14 February 2020

Nicolo Tamberi is a Research Assistant in Economics for the UK Trade Policy Observatory. 

An important question arising from the UK’s decision to leave the EU is around the impact on foreign direct investment (FDI) in the country, with many academics and commentators suggesting that exiting the EU may accelerate the decline of British manufacturing.

Car manufacturers such as Honda and Toyota came to the UK in the 1980s with the aim of selling to the whole European market. While the car industry is often used as an example, other industries appear to be affected by uncertainty as well. Hiroaki Nakanishi, chairman of the board of Hitachi, wrote in the Financial Times: ‘We invested in [the UK] as the best base for access to the entire EU market’. The Japanese government’s letter to the United Kingdom clearly stated that for Japanese firms in the UK frictionless access to the European market is vital for their business.

While the referendum on leaving the EU did not change the UK-EU relationship immediately, it generated uncertainty about future UK-EU trade policy. To try to understand whether firms have chosen not to invest in the UK because of this uncertainty, we looked at the investment behaviour of manufacturing firms from outside the EU that have developed export platforms in the UK – production facilities to sell to the entire EU market – both before and after the referendum.

Our analysis (see working paper) indicates that this trade policy uncertainty caused a reduction of export-platform FDI of 13.5%. We find an opposite effect on other European countries, suggesting that some manufacturing firms switched from investing in the UK to investing in other EU Member States as a platform to the European market.

We obtained this result by considering the choices of a firm from outside the EU that is deciding how to serve the whole EU market. The firm has three options:

1. it can directly export to all EU members;
2. it can set-up foreign affiliates in several EU countries; or
3. it can build an export-platform in one of the EU countries.

The firm’s choices depend on the trade-offs between the fixed costs of investing, and the costs associated with exporting, including whether or not the firm faces tariffs. For example, trade from outside the EU as a third country would involve facing the EU’s Most Favoured Nation (MFN) tariff. On the other hand, settling production facilities in each Member State involves high fixed costs (for building new plants, staffing etc.) but there would be lower trade costs (such as transportation) since sales are domestic. The export-platform strategy lies in between these two options: there are intermediate fixed costs (only one new plant must be built) and low trade costs (within the EU there are only shipping costs but no tariffs to pay).

If the UK does not manage to negotiate a friction-free trade agreement with the EU before the end of 2020, then its exports to the EU would face the EU’s MFN tariff. This would increase the cost of trade. The possibility of a future increase in trade costs makes the export-platform strategy less attractive to firms, and the higher the MFN tariff rate the higher the potential cost. We looked at the growth of manufacturing FDI before and after the referendum (2014-18) by non-EU firms and tested whether sectors with higher EU MFN tariffs faced a larger reduction in export-platform FDI. Our analysis shows that the higher the potential tariff, the greater the reduction in FDI. Since our approach is based on the possibility of the UK leaving the EU without a deal, we are able to estimate that non-EU firms perceived a probability of a no-deal exit of 18%.

Some of the firms might have just delayed investments in the UK during the period of uncertainty, but our results suggest that some investments might have gone to other EU countries rather than to the UK. Whether leaving the European Union will accelerate the decline of the manufacturing sector in the UK is a question that we can answer only in few years. What we see for now is that the uncertainty that dominated the last three years is taking the country in that direction.

The outcome of negotiations on a final agreement between the UK and the EU will be crucial for any business decision. In the meantime, uncertainty over the future trade relationship with the continent will keep affecting foreign direct investments in the UK. However, more transparency does not necessarily mean more investments. Indeed, if the Government announced that there is definitely a ‘no-deal’ exit from the EU, there would be certainty about higher trade costs that would deter export-platform investments. What our analysis shows is that just the possibility of a ‘no-deal’ exit affected export-platform FDI. A definite no-deal might have even larger effects.

Given that the response to policy changes is likely to differ across sectors, consultations with the various industries matter. Having a full picture of the potential responses from industry will help the Government to tailor its policy in order to mitigate any negative effects on FDI. At the same time, consultations might allow firms to accommodate better to policy changes. Finally, it should be recognised that some of the firms currently serving the British market from the continent might consider investing in the UK in response to increase in trade costs (see Nissan leaked scenario planning). Understanding all these possible reactions will help the Government to shape policies and minimise disruptions.

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The opinions expressed in this blog are those of the author alone and do not necessarily represent the opinions of the University of Sussex or UK Trade Policy Observatory.

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