JCMS 2011 Volume 49. Number 2. pp.

463483
DOI: 10.1111/j.1468-5965.2010.02124.x

The Effects on American Foreign Direct

Investment in the United Kingdom from Not
Adopting the Euro*
jcms_2124 463..484

MARCOS SANSO-NAVARRO
Universidad de Zaragoza

Abstract
The decision of the United Kingdom not to adopt the common European currency can
be understood as a policy intervention in a single country within the European Union.
The aim of this article is to analyse the consequences of this decision on the foreign
direct investment received by this country. This is done by the application of a
synthetic control method designed for policy evaluation. As a result, evidence of a
significant cost in terms of inward foreign direct investment from the United States is
obtained.

Introduction
There has been growing interest in analysing the effects of euro adoption
on European monetary union (EMU) member countries in recent years.
Although a wide array of variables have been considered, interest has mainly
focused on aspects related to investment and trade issues: foreign exchange
risk exposures (Bartram and Karolyi, 2006), financial market dependence
(Bartram et al., 2007), firms investment rates (Bris et al., 2006), trade flows
(Baldwin and Taglioni, 2007; Brouwer et al., 2008) and foreign direct investment (FDI) (Petroulas, 2007; Schiavo, 2007; Taylor, 2008; Brouwer et al.,
* The author has benefited from the helpful comments of an anonymous referee. Financial support from
Ministerio de Educacin y Ciencia (SEJ2006-14397 project) and the Regional Government of Aragn
(ADETRE Research Group) is acknowledged.
2011 The Author(s)
JCMS: Journal of Common Market Studies 2011 Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main
Street, Malden, MA 02148, USA

464

MARCOS SANSO-NAVARRO

2008; De Sousa and Lochard, forthcoming). This article aims to contribute to

the literature on the relationship between EMU membership and FDI from a
different perspective. The main difference with respect to existing studies is
that this article focuses on the consequences of not adopting the euro in a
single country. Using a comparative case study, the assessment of the effects
on inward FDI from the United States is made for the most controversial euro
non-enrolment case: the United Kingdom.
The importance of the relationship between EMU membership and the
FDI received by the United Kingdom can be inferred from the Five Economic
Tests (Her Majestys Treasury, 1997, 2003; see also Artis, 2006) conducted
by the British authorities in order to decide whether or not to adopt the euro.
They consisted of answering the following questions:
1. Were the business cycles and economic structures of all potential members
compatible enough to evolve comfortably with a common interest rate on
a permanent basis?
2. Was there sufficient flexibility to deal with future problems?
3. Would joining the EMU create better conditions for firms making longterm decisions to invest in Britain?
4. What impact would EMU membership have on the competitive position of
the United Kingdoms financial services industry?1
5. Summarizing, will joining the EMU promote higher growth, stability and
employment?
The third test is directly related to the question posed in this article, and was
mainly motivated by the fact that Britain received the highest FDI inflows as
a percentage of the GDP among the European Union (EU) members, especially for inward FDI coming from outside Europe. According to the recently
established Export-Platform FDI patterns (Ekholm et al., 2007), the decision not to join the EMU should have dissuaded American and Japanese
investors from considering the United Kingdom as a gateway into the European market. Furthermore, the impact of the EMU on FDI became one of the
key issues in the economic debate2 between those who saw major advantages
in the outs adopting the euro and those who saw more costs than benefits
(Barr et al., 2003).
Our approach considers the decision adopted by the British authorities of
not joining the euro as a policy intervention in a single country within the EU.
This perspective allows us to assess the effects on FDI by means of a synthetic
control method (Abadie and Gardeazbal, 2003; Abadie et al., 2010) that is
1

Particularly thinking of the Citys wholesale markets.

Some examples of related independent reports are Layard et al. (2002), Begg et al. (2003) and the
references therein.
2

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THE EFFECTS ON AMERICAN FOREIGN DIRECT INVESTMENT IN THE UNITED KINGDOM

465

suitable for the evaluation of policy measures implemented at a country

level.3 The main result of this assessment is that there exists a significant cost
derived from this decision in terms of inward FDI from the United States. The
magnitude of this estimated effect is compared and integrated with studies
about the influence of EMU membership on FDI that have been carried out
with different methodologies and data sources.
The rest of this article is structured as follows. Section I briefly reviews the
literature on the relationship between EMU membership and FDI. Section II
describes the main features of the synthetic control method applied, while
section III deals with its empirical implementation in our context. Section IV
develops a preliminary analysis of FDI flows time-series for selected EU
countries, presents the results obtained from the policy evaluation and draws
inferences about their significance. Finally, the article concludes with a discussion of the estimated effects.
I. EMU and FDI: The Background
Early assessments of the effects of not joining the euro on Britains inward
FDI appeared around four years after the start of the third stage of the EMU.
Their main limitation was that data availability did not allow strong conclusions to be drawn. This was aggravated by the fact that FDI flows are highly
variable. A summary of the studies dealing with the relationship between the
EMU and FDI reviewed in this section is reported in Table 1.
In the evaluation of the Five Economic Tests conducted by the British
Treasury (Her Majestys Treasury, 2003), it was recognized that Britains
share of FDI flows from the rest of the world to the EU decreased after the
start of the EMU. In addition, it was emphasized that this fall coincided with
an increase in the flows received by the EMU member countries. Similar
arguments were put forward by Layard et al. (2002) who argued that the
above-mentioned share had more than halved in the period 19992001 with
respect to the two previous years. Another study reaching the same conclusion is Begg et al. (2003). Furthermore, Barr et al. (2003) concluded that half
of this fall was related to an increase in the relative investment costs of the
United Kingdom but did not attribute any effect to being outside the EMU.
Given that these studies analysed the shares of total FDI received by the EU,
they reflected worse behaviour than the EMU countries.
Empirical studies about the positive effects of the EMU on the FDI
received by its member countries have appeared in recent years. De Sousa and
3
Another recent study analysing the economic consequences of not joining the euro is Pesaran et al.
(2007). These authors estimate the effects on output and prices in the United Kingdom and Sweden using
a Global VAR framework.

2011 The Author(s)

JCMS: Journal of Common Market Studies 2011 Blackwell Publishing Ltd

Share of flows into EU

Share of flows into EU

Begg et al.
(2003)

Her Majestys
Treasury (2003)

2011 The Author(s)

JCMS: Journal of Common Market Studies 2011 Blackwell Publishing Ltd

Bilateral flows

Outward stocks

Bilateral flows

Schiavo (2007)

Brouwer et al.
(2008)

Taylor (2008)

Source: Authors own data.

Flows as % of GDP

Inward flows

Bilateral flows

Bilateral stocks

Petroulas (2007)

De Sousa and
Lochard (2009)

Share of stocks in EU
Share of US flows into
EU

Barr et al.
(2003)

Share of flows within

EU

Share of flows into EU

FDI measure

Layard et al.
(2002)

Authors

OECD and UK Office of

National Statistics

Eurostat

International Direct
Investment Database

International Direct
Investment Database

Eurostat

International Direct
Investment Database

UNCTAD
Eurostat
Eurostat

Eurostat

UNCTAD
Bureau of Economic
Analysis

European Commission
and Eurostat

Data sources

19802003

19942003

19902004

19802001

19922001

19922005

19992001
19982001
19952001

19982001

19982001
19982001

19972001

Sample
period

Home
countries

EMU
Non-EMU
EMU
Non-EMU
EMU
Non-EMU

EMU
EMU
EMU
EMU
UK
UK

EU entrants
in 2004

EMU
UK and
Denmark

EMU
OECD
OECD

EMU

Non-EMU
Non-EMU

EMU
Non-EMU
OECD

EMU

EMU

UK
UK
UK

UK
EMU

UK
UK

UK

Host
countries

EMU

EMU

All
Non-EU
EU

All
All

All
US

All

Table 1: Summary of the Literature Examining EMU Effects on FDI

Extrapolated log-linear trends

Descriptive analysis

Error-component gravity models

Simulated scenarios

Gravity specification
Fixed effects panel estimation
Tobit model

Gravity regressions
Differences-in-differences

Gravity specification
Panel within estimation

Descriptive analysis

Descriptive analysis

Descriptive analysis

Descriptive analysis

Methodology

80282
227517
-1270
95263
112
-28

18.530

Positive
No effect

Positive

11
8

16

31
62

-43
-50
No effect

-60
75

-11
-29

-54

EMU
effect (%)

466
MARCOS SANSO-NAVARRO

THE EFFECTS ON AMERICAN FOREIGN DIRECT INVESTMENT IN THE UNITED KINGDOM

467

Lochard (forthcoming) developed a theoretical model for bilateral FDI stocks

that led to a gravity-like specification made up of four components: inward
effect (origin), outward effect (destination), bilateral effect (transaction costs)
and multilateral effect (alternative locations). Using data from 21 OECD
countries in the period 19922005 and panel estimation techniques, they
established that the adoption of the euro increased intra-EMU FDI stocks by
around 31 per cent. According to Barr et al. (2003), the corresponding effect
on FDI flows is more than double (62 per cent) that on stocks. Moreover, they
found that the magnitude of these positive effects was higher in the peripheral
countries. Using the same specification, Petroulas (2007) obtained a positive
effect of the EMU on inward FDI flows of 16 per cent within the eurozone
using a sample of 18 developed countries for the years 19922001 and a
differences-in-differences approach. Furthermore, spillover effects to and
from non-EMU countries were found. Thus, these two studies have established the global effects of the euro on FDI.
Schiavo (2007) studied the link between currency unions and cross-border
investment through the reduction in exchange rate uncertainty. He found a
positive effect of the EMU on FDI flows not only for its members even
after controlling for exchange rate volatility in an empirical linear gravity
model. The sample consisted of 22 OECD countries in the period 19802001.
In addition, he did not find any adverse effect on the inward investment
flows received by the United Kingdom and Denmark as a consequence of
their decision to stay outside the euro. A similar specification augmented with
distance-related variables was used by Brouwer et al. (2008) in order to
predict the implications on (trade and) FDI of a potential EMU enlargement
to the countries that joined the EU in 2004. Using an unbalanced panel of
outward bilateral FDI stocks for 29 countries in 19902004, the simulated
effects were between 18.5 and 30 per cent.
A recent exhaustive analysis using several data sources and a time span of
more than 20 years is carried out in Taylor (2008) who reports a broad array of
impact magnitudes for the 12 EMU countries, the United Kingdom, Japan and
the United States. Among many other conclusions, this author states that most
of the FDI inflows within the eurozone after 1999 were a consequence of the
end-of-century takeover boom. However, he also recognizes that the EMU has
stimulated FDI inflows in the eurozone from the other major investing countries. In addition, it is established that Britains inflows from countries other
than the EU members were 28 per cent below trend after the introduction of the
euro. The main caveat is that this author calculated these trends with data prior
to 1999 using log-linear trends from a standard OLS fit. Resulting estimates are
used as a counterfactual for the subsequent years. In addition, there are no
inferences about the significance of the reported effects.
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MARCOS SANSO-NAVARRO

This article aims to contribute to this literature by assessing the effects of

the United Kingdom not joining the euro on the FDI received from the United
States using a comparative case study. To do so, the British decision is
considered as a policy intervention in a single country within the EU. For this
reason, the consequences derived are estimated by the application of a synthetic control method for policy evaluation described in the following section.
II. Policy Evaluation Using Synthetic Controls
Comparative case studies are commonly used to estimate the effects of policy
interventions. These studies compare the evolution of the variables under
scrutiny in the case of one agent affected by the policy (treated) with the
evolution of the same variables in a group of unaffected agents (controls).4
The main difficulties when applying this approach are, first, how to choose
the units of comparison, and second, the uncertainty related to the ability
of the controls to reproduce the counterfactual situation of interest.
The proposal in Abadie and Gardeazbal (2003) is an appealing datadriven procedure to build a control group for the study of policies implemented at country level. Its main idea is that a combination of countries is
expected to provide a better counterfactual for the treated country than a
single one. In the rest of this section, the model used by Abadie et al. (2010)
to explain the applicability of synthetic controls in comparative case studies
is briefly described as well as its empirical implementation.
Assume that we have information about J + 1 (i = 1, . . . , J + 1) countries
during T time periods. The first of them (i = 1) is the one to which the
intervention analysed has been applied after a certain date T0 (1 T0 < T).
Therefore, we have J countries that can be labelled as potential controls. Let
YitN be the variable of interest observed in absence of policy intervention for
country i at period t and Y1It its corresponding values for the treated country
during the implementation period (t {T0 + 1, . . . , T}). Assuming that the
intervention has no effect before its implementation, 1t = Y1It Y1Nt is the
policy effect in the treated country. This allows us to express the observed
outcome Yit for country i in period t as:

Yit = YitN + it Dit

1 if i = 1 and t > T0
Dit =
0 otherwise
4

(1)

In fact, our case is the study of a no intervention policy. The difference is established by the group of
comparison (the donor pool).

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THE EFFECTS ON AMERICAN FOREIGN DIRECT INVESTMENT IN THE UNITED KINGDOM

469

We want to estimate 1t = Y1t Y1Nt , which is equivalent to estimating Y1Nt .

With this objective in mind, a factor model is specified for YitN :

YitN = t + Z i t + t i + it

(2)

where: dt is an unknown common factor with the same effect on all countries;
Zi(1 r) are the observed explanatory factors; qt(r 1) includes unknown
parameters; lt(1 F) are the unobserved common factors; mi(F 1) are the
unknown loadings of the unobserved common factors; and eit is the error
term, assumed to have a zero mean for all i.
J +1

This structure is used to propose 1t = Y1t w*j Y jt as an estimator for a1t

j =2

(t {T0 + 1, . . . , T}), where w*j denotes the j - th element of a (J 1) vector

W* of weights. Therefore, an estimation of the counterfactual situation for the
treated country in the post-intervention period is obtained as a linear combination of the outcomes in the potential controls:
J +1

Y1Nt = w*j Y jt ; t {T0 + 1,, T }

j =2

(3)

This estimator will be unbiased if W* is obtained solving the following

optimization problem:

min X1 0W
W

= (X1 0W )V ( X1 0W )

(4)

subject to the following constraints on the weights:

w*j 0; for

j = 2,, J + 1

(5)

w*2 + + w*J +1 = 1
where:

X1 = ( Z1 , Y11 ,, Y1M )
0 = ( X 2 , X 3 ,, X J +1); X i = ( Z iYi1 ,, Yi M ); i = 2,, J + 1
J +1

w*j Y
j =2

1
j

J +1

= Y ,, w*j Y
1
1

j =2

M
j

= Y1

J +1

and

(6)

w*j Z j = Z1
j =2

X1 is a (k 1) vector of pre-intervention (t T0) characteristics in the

treated country, c0 its equivalent (k J) matrix for the potential controls and
Yi1 , . . . , Yi M are M linear functions of the outcomes before the policy was
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MARCOS SANSO-NAVARRO

implemented in a given country i satisfying M F. V is a diagonal, positive

and semidefinite (k k) matrix determined by the predictive power of the
explanatory variables during the pre-intervention period.
In the application below, we assume the presence of a single unobserved
common factor with different effects on each country and that the linear
function of the pre-intervention outcomes in (6) is the simple average
(M = F = 1). W in (4), conditional on V, is searched for among all the possible combinations using a fully nested optimization procedure.5 Three different starting points for V have been considered in order to avoid local
minima: equal-weighted, regression-based and determined by maximum
likelihood.
The measure of FDI inflows from the US into a given country (Yi) will
be introduced in the following section. Moreover, a justification of the variables included in the vector of observed explanatory factors (Zi) will also be
given in accordance with existing empirical studies and evidence about FDI
determinants.
III. FDI Determinants: Data Sources and Variable Construction
Traditional theoretical models of FDI distinguished between vertical
(Helpman, 1984) and horizontal (Markusen, 1984) motivations for the behaviour of multinational enterprises. These two approaches were later reconciled
in the knowledge-capital model (see Markusen, 2002) and more complex
strategies have recently appeared in the literature (see Baltagi et al., 2007, for
a review).
An empirical literature on FDI determinants has developed on the basis of
all these theoretical models. The exhaustive survey on this issue in Blonigen
(2005) contains two ideas that will be useful for the purpose of this article.
First, it is observed that FDI tends to be horizontal and between industrialized
countries. Second, a gravity specification fits cross-sectional FDI flows data
quite accurately.
The measure of FDI that will be analysed below is the American capital
outflows to the United Kingdom and the potential control countries as a
percentage of their GDP. These FDI flows data have been obtained from the
Bureau of Economic Analysis and refer to the period 19862006.6 They
include equity capital transactions, reinvested earnings and intercompany
5

This methodology has been applied in the subsequent analysis using the Stata version of the related
software provided by Jens Hainmueller in his homepage.
Two missing values for Portugal (1989 and 1990) and one for Spain (1995) have been interpolated using
the TRAMO/SEATS Econometric Package.

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THE EFFECTS ON AMERICAN FOREIGN DIRECT INVESTMENT IN THE UNITED KINGDOM

471

debt transactions and are measured on an historical-cost basis.7 Current

GDPs, in PPP terms, have been extracted from the World Banks World
Development Indicators database.
The variables used as FDI determinants have been selected according to
the modified gravity specification in Blonigen et al. (2007). First, the host
countrys GDP and population have been included in order to reflect its
potential market size. These data have also been extracted from the World
Development Indicators database. In addition, note that GDP data are
expressed in constant 2005 PPP terms. Openness has been included as a
measure of trade costs. It is equal to the sum of exports plus imports over
GDP, is expressed in constant terms and has been extracted from the Penn
World Table (v.6.2). Educational skills in the host country have been
proxied by the average years of schooling for people over 25 from the
Barro and Lee (2001) database.8 The distance to the United States has also
been considered and comes from the Centre dEtudes, Prospectives et
dInformations Internationales. Finally, a variable reflecting the EU surrounding market potential of a country has also been included. For a given
year, it has been calculated as an inverse-distance weighted-sum of the
GDPs in other EU countries.
Summarizing, the variables of interest that will be analysed below are the
American FDI flows to a given country as a percentage of its GDP. The
explanatory factors in Zi are the following variables referring to the host
country: constant GDP in PPP terms, population, distance to the United
States, openness, educational skills and a measure of the EU surrounding
market potential.
IV. Assessing the Effects on American FDI Flows to the United
Kingdom Derived from Euro Non-adoption
Preliminary Analysis: Testing for a Break in Trend
Before applying the policy evaluation method to the FDI flows data, their
time-series properties, both in the United Kingdom and its potential controls,
have been analysed. The latter are the EU members in 1986 that joined the

This is the only way that detailed data by country are provided by the Bureau of Economic Analysis
(BEA). As can be observed in Table 1, there are other databases from which American FDI outflows to a
given country can be obtained (Eurostat and International Direct Investment Database). However, the data
compiled by the BEA allow us to work with a balanced panel with the least need for interpolation and
the greatest number of potential controls.
8
This variable is reported in the database every five years. Following Blonigen et al. (2007), it has been
transformed to a yearly frequency using linear interpolation.
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MARCOS SANSO-NAVARRO

third stage of the EMU in 1999.9 We test for the presence of a single break in
the trend of the American FDI inflows as a percentage of GDP. Three different
techniques have been applied with this aim.
The first one is the SupF test for a structural change of unknown date in
regression models developed by Andrews (1993). The second one follows Bai
and Perron (1998) and determines whether or not a trend shift is present by
the use of information criteria. In order to apply these two methods, the
deterministic component has been considered to be made up of a constant and
a trend. The statistical significance of a change in the coefficient of the latter
term is analysed. An interesting alternative technique has been recently proposed by Perron and Yabu (2009). It consists of a powerful test for a structural
change in the trend of a univariate time-series that does not depend on its
order of integration. In line with the two methods previously described, it has
been applied looking for a structural change in slope. Structural break testing
results are found in Table 2.
The SupF test statistic for each country is reported in the second column
of Table 2. There is evidence of a break in the trend only for Belgium and the
United Kingdom. These breaks are statistically significant at the 1 per cent
level. Therefore, the null hypothesis of no structural break cannot be rejected
in the other cases at a significance level smaller than or equal to 10 per cent.
These findings are corroborated by the application of both the Akaike and
Schwartz information criteria. Results from the application of the Exp test by
Perron and Yabu (2009)10 are reported in the fourth column. In line with the
results presented above, they also give evidence of a structural change in
slope for both Belgium and the United Kingdom at the 1 per cent significance
level. In addition, the null of no break in trend is rejected for Portugal at the
5 per cent significance level.
Perron and Zhu (2005) demonstrated that a consistent estimation of the
break dates can be obtained by the minimization of the sum of squared
residuals. This has been done for a regression of the analysed series on a
constant, a time trend and a slope shift dummy. Estimated break dates are
presented in the sixth column of Table 2. All of them are located at the end of
the sample period analysed, the earliest being one corresponding to the
United Kingdom which is suggested to be the year 2000. Break dates for
Belgium and Portugal are 2003 and 2002, respectively.
Once the presence of structural breaks has been tested for and their dates
determined, the corresponding trends have been fitted using OLS regressions.
9

The exception is Luxembourg due to the lack of educational skills data. Therefore, the EMU donor pool
is made up of Belgium, France, Germany, Ireland, Italy, the Netherlands, Portugal and Spain.
10
The author acknowledges Tomoyoshi Yabu for allowing the use of his code.
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12.82***
0.71
0.56
4.08
0.12
2.74
1.12
0.75
40.68***

1
0
0
0
0
0
0
0
1

AIC / BIC
6.48***
0.69
-0.15
0.17
-0.11
0.03
2.86**
-0.06
48.97***

Exp
test

SSR
4.65

0.39

7.05

Source: Authors own calculations.

Note: ***, ** and * statistically significant at the 1, 5 and 10% levels, respectively.

Belgium
France
Germany
Italy
Ireland
Netherlands
Portugal
Spain
United Kingdom

SupF
test
2003

2002

2000

Break
date
0.25
0.18***
0.05
0.09
1.11
0.79
0.14*
0.09
0.18

Constant
0.03
1 10-3
0.01***
3 10-3
0.21**
0.08
2 10-6
0.01
0.13***

Trend1

Table 2: Structural Break in Trend Testing. US FDI Flows to Selected EU Countries (% GDP), 19862006

0.43**

3 10-3

-0.38***

Trend2

THE EFFECTS ON AMERICAN FOREIGN DIRECT INVESTMENT IN THE UNITED KINGDOM

473

474

MARCOS SANSO-NAVARRO

The results are in the last three columns of Table 2. It can be appreciated that
all of them are upward trends except that followed by the series of FDI flows
to the United Kingdom after the shift in the year 2000. In the latter case, the
slope coefficient is negative and highly significant.
Both the observed American FDI flows to a given country as a percentage of its GDP and their estimated trends are plotted in Figure 1. While the
American FDI flows to the selected EMU countries have maintained, if not
increased, their upward trend, this has not been the case for the United
Kingdom. This variable has, in fact, followed a decreasing path after the
third stage of EMU started. In addition, an important increase in the trend
of the FDI flows to Belgium is also observed in the final years of the
sample period. The significance and magnitude of the Portuguese trend shift
is lower.
Finally, it should be noted that some of the estimated upward trends could
be approximated by a shift towards a higher level in the aftermath of the euro.
This seems to be the case for Germany and Ireland,11 but could perfectly apply
to the Netherlands and Spain.
Results from the Synthetic Control Approach
As pointed out before, an estimation of the American FDI flows into the
United Kingdom that would have taken place if it had adopted the euro can be
obtained through the application of the synthetic control method. This subsection presents the results.
Weights assigned to each country in the EMU donor pool when constructing the synthetic United Kingdom are found in Table 3. The counterfactual
situation that best resembles the evolution of observed American FDI flows
into Britain before the third stage of the EMU is built as a linear combination
of those received by four countries. Not surprisingly, the highest weight
corresponds to Germany (0.43). The other three countries from which the
synthetic United Kingdom has been constructed are the Netherlands (0.22),
Ireland (0.18) and France (0.17).
Apart from the countries selected and the weights assigned to them in
order to construct the synthetic control, the suitability of the applied technique in this context can also be inferred from Table 4. Average values of the
FDI determinants in the period 198698 for the United Kingdom and its EMU
synthetic counterpart are shown in its second and third columns, respectively.
It can be observed that the synthetic control has mean values for the explanatory variables relatively close to those in the United Kingdom before 1999.
11

The Irish government set up aggressive fiscal measures in order to attract FDI.

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475

Source: Authors own calculations.

Figure 1: US FDI Flows to Selected EU Countries (% GDP, Bold) and Estimated Trend (Dotted)

THE EFFECTS ON AMERICAN FOREIGN DIRECT INVESTMENT IN THE UNITED KINGDOM

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MARCOS SANSO-NAVARRO

Table 3: Weights Assigned to Selected EMU Countries in Order to Construct the

Synthetic UK
Belgium

France

Germany

Ireland

Italy

0
0.17
0.43
0.18
0
Root Mean Square Prediction Error (RMSPE) = 0.63

Netherlands

Portugal

Spain

0.22

Source: Authors own calculations.

Table 4: Mean Values for the FDI Determinants in the UK and Its Synthetic
Control in the Pre-intervention Period (198698)

GDP
Population
Distance to the US
Openness
Education
EU surrounding
market potential

United Kingdom

Synthetic United Kingdom

from EMU countries

1.35 1012
5.76 107
5901.34
44.01
8.86
1.28 1010

1.23 1012
4.83 107
6282.61
68.67
8.86
1.13 1010

Source: Authors own calculations.

This is especially true with regard to educational skills. The biggest difference
in relative terms corresponds to openness.
The main results obtained from the synthetic control approach are displayed in Figure 2 where the evolution of the observed values for American
FDI flows to the United Kingdom and those corresponding to its synthetic
counterpart are plotted. As mentioned before, these flows followed an upward
trend in the period 198699 reaching several peaks in the years 1989, 1993
and 1999. However, this increasing trend was reversed in 2000. To give an
idea of the extent of this fall, the share of FDI inflows as a percentage of GDP
in 2001 was almost the same as that received in 1991. Moreover, it should be
noted that the percentage of FDI inflows at the end of the pre-intervention
period has never been equalled since then.
Estimated FDI flows for the synthetic United Kingdom also follow an
upward trend after 1990. Furthermore, they closely resemble the evolution of
those really observed. There is a little difference since their values are slightly
lower than the real ones and the last peak is reached one year earlier. Contrary
to the experience of observed American FDI flows to the United Kingdom,
those corresponding to the synthetic control maintain the steadily increasing
path that began in 1990 instead of changing their trend after 1999. This
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Figure 2: US FDI Flows to the UK (% GDP, Bold) and Synthetic Control Constructed
from Selected EMU Countries (Dotted)

3
2
1
0
1
2
1986

1991

1996

2001

2006

Source: Authors own calculations.

impression is confirmed by the three methods described in the previous

subsection.12 As a result, the share of FDI flows as percentage of GDP
corresponding to the synthetic United Kingdom constructed from EMU countries is generally higher than that really observed from the year 2000 onwards.
The exception is the year 2005 when the synthetic control experiences a
sharp drop. Although something similar happened in the United Kingdom, the
magnitude was smaller. As can be observed in Figure 1, the American FDI
flows received by several EMU countries also fell that year. These reductions
were especially important for Ireland and the Netherlands, but their causes
were different. While, in Ireland, it was a consequence of the reduction in the
indebtness of Irish affiliates to their American parents, the fall in the Netherlands was driven by the fact that reinvested earnings turned highly negative
a consequence of tax incentives provided by the American Job Creation Act
of 2004 (Koncz and Yorgason, 2006). Moreover, it should be noted that this
data point is considered to be an additive outlier13 in the corresponding
12
Obtained statistics are 1.42 and 0.30 for the supF and Exp tests, respectively. In neither of these two cases
can the null of no structural break be rejected at a significance level lower than 10 per cent. These
conclusions are corroborated by the Akaike and Schwartz information criteria.
13
An aberrant data point with a cause outside the intrinsic economic environment that generates the time
series data (Franses and Van Dijk, 2000).

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MARCOS SANSO-NAVARRO

time-series of these two countries by the detection procedure proposed in

Chen and Liu (1993). This conclusion also applies to the synthetic United
Kingdom and is reasonable since Ireland and the Netherlands account for 40
per cent of it. However, this test does not detect any additive outlier in the
observed FDI flows to the United Kingdom.
The highest negative difference between the observed American FDI flows
into the United Kingdom and those predicted by the synthetic control corresponds to the final year of the period analysed. While American FDI flows to
the United Kingdom represented 0.98 per cent of its GDP, the percentage for
the synthetic control was 2.78 per cent. This is equivalent to saying that the
policy evaluation method applied suggests that British FDI inflows from the
United States in 2006 are around 65 per cent lower than if the country had
adopted the euro. Taking into account the whole post-EMU period, the gap
between the trends followed by the FDI flows to the United Kingdom and its
synthetic control increases after 2000. The average decrease for the years
200006 is 15.40 per cent.14
It can be concluded from the results presented above that the decision not
to join the third stage of the EMU has had an important negative effect on
British inward investment from the United States in comparison to the 1986
EU members that joined the European single currency in 1999. These results
contrast with those by Schiavo (2007) who did not find any adverse effect on
the FDI flows received by the United Kingdom. This might be related both to
the different time span (19802001) and the origin of the FDI flows (OECD
countries) considered. However, the magnitude of this estimated effect is in
line with the fall in the share of American flows into the EU corresponding to
the United Kingdom reported by Barr et al. (2003) until the year 2001 and the
share of FDI inflows from non-EMU countries into Britain as a percentage of
its GDP until 2003 in Taylor (2008).15 An important difference between
Taylors article and this one is that he uses estimations up to a certain date in
order to construct counterfactual scenarios for future time periods. A case
study seems to be a more appropriate framework with which to estimate
causal effects derived from a certain event. Moreover, the synthetic control
method applied in this article is valid under more flexible conditions than
alternative techniques like the differences-in-differences approach used in
Petroulas (2007).

14

This average negative impact increases to 36.15 per cent if the outlier in 2005 is neglected.
The average gap predicted by the synthetic control method after 1999 is equal to -25.48 per cent
until 2001 and -30.13 per cent until 2003. These figures should be compared with those reported in
Table 1.
15

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Evaluating the Robustness and Significance of the Estimated Effects

I should begin by noting that the use of total GDP as an FDI flows determinant
when applying the synthetic control policy evaluation method could raise
concerns. This is because this variable might have been affected by the policy
intervention analysed and, hence, endogeneity problems could arise. As an
alternative, the same analysis as before has been carried out using GDP per
capita. The reason is that this variable should be less influenced by the EMU
than total GDP itself. The results from this robustness check do not significantly change with respect to those previously presented.16 The first difference found is that Belgium replaces France as a country from which the
synthetic control is constructed. Germany reduces its weight and represents
62 per cent with Belgium. The remaining 38 per cent is also distributed evenly
between Ireland and the Netherlands. In spite of this change in the composition of the synthetic control, its evolution during the whole sample period is
very similar to that displayed in Figure 2. As was also the case before, the
average estimated negative gap in 200006 is equal to 15 per cent with this
alternative specification.
One way of testing for the significance of the differences between the
observed series for the country studied and its synthetic control is by applying the Matched-Pairs Signed-Ranks test by Wilcoxon (1945). This nonparametric test between two related samples is often used to compare scores
of data collected before and after an experimental manipulation. It is an
alternative to the paired Students t-test when the data cannot be assumed to
be normally distributed. Under the null hypothesis, the median of the differences is expected to be zero. In our context, instead of comparing individuals,
the observational units will be time periods.
Results obtained from the comparison of the observed values for American
FDI flows to the United Kingdom as a percentage of its GDP and those
predicted by the synthetic control method are shown in Table 5. When considering the whole post-intervention period, the null hypothesis cannot be
rejected at the 10 per cent significance level. Although this test can be used
with sample sizes as small as the case analysed here, it is expected to have low
power. This could be exacerbated in the presence of outliers. Because of this,
the test has been applied to the whole post-intervention period excluding the
year 2005. Now, the null hypothesis of a median difference equal to zero is
rejected at the 5 per cent significance level. Therefore, these findings allow us
to state that the predicted values for American FDI flows to the United
Kingdom by the synthetic control are significantly different to those really
observed in most of the years after the euro started.
16

Further details are available from the author upon request.

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Table 5: Wilcoxon Matched-Pairs Signed-Rank Test. Differences between

Observed US FDI Flows to the UK (% GDP) and Its Synthetic Control
Post-intervention
period
All
Except 2005

Number of observations
Positive
Negative
Total
2
1

5
5

7
6

W+

W-

Test statistic

8
1

20
20

-1.01
-1.99**

Source: Authors own calculations.

Note: ** Statistically significant at the 5% level.

Figure 3: US FDI Flows to the UK (% GDP, Bold) and Fitted Trend for the Synthetic
Control Constructed from Selected EMU Countries (Dotted, 2 serror Bands)
3.5

2.5

1.5

0.5

0.5

1986

1991

1996

2001

2006

Source: Authors own calculations.

As an alternative, the observed FDI flows can be compared with the

estimated trend of their synthetic control. These results are plotted in Figure 3.
Bands representing 2 times the standard deviation of the estimation errors
are also reported. The observed flows are inside the bands in most of the
pre-intervention period. The values outside the limits are always above the
upper band and correspond to the peaks of the years 1989, 1993 and 1999. In
addition, the FDI flows are generally above the trend because the estimated
slope for the synthetic control is less steep than that of the observed flows
before the break. These findings change in the post-intervention period, when
observed FDI flows are systematically below the estimated trend after 2000.
Moreover, they fall below the lower band in all the years except 2003 and 2004.
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Nonetheless, they are very close to the lower limit in these two cases. Finally,
it should also be noted that Figure 3 reflects the divergent trend followed after
the start of the third stage of the EMU by the American FDI flows in the United
Kingdom and that predicted by the policy evaluation method.
Summarizing, it can be concluded that the results presented throughout
this subsection corroborate the robustness and significance of the estimated
negative effect on the FDI flows from the United States received by the United
Kingdom after the launch of the euro derived from its decision to stay out.
Conclusions
This article has shown evidence of a structural break in the trend of FDI flows
received by the United Kingdom from the United States after the start of the
third stage of EMU. This break led the FDI flows to turn their upward trend
in 2000 into a decreasing path. More interestingly, this observation is only
found for this country of all the selected countries that had been EU members
since 1986. All these countries, that later joined the EMU, have maintained,
if not increased, their upward trends.
The results obtained from the application of a synthetic control method
designed for policy evaluation suggest that, on average, the American FDI
flows to the United Kingdom as a percentage of its GDP have been 15 per cent
smaller than if this country had adopted the euro after 1999. The estimated
magnitude of this effect is much higher in some periods, reaching 65 per cent
in the final year of the sample analysed.
The significance of the estimated effects has been analysed using formal
statistical tests. Moreover, its magnitude has been adequately compared and
integrated into the literature analysing the effects of the EMU on FDI. I find
that it is similar to some of those already established for FDI flows in the
United Kingdom from the United States and other non-EMU countries. In
addition to the wider sample period analysed, the main difference is that this
article uses a methodology that allows us to estimate causal effects under
more flexible conditions than alternative policy evaluation methods used in
previous studies.
Correspondence:
Marcos Sanso-Navarro
Departamento de Anlisis Econmico
Facultad de Ciencias Econmicas y Empresariales
Gran Va, 2. 50005, Zaragoza (Spain)
Tel (+34) 976761000 Ext. 4629. Fax (+34) 976761996
email marcossn@unizar.es. Homepage http://dae.unizar.es/marcossn/index.html.
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MARCOS SANSO-NAVARRO

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