After Brexit... how will the UK protect its leading FDI status in the EU?

The ‘leave’ vote in the UK’s EU referendum will be one of the important factors to influence economic policy on the continent in the near future. Naturally, the UK’s eventual departure from the EU is expected to transform competition for inward FDI as well as policies that relate to the attraction of inward FDI.

EU member countries are granted free-trade access to other EU members. This access is one of the most important factors of the UK’s success as an inward FDI destination in the EU over the past two decades. Assuming that one consequence of an eventual ‘Brexit’ will be a less than free-trade access of UK-based companies to the common market, then the UK faces an erosion of its competitive position for attraction of inward FDI with regard to the EU economies.

How to counter losses?

Is there anything UK policymakers can do to counterbalance this loss in the competitive position of the country in terms of attracting inward FDI?

One policy decision could be the establishment of the UK as one of the most business-friendly economies on the European continent in terms of regulation. In this way, potential losses in the UK’s competitive position as an inward FDI destination in Europe could be limited, at least partly, by rendering it the easiest place in Europe to do business. Put simply, companies planning to locate in the UK could be compensated for the cost of less than free-trade access to the EU by a low regulatory burden.

Two issues arise from the above proposition. The first is the need to identify the EU countries that are the most competitive with the UK in terms of inward FDI. The second is to benchmark the regulatory environment of the UK against its most important competitors and detect areas for improvement.

FDI Similarity Index

To identify the UK’s most important competitors in terms of inward FDI in the EU, we employ the FDI Similarity Index proposed by Kalyvas and Webster (2011)*. This index measures the extent to which two countries have similar sectoral patterns in terms of inward FDI. Therefore, the FDI Similarity Index is able to detect the EU countries that are in most direct competition with the UK for inward FDI. We define the FDI similarity index to be:

FDI similarity between county A and B = the sum of the minimums between the inward FDI share in each sector in country A and the inward FDI share in each sector in country B. The FDI Similarity Index could range between 0% (when two countries have a completely different sectoral composition of inward FDI) and 100% (when two countries have an identical composition).

We use inward FDI data from crossborder greenfield investment monitor fDi Markets for 39 sectors in 18 EU economies over the 2012-15 period. These 18 economies are the EU15 group, which comprise the mature EU economies and the three biggest new EU member states (Poland, Czech Republic and Romania). We calculate FDI similarity indices both in terms of FDI projects and in terms of FDI capital expenditure (capex).

Then we estimate the overall FDI similarity index between the UK and each of these economies by assigning a 50% weight for the FDI similarity in terms of projects and a 50% weight for the FDI similarity in terms of capex. In Table 1 we demonstrate, as an example, how we estimate the overall FDI similarity between the UK and Germany, which stands at about 71.2%.

Then we repeat this process for the rest of the countries in our sample and calculate the FDI similarity indices of the UK with the rest of the EU economies. Furthermore, we define the EU countries that are in intense competition with the UK in terms of inward FDI to be the ones with an FDI similarity with the UK higher than the FDI similarity of the UK with the EU as a whole.

One can see in Table 2 that the UK has a high FDI similarity – and therefore is in intense competition for inward FDI – with a clearly identified group of countries. This group comprises the countries of the EU core (Germany, France, Denmark and the Netherlands). Furthermore, the UK faces a high level of competition for inward FDI from the Scandinavian economies (Sweden and Finland), some of the emerging markets of the EU (Poland and Romania), as well as Spain.

Cues for policymakers

The identification, with the use of FDI Similarity Indices, of the UK’s most important competitors for inward FDI in the EU has important policy implications. As proposed in this article, policymakers in the UK could improve business regulation in order to counterbalance the potential loss of its inward FDI attractiveness due to eventual less than free-trade access to the EU.

It would be logical, then, to benchmark the UK regulatory framework against the EU economies that are in intense competition with the UK in terms of inward FDI. For example, it would make more sense to benchmark the regulatory environment of the UK against France (FDI similarity with the UK is 69.8%) than against Austria (FDI similarity with the UK is 51%).

As a second step in our analysis, we benchmark the business regulations of the UK against the countries that are in most intense competition for inward FDI with the UK as identified in Table 2. We source the regulatory indices from the 2016 edition of the World Bank's Doing Business report.

Furthermore, we employ the distance-to-frontier (DTF) measure of business regulations. This measure shows the distance of each economy to the ‘frontier’, which represents the best regulatory performance globally. The DTF measure ranges from 0 to 100, with higher values denoting more efficient regulation. This benchmark exercise is available in Table 3.

One can see the UK ranks second against its inward FDI competitors in the EU in terms of the overall business regulations framework. This is something that UK investment promotion agencies could emphasise in their efforts to convince potential inward FDI investors that losses from less than free-trade access to the EU for UK-based companies could be compensated by the more efficient regulatory framework in the UK compared with most EU competitors.

Strengths and weaknesses

In terms of different types of business regulation, we also observe that the performance of the UK regarding most of its EU competitors for inward FDI is very strong in the ‘starting a business’, ‘paying taxes’, ‘getting electricity’ and ‘dealing with construction permits’ types of business regulation.

However, we identify some types of business regulation that the UK could significantly improve as its position against its inward FDI competitor is (at best) average. These are the ‘registering property’, ‘enforcing contracts’ and ‘trading across borders’ categories of regulation.

The fact that the UK ranks last against its inward FDI competitors in the ‘trading across borders’ category is worrying. This type of business regulation is important for foreign companies that would consider locating in the UK to export their products/services to the continent, and could compound the negative effect of less than free-trade access to the EU for UK-based companies.

Therefore, UK policymakers should emphasise the improvement of its competitive position in regulation related to ‘trading across borders’. For example, according to the World Bank, the time to export in terms of border compliance (time required to obtain, prepare and submit documents during port or border handling) is about 24 hours in the UK while it is only two hours in Sweden, an important competitor.

In this article we have discussed how a simple FDI Similarity Index could identify the most direct competitors of a country in terms of inward FDI. This in turn could help policymakers and IPA professionals to design policies that could boost the country’s FDI attractiveness against its most important competitors.

While this article focuses on the UK and the post-Brexit inward FDI competition in the EU, analysis based on FDI Similarity Indices could easily be applied to any country or region.

Dr Antonios Kalyvas is a lecturer in financial economics and banking at the University of Greenwich, UK. Dr Theodora Bermpei is a lecturer in finance at the University of Nottingham Trent, UK.

* Kalyvas, AN, & Webster, A (2011). A simple measure of the similarity of the sectoral composition of inward investment and its possible uses. Bournemouth University Working Paper series.