It's been over 4 decades since the UK was in charge of trade negotiations, so what now?

Editors' note: This column first appeared as a chapter in the VoxEU ebook, Brexit Beckons: Thinking ahead by leading economists, available to download free of charge here.

One reason for the UK leaving the EU was the promise of "taking back control" of trade policy. The UK would give up its influence and vote on EU policies for the freedom to negotiate its own trade agreements with countries around the rest of the world.

Watch Angus Armstrong discuss the impact of Brexit on the UK's trade patterns in the video below

It is more than four decades since the UK last was in charge of trade negotiations. Back then, exports were mostly domestic manufactured goods, where a pound of exports meant a pound of local profits and wages. Today, the UK is at the forefront of complex global value chains where services generate more than half of its domestic profits and wages from trade. This matters when negotiating the best type of trade arrangements. Trade policy is no longer just about reducing tariffs and subsidies to unprofitable industries; it is common standards and regulation, property rights and investment protection, infrastructure and communications, and the free movement of ideas and human capital. This chapter looks at the priorities for UK trade negotiations in light of the decision to leave the EU.

Three tasks ahead

The tasks facing the UK can be considered in three parts (not necessarily in order).

-First, on leaving the EU the UK must renegotiate its WTO membership agreement.

There is no precedent for this particular process, and the UK will need to agree its terms of engagement outside of the EU with the other 160 member states (i.e. establish 'most favoured nation' terms). The list of policy areas to consider goes well beyond tariffs. The most expedient approach may be to transpose, where appropriate, most of the existing commitments under its EU membership to avoid a lengthy negotiation.

-Second, the UK has to enter into a new governance arrangement with the EU.

The government has indicated that it will submit its notice to withdraw from the EU under Article 50 of the Treaty early next year. This will start a two-year negotiation period by the end of which the UK will not be a member of the EU, unless an extension to the timetable is granted by unanimous agreement. The new arrangement will go far beyond trade. It is likely to be negotiated in parallel to the Article 50 process. But the complexity and need for unanimous agreement, and even ratification in some national assemblies, suggest an interim arrangement may be required.

-Third, the UK has the opportunity to strike new trade agreements beyond EU.

The EU has 53 preferential trade agreements - mostly with developing states - that will no longer cover the UK after withdrawal. The UK would also need to consider if, and how, to be included in the US-EU Transatlantic Trade and Investment Partnership (TTIP) and other free trade agreements (FTAs) under negotiation. The UK can seek to join regional trade agreements such as the Trans-Pacific Partnership, and enter into other negotiations such as the Trade in Services Agreement (TiSA). Whether the UK has more success or less influence outside the EU remains to be seen.

Figure 1 puts these tasks into perspective. Just over half of UK trade is with the EU. If we add the other countries in the European Economic Area (EEA) and the Customs Union, the share of trade reaches 53%. Including those countries that have existing PTAs with the EU covers 62% of UK trade. Finally, including countries which are currently negotiating PTAs with the EU covers 82% of total UK trade. Most of the remaining 18% of UK trade is mostly covered by the rules of the WTO.

Figure 1 Share of total UK trade covered by trade agreements

EU priorities

The UK's first priority is likely to be with its largest potential trade partner. One of the most pervasive results in applied trade studies is that distance matters to the amount of trade. Head and Meyer (2014) report a distance elasticity of -0.93, which suggests that a doubling of distance from the UK almost halves the amount of trade. Perhaps surprisingly, the rise in global value chains has made distance more rather than less important. Johnson and Noguera (2012) find that proximity is especially important for intermediate trade. As production becomes more fragmented, distance appears to matter slightly more. A corollary is that the UK value added in exports to Europe is slightly less than the gross trade figures suggest.

In all likelihood, the UK will have to first establish its new trade arrangements with the EU as the basis for agreements with other countries. Each of the UKís options involves a trade-off between degrees of access to the Single Market and control over economic policy leavers. As a member of the EEA, the UK would have access to, but would not be part of, the Single Market. The UK would not have a vote on the rules and regulations of the market or access to the same courts in case of disputes. EEA membership involves accepting the free movement of labour, or at least with minimal temporary restrictions. UK exports would be subject to 'rules of origin' to tax the intermediate trade from outside of the EU. This would be invasive and expensive, given the trend towards global value chains.

The second option is for the UK to re-join the European Free Trade Association (EFTA). This is similar to the EEA option, but with less access to the Single Market beyond goods trade. Switzerland is the most prominent EFTA member and is required to strike bilateral treaties with the EU to secure access to the Single Market for specific services only. This carries a significant cost as many services, for example financial services, are carried out through third countries such as the UK. In 2014 the Swiss voted in favour of restricting migration. The EU has made it clear that this is incompatible with access to the Single Market. Switzerland makes a smaller per capita contribution to the EU budget than Norway in the EEA, to reflect the lower level of market access.

Industry priorities

The UK must also consider the market structure of its most successful industries when considering trade negotiations. It is important to know which sectors generate the most value added for UK firms and not just the gross trade flows. According to the gross trade data, services industries account for 44% of total exports. Yet the OECD estimates that in 2011 (the latest data available) 52% of the value added in UK exports was generated by domestic service sector firms. A short animation shows why trading services is fundamentally different to trading goods. The right to establish firms in overseas markets, the same rules and regulations, mutual recognition of providers and free movement of labour are all necessary for being part of a Single Market for services exports.

Figure 2 gives a breakdown of value added by domestic and foreign firms in UK exports by the most important trading sectors. It is striking that business services, finance, and wholesale and retail trade account for the same domestic value added as the 17 other sectors from chemicals onwards. For these businesses, trade policy is about market access, equivalent regulations, and mutual recognition. Many FTAs include service sector provisions, but they typically involve official procurement opportunities, cross-border exports of services (as opposed to locating firms in foreign markets) and transparency agreements, and cover specific sectors only. No FTAs offer anything like the service sector access offered by the Single Market.

Figure 2 Domestic and foreign value added in exports by industry

Conclusion

The challenge for trade negotiators is to get the best possible package for each of the alternative trade arrangements. But it is ultimately for politicians to decide how the preferences of UK citizens might best map onto these alternative arrangements. From an economics perspective, it is clear that agreements offering deep market access are more preferable than WTO access and many FTAs. The problem is that policies which enable deep market access encroach on the traditional domain of domestic policy. The optimal solution is to combine future trade arrangements with domestic policy. It might be possible to take the gains from trade while compensating for the social costs.

References

Head, K. and T. Mayer (2014), "Gravity Equations: Workhorse,Toolkit, and Cookbook", in G. Gopinath, E. Helpman and K. Rogoff (eds), Handbook of International Economics, Volume 4, Elsevier, pp. 131-195.

Hoekman, B. (2014), Supply Chains, Mega-regionals and Multilateralism, CEPR Press.

Johnson, R. and G. Noguera (2012), "Fragmentation and Trade in Value Added Over Four Decades", NBER Working Paper No. 18186

OECD-WTO (2015), Trade in Value Added: United Kingdom.