This paper reviews economic developments in the United Kingdom during 1991–96. The paper examines two sets of possible reasons why the United Kingdom's savings and investment rates are lower than elsewhere. The first consists of factors leading to lower optimal rates of savings and investment: these include demographics, economic structure and technology, a liberalized financial environment, and so on. The second consists of distortions leading to lower-than-optimal savings and investment rates. The paper also presents new estimates for the potential growth rate, the output gap, and the natural rate of unemployment.


This paper reviews economic developments in the United Kingdom during 1991–96. The paper examines two sets of possible reasons why the United Kingdom's savings and investment rates are lower than elsewhere. The first consists of factors leading to lower optimal rates of savings and investment: these include demographics, economic structure and technology, a liberalized financial environment, and so on. The second consists of distortions leading to lower-than-optimal savings and investment rates. The paper also presents new estimates for the potential growth rate, the output gap, and the natural rate of unemployment.


235. Inward foreign direct investment to the United Kingdom has increased markedly over the past decade. Both the stock and flow of United Kingdom’s inward (and outward) investment, relative to GDP, exceed that of any other G–7 economy. This chapter documents the magnitude and source of inward direct investment in recent years and it then discusses some of the likely factors behind the high rates of inward investment. It concludes with an assessment of the benefits of such investment and some policy issues.

A. Inward Investment in the United Kingdom

236. The stock of inward direct investment in the United Kingdom in 1995 was nearly £160 billion, three times the level recorded a decade earlier.92 As a percent of GDP, this stock is by far the largest of any G–7 economy (H.M. Treasury 1996). As Table 1 illustrates, in terms of flows also, the United Kingdom has had a higher ratio of inward direct investment to GDP than any other major industrial economy. During the late 1980s, the inflows to the United Kingdom relative to GDP were several times larger than in the other three major European countries, and nearly three times as large as those to the United States. Based on these statistics, several commentators have described the United Kingdom as the “enterprise center of Europe” (Cassell, 1996).

Table 1.

Inward Direct Investment in Major European Countries and the United States

(As percent of GDP)

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Source: Computed from H.M. Treasury, 1996, Annex, Table E.

237. The evolution of inward investment to the United Kingdom over the past decade is illustrated in Table 2. These data suggest that while inward direct investment has been volatile from year to year, there was a marked increase in the rate of such investment in the late 1980s, and again in 1995. The volatility reflects the fact that the total is generally dominated by a relatively small number of large investments, both “greenfield” investments and acquisition of existing companies. Small changes in the timing of just a few of these investments can have substantial effects on the annual totals.

Table 2.

Inward Direct Investment in the United Kingdom

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Source: Camell (1996), H.M. Treasury (1996), and Fund staff calculations.

238. In recent years, there also appears to have been a cyclical pattern in inward investment to the United Kingdom, with investment lower between 1991 and 1994 than in the late 1980s, then picking up strongly in 1995. This pattern is similar to that of total domestic fixed investment at least up to 1994, and may reflect the depressing effect on capital formation generally of spare capacity in the economy during and after a recession. In 1995, however, the surge in inward FDI contrasts markedly with continued sluggishness in aggregate investment (see Chapter I), partly as a result of specific factors related to investment in financial services.

239. An analysis by country of origin shows that the bulk of inward investment to the United Kingdom is accounted for by a small number of industrial countries (Table 3). At end–1994, the United States was by far the largest investor, accounting for over 40 percent of the stock of inward investment. The Netherlands was the next largest source, with just under 16 percent of the total. Of the other G–7 economies, France accounted for 6 percent while Germany, Japan and Canada accounted for under 5 percent each.

Table 3.

United Kingdom Inward Direct Investment by Country

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Source: H.M. Treasury.

240. An analysis by industry shows that the services sector has been the recipient of the largest share of investment flows, accounting for nearly 40 percent of the outstanding stock of inward investment in 1994 (Table 4). Within services, financial services account for nearly half of the total. The manufacturing sector accounts for nearly a third of the total stock of inward investment. Around two–fifths of all inward manufacturing investment into the European Union since 1990 have been to the United Kingdom (Cassell, 1996).

Table 4.

United Kingdom Inward Direct Investment by Sector

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Source: H.M. Treasury.

241. The United Kingdom’s stock of direct investment overseas, as well as outward flows of direct investment, are also the largest of any other G–7 economy in relation to GDP. The geographical distribution of United Kingdom’s outward investment stock is similar to that of inward investment. About 40 percent of outward investment is located in the United States and Canada, while about 30 percent is in the European Union countries. By comparison, around 60 percent of the United Kingdom’s visible trade is with the European Union and around 15 percent with North America. High levels of both inward and outward direct investments as well as substantial portfolio investments underline the significantly greater integration of the United Kingdom economy with the world economy than would appear by an assessment of its trade flows alone.

B. Factors Influencing Inward Investment

242. The determinants of inward investment into the United Kingdom can be examined with reference to the operations of multinational enterprises. The literature in this area sets out two general considerations which induce multinational firms to set up and maintain operations overseas (Krugman, 1995). Considerations of industrial organization, reflecting imperfections in product and factor markets, suggest advantages to placing a firm’s activities under common ownership and control rather than being conducted at “arms’ length.” Comparative advantage provides the motivation for these activities to be placed in separate countries.

243. In the case of the United Kingdom, it can be argued that in addition to the above two general considerations, structural changes in the economy over the past decade have boosted inward investment. More concretely, five sets of factors can be identified which have been instrumental in attracting increasing foreign direct investment into the United Kingdom: first, locational factors; second, the prevailing business environment; third, comparatively low unit labor costs; fourth, flexible employment conditions, and fifth, specific policies to promote investment. In the absence of a detailed structural model of direct investment, it is not possible to deduce the relative importance of these factors. However, the discussion below tries to provide a flavor of the various arguments concerning these five factors. Based on surveys and other evidence, the discussion concludes that to varying degrees these factors have all played a role in attracting and sustaining foreign direct investment into the United Kingdom in recent years, with specific policies to promote FDI playing at most a secondary role.

Locational considerations

244. The location considerations are, of course, not new. Even in the 1960s and 1970s, the United Kingdom attracted substantial investment particularly from the United States. The first large Japanese investments in the United Kingdom were also made in the early 1970s. Then, as now, there were then strong commercial arguments for investing in an offshore European economy which provided access to an expanding economic community. The openness of the United Kingdom economy, with strong trade linkages with continental Europe, was thus an important attraction. These considerations have continued to be relevant and provided a significant boost to inward investment in the late 1980s in the run up to the establishment of the European single market. Recent surveys suggest that foreign companies continue to feel that the United Kingdom provides one of the most attractive “bridge–heads” to continental markets.93

245. Within the United Kingdom itself, an advanced international transport and telecommunications network, together with the predominance of the City of London in international financial markets are often cited as important factors in foreign firms’ investment decisions (IBB, 1996). In addition, the use of English as the international language of business was, and continues to be, an important factor.

Business environment

246. The relatively more stable macroeconomic environment in recent years has been an attractive feature of the United Kingdom economy, according to survey evidence (IBB, 1996). The more transparent, and certain, regulatory factors and tax regime have also received increasing emphasis in recent years with firms, foreign as well as domestic, emphasizing their ability to plan ahead better because of greater certainty.

247. The most important aspect of the business environment is the structure of corporate taxation. The United Kingdom’s mainstream corporation tax at 33 percent is the lowest of all major industrialized countries. At the same time, overall taxation in the United Kingdom is below the European Union average. Nevertheless, the impact of changes in corporate tax rates on profitability of investment is not straightforward, because of various ranks governing taxation of multinational enterprise—for instance, the fact that overseas earnings of United States companies are domestically taxed at the greater of the overseas and domestic tax rates.94

Relative labor costs

248. The United Kingdom is becoming more competitive on the basis of unit labor costs vis-à-vis its main trading partners. OECD (1995) and O’Mahony (1995) present estimates of labor costs per unit of output in the United Kingdom relative to those in France, Germany and the United States for the early 1990s.95 The estimates are based on information from both the national accounts and the production census, making use of productivity estimates obtained in a number of other studies. The results show that for aggregate manufacturing labor compensation per hour has been significantly higher in these countries than in the United Kingdom.

249. While wage differences have been compensated for to a large extent by higher productivity, unit labor costs for Germany and France have in recent years, been higher than in the United Kingdom (Table 5; see also Oulton, 1994). In the case of the United States, the large depreciation of the U.S. dollar from 1989 onwards weakened the United Kingdom’s competitiveness vis-à-vis the United States. However, the decline in the exchange rate following United Kingdom’s exit from ERM improved United Kingdom’s competitiveness vis-à-vis the United States and especially to Germany and France.

Table 5.

Relative Unit Labor Costs 1/

(Indices, 1990=100)

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Source: IMF, International Financial Statistics.

In manufacturing, expressed in a common currency.

250. An analysis of individual industries supports the above aggregative evidence and shows the increasing competitiveness of the United Kingdom industries relative to France and Germany. In a number of industries, such as engineering and chemicals, that employ a high proportion of skilled workers the improvement has been particularly marked in recent years. These are the very industries that have seen an increase in inward investment over the past decade.

251. Non–wage labor costs have also favored the United Kingdom in recent years. Recent estimates by the United Kingdom Treasury suggest that for every £100 spent on wages in the United Kingdom, an employer has to add an extra £18 in non–wage costs in the United Kingdom. In Germany, the additional costs are £32, in France £44, and in Spain £34 (Cassell, 1996).

Labor market flexibility

252. The flexibility of the labor markets in the United Kingdom is being cited a key factor in attracting investment. This is becoming increasingly critical as a determinant of location decisions because of the increasing technology and capital intensive nature of many new investments. Indeed, survey evidence suggests that over the medium–term it will be the development of industries in which wages and salaries account for less than 20 percent of the total costs that would provide the impetus for future corporate development in Europe.

253. Significant reforms in employment law in the 1980s made strikes rare and led to single and non–union agreements helping transform the country’s record on industrial disputes. Flexibility has also been reflected in significant increase in shiftwork, part–time and over–time work offering investors a production regime to suit their needs.

Promotion Initiatives

254. In addition to competitiveness factors, there have been a number of specific initiatives to promote foreign investment into the United Kingdom. Regional policy and the provision of “Regional Selective Assistance” (RSA) and other grants have played a key role. The purpose of RSA is to “create jobs in areas of high unemployment and to attract industrial investment into the United Kingdom” (Trade and Industry Committee 1995, p. xi). Under the Industrial Development Act of 1982, RSA can be awarded for purposes such as the development or modernization of industry if it is likely to provide, maintain or safeguard employment in the “Assisted Areas.”96 The RSA is available in Scotland and Wales on the same basis as in England, but in other respects there are major differences, especially the more integrated organization at national, regional and local levels and the greater discretion to tailor regional activity to meet particular regional or local problems.

255. While there have been some controversial specific projects, the overall magnitude of the financial assistance provided has not been such as to suggest that this has been a key factor. For instance, during 1991/92 to 1993/94, the total amount of RSA averaged around $250 million per annum—about one-tenth of one percent of the total stock of foreign investment in the United Kingdom economy. Moreover, well over half of even this amount was paid to United Kingdom–owned companies, with the avowed government policy being not to discriminate between foreign and domestic firms. Several surveys also point out that the grant element is not crucial for inward investment compared with long–term market considerations. At the margin, such assistance may have been important in specific cases; a study prepared for the Commons Trade and Industry Committee concluded that “RSA had been instrumental in attracting a substantial inward investment into the United Kingdom that would otherwise have been located in assisted regions elsewhere in Europe or further afield” (Trade and Industry Committee, 1995).

256. In addition to the provision of financial assistance, a collection of a wide range of economic development organizations, led at the national level by the “Invest in Britain Bureau” (IBB) has apparently played a key role in attracting inward investment.97 The IBB was specifically set up with overall responsibility for promoting the United Kingdom economy to international investors. It has been concentrating its overseas promotional efforts in North America, the Far East and elsewhere in Europe. Industrial sectors singled out for special attention include the automotive, electronic, pharmaceutical, biotechnology, medical services and financial services sectors, which have seen substantial increases in investment in recent years. It is also giving high priority to ensuring that foreign investors already established in the United Kingdom—who now account for 60 percent of all new foreign investment decisions—choose the country for any expansion programs.98

C. Benefits and Prospects

257. The gains to the United Kingdom from inward investment are both direct and indirect. Direct benefits have been in terms of the balance of payments, with contributions to both capital and current accounts. Recent estimates suggest that at least a third of the United Kingdom’s manufacturing exports are produced by foreign owned companies (see OECD, 1992; Parker and Glover, 1996). In manufacturing, foreign owned firms account for nearly a third of all investment, and nearly one job in five is in a foreign-owned company. The indirect or spill-over benefits have been equally important. The most important of these is the role foreign owned companies have played in introducing new management techniques, labor practices and training, and new technology. A number of observers have argued that the direct and indirect benefits may be a significant element in reducing the United Kingdom’s productivity gap with France and Germany in the 1980s and 1990s (Eltis, 1995). More generally, inward investment may, over time, contribute to raising the potential growth rate (see Oulton, 1995 and Chapter II of this paper).

258. The specific benefits of inward investment do, however, vary significantly according to whether they are new ventures on “greenfield” sites or acquisitions, the degree to which they use local components, and whether assembly work is accompanied by higher value activities such as research and development and product development. Moreover, not all inward projects have been entirely successful, with low profitability levels a source of concern among some companies. Nevertheless, it has been shown that, in general, inward investors tend to have higher productivity than average United Kingdom–owned firms and to bring more efficient working practices, which have had positive spill–over effects. This boost to competitiveness has been regarded as more important than direct job creation. In terms of regional development, it has been seen that while indigenous development and inward investment are equally important, the former is likely to be a long–term process whereas the latter can bring much faster results.

259. Looking ahead, two main issues can be identified with regard to the inflow of direct investment. The first is how to ensure that the United Kingdom remains an attractive location for the foreign investors who are looking for a European destination. This issue is coming to the fore in the light of concerns that on cost calculations alone, a number of Eastern European countries may attract some of the investment which might otherwise have come to the United Kingdom (see Lansbury, Pain and Smidkova, 1996). Even though the absorptive capacity of these countries is considered limited, these concerns have led to a renewed emphasis on United Kingdom’s broad strategy toward encouraging direct investment. In addition, with competition for inward investment increasing, the United Kingdom has been placing a fresh emphasis on so–called “after–sales”–maintaining continuing links with new investors. However, as emphasized above, specific measures to promote FDI have been less important than location, comparative advantage, and rather aspects of the economic environment.

260. In the United Kingdom itself, in addition to the need for a stable macroeconomic environment and transparent regulatory regime, the availability of skilled labor has been identified as an important element. A number of European companies, in particular, have emphasized concern that over the medium–term, inadequate skilled labor may become a constraint. There are also concerns about the availability of infrastructure—and whether it can keep pace with the needs of increasing activity.

261. With regard to the maintenance of the competitive cost advantage in the United Kingdom, there are two other rather contentious issues which have generated some uncertainty. The first is the opt–out clause of the European Union social chapter. The government has resolved to reject the implementation of this on the grounds that to do so would likely damage United Kingdom’s international competitiveness. A minimum wage is also rejected by the government, although the main opposition party has proposed its introduction (at a level yet to be specified).

262. There is also the issue of to what extent uncertainty over European Monetary Union is likely to deter future investment. At present, it does not appear to be having an adverse effect. There is some concern, however, that the uncertainty regarding the United Kingdom’s position vis-à-vis the European Monetary Union may begin to have some deleterious effect (Cassell, 1996).

263. A second key issue has been the extent to which there is a national cohesion in the campaign to attract foreign investment. This issue has come up most recently in the context of intense and, as is generally acknowledged, counter–productive regional rivalry.99 A recent report also suggested that most local authorities viewed their neighboring regions as their principal competitors for inward investment, highlighting undesirable regional competitiveness (Trade and Industry Committee, 1995). The IBB recognizes that there will be rivalries and tensions between the regions and the bodies charged with attracting new investment. But it has to try to ensure that these rivalries do not end up as bidding–wars for inward investment. Excessive competition in this area would not only be costly, but could also distort investment decisions and lead to inefficient allocation of valuable investment resources.


Table A1.

United Kingdom: Real Output and Its Major Components at Constant Factor Cost

(Percentage change over preceding year)

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Source: Central Statistical Office, Economic Trends.

Includes oil and gas extraction.

Based on output data.

Table A2.

United Kingdom: Labor Market Indicators

(In thousands)

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Source: Department of Employment, Employment Gazette

Not adjusted for seasonal variation.

Estimates of the self-employed, with or without employees, are based on labor force surveys for data through 1990, and on Department of Employment estimates thereafter.

Great Britain, percent of total.

Claimants basis.

Over 52 weeks.

Table A3.

United Kingdom: Selected National Accounts Aggregates at 1990 Market Prices

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Sources: Central Statistical Office, Economic Trends.

Half yearly and quarterly levels at seasonally adjusted annual rates or changes from a year ago.

An unweighted average of expenditure, income, and output estimates.

Contribution to growth of GDP (average estimate).

Average measure in billions of pounds.

Table A4.

United Kingdom: Selected Personal Sector

(In percent of GDP)

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Sources: CSO, Financial Statistics, Economic Trends: and staff estimates.

New dwellings, mortgage approved. Data for December of each year.

Table A5.

United Kingdom: Components of Personal Income

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Source: Central Statistical Office, United Kingdom National Accounts

Half yearly and quarterly levels at seasonally adjusted annual rates or changes from a year ago.

In 1990 prices, deflated by the implied deflator for consumers’ expenditure.

Relative to personal disposable income.

Contribution to growth in disposable income.

Table A6.

United Kingdom: Selected Financial Statistics–and Commercial Companies

(In percent of GDP)

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Source: CSO, Financial Statistics.

First two quarters at an annual rate.

Net of stock appreciation.

Bank borrowing and other loans less bank deposits.

Large companies.

Ratio of interest payments to post-tax income.

Table A7.

United Kingdom: Selected Indicators of Investment Activity

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Source: Central Statistical Office, United Kingdom National Accounts.

Half yearly and quarterly levels at seasonally adjusted annual rates or changes from a year ago.

Table A8.

United Kingdom: Selected Indicators of Wage Developments 1/

(Percentage changes from previous year)

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Sources: Central Statistical Office, Economic Trends; and Department of Employment, Employment Gazette.

Great Britain.

Relative to the same period in the previous year.

Wages and salaries per unit of output, based on seasonally adjusted monthly statistics for earnings, employment and output.

Table A9.

United Kingdom: Selected Indicators of Price Developments

(Percentage change from corresponding period of previous year)

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Source: Central Statistical Office, Economic Trends.

Based on expenditure estimate.

Table A10.

United Kingdom: Selected Balance of Payments Indicators

(In billions of pounds sterling)

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Source: CSO, Financial Statistics.

First two quarters at an annual rate based on seasonally adjusted data for the current account and its components; seasonally unadjusted data for the basic balance and capital account.