If the British government chooses not to align with EU regulations post-Brexit, the consequences for inward foreign direct investment to the UK may be significant
It has been argued that Brexit will result in a decline in foreign direct investment (FDI) to the UK, perhaps by as much as 22% over the next decade. FDI inflow would, in particular, be adversely affected by the UK opting out of the EU’s single market. Data suggest that integration with the single market has played an important role in driving both inflow and outflow of FDI from the UK.
An important component of this decline in inward FDI could be the decision by companies to direct their new investments (or investment in new products and product line) to their EU plants, even if companies do not actively sell off their UK assets. The extent of redirection of new investments to EU-based production units may, in particular, be significant if the UK government pursues a policy (or strategy) of non-alignment with EU regulations after 31 December 2020.
It is difficult to determine whether the threat to diverged from EU regulations that is currently being suggested by the government is merely aimed at their own supporters or whether it is the opening gambit of a strategy for something more meaningful in terms of the direction the government wants to go.
Those advocating this are of course correct in that the UK once outside of the EU can pursue whatever policy it wishes. However, the further we divert, the harder it will be for UK based firms, whether UK owned or foreign owned, to sell into EU markets. At the same time the EU has a large number of bilateral arrangements over standards and market access with countries such as Japan, Korea, Chile, Mexico, Turkey and Canada, and the further we diverge from EU regulations, the more pressure the EU are likely to put on such partners to not do favourable deals with the UK.
Companies that are highly productive and have the capability to compete globally are more likely to locate significant proportions of their assets in the EU. This follows from the observation that moving assets and making investments across borders, to different regulatory and legal jurisdictions, is a complex and costly process which only relatively few companies are able to bear. Indeed, the very basis for policies that aim to attract multinational enterprises (MNEs) – those who can expand their operations beyond their home contexts – to a country is that these companies have technological and other advantages from which domestic companies can benefit directly or indirectly. This technological (and, hence, productivity) advantage can, in turn, be a manifestation of better management practices.
It is reasonable to expect, therefore, that in the aftermath of the shakeout, better managed and more productive companies that are globally competitive will focus more on developing their EU production bases, perhaps by shrinking their investment in the UK in relative terms.
The vast majority of the companies in the UK will not fall in this category.
These companies – the majority of which will retain their operations largely or entirely within the UK – will have to contend with a number of different shocks. Brexit itself may result in imposition of tariffs and border controls, thereby raising the cost of doing business with the EU – the nearest and, for many of these firms, the largest overseas market. The impact of tariffs and costs associated with border controls and non-tariff barriers can perhaps be ameliorated by the depreciation of the pound sterling (which will make British goods and services cheaper than those of their EU-based competitors). However, a sharp fall in the value of the pound vis-à-vis the euro and the US dollar will raise the price of imported goods and services. This, in turn, will raise the cost of production of companies that are reliant on imported raw materials and components, and also reduce the purchasing power of the average British consumer.
Further, evidence from around the world suggests that distance matters for trade, especially for smaller companies, and hence these companies are unlikely to be able to make up any loss of the EU market for their goods and services by diverting sales to other countries such as the USA. Most importantly, these (and all other) companies will operate in the (post-) Covid-19 world in which aggregate demand would be lower compared to the pre-pandemic world, perhaps for an extended period of time. In that era, companies with weak technological and managerial capabilities may be at a disadvantage.
Experience suggests that any group of people or companies that lose on account of any disruption in its environment but cannot move to a different context – a different country, for example – to mitigate the extent of this loss, is likely to lobby the government to implement policies that would enable them to survive and, at the very least, reduce their losses.
One option for the companies that cannot redirect their investments to EU locations would be to lobby for greater alignment with EU regulations and product standards, and for tariff-free trade with the EU. If, however, such alignment is politically infeasible in a post-Brexit UK, they may lobby for greater protection from competition instead, and this would be consistent with the rise in protectionist measures that we have observed globally since the financial crisis.
The government has for example recently announced a tariff schedule, aimed at making it cheaper for firms to import key components into the UK, while having tariffs on for example cars to protect inward investors. The issue then becomes how the EU respond to this, and whether this encourages any ‘tariff jumping’ – and if so in which direction.
If this comes to pass, and is reflected in the tone and nature of the trade and investment agreements/treaties that the UK will have to negotiate over the next decade, we should be pessimistic about the long term productivity growth in the UK – greater openness is associated with higher productivity growth – and, correspondingly, about the country’s long term prosperity.
This blog was first published by The UK in a Changing Europe and is reproduced with permission.