Trading places

Exit from the EU has catapulted the UK into the most significant debate on the future of international trade in half a century. But that political and policy debate is currently preoccupied with individual trade deals that the UK can now pursue. Largely ignored are the big questions that such a fundamental shift in openness of the UK economy poses for the shape of our economy, the nature of jobs for millions and our prosperity. So, as well as focussing on potential new trade deals, we need to step back to consider the fundamental goals of a new economic policy agenda and to examine the wider changes brought about by Brexit which, along with net zero and the fallout from Covid-19, mean that the 2020s will be a decisive decade for the UK economy. How those changes can be managed, and how the UK’s economic strategy should be reshaped in their light, is the motivation for The Economy 2030 Inquiry to which this paper is a contribution.

History shows us that major shifts in the level and nature of openness have big direct impacts on people, places and firms, but they are also intertwined with the overall economic strategy of the country, reshaping it whether intentionally or not. In this paper we present evidence that the direct impacts of leaving the EU have started to materialise, but the accompanying more fundamental implications for the UK’s economy have not. This means that now is the time to ask the most important questions Brexit brings: how open the UK should be; whether to maintain the existing economic strategy, or change it; and how the UK should position itself in a world trading system dominated by three major trading blocs. In asking these questions we focus on openness to trade and investment, we will return to the issue of migration policy in a future paper.

The last big debate about UK openness – leading to the UK joining the EU – led to marked changes to the size and nature of trade flows and to a new political and economic context that shaped the country’s economic strategy.

Joining the EU increased both the overall level of UK trade and the share of trade with the EU and contributed to the increased specialisation of the UK in exporting services over goods. The UK’s share of total Economic Communities (EC) trade, the predecessor of the EU, increased by 3 percentage points between 1972 and 1990 and the pace of average annual trade growth with the EU outpaced non-EU trade growth between 1973 and 1990 by around 4 percentage points. Some of this came at the expense of trade with the Commonwealth – with countries such as New Zealand, who had been sending around 50 per cent of their exports to the UK in the 1960s – being forced to redesign their economic strategies.

But the past also shows us, that in addition to these direct impacts, such large-scale changes to openness also leads to shifts in the country’s overall economic strategy. Increased competition and flows of foreign investment were encouraged to increase firm innovation and productivity – particularly in UK manufacturing that had been flagging relative to overseas competitors.

Increased openness also allowed the UK to specialise in high-value tradeable services – in line with its comparative advantage. This led to relatively large increases in services exports as a share of GDP, which grew by 9 percentage points between 1972 and 2019, compared to growth of 5 percentage points on average for the rest of the OECD. Measured in value-added terms, nearly £7 in every £10 of UK exports (68.5 per cent) was services. This is well above the OECD average of just over half.

The UK became one of the most attractive Foreign Direct Investment (FDI) destinations, given access to the EU market and government focus on removing restrictions to capital flows and creating a stable investment environment. The UK attracted 6 per cent of total FDI inflows between 1990 and 2019, outstripping its share of global GDP. In addition, both inflows as a share of capital formation and FDI stock as a share of GDP were above the EU and developed countries’ average.

On the face of it the strategy of driving faster productivity growth through increased competition, specialisation in services and FDI inflows was successful as the UK’s relative economic performance improved. The productivity gap with France and Germany, which had been widening up to 1975, stopped growing as the UK kept pace with Europe over the following decade and even closed some of the gap with the US. There was then a sustained period of two decades in which the UK caught up to its peers.

But while the disruptive effects of this transition were widespread across the country, the new opportunities from expansion of tradeable services and FDI were concentrated in London and the South of England. Regional inequality increased markedly between 1975 and 1990: the variance in household incomes across regions and nations of the UK increased by around 9 percentage points. Moreover, the shift in employment from manufacturing to services was associated with a shift in the nature of job opportunities with lower skilled workers losing out on ‘wage premiums’ for manufacturing jobs.

Brexit represents one of the most significant shifts to international trade and investment policy across the world. It is also highly unusual in that Brexit will increase barriers to trade with the UK’s largest trading partner. Given history shows that we should expect both significant direct impacts, as well as disruption to the UK’s current economic strategy, are such effects already evident?

The data so far suggest that the direct impacts from the changes to the UK’s closest trading relationship have already been substantial.

It is clear that investment, prices and real wages have all been affected. Financial and currency markets were the first to respond after the referendum. In its aftermath, sterling depreciated by around 10 per cent on a trade weighted basis leading to higher prices and falling real wages. The depreciation is estimated to have increased prices faced by consumers by 2.9 per cent, equivalent to an £870 increase in the cost of living per year for the average household. For firms, the referendum increased uncertainty, providing an unwelcome headwind to investment. Even by December 2020 the prospect of a ‘no deal’ Brexit had not been ruled out, with just 59 per cent of businesses saying that they were at least somewhat prepared for that eventuality. This increased uncertainty weighed on investment, which has slowed with average quarterly investment growth in the three years post-referendum falling to -0.1 per cent, compared to 1.7 per cent in the three years pre-referendum.

And early data for 2021 suggest that the implementation of the Trade and Cooperation Agreement (TCA) with the EU has prompted changes to trade flows. Goods and services trade with the EU have fallen by between 10 and 20 per cent relative to non-EU trade this year, a clear break with the close past relationship between such trade flows. But UK firms are starting to report fewer challenges to exporting attributed mainly to the end of the EU transition period, indicating they may have started to adapt to the new arrangement. Taken together it appears that direct effects of Brexit on trade flows are materialising, although the impacts have been compounded by the impact of Covid-19 on global trade flows.

Looking ahead, however, the longer-term implications of Brexit for the UK’s economic strategy will take time to become clear.

The policy debate is fixated on the nuts and bolts of the individual trade deals that may be possible after Brexit. But such a debate misses the more important issues. Focusing on individual deals presupposes the UK is on a path towards becoming more open, without asking the fundamental question: how open should the economy be? In turn, any decision on how to approach openness must be informed by the question of whether to maintain the existing economic strategy, or change it? Here it is crucial that any change in strategy be grounded in the realities of the world trading system. For this reason, we must also ask what is the UK’s place in the world trading system; as geopolitical tensions escalate among the world’s trading superpowers, where does ‘Global Britain’ fit in? The answers to these three fundamental questions about where the UK is heading will govern what policy makers should do today.

It is clear that policy makers are focussed on striking bilateral trade agreements as quickly as possible. The Government is ambitious in this regard – signalling that it is aiming for trade agreements covering 80 per cent of UK trade by the end of the 2022. The first phase involved frantically negotiating agreements which rollover those the UK benefited from as part of EU membership. In this respect there has been success with over 60 per cent of trade now covered by existing trade deals.

Much has also been made of new deals that may be in the offing. This is at least in part because such deals are popular with the UK public. According to Government surveys around three quarters of the public supports the UK pursuing free trade agreements, with only 8 per cent against. A trade deal with the US is often held up as one of the major opportunities of leaving the EU. The US made up 16 per cent of UK trade in 2019, by far the largest trading partner outside of the EU (the next largest partner is China with 6 per cent of UK trade in 2019). So, it can be no surprise that no time has been lost in launching negotiations with the US. Unfortunately, however, the current US administration has taken a decision not to pursue new trade agreements and paused negotiations with the UK indefinitely. In response, the Government’s new priority appears to be attempting to capture the trade opportunities created by the growing middle class in the Asia-Pacific region. In this context, there has been a lot of debate about the implications of trade deals with Australia and New Zealand, particularly for farming. This will, however, do little to offset the substantial loss of EU market access, particularly in the short run. This is because trade with Asia and Australasia is smaller (just 22 per cent of UK trade in 2019, a quarter of which was with China, less than half the trade the UK does with the EU).

The current trade strategy does not show clear signs of prioritising services liberalisation, despite the highly specialised nature of the UK economy in exporting services. A service orientated trade strategy would instead prioritise reopening deals with our largest export markets for services (in the continued absence of a US deal). However, delivering deep services liberalisation remains highly challenging. Even the EU’s most ambitious free trade agreements on services to date have managed very little liberalisation of current barriers to trade relative to the liberalisation within the Single Market. According to Government analysis, using the OECD Services Trade Restrictiveness Index (STRI), the UK’s deal with Canada reduced a tiny fraction, significantly less than 1 per cent, of the barriers to services liberalised within the EU. As a result, negotiations would be slow as they require difficult trade-offs, for example on the freedom of movement of people. This is incompatible with rapidly delivering deals to reach the Government aim of covering 80 per cent of trade with trade agreements.

All this adds up to a limited scope for increasing openness beyond the EU given the limited availability of willing partners. The reality, then, is that leaving the EU will ultimately make the UK less open. The priority moving forward must be recognising that the economic strategy and international positioning of the UK must be revaluated in this context.

What does reduced openness mean for the UK’s economic strategy?

EU membership has been a cornerstone of the UK’s economic strategy and a key challenge for this decade is deciding what replaces that. A less open economy means that the strategy of driving increases in productivity and prosperity through EU competition and FDI inflows will no longer be available to the same extent. Despite the significant direct impacts already seen, the Government position has been to downplay the scale of trade policy change implied by Brexit, and therefore the impact that might have for the UK’s economic strategy. This is in marked contrast to the Prime Minister’s argument that the UK’s new migration regime post-Brexit will be a key driver of change to our economic model, with an end to the availability of lower-paid migrant labour forcing firms to invest and driving “a high wage, high skill, high productivity” economy.

It is true there are relatively few signs of a fundamental shift in the structure or drivers of productivity of the UK economy as yet. For example, although there is evidence the referendum caused a reduction in inward FDI transactions to the UK, and increased outward FDI transactions into the EU, overall inflows have not yet fallen anywhere near as far as feared yet (around 20 per cent).

But such a significant shift in the degree and nature of openness will matter for the shape of the UK economy in the longer term. Trade policy has differential effects across jobs, industries, and regions. For example, the Government’s own analysis of EU exit indicates that Brexit will lead to larger relative declines in output and an associated movement of jobs out of sectors including chemicals, motor vehicles, agri-food and financial services. The chemical sector, for example, is expected to be almost 20 per cent smaller in GVA terms than within the EU.

In time policy makers will need to decide how to respond to these pressures for change. This will include knowing whether we are aiming to maintain the status quo amid less openness – for example with more support for sectors adversely affected – or choose to embrace some refashioning of our economic strategy to reflect this new reality. There are early signs of areas where politicians are keener to embrace change, although not always with a desire to raise productivity. This is important because productivity growth is the ultimate driver of the higher wage economy the Prime Minister wants to see. Sectorally, political preferences have shifted from wishing to build on the UK’s comparative advantage in tradable services to a desire for manufacturing to play a greater role in the UK economy. Insofar as that involves fewer service exports and more manufacturing for a domestic market, it may go with the grain of Brexit’s impact as well as the cross-party consensus in favour of rebalancing regional economic activity, albeit at the price of lower productivity in aggregate. For the past four decades active support for FDI and foreign ownership of UK firms has been an explicit part of the UK’s economic strategy, supporting higher productivity via capital and better management. That support appears to be becoming more ambiguous, with the Government undertaking consultations on the handling of mergers, indicating a desire to take a more interventionist approach. Again, this would go with the grain of the impact of Brexit.

Of course, a new strategy would ideally be about more than embracing some elements of change that, however desirable, are likely to push down on productivity. Indeed, it should explicitly aim to scale up alternative productivity drivers, to mitigate the impacts of reduced openness on competition and diffusion of overseas innovation through investment. There are signs the Government believes this could come from regulatory reform, where the objective is to give UK firms competitive advantages via a more flexible and agile regime. There is scope for a different approach now the UK has left the EU, although it is not clear that substantial gains in this area are possible if the focus is simply on having less regulation. The UK is already ranked as having the lowest level of product market regulation among OECD countries. Indeed, rather than a smaller role for the state, the indicators are that the Government favours a more active, interventionist role. The establishment of the UK Infrastructure Bank, which has seen the UK take an equity stake in a number of start-up businesses across a variety of sectors, suggests that there is an intention to proactively promote private sector investment and innovation. This requires institutional infrastructure to ascertain and monitor the productivity benefits from the use of public monies and is likely to be successful when there are clear objectives to the overall economic strategy that the government intervention is seeking to achieve. How an approach that favours more regulatory nimbleness and state activism will be institutionalised to maximise any benefits and avoid capture by particular private interests remains to be seen.

It is important to recognise that the UK will not be setting its policy in isolation, rather it must set its post-Brexit course in the emerging new era of global geopolitics. The UK is leaving the EU during an era of trade defined by the actions of three highly connected but increasingly competitive superpowers – the EU, the US and China – which together make up almost 60 per cent of world GDP. China’s successful export-led growth model has made it the largest source of imports to both the EU and the US. The three global powers are also deeply economically connected through cross-border supply chains and the ownership of debt. Almost 20 per cent of the foreign content of US exports comes from China. And China holds over $1 trillion of US debt, making it the second largest foreign owner of such debt after Japan. This shows how interconnected these global powers have become.

However, current trading relations between the three are tense and complex. The US introduced a number of retaliatory tariffs on Chinese and EU goods in 2018 and 2019 respectively, put in place in response to claimed violations of WTO intellectual property and subsidy rules, many of which have not been revoked by the Biden administration. Both responded with their own retaliatory tariffs against the US. The EU also implemented or sought to introduce a range of policies, including changes to rules on digital localisation and a new digital tax, that were seen as aggressive new trade barriers for large US tech firms, despite being designed to address data privacy and tax avoidance issues.

The UK’s position, in the past, was to a large extent governed by collective agreement of the EU, including where and when to use retaliatory tariffs and where and when to deescalate tensions. Now the UK must decide its position independently, accounting for the fact these three global trade superpowers account for almost 70 per cent of UK trade. The UK may want to minimise any further disruption to trade with any of its major partners as it adjusts to the change in openness with the EU, but the UK risks being caught up in rising US-China tensions.

The Government seems to be aiming to align politically with the US, at the expense of China and the EU. This is demonstrated by stepping up collaboration on security, for example UK membership of AUSUK that aligns the UK with the US (and Australia) against China. The UK is also ramping up bilateral action against China, due to rising concerns about Chinese involvement in critical national infrastructure, including banning Chinese firms from delivering 5G networks and nuclear power services. The EU-UK relationship remains strained following the Brexit negotiations, with unresolved issues around the Northern Ireland protocol a continuing source of tension.

However, the extent to which this approach is compatible with a trade strategy that appears to prioritise liberalising with and promoting Asia-Pacific trade is questionable. The current US administration does not present an opportunity for liberalisation of trade. However, China requesting to join the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), which the UK has already applied to join, could force the UK to directly confront this conflict. Alternative strategies open to the UK all come with strategic trade-offs. Continued alignment with the EU, in the absence of a US deal being available, might be most valuable from a trade perspective – but runs directly counter to the Government’s objectives of securing trade and regulatory freedoms. Alternatively, the UK could tread the path commonly adopted by smaller very open economies: avoiding global tensions, remaining open to all and hoping to be the beneficiary of rising tensions and barriers to trade between the three main actors. Some economic models would suggest such a position would be economically advantageous, but operationalising it would likely involve sacrificing international influence and activism in a way that UK governments have historically been reluctant to do.

Starting to tackle the three big questions we pose above makes it clear in broad terms what the Government must do. First, policy makers must shift their focus away from individual trade deals and instead recognise the underlying reality that the UK will be a less open economy. Second, they must decide what the new economic strategy should be. And third, consider how to make this consistent with the global situation. In short, what is needed is a post-Brexit trade policy informed by an economic strategy.

The Economy 2030 Inquiry will deliver just that. But doing so with any specificity requires that we seek to further unpick the relationship between openness and the structure of the UK economy – including the impact of changes to the regime for migration. Over the next two years the Inquiry will investigate the nature of the economy today and the change to come and explore what this means for people, places and firms across the UK. We will also consider how the availability of trade deals with countries around the world could fit into a coherent strategy for generating lasting improvements in living standards. Most importantly, such evidence must inform wider thinking on how the UK economy will change given wider sources of economic change such as the pandemic and net zero, and how we can successfully shape the decisive decade ahead.

• Joining the EC (the forerunner to the EU) half a century ago fundamentally altered our national economic model by making it more open and competitive. This precipitated increases in trade with the EU, and a shift away from manufacturing and towards services with the increase in services exports as a share of the economy was twice the OCED average. 
• Some of the direct economic changes are already emerging. Trade in goods and services with the EU has fallen by 10-20 per cent relative to non-EU trade with services trade more affected.  

• While there is evidence the referendum prompted a reduction in inwards foreign investment transaction and an increase in outward transactions into the EU, foreign investment has not yet fallen as much as expected.  
• Scope for liberalisation beyond the EU is limited by the availability of willing partners, rather than public support. Around 3 out of 4 individuals in the UK support the free trade agreements. 
• Brexit may provide some scope for rebalancing regional economic activity, albeit through lower aggregate productivity, as both foreign investment and tradeable services are concentrated in the highest income regions. 
• A sustainable plan for the UK’s trade policy will need to be embedded within a wider strategy that reconciles the UK’s wish as a smaller open economy to have good relations with the world’s three major trading blocs (US, EU and China), with its ambitions to play an active geo-political leadership role. 
• Britain’s conversation on trade must focus on how to adapt our economic strategy to find alternative productivity drivers, in the face of lower foreign competition and investment.