all EU regulations without a vote on the rules and must allow free labour mobility with the EU. And even for these countries, like Norway who must “pay and obey with no say”, there seem to be greater difficulties in doing business than a full EU member.
Staying in the EU also gives the UK the ability to challenge new regulations in the European Court of Justice, a right that was successfully exercised when the European Central Bank wanted to limit clearing-house activities to the euro area. If the UK leaves the EU, it would lose its leverage in negotiating and challenging future EU regulations.
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. The UK received about £44 billion of new FDI inflows in 2014 according to UKTI – losing almost £10 billion of this after an EU exit would be no laughing matter.
This article was co-published with the LSE Business Review blog.