Appendix to Brexit and the UK’s Services Trade

The baseline forecast for the UK in NiGEM is based on the following assumptions:

• Exports: In the baseline central case the UK maintains a close but not complete trading relationship with the EU. The fact that this is a less comprehensive relationship than currently is formally reflected by negative residuals in the export and import volume equations.
• Business Investment: The reduction in trade and increase in uncertainty will likely reduce investment by UK-based firms as well as (inward) foreign direct investment. In our central baseline forecast, we expect business investment to grow by 2–3 per cent on average over the next five years.
• Migration: The baseline forecast is based on the updated population projections by the Office of National Statistics (ONS).
• Productivity: The smaller degree of competition due to lower trade volumes, less investment and a reduction in skilled migration would almost certainly drive productivity lower. However, in the baseline there is no explicit Brexit-related productivity shock.
• Fiscal: According to the UK government, applying the methodology set out in the Phase 1 agreement implies a financial settlement with the EU of £35-£39 billion. The schedule of payments is yet to be decided although the Phase 1 agreement makes clear that the UK will not be required to make any payments earlier than if the UK had remained a member state. We have, as a result, adopted the latest Office for Budget Responsibility (OBR) fiscal projections for EU contributions in our central case and assumed that the UK continues to make contributions beyond 2022 as if it were a member of the EU.

The baseline assumptions outlined above are contrasted with the following three alternative scenarios:
 

‘WTO’

• Goods trade: 53 per cent reduction (Baier et al., 2008)
• Services trade: 65 per cent reduction (Baier et al., 2008 and Ebell, 2016 suggest almost identical impact reduction of 65 per cent or of 62 per cent, respectively; we run the more pessimistic assumption, i.e.: reduction of 65 per cent)
• Foreign direct investment (FDI): 24 per cent reduction in FDI inflows (Ramasamy and Yeung, 2010 and Dhingra et al., 2017; see also NIER August 2018);
  We split the overall impact on GDP of the effect attributable to services and goods by using the shares of the UK inward FDI destined to services and goods sectors in 2016 (ONS; 64% and 34%, respectively)
• Productivity:  We calibrate the long-term trade-related effect of Brexit on productivity based on Behrens and Mion, 2017 who separately estimate the impact of Brexit on productivity, looking separately at the goods and services trade flows. We use their estimate of 1.4 per cent reduction in productivity due to reduced services trade and 0.16 per cent reduction due to goods trade. The services-related effect is of a greater order of magnitude because of the greater sensitivity of services trade due to non-tariff measures brought about by Brexit.
• Migration: Migration effects are generally difficult to assess, and it is even more difficult to disentangle trade as opposed to the non-trade related impact of Brexit on migration. We base our overall migration shock on the ONS low migration scenario (reduction in net migration of 100,000 annually). We assume this is Brexit-related realisation and we attempt to extract the trade-related component of this shock, and we further split it into parts related to services and goods. We do so by attributing the trade-related part of this shock to the services sector by the share of the services sector that relies on the exports to the EU:
  0.788 (share of services in the UK economy) * 0.1339 (GDP contribution of services exports) * 0.37 (share of services exports destined to the EU) = 0.04
  Analogously, we attribute the trade-related part of migration shock to goods:
  0.212 (share of goods in the UK economy)* 0.1681 (GDP contribution of goods exports) * 0.48 (share of goods exported destined to the EU) = 0.02
• Fiscal contributions: We assume that the UK honours its commitment to the current EU budget in line with the Phase 1 agreement. After the budgetary framework ends in 2020, we assume that annual net contributions to the EU do not fall to zero but reduce by one half as outstanding liabilities will need to be paid and the UK may decide to continue being part of initiatives such as Horizon 2020, for which contributions will have to be paid (see NIESR February 2018)

‘Chequers’

• Goods trade: 32 per cent reduction (Baier et al., 2008)
• Services trade (max): 62 per cent reduction (Ebell, 2016)
• FDI: 12 per cent reduction in FDI inflows (Ramasamy and Yeung, 2010 and Dhingra et al., 2017; see also NIER August 2018)
  We split the overall impact on GDP of the effect attributable to services and goods by using the shares of the UK inward FDI destined to services and goods sectors in 2016 (ONS; 64% and 34%, respectively)
• Productivity:  We calibrate the long-term trade-related effect of Brexit on productivity based on Behrens and Mion, 2017 who separately estimate the effect of goods and services trade on productivity. For this scenario we apply only the 1.4 per cent reduction in productivity due to reduced services trade (as the scenario assumes an ‘almost free trade area in goods trade’).
• Migration: Migration effects modelled similarly to the WTO scenario explained above. For this scenario we extract only the service-related part of the shock as the ‘Chequers’ scenario assumes an ‘almost free trade area in goods trade’.
• Fiscal contributions: See detailed assumptions on White Paper Fiscal Contributions modelling by NIESR.1https://www.niesr.ac.uk/blog/how-much-would-%E2%80%98white-paper-brexit%E2%80%99-cost-uk-economy

‘Norway’

• Goods trade: 32 per cent reduction (Baier et al., 2008)
• Services trade: 24 per cent reduction (Baier et al., 2008)
• Productivity:  Not affected
• FDI, fiscal contributions and migration: It is expected that under the Norway scenario the UK will have to accept freedom of labour and contribute to the budget. We assume there will be no harm to incentives to invest in the UK (no FDI change).

Baier, S., Bergstrand, J., Egger, P. and McLaughlin, P. (2008), ‘Do economic integration agreements actually work? Issues in understanding the causes and consequences of the growth in regionalism’, The World Economy, 31(4), pp. 461–97.

Ceglowski, J. (2006), ‘Does gravity matter in a service economy? Review of World Economics, 142(2), pp. 307–29.

Dhingra, S., Ottaviano, G., Rappoport, V., Sampson,T. and Thomas, C. (2017), UK trade and FDI: A post-Brexit perspective, Papers in Regional Science, 97(1).

National Institute of Economic and Social Research (2018) "The UK Economy: Forecast Summary," National Institute Economic Review, National Institute of Economic and Social Research, vol 243(1), February.

National Institute of Economic and Social Research (2018), "The UK Economy: Forecast Summary," National Institute Economic Review, National Institute of Economic and Social Research, vol. 245(1), August.

Ramasamy, B. and Yeung, M. (2010), ‘The determinants of foreign direct investment in services’, The World Economy, pp. 573-596.

Behrens, K. and Mion, G. (2017), ‘Estimating the costs and gains of TTIP and BREXIT for EU countries’, PRONTO Research Network working papers, https://prontonetwork.org/.