Brexit and Gravity: Trade Implications

United Kingdom and the WTO

The UK has been a member of the WTO since 1995 and was a member of GATT since 1948.
Prior to Brexit, the UK's Most Favored Nation (MFN) tariffs were the same as the EU's due to the common external tariffs applied by all EU members.
Post-Brexit, the UK can independently determine its MFN tariff rates.
Within the EU, there was free movement of goods.
Outside the EU (2018):
- Average MFN tariff: $5.2\%$
- Average MFN tariff for agricultural products: $12\%$
- Average MFN tariff for non-agricultural products: $4.2\%$
High tariffs on some products:
- Dairy products: $43.7\%$
- Sugars and confectionery: $27.\%$
- Beverages & tobacco: $19.8\%$
- Animal products: $17.9\%$
In 2019, the UK's total trade was $63.5\%$ of its GDP, with exports accounting for $31.1\%$ of GDP.
Top 10 UK trading partners (2018):
1. United States ( $15\%$ of total trade)
2. Germany (10.1\%$)
3. Netherlands (7.1\%$)
4. France (6.4\%$)
5. China (5.1\%$)
6. Ireland (4.7\%$)
7. Spain (3.8\%$)
8. Belgium (3.6\%$)
9. Italy (3.5\%$)
10. Switzerland (2.6\%$)
Top 10 UK Non-EU trading partners (2018):
1. United States (15\% of total trade)
2. China (5.1\%$)
3. Switzerland (2.6\%$)
4. Japan (2.2\%$)
5. Norway (2.2\%$)
6. India (1.6\%$)
7. Hong Kong (1.6\%$)
8. Canada (1.5\%$)
9. United Arab Emirates (1.3\%$)
10. Turkey (1.3\%$)
The UK trades significantly with both EU and non-EU countries, making it crucial to maintain trade relations with both.
The UK is negotiating trade agreements with various trading partners. If no trade agreement is in place with a WTO member by December 31, 2020, trade will occur under WTO rules.
WTO rules mandate Most Favored Nation (MFN) treatment, ensuring the same trading terms are applied to all WTO members without discrimination. If the UK lacks trade agreements with China and Malaysia, it cannot apply different tariff rates to the same good from these countries.

Gravity Model of International Trade

The gravity model is a primary tool in applied international trade literature.
It's used to estimate the trade impacts of various trade-related policies.
Originating from Tinbergen (1962), the gravity model has been extensively studied, with numerous publications across different regions, time periods, and sectors.
The model links trade flows to economic size and inversely to trade costs, with geographical distance often used to represent transport costs.
Basic form of the gravity model: $logX{ij} = c + b1logGDPi + b2logGDPj + b3log\tau{ij} + e{ij}$ $log\tau{ij} = log(distance{ij})$ Where:
- $X_{ij}$ is exports from country i to country j
- GDP is each country’s gross domestic product
- $\tau_{ij}$ is trade costs between country i and j
- $distance_{ij}$ is the geographical distance between country i and j
- $e_{ij}$ is a random error term
- c is a regression constant
The term "gravity" is derived from its resemblance to Newton’s law of gravity in physics: $F1 = F2 = G \frac{m1 \times m2}{r^2}$
The model suggests larger country pairs trade more, while countries farther apart trade less due to higher transport costs.
Dataset on bilateral trade in services compiled by Francois et al (2009) supports the gravity intuition.

Can Brexit Defy Gravity?

Considering Estrin, Cote, and Shapiro (2018), how will the UK's future trade pattern evolve post-Brexit?
Will the UK trade more with the EU or non-EU countries?
A rationale for the UK's withdrawal from the EU is that deep trade integration within the EU restricts the UK's ability to trade with other regions like Asia and the Americas.
Europe's growth rate (1.6\%$%) is lower compared to regions like South Asia (7\%$%) and Sub-Saharan Africa (5.4\%$%).
The argument suggests the UK should reorient its trade and FDI towards faster-growing regions instead of being tied to the EU.
Estrin et al. argue that the main economic relations (trade, FDI, migration) are driven by:
- Size (GDP) of the exporting economy (positive, linear relationship)
- Size (GDP) of the importing economy (positive, linear relationship)
- Distance between them (negative, non-linear, exponential relationship)
These factors' impact on trade is studied in the gravity model literature.
Ignoring distance, an economy 5 times larger than another is expected to have approximately 5 times larger imports and exports.
UK's trade with China might be expected to be slightly less than 5 times larger than trade with France, disregarding distance.
However, distance significantly impacts trade. Trade decreases at an accelerating rate as distance increases.
London to Paris is approximately 300 miles, while London to Beijing is approximately 5000 miles. The gravity model implies the distance effect will reduce trade between the UK and China relative to the UK and France by a factor of 16.62 = 277 times.
The negative impact of distance can outweigh the positive impact of trading with larger or faster-growing economies.
With the internet and global value chains, does distance matter less now than before?
According to UNCTAD (2013), 60\%$$ of world trade is in intermediate goods, largely within multinational enterprises' value chains.
Trade in goods and FDI are closely linked, with economic activity distributed by function.
Value chains rely on cost factors beyond transport costs, such as labor costs.
Historically, distance effects due to transport costs have been decreasing, potentially reducing constraints on trade and FDI.
Perhaps gravity is becoming less important.
UK-Canada trade (1995-2016) exemplifies the implication of gravity: both countries are large, but geographically distant. London to Ottawa is 10 times farther than London to Paris.
Canada's main trading partner is the US.
Despite historical and cultural ties, UK trade with Canada has remained at a lower level.
Conclusion by Estrin et al.: While the long-term outlook for post-Brexit UK may not be bleak, the effects of distance remain important in the near term.
Even after Brexit, the EU, as the UK's neighbor, will remain a significant trading partner, and trading with distant partners will still incur costs due to distance.