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Foreign investment, European integration, and the Single Market

Summary:
Foreign direct investment (FDI) can play a central role in economic development. As a form of capital accumulation, FDI can support economic growth (Alfaro et al. 2004) by enhancing productivity, both horizontally within industries (Haskel et al. 2007) and vertically up and down supply chains (Javorcik 2004). Indeed, the literature has argued that FDI can stimulate technological innovation (Bransletter 2006), increase competition in domestic markets (Mastromarco and Simar 2015), and disseminate frontier management practices (Bloom et al. 2012). The resulting productivity payoffs are the main reason why it is important to understand which factors matter in attracting FDI. In such research, economic integration has received much less attention than factors such as distance, cost

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Foreign direct investment (FDI) can play a central role in economic development. As a form of capital accumulation, FDI can support economic growth (Alfaro et al. 2004) by enhancing productivity, both horizontally within industries (Haskel et al. 2007) and vertically up and down supply chains (Javorcik 2004). Indeed, the literature has argued that FDI can stimulate technological innovation (Bransletter 2006), increase competition in domestic markets (Mastromarco and Simar 2015), and disseminate frontier management practices (Bloom et al. 2012). The resulting productivity payoffs are the main reason why it is important to understand which factors matter in attracting FDI. In such research, economic integration has received much less attention than factors such as distance, cost differentials, natural resources, and institutional characteristics. This column reports evidence shedding new light on the role of integration in attracting FDI, with special reference to the European experience (Bergstrand 2008) and the key role of the Single Market. 

The European Single Market represents a substantial deepening of the European integration process (Baldwin 1989, Grin 2003, Campos et al. 2015). The origin of the Single Market was a 1985 White Paper that identified and articulated an extensive set of about 300 measures, with the objective of completing what was known at the time as the common or the internal market (Young 2015). Although the 1957 Treaty of Rome had created a common market based on the free movement of goods, people, services and capital, it was clear by the early 1980s that significantly more integration was needed regarding people, services as well as capital. The 1986 Single European Act changed the decision-making process (from unanimity to qualified majority) in European institutions and established a deadline to complete the implementation of that set of measures (December 31, 1992). 

The potential impact of the Single Market on FDI has been considered by Dunning (1997), Neary (2002) and Kaloty (2006), among others, but not in recent years, and not after the Single Market became embedded. The Single Market may have been an important driver of FDI. This is because it created a unified market across Europe, so market seeking FDI from outside the EU would be attracted to the EU because of the larger size of the ‘domestic’ market and the possibilities to exploit scale economies and reduce transactions costs (Aristotelous and Fountas 1996). Since the EU lacks abundant natural resources, market-seeking, efficiency-seeking and strategic asset-seeking motives predominate (Kaloty 2006).  In addition, the Single Market may stimulate additional FDI both from within and outside the EU.  It may also increase FDI between member states, because of cost differences, especially in labour costs, combined with relatively short supply chains and low transaction and coordination costs. Thus, efficiency-seeking motives probably predominated in intra-EU FDI. 

Empirical work on the impact of EU membership and the role of the Single Market on FDI has lagged behind the theoretical discussion, largely because of data availability problems. Previous research on FDI and European integration has only covered a few source or host economies, usually from among advanced economies, and often sought to model FDI inflows to a country rather than the determinants of inter-country (bilateral) flows.  

In Bruno et al. (forthcoming) we exploit new longer global bilateral datasets and use frontier estimation methods to provide robust measures of the effects of EU membership and the Single Market on FDI. We also compare the impact of other models of economic integration, including the North American Free Trade Area agreement (NAFTA) and Mercosur Agreements. Bilateral data on FDI inflows for almost every economy in the world have just been made available from UNCTAD, while previously such bilateral data were restricted to OECD economies (Schiavo 2007). Our work is perhaps the first to use this new FDI data resource – the comprehensive UNCTAD bilateral FDI dataset.1 This allows us to consider a much wider range of countries (142 countries, including all the principal emerging economies) and a much longer period (1985–2018) than previous studies. Thus, we can estimate the effects of integration over a much longer time window, and also compare the effects of the EU membership with a fuller range of other trading/integration arrangements.  It also enables study of the effects of EU membership on FDI, not only for countries in the EU itself (De Sousa and Lochard 2011) or between EU members and other advanced economies, but also including FDI from emerging economies. This is critical because in recent years, FDI from emerging economies has represented up to a third of total outflows and China has often been the largest single FDI source economy.

New estimates 

There are three main novel findings. We find that the impact of EU membership on FDI into the host economy is always positive, significant, and quite large – in the order of 60% for inward investment from outside the EU, and around 50% for intra-EU FDI (Figures 1 and 2). Indeed, these estimates show the EU is the only bloc for which there are significant FDI increases from both outside and within the bloc.

Figure 1 The effect of EU, NAFTA, EFTA and MERCOSUR membership in terms of FDI inflows (from outside the bloc)

Foreign investment, European integration, and the Single Market

Figure 2 The effect of EU, NAFTA, EFTA and MERCOSUR membership in terms of FDI inflows (from within each bloc)

Foreign investment, European integration, and the Single Market

Conversely, the 60% estimate implies that leaving the Single Market would lead to a decrease of FDI inflows of 37.5%. For example, in considering the effects of Brexit, one needs to run the experiment in reverse so the proportionate effect is smaller.  If joining the EU increases FDI by 60%, one would predict that leaving the EU would reduce FDI by 37.5% (= 0.60/(1+0.60)). This is more than 50% greater than previous estimates which suggested a 25% long-run impact (Bruno et al. 2017). The difference may be explained by the increase in the number of countries studied (in the pre-Brexit estimates there were fewer than 40 countries, against more than 140 in this study) as well as better temporal coverage and improved methodology.  

A second important finding is that the effect of the EU membership on FDI is significantly larger than in NAFTA, EFTA, and Mercosur, supporting the view of the greater benefits of deep as against shallow economic integration in capital inflows as well as trade. 

A third important finding is that we are able to econometrically separate the effects of the EU membership before and after the implementation of the Single Market in 1993. Our preferred results, those accounting for ‘multilateral resistance terms,’ show that the Single Market is the cornerstone of the differential impact of deep against shallow integration. Accordingly, before the Single Market, EU membership did not actually have a significant effect on FDI. Instead, the positive significant impact of the EU membership on FDI only holds for the period after the Single Market is implemented.

Implications for policy and future research 

In terms of future research, we think that four main issues arise from our study. First, there is the issue of the sectoral composition of FDI since the integration effects may be heterogeneous across sectors, for instance services versus manufacturing. A second recommendation is to investigate whether there are complementary relationships between FDI and other forms of integration, such as trade or financial flows (Haaland and Wooton 2021). A third would be to dwell deeper on those institutional aspects that have so far received limited attention in the literature. These might include issues such as corruption, the rule of law, inequality, and the quality of state institutions, on the one hand, and corporate tax rates and tax havens, on the other. Finally, we think the issue of expectations deserves more detailed treatment. For instance, we know EU accession measured by its date does not fully capture FDI effects that occur prior to EU membership (e.g. accession negotiations and/or changes to candidate status). 

Regarding policy implications, until very recently FDI has been one of the areas on which the EU was broadly silent. However, this has recently begun to change. Former Commission President Juncker presented a proposal to create the first EU-wide framework for FDI during his 2017 State of the Union address. The proposal was adopted by the European Parliament and the Council in March 2019 and has now entered into force, although it was restricted to screening foreign investment into the EU. Europe was still recovering from a global financial crisis in which an investment slowdown played a central role when the pandemic hit. Many well‐designed policy proposals were on the table but have not yet received the financial resources and political support that they require (Evenett and Fritz 2021). This new framework is a step in the right direction, but it does not suffice. In principle, FDI can play a key role in accelerating and deepening the recovery because of the robustness of its long‐term productivity effects. We have shown that these can be effectively shored up by EU integration.  

References 

Alfaro, A C, S Kalemli-Ozcan and S Sayek (2004), “FDI and Economic Growth: The Role of Local Financial Markets”, Journal of International Economics 64 (1): 89–112.

Aristotelous, K and S Fountas (1996), “An Empirical Analysis of Inward Foreign Direct Investment Flows in the EU with Emphasis on the Market Enlargement Hypothesis”, Journal of Common Market Studies 34 (4): 571–583.

Baldwin, R (1989), “The Growth Effects of 1992,” Economic Policy 4(9): 247-281.

Bergstrand, J (2008), “How much has European economic integration actually increased members” trade?", VoxEU.org, 6 September. 

Bloom, N, C Genakos, R Sadun and J Van Reenen (2012), “Management practices across firms and countries”, Academy of Management Perspectives 26 (1): 12-33.

Branstetter, L (2006), “Is Foreign Direct Investment a Channel of Knowledge Spillovers?”, Journal of International Economics 68(2): 325-344.

Bruno, R, N Campos, S Estrin and Meng Tian (2017), “Foreign Direct Investment and the Relationship between the United Kingdom and the European Union,” in N. Campos and F. Coricelli (eds.) The Economics of the UK-EU Relationship: From the Treaty of Rome to the Vote for Brexit, Palgrave-McMillan, pp. 139-174.

Bruno, R,  N Campos and S Estrin (forthcoming), “The Effect on Foreign Direct Investment of Membership in the European Union,” Journal of Common Market Studies.

Campos, N, F Coricelli and L Moretti (2015), “European integration: Benefits of deep versus shallow integration,” VoxEU.org, 19 June. 

De Sousa, J and J Lochard (2011), “Does the Single Currency Affect Foreign Direct Investment?” Scandinavian Journal of Economics 113: 553–578.

Dunning, J (1997), “The European Internal Market Programme and Inbound Foreign Direct Investment”, Journal of Common Market Studies 35(2): 189-223.

Evenett, Simon and Johannes Fritz (2021), “FDI is in big trouble: Insights from the 27th Global Trade Alert report,” VoxEU.org.

Grin, G (2003), The Battle of the Single European Market: Achievements and Economic Thought 1985-2000, Routledge.

Haaland, J and I Wooton (2021), “Free trade agreements do not always ensure free trade,” VoxEU.org, 14 May. 

Haskel, J, S Pereira and M Slaughter (2007), “Does Inward Foreign Direct Investment Boost the Productivity of Domestic Firms?” Review of Economics and Statistics 89: 482–496.

Javorcik, B S (2004), “Does Foreign Direct Investment Increase the Productivity of Domestic Firms? In Search of Spillovers through Backward Linkages”, American Economic Review 94: 605–627.

Kalotay, K (2006), “The Impact of EU Enlargement on FDI Flows,” in J A Batten and C Kearney (eds), Emerging European Financial Markets: Independence and Integration Post-Enlargement (International Finance Review, Vol. 6), pp. 473-499.

Mastromarco, C and L Simar (2015), “Effect of FDI and Time on Catching Up: New Insights from a Conditional Nonparametric Frontier Analysis”, Journal of Applied Econometrics 30: 826–847.

Neary, P (2002), “Foreign Direct Investment and the Single Market”, Manchester School 70(3): 291-394.

Schiavo, S (2007), “Common Currencies and FDI Flows”, Oxford Economic Papers 59(3): 536–60.

Young, A (2015), “The Single Market: From Stagnation to Renewal”, in H Wallace, M A Pollack and A R Young (eds), Policy Making in the European Union, 7th ed., Oxford University Press, pp. 115-140.

Endnotes

1 See for details https://unctadstat.unctad.org/wds/ReportFolders/reportFolders.aspx?sCS_ChosenLang=en.

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