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Dec 18, 2020 | Foreign Exchange

The services trade opportunity hidden behind Brexit

Deal or no deal on Brexit, long-term changes to the economy, trade, and exchange rates beckon. However, rather than focus on the December 31 deadline, this article aims to shed light on an increasingly likely opportunity that could emerge in a post-Brexit world where Britain’s dominant services sector could help lead a global services trade revolution between now and 2025. Before we examine this future though, let’s start with the current economic climate.

George Vessey, FX & Macro Strategist, Western Union Business Solutions

An uncertain road ahead

The combined impacts of Covid-19 and Brexit make the UK’s economic outlook exceptionally uncertain and this poses considerable challenges to businesses. In its December economic outlook, the OECD1 reported the UK could suffer more than any other leading economy as a result of the pandemic. Firstly, the anticipated loss in total output is estimated to be 11.2% in 2020 and secondly, the unemployment rate is projected to average 7.4% towards the end of 2021 versus the 3.9% average in 2019. Oxford Economics paint a similar picture but forecast the economy to have recovered to pre-pandemic levels by 2022. Regarding Brexit, the Office for Budget Responsibility (OBR)2 recently said that leaving the EU would cost Britain 4% of lost output (GDP) in the long run. What’s really important to note here is that these forecasts assume a smooth transition to a UK-EU Free Trade Agreement (FTA).

Different consequences for different industries

At 11pm (GMT) on December 31, the Brexit transition period expires, and the EU’s Common External Tariff will be replaced by the UK Global Tariff. Inevitably, there will be disruption – the UK economy’s productive capacity may be undermined, and the vulnerability of industries varies significantly depending on the share of trade with the EU and the level of barriers resulting from alternative post-Brexit outcomes. For example, a report3 on the future of UK trade suggests the healthcare sector would be worse off than automotive in a FTA because of relatively high non-tariff barriers in the pharmaceutical industry. Contrariwise, a no-deal scenario would hit the automotive sector harder amidst mass disruption to operations, longer lead times and higher costs.

Regardless of whether a new trade deal is agreed, the UK-EU trading relationship looks set to loosen considerably over the long term, with both risks and new opportunities on the horizon.

Fast-tracking the decoupling trend

Even before the Brexit referendum in 2016, the UK’s concentration in trade had been diversifying away from the EU since the 1990s. Back then, over 60% of UK goods exports went to the EU, but this has fallen to around 46%4. In a FTA scenario, the above UK-EU trade ratio could fall to 42% according to Oxford Economics’ analysis using the GTAP forecasting model5.

In the case of a no deal, the share of UK trade with the EU could even slide back to levels not seen since the 1960s, which brings into debate the nearshoring of supply chains – the idea of outsourcing processes overseas but to less distant regions. The Covid-19 crisis has exposed the unexpected adverse effects of globalisation on trade and the fragility of offshoring supply chains – outsourcing processes to the world’s further corners. Supply chain nearshoring by UK firms to help counter Covid-19 risks could have actually resulted in much closer UK-EU trade relations, reversing the multi-decade decoupling trend that is expected to accelerate now because of Brexit.

A foregone conclusion of Brexit is this long-term UK-EU trade decoupling, but the UK is also party to over 40 FTAs, equating to 11% of total UK trade, with non-EU countries like Japan and Singapore by virtue of its EU membership. Replicating these trade deals and forging new ones with some of the world’s fastest growing and populous economies is a huge task but also provides a great opportunity. In 2019, the UK had a trade deficit of -£79 billion with the EU but a surplus of £49 billion with non-EU countries. In addition, although often overlooked, the UK has recorded a trade surplus in services with the EU in every year since 2005. Is trade in services where the opportunity to thrive really exists?

Playing to your strengths

It is the dominance of services industries that could reshape the global economy and drive recovery prospects for the UK outside the EU. It is the largest part of the UK economy, forming approximately 80%6 of its gross domestic product , which reflects why the UK is generally viewed as a world leader in many service activities such as financial and business services. The complexity of international trade in services makes it harder to visualise compared to that of trade in goods because services can be traded in various ways. Furthermore, unlike goods trade, services are not restricted by tariff barriers and border checks. Instead, they are hampered by behind-the-border requirements and regulations, which can make selling services in another country complicated.

The substantial role of services exports in the UK economy tells us that access conditions to international markets will be crucial in the future. In our recent report – The Global Services Revolution – we forecast that world trade in services could potentially increase $1.9trn by 2025, powered by an estimated $900bn worldwide investment in 5G networks and ongoing technological innovations. You only need to look at initiatives like the Trade in Services Agreement (TiSA) to see the future growth potential if the UK can manage to liberalise its global trade in services.

One of the top services exported by the UK is financial services, which makes up nearly 20% of total services exported. However, over 7,500 jobs in financial services have already relocated to Europe since the referendum in 20167 and this highlights the challenges faced by ongoing uncertainty about future relations and regulations. Services trade could certainly steer the economic recovery not just in the UK, but globally, given how the pandemic has accelerated digitalisation of working practises and the adoption of new technologies.

The trade in services opportunity

The growth of international trade in services has increased by around 50% over the past decade, double the pace of growth in goods trade. Services is also estimated to currently account for over half of all global trade flows8. While the EU’s single market is the most integrated area for trade in services in the world, there are hotspots outside the EU which offer huge potential based on their technological capacity, such as Japan or Korea. Opportunities like this for the UK could multiply outside the constraints of EU regulation. Although greater divergence from the EU will lead to higher barriers to trade and be costlier to UK companies exporting to the EU and vice versa, the UK could capitalise on the growth of services trade elsewhere, particularly if new digital technologies and the liberalisation of trade policies increase the scope of what is possible to trade internationally.

Despite the bleak economic forecasts by the OECD I mentioned earlier in this article, the organisation also states that productivity growth in service sectors will play a vital role in a sustainable economic recovery. Prioritising investment in this area and embracing digital services should meet emerging global demands, foster innovation, and boost long-term growth prospects. The UK certainty has the capability to benefit from this shift, as evidenced by its ranking in the top 15 countries in Harvard’s global economic complexity index - ranked #139.

How can companies respond?

Brexit could herald profound structural changes for the UK economy, and although some may argue the timing could not be worse, others may argue it could not be better. Significant challenges await, but so do significant opportunities for businesses, particularly in the wake of a rapidly evolving and digitalised global economy, fast-tracked by the pandemic.

Businesses are looking to shockproof operations and manage supply chain disruptions by diversifying their supplier base but are also reassessing and adapting to the swift digitalisation of the economy, such as the shift from high street retail to e-commerce. Deal or no-deal Brexit, “it’s not the end of something but the beginning of a new relationship between the UK and EU” (Ursula von der Leyen – European Commission President, 2020) and it could be the beginning of the next generation of services trade globally.

Looking ahead, we understand there are many unknowns about the post-Brexit world, including how the value of sterling could be impacted, as well as other global factors to consider. For example, will Covid-19 vaccination programmes be successfully rolled out before another potential wave of infections? Will emergency stimulus measures continue to support economies worldwide?

If your company requires support with Brexit and Covid-19 response planning, then don’t hesitate to contact our solutions experts to see how we help up to 60,000 individuals and business clients worldwide, across different sectors, with solutions to currency volatility, international payments and trade.

1The Organisation for Economic Co-operation and Development: http://www.oecd.org/economic-outlook/december-2020/
2Office for Budget Responsibility: https://obr.uk/
8The Global Services Revolution Report – Oxford Economics & Western Union Business Solutions, June 2020