UK trade opportunities revealed by the gravity model
The Russian anomaly
The Gravity Model of Trade (http://www.nber.org/papers/w19285) is one of the more robust models in economics. It is based on the observation that levels of trade between countries depend on the size of the economies and the inverse square of the distance between them just like Newton’s law for gravity between two planets. For example, in 2016 on MIT OEC figures, the UK exported $ 21.1 Bn of goods to Ireland and $ 25,5 Bn to the Netherlands but only $6.24 Bn to Canada, a much larger economy than either. Double the distance between a pair of countries and trade falls to a quarter of previous values.
The G20 is a grouping of countries that represents 85% of World GDP. Additionally, Iran and the UAE are outside this group but have larger economies than some members. This table presents the pull of gravity for all the G20 economies with a commercial capital within 5,000 miles of London. Although more than 5,000 miles away, Indonesia and China have been added as much effort is being expended there in hopes of post Brexit explosions of trade.
Intellectual property such as design rights to ARM chips or Liquid Crystal Displays may seem free of distance but even in such a case time zone differences and the trouble and expense of intercontinental flights can be a factor in encumbering sales effort. Yet even services are usually a face to face business. Differences in time zones and long travel times erode the opportunity to deliver services from a remote base. Tokyo, Hong Kong, Singapore, Dubai and New York compete with London financial services at least partly due to time zones and distance to travel to meet clients.
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So where beyond the borders of the Rest of the EU is the biggest gravitational pull for exports of British goods and services? While the table shows the numbers, perhaps a graphical representation is easier to follow. The EU has been removed from the chart as it is so large it overwhelms the other markets. (Incidentally, the UK greatly underperforms in exports to the EU according to the gravity model).
The trend line strongly confirms the Gravity Model of Trade, as expected. There is more trade with countries with a higher index. There is an obvious anomaly, Russia. The UK is exporting FAR less than it should to Russia. The factor is about 5 times. Growth rates fluctuate. Focus on short term growth rates for export opportunities has made Russia disappear from export discussion since 2014. However, the gravity model endures over trade cycles. Russia is a huge neglected opportunity. China by comparison is already over performing. Further improvement may be increasingly difficult.
Is the UK underperformance due to post Crimea and Donbass sanctions? There were EU sanctions against individual members of the Russian elite and Russian counter sanctions against EU food suppliers. It is not.
Germany, also in the EU, outsells Britain by a factor of 5.5 times in goods selling a similar mix of products to that of the UK. France outsells the UK by a factor of 2.4 and Italy by 2.2. France did sell more but lost significantly due to Russian counter sanctions in food and the © Volga Trader 2018 Write to [email protected] for permission to republish
failure to sell an aircraft carrier. UK, Germany and Italy were much less affected by these issues. According to the gravity model, all three countries underperformed but not as dramatically as the UK. In services, for which comparable datasets do not exist, a relatively better performance in exporting financial and legal services from London does not excuse this underperformance in manufactures. Britain outside the Home Counties deserves some support and attention.
The failure to match our European partners in Russia is a failure of political economy and perhaps a lack of ambition by British manufacturers confining themselves to easy wins in the EU and USA. Volg Trader’s direct experience with UK firms suggest a reluctance to invest a penny in setting up a sales operation other than seeking to find an importer/distributor already engaged in the same trade and so selling a competitor’s products. Engagement with Russia is almost entirely driven by Sales Managers whose horizon is limited to meeting a single years sales target. Unlike the EU, Russia is a real foreign country and there are regulations and customers procedures to fulfill. These take time and money. The greater strength of Chambers of Commerce on the continent may be a factor. Russia has a strong matching Chamber of Commerce system. The UK may have particularly bad language skills. Few Russian business people speak English well. There is clearly a need for government to look at the causes for this huge underperformance with respect to Russia. It is beyond the policy of some particular firm.
As the inclusion of China and Indonesia in the analysis shows, post Brexit trade policy that concentrates on the far side of the world is unlikely to deliver comparable results. China is already ahead of its natural position. The gravity model is strongly predictive. Russia is particularly open to a seperate trade deal. In essence, Russia trades with the EU on WTO terms. The UK has an attractive food market that could be used to influence concessions by Russia in areas of British interest. Russia, a recent member of the WTO, is slowly reducing tariffs on goods to WTO levels but many are still relatively high. The reward to the UK could be $15 Bn extra exports and comparable increased trade in imports. The post Brexit survival of the Ford Bridgend Engine plant is an example of the potential for export to Russia with duty free access. Ford has a substantial operation in Russia.
This discussion has focussed on the potential for British exports. Imports matter too. They are not a matter of charity. Russia is the world’s largest exporter of wheat, barley and sunflower oil products. Post Brexit tariff reductions, given the modest distances involved, Russian grains are likely to be very competitive in the UK market. Also. Russia is already an exporter of chicken (not chemically washed) and becoming one in pork. Russia may yet deliver the food price reductions sought by hard Brexiteers without the regulatory compromises involved with the US (Russian regulations, in principle, match or exceed those of the EU, for example with GMO’s or chemically washed chicken).
The author of this piece was Philip Owen, a consultant with Volga Trader a firm advising on export to and investment in Russia. Philip Owen is the Welsh representative on the Westminster Russia Forum committee.
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