University of Bielefeld

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1 University of Bielefeld Faculty Economics and Management National trade policy under cross-border ownership - Implications of possible scenarios after Brexit for FDI in the UK Course: Masterseminar zur Außenwirtschaft (312839) by Michael Gerhards Matriculation number: Bielefeld, 31 st of January 2017

2 Contents 1. Introduction Importance of FDI for the British economy Benefits of FDI FDI in the UK Scenarios after Brexit The Procedure FTA Scenario WTO Scenario EEA Scenario Implications for non-eu FDI Conclusion References II

3 1. Introduction On 23th of July 2016 the United Kingdom held a referendum about their membership in the European Union (EU). This referendum has not been the first of its kind in the UK. Already in 1975 the British population was asked to vote for or against the exit from the European Economic Community (EEC), which was a kind of a predecessor to the European Union, that we know today. Back then, the result was, that the UK remains in the EEC. 36 years later, the British population was less positive towards European cooperation. It is well-known, that the result of this referendum was, that the UK will withdraw from the EU within the next years. This is the first time, that a member of the European costumes union decides to exit. Hence there is a large uncertainty under politicians, economists, legal experts, industry representatives and the population around the world about the next steps that must be proceeded. Even though there is the infamous article 50 in the Treaty of European Union (TEU) there are still some difficult technical issues that will need to be traversed carefully (Allen & Overy, 2016 p. 7) left. There have been two very popular reasons for the British citizens to vote for leave. First, they had the opinion, that the UK had no control about the immigration of refugees. Second, they felt disadvantaged by economic decisions that were made by EU s institutions. For example, about contributions to the EU household. However, we will neither look at reasons for or against the Brexit in this paper, nor will we assess, whether leaving the EU was the right or the wrong decision for UK s economy or population. We will rather have a look on Foreign direct investment (FDI) since this economic factor is deeply embedded in the British economy. Nowadays UK s inward and outward FDI flows sum up to more than 1 Trillion Pounds a year. Its most important partner in trade and FDI is the European Union. Although it is hard to find empirical evidence for a strictly positive influence of FDI in the host country, we will see, that the prevailing opinion among economists indicates, that FDI inflows create spillover effects, which are mostly positive for the hosts economy. Hence it is essential to think about the consequences for FDI, when the future UK-EU trade relations and its framework conditions are designed. 3

4 In this paper, we will discuss the consequences of different scenarios that are possible after the formal exit is proceeded. In the first section, we will consider the importance of FDI for the British economy. We will start quite generically with an overview over the benefits of FDI for host countries and its economy. We will go on by giving an impression about the volumes and the development of FDI inflows into the UK. In the second section, we will give an insight about the procedure that lies ahead for the British government and the European institutions when executing the formal exit. Afterwards we will consider the different imaginable trading policies, that can be enforced after the exit is performed. Then we will have a closer look at three of these possibilities and their consequences for FDI flows into the UK. The section will be completed by an outlook on FDI flows and trade relations between the UK and other non-eu countries after UK s membership in the EU ended. The last section will conclude. 2. Importance of FDI for the British economy 2.1. Benefits of FDI FDI is a very important factor for a countries economy. It is not only a possibility to get working capital from other countries into the own economy, but also gives the opportunity to use spillover effects and thereby enhances the hosts countries productivity level. For example, Driffield (2001) found evidence for a kind of a catching up effect. That means, that less effective domestic firms are motivated to invest in efficiency enhancing methods or products, to be able to compete with foreign MNEs. There even is statistical evidence, that multinational enterprises do generate positive productivity spillovers in UK industries (Liu et al., 2000 p. 420). Furthermore, one can assume, that the amount of inward FDI is affecting the level of growth, if the schooling level and thereby the human capital in the host country is high enough (Borensztein, 1998). Indeed, the United Kingdom had an education index of 0.86 in 2013, as the human development report indicates. This is the 13 th highest score worldwide. 4

5 Blomström and Kokko (1998) identified five important areas, where spillover effects from MNEs might affect the hosts countries economy: 1. FDI can break supply bottlenecks, which has positive effects on the hosts countries enterprises. 2. MNEs will show new technologies and will train workers, who are working for domestic firms later. 3. MNEs can break down monopolies and enhance competition. But they might also break down competition and create a monopolistic market, if they are far more productive than the competitors from the home country. 4. They might also bring new standards in quality and techniques to their local partners (suppliers and/or distributors). 5. The host countries enterprises are forced to increase their own marketing techniques and may be pressured to use MNEs processes on local or international markets. Overall one can say, that in the literature FDI is mostly evaluated as welfare rising and therefor it is obvious, that the UK should try to keep the level of foreign investments on a high level after the Brexit FDI in the UK From an historical point of view we can state, that the level of worldwide FDI has been very high in the beginning of the 20 th century, decreased over time and then started growing in the second half of the last century again (te Velde, 2006). We can observe this tendency of rising FDI volumes over the last centuries in the UK as well. 5

6 Net FDI inflows in Million USD Chart 1: Net FDI inflows into the UK in Million USD (Source: Worldbank Data) In chart 1 we cannot only see, that the volume of inward FDI has a clearly increasing long-run tendency in the years from 1970 to 2015, but also, that the volatility was very high in the years from 1998 to We can see very drastic drops in the early years of the 21 st century and in 2009, which is not surprising, if we keep in mind the worldwide economic situation in these years, especially in the sector of the financial markets. Net FDI inflows in % of GDP FDI in % of GDP GDP in Billion USD 12,00% 10,00% 8,00% 6,00% 4,00% 2,00% 0,00% Chart 2: FDI inflows in % of GDP If we look at the Net FDI inflows in percentage of GDP in chart 2, we can see, that the share of FDI inflows into the British economy has risen until However, this number is comparably low since 2009 and did fall again in In the 6

7 interpretation of this result, we must consider, that UK s GDP kept rising almost permanently. FDI inflow in % by partner 10% 7% EU27 United States ASIA Others 34% 49% Chart 3: FDI inflow in % by partner in 2012 (Source: OECD data) Chart 3 shows, that in 2012 almost one half of all the FDI inflows into the UK came from the other EU members. This represents a volume of about 27.6 Billion Dollars. The next biggest partner in FDI inflows are the USA with a volume of about 19.2 Billion Dollars, which is equivalent to 34% of the net FDI inflow. (Source: OECD data) This shows, how closely linked UK s economy is to the European single market. Thereby it is obvious, that the British government is welladvised in doing their best, putting the UK in a good position for further trade relations to the EU in the future. Above that, as chart 4 indicates, the UK enjoys the biggest share in EU s FDI inflows, by far. To keep investors from other countries active in the UK, it will be essential, to be able to provide access to the European single market. Otherwise one major motivation for FDI in the UK will drop out (Ernst & Young, 2015). 7

8 UK's share in FDI inflows to EU15 40,0 35,0 30,0 25,0 20,0 15,0 10,0 5,0 0,0-5,0 BEL DEU GRC DNK AUT LUX IRL PRT SWE ITA FRA FIN ESP NLD UK Chart 4: (cf. Kierzenkowski et al., 2016 p.24) At this point it shall be mentioned, that it is not only in UK s interest to keep its FDI flows on a high level. As European enterprise are obviously very active in the UK, it is also in the EU s interests to give them a good environment, to continue their businesses. Above that, as the UK serves as the source of many activities of non- EU enterprises in the whole EU, the EU profits from non-eu FDI in the UK as well. Hence there is a bilateral interest for good long-term trade relations between the EU and the UK. 3. Scenarios after Brexit 3.1. The Procedure There are different possible scenarios, how the trade relations between the UK and the EU can be designed after the UK left the EU. However, the first thing that will happen, once the British empire requests to leave the EU officially, is that the well-known article 50 TEU will be applied. This article describes the process, that has to be performed, when a country wants to withdraw from the EU. However, it is not said, how the trade relations between the exiting country and the remaining part of the EU will go on. Obviously, UK s economy is very well interlinked with EU s economy. But the political representors will have to start negotiations about trade agreements. However, it is not certain, that these negotiations lead to any 8

9 kind of FTA, or even end up in the membership of the UK in the European Economic Area (EEA). Nevertheless, we must be clear about the time horizon, it will take the UK to leave the EU. The procedure, that is described in article 50 TEU says, that once the UK did hand in notice to the EU officially, there will be two-year period of negotiations, before the UK will exit the EU formally. During this time, there is the possibility to negotiate about trade agreements. In January 2017, the British prime minister, Theresa May, did announce, that the UK is going to give the two years notice to the EU by the end of March So, we can expect the exit to be completed in Thereby it would be the best, if by 2020 it is clear, how the trade relation between the UK and the EU will be designed from 2020 onwards. Chart 5: Schedule for exit (cf. PWC, 2016 p. 13) Economists say, there are basically four possible groups of scenarios about the way the UK will be trading with the EU, after they left the single European market (e.g. Kierzenkowski, 2016). First, there is the possibility, of an UK-EU free trade agreement (FTA). This would imply free trade of goods between the EU s single market and the UK. In this scenario, the UK is free to decide about any regulatory issues in their own economy for themselves. Further they don t have to accept free movement of citizens or workers in this scenario. Second, there is the possibility to go back to a pre-eu model, which would mean, that the UK and the EU would trade under WTO rules on a most favoured nation (MFN) basis. This would mean, that the UK is completely free in its internal decisions about immigration, tariffs on trade etc.. But, also the EU and other countries, that are current trading partners probably will enforce tariffs against 9

10 products from the UK. Beyond that, products from enterprises based in the UK will still have to meet up with EU regulations, if they are produced for the EU market. (PWC, 2016) Third, there is the possibility, that the UK remains in the European Economic Area. As a member of the EU it is automatically a member of the EEA. However, it is not entirely clear, whether an exit from the EU automatically means an exit from the EEA (Allen & Overy, 2016). Even though remaining in the EEA would bring some significant benefits from an economic point of view, it is questionable, that this model is a serious option for the British government and the European representatives during the negotiations. We will come back to thee concerns later. Fourth there is the option to follow the swiss model. Namely to set up several bespoke bilateral deals. This would mean, that the UK and the EU would negotiate a number of deals, that contain regulations for specific areas of trade, migration, movement of workers etc. Other authors are very pessimistic concerning the development of new direct investment into the UK in the years after the exit. They state, that even being a member of the European Free Trade Association (EFTA) like Switzerland does not restore the FDI benefits of being in the EU. (Dhingra et al., 2016 p.26) So it is very likely, in their opinion, that in the long run the exit from the EU does lead to a decrease in FDI from the EU to the UK. Dhingra et al. (2016) quantify this by expecting a FDI level of around 22% less in the long run compared to their expectations, if the UK would remain in the EU. In the following sections, we will have a closer look at the first three scenarios. We will drop the model of bespoke bilateral deals, because of the following reasons: First, we can t predict, what these deals might include or exclude, because the British economy and its link to the European economy is not comparable to the swiss economy directly. Second the pros and cons in this scenario are pretty similar to the ones in the EEA Scenario. Hence the results would probably neither differ to much from the results in the third scenario, nor would they be robust against differences between possible UK-EU deals and the Switzerland-EU deals. It shall be said, that we will concentrate mainly on inward FDI in the following explanations. This is due to the fact, that the British government will be totally free 10

11 to decide about their policy concerning UK enterprises, that decide to proceed FDI in other countries. Hence it would go beyond the scope of this paper to examine all the possible combinations of outward and inward FDI policies FTA Scenario Let us assume, that after the UK exits the EU, they manage to negotiate a free trade agreement, that includes free trade of goods between the EU s single market and the UK. On this way, the UK would be able to keep the trade with the EU on a very high level, without accepting the regulations concerning the free movement of EU citizens and keeps his independence in refugee-related questions (cf. PWC, 2016) Further, it probably will be able to gain more control in the field of market and product regulations, than it has as a member of the EU. We can assume, that the trade between the EU and the UK will not be affected to much in this case in the short term. But in the long term, there will probably arise some regulatory divergence between the UK and EU over time, leading to an increase in non-tariff barriers. (PWC, 2016 p.14) As there is robust evidence of the negative effect of the heterogeneity of regulations on FDI (Fournier, 2015 p. 24), these non-tariff barriers will nevertheless lead to a decrease in trade relations and thereby in FDI. This heterogeneity in regulations is the main reason for PWC to predict that Brexit caused trade decreases will lead to a decrease in UK s GDP of about 0,5% from 2020 onwards. The HM Treasury (2016) is more drastic in its conclusions than PWC (2016) in its predictions about the FTA scenario. It expects an overall impact on total FDI inflows into the UK from EU and non-eu countries under FTA of -15% to -20%. This would obviously mean a drastic change in the structure of UK s economy and its possibility to benefit from spill overs from foreign direct investments WTO Scenario If the UK and the EU don t manage to negotiate an FTA, another realistic scenario is, that the UK and the UK trade under WTO rules on an MFN basis. This can be seen as the worst-case-scenario, as it would imply, that the trade relations between the UK and the EU go back into a pre-eu situation, without any special 11

12 trade contracts. This would mean, that the UK has low access to the EU s single market and basically no influence over EU regulations. In exchange to that, the UK would be totally free in its decisions about regulations in its economy. However, the UK must acknowledge, that the EU is its most important trading partner. Thereby, in order to keep its export level on an acceptable level, it will need to meet EU product standards anyway in most sectors (cf. PWC, 2016). In the WTO scenario, the UK and the EU will introduce tariffs towards each other. The PWC study predicts, that this, in addition to non-tariff barriers, will lead to a major drop in trade, that causes a long term decrease of 1,7% in UK S GDP in 2020 and 2.1% in Further, the UK was the destination of almost 35% of inward FDI flows into the EU in And even if there is no statistical difference between being in EFTA compared with being completely outside the EU (Dhingra et al., 2016 p.26), we must consider, that the UK is the most attractive destination for FDI in the EU, partly owning access to the EU internal market (Kierzenkowski et al., 2016 p.24). Ernst & Young (2015) stated, that 72% of investors [were] citing access to the European single market as important to the UK s attractiveness (Ernst & Young, 2015 p. 4). Whilst benefits of the UK market for foreign investors like flexible labour markets will probably keep existent after the exit, we can expect, many firms to rather invest in other countries in the EU in the future, because the UK can t offer access to the EU s single market anymore. There already is prominent evidence to this in the financial sector, where the first banks did announce to move their European headquarters partly or completely from London to Paris or Frankfurt for these reasons (i.e. VTB, or HSBC). The HM Treasury (2016) expect the WTO scenario as very inhibiting for inward FDI flows. Their analyses suppose, that a long-term solution under WTO rules will lead to a decrease in FDI flows into the UK of 18% to 26% EEA Scenario The third possible way of trading between the EU and the UK after the Brexit is, that the UK enters the European Economic Area which currently consists of the 28 EU member states (including Great Britain) and the EFTA states Iceland, 12

13 Lichtenstein and Norway (excluding Switzerland). Countries that are part of the EEA but not members of the EU can participate in the EU s single market. Especially, the four freedoms (free movement of persons, services, goods and capital) are valid for all members of the EEA. Entering the EEA does also mean, that the country faces the same obligations, EU members do. (Gullberg, 2015) So once new EU legislation has been incorporated into the EEA Agreement, each of the EEA Member States is bound by it regardless of whether they also happen to be members of the EU (Allen & Overy, 2016) However, the UK would not have any representation in EU institutions, which is pushing them into the position of a pure rule-taker (Pisani-Ferry et al., 2016 p. 3). Some argue, that the EEA scenario is not realistic, because this option is characterised by some of the features of the European Union, that used to be part of the argumentation for leaving the EU. So especially the free movement of workers, within the EEA would contradict some very central arguments that were used by Brexit supporters during the campaign in 2015 and 2016 (e.g. PWC, 2016). On the other hand, one must acknowledge, that the EEA solution would affect the FDI inflow into the UK less than the WTO or the FTA solution, since there would not only be no tariffs, but also no regulatory barriers between the UK and the EU. The HM Treasury (2016) predicts a loss of inward FDI flows of 10% in the case of an EEA scenario. However, it is questionable, whether the other EU members would agree to this solution. As this approach would be open to the justified criticism of the UK cherry-picking its participation in a shared public good. (Pisani-Ferry, 2016 p. 3) Hence, we can conclude, that the EEA scenario is the economically best way out of the trouble of the Brexit, however, to be realistic, not very likely to be set in place Implications for non-eu FDI More than 50% of FDI flows into the UK are from non-eu countries. Obviously, these are not directly affected by the Brexit decision. However, the UK also profits from trade agreement of the EU with other countries. At the moment EU members have preferential access to 53 non-eu countries. After the Brexit, the UK will have to trade with these countries under WTO rules, if they don t manage to negotiate 13

14 trading contracts with them early enough. This would imply higher tariffs and other barriers, that reduce trade to these countries (Kierzenkowski, 2016). Beyond that, the EU is negotiating even more such agreements with very important trade partners, like TTIP with the USA. In the future, the UK is forced to negotiate these agreements on their own. There are two reasons, why this will be a hard task for the British government: First, as we already discussed, one of the main reasons for direct investment into the EU is its free access to the EU s single market (Ernst & Young, 2015). This access would obviously be a good argument for other countries to negotiate a FTA with the UK. But that advantage in negotiations drops out, if the UK leaves the Euroean internal market. Second, the UK is under a fifth of the economic size of the EU s Single Market. It would simply have much less bargaining clout than the EU currently enjoys. (Dhingra et al., 2016) It is well known, that in negotiations about FTAs a relatively small country will have worse chances to enforce its own interests in areas like product or service regulatory. Hence, the UK will probably have to accept many rules, which are set in place by their most important trade partners. From an economic point of view, this is not too bad, but in politic terms, this will put them in the position, the British population tried to escape from by voting for the Brexit. So, the task for the British government will be, to establish its own regulations and objectives in the negotiations with partners, that are economically much larger than the UK. However, the UK is also free to negotiate completely new trade agreements with partners, that the EU won t consider for FTAs for any reason. So, the UK is free to choose their partners in the way, they want, respectively, in the way, that is best for their single economy. Yet, negotiations about trade agreements are typically a very long process. For example, it took seven years for the EU and Canada to negotiate about their trade agreement and four years for the European Union- South Korea Free Trade Agreement. Thereby, we must expect, that, no matter which partners the UK decides to negotiate with, it will be a long process until all these agreements are in force. This means, that especially in the first years after 14

15 the formal exit, the trade relations to non-eu countries will not be very easy to handle. Hence, we can expect, that creating FDI flows between the UK and non-eu countries will not be as easy for the UK after the exit, as it would have been, if they would have decided to remain in the EU. 4. Conclusion We started this paper by stating, that FDI is a very big factor in the structure of British economy. Although inward FDI dropped in the years after the last financial crisis, one can not deny, that the growth in the UK is (among a lot of other factors) driven by foreign MNEs, that invest in the UK. We went on arguing that there are four possibilities for the future UK-EU trading environment. We found, that there are very different opinions about the likelihood of these scenarios, especially concerning the EEA model. However, we tried to estimate the consequences of the three most likely options and found, that they differ in their impact in FDI inflows. Before we care about the long term solution, we must consider, that the Brexit did and will cause uncertainty under foreign investors, which leads to lower investments in the upcoming years, independent from the scenario, that will be enforced in There have been different studies and analyses, that predict different consequences for the scenarios. For the FTA option, we found, that PWC (2016) doesn t expect very big drawbacks for British FDIs whilst the HM Treasury (2016) expects a decrease in FDIs of 15% to 20%. All studies, we considered, agree on the fact that the WTO scenario would have the most drastic consequences for UK s FDI. PWC (2016) doesn t name an exact number, but expects, that the GDP will be 1,7% lower in 2020 and 2.1% lower in 2030 compared to their expectations in the case, that the EU would remain in the EU, only due to decreasing trade volumes. The HM Treasury expects a drop of 15

16 18% to 26% in FDI in the long run due to the Brexit, if the WTO rules will be enforced on a MFN basis. The third option which is considered as very unlikely by PWC (2016) is the EEA scenario, because in this option the trade regulations basically stay the same and the British economy will keep facing the EU regulations in all production and society related areas. In fact, the only differences to the current situation would be, that the UK has no representation in EU s institutions, and the right to negotiate own FTAs with other non-eu countries. The HM Treasury (2016) expects a drop in FDI of 10% in this case. Further it should be mentioned, the British Government published a white paper about its plan to exit the European Union in February 2017, which specifies the 12- point plan, which was announced in January (HM Government, 2017) However, this publication fails in giving a concrete idea about the plans about a trade agreement with the European Union. It does say though, that the aim is, to negotiate a EU-UK FTA, but it is left to see, whether the EU will accept the ideas, the British government presents in this white paper. In the discussions about the consequences of different scenarios for FDI into the UK we mostly excluded the outward FDI flows. This is caused by the fact, that the UK is totally free to decide about tariffs and/or subsidies for British enterprises. Hence we can t expect any findings in this area to be reliable. To assess the different scenarios in their whole complexity, we would need a closer look at many other fields, that are affected by the Brexit. These would, for example, include the migration policy, the contributions to EU s budget and economy related laws, that must be formulated and enforced by UK s government, as soon as the EU laws aren t in force anymore. 16

17 References Allen & Overy (2016). Implications of EEA membership outside the EU different Law/Documents/Macro/EU/AO_BrexitLaw_-_EEA_Membership_Jul_2016.PDF Baier, S. L., Bergstrand, J. H., Egger, P., & McLaughlin, P. A. (2008). Do economic integration agreements actually work? Issues in understanding the causes and consequences of the growth of regionalism. The World Economy, 31(4), Blomström, M., & Kokko, A. (1998). Multinational corporations and spillovers. Journal of Economic surveys, 12(3), Borensztein, E., De Gregorio, J., & Lee, J. W. (1998). How does foreign direct investment affect economic growth?. Journal of international Economics, 45(1), Dhingra, S., Ottaviano, G., Sampson, T., & Van Reenen, J. (2016). The impact of Brexit on foreign investment in the UK. BREXIT 2016, 24. Driffield, N. (2001). The Impact on Domestic Productivity of Inward Investment in the UK. Manchester School, Vol. 69 (1), Ernst & Young (2015). UK attractiveness survey. name, same game? Survey/$FILE/EY-UK-Attractiveness-Survey-2016.pdf Fournier, J. (2015). The negative effect of regulatory divergence on foreign direct investment, OECD Economics Department Working Papers, No. 1268, OECD Publishing, Paris 17

18 Gullberg, Anne Therese. (2015). Lobbying in Oslo or in Brussels? The case of a European Economic Area country. Journal of European Public Policy, 2015, 22, 10, 1531 HM Government (2016). HM Treasury analysis: the long term economic impact of EU membership and the alternatives /treasury_analysis_economic_impact_of_eu_membership_web.pdf HM Government (2017). The United Kingdom s exit from and new partnership with the European Union 191/The_United_Kingdoms_exit_from_and_partnership_with_the_EU_Web.pdf Kierzenkowski, R., Pain, N., Rusticelli, E., & Zwart, S. (2016). The economic consequences of Brexit: a taxing decision. OECD Economic Policy Papers, (16), 1. Liu, X. and P. Siler, C. Wang and Y. Wei (2000). Productivity Spillovers from Foreign Direct Investment: Evidence from UK Industry Level Panel Data. Journal of International Business Studies, Vol. 31 (3), Pisani-Ferry, J., Röttgen, N., Sapir, A., Tucker, P., & Wolff, G. B. (2016). Europe after Brexit: A proposal for a continental partnership. Bruegel External Publication, Brussels PWC (2016). Leaving the EU: Implications for the UK economy 18

19 Te Velde, D. W., & by UNCTAD, C. (2006). Foreign direct investment and development: an historical perspective. Background Paper for World Economic and Social Survey for. 19