The Gravity-Model-of-Trade for opportunities beyond the EU after #Brexit. The #Russian anomaly.

There is a more up to date, better version of this at the UK Houses of Parliament.

https://committees.parliament.uk/writtenevidence/12422/html/

This analysis is aimed at businesses considering what opportunities are available beyond the EU following Brexit. It uses the gravity model of trade to show that the potential of Russia as a trade partner beyond the EU is second only to the US. It shows that the UK already tends to trade above potential with English speaking countries. It trades well below potential with Russia, Indonesia and Argentina. The shortfall with Russia is such that meeting average performance is worth more than any deal in Asia.

The Gravity Model of Trade (http://www.nber.org/papers/w19285) is one of the more robust models in economics. It is based on the observation that levels of trade between countries depend on the size of the economies and the inverse square of the distance between them. Double the distance between a pair of countries and the potential for trade falls to a quarter. The gravity model is persistent over time as it is includes geography which does not change. Growth rates in GDP and exchange rate shifts come and go. Responding to them is an opportunistic tactic. The gravity model shows the strategic targets for increased trade.

While it is obvious, that say, shipping costs and delays influence the attractiveness of goods sold at a distance, services also often follow the gravity model. Intellectual property monopolies such as design rights to ARM chips or Liquid Crystal Displays may seem free of distance but even in such a case time zone differences and the trouble and expense of intercontinental flights can be a factor in encumbering sales effort. Often services are a face to face business. Differences in time zones and long travel times erode the opportunity to deliver services from a remote base. Tokyo, Hong Kong, Singapore, Dubai, New York and Chicago compete with London financial services at least partly due to time zones and distance to travel to meet clients. That said, there is a bias in service exports to English speaking countries, especially the US and also to the EU. This could also be a bias to developed countries which have larger service economies anyway.

The G20 is a grouping of countries that represents 85% of World GDP. Confining this analysis to the G20 captures the all significant opportunities without cluttering the presentation. The UAE and Iran are not in the G20 although on some measures they are bigger than the smaller members such as Argentina.

Most of these countries have a trade arrangement with the EU or are negotiating one. These will be among the 70 odd trade agreements that the UK will lose after Brexit. The countries not engaged with the EU where EU membership may in some unspecified way be holding British exports back are the USA (but the TTIP may come back in even more pro US form), Russia, Saudi Arabia and Indonesia. (Brazil and Argentina belong to Mercosur).

While the table shows the numbers graphical representations are easier to follow.

In terms of both export sales and the gravity index, the EU is absolutely dominant which was to be expected. The only other country in the same order of magnitude on either scale is the USA. The trend line shows the potential implied by the gravity model if exports were at the average level for that country. The USA clearly exceeds potential. Most of this over performance is in services which seems partly due to a common language and partly due to the level of development. Developed countries tend to buy a greater proportion of services. Within the EU, the original 6 and Scandinavia take disproportionately more services than new members in the South and East give or take a tax haven.

The EU and the USA are so dominant that the post Brexit question comes down to the UK’s ability to increase exports  and decrease paperwork and regulations to the USA more than the likely losses to the EU. It’s an exciting challenge. for every 1% we lose from our export trade with the EU we need to increase our trade with the US by 2.3%. We already do very well in both goods and services with the US. There seems to be no mechanism to create a speedy large increase in exports to the US. The TTIP was found to be unacceptable to both sides. It implied privatising the NHS, already the most cost effective health system in the world (everything can be improved but the US model is not a good example). The US has been a difficult partner in NAFTA, TTP and the proposed TTIP.

For goods, UK companies can make products according to EU and US standards by varying designs. We will presumably keep EU standards for our own use. Services are very different. They are more affected by regulatory environments than goods. The EU is so far the only international trading area that has got to grips with services. The US TTIP proposal included services but included punitive measures to protect US firms from government legislation. It was certainly not "Taking back control".

The next chart shows the countries lost in the corner. The trend line is the same as for the previous chart.

The trend line shows the potential export level based on average performance. There are obvious anomalies. The UK is not meeting its potential with Russia, Argentina and Indonesia. All three  are oil exporters. Argentina and Indonesia have little else to sustain them but Russia is like Canada, it retains a large manufacturing sector and developed agriculture.  UK is exporting about half of what it should to Russia. English speaking countries, assuming Hong Kong is a gateway to China tend to be more accepting of UK exports, especially services, not shown separately. Canada is English speaking but an oil importer. Australia, further from the USA than Canada is well above its market potential for buying from the UK (more services than goods). India (the UK is blocking an EU trade deal with India) and South Africa do not show an English speaking effect.

The Russian Anomaly
Russia is the #3 gravity model opportunity for the UK (it's close by and quite a big economy) so let's discuss it in depth.

Is the UK under performance in Russia due to post Crimea and Donbass sanctions? There were EU sanctions against individual members of the Russian elite and Russian counter sanctions against EU food suppliers.

It is not.

In 2016, after the oil price crash, Germany, also in the EU, outsold Britain by a factor of 5.5 times in goods selling a similar mix of products to that of the UK. Germany is a bigger economy, closer to Russia and has significant a population with Russian language skills but this does not explain a 5.5 times out performance. France outsold the UK by a factor of 2.4 and Italy by 2.2. France did sell even more relative to the UK in previous years but lost significant trade in 2014 due to Russian counter sanctions in food and the failure to deliver an aircraft carrier. UK, Germany and Italy were less affected. The UK competes better in selling services but goods still predominate in the Russian case. However, success in exporting media, financial and legal services from London does not excuse this underperformance in manufactures. Britain outside the Home Counties deserves some support and attention from government.

The graph shows above trend  performance in English speaking countries. The UK may have particularly bad language skills for the three leading opportunities; Russia, China and Turkey. This is solvable. The UK contains many immigrant communities, including Russians from the Baltic countries (at one time the cleaner in Volga Trader' office block was an ethnic Russian history teacher from Lithuania), Chinese from Hong Kong and recently arrived Turkish immigrants. These groups tend to get pushed into low-level jobs or self-employment. It would be of advantage to the country if they could be offered training programs to make them commercially useful to British exporters. Although they do less skilled jobs, in terms of their own qualifications they are not always unskilled.

Harmonization of regulations is improving. Russian belongs to the Eurasian Economic Union. There is a customs union already operating and a single market with regulations harmonized to European Union standards in construction. RUSSIAN ALREADY IMPOSES EU REGULATIONS ON ITSELF. In tariff terms, since 2012, Russia trades with the world on WTO rules. The Russian economy will grow. Russia still has very large Sovereign Wealth funds. In a speech to the Federal Assembly in March 2018 President Putin announced major spending plans for these funds. He plans a 7% growth rate in the next two years well ahead of the world average. Huge infrastructure and housing projects will take place. Social spending on healthcare may double. The economic content was rather overshadowed by the announcements of new types of missiles.

Naturally, the leaders of Leave in the UK are strongly anti-Russian although it is trade opportunity #3. Tariffs are not very important to the very high tech products that are at the core of UK exports. Regulations about services are far more important. The EU has agreements in place or under way with most of the top 20 economies. It is hard to see how an independent UK will get better deals except perhaps with Russia, although a small plus with China could bring a pick result in some specialist field.

It is difficult to see trade advantages from Brexit.