Select Committee on Treasury Written Evidence


Memorandum submitted by Dr Mark J Baimbridge, European Economies Research Unit, University of Bradford, and Dr Philip B Whyman, University of Central Lancashire

EXECUTIVE SUMMARY

  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 GOVERNMENT'S DOMESTIC POLICY RESPONSE TO GLOBALISATION

The relevance of globalisation to the Government's policies on: business investment

INTRODUCTION

  1.  Business investment is a significant determinant of economic success, at least in so far as this occurs in productive assets—ie 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).

DEFINITION OF FDI

  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.

POLICY IMPORTANCE OF FDI

  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 opportunities—albeit 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).

FACTORS INFLUENCING THE LOCATION OF FDI

  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).

Figure 1


  (Source: Whyman and Baimbridge, 2005a).

Demand factors

  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, 2005a&b).

Cost factors

  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, 2005a&b).

Minimising risk

  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.

National-specific factors

  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).

SIGNIFICANCE FOR GOVERNMENT POLICY

  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 successful in developing international competitive advantage (Dunning, 1988; Cantwell, 1989; Porter, 1990; Patel and Pavitt, 1991).

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May 2006





 
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