EMU, investment and growth: some unresolved issues.

Pain, Nigel

At the heart of the evaluation of the economic costs and benefits of adopting the euro lies the question of whether living standards would be higher outside or inside the Euro Area. It is well established that there is a strong positive relationship between openness to international trade and investment and the performance of the UK economy. European integration is continuing to help raise the openness of the UK economy, as well as stimulating product market competition and making the UK a more attractive location for mobile investments. This provides an additional channel through which potential output in the UK is linked to the degree of integration with the rest of Europe. Adopting a common currency may bring modest further gains to productivity and living standards by stimulating trade as well as competition. Reducing exchange rate volatility may also raise the level of fixed capital investment in the UK, although the direct evidence for this is limited, and stimulate inward investment from outside Europe , but could reduce the level of foreign direct investment between the UK and the Euro Area. However it is far from clear how big the net benefits might be or how soon they might start to appear. If the UK were to enter monetary union at a significantly overvalued real exchange rate the gains might never materialise at all and there could easily be significant net losses.

Introduction

The UK government has just begun a formal evaluation of the economic costs and benefits of entry into the Euro Area based around the five economic tests originally set out in HM Treasury (1997). At the heart of these tests, although it is not spelt out explicitly, is the question of whether living standards would be higher inside or outside monetary union. Two tests in particular relate to this issue - the third test on investment and the fifth test as to whether joining EMU will promote higher growth, stability and a lasting increase in jobs. Whilst it must be doubted whether monetary arrangements such as membership of a common currency area will have any direct impact on employment rates, it is perfectly possible that they may affect both the level of fixed capital investment by domestic and foreign firms, the productivity of those in work, and hence long-run living standards. (1)

There are two main channels which link the issue of EMU membership to investment and productivity. The first concerns the impact of membership on macroeconomic conditions, and in particular the extent of macroeconomic volatility facing firms located in the UK. The second, which is the principal focus of the literature surveyed in this paper, concerns the extent to which potential output in the UK economy is linked to the degree of integration with the rest of Europe and the specific impact of adopting a common currency on the level of international trade, the level of output and the quantity of investment by domestic and foreign firms.

It is well established that there is a strong positive relationship between international openness and economic performance. Countries who are open to international trade and investment have enjoyed faster rates of growth than those who are not. Research at NIESR and elsewhere has shown that international trade and inward direct investment have both helped to raise the rate of productivity growth in the UK during the past thirty years. Equally there is a substantive body of evidence which suggests that successive stages of European integration since the 1950s have helped to raise the openness of all EU member states, including the UK, and also to improve business efficiency by making product markets more competitive. If monetary union helps to reduce market segmentation further and raise the level of intra-EU trade, as some recent papers suggest, then it can be expected to have a positive impact on average per capita incomes in the participating economies.

Of course these gains are not automatic and could be outweighed by other factors stemming from the loss of some macroeconomic policy independence. Reduced exchange rate volatility may stimulate trade but lower cross-border investment compared to what might otherwise have occurred, particularly within the Euro Area. The rate of return on some investments that had previously been diverted into second-best locations by currency volatility might rise as a result, but the opportunities for domestic producers to benefit from the presence of foreign firms would be diminished. Path dependence in the growth process also means that entering monetary union with an overvalued real exchange rate could have long-lasting costs.

But, on balance, the literature suggests that whilst international openness is certainly not the only factor driving technical change within the UK, and the gains from further openness may not necessarily be large, there are reasons to believe that it is one means through which living standards might be raised in the UK by participating in monetary union. At the very least, it is an important factor that the UK government should consider in the evaluation of whether to enter the Euro Area.

Openness and growth: some theoretical issues

Economic growth comes from two principal sources - a rise in the quantity and quality of inputs into the production process, and improvements in the efficiency with which those inputs are utilised. Such improvements can be generated by internal organisational change and the elimination of X-inefficiencies in response to greater product market competition, the exploitation of economies of scale, from technical change arising from the development of new ideas and products or through the entry and exit of firms of different efficiencies. All of these may be affected by openness to international trade and investment, as may the incentives to undertake additional fixed capital formation.

International investment, especially foreign direct investment, may involve the direct transfer of technology or physical capital or new ideas, and international trade makes available products that embody foreign knowledge. The entry of foreign firms and reductions in barriers to trade, such as those brought about by the formation of the European Economic Area (EEA), also raise the degree of contestability of national product markets.

Standard theories of trade under perfect competition indicate that trade can enhance allocative efficiency and welfare in the economy as a whole by allowing resources to be transferred from import-substituting activities into ones in which countries have a comparative advantage. Such a shift could be expected to raise the level of income, but would not have a permanent impact on the growth rate, although faster growth would be observed for a period of time as the economy moved towards the new long-run output frontier. At the level of the individual firm, the ability to access international markets could be expected to enhance efficiency by allowing economies of scale to be exploited fully. Microeconometric evidence suggests that entry into international markets also helps efficient firms to survive, even if it does not always raise their rates of productivity growth (Bernard and Jensen, 1999). Of course there may be a trade-off between the various forces at work; one example would be the extent to which firms are able to exploit economies of scale if product market competition becomes more intense.

Recent advances in trade and growth theory stress the importance of imperfect competition, economies of scale, product diversity and the endogenous spread of ideas and organisational techniques across international borders. The creation and exploitation of knowledge are two of the key factors driving the growth process in many theoretical and empirical models of growth and technological change. In models with endogenous growth and technologies, openness can have long-lasting effects on economic growth as well as on the level of per capita incomes by influencing the rate of domestic innovation and the rate at which technologies developed elsewhere are adopted (Grossman and Helpman, 1991; Aghion and Howitt, 1998). (2)

New theories of international trade and economic geography with imperfect competition and increasing returns to scale also suggest that comparative advantage and growth patterns can be path dependant (Krugman, 1991; Fujita et al., 1999). Temporary differences in national characteristics that affect location decisions, such as lower transactions costs from participating in a currency union, can have permanent effects on the location of activities if other firms are subsequently drawn to those locations by the availability of agglomeration economies. Such economies arise from any location-bound economic activity that generates positive externalities for nearby firms. Examples include the availability of skilled labour, or proximity to suppliers and customers or the existence of clusters of innovating firms. The concentration of financial services in the City of London is one obvious example. These models help to explain why regions with similar factor endowments and similar factor prices may have very different industrial structures.

Openness and growth: empirical evidence

There is considerable support in the literature for the proposition that there is a positive association between openness to international trade and per capita incomes. Ben-David et al. (2000, Chapter 1, Annex Table 1) cite twenty empirical studies published between 1977 and 1998 which use cross-country evidence and trade policy indicators and find that open and outward orientated economies tend to enjoy faster economic growth. The indicators used include trade ratios, tariff levels and indices of price and exchange rate distortions.

Of course it is difficult to attribute causality in regressions of this kind. If richer countries tend to trade more, or can afford to forego many trade policy restrictions, then causality may run from income levels to policy. It may also be the case that, in at least some studies, indicators of openness are highly correlated with other variables that are themselves determinants of growth, such as the quality of institutions or macroeconomic stability (Rodriguez and Rodrik, 2000).

Hoeller et al. (1998) estimate a common production function for a panel of eleven EU economies over the period 1970-95 in which they include the share of total trade in GDP as a proxy for the impact of openness on total factor productivity. This is found to have a significant positive coefficient, with a 1 percentage point change in openness being associated, on average, with a 0.09 per cent increase in GDP growth per annum. Taken literally, this implies that a rise in the trade to GDP ratio of the magnitude seen in the UK since entry into the EU will eventually raise the growth rate of the economy by almost half a percentage point per annum.

The Openness and Growth project at the Bank of England (Proudman and Redding, 1998) used sectoral data to look at the factors driving growth in UK manufacturing industry between 1970 and 1992. Sectors were divided into 'open' and 'closed' groups based on ratios of trade and FDI flows. Those classified as open had an average total factor productivity (TFP) growth rate of 2.1 per cent per annum, whilst those classified as closed had TFP growth of just 0.9 per cent per annum. The study also found that the openness measures could collectively account for around half of the narrowing of the manufacturing productivity gap between the UK and the US over the period from 1970-90.

Work at the National Institute and elsewhere has also emphasised the potential benefits that may be brought by inward investors in the UK (Pain, 2000). As in other countries the average foreign-owned firm in the UK is larger, more capital intensive and has higher labour productivity than the average UK-owned firm. Controlling for size, industrial composition and the factor mix, Oulton (2000) estimates that foreign-owned firms have a 5-15 per cent productivity advantage over domestic firms, with the largest advantage being found for US-owned firms. A rising proportion of foreign-owned firms in the economy thus has a favourable compositional effect on the average level of labour productivity, other things being equal. Of more interest is the question of whether there are beneficial spillovers of technologies and ideas from foreign to domestic firms which raise the productivity levels of the latter and hence raise national income.

Evidence in favour of spillovers in the UK is reported in Hubert and Pain (2000, 2001), building on the framework developed by Barrell and Pain (1997, 1998), with higher levels of output and investment by foreign firms found to have a significant positive effect on the level of labour-augmenting technical progress, and hence, other things being equal, labour productivity, in UK-owned firms. These results appear to be robust to the inclusion of other determinants of technical progress such as R&D and imports. However there is certainly no reason to suppose that the externalities from inward investment are distributed equally across industries or regions (Girma et al., 2001).

Whilst some questions could be asked of all the studies mentioned above, either about the methodologies employed, or the extent to which other factors have been adequately controlled for, it is striking that the different approaches have all pointed towards a similar conclusion -- that greater international openness in the UK and elsewhere is associated with improved living standards. However the empirical evidence does not yet provide a convincing affirmation of the potential benefits of openness in models of endogenous growth. Most of the evidence points towards permanent effects on the levels of technical efficiency and per capita incomes. Of course, discriminating between changes which have small, but long-lasting, effects on growth, and others which ultimately have large effects on the level of output, may be very difficult to do.

Openness and European integration

If international openness matters for per capita incomes, are there any reasons for believing that participation in EMU will raise the exposure of the UK economy to international trade and investment? Some useful lessons can be learnt from postwar European experience and from the nascent literatures on common currencies and trade and on exchange rate volatility and investment by domestic and foreign firms.

Reductions in internal barriers to trade and capital mobility have created new market opportunities and been an important force behind the convergence of income levels within Europe over the past forty years. Ben-David (1993, 1996) emphasises the linkages between formal trade liberalisation amongst the founder members of the European Economic Community in the 1950s, the associated convergence of income levels between these countries and the apparent stimulus trade reform has provided to longer-term growth. Coe and Moghadam (1993) find that intra-European trade as a share of European GDP has been a key determinant of economic growth in France. (3)

There is some evidence that membership of the EU has helped to raise the overall openness of the UK economy. Chart 1 shows that entry into the (then) European Economic Community coincided with a rise in the international openness of the UK economy, as measured by the share of total merchandise trade in GDP. In part this stemmed from the improved access UK exporters had to European markets; chart 2 shows that the UK-produced share of imports into the original six members of the EEC declined continuously in the 1960s, but rose after entry into the EEC in 1973. A further point of interest is that there has been a noticeable decline in the UK share in more recent years, although formal econometric evidence is required to test whether this has anything to do with the advent of monetary union rather than other factors such as the level of the UK real exchange rate.

There is also evidence that the integration process in Europe has improved economic welfare by raising product market contestability through the elimination of restrictions on market access. Allen et al. (1998) use a CGE model to estimate that the reduction of price-cost margins brought about by the Single Market Programme (SMP) has raised UK GDP by 1.11 per cent, under an assumption of integrated product markets in the EU. Griffith (2001) also focuses on the SMP. Using UK manufacturing data for 1980-96, she finds that establishments in those sectors in which there was an a priori expectation of significant effects from the SMP in the Cecchini Report experienced a significant rise in both the level and growth of efficiency, as measured either by labour productivity or TFP, after the start of the Programme. This was not observed for establishments in sectors expected to be unaffected by the SMP. Thus the evidence appears to support the hypothesis that product market competition brought about by European integr ation matters.

European integration has also had an important effect on the pattern and level of FDI within Europe. The growth of inward investment in the UK needs to be viewed not only in terms of the national policies an institutions that have served to make the UK a desirable location for investors, but also in the context of the policies pursued collectively by all European governments and the European Commission that have helped to stimulate cross-border investments by firms from inside and outside the region. Western Europe has now be come the dominant host region for foreign direct investment amongst the developed economies, with the amount of investment held in Europe having risen especially rapidly since 1985. (4)

The implementation of the Single Market Programme (SMP), has clearly stimulated the mobility of capital and generated a significant change in investment patterns and levels of foreign involvement both in manufacturing and in services. Work undertaken for the European Commission by Arrowsmith et al. (1997) and Pain (1997) on European capital markets and on foreign direct investment shows clear positive effects from the SMP on the level of inward direct investment in both service and manufacturing activities in the UK, as do the other studies surveyed in Dunning (1997).

At the same time, the external barriers to trading with the European Union faced by producers located outside Europe have encouraged additional flows of investment into the EU, with production bases now having guaranteed access to a European-wide market. This has been particularly important for many Asian companies (Barrell and Pain, 1999a). A low level of labour costs per unit of output compared to that in many other EU member states has helped the UK to attract many of the resulting investment projects.

The major source of inward investment in the European Union, and the UK, is the United States. (5) Chart 3 shows the share of the US foreign direct investment stock located in the current members of the EU. What is striking about this picture is not just the longstanding upward trend in the share of FDI in Europe, but also that the upward trend has tended to accelerate at times of greater integration, such as the initial reduction of tariff barriers in the 1960s, the enlargement of the EU in 1973-4, the advent of the SMP in the latter half of the 1980s and the start of monetary union. Entry into the European Union has been shown to have had a significant positive impact on the level of US FDI in the UK as well as other countries such as Ireland, Spain and Sweden (Blair, 1987; Barrell and Pain, 1998).

The balance of the evidence thus appears to suggest that past European integration has helped to stimulate trade and cross-border investment within the European Union and the UK. In turn this has helped to raise living standards. Thus to the extent that adopting a common currency in Europe helps to foster further integration, there may be further gains to be obtained. These might arise through many different channels. Enhanced price transparency should help to make product markets more contestable and raise business efficiency. Greater price level stability could help to encourage longer-term capital investments, an issue discussed in detail in the accompanying paper by Ray Barrell in this Review. A third route might be that reduced exchange rate volatility has a direct impact on trade and investment by domestic and foreign firms. This third route is the main focus of the remainder of the paper. (6)

Common currencies and trade levels

One potential route through which the adoption of a common currency might affect trade levels is if exchange rate variability creates uncertainty which either discourages trade or raises the costs of trade if investments are made to hedge currency risk. The UK real effective exchange rate has been considerably more volatile than that of other major economies over the past two decades, as chart 4 illustrates using a rolling 3 year standard deviation of the real exchange rate. (7)

The question of the impact of adopting a common currency on international trade is one that has been of considerable interest to academics for many years. Until recently the effects of adopting a common currency were widely believed to be positive, but small, reflecting the comparatively weak evidence that exchange rate volatility had a negative effect on trade. Anderton and Skudelny (2001) provide a useful review of this literature. Their own estimates, using a panel for bilateral trade between Euro Area members and six major non-Euro Area trading partners over 1989-99, (8) suggest that on average exchange rate volatility reduced the level of merchandise imports by the Euro Area countries from the non-members by around 10 per cent. In 2001 this would have been equivalent to a rise of [pounds sterling]10.4 billion in the value of UK merchandise exports to the Euro Area. If eliminating sterling-euro volatility helped to raise the level of trade, with consequential supply-side benefits, then UK GDP would increa se as a result.

The gains could be small, but might still be worth having. More recent evidence has raised the possibility that the potential gains from a common currency could in fact be quite large. Using cross-section data for 186 countries (9) in 1970, 1975, 1980, 1985 and 1990, Rose (2000) estimated that, on average, the level of bilateral trade between two countries with a common currency was approximately three times the level that might otherwise have been expected. The effects from a common currency were found to be robust to other controls such as participation in a regional integration regime or free trade area, and bilateral exchange rate volatility. In other words, whatever the gains are from adopting a common currency, they are over and above those from eliminating currency volatility or adopting preferential trade agreements.

The potential importance of this finding is emphasised by the calculations in Frankel and Rose (2002). There are two steps in their analysis. First, they extend Rose (2000) to include data for 1995, which makes little difference to the estimated effect of a common currency on trade. Second, they examine the impact of trade on per capita incomes in a cross-sectional data set for more than 100 countries in 1990, controlling for income levels in 1970 and a number of other factors. Their preferred results suggest that every 3 percentage point rise in the ratio of international trade to GDP is associated with a rise of 1 per cent in per capita incomes over the following 20 years. Putting these two pieces of evidence together, Frankel and Rose (op. cit., Table 5) estimate that entry into EMU could eventually raise UK GDP by up to 20 per cent. (10)

Another interesting finding in Frankel and Rose (2002) is that a dummy variable for participation in a common currency is not significant when added to their growth regression. This suggests that the gains from adopting a common currency are more likely to be mediated through trade rather than through other channels such as greater macroeconomic stability. In turn this implies that any gains from adopting a common currency are more likely to arise if the currency is one of a major trading partner, as is the case for the UK and the Euro Area.

Not surprisingly, the work by Rose (2000) has generated considerable controversy. One problem stems from the small number of bilateral trade relationships between partners with the same currency in the data set. Although the pooled cross-section in Rose (2000) has around 23,000 observations, only 1 per cent of these cover partners with a common currency. Moreover most of these involve at least one country that is small and under-developed. It is not clear whether such examples are relevant to the case of the UK and the Euro Area. Persson (2001) argues that attention should be confined to those countries that have characteristics similar to the typical country pair with a common currency. Using a non-parametric matching technique his estimates suggest a considerably lower effect of a common currency on trade, of around 40 per cent.

There are other examples which indicate that the results are sensitive to the estimator used. Pakko and Wall (2001) and Rose (2001) both show that the inclusion of fixed effects for each pair of partner countries instead of separate controls for time-invariant cultural, geographical and historical factors causes the currency union effect to become negative and insignificant. Whilst the fixed effects estimator clearly provides a better statistical description of the data (see Pakko and Wall, 2001) it has the disadvantage of very few observations from which to estimate the currency union effect, since it has to rely on examples of partner countries either adopting or foregoing a common currency during the sample period. (11)

Glick and Rose (2002) attempt to overcome this problem by utilising an alternative data set for 217 countries over the period from 1948 to 1997. Although the number of bilateral pairings with a common currency is still around only 1 per cent of the total number of observations, the longer run of time series data means that there are 146 examples of the adoption or foregoing of a common currency during the sample period, allowing a fixed effects estimator to be employed. The resulting estimates suggest that adopting a common currency doubles the level of trade between partner countries. No evidence was found of significant trade diversion from countries which did not share a common currency with one or other of the partner countries which did. (12)

Thus there does appear to be a considerable body of evidence which suggests that, on average, adopting a common currency promotes trade. The question remains as to whether this evidence is applicable to the entry of the UK into EMU. For example, of the 146 switches in the Glick and Rose sample, only 16 involve the adoption of a common currency. There has been little empirical analysis of the separate impact on those countries which have joined a common currency. In many cases the ending of a currency arrangement has been associated with other significant changes in economic policies and institutions that will have reduced the level of trade. For example, ties between Portugal and her former African colonies, such as Angola and Mozambique, were ended in the mid-1970s, but it is difficult to believe that the subsequent trends in bilateral trade were driven primarily by the adoption of different currencies rather than by the disruption caused by the civil wars in the former colonies.

A revealing counter-example is provided by Thom and Walsh (2002), who examine the impact of Ireland's break with sterling in 1979 on the volume of bilateral trade between Ireland and the UK. Their empirical analysis suggests that the ending of the sterling link had only a negligible, and generally insignificant, effect on the level of trade. One explanation for this is that both countries were already well developed, in contrast to the typical examples in the Glick and Rose sample, and both maintained common trade policies as a result of their membership of the European Union. This evidence suggests that the impact of EMU entry on UK trade levels may be rather lower than the average effects derived by Rose (2000) and Glick and Rose (2002).

However, whilst their estimates of the impact of a common currency on trade may seem large, this is not in itself a reason for dismissing them completely, particularly in the light of the literature on home bias in trade. For instance McCallum (1995) finds that the level of trade between Canadian provinces is between ten to twenty times the size of that between Canadian provinces and US states controlling for other factors. Nitsch (2000) finds that the average EU country still exports about seven to ten times more to itself than to a partner country after controlling for factors such as size, distance and language. The reasons for this home bias are not perfectly understood, but it is at least possible that some of the estimated effects from adopting a common currency are associated with a reduction in the home bias in trade patterns.

Another factor might be that industrial specialisation, and hence trade, rises in a currency union if it stimulates firms to concentrate their activites in a single location. Midlefart-Knarvik et al. (2000) document how the process of European integration has slowly raised industrial specialisation within the European Union in the past.

Exchange rate uncertainty and fixed investment

There are also grounds for believing that exchange rate uncertainty might affect both fixed capital investment in the UK by domestic and foreign firms, particularly if some investments are irreversible. At the present time it may be possible that some firms are waiting to see whether the UK chooses to enter EMU, and if so at what exchange rate, before committing funds to undertake additional investment in the UK.

One important insight of models of investment with irreversibility and uncertainty about future economic conditions is that waiting can be a valuable option (Dixit and Pindyck, 1994). If a firm can postpone investment today and wait for new information about market conditions, then there is a net value to waiting provided the firm can still undertake the same investment opportunity in the future. By not investing, the firm forgoes an expected profit stream, but retains the ability to make more profitable choices in the future. This option value needs to be taken into account in formulating the investment decision rule and is likely to rise the greater the degree of uncertainty. Investment takes place when the expected marginal revenue product of capital is at or above a particular hurdle rate set by the firm. Increased uncertainty can be expected to raise the hurdle rate and thus reduce the current level of investment. A policy implication of this is that greater stability in the macroeconomic environment may be as, if not more, important than changes in tax policy or interest rates if the objective is to stimulate investment over some particular short to medium-term horizon.

Of course, this model really relates to the timing of investment rather than its long-run equilibrium level. It does not mean that aggregate or firm-specific uncertainty will reduce investment in all circumstances, although the majority of the empirical literature for the UK and other countries does suggest that measures of uncertainty have a negative long-run effect on fixed capital investment (Carruth et al., 2000; Ashworth et al., 2001). At times investment can create rather than destroy options. For instance, if patent laws are strictly enforced, there could be strategic reasons for being the first to invest in new technologies. Another example might be if investment had an information value by revealing information about previously unknown outcomes, such as the geology and reserves of oilfields. Equally, as we discuss below, investing overseas can at times create options for firms.

Abel and Eberly (1999) show that in general the impact of uncertainty on the long-run capital stock in the presence of irreversibilities will depend on two factors, the user cost of capital and a 'hangover' effect. The latter arises because at any point in time the firm can find itself with a capital stock different from the level it would choose if it was becoming established for the first time, even if investment choices in the past were optimal given economic conditions at the time. Their analysis suggests that the user cost and hangover effects work in different directions, with the former reducing the capital stock when uncertainty is increased, but the latter raising investment under uncertainty. (13) Simulation results in Abel and Eberly suggest that the user cost effect dominates only when uncertainty, as represented by the standard deviation of the expected growth rate of demand, becomes large relative to the mean expected growth rate.

The implications of the literature are thus unclear. The impact of changes in the extent of uncertainty about factors such as demand, inflation and exchange rate on fixed capital investment may well vary across industries according to their structure, and across types of capital goods according to their ease of resale.

Darby et al. (1999) examine the separate impact of exchange rate volatility on business investment in five countries - France, Germany, Italy, UK and US between 1976 and 1994. Exchange rate volatility, measured using a two-year moving standard deviation of the rate of change in the real effective exchange rate, is found to have a negative long-run effect on investment in France, Germany and the US, but in the UK and Italy the negative effect is only temporary. (14) Thus real exchange rate stability will not in itself have any effect on the long-run investment-output ratio in these countries. However the authors also find that a sustained real exchange misalignment, calculated as the deviation of the real effective exchange rate from a trend obtained by applying the Hodrick-Prescott filter to the log of the real effective exchange rate, will have a long-run negative effect in the UK, France and the US. This suggests that the level of the real exchange rate rather than the volatility of the rate may matter for investment, a point we return to below in discussing foreign direct investment. (15)

In general the impact of exchange rate fluctuations on individual firms might be expected to vary according to the extent of their international exposure and factors such as the share of total revenues derived by exporting, the ratio of imported inputs in production and the extent of foreign competition in the home market (Gampa and Goldberg, 1999; Nucci and Pozzolo, 2001). Market structure is likely to matter, with more competitive industries likely to be more heavily affected by exchange rate fluctuations since firms in these industries have less scope to absorb currency fluctuations in profit margins. An implication of this is that moves to raise product market competition, of the type being undertaken by the current UK government, may raise the sensitivity of investment to the exchange rate.

Exchange rate uncertainty and foreign direct investment

Many of the factors discussed above also affect the decisions of firms to undertake foreign direct investment. (16) In general the extant literature does not provide a clear guide as to the impact of exchange rate uncertainty on FDI. Sunk costs may well mean that decisions over whether to expand an existing foreign investment in the presence of currency uncertainty differ from decisions as to whether to set up foreign establishments for the first time. Of course there are reasons why there might be a negative relationship between currency variability and foreign investment. Domestic shareholders care about the income earned on their capital, and currency instability can adversely affect expected returns, especially in developing economies (Benassy-Quere et al., 2001). (17) Equally, if investment at home involves risk, but investment abroad involves uncertainty (in the Knightian sense), then exchange rate variability may generate a bias towards home country investment (Epstein and Miao, 2002).

But there are also reasons why firms may wish to invest abroad when currencies are volatile. One reason is that in the presence of barriers to international trade, exports and foreign production may be alternative ways of entering foreign markets. So real exchange rate volatility may discourage trade, but raise FDI. However this may not always be efficient if investment is being diverted to locations in which the overall returns are lower, even if profits are being made. Two particular general motivations have been identified in the literature -- the gains from production flexibility and the gains from diversifying risk (Aizenman, 1992; Goldberg and Kolstad, 1995). Having a portfolio of plants in different locations gives firms flexibility to locate production where it is cheapest, given fluctuations in costs. (18) Ensuring a closer link between the currencies in which costs and revenues are denominated can also help to reduce the exposure of profits to short-term currency fluctuations.

The diverse predictions from the theoretical literature are reflected in the available empirical studies on FDI. Campa (1993) finds that exchange rate volatility reduces levels of FDI into the US, particularly in industries in which sunk costs are high. Goldberg and Kolstad (1995) find that in general greater real exchange rate volatility increases the share of total production that firms choose to locate abroad, although they do not find any significant effect on the level of inward investment in the UK by US-owned firms. Estimating a gravity model for bilateral FDI flows between a sample of OECD countries over 1982-94, De Menil (1999) obtains a significant positive effect from bilateral real exchange volatility, with the coefficients implying that a sustained 10 per cent increase in the standard deviation of the real exchange rate would eventually raise the level of FDI by 15 per cent. For a given market size, this implies that EMU will reduce the level of cross-border FDI within the Euro Area.

Aizenman and Marion (2001) suggest that the impact of uncertainty on FDI might vary according to the form of investment being undertaken. For instance, vertical FDI, involving the fragmentation of the production process across different countries, might be discouraged by exchange rate uncertainty because of the need to engage in intra-firm trade. In contrast, horizontal FDI, in which similar activities are undertaken in different locations, might be encouraged by exchange rate uncertainty. As horizontal FDI is typically observed in the major industrialised economies, this model also suggests that reducing currency volatility might reduce the level of inward investment in the UK, at least from other EU economies, as well as the level of investment in the Euro Area by UK-owned firms.

More generally, it can be argued that the changes resulting from the decision to adopt another currency may differ according to the size of the potential host and the location of the potential investor. Small host economies such as Ireland, that primarily attract investments to produce goods and services that are then traded in a wider supranational market (the EEA), may have much to gain by adopting a common currency with the countries in the larger market. But larger host economies such as the UK, that also attract investments designed to serve the host market, may experience both effects. Exchange rate volatility can encourage inward investment to serve the host market, but discourage investment designed to serve other markets.

There may also be interesting distinctions in the attitudes of investors according to their nationality. In particular investors in the UK from outside Europe, especially the US and Japan, may have more to gain from UK entry into EMU than investors from other European countries. This is because the large non-European investors in the manufacturing sector export a larger proportion of their output, and are more likely to export to other European destinations, as table 1 shows. The table contains data for 67 of the UK's largest exporters in 1997. In total these firms accounted for 25 per cent of exports that year.

But, overall, there appear to be few grounds for presently concluding that adopting the euro would have large effects on the level of inward investment in the UK as a result of changing currency volatility. If anything, the balance of the current evidence suggests that inflows might be smaller, other things being equal, although there is a clear need for further research on this issue. Outward investment from the UK into the Euro Area might also be lower than if the UK did not adopt the euro, which could raise the resources available to finance fixed capital formation in the UK.

The real exchange rate and location

However, as Barrell and Pain (1998) stress, the literature on the determinants of FDI provides a much clearer implication with regard to the level of the real exchange rate. Studies of investment decisions by US, Japanese, UK and German companies all suggest that the relative cost of different locations within the EEA has a significant, and non-negligible, effect on the location of investment (Pain, 1997; Barrell and Pain, 1999a and b; Pain and Hubert, 2002). There are potentially large costs to entering monetary union with an overvalued real exchange rate against the other members. This is because path dependence in the growth process means that that real exchange rate misalignments can have permanent effects on living standards (see also Darby et al., 1999). It is likely to take many more years for relative prices to correct a misalignment of the real exchange rate than it is for the nominal exchange rate to do so.

The UK real exchange rate relative to (a weighted average of) the other EU members is presently well above the historical average, as chart 5 shows using a measure based on economy-wide unit labour costs. This does not appear to be the case with the real exchange rate against the major non-EU economies. Of course it is not known whether existing investors in the UK are unaffected by the current level of the real exchange rate, or whether they are choosing to reduce profit margins in the expectation of an eventual depreciation. There are some grounds for believing the latter is true, most notably the current low level of returns on capital in the manufacturing sector and the persistent reduction in export margins since the mid-1990s, but it would be useful to have some direct survey evidence for the corporate sector. (19) Joining the euro at the current real exchange rate might be costly; joining at the current exchange rate and then seeing the euro appreciate against other currencies certainly would be, as th e accompanying paper in this Review by Ray Barrell also emphasises.

Conclusions

The adoption of a common currency by a number of European economies can be seen as a natural continuation of the process of ever-deeper economic integration in Europe over the past forty years. The stimulus to international trade, cross-border investment and product market competition provided by the ongoing integration process is clearly continuing to have a beneficial impact on living standards in all participating economies, including the UK.

These benefits arrive in many different ways. Greater openness to trade and FDI helps to transmit new products, technologies and ideas across national borders, with potential benefits for the productivity of domestic companies and their incentives to undertake fixed capital formation. Enhanced contestability of product markets undoubtedly helps to spur organisational efficiency. The size of national economies in Europe has to be seen as endogenous, determined in part by their acquired characteristics and the extent to which they choose to integrate with other economies rather than just by their endowed characteristics.

Thus it appears reasonable to suggest that the adoption of a common currency, with the associated improvements in intra-area price transparency and competition, could on balance increase the long-run level of output in participating economies and, for a time at least, the potential rate of output growth, provided that it helps to further stimulate trade and investment. But it is far from clear how big the net benefits might be or how soon they might start to appear. Indeed, if the UK were to enter monetary union at a significantly overvalued real exchange rate, the gains might never materialise at all and there could in fact easily be significant net losses.

Some studies suggest that the effects of adopting a common currency on the level of trade with other users of that currency are large, but there are reasons for doubting that the magnitude would be as great for the UK and the countries in the Euro Area. An associated reduction in real exchange rate volatility might also have an impact on the level of fixed capital formation in the UK and, more generally, on the location of economic activities across countries. Numerous studies have shown that macroeconomic uncertainty has negative effects on fixed investment in the UK and so, whilst there is only a small amount of direct evidence regarding exchange rate uncertainty, it would seem likely that this also acts to deter investment, at least in the short term. The impact of lower currency volatility on the location of economic activities, and hence on the potential extent to which technical change is boosted by knowledge transmitted across national borders, is ambiguous, with the effects likely to vary according to the motivations for cross-border investment. It is quite possible that a reduction in the volatility of the sterling-euro real exchange rate will reduce intra-area FDI relative to what might have occurred, but stimulate investment from outside Europe by investors who wish to use the UK as a base for serving the wider European market.

The linkages discussed in this paper are, of course, only one part of the overall impact that EMU entry would have on the British economy. To date the effects on domestic macroeconomic volatility have received more attention than the changes that could result if integration with the rest of Europe helped the UK economy to become more open and raised the competitive pressures on UK-located businesses. These latter effects are implicit in government's economic tests and the initial work done by HM Treasury. Their potential scale and significance means that they deserve to receive considerably more attention than they have done to date.

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Table 1

The UK's major exporters in 1997

 UK European Non-European
 firms firms firms

Number of firms 37 9 21
Total exports ([pounds sterling]bn) 29.7 9.9 18.3
 Europe (%) 43.9 41.6 76.1
 Non-Europe (%) 56.1 58.4 23.9
Total exports/turnover 37.3% 39.5% 47.6%
UK Employees 505,251 102,127 97,360

Source: Pain (2000).

NOTES

(1.) This could have an indirect effect on employment rates if it affected labour force participation.

(2.) One of the benefits of openness in this framework is that it can raise the resources available to undertake domestic innovation, with access to foreign technologies and ideas providing a larger pool of knowledge that can be used in subsequent research. International knowledge spillovers of this kind can arise from all forms of international contact, including the mobility of skilled labour, inward investment and trade.

(3.) Hoeller et al. (1998) also include a measure of intra-European trade in their production function model. They obtain a positive, but insignificant, coefficient, implying that regional trade integration did not provide a significant stimulus to productivity growth over and above that arising from the general rise in openness to trade.

(4.) At the end of 2000 the stock of inward direct investment in the European Union represented 56.4 per cent of that held in developed economies and 37.6 per cent of the world total (UNCTAD, 2001). In 1985 the corresponding figures were 43.3 per cent and 26.5 per cent respectively.

(5.) At the end of 2000, US-owned firms accounted for some 34.4 per cent of the total stock of inward FDI in the UK.

(6.) It would also be of interest to look at R&D, but there is no empirical literature on the impact of currency volatility or indeed most other forms of macroeconomic volatility on R&D (Becker and Pain, 2002).

(7.) The real exchange rate is constructed using whole economy unit labour costs, with quarterly data being used to calculate the standard deviation.

(8.) The six countries are the UK, the US, Japan, Denmark, Sweden and Switzerland.

(9.) The 'countries' include a number of overseas departments, dependencies and territories as well as internationally recognised sovereign nations.

(10.) In 2001, 51.1 per cent of UK merchandise trade was with the Euro Area. The precise magnitude of the effect will depend on the base year used in any calculation. To illustrate, in 2001 UK exports plus imports of goods and services amounted to 56.4 per cent of GDP at 2001 market prices. If half of this was trade with the Euro Area, and this tripled after adopting a common currency, the ratio of total trade to GDP would rise by 56.4 percentage points. In turn this would raise GDP by 18 3/4 per cent. Estimates of this kind are also made in Andrew Rose's report for Britain in Europe entitled 'EMU's potential effect on British trade: a quantitative assessment', available at http://haas.berkeley.edu/-arose/UKEMUTrd.PDF.

(11.) The partner countries fixed effect will automatically pick up any common currency effect that was maintained throughout the sample period. Rose (2001) notes that there are only 8 switches in his original sample.

(12.) Rose (2001) suggests that the conclusions from this data set are robust to the critique made by Persson (2001) about his earlier work

(13.) This result relies upon the assumption that the marginal revenue product of the firm is a decreasing function of the capital stock, giving a link between future returns and current investment.

(14.) However the hypothesis of common effects across all countries is not tested formally.

(15.) Becker and Pain (2002) report provisional results that the level of the real effective exchange rate also has a negative impact on R&D expenditure in the UK.

(16.) Foreign direct investment may differ from fixed capital investment by foreign firms. The former is a financial flow and is just one means through which inward investors can finance their activities. Tacit and codified firm-specific knowledge can be transferred continually from parent companies independently of other financial transactions and productive facilities can be established and expanded using capital raised outside the home country of the parent firm. Such finance will not be included in the FDI statistics.

(17.) The implications of this model are similar to those of the work on currency unions and trade. Other things being equal, developing countries would gain more inward investment by linking their currencies to those of their major investors.

(18.) It can also guard against other forms of risk, as in the case of investment in oil fields and refineries for example.

(19.) The initial outturn data suggest that the net rate of return on capital in the manufacturing sector was 5.5 per cent in 2001, down from a local peak of 11.9 per cent in 1997. The 2001 outturn was the lowest since 1992.

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Nigel Pain (*)

(*.) National Institute of Economic and Social Research. e-mail: n.pain@niesr.ac.uk. I would like to thank Ray Barrell, Martin Weale and participants in presentations given at Bloomberg, Cazenove and Co, the Statistical and Social Inquiry Society of Ireland symposium on Economic Growth in Ireland and the CEPII/NIESR conference on British Business and the Euro for helpful comments and suggestions. I am also grateful to the ESRC for providing financial support.