Memorandum submitted by Dr Mark J Baimbridge,
European Economies Research Unit, University of Bradford, and
Dr Philip B Whyman, University of Central Lancashire
This memorandum addresses the Committee's inquiry
into the Government's adoption of the most appropriate policies
in relation to business and the labour market based on our recent
research on the twin concepts of Foreign Direct Investment and
Labour Market Flexibility (Whyman and Baimbridge, 2005a&b).
The successful combination of these two economic factors has been
identified by HM Treasury (1997) as key prerequisites regarding
the assessment of the UK's suitability for EMU membership. Moreover,
they are at the heart of the EU's Lisbon Agenda to make the EU
"the most competitive and dynamic knowledge-driven economy
by 2010". Consequently, this memorandum reviews the importance
of motivational drivers behind FDI within the context of increasingly
competitive global markets.
Firstly, we discuss the significance of business
investment to the real economy in terms of its importance for
long-term, sustainable economic growth, job creation and technological
innovation. Secondly, the concept of FDI is examined in terms
of its importance to developed economies with specific emphasis
placed upon those disaggregated factors determining its location.
Given the necessity of investment as the life-blood of any economy,
the significance of FDI as a critical component cannot be underestimated.
Hence, for the formulation of optimal Government policy in response
to globalisation these determinants must be understood and acted
upon. Thus the main body of this memorandum discusses the essential
elements of these demand, cost, national specific and risk factors.
Consequently, it is through consideration of
cost factors as a disaggregated determinant of FDI that we proceed
to a discussion of Labour Market Flexibility (LMF) in terms of
the concepts of numerical, functional and wage-cost flexibility.
Hence, in our summary of key issues regarding both FDI and LMF
we seek to draw the Committee's attention to the principal findings
of the academic literature when examining these phenomenon in
terms of the crucial forces that both attract and repel. However,
we conclude that a number of significant limitations exist in
the sole reliance of FDI as an economic panacea. Rather a more
holistic national/regional policy aimed at developing a "national
system of innovation" would provide a longer-term sustainable
enhancement to the UK's real economy.
The relevance of globalisation to the Government's
policies on: business investment
1. Business investment is a significant
determinant of economic success, at least in so far as this occurs
in productive assetsie investment in manufacturing plant
will have greater net benefits to the economy, in terms of innovation,
development of competitive advantage and export-led growth, than
investment in a golf course or hotel complex. It is a major determinant
of domestic demand, yet, uncompensated, its volatility can cause
unsustainable booms and avoidable recessions. Moreover, according
to both the Solow neo-classical and endogenous growth models (the
latter, in conjunction with human capital formation), investment
is a key determinant of economic growth. Investment is a crucial
factor underlying innovation and technological development, whilst
its role in determining the level of productive capacity in the
economy has major effects upon the level of employment (Bean,
1989; Rowthorn, 1995; Ball, 1999).
2. Business investment depends upon the
combination of expectations, together with the availability and
cost of capital. Thus, businesses invest on the basis of expected
future profitability, and fund much of this through retained profits
(Keynes, 1936: 135-141). Government has sought to influence business
investment through policies intended to raise current profitability
(and thereby inflate expectations of future returns), reduce the
cost of capital (through maintaining low rates of interest) and
enhancing the supply of risk capital (through provision of tax
breaks for private investment, regulation of the financial sector
to constrain non-productive investment forms and/or provision
of public capital through pension funds and regional development
agencies, etc). More recently, as the range of economic policy
instruments being utilised by government has become increasingly
limited (due to perceptions that globalisation has constrained
the use of certain forms of regulation and active macroeconomic
policy), the attraction of Foreign Direct Investment (FDI) has
become increasingly important. Indeed, despite the fact that,
for most industrialised economies total FDI flows represent only
a small proportion of GDP and are exceeded by domestic investment
by at least a factor of nine-to-one, its significance outweighs
this statistic due to the potential for technological and knowledge
transfer, together with its importance in government industrial
and regional policy (Weiss, 1998:174; Wren and Taylor, 1999; Driffield
and Taylor, 2000:93).
3. Foreign Direct Investment (FDI) may be
defined as capital invested for the purpose of acquiring a lasting
interest in an enterprise, whilst simultaneously exerting a degree
of influence on its operations. It is this combination of ownership
and control that distinguishes FDI from other forms of trans-national
investment and/or production, such as portfolio investment and
franchising (Dunning, 1979).
4. Trans-National Corporations (TNCs) are
estimated to account for more than one-fifth of global employment
in the non-agricultural sectors, with global sales of $19 trillion,
double the value of world exports (Dunning, 1993:15; Scholte,
2000:130; UNCTAD, 2002). Thus, FDI has become an increasingly
significant factor in influencing the level of economic activity
in developed, in addition to developing, nations.
5. In a world characterised by the free
flow of capital, nation states have sought to compete with each
other to attract FDI as a means of attracting inward flows of
capital and technology, together with innovation in management
techniques and the organisation of work and distributional networks.
FDI may therefore raise aggregate productivity, thereby facilitating
the rising skill level of the workforce through the provision
of high-skill employment opportunitiesalbeit that the shift
in demand towards skilled workers will occur at the expense of
unskilled workers (OECD, 1991; Barrell and Pain, 1997; Driffield
and Taylor, 2000). Accordingly, FDI should improve allocative
efficiency, as resources are transferred towards the most efficient
new entrants to the host market (Dunning, 1988). FDI may additionally
produce beneficial externalities for domestic producers, through
spillovers in the areas of technology and work organisation, together
with a positive association with increased investment by national
investors (Borensztein et al, 1998; Aitken and Harrison,
1999; Bosworth and Collins, 1999; Driffeld and Munday, 2000).
Furthermore, in so far as regional regeneration is facilitated
through the infusion of new capital, technology and creation of
skilled employment opportunities, FDI would appear to have significant
potential in this regard (Young et al, 1988, 1994; Neven
and Siotis, 1996).
6. Balance of payment effects are indeterminate
because the initial inward capital transfer may be offset by a
reluctance to permit inter-subsidiary competition and/or the reduction
in competition arising from the takeover of an existing producer
(Bairoch, 1993:183-4). Thus, the beneficial impact associated
with FDI may be partially or wholly negated by deadweight effects
if FDI occurred through the takeover of a export-orientated domestic
firm, and through the long-term repatriation of profits to the
home economy (OECD, 1998). Evidence on this point indicates that
only 14% of FDI flows were associated with the establishment of
new businesses (Fallows 1994:481). Consequently, it is not surprising
that the capability to induce rising FDI flows into its economy
has become an important policy objective of many governments.
7. In terms of the UK, the importance of
FDI inward flows during the past two decades is illustrated by
the fact that, as early as 1989, TNCs employed 40% of the manufacturing
sector (Ladipo and Wilkinson, 2002:12-13), whilst FDI is estimated
to account for 30% of the productivity growth in UK manufacturing
industry (Barrell and Pain, 1997). Moreover, the productivity
advantage over domestic companies approximates to 20% (Davies
and Lyons, 1991). As a result, the attraction of inward investment
has become "the chief instrument of industrial policy in
the UK over the past 20 years" (Driffield and Taylor, 2000:93;
Wren and Taylor, 1999). Furthermore, the importance given to the
continued attraction of FDI by the UK government is reflected
in the fact that it features prominently as one of the Chancellor's
"Five Tests" established to ascertain the potential
impact of participation in Economic and Monetary Union (EMU) upon
key aspects of the UK economy (HM Treasury, 1997).
8. The international business literature
proposes that firms tend to consider FDI once they have developed
certain competitive advantages that they feel they can more effectively
exploit by engaging in a strategic location of production abroad
rather than export goods and services, whilst maintaining their
direct control over the process to minimise transaction costs,
retain control over technological and other elements of the production
process, together with organisation knowledge (Morgan, 1997).
Assuming rational action, firms must be responding to, firstly,
incentives to locate production abroad rather than export from
their existing home base, and secondly, a separate set of incentives
to internalise the production process.
9. The United Nations World Investment Report
(UNCTAD, 1998) argued that FDI arises due to a combination of,
firstly, host country (or locational) determinants based upon
the social and economic factors, together with the attractiveness
of government policy framework for the attraction of FDI, and
secondly, the strategic motives of TNCs. Thus, the decision for
a TNC to invest in a particular country will depend upon a composite
of variables of demand, cost, national specific and risk factors
(summarised in Figure 1).
(Source: Whyman and Baimbridge, 2005a).
10. These factors, in aggregate, appear
to be the strongest determinants of the location of FDI, with
the size and growth rate of national markets being the most significant
element, since it is primarily to serve this market by localised
production, rather than export from the home nation, that FDI
occurs (Culem, 1988; Jost, 1997; Pain and Lansbury, 1997). Evidence
tends to suggest that investors prefer nations with relatively
liberal trade regimes. However, whilst anecdotal evidence would
suggest that membership of the EU's Single Internal Market would
be a particular advantage in this regard, the evidence here is
rather more mixed than might be anticipated (Whyman and Baimbridge,
11. FDI is influenced by the relative cost
of production and distribution within potential host nations.
This is determined by the quality and reliability of physical
and communications infrastructure, relative unit costs, the cost
and ease of access to raw materials and the cost of capital. The
latter could be eased by monetary policy maintaining a relatively
low rate of interest and/or full integration within international
financial markets. Macroeconomic policy targeted at maintaining
high levels of capacity utilisation may additionally induce lower
average unit costs. Labour costs can be affected by a number of
variables, including the design of institutions and patterns of
wage bargaining, labour market policies designed to solve skill
shortages and thereby remove inflationary employment bottlenecks,
together with the overall macroeconomic stance of the government.
The latter may involve a tight monetary and fiscal policy, designed
to restrain wages and inflation, which may in the process improve
national competitiveness. It may equally pertain to the maintenance
of a high level of aggregate demand, intended to sustain high
rates of industrial capacity, thereby encouraging future investment
in capacity and reducing unit costs as these are borne by a larger
volume of output. Finally, it may also involve exchange rate management
to attempt to maintain competitive unit costs through currency
appreciation or devaluation, as necessary.
12. The evidence of the effects of labour
costs on FDI is mixed, but tends to indicate a negative association
(Cooke and Noble, 1998; Head et al, 1999; Floyd, 2003).
Nevertheless, it remains the case that four-fifths of the world
stock of FDI is located in the high-wage and relatively high-tax
nations, primarily the USA, UK, Germany and Canada, where this
proportion has increased by 12% over two decades (Weiss, 1998:186).
Alternative evidence suggests that labour costs are not ranked
very highly amongst other determinants of FDI (Traxler and Woitech,
2000). Indeed, a majority of UK-owned TNCs do not even bother
to collect data on overall labour costs and labour productivity
(Marginson et al, 1996), whilst a sizeable (and growing)
differences in unit labour costs, amongst EU nations during the
1980s, failed to result in significant differences in FDI (Erickson
and Kuruvilla, 1994).
13. Finally, the fact that 81% of global
FDI stock is located in high wage, high tax OECD nations, indicates
that cost reduction is not the overwhelming factor causing the
globalisation of production (Weiss, 1998:186).
14. Intrinsically linked to the concept
of cost factors is the key issue of labour market flexibility,
which can be identified with the concepts of numerical, functional
and wage-cost flexibility (Burchell et al, 1999; Weiss
2001; Monastiriotis, 2003; Whyman and Baimbridge, 2005a&b).
Numerical flexibility is associated with the supply of labour,
functional flexibility with the adaptability of working practices,
demand factors with potential product demand, risk factors with
perceptions of instability and protection of property rights and
cost variables dependant upon government policy and labour markets.
15. Rigid regulation of the labour market
is generally perceived to be a disadvantage for a nation seeking
to attract FDI, and particularly so for those industries subject
to a greater than average risk of failure, whereby exit costs
from a particular market becomes increasingly important. Flexible
labour markets characterised by low closure costs may therefore
attract FDI, although it may equally facilitate outward disinvestment
during periods of economic downturn (Bentolila and Bertola, 1990;
Dewit et al, 2003). However, evidence on this point is
mixed. Labour market regulation is generally perceived to be a
disadvantage for a nation seeking to attract FDI (Bentolila and
Bertola, 1990; Cooke and Noble, 1998; Haaland et al, 2003).
However, other studies found no statistical significance (Leonard
and Schettkat, 1991), and it is a stylistic fact that FDI tends
to be higher in countries with stronger employment rights (Kucera,
2002:63). Thus, labour market regulation may, under certain circumstances,
reinforce commitment and loyalty to the employing firm, with the
subsequent reduction in labour turnover costs, together with the
maintenance of a trained workforce, offsetting perceived rigidities
(Streeck, 1991). Similarly, the literature distinguishes between
macro and micro flexibility, where decentralised (or workplace
centred) wage formation may provide flexibility at firm level,
yet may fail to secure the slower rate of growth in aggregate
real wages, reduced labour turnover and lower rate of industrial
conflict often associated with economies persisting with more
co-ordinated wage setting (Bruno and Sachs, 1985; Calmfors and
Driffill 1988; Rowthorn and Glyn, 1990). However, the evidence
of the effects of flexible labour markets is mixed, since studies
tend to associate high labour costs negatively with FDI flows
(Schneider and Frey, 1985; Culem, 1988; Friedman et al,
1992; OECD, 2000). Yet four-fifths of the world stock of FDI is
located in high-wage and relatively high-tax nations (Weiss, 1998).
16. Trade union activity and the institutional
arrangements facilitating wage bargaining tend to be insignificant
(Floyd, 2003). Hence, the evidence indicates that labour factors
are not ranked amongst the leading determinants of FDI (Erickson
and Kuruvilla, 1994; Marginson et al, 1996; Traxler and
Woitech, 2000). Nevertheless, to the extent that labour market
characteristics can influence inward FDI, the most important element
concerns the level of factor endowments, followed by numerical
flexibility and functional flexibility (Whyman and Baimbridge,
17. TNCs prefer to minimise the risk associated
with their investments, and therefore they prefer the combination
of a stable political climate together with a dependable macroeconomic
framework (Wheeler and Mody, 1992). Indicators of the latter include
low rates of inflation, budget deficits and government debt, together
with a relatively stable exchange rate. High rates of any or all
of these variables threaten to erode the financial value of the
assets purchased or developed by the inward investor, and thereby
increase the risk premium of FDI in that particular nation. Interestingly,
given the relevance to the issue for the membership of the Euro,
this does not necessarily imply a preference for a fixed exchange
rate, but does indicate a general dislike of excessive exchange
rate variability. Inward investors additionally minimise risk
through their preferences for operating within a secure and transparent
legal framework, designed to protect their property and security
of their business contracts. Additional attractive policy-related
factors include the maintenance of a reasonable rate of economic
growth, low costs of borrowing, low levels of taxation and/or
the provision of specific investment incentives intended to lower
the cost of inward investment. Furthermore, the potential offered
by privatisation, through potential undervaluing of former state
assets and/or the opportunity provided to purchase strategically
valuable assets, has further encouraged increases in FDI throughout
the past two decades.
18. These include the existence of natural
resources, the relative quality of physical and informational
infrastructure, possession of distinctive technology and production
methods protected by legal patent, to which the TNC wishes to
gain access (Cantwell, 1989; Caves, 1996; Neven and Siotis, 1996;
Dunning, 1988). Government policy can influence FDI either positively
or negatively, and these factors include relative tax rates, the
degree of regulation, provision of location incentives and the
existence of labour market rigidities. Macroeconomic policy can
induce FDI, either through the balance of fiscal and monetary
policy to lower the cost of capital and/or stimulate economic
growth, the maintenance of a competitive exchange rate to facilitate
international competitiveness and the maintenance of conditions
conducive to capital accumulation. Industrial policy may prove
beneficial in so far as it encourages the development of business
clusters and a supportive infrastructure that facilitate innovation
and technological development. Labour market policy can encourage
inward investment through investment in human capital investment
and setting a favourable environment that may encourage numerical
and functional flexibility.
19. Available evidence suggests that firms
with lower risk technology and embracing a low cost strategy have
a relative predisposition towards primarily national factors,
such as size of national market, policy-related variables, including
deregulation, tax rates and the maintenance of a low cost of capital,
whilst firms utilising high risk technology and operating a differentiated-niche
strategy are primarily concerned with the quality of a nation's
physical infrastructure (Whyman and Baimbridge, 2005a).
20. The material reviewed in this memorandum
suggests that it is important for policymakers to keep in mind
the fact that FDI is determined by an agglomeration of multiple
individual characteristics, many of which have the potential to
conflict with each other in practice. Moreover, numerous studies
have indicated that it is only with certain of these characteristics
that they are primarily concerned. Thus, there exists a clear
potential for a degree of misdirection inherent within policy
reforms intended to promote FDI by strengthening the less significant
attractors. Thus, for government policy to provide a wealthy economy,
a high quality infrastructure and facilitating human capital investment
are more significant factors in terms of inducing additional inwards
investment flows than policies related to exchange rates, deregulation,
labour costs and wage flexibility, together with maintaining tight
legal constraints upon trade unions (Whyman and Baimbridge, 2005a&b).
Consequently, it would appear useful for government policy to
seek to identify the preferred profile for those firms considering
UK investment, before determining which factor will prove the
most attractive to the potential investor.
21. However, there are a number of limitations
inherent in utilising FDI as an economic policy measure. For example,
the majority of FDI occurs in non-industrial settings and is therefore
directed towards less productive (or speculative) ventures such
as golf courses, property (commercial and residential), hotels
and shopping centres (Weiss, 1998:173). Moreover, a large proportion
of FDI is used to acquire existing assets rather than construct
new productive facilities and is therefore less effective in improving
competition and providing additionality to the host economy (Fallows,
1994:481). Furthermore, although FDI is associated with an increase
in the skill intensity in host markets, approximately half of
this relationship is considered to be due to the "composition
effect", whereby the distribution of TNCs is disproportionately
skewed towards higher-skill industries (Davies and Lyons, 1991).
Indeed, studies suggest that TNCs are unlikely to engage in training
skilled workers and prefer to recruit them from existing firms
or rely upon ex-patriots (Driffield and Taylor, 2000). Consequently,
it is unlikely that FDI, in and of itself, can solve problems
of long term unemployment amongst unskilled workers.
22. Consequently, a more rounded industrial
and regional policy would not focus almost exclusively upon the
attraction of FDI, but would seek to develop a "national
system of innovation" through establishing efficient institutions
and networks of support for the real economy, which can be extremely
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