26 January 2021

Vox: Brexit uncertainty and trade disintegration in Europe and beyond

Following the Brexit referendum five years ago, firms in the UK and also those in the EU and other countries operated in an environment with increased uncertainty over future trade policies. This column presents evidence of the detrimental effects of this uncertainty on trade in the UK before any changes to trade policy had taken place.

 Studying the period after the Conservative Party won the general election in May 2015 until just after the Brexit referendum in June 2016, it finds that an increasing probability of Brexit significantly reduced UK export values and product entry, while increasing product exit.

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....

Full paper Vox

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