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– Jul 20th, 2023

How Foreign Direct Investment can provide productivity boost to business and the wider economy

Professor Nigel Driffield is Professor of International Business at Warwick Business School (WBS) and the lead of our Organisational Capital research theme. He details the importance of Foreign Direct Investment (FDI) in this blog, which has been co-written by Xiaocan Yuan, a post-doc Research Fellow at WBS and Fernando Gutierrez Barragan, Head of Trade and Investment at Moody’s Analytics. 

Inward investors in the UK are reported to have a productivity advantage and pay higher wages compared with the average level of the UK firms. Such proved foreign productivity advantage offers us the rationale for presuming that inward investment can play an important role in improving the UK productivity. Essentially, two mechanisms through which inward investment can generate productivity growth in the host economy, which are explained in depth in our working paper Inward investment and UK productivity.

The first is the batting average effect, that is the presence of higher productivity level of (new) inward investors, higher than the average level of the region, will increase the average productivity.

The second mechanism concerns whether (and how) the presence of such investment creates productivity growth within the wider economy, typically explained in terms of a range of effects known as ‘FDI spillovers’. This is explored in detail in our working paper and places a number of demands on the data that are typically not met by official statistics, including:

  • Why a firm chooses to enter a given location (for our purposes the UK).
  • The financial performance of the parent company, and where else it has subsidiaries (and the sectors that they are in).
  • The nature of the investment – whether it is “greenfield” or acquisition.
  • The ownership share that the firm takes.

All of these factors have been shown in the literature to be linked to knowledge transfer from parent to affiliate, and in turn to productivity. The motive for engaging in FDI in a specific location determines not only the nature of cross-border knowledge transfer between the parent company and its foreign affiliates, or between affiliates, but also the firm’s interaction with local businesses within the local ecosystem. On the other hand, as Brexit has decoupled the European Union from the UK, the value proposition of UK for inward investors is going to change. As a result, this needs to be fundamentally revisited to take into account the evolution of internal and external factors.

Evaluating the post-Brexit landscape

In order to address these two issues, specific data requirements are emerging. Specifically, we need more detailed information that can tell us more than just an investment decision but allow one to dig into the nature and makeup of such investment, including motives, type of market served, sectoral distribution, etc. At the same time, timely data of the most recent investments are of great importance which enables us to delineate the up-to-date investment trend and acquire valuable insights.

To respond that, we resort to FDI data extracted from Orbis Crossborder Investment database provided by Bureau van Dijk (BvD, now part of Moodys). This is a bespoke database covering both greenfield and Merger and Acquisitions (M&A) FDI. As the only global database tracking both forms of equity cross-border investment at the company level, this data tool, based on daily tracking of news sources, is able to provide unique insights into how companies are globalising, with detailed information on the various FDI determinants. To find out more about how this database works, read our blog Analysing the effect of FDI on UK’s Firm Productivity Performance: The Orbis Crossborder Investment Database.

As part of the research agenda pursued by The Productivity Institute, we have utilised this data in our briefing papers (see Briefing 1, Briefing 2 and Briefing 3) to disentangle the UK productivity puzzle by studying the changing make up of FDI into the UK since Brexit.

Understanding greenfield investment

Greenfield investment is form of FDI where a parent company starts a new venture in a foreign country by constructing new operational facilities from the ground up. In addition to building new facilities, most parent companies also create new long-term jobs in the foreign country by hiring new employees. It is recognised that FDI from other developed countries, particularly in the form of greenfield FDI, contributes the most to productivity, both directly and indirectly. We discuss the patterns of this type of FDI into the UK in our first briefing.

Despite the downturn following Brexit and more significantly, following the COVID-19 pandemic, the shares on investment from the richest countries remain fairly consistent.

However, there is an increased tendency for the UK to attract FDI which is then focussed on UK markets rather than exports.

The regional data also illustrates this, with several regions reporting high levels of investment in transport, freight & storage in addition to business services. What is also noticeable, as with the M&As data, is that both the more prosperous regions of the UK such as South East England and East of England, but also in Scotland, North West England and West Midlands, attract investments in similar sectors.

These are sectors that facilitate productivity growth in other sectors through the services that they provide, often in conjunction with state infrastructure such as transport or digital connectivity. Thus, if FDI is to be part of the ‘Levelling Up’ agenda in the UK, this places the onus on government to put in place investments to maximise the benefits of this, both along supply chains and into customers of these services.

The knowledge benefits of FDI through Mergers & Acquisitions

Any contribution that foreign M&As make to UK productivity are more indirect, depending on the extent to which changes of ownership lead to higher levels of investment, innovation or knowledge transfer from the parent company. Equally, the effects also vary by the motive for the investment.

It is clear from a perusal of the “mega deals” for example that many of these are either what one may call “technology sourcing FDI” –the objective of the acquiring company is to acquire the knowledge or intellectual property of the target firm, or to acquire new markets. Typically, these are associated with lower levels of subsequent productivity growth than, for example, FDI motivated by the desire to lever its existing technology into new markets.