23 February 2022

SUERF: Brexit: Trade diversion due to trade policy uncertainty

During the long process of negotiation after the 2016 Brexit referendum, there was a high uncertainty about the final shape of bilateral trade relations between the European Union (EU) and the United Kingdom (UK).

This uncertainty provoked a significant trade diversion in the case of Spanish exporters highly exposed to the UK (above 10%), while it was more limited in the case of imports. Regarding the destination market, trade diversion appears to be more intense towards the EU, where exporters and importers maintain stable trade relationships.

Introduction

The unexpected vote of the United Kingdom (UK) electorate to leave the European Union (EU) initiated a negotiation period in which uncertainty about trade relations between these regions was very high. Although the two regions finally reached an agreement on December 2020 whereby no bilateral tariffs have been established, the uncertainty surrounding the long process of negotiations was very high. In response, Spanish firms could have partially replaced the British market with domestic flows as well as alternative partners. In our recent paper (Gutiérrez et al., 2021), we explore the effect of uncertainty on trade and the capacity of firms to substitute markets using Brexit as a quasi-natural experiment.

In order to so, first, we explore how firm participation in the British market changed under the renegotiation of an existing agreement. We implement a difference in difference strategy to estimate the impact of uncertainty on the intensive margin of bilateral trade with the UK. Uncertainty is captured through future potential losses, which are proxied with potential tariffs in absence of a trade deal and the firm level dependence on the UK. In a second step, we analyze trade diversion patterns exploiting the interaction of uncertainty indicators as instrument for changes in trade with the British market. This market substitution might reveal firms’ contingency plans in response to potential significant losses provoked by Brexit.

Crucially, our results point to an almost full trade diversion in the case of those firms more exposed to that particular market (above 10%), while the response is heterogeneous for Spanish firms with a low share of British bilateral flows over total trade. Thus, this note focuses on the group of firms highly exposed to the UK, whose exports might have been severely hit since the Referendum.

Data and framework

We employ three different data sources to assess trade diversion patterns. First, we use information of monthly declared exports and imports with the UK, EU27 and Rest of the World per operator exposed to the UK between 2015 and 2018 which is provided by the customs agency. Second, an annual firm level database including their sector of activity, turnover, and number of employees coming from the Central Business Register (National Statistics Institute - INE). Lastly, in order to incorporate potential trade barriers, we construct sectoral tariffs by exploiting Most Favored Nation (MFN) tariffs at the HS2 level from the World Trade Organization (WTO).

We end up with a database including about 35,656 exporters and 40,394 importers, which account for around 90% of exports and 85% of imports with the UK containing sectoral MFN tariffs, and firm level sector of activity, employment, turnover, and sales and acquisitions with the UK/EU/RoW. Information for 75 sectors is provided at the NACE-2, 3 and 4-digit level with more details on particular sectors that have large trading flows.

With respect to the framework of the analysis, the effect of uncertainty on trade with the UK is assessed. Firm level uncertainty is measured as the interaction between its relative trade exposure to the UK in the past and potential sectoral tariffs after Brexit which may affect the firm. We expect a negative response of trade flows with the UK to potential tariffs, especially in those firms where sales or purchases were more concentrated in the affected market.

Then, we quantify trade diversion patterns using the predictions of the first stage above. On the one hand, those firms which would face higher tariffs in case of hard Brexit, due to their main sectoral activity, might have reduced their trade with the UK more intensely and replaced, at least partially, the British market with other alternative destinations. Additionally, a higher firm’s relative exposure to the UK will increase the risks associated with Brexit, and thus could lead in turn to a higher trade diversion....

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