Factors that affect foreign direct investment (FDI)

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Readers Question: why some countries are more successful in attracting Foreign Direct Investment than others? Foreign direct investment (FDI) means companies purchase capital and invest in a foreign country. For example, if a US multinational, such as Nike built a factory for making trainers in Pakistan; this would count as foreign direct investment. In summary, …

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Gross Fixed Capital Formation

mec-investment-cut-interest-rates

Definition: Gross fixed capital formation is essentially net investment. It is a component of the Expenditure method of calculating GDP.

To be more precise Gross fixed capital formation measures the net increase in fixed capital.

Gross fixed capital formation includes spending on land improvements (fences, ditches, drains, and so on); plant, machinery, and equipment purchases; the construction of roads, railways, private residential dwellings, and commercial and industrial buildings. Disposal of fixed assets is taken away from the total.

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Gross fixed capital formation – UK

The fall in Gross Fixed capital formation has been a significant contributor to the recent UK recession.  (contributions to UK growth)

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Impact of a Fall in Public Sector Investment

Source ONS | NTV

A possible unit 4 A Level question this summer could be:

Discuss the impact of a fall in public sector investment on the UK economy?

The graph shows a fall in public sector investment from 3.5% of GDP in 2008  to 1.5% in 2011. This means cuts of approximately £30bn a year.

It means the government is spending less on capital investment projects such as new schools, new roads and other infrastructure investment.

That is quite a significant fall. With a fall in government investment, the first impact will be to reduce aggregate demand, lower economic growth and lead to higher unemployment.

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Investment spending in the construction sector also tends to have a high multiplier effect (1.7 – 2.0). This study by RICS claims a multiplier of 2.84. If there are fewer investment projects, construction workers will be more likely to be unemployed, and therefore, they will spend less causing a further fall in demand in the economy. Therefore, a fall in investment spending could cause a bigger fall in AD, than the initial cut in government spending.

Furthermore, given the weakness of other areas of the economy, this fall in government spending will lead to a significant fall in AD. If the economy was in robust shape with growing private sector demand and a strong export sector, this fall in public sector spending would not be so serious. But, the UK economy remains in a double dip recession with the uncertainty of the Euro crisis discouraging private sector investment.

One benefit of cutting public sector investment is that it will help reduce government borrowing. In the UK borrowing is forecast to be £123bn in 2011-12. Therefore, without a plan to reduce government spending and deficit, we may see a rise in bond yields as markets are concerned about the rise in government debt. An increase in interest rates would be very damaging for the UK economy given the levels of household debt and fragile nature of spending.

Another argument is that cutting government spending should enable ‘more efficient’ private sector spending and investment. It is argued, government spending can ‘crowd out’ the private sector spending. Reducing government spending helps reduce government borrowing, keeps interest rates low and encourages the private sector to spend and invest.

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However, it is debatable whether interest rates would actually rise if the government invested an extra £30bn. Interest rates have fallen since 2008 because there has been a rise in private sector saving and demand for buying secure bonds. The interest rate on long term index-linked yields is low at 0.5%. This suggests public sector investment could be financed for a very low annual interest payment.

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Investment in UK – Business and Public Sector

 

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Total UK Business investment since 1980, slow recovery from 2009. (seasonally adjusted.)

Business investment in past ten years

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Source: ONS NPEN

From 2007 to 2010 we see a 22% fall in private sector business investment. This was the result of

  • Banking crisis – banks didn’t want to lend
  • Fall in consumer confidence
  • Recession, which caused firms to hold bank from investment

Recovery in business investment since 2010

  • From a low basis and 20% fall
  • Helped by low interest rates making investment more attractive, but availability of funds a bigger problem than the cost of borrowing.
  • Business investment has fallen behind past trend growth in value of business investment.
  • Still volatile and uncertain, e.g falls in 2014 and the end of 2015

Factors influencing future investment levels

  • Despite low interest rates, banks are maintaining strict lending criteria and rationing finance. Many small and medium sized firms still state finance is difficult to come by.
  • Prospects for economic recovery are poor. The Bank of England’s latest inflation report painted a gloomy picture of an economy struggling to post positive economic growth.
  • Fall in inflation rate and possible deflationary pressures
  • Uncertainties over Britain’s place in Europe.
  • Euro-zone debt crisis and EU recession also weigh heavily on UK investment decisions.
  • Future of interest rates. Will interest rates rise to increase the cost of borrowing.

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Importance of Bank Lending to UK Economy

Readers Question: What is the importance of bank lending to the UK economy?

Bank lending plays an important role in influencing levels of consumer spending, investment and economic growth.

When bank lending reduced at the start of the credit crunch in 2008 – this decline in bank lending was a significant factor in causing the 2008 recession.

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Source: News Release – Quarterly Bulletin 2012 Q4

This graph shows that lending to UK households and business was growing rapidly during the period 2000-2008. However, the credit crunch caused a precipitous fall in the growth of bank lending. Bank lending fell from growth of +10% to negative growth during 2010 and 2011.

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