Five years after the Brexit referendum, research has evaluated its impact so far on UK trade. The findings show that the ongoing Brexit uncertainty has already reduced UK trade in goods and services before any actual policy changes took place. This disintegration is present in UK trade, with countries potentially affected by trade policy changes including the EU and other UK preferential trade partners. Firms in these countries faced increased trade policy uncertainty, leading to depressed export investments.
We discuss the importance of policy stability and commitments, and their effects on business decisions and investment generally (Bloom et al. 2018, 2019). We focus on recent evidence drawn for the impact of Brexit uncertainty on UK trade in goods and services and conclude with some policy remarks.
The role of trade policy uncertainty
Exporting generally involves sunk investments, such as compliance with border and national regulations, learning about demand, and setting up distribution networks. Examples of these and other export costs have multiplied in the media post-Brexit.1 Firms make these investments today if the expected profit is higher now than in the future. But increases in uncertainty raise the risk of current export investments, increasing the option value of waiting and thus lowering current firm exports.
Trade agreements aim to reduce trade policy uncertainty and evidence shows that in doing so they promote integration. One example is Portugal’s accession to the EU in 1986. Even prior to 1986 Portuguese exporters mostly faced zero tariffs in the EU. However, this market access was uncertain since tariffs or other barriers could be raised at any time. Handley and Limão (2015) find that this uncertainty was eliminated post-accession, leading to an increase in the number of Portuguese exporters and trade even if tariffs remained constant.2 Brexit is analogous to a reversal of this process: the UK-EU market access is becoming more uncertain and is therefore a source of trade disintegration.
The impact of Brexit uncertainty on EU-UK trade in goods
In May 2015, the Conservative Party won the general election after promising a referendum on the EU membership of the UK. The Conservative government introduced the referendum bill days after the election. For more than a year after that, both UK and EU firms operated knowing that there was a real, politically enabled probability of the UK leaving the EU. In June 2016, the ‘Leave’ campaign won.
Crowley et al. (2019) find that Brexit uncertainty reduced UK firm export participation by comparing pre- and post-referendum firm export entry and exit. In Graziano et al. (forthcoming), we focus on the effect of Brexit uncertainty between the conservative election and the referendum. We explore variation in the probability of Brexit – measured via prediction market contracts (or polls) – and find that the higher the predicted probability of Brexit, the lower trade. This effect is expected to be more pronounced for riskier industries, i.e. those facing potentially higher protection in case of a hard Brexit, as measured by the most-favoured nation tariffs. Hence, increases in the Brexit probability should be positively associated with the trade share of lower risk industries, as we observe in Figure 1.
Figure 1 Brexit 60-day moving average contract price and low MFN risk trade shares
Source: Graziano et al. (forthcoming)
We estimate a structural equation relating monthly bilateral industry exports and trade policy uncertainty, after controlling for other trade determinants. The uncertainty measure reflects industry-specific tail risk as well as the Brexit probability, and has a significant negative effect on exports. Consistent with the theory, the trade policy uncertainty (TPU) effect reduced product entry and increased exit, and is only present in industries with significant export sunk costs.
To quantify the average impact of the referendum on UK-EU trade, we apply the estimated uncertainty elasticity to the implied change in the probability of Brexit once the Leave option won the referendum. These impacts are calculated at the average tariff risk. The implied increase in TPU due to the referendum changed UK-EU trade as depicted in Figure 2 (-18 log points for export values, -29% for entry, and 18% for exit).
Figure 2 Brexit referendum uncertainty impact at average MFN risk
Source: Graziano et al (2020). Export value changes in log points; entry and exit represent percent changes.
Brexit externalities beyond the EU
Brexit uncertainty spilled over to trade between the UK and preferential partners beyond the EU – such as South Korea, Turkey and Israel – suggesting that firms in these countries also faced tariff risk. This implies that a referendum that was mainly about defining UK-EU integration caused externalities for third countries since they had preferential trade arrangements (PTAs) with the EU. We apply the framework described above for UK-EU trade to these other countries and find very similar effects as shown in Figure 2.
Brexit (dis)service effects
UK trade in services was also negatively impacted by Brexit uncertainty. Services account for over 70% of UK GDP, and exports of services account for about half of its total exports. Further, the EU is the main export market for UK services. Consequently, Brexit uncertainty and the possibility of new barriers has threatened the UK prominence in the financial and insurance industries.
The December 2020 Trade and Cooperation Agreement will entail some increases in services restrictions and we will learn more about their effects. But it is important to recognize that some of those effects were expected and have already affected services trade. Douch and Huw (2021) find that UK commercial service exports to the EU decreased by about 7% soon after the referendum.
In order to identify Brexit uncertainty effects, Ahmad et al. (2020) explore new detailed data on services trade and restrictions. They employ the basic approach used in our research to quarterly UK services exports by industry. Policy risk is measured by the increase in services restrictiveness indices that UK and EU firms are now likely to face post-Brexit. Ahmad et al. (2020) find that Brexit uncertainty impacted trade values and participation negatively. The increased probability of Brexit in 2016Q1-2018Q4 caused by the referendum and triggering of article 50 reduced services exports by at least 20 log points.
In 2021, the UK and EU agreed to a new trading framework, which will help reduce the considerable uncertainty created since the May 2015 election and the subsequent Brexit process. The trade costs of that uncertainty have lasted for at least 5 years but will likely continue until firms have learned and adapted to the new rules. More importantly, the process has shown that even those agreements thought to be most secure are subject to renegotiation and revocation and this threatens trade integration beyond the UK and its trade partners. Future trade negotiations must consider that threats can act as de facto barriers and cause disintegration for extended periods until the agreements’ credibility is restored.
Ahmad, S, N Limão, S Oliver and S Shikher (2020), “Brexit Uncertainty and its (Dis) Service Effects”, NBER Working Paper No 28053.
Bloom, N, S Chen and P Mizen (2018), “Rising Brexit Uncertainty Has Reduced Investment and Employment”, VoxEU.org, 16 November.
Bloom, N, P Bunn, S Chen, P Mizen, P Smietanka and G Thwaites (2019), “The Impact of Brexit on UK Firms”, VoxEU.org, 04 September.
Carballo, J, K Handley and N Limão (2018), "Trade Cold Wars and the Value of Agreements during Crises", VoxEU.org, 16 March.
Crowley, M, O Exton and L Han (2019), “The Impact of Brexit Uncertainty on UK exports”, VoxEU.org, 21 January.
Douch, M, T W Edwards (2021), “The Brexit Policy Shock: Were UK Services Exports Affected, and When?”, Journal of Economic Behavior & Organization 182: 248-263.
Graziano, A G, K Handley and N Limão (2020), "Brexit Uncertainty: Trade Externalities beyond Europe", AEA Papers and Proceedings 110: 552–56.
Graziano, A G, K Handley and N Limão (forthcoming), “Brexit Uncertainty and Trade Disintegration” The Economic Journal.
Handley, K (2014), “Exporting under Trade Policy Uncertainty: Theory and Evidence”, Journal of International Economics 94(1): 50–66.
Handley, K, N Limão (2015), “Trade and Investment under Policy Uncertainty: Theory and Firm Evidence”, American Economic Journal: Economic Policy 7(4): 189-222.
1 See for example “EU firms refuse UK deliveries over Brexit tax changes”.
2 There is also evidence that tariff bindings negotiated in the World Trade Organization lower trade policy uncertainty and increase trade (Handley 2014) and that PTAs can insure partners against trade wars (Carballo et al. 2018).