Will the Future EU-UK Free Trade Agreement Affect Foreign Direct Investment?

Brexit DOI: 10.1007/s10272-020-0911-3 Federico Carril-Caccia* Will the Future EU-UK Free Trade Agreement Affect Foreign Direct Investment? This article aims to provide new insight on how Brexit will affect foreign direct investment (FDI) into the UK. By estimating an augmented gravity equation which accounts for the depth of free trade agreements (FTAs) as well as for EU and euro area membership, the article gauges the potential impact that different EU-UK trade scenarios might have on FDI flows and stocks. Results show that under a no-deal scenario, FDI flows from the EU into the UK would plunge by 25.9% - 40.6%, and inward FDI stocks would decrease by 49.2% - 53.9%. However, the depth of the future FTA can mitigate this negative outcome. More generally, the article shows that the FDI costs of leaving the EU would be significantly higher for the euro area countries. Extensive research has highlighted the benefits from the European Union (EU) and the Economic and Monetary Union in terms of trade and foreign direct investment (FDI). The acquis communautaire, common currency and the free movement of goods, services, people and capital appear to have reduced transaction costs and fostered the development of economic activities by multinational enterprises (e.g. Carril-Caccia and Pavlova, 2018; Coeurdacier et al., 2009; De Sousa and Lochard, 2011; Martínez-San Román et al., 2016; Umber et al., 2014). Most of the available analysis agrees on the negative consequences that Brexit could have on trade, FDI and welfare (e.g. Bailey et al., 2019; Bruno et al., 2016; Dhingra et al., 2017; Driffield and Karoglou, 2019; Greenaway and Milner, 2019; Mulabdic et al., 2017; Simionescu, 2018). In fact, the uncertainty brought about by the Brexit announcement appears to have already negatively impacted the UK’s financial market stability and trade (e.g. Belke et al., 2018; Douch et al., 2018; Korus and Celebi, 2019). There has been a great deal of Euroscepticism in the last few years despite the fact that the EU project seems to have delivered relevant economic benefits to its member states. In the UK, this scepticism resulted in the Brexit vote on 23 June 2016. More than three years later, after significant political convulsion and uncertainty, the UK has left the EU. This year, the EU and the UK will negotiate the future trade deal that will condition the future relations between both parties. The economic consequences of Brexit will depend on this deal (Dhingra et al., 2017). While the British government seeks a trade deal similar to the one that the EU signed with Canada (CETA), the EU is after a more comprehensive one (Adler, 2020, March 2). Dhingra et al. (2017) point out that in the hard Brexit scenario, in which no free trade agreement (FTA) is signed and the UK and the EU trade under the World Trade Organization (WTO) rules, British income per capita would plunge by 9.4%. Dhingra et al. (2017) highlight that not only trade but also the potential drop in FDI might be responsible for this outcome. In this case, research highlights the positive effect of FDI on economic growth or productivity in developed countries (e.g. Alfaro et al., 2004; Ashraf et al., 2015). © The Author(s) 2020. Open Access: This article is distributed under the terms of the Creative Commons Attribution 4.0 International License (https://creativecommons.org/licenses/by/4.0/). Open Access funding provided by ZBW – Leibniz Information Centre for Economics. * This work was supported by Generalitat Valenciana [GV/2017/052]; Junta de Andalucía [SEJ 340]. Federico Carril-Caccia, University of Deusto; and University of Granada, Spain. 266 Theoretically, there are four main channels through which trade may affect inward FDI. First, with horizontal FDI, FDI and bilateral trade are substitutes. Multinational enterprises (MNEs) follow this strategy to serve the foreign market and to avoid trade costs (Horstmann and Markusen, 1987). If this MNEs investment strategy is predominant in the UK, the future new trade barriers between the EU and the UK will foster bilateral FDI. Second, vertical FDI is positively associated with bilateral trade liberalisation. In this type of investment, MNEs establish production networks across borders that are linked through trade (Hanson, 2005). Intereconomics 2020 | 4 Brexit Third, export supporting FDI is also positively moderated by bilateral trade liberalisation. It refers to the investments that seek to enhance the market penetration from exports in a host country (Krautheim, 2013). Fourth, MNEs may also create export platform subsidiaries in a country with the objective of serving third countries’ markets through exports (Ekholm et al., 2007). Through these FDI strategies, MNEs set subsidiaries to perform specific economic activities and link through trade, and in doing so, configure their global value chains (e.g. Amendolagine et al., 2017; Beugelsdijk et al., 2009; Krugman et al., 1995). If these MNEs’ investment strategies are predominant, new barriers to trade brought by Brexit will hamper inward FDI into the UK. In this regard, Bailey et al. (2019) describe the potential negative consequences that Brexit might have on the automotive sector. More generally, Carril-Caccia and Pavlova (2020) show how global value chains participation and the capacity of exporting to (and importing from) a wider number of countries has a positive impact on the capacity of attracting cross-border mergers and acquisitions. This article presents a study on how the depth of FTAs affects bilateral FDI, a topic rarely considered by previous literature. Indeed, FTAs have been extensively included as a determinant of FDI (e.g. Carril-Caccia and Pavlova, 2020; Garret, 2016; Hyun and Kim, 2010; Jang, 2011; Paniagua and Sapena, 2014), but FTAs are often assumed to be homogeneous by only considering whether a pair of countries have signed one or not. Nevertheless, countries sign FTAs with varying numbers of provisions that cover different policy areas like anti-dumping, competition, tariffs, intellectual property rights or data protection. In this way, the depth of FTAs is determined by their coverage in terms of policy areas. Based on the relationship between FDI and the depth of bilateral trade integration, this work also extends the literature, which gauges the consequences of Brexit on FDI (e.g. Bruno et al., 2016). In particular, it sheds new light on the potential consequences that Brexit might have on FDI in different EU-UK trade agreements scenarios, and more generally disentangles the effect of leaving the EU for those countries that belong to the euro area (EA) and those that do not. Three different scenarios are considered: WTO rules (no FTA), an agreement similar to that between the EU and the European Free Trade Association (EFTA) and an agreement like the EU-South Korea FTA.1 1 Ideally we would like to include in the analysis the CETA-EU agreement, but the signature of this agreement is (...truncated)