Lost in transition – UK FDI falls due to Brexit

UK FDI sends a worrying message …

Foreign Direct Investment (FDI) is an important source of capital and capability for countries and offers a unique view on how foreign investors and businesses perceive a country’s economic potential. EY’s 2019 UK Attractiveness report shows how the UK’s FDI performance has changed since our 2018 report, suggesting we should be concerned about the UK economic outlook. The UK has lost ground in Europe as its appeal as a destination for FDI has declined, risking the UK’s future growth potential. The UK needs to respond urgently or risk a further weakening of its position in the coming years.

… with a fall of 13% in project volumes in 2018 …

The UK attracted 13% less FDI projects compared to 2017, with total projects falling from 1,205 to 1,054. While the European market for FDI also fell, shrinking by 4%, the fact that projects into Germany fell by 13%, largely due to a slump in business services investment, means that when we exclude Germany and the UK, the European market was flat year-on-year.

… a loss of market share …

The UK’s greater decline in project numbers than the market meant that its market share of all FDI projects secured in Europe fell from 18% to 17%, having been at 21% as recently as 2015. This is the lowest share achieved by the UK in the two decades EY has been tracking FDI flows and its worst ever performance relative to the European market.

… and a softening of the digital sector …

Last year saw the first signs of a challenge to the UK’s leadership of the digital sector in Europe, with the UK’s 27% growth lagging market growth of 33%. The digital sector in Europe grew by 5% in 2018, despite a declining overall FDI market, but the UK’s share fell four points to 23% as project numbers fell 10% from 320 to 288.

… as Brexit adversely impacts the UK’s appeal …

While, on first pass, the similarity in performance between Germany and the UK suggests that Brexit may not be the cause of the decline in the UK’s performance. However, our analysis shows that the shift in German performance is due to different factors than the UK, primarily due to a fall in investment in the business services and consumer sectors.

By contrast, the results of our survey of over 400 investors show how FDI into the UK has been impacted by the Brexit process. When asked how their investment activity in the UK has changed since the referendum on EU membership, 15% of investors said they have put their plans on hold. This represents a near doubling from the 8% of investors last year who told us they had paused activity. The positive perspective is that this paused investment has not been cancelled and is still “in-play”. Identifying how to free up this paused capital should be an immediate policy priority.

Moreover, the fall in UK FDI in areas identified by investors as most likely to be negatively impacted by Brexit such as manufacturing (projects down 35% in 2018 against market decline of 6%), a 50% decline in HQ projects to a level one-third of that in 2015, automotive (down 32% in a market that grew by 1%), R&D projects (down 26% against 15% growth) and chemicals (down three times the level of market decline) clearly demonstrate that Brexit was far and away the most important factor in the decline of UK FDI in 2018.

… with significant implications across the country …

In 2017, the North and Midlands performed relatively strongly compared to London and the South East in attracting FDI. The performance of the UK’s regions was very different in 2018: London saw only a 0.2% decline in projects and the South East, Wales and the East Midlands all experienced very slight falls in volumes of only single digit percentages. But the rest of the country saw significant declines in project volumes with the weak performance of manufacturing hitting the northern and western most regions of England. While experiencing falls in project numbers, Scotland and the West Midlands managed to limit the falls compared to other regions, with the latter performing strongly in the digital sector.

The relatively strong performance of London and the South East suggests that attempts to rebalance the UK geographically may be harder to realize given the challenges posed by Brexit and raise concerns about the future performance of places outside of the main urban centres. Projects in the UK’s 12 core cities fell by 3% in 2018 and by 10% when we exclude London but the decline in the rest of the country outside of the 12 core cities was 23%. It appears that Brexit not only reduces the UK’s overall appeal, but it is having a much greater negative impact outside of the UK’s major cities.

… as investors from fast growth regions become wary of the UK …

The shifts in the sources of the UK’s FDI give further cause for concern. While the UK continued to be the leading destination in Europe for investment from the US, performance was poor with most other major FDI source countries with a 13% fall in investment from the rest of Europe.

Most striking was the fall of 65% in projects from China between 2017 and 2018, compared to a 4% fall across Europe, and a significant if slightly lower decline of 24% in Japanese projects, much worse than the falls of 2% in Germany and 4% in France. The UK also saw a decline to 150 projects from the Commonwealth compared to 192 in 2017.

Brexit has impacted sentiment: Asian investors are nearly three times more likely than US investors to have reduced their investment, and both Asian and West European investors are more than 10% more likely than average to have paused projects.

… just as UK businesses increase their commitment to Europe.

There was a geographic shift in UK FDI in 2017 with a 35% increase in UK outbound projects over 2016, the highest-ever UK outflow. This trend continued in 2018 with a new record level of 480 outbound investments. Since the referendum in 2016, UK outbound HQ projects have increased almost fourfold, digital, financial services and research and development (R&D) flows out of the UK have more than doubled, and there were 79 outbound manufacturing projects in 2018 compared to 43 in 2016. With UK business investment falling by 2.5% in 2018, the FDI data shows that, just like their international peers, UK businesses and investors are reacting to the change in the UK’s relationship with the EU by allocating capital to Europe.

And while investor perceptions point to no short-term crisis …

Our survey of perceptions among global investors reveals the proportion of investors planning to establish or expand operations in the UK over the coming year is 23%, the equal lowest score over the last decade but only slightly down on the 24% recorded last year. And, while this level is below the 27% average across Europe, as Europe’s comparable level was 35% last year, the UK is relatively closer to the European figure, suggesting no short-term shock is looming.

… longer-term sentiment is increasingly negative …

However, the perception survey responses also contain worrying indicators for the future attractiveness of the UK for FDI. Our survey found that 42% of investors expect the UK’s attractiveness for FDI to decline over the coming three years, while only 26% expect it to improve. The resulting net negative intention of 16% is the worst-ever result in the decade we have been running our annual survey.

… as the UK’s attractiveness ranking has shifted downwards.

The UK’s FDI performance in 2018 reflects a changed investor view of the UK’s attractiveness. And current perceptions are still significantly lower than the pre-referendum levels on 12 of the 13 attributes we have tracked for at least five years (the exception is the cost and availability of real estate which is at its 2016 level).

Our research shows how perceptions have changed since 2016. The UK has always benefitted from its “soft” appeal and as such it is striking just how far investor perceptions of the stability of the social climate have fallen (down from its best-ever rating of 86% positive to 61%), and how opinion on the stability and transparency of the political, legal and regulatory environment has slumped to 53% compared to a high point of 86%. Investors see the UK as less welcoming and much harder to understand.

Businesses are not planning a mass exodus from the UK …

In this challenging environment, one piece of good news is that only 6% of investors indicated that they expect to move assets out of the UK in the next three years, although the sentiment varied significantly across sectors, with 15% of Asian investors and 8% of manufacturers and chemicals companies indicating that they were likely to move assets.

… but we need to respond now.

The risk is not of a mass exodus but a gradual weakening of the UK economy as FDI is deferred and then probably reallocated to other countries. Investors are signaling that they have downgraded their view of the UK and are likely to treat the UK as a distribution and sales channel rather than the hub of their future high value manufacturing, digital and research operations. Urgent action is required to reverse this shift and I will set out how the UK can respond to restore its appeal in my next blog.