Stephen King: It's all very well beating the French, but it's the Chinese we really have to worry about

The 2005 World Investment Report released by the United Nations Conference on Trade and Development (UNCTAD) at first sight suggests that the policies of recent years are already paying dividends (http://www.unctad.org/en/docs/wir2005overview_en.pdf). The report was greeted with patriotic fervour in the UK press last week. The key nugget was the huge surge in foreign direct investment into the United Kingdom in 2004, up fourfold compared with 2003. The total amounted to $78bn. This is an impressive result: from 1985 through to 1995, the average amount of inward investment per year was around $17bn and, in the early years of this decade, the figure was around $30bn.

But there's more than one form of foreign direct investment. Ideally, it would be good to see a lot of greenfield sites being developed, leading to extra capacity and more jobs in British industry. Much of Britain's inward investment, however, isn't really of this kind. Of the total inflow of $78bn, $58bn represented merger and acquisition activity of which a big slug came from the $16bn takeover of Abbey National by Santander Central Hispano, the Spanish bank. I have no view on the specifics of this particular takeover, but M&A activity is not guaranteed to add to a nation's wealth. Indeed, by disposing of assets to foreigners - particularly for a country running a current account deficit - a cynic might argue that this amounts to selling the family silver.

The cynic's argument, though, only works if we assume that the Spanish company is owned by Spaniards. In fact, Santander, alongside most other international companies, is owned by a wide range of shareholders of differing nationalities. It may be listed in Spain but at least some of its owners are British so, on that basis, it may be more a case simply of re-labelling the family silver: whether it's called Abbey or Santander, as a British citizen you are still free to own the shares. Put this way, it's not quite so obvious what Britain has achieved by "attracting" $78bn of foreign direct investment. After all, Luxembourg comes fourth in the list of countries attracting FDI and no one is suggesting that Luxembourg, despite its undoubted charms, is an international economic powerhouse.

Nevertheless, the United Nations data suggest that this was the first year in quite a while in which the inflows into the UK exceeded the outflows (which, for the record, amounted to around $65bn), so there is at least a suggestion that the UK is increasingly regarded as a good place to invest. This conclusion is also supported by the more general trend in inward investment across developed markets. Inward investment into France, for example, dropped from $42bn in 2003 to $24bn in 2004, while for the EU as a whole, inward investment dropped from $338bn to $216bn. For the entire developed world, inward investment fell from $442bn to $380bn. Against this backdrop, the UK does seem to be doing rather well.

Yet this is not a reason for complacency. The United Nations report contained a lot of other information which provides uncomfortable reading for anyone thinking about the UK's longer term abilities to cope with globalisation. First, the real competition for inward investment is increasingly coming from China and India (no surprise there). Beating the French might be seen by some as Britain's national pastime but this smacks too much of nostalgia for Agincourt than a rational response to the big changes taking place in the global economy. Second, the "education, education, education" mantra - one of New Labour's favourites - is all very well but doesn't quite deal with the fact that many millions of Chinese and Indians are also becoming very well educated.

The UNCTAD report contains a special section on research and development (R&D) carried out by what the United Nations calls transnational companies (or, in more familiar parlance, multinationals). Within this section, there's an attempt to gauge the location of "foreign" R&D. In other words, where, other than within their domestic economies, do companies choose to site their R&D facilities? The results provided by the United Nations make for fascinating reading, partly because R&D is precisely the sort of thing that New Labour - and, presumably, any New Conservatives out there - want to invest in. After all, R&D involves science, creativity and inventiveness, the very things that Gordon Brown hopes to unleash on the nation through the devotion of more resources to education.

The good news here is that, of the non-UK-based transnational companies surveyed, 48 per cent have located at least some of their R&D facilities in the UK. This is an impressive result. On this particular ranking, the UK comes second only to the US as a preferred "foreign" location for R&D spending. In third place, though, is China, favoured by 35 per cent of companies, thereby keeping the Germans, the French, the Italians, the Japanese and the Canadians at bay: in other words, China has already picked off five G7 members. India is not far behind: 25 per cent of companies have some R&D facilities there, placing India in sixth place in the global rankings.

The less encouraging news is that companies are not planning to stay where they are. As things stand, most companies have their eyes on only three major economies when it comes to future R&D plans: China comes top, followed by the United States, with India in third position. Europe, the UK included, doesn't make it onto the R&D equivalent of the Olympic podium. This is an extraordinary change. It was only 12 years ago that Motorola pioneered the first foreign company R&D move into China: now there are 700 R&D facilities there. Many pharmaceutical companies now run clinical research facilities in India. A huge chunk of global R&D spending on semiconductors now takes place in Asia. And these numbers are growing all the time.

So while no one can fault either Tony Blair's comment that globalisation is inevitable, or Gordon Brown's commitment to free and fair trade, it's not clear to me that education alone is the way forward. If China and India are already attracting lots of R&D investment, and if they are likely to attract a whole lot more in the years ahead, no amount of extra British graduates is likely to make a huge difference to our relative competitive position: the truth of the matter is that graduates in these other parts of the world are paid substantially less than their British peers and, as a result, will continue to act as a magnet for global capital. More important is likely to be the flexibility to adapt: no government is capable of picking economic winners, so the next best thing is to equip our population with the skills to handle a number of different economic terrains. And that, in part, requires a change of attitude and culture: Mr Blair's and Mr Brown's speeches should be seen as two small contributions to this essential, yet enormous, change.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com