7. Foreign direct investment
- UK has been an attractive destination for FDI:
- In 2019, UK ranked 4th globally for FDI stock and 8th for FDI inflows
- UK’s stock of inward FDI comes mainly from its top trading partners – EU27 and US
- 2019 was the third successive year of falls in inward FDI to the UK
- In 2019, wider business investment intentions remained depressed by slower global growth and political uncertainty
- COVID-19 crisis will cause a dramatic fall in FDI in 2020
- Freeports provide limited benefits, but government intends to create ten
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Foreign direct investment
What does FDI mean?
Foreign direct investment (FDI) is measured in two ways – stock and flow.
- Stock of FDI is the cumulative amount invested over a number of years.
- Flow of FDI is the amount invested in a given period, usually one year.
- There is inward and outward FDI:
- If UK receives FDI, it’s ‘inward FDI’;
- If UK sends FDI to other countries, it’s ‘outward FDI’.
FDI represents investments where the investor is looking to have an ‘effective voice’ in the management of the project or the company concerned. There are two main types of FDI:
- Investment in greenfield projects (in construction, manufacturing, retail, business services etc.);
- Mergers and acquisitions of companies.
In FDI statistics, ‘effective voice’ means investments of ten per cent or more in a given company or project. FDI excludes investing small percentage stakes as part of a portfolio (in the way that, for example, pension funds and insurance companies make investments).
World rankings – stock
FDI plays an important role in the UK economy. The UK has been an attractive destination for foreign investors: in 2019, the UK ranked fourth globally in terms of FDI stock, behind the EU, US and China. See Figure 7.1.
Source: OECD, FDI in Figures, April 2020
According to the OECD, FDI continued the downward trend since 2015;
“Despite an increase of 12% in 2019 to USD 1,426 billion, global FDI flows remained below levels recorded between 2010 and 2017. Compared to 2017, FDI flows decreased by 15%, continuing the downward trend observed since 2015. FDI flows were already struggling before the COVID-19 pandemic. FDI flows are expected to drop by more than 30% in 2020, even under the most optimistic scenario”.
In 2020, COVID-19 will have a major impact according to UNCTAD::
“The COVID-19 crisis will cause a dramatic fall in FDI. Global FDI flows are forecast to decrease by up to 40 per cent in 2020, from their 2019 value of $1.54 trillion. This would bring FDI below $1 trillion for the first time since 2005. FDI is projected to decrease by a further 5 to 10 per cent in 2021 and to initiate a recovery in 2022. A rebound in 2022, with FDI reverting to the pre-pandemic underlying trend, is possible, but only at the upper bound of expectations.”
World rankings – inflows
In 2019, the UK ranked eighth in 2019 inflows (see Figure 7.2).
- Mergers and acquisitions (M&A) accounted for $49bn of UK inward FDI in 2019.
- The greenfield component of UK inward FDI was US$36bn.
Figure 7.2: FDI inflows 2019 and 2018 ($bn)
UNCTAD, World Investment Report, 2020
UNCTAD, World Investment Report, UK country fact sheet, 2020
Sources of UK FDI
The UK’s stock of FDI comes mainly from the UK’s top trading partners – the EU27 and the US.
The EU27 was the largest provider of FDI stock from 2018 at just under £0.6 trillion, providing just under £0.2 trillion more than the USA (see Figure 7.3) which increased in 2017 and 2018. In addition, access to the EU Single Market has helped attract investment into the UK from outside the EU.
Europe (EU and non-EU) is the largest source of FDI stock accounting for 53% in 2018 (compared to 27% for the USA).
Inward UK FDI stock by industry sector
Foreign investors have invested mainly in the UK’s financial service sector (see Figure 7.4) which, like many sectors, has benefited from UK membership of the EU single market. In 2018, this sector accounted for £438 billion (just under 29% of total) of FDI stock. A further £304 billion (20%) was accounted for by professional and other services.
Manufacturing has also attracted significant FDI accounting for £255 billion (17%) in 2018 across a variety of sectors (not all shown separately in figure 7.4).
FDI stock increased for all industry groupings between 2015 and 2018, but the largest sector increase over this period occurred in the financial services sector.
Inward UK FDI trends
Brexit and Brexit uncertainty has caused investment decisions to be delayed and the overall level of business investment to fall.
The value of net FDI flows into the UK was £35.6 billion in 2019 the third successive year inward investment in the UK has fallen (ONS figures) – see Figure 7.5.
FDI inflows were:
- Worth a record £192.0 billion in 2016 – largely due to a few high-value mergers and acquisitions.
- £74.9 billion in 2017, £65.9 billion in 2018 and £35.6 billion in 2019.
- 2% of GDP in 2019 – the average over the last 10 years has been 3%.
- £28.2 billion from EU member states in 2019.
Figure 7.5: Trend in net FDI inflows to the UK
The 2019 trend in numbers of projects was slightly different. EY’s latest annual UK attractiveness survey on 2019 data on project numbers commented:
- UK achieved a 5% increase in inbound FDI projects compared to 2018, ending three years of declining European market share since the EU Referendum, but France’s 17% growth saw it rank in first place in Europe
- UK surged ahead in digital tech attracting 432 projects (36% increase), representing a 30% share of all European FDI projects, more than France and Germany combined
- R&D projects increased to a decade high, evidencing the UK’s ongoing economic transformation
- London had its best-ever year, but there were no signs of ‘levelling up’ across the UK with project numbers down in most English regions
- Investors perceive the UK to be resilient compared to European peers as Brexit fades as an influence on investment decisions
The EY survey has run for 19 years and is well-regarded.
Looking at investment more broadly, in March 2019, ONS statistics reported that business investment in the UK dropped in each of the four quarters of 2018.
The BoE publishes quarterly Agents’ Reports which assess the level of business activity and comment on investment intentions (not just FDI), based on discussions with about 1,000 businesses.
In the fourth quarter of 2019, the Agents reported:
- Growth in consumption was muted, particularly in services. Sales of big-ticket household goods and new cars remained weak.
- Growth in business services weakened. Uncertainty about Brexit and the General Election weighed on activity.
- Manufacturing output fell, reflecting weaker domestic and global demand.
- Investment intentions remained depressed by slower global growth and political uncertainty.
In June 2020, reflecting the impact of COVID-19, they reported on investment that:
- Contacts said they had cut investment spending by around half, or more for companies most severely affected by the pandemic.
- Some contacts redirected investment to finance social distancing measures and facilitate remote working, and a few contacts, for example in IT and pharmaceuticals, continued with investment projects.
- Some companies said they planned to review their investment plans next year. Decisions will depend on how their finances have been affected by the pandemic, as well as other factors, such as Brexit.
- Some contacts said they expected to have to streamline their business to adjust to a new normality, though others thought there might be opportunities to make acquisitions.
- For contacts in hospitality, tourism, leisure and transport, the outlook for investment is particularly uncertain.
House of Commons Library, Research Briefing, Foreign Direct Investment (FDI) Statistics, 23 December 2020
House of Commons Library, ONS, Business investment in the UK: analysis by asset, 29 March 2019
Bank of England, Agents’ summary of business conditions – 2019 Q4
EY, UK attractiveness survey 2020, June 2020
Bank of England, Agents’ summary of business conditions – 2020 Q2
Free zones such as freeports and enterprise zones are often used to attract investment – both domestic investment and FDI. This section looks at:
- UK enterprise zones
- EU rules
- Post-Brexit considerations
The section is based mainly on an excellent paper by the UK Trade Policy Observatory. This includes references to further sources. In March 2021, UK in a Changing Europe published a paper on freeports which focused on the potential role of freeports in the UK after Brexit.
A freeport is a type of free zone, which is subject to special regulatory requirements, tax breaks and government support. A freeport aims to encourage businesses that import, process and then re-export goods, whereas an enterprise zone aims at general business support or regeneration objectives.
Freeports can range from secure warehouses to sites where added-value manufacturing occurs before goods are re-exported.
There were freeports (designated airports or seaports) in the UK until 2012, when the government allowed the UK laws that set them up to expire. The UK had several freeports, including Liverpool, Southampton, the Port of Tilbury and Glasgow Prestwick Airport. In all, there were seven freeports between 1984 and 2012.
Freeports are places where normal tax and customs rules do not apply. At a freeport, imports can enter with simplified customs documentation and without paying tariffs. Businesses operating inside and around the port can manufacture goods using the imports and add value, before exporting again without full tariffs or procedures. However, if the goods move out of the freeport into another part of the country or as exports, they must go through the full import process and pay tariffs. Note that freeports may simplify some trade in goods but do little for services.
There are around 80 free zones within the EU. EU freeports are more limited in their powers than other free ports around the world.
Businesses operating in freeports can benefit from:
- Simplified customs procedures;
- Relief on customs duties relating to transhipment, handling and processing of goods destined for re-export;
- Cash-flow benefits of duty deferral until goods are released to the domestic economy (or used within the free zone);
- Added security from the perimeter fence enclosing the free zone;
- Tariff inversion: some finished goods incur lower tariffs than intermediate goods; this means that goods can be imported to free zone tariff-free, processed and sold as a final product incurring lower tariff rates.
UK enterprise zones
- Business-rate discounts (up to £275,000 per business over five years);
- Tax breaks for new plant or machinery;
- Location-specific amenities (such as rail links, ports, high-speed broadband);
- Simplified planning process.
There are 61 enterprise areas across the UK: 48 in England, eight in Wales, four in Scotland and one in Northern Ireland.
The UK experience of enterprise zones in the 1980s found:
- Success in dealing with dereliction and considerable environmental improvement (e.g. Isle of Dogs).
- Often created in areas that only offered a limited chance of long-term success (for example, in areas with poor transport connectivity or with limited access to large, skilled labour markets, suppliers, customers).
- Inner city zones were more successful at creating new jobs than those outside urban centres and in remote areas.
- Simplified planning processes were not delivered in practice.
- Rather than creating additional jobs, economic activity was displaced:
- Up to 41% of the 58,000 jobs created in the enterprise zones of the 1980s were relocated from elsewhere in the UK.
- The zones were expensive:
- Public sector cost per additional job created in a zone was £17,000 per job in 1994-95 prices.
- Business rates relief and enhanced capital allowances were the main attractions for businesses.
- In practice, business rates relief often led to higher rents, which benefited landlords. Occupiers gained only around 10-55% in urban zones, 30-50% in accessible zones, and between -25 to +45% in remote zones.
Medium-sized enterprises are entitled to aid of 10% of the total investment (in addition to any regional aid they have already received), while small companies are entitled to 20% more.
EU state aid rules constrain the options for free zone and enterprise zone operations, but exemptions may be granted if the zone benefits the economic and social development of underdeveloped EU regions:
- Areas where the standard of living is abnormally low or where there is serious underemployment, and of the regions.
- Where aid does not affect trading conditions contrary to the common interest.
Many EU free zones and enterprise zones are in the ‘new’ EU Member States in Central and Eastern Europe. They set up special economic zones in the mid-1990s to attract FDI offering incentive schemes such as tax holidays, reduced corporate income tax rates or customs duty exemptions / deferrals. However, in the run-up to EU accession, these countries had to revise their schemes to align with EU state aid rules.
EU rules mean it’s more difficult for EU businesses to engage in “tariff inversion”.
The 2019 Conservative manifesto committed to set up ten freeports around the UK. This followed a 2016paper from the Centre for Policy Studies by Rishi Sunak on the topic. The government published a consultation paper on freeports in February 2020: ‘Boosting Trade, Jobs and Investment Across the UK’. After publishing its response to the consultation in October 2020, the government then invited bids for the ten freeports.
Freeports and enterprise zones could help with shaping export-oriented and regional development programmes. However, the economic benefits are likely to be small:
- Studies show that the net benefit of free zones is limited.
- For example, there are many jobs in the US Foreign-Trade Zones, but little evidence of how many are net creations. The main purpose of the US Zones appears to be to supply the domestic market without having to pay high tariffs on imported inputs.
- When tariffs are low, the benefits of freeports are small. They do not allow suppliers to obtain duty-free access to final markets (unless inverted tariffs are avoided).
- UK Global Tariff rates mean that there are not any major differences between the rates for component goods and the final products. This means the benefits from tariff inversion will be small.
- Freeports defer duty payments and import VAT, which gives a small gain to cash-flow.
- There may be some potential benefits from simplified customs procedures.
Bigger gains could come from wider use of enterprise zones. These could transfer economic activity to underdeveloped areas to help them. However, if the advantages are ‘hidden subsidies’, they would be subject to WTO Subsidies Agreement rules and to any commitments under level-playing-field provisions. For example, the EU could object to tax breaks.
And, of course, to attract businesses and investment to the UK, the government should also focus on minimising frictions to UK-EU trade, not maximising them.