Distance and economy size are the most important factors determining the level of trade between two countries. This observation, underpinning the ‘gravity’ model of trade, has proven remarkably robust. Applying this model to the UK shows the EU is the country’s natural trading partner; that the single market has done more to raise trade in services than free trade agreements; and that barriers thrown up as a consequence of the UK leaving the European Union will be hard to offset through lower trade barriers with the rest of the world.
Nearly half of the UK’s exports are in services – an unusually high proportion for a medium-sized economy. On 14 February, Boris Johnson, the UK’s foreign secretary, stated, ‘Brexit need not be nationalist but can be internationalist.’ Liam Fox, the secretary of state for international trade, has heralded the post-Brexit opportunities on offer in a ‘post-geography trading world’. The implication is that the UK’s prowess in services means distance will become irrelevant.
It is intuitive that distance should matter less in services than in goods. Britain does conduct more trade with countries with which it shares a language than economic size and distance would predict. And services are increasingly delivered electronically, with financial transactions, advertisement mock-ups and architectural blueprints sent to clients over the internet. The cost of air travel has fallen. However, this intuition does not show up in the data. The effect of distance on trade in services is similar to its effect on goods: a 10% increase in distance between countries reduces services trade by 7%.
The US is by far the UK’s biggest individual market, thanks to large flows of financial services between the City, New York and other US banking centres. But the EU is a far bigger market. Italy buys a similar amount of Britain’s services as Japan, despite Japan’s economy being 2.5 times larger.
The EU is a rich, large market on the UK’s doorstep, and its single market has proved more effective at reducing barriers to services trade than bilateral free trade agreements. The EU’s rules have boosted services trade between member states by an estimated 60%, while FTAs have had no discernible effect.
Services are largely delivered by people. While technology has certainly made interactions at a distance easier, these interactions still often require both parties to be in the same place.
Goods are also no longer just goods. Products and services are increasingly bundled together. As such, services inputs, such as consultation and design, account for a significant amount of the value embodied in a manufactured product – estimates range from 20% to 47% across all sectors. Ignoring the contribution of embedded services to UK goods exports risks underplaying the degree to which the UK services sector is dependent on pan-European manufacturing supply chains.
Trade policy plays its part. To qualify for a free trade agreement, an exporter must demonstrate that a sufficient amount of the value of the product they are selling was realised within the territory of a party to the agreement. For example, for a European car exporter to qualify for tariff-free treatment under the EU-South Korea free trade agreement, it must show that 55% or more of the car’s value originates within the EU. This can be complicated. Accounting for the value-added input of services makes it more so.
World Trade Organisation rules on customs valuations are technologically outdated. As the rules are modernised, they will probably become more geographically restrictive. This means that, when relying on domestic services inputs to qualify for a trade agreement, there is little room for ambiguity as to where the services inputs are from.
Post-Brexit, the UK will find opening up new markets for its services exporters difficult. Multilateral services liberalisation has struggled to progress beyond the commitments made during the 1995 WTO General Agreement on Trade in Services. At a bilateral and regional level it has fared little better. Regulatory barriers abound, and, as the EU discovered when negotiating a trade agreement with India, talks of services liberalisation quickly become tied to politically challenging demands on the movement of people and business visas.
The idea that globalisation has become unmoored from geography – and Britain is about to reap the rewards – is wishful thinking. Brexit will damage the UK’s flagship services sector, rather than liberating it.
John Springford is Deputy Director and Sam Lowe a Research Fellow at the Centre for European Reform. This is an edited version of an article first published by the CER.