Now that Theresa May, the British prime minister, has announced that the UK will invoke Article 50, triggering a two-year countdown to withdrawal from the European Union, some things have become clearer. Though it is hard to predict how a bargaining game involving strong emotions as well as economics will play out, we can offer some conjectures about what will happen.
These conjectures are mostly based on what I have called the law of distance — the observation that the interactions between two countries are proportional to their sizes (GDPs) and inversely proportional to the distance between them. Distance, in this sense, is not just physical distance but also cultural distance (e.g., whether two countries have different/similar official languages) and administrative distance (e.g., the absence or presence of a historical colony-colonizer link between the two). The law of distance has been associated with some of the most robust results in international economics, which is why it underpinned the UK Treasury’s generally well-regarded analysis, a year ago, of the long-term consequences of Brexit.
The UK’s Natural Markets
First, think of the claim, made repeatedly by the UKIP and other pro-Brexiteers: that the UK’s “real friends” (in Nigel Farage’s words) are better targets for British commercial policy than the EU. Or, as UKIP’s spokesman for the Commonwealth poetically put it, “Outside the EU, the world is our oyster, and the Commonwealth remains that precious pearl within.”
How realistic is the assertion that the UK might be able to gain more from a free hand in negotiating with the Commonwealth — former British Empire states such as Canada, Australia, India, and South Africa — than it might lose in terms of access to the EU? Note, first of all, that the GDP of the rest of the Commonwealth is only 55% as large as that of the rest of the EU — a difference that seems to disfavor the assertion — as captured in the circle on the left in the graphic below. The middle circle shows this adjusted for the effect of physical distance, since the economic mass of the EU is 8.4 times closer than the Commonwealth. The blue circle in this part of the graphic uses a more generous estimate of distance-sensitivity, while the dashed line uses a more conservative one (drawn from hundreds of studies of merchandise exports). Using that more conservative measure reduces the estimated market potential for the Commonwealth versus the EU even further, to less than 2%.
Of course, we also have to account for the cultural and administrative respects in which the Commonwealth might be intrinsically closer to the UK and the EU. The UK has a common official language (English) with 91% of the rest of the Commonwealth (on a GDP-weighted basis) and a colony-colonizer link with 99%, versus only 2% on both factors with the rest of the EU. Based on my estimates that a common language normally boosts trade by 2.2x and that a colony-colonizer link has a multiplier effect of 2.5x, the joint effect of the two (5.5x) in boosting market potential in the Commonwealth is substantial, as the blue circle on the right-hand side of the figure above shows. Even so, the predicted market opportunity in the rest of the EU remains several times larger. (Again, the dashed line is the more conservative estimate.)
The joint effect of a common language and colony-colonizer link would have to be much larger than in any previous study of which I am aware to reverse the conclusion of a larger natural market in the EU. Additionally, it holds well beyond the realm of merchandise trade: It also applies to services trade and by extension foreign direct investment (FDI), which are particularly important for the UK.
The snapshot nature of this analysis also skips over some of the dynamics of actually negotiating trade agreements with the 52 other countries in the Commonwealth — at a time when Britain has very few experienced trade negotiators (as of last summer, roughly 0.5 per Commonwealth country).
Will the UK on its own really have the leverage to achieve better terms with the Commonwealth countries than it currently enjoys with the EU? Consider that Britain accounts for only 16% of EU GDP. One pessimistic perspective on the hope of real friendship trumping all else is provided by the generally disappointing results of Theresa May’s visit to India last November. While the British wanted more trade and investment ties, Narendra Modi, prime minister of India, explicitly linked that to relaxation of British visa conditions for Indians intent on studying the UK. Like the EU, India has problems with British insistence on stringent controls over people inflows.
Moreover, the tenor of the relationship between the UK and the EU is not good: Compare Britons insisting that the UK could exit without paying a “brass farthing” versus the EU’s claims for £50 billion or more. Consider the combative personalities of some of the key negotiators. Add in the consideration that Brexit, even if accomplished with a maximum rather than minimum of goodwill, will hurt Britain’s trade with the EU for purely technical reasons, and it seems safe to predict that there will be a deterioration of trading relationships with Britain’s largest natural market; the only question is to what extent.
Industry Implications
Given that relatively safe prediction, the natural next question is which industries and companies are likely to be hurt the most and therefore face the greatest need to reconsider their current operating models.
In this context, what Brexit is likely to change the most is the administrative distance between the UK and its former partners in the EU. This suggests that industries with a high degree of sensitivity to administrative distance are likely to be affected the most — unless, of course, the provisions under which UK-based operations can access EU markets happen to be eased the most for them (which, at least from the perspective of EU concessions, looks implausible right now).
Note that (correlated) indicators of administrative sensitivity include industries that are subject to high levels of regulation, produce staples or “entitlement” goods or services, are large employers or suppliers to the government, include national champions, are construed as vital to national security, control natural resources, or require large, irreversible, geographically specific investments. No wonder financial services firms with extensive cross-border operations, for whom the EU “financial passport” is very important, are rethinking the extent to which their European personnel are based in the UK or on the continent (e.g., Goldman Sachs’ announcement, earlier this week, that it would be will shifting jobs away from London while adding several hundred in Europe—during just the first stage of Brexit).
Other markers of industry sensitivity to Brexit include high levels of scale economies that need to be amortized over (international) regional markets, rather than just by national markets (BMW’s discussions of whether to move the manufacture of the Mini outside the UK despite the very British image of that brand); high levels of trade-dependence on either the export or the import side (the EU is an even more important source for the UK’s imports than it is a destination for the UK’s exports); and belonging to the service sector (a sector of particular importance to Britain but one in which overcoming barriers often requires investment treaties as well as trade agreements).
Company Implications
At the company level, there are some additional attributes that seem likely to be associated with high degrees of exposure to Brexit. Companies with particularly high levels of export or import-dependency in relation to their competitors are likely to be hardest hit (think, in the U.S. context, of the asymmetric responses of New Balance and Nike to Trump’s scrapping of TPP — the former had stayed focused on local manufacture whereas the latter had built up international supply chains). Small firms that aren’t yet exporters or importers are also likely to be hurt more, at least in terms of a narrowing of their opportunity sets: Such firms typically look nearby for their first international transactions. And even where products or services aren’t flowing across borders, companies that use Britain, particularly London, as their regional headquarters for serving all of Europe (e.g., many U.S. multinationals) are likely to need to reconsider basing that role there — as may, for that matter, companies that use London as their global headquarters, especially if most of their business is outside the UK (e.g., Vodafone, which derives some 85% of its revenues from outside the UK, according to Bloomberg).
The British companies that may have private reasons to cheer are those focused on the UK that are trying to hold off regional or even global competitors at home. Which is a reminder of the importance of granularity in forming such assessments — not all companies within the same industry, let alone all industries, will be affected in the same way. Similarly, in terms of what is to be done, once again, the appropriate response will be predicated on the specifics of a company’s situation.
But given the separate tracks down which the UK and the EU seem to be moving, there is more cause than not to consider making changes to your strategy.
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