Why the U.K. Must Take Japan's Brexit Warning Seriously

Theresa May at G20 summit
British Prime Minister Theresa May leaving a news conference after the closing of G20 Summit in Hangzhou, Zhejiang Province, China, September 5. The government faces a legal challenge over the issuing of Article 50 to initiate the process of Brexit. Damir Sagolj/Reuters

This article was originally published in The Conversation. Read the original article.

Japan's warning that its companies may move their operations outside the U.K. if it fails to negotiate favourable Brexit terms is the first major sign of how leaving the EU could affect foreign investment into Britain. Chief among Japan's concerns is whether or not the U.K. will remain part of the EU's crucial four free movements of—people, goods, services and capital.

This is no small matter. Although Japanese investment in the UK only accounts for around 6 percent of inward investment to the country, it is not evenly spread and is concentrated in certain high-profile sectors such as financial services and car manufacturing – of which production has become synonymous with certain regions, Nissan in the north-east of England and Toyota in Derbyshire, for example.

As a result, these companies play crucial roles in local economies. Average earnings in their factories are among the highest where they are located, and their investments support a large number of jobs in related sectors.

The single market has been a boon to the car industry and other companies that use advanced manufacturing because it allows them to spread the activity of their supply chains across Europe. Activities are not constrained by international borders, but based purely on cost and return, with high levels of coordination between plants. Companies can use the rules of the single market to move goods and, when necessary labour, freely across the continent. Production becomes more flexible, and with it more profitable.

Leaving the single market and losing these freedoms of movement would therefore put the U.K.'s continued participation in these supply chains at risk. Companies would not necessarily leave overnight, but it is likely that, over time, inward investors will prioritise other locations over their U.K. operations. And this applies to all foreign investors—not just the Japanese.

Maintaining inward investment

Research makes it clear that the prospects for inward investment by foreign companies into the U.K. is threatened by Brexit. This is because stability over labour markets, institutions, exchange rates and interest rates are a big part of what attracts inward investment to the U.K. So Japan's message to the UK called for it to stay part of the EU's free trade area, "access to workforces" and "harmonised regulations and standards between the U.K. and EU."

It is well understood that inward investment is of vital importance to the U.K. economy. This is not merely because of the employment opportunities foreign firms create, often in areas of high unemployment. It also has knock-on benefits for training, technology transfer and employment through related jobs. But possibly the most important contribution that inward investment makes to the economy is in mitigating the effects of an almost permanent trade deficit.

Turnover by foreign-owned businesses in the U.K. is just more than £12.5 billion (some 80 percent of this is in firms that employ more than 250 people in the U.K.). This is not evenly spread. The north of England, Wales and Scotland have much higher shares of non-financial sector, foreign-owned activity as a percentage of their total than the south-east of England for example.

Uncertainty and investment

The biggest single barrier to foreign investment is uncertainty. The more uncertainty that firms attach to their value calculations, the less likely they are to invest.

The single event that caused the greatest decline in inward investment was Britain leaving the European Exchange Rate Mechanism in 1992. This was not because it necessarily implied any particular weakness about the U.K. economy, but because of the uncertainty that surrounded it. This could be exchange rate risk, inflation, or concerns over future growth, as well as the more obvious ones perhaps associated with risk in developing or emerging economies.

Meanwhile, the single event that has had the greatest positive impact on inward investment into the U.K. was the creation of the single market. The other notable advantages the U.K. offers investors from outside the EU is a flexible labor market, compared with countries such as France and Germany.

Based on similar historical events, it is likely that Brexit would stunt the long-term growth trend of inward investment coming to the U.K. Research I have done into this indicates that there would be a larger short-term shock, which would take about four years to recover from, before developing a new (lower) trend of inward investment. Even once this period had passed, the uncertainty over being in a club where others write the rules and the uncertainty over access to markets will dominate. So Japan's warning over Brexit comes as little surprise.

International companies with operations in the U.K. will want, at worst, a "soft Brexit". This means retaining access to the single market and the ability to move people between facilities at short notice, without recourse to work permits or quotas. It is clear that this is at odds with what many champions of Brexit seek.

The road to Brexit looks long and winding, but it seems extremely unlikely that any outcome which threatens the long-term viability of foreign investment in the U.K. will be tenable. It is possible that the government will contemplate other ways to retain its attractiveness to investors. This could include lower tax rates, even higher degrees of labour market flexibility (so less protection for workers) and possibly even a lowering of environmental standards. This would doubtless find favour with many of the free-market champions of Brexit, but is likely to make Britain even more unpopular in Europe.

Nigel Driffield is professor of international business atWarwick Business School, University of Warwick