Archive for the ‘Economics of Brexit’ Category

The effect on foreign multinationals: an under-explored aspect of Brexit

maria latorreWhile most of the studies on Brexit have focused on its trade effects, very few have analysed the likely impact on foreign multinationals. Claudia Fernández-Pacheco Theurer (Universidad Autonoma de Madrid), Jose Luis López Ruiz and María C. Latorre (Universidad Complutense de Madrid, left) argue that this is an important omission. They show how data on trade and foreign multinationals affiliates’ sales underlines the different relationship between the UK and EU-27 on both fronts. They go on to explain the EU trade and investment regulatory regimes and analyse a few studies of Brexit, including its effect on multinationals.

Data on trade and foreign multinationals’ affiliates

Trade relationships between the UK and the EU-27 are much stronger than the ties created by their foreign affiliates’ sales. The EU-27 accounts for 53.1% and 44.5% of total UK’s imports and exports, respectively, in 2017. By contrast, the EU-27 accounts for 36.6% of total foreign affiliate sales in the UK (12.8% of total sales within the UK), while the UK’s foreign affiliate sales in the EU-27 account for 25% of total UK’s foreign affiliate sales abroad in 2015. This has been a common trend in the last years (Figures 1 and 2).

Figure 1. UK’s exports to the EU-27 over total UK’s exports and UK’s foreign affiliate sales in the EU-27 over total UK’s foreign affiliate abroad (in percentages)

Source: Updated from Fernández-Pacheco et al. (2018) © Emerald

Figure 1 shows that the EU-27 has lost importance as an investment destination for the UK, although the shares (around 25%) in 2014 and 2015 are still considerable. By contrast, the EU-27 is crucial for the UK’s exports, which are always well beyond 40%. Note that the UK’s foreign affiliate sales and the UK’s exports represent two different forms of provision of UK products in foreign markets.

Figure 2. UK’s imports from the EU-27 over total UK’s imports and EU-27’s foreign affiliate sales in UK over total foreign affiliate sales in the UK (in percentages)

Source: Updated from Fernández-Pacheco et al. (2018) © Emerald

In Figure 2 we see the share in the UK’s imports from the EU-27 has been much larger than the share of EU-27’s foreign affiliate sales in total foreign affiliates operating in the UK since 2008. However, it is important to note that the operations of foreign affiliates in the UK are of great relevance.

Figure 3 makes clear that the share of total (EU-27 and non-EU-27) foreign affiliates in UK stands out with 37.4%, compared to other large economies, such as Germany (22.7 per cent), Spain (27.2%), France (20.4%) or Italy (18.1%) and also compared to the average of the EU-28 (28.6%) in 2014.

Fernández-Pacheco et al. (2018) show the shares of the top 15 UK trade and investment partners, of which the US is the main one in investment, apart from a key trade partner. The US is the first destination of the UK’s exports (18.2% in 2014) and second main importing source (with 11.9% of total UK imports following Germany, which accounts for 13.5% of them, in 2014). The US accounts for 30.3% of total UK foreign affiliates abroad and 26.5% of total foreign affiliates within the UK (in 2014).

Figure 3. Shares of national firms and foreign affiliates in total sales by EU country (%)

Source: Fernández-Pacheco et al. (2018) © Emerald

The EU foreign trade and investment legislative regime

While foreign trade policies have, since the Treaty of Rome (1957), been the exclusive competence of the European Commission, investment policies with third countries have been completely in the hands of EU sovereign states. However, after the entry into force of the 2009 Lisbon Treaty, foreign investment policies will also be transferred to the European Commission. The implementation of this new regime will take some time and its exact scope and content still remains a controversial issue (Fernández-Pacheco et al., 2018). But it seems that the UK will be able to continue its investment policies as it wishes, contrary to the situation in other EU member states. Nevertheless, the UK’s leveraging power will be reduced outside the EU.

In the past, EU members regulated their investment with third countries through the so called Bilateral Investment Treaties (BITs). The UK has signed over 1000 BITs since 1975. What is going to happen to them after Brexit? In principle, they will remain valid (Molinonuevo, 2017). As the UK negotiated and signed them in its own capacity and independently of the EU, Britain’s separation from the EU should not necessarily have any direct legal effect on these treaties. However, Brexit will mean that the UK-based firms, including foreign-owned firms, will no longer benefit from the UK’s access to the EU single market, which has the tiniest possible barriers between different countries to exist globally. Thus, third countries may seek some form of compensation. What is more, amendments to BITs would be possible even if those treaties do not expressly address this possibility by invoking the rebus sic stantibus doctrine of international law, which allows for a termination of an international agreement because of a fundamental change of circumstances (Molinonuevo, 2017).

Brexit studies including multinationals

In Fernández-Pacheco et al. (2018) we explain in depth why modelling foreign investment is challenging, and  the problems with the data. Given these difficulties, we should be prudent regarding the effects on multinationals after Brexit. However, a few studies suggest it is hard to overcome the negative impact of trade with multinationals’ operations. Latorre et al. (2018a) calculate the emergence of barriers to foreign affiliate sales in services sectors would account for one third of the overall negative impact of Brexit, with the remaining negative two thirds being explained by trade. To be more specific, in Latorre et al. (2018a) a hard (soft) Brexit would lead to a total decrease in UK’s GDP of -2.53% (-1.23%), while the foreign affiliates’ component alone would cause a reduction of -0.83% (-0.41%). By contrast, Ciuriak et al., (2015, Table 2, p. 14) obtain a negligible impact from multinationals effects after Brexit, although Brexit will continue to be quite harmful for the UK. According to Latorre et al. (2018b) a UK-US deep trade and FDI agreement would be far from compensating the harmful effects of Brexit. They further explore potential agreements with China, Japan and India and find their effects to be positive but very small. Latorre et al. (2018c) have also explored in more detail the potential expansion of UK investments in China and find its impact will be very limited. Finally, Latorre et al. (2018d) explore in more detail the impact of foreign multinationals operating in services sectors in UK after Brexit. They find that the barriers to investment rise the price of services and also reduce production not only in services but also in manufacturing. This latter effect may be surprising – since the barriers to investment affect only the service sector directly – but nonetheless manufacturing production is also harmed across the board because services provide important intermediates for manufacturing sectors.

Conclusions

For the UK, the EU is a much less important partner for investment than it is for trade. The implementation of the 2009 Lisbon Treaty implies that in the future the UK will be able to continue with its own investment policies after Brexit, contrary to other EU member states that will share a common investment regime similar to the EU’s common commercial policy. However, UK’s negotiation leverage will be reduced compared to when it was as a member of the EU. Although modelling economy-wide impact of multinationals’ affiliates and investment is challenging and there are difficulties with the data, a few studies suggest that their effect will not be able to compensate for the sizeable negative impact of trade after Brexit – and will even exacerbate its harmful impact.

References

Ciuriak, D., Xiao, J., Ciuriak, N., Dadkhah, A., Lysenko, D. and Narayanan G. B. (2015) “The trade-related impact of a UK exit from the EU single market”, Ciuriak Consulting, April.

Fernández-Pacheco, C., Lopez, J.L. and Latorre, M.C. (2018) “Multinationals’ effects: A nearly unexplored aspect of Brexit”, Journal of International Trade Law and Policy, vol. 17, issue: 1/2, pp.2-18.

Latorre, M.C. Olekseyuk, Z. and Yonezawa, H. (2018a) “Trade and FDI-related impacts of Brexit”, ssrn working paper, April 25.

Latorre, M.C. Olekseyuk, Z. and Yonezawa, H. (2018b) “Can Brexit be overturned by other Trade and FDI agreements?”, Paper presented at the 21th Annual Conference on Global Economic Analysis, Cartagena de Indias, Colombia, June 13-15.

Latorre, M.C., Yonezawa, H. and Zhou, J. (2018c) “A general equilibrium analysis of FDI growth in Chinese services’ sectors”, China Economic Review, vol. 47, pp. 172-188.

Latorre, M.C. Olekseyuk, Z. and Yonezawa, H. (2018d) “On the nature of foreign multinationals in services sectors: A general equilibrium analysis applied to the impact of Brexit”, mimeo, available upon request.

Molinonuevo, M. (2017) “Brexit: Trade governance and legal implications for third countries”, Policy Research Working Paper No. 8010, Trade and Competitiveness Global Practice Group,
March.

This post represents the views of the authors and not those of the Brexit blog, nor the LSE. It relies heavily on Fernández-Pacheco et al. (2018).

Claudia Fernández-Pacheco Theurer is a researcher at Universidad Autonoma de Madrid.

Jose Luis López Ruiz is a researcher at Universidad Complutense de Madrid.

María C. Latorre is Assistant Professor at Universidad Complutense de Madrid (UCM) and Vice Dean for Research, Postgraduate Studies and International Affairs of the Faculty of Statistical Studies, UCM.

Long read: Global cities, multinationals, and trade in the age of Brexit

Expert Image

This post is the third in a series analysing the prospects for trade and foreign direct investment (FDI) diversification, with a particular focus on the UK and Canada in the age of Brexit. Daniel Shapiro, Saul EstrinChristine Cote, Klaus Meyer, and Jing Li examine the nature of trade in services using ideas developed in the international business and economic geography literature to explore the interrelationships among multinational enterprises, global value chains and cities. 

Previous contributions (here and here) focused on trade in goods and services, concluding that distance still matters for trade in goods, but possibly less so for services, and that services, therefore, represent a more promising route to diversification. However, it has also been noted that trade in services is more complicated than trade in goods because the former typically involves movements of knowledge, people and capital. Trade in services is different because it involves a range of cross-border transaction including IT services, transportation services, tourism services, local offices providing banking, insurance, and communications services, and the short-run movement of service workers in these industries. At the same time, advances in digital technologies have served to expand the potential for trade and FDI in strategic business services including design, development and testing; education and training; sales and marketing; and R&D. 

The idea that developed economies like the UK and Canada should pursue diversification via trade in services is not new. For example, in a recent report, HSBC and Oxford Economics (HSBC, 2016) documented the potential for expanded trade in services. Nevertheless, as we discussed in a previous post, there are still doubts regarding the degree to which this is possible. In this post, we examine the nature of trade in services through a different lens. Using ideas developed in the international business and economic geography literatures, we explore the interrelationships among multinational enterprises (MNEs), global value chains (GVCs) and cities. We discuss in particular how global cities and MNEs are connected through changes in GVCs such that high value-added knowledge-based services and activities such as R&D, marketing and financial services tend to agglomerate in a relatively small number of global cities, and these cities, in turn, become both homes and hosts to MNEs. We focus on MNEs because it is well-known that the majority of global trade is orchestrated by MNEs, often through internal transfers of knowledge and services (Iammarino and McCann, 2013), and we focus on global cities because as we document below much of the international trade and investment in services originates in these cities. In essence, global cities help MNEs offset the costs of distance, particularly in knowledge-intensive activities, by providing location-specific advantages that match the firm-specific needs of MNEs.

Our analysis centres on MNEs and global cities. However, we emphasize that many of the factors that make a city attractive to MNEs, also contribute to an entrepreneurial culture that facilitates the growth of smaller domestic knowledge-based companies. These entrepreneurial companies also extensively engage in cross-border activities, a process hastened by the diffusion of digital technologies (Autio et al, 2018).

Image by kloniwotski(CC BY-SA 2.0).

Global Cities and Services

Both world population and economic activity are increasingly concentrated in major cities and these cities represent important trade hubs (Berube and Parilla, 2012). However, the importance of cities relative to the size of national economies varies across countries. As indicated in Figure 1, London accounts for some 28% of UK GDP, while Toronto and Montreal together account for about the same percentage of Canadian GDP. In both countries, there a number of other cities that account for important percentages of population and GDP (see Figure 2) but a large percentage of GDP is concentrated in a relatively small number of cities.

Perhaps not surprisingly, the largest cities attract significant amounts of FDI, most of it in services. For example, according to fDi Intelligence, a service of the Financial Times that collects data on greenfield FDI, from 2012-2017 London attracted far more foreign investments than any other EU city and the same number as the next three largest (Paris, Dublin, Berlin). The vast majority of these investments (over 80%) were in services, including software and IT services, business services and financial services. Similarly, New York was the primary recipient of projects in the Americas, but Toronto was ranked fourth. Similar to London, Toronto attracted the majority of FDI to Canada (about one-third), and over 70% of those investments were in services. It is also worth noting that Montreal increased its share of Canadian FDI from 6% to 13% over this period, largely because of an increase in investments from France, perhaps the result of the Canada-France Joint Action Plan for 2012-2013.

MNEs are the vehicles through which much of this trade and investment occurs. While it is difficult to isolate services, in its World Investment Report 2013, the United Nations Conference on Trade and Development (UNCTAD 2013) estimated that some 80% of international trade was being organized by lead MNEs investing in cross-border production and, then, trading with suppliers and customers worldwide. Thus trade and FDI are linked (Hoeckman, 2014). The World Bank (2017) suggests that some 30% (60%) of US exports (imports) occur through intra-firm trade. Moreover, a third of the world’s largest corporations are concentrated in only 20 major cities (McKinsey Global Institute, 2013), and this is expected to increase (KPMG, 2015). Our own calculations indicate that as of 2018, nearly half of the Fortune 500 largest companies were located in just 20 cities, including London, UK (14 headquarters, ranked 5th) and Toronto (7, ranked 9th).

Global Cities, Global Companies and Global Value Chains

A feature of the global economy is the unbundling of activities along the global value chain (GVC) such that different activities are performed in different locations and traded internationally (Gereffi and Fernandez-Stark, 2016; Fu, 2018; Timmer et al, 2014). Thus countries, and in the case of services and intangible goods, cities, tend to specialize in some specific segment of the GVC. The nature of the division of activities across countries is often summarized in the “Smile Curve” (Figure 3), which suggests that higher value-added activities associated with R&D, design and business support services tend to be located in developed countries, and as suggested above, in cities. Importantly, these investments are often undertaken by firms that are not in the service industries. One estimate suggests that in 2011, 35% of foreign investment projects by large MNEs (including those not in service industries) were in support services, including marketing and sales, design, and R&D (Belderbos et al, 2016, Figure 3), up from 25% in 2003. These investments include units with coordination functions such as divisional or regional headquarters (HQ), or holding companies – a type of subsidiary historically particularly attracted to London, UK because of its springboard position to European markets.

The link between the location of higher value-added activities and cities occurs because cities can minimize the spatial transaction costs related to trade in knowledge-based services (Cano-Kollmann et al., 2016). For example, large cities provide access to a wide variety of complementary services, larger pools of specialized labour, and a sophisticated transportation and communications infrastructure. Thus, one observes the emergence of interconnected global cities as providers of advanced knowledge-based services for the global economy (Sassen, 1991; 2012; Taylor and Derudder, 2016). Indeed, one prominent approach to measuring global cities (Beaverstock, et al, 1999) builds on Sassen to use data on the presence of advanced producer services (service MNEs in advertising, law, accounting, finance, insurance) as the basis for ranking cities. Another, and more recent version of the ranking is illustrated in Figure 4 (Taylor et al, 2009). This method allows cities to be ranked according to both the presence of service MNEs and the degree to which city pairs share the same set of firms. Global cities are therefore understood as key nodes in global knowledge and trade networks. In the example provided in Figure 4, 100 service providers are measured in 315 cities, which are then ranked and grouped into categories. The most global cities attract the greatest number of advanced service providers and are most connected to other such cities. It should be noted that alternative measures are available, for example AT Kearney’s list of Global Cities which uses an expanded set of criteria to rank cities. However, for our purposes, it is sufficient to note that both rank London and Toronto among the top 20 global cities, and this would be the case for most definitions. However, the definition of a global city varies from study to study, as will the number of ranked cities.

One important consequence of the unbundling of GVCs, is that R&D and other innovative activities associated with MNEs are increasingly dispersed around the world. However, the decisions regarding the location of these activities is frequently city, not country, based. For example, Samsung’s semiconductor business unit has R&D centres in 11 cities around the world. In a comprehensive analysis of the fDi data discussed above, Belderbos et al (2016) conclude that some 40% of inbound global cross-border R&D projects are directed towards 57 global cities (including London, Edinburgh, Toronto, Montreal and Vancouver), and 40% is accounted for by large MNEs. Importantly, the 57 global cities also account for about 40% of outbound R&D projects. Global cities are therefore both primary homes and hosts to knowledge-based investments in R&D and design, as well as other advanced business services. This suggests that cities should not be viewed only as providers of advanced business services, but also as critical elements in the creation and global diffusion of knowledge and that MNEs act as orchestrators and connectors of spatially dispersed knowledge sources (Cano-Kollmann et al. 2016).

Indeed, in the international business literature, the MNE is conceived as a global creator, organizer, and connector of knowledge networks across locations, rather than a simple vehicle for technology transfer between given locations (Beugelsdijk and Mudambi, 2013; Cantwell, 2017). Innovative and knowledge-based activities are therefore understood as a combination of firm- and location-specific advantages. Thus “the two processes of innovation and internationalization have become ever more interconnected as central drivers of development” (Cantwell, 2017: 41). In essence, the increased importance of knowledge-based activities to the MNE and the global sourcing of knowledge accompanying the emergence of global value chains have “linked localized innovation systems to international business and to international knowledge exchange” (Cantwell, 2017: 42). In other words, one function of the MNE is to exchange knowledge across locations.

The “localized innovation” referred suggests a sub-national location, which may be a global city, however defined, or it may be a specialized knowledge cluster within a global city, or it may be a city-region (a region anchored by a global city such as the “golden horseshoe” in the Toronto area). The point is, however, that global cities both attract and create knowledge. As a corollary, recent literature has focused on the role of cities as facilitators of entrepreneurship and new firm creation (Audretsch, Belitski & Desai, 2015; 2018), including those that are “born global” MNEs (Knight & Liesch, 2016).  Many of these are likely to be based on digital platforms or knowledge platforms that result in firms selling services or locating abroad at an early stage (Autio et al, 2018). Thus, global cities both attract MNEs and facilitate their creation.

Thus, we conclude that global cities reduce spatial transaction costs, which reduces the costs of distance, and favours them as locations for advanced knowledge-based services, including innovative activity. In consequence, knowledge-based services tend to be concentrated in global cities, and to some degree define them. Together they form networks of cities among which these services are traded. At the same time, global cities both attract firms that trade and invest in services, but also create the conditions for the emergence of new global firms. Many of these are likely to be based on digital platforms that result in firms selling services abroad at an early stage (Autio et al, 2018).

Global Cities and International Business: Recent Empirical Evidence

Although the importance of cities has been studied by economic geographers, it has until recently been less prominent in the international business (IB) literature which viewed “location” from a country perspective (see Iammarino, McCann, Ortega-Argilés, 2018 for a survey). However, this has changed over the last few years, with an increasing recognition by scholars of the role of cities as essential components of the process of knowledge creation and diffusion across borders (Cano-Kollmann, Cantwell, Hannigan, Mudambi, & Song, 2016; Santangelo, 2018; Mudambi, Narula & Santangelo, 2018).

A number of empirical studies confirm that global cities are preferred locations for MNEs (Goerzen, Asmussen, and Nielsen 2013; Blevens et al, 2016; Belderbos, Du & Goerzen, 2017; Asmussen et al, 2018), and that peripheral cities are preferred locations if they are proximate to a global city (McDonald et al, 2018). For example, Goerzen et al (2013) argue that global cities reduce the costs of distance, often referred to as the liability of foreignness because they agglomerate advanced service providers, facilitate knowledge flows within and between MNEs, and provide cosmopolitan environments that welcome the foreign presence. Moreover, as emphasized by Belderbos and his collaborators (2016), R&D is an important part of the smile curve, and MNEs have begun to both internationalize their R&D activities, and to co-locate with other MNEs in specific city locations. Thus global cities provide strong incentives for MNEs to locate in them, and these same incentive encourage co-location and co-evolution of firm and location.

Global cities are also preferred locations for HQ functions. For example, Belderbos et al (2017) find that connected global cities are favoured as locations for regional HQs. Asmussen et al (2018) continue this theme and find that global cities provide locational advantages for regional headquarters, which in turn serve as a “beachhead” investment. They provide as an example, the case of Schneider Electric SA, the French energy management and engineering MNE with operations in more than 100 countries. Schneider’s main subsidiary in Denmark is Schneider Nordic Baltic A/S, located in central Copenhagen, listed by AT Kearney as a global city. However, Schneider Nordic Baltic A/S, owns other firms in Denmark, and thus operates as a regional investment platform from its base in Copenhagen. MNEs also prefer to locate R&D and design activities in global cities, as shown for example by Castellani and Lavoratori (2017). At the cluster level, Li & Bathelt (2018) find that knowledge intensive firms are more likely to locate in clusters, both at home and abroad. Thus, MNEs leverage local knowledge pools by strategically locating affiliates across clusters. In addition, there is evidence that internationally connected innovation clusters have performance advantages, supporting the idea that firms and locations co-evolve (Turkina & Van Assche, 2018).

In sum, there is accumulating evidence that globally connected cities and clusters reduce the costs of distance, and thereby attract investment by MNEs. At the same time, these investments link the host location to a global network of knowledge-based locations. Thus, we observe the co-evolution of firms and locations, and an increase in international knowledge-based transactions.

Public Policy

We conclude that the most promising prospects for international diversification that overcomes the costs of distance is in knowledge-based activities and services, and that the location of these services is concentrated in subnational entities, mainly global cities of various kinds. Global cities serve as both innovation and service hubs, with connections among them linked to the activities of MNEs. However, it is not clear whether or how public policy, notably with respect to trade, can effectively recognize the importance of this network of global cities, and become more “place sensitive” (Iammarino et al, 2018).

We propose at least four priority areas:

  1. Domestic policies that foster innovation and clusters in cities are a critical component of an international diversification strategy, because these investments can attract FDI and promote trade in knowledge-based services, and can facilitate the creation of home-grown MNEs. They should, therefore, be understood as the provision of trade-related infrastructure. These policies should incorporate the specific nature of “global” cities, and the different roles each can play. In other words, we propose that domestic policies that strengthen global cities, global clusters or global city regions should be understood as part of a trade diversification strategy. Such policies should consider not only place (where the activity occurs), but space (how it is connected).
  2. Global cities benefit from the strength of their economic clusters. Policies that strengthen clusters not only strengthen the global city but also help spread the benefits to the periphery of global cities as knowledge spills over. Public policy should, therefore, support investments in the infrastructure that connects global cities with their peripheral areas. Due to the different geographies of Canada and the UK the implications of this argument may vary in terms of the number of hubs considered.
  3. Investment promotion agencies representing global cities should focus on developing focused ties with other global cities, and promote cross-border alliances among them. These alliances should be formed with recognition of the different global rankings of cities, and with the goal of seeking complementary industry specialization of the participating global cities. An important outstanding policy question is how the activities of these agencies can be developed as part of a national trade diversification strategy (for example, London & Partners; Toronto Global.)
  4. Global cities should be represented in international trade negotiations to be able to make their interests heard, and to identify trade development opportunities. This applies in particular with respect to provisions regarding services. The question is whether this can be accomplished within current trade negotiation frameworks or whether it implies the creation of new cooperative and deliberative mechanisms (Hoeckman, 2014; (Stephenson, 2016), which include cities in their design.

This post represents the views of the author and not those of the Brexit blog, nor the LSE. 

Daniel Shapiro is Professor of Global Business Strategy at the Beedie School of Business, Simon Fraser University, and co-editor, Multinational Business Review

Saul Estrin is Professor of Management at the London School of Economics.

Christine Cote is Senior Lecturer in Practice at the Department of Management (LSE).

Klaus E. Meyer is Professor of International Business at Ivey Business School. 

Jing Li is Associate Professor of International Business at Beedie School of Business.

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Long read: Can the UK capitalise on its service-based economy for trade diversification post Brexit?

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As concerns increase over the prospects for a positive post-Brexit agreement with the EU on the terms of exit, much attention continues to be focused on the attractiveness and viability of UK trade diversification. Our first post concluded that physical distance still matters in economic relations between countries and that the role of gravity when considering trade in goods, while diminishing slightly, is still paramount. This suggests that the EU’s role as the UK’s most proximate and natural trading partner will be difficult to replace with countries at a greater physical distance. While distance still matters for trade in goods, can the same be said for trade in services? Can the UK capitalise on its service-based economy for trade diversification post-Brexit, ask Saul EstrinChristine Cote, and Daniel Shapiro?

A further elaboration of the concept of distance which captures geographic distance, but also administrative, economic and cultural distance (Ghemawat 2014) paints a slightly more positive picture in the sense that the UK also has relatively lower “psychic distance” with many members of the Commonwealth, including Canada. Ghemawat’s CAGE distance theory, therefore, lends greater weight to the attractiveness and fit of trade and investment diversification with certain administratively and culturally similar markets to the UK, such as Canada. However, the prospect of trade diversification beyond the EU appears even more attractive when we consider trade in services, a sector which accounts for 80% of the UK economy and 45% of total UK exports (Office of National Statistics (ONS)). The balance of empirical studies suggests that physical distance matters less when it comes to trade in services than it does for goods, though some of the evidence is mixed. Moreover, it is unclear to what extent such economic relationships might replace the magnitude of returns currently achieved through EU membership. Nonetheless, as the UK contemplates alternative markets with which it might pursue trade and investment post-Brexit, the idea of focusing on trade in services with a country like Canada seems potentially promising.

But Services by their very nature are typically more intangible and complex than physical goods hence the rules needed to ensure that the barriers to trade in services are low are often very difficult to craft. Can the UK and Canada develop an Agreement for trade in services which provides the maximum market access, generating the maximum benefits for business and consumers? Furthermore, what are the challenges or barriers to trade such an agreement would need to address? In particular, to what extent do the state-of-the-art service agreements recently negotiated or under discussion, namely the EU-Canada Comprehensive Economic and Trade Agreement (CETA), the formally named Transpacific Partnership (now CPTPP), and the WTO Trade in Services Agreement (TISA), provide guidance for the crafting of new Agreements? Answers must take account of the fact that in some ways even these Agreements remain deficient in recognizing the new reality of the fragmentation of production, the proliferation of global value chains and the greater integration of manufacturing, services and investment activity?

Image by PhilafrenzyCC BY-SA 4.0.

Distance matters less for trade in services

It is clear from gravity model studies which posit that a country’s trade patterns depend on the size of the exporting and recipient economies and the distance between them, that trade with neighbors will be greater than trade with countries located further away.  Additionally, distance appears to play an even more marked role for intermediate than final goods, ‘an important component of supply chains’ (Freeman and Pienknajura 2018). When we turn however to services, the story is slightly different. While gravity models have been shown to fit the flow of trade in services in a similar manner to that of goods, demonstrating that issues such as the income of a country and a common language positively influence trade in services, distance per se has not been found to be a significant factor (Walsh 2008; Kandilov and Grennes 2012).

Gravity model studies also show for example that trade barriers and thus costs resulting from geographic distance are much lower in online services (Alaveras and Martens 2015) and that trade in services is significantly greater in virtually-proximate countries, especially, trade in financial, communication and insurance services. Therefore, where services are information-intensive, they have been found to be ‘highly responsive to online bilateral information flows’ (Hellmanzik and Schmitz 2016). Moreover, where services are traded through a commercial presence, such as R&D based foreign direct investment (FDI), and involve the ‘international transfer, absorption and use of knowledge’, their sensitivity to distance is significantly less than with manufacturing FDI (Castellani et al 2013).

However, as yet, the empirical evidence is not definitive and is contingent on the nature of the services in question. Some studies find that physical distance still matters for trade in services because it raises the costs for example of operating across differences in time zones (Christen 2018); of employing foreign service workers; or it increases complexity due to the need for proximity in the provision of many services. Even in these studies however, either while costs of distance were present, they were declining (Christen 2017; Head, Mayer and Ries 2009), or while the effect of distance on trade in goods and services were both significant, the impact is lower in the case of services (Eaton and Kortum 2018).

Services are a growing component of global and UK economic activity

Thus, distance appears to matter less when establishing economic trade relations focused on services, particularly those which rely on virtual connectedness between countries or the international transfer and absorption of information. How might this benefit the UK post-Brexit? First, evidence suggests that there has been considerable growth in trade in services, the fastest growing sector of the global economy.  Such growth is also more recent, with liberalization in services under the General Agreement on Trade in Services (GATS) taking off in the 1990s and in particular in the area of digital services as outlined in Figure 1. The importance of services to developed and many emerging market economies is therefore on the rise.  However, while the services component of output or GDP is quite high in many developed countries, the services share of total world trade is still only between 20-25% according to a 2016 HSBC Commercial Banking Report, with much room for future growth.

Figure 1: Trade in services is increasing rapidly

Source: Erik van der Marel, https://sites.google.com/site/erikvandermarel/What-s-on

Second, this is all good news for the UK. The UK is a predominantly service driven economy where 80% of output is services based. As a trading nation, 45% of UK exports are in services with the largest share in professional services such as financial, management consulting and R&D services.

Third, when considering the issue of trade diversification and opportunities with countries further afield such as Canada, the potential is evident. For example, Canada’s economy is also highly service based at 70% of GDP, with exports and imports in services similarly focused on knowledge-intensive industries such as management consulting, engineering, architecture, R&D and financial services. To date, however, the overall level of trade between the UK and Canada is quite low at under 2% of the total value, in the case of the UK and around 6-7% for Canada (Figure 2). Not surprisingly the majority of services trade for the UK and Canada remains with their immediate neighbors. 50% of the UK services exports are with the EU, led by Germany as the main recipient. The US currently accounts for over 50% of Canada’s services trade. However, this could change under a concerted strategy of trade diversification by the UK in the wake of Brexit.

Figure 2: Trade in services is more important to Canada

The gravity model provides an appropriate starting point to consider the untapped potential of the UK-Canada trading relationship. In a recent study, van der Marel considered the extent to which Canada’s existing services exports differed from predictions made by a global gravity model, which was estimated based on the World Bank, Trade in Services Database, World Development Indicators and Services Trade Restrictiveness Index. Based on his analysis of factors such as distance, size of a country’s GDP and other institutional indicators, he found evidence (as outlined in Figure 3), that Canada is currently under-trading in services with a number of key trading partners including the UK (van der Marel 2016).

Figure 3 

Overcoming barriers to trade in services with countries outside the EU

Given the potential opportunity for the UK in the diversification of its services trade, what are the challenges? The first type of challenge relates to the character of the service sector. For example, services as a product are often subject to specific constraints such as the requirements for close physical proximity of service provider and consumer (e.g. after sales services in traditional machine building such as aircraft engines); the different manner in which services are regulated (e.g. professional services qualifications differ between countries and even across provinces within Canada); and the role of the public sector in the supply of some services such as health and education (Sauve and Roy 2016).

Furthermore, understanding what we mean by services can be challenging as services can involve a range of activities which make it difficult to provide an exact definition.  The World Trade Organization (WTO) has classified services into four modes of supply including those supplied cross-border such as computer services (mode 1), those consumed abroad such as through tourism (mode 2), those supplied through a commercial presence such as an automotive branch plant or MNE subsidiary (mode 3) and those supplied through the presence of a natural person such as a touring rock band performing a concert in a foreign country (mode 4).  Figure 4 outlines the way in which the different types of services are supplied.

Figure 4: Under WTO GATS, services are supplied under four modes

The second challenge relates to the way services are regulated. Trade costs in services are two to three times higher than in the goods sector. They have remained high while trade costs in goods have fallen. This is due to the regulatory burdens facing the services sector even in the single market of the EU (Miroudot, Sauvage and Shepherd 2013).  Policy barriers or regulations as measured by the World Bank Services Trade Restrictiveness Indices have a negative and significant impact on total services trade (van der Marel and Shepherd 2013), and remain high in countries like the UK and Canada (Figure 5).

Figure 5

The third challenge is that service liberalisation agreements are much harder to achieve than with trade in goods. The impact of trade policy on services trade is complicated by the fact that services transactions are harder to measure than with goods and the data are not as good.  Furthermore, production and trade in goods and services are often quite integrated, even inseparable. (Egger, Larch and Staub 2012). Therefore, crafting trade in services agreements which can overcome barriers effectively is very difficult.

Policy implications

Just as trade in services has increased at a rapid pace in the last few decades, so have the rules governing it. These have been negotiated at the regional or bilateral level as well as multilaterally at the WTO under GATS and the ongoing TISA. The WTO currently lists 285 active regional trade agreements, many negotiated during the period of rapid growth in the 1990s.  The majority of these would have provisions dealing with the trade in services. At the same time, the nature of global services activity has been changing. The way that services flow across borders has been fundamentally altered by the fragmentation of production and the associated emergence of global value chains, as well as the integration of production networks facilitated by services including transport, logistics, telecoms, marketing and R&D. Cross-border service activity has also become more significant because of  the rise in the digital economy, with staggering increases in the number of internet and mobile phone users and the explosion in data flows.

In considering an effective set of policies aimed at facilitating trade in services in the context of the UK-Canada relationship, what lessons can we take from existing state-of-the-art services trade agreements such as CETA, TPP and TISA and to what extent have these instruments been rendered irrelevant by their inability to address these changing service sector dynamics? New trade agreements and in particular CETA, which is considered the gold standard, have provisions aimed at liberalizing services through market access and non-discriminatory treatment for service providers. Sector-specific provisions deal directly with sectors such as financial services, telecommunications and air transport but also address new areas such as e-commerce and maritime transport services. Furthermore, CETA seeks to facilitate the provision of services once they cross the border through rules on domestic regulation as well as by tackling regulatory cooperation and coherence and addressing the mutual recognition of professional qualifications.

The problem is that CETA and other services agreements continue to provide for special treatment for countries’ sensitive sectors, allowing them to maintain market access restrictions which inhibit trade and investment flows. Canada, for example, has preserved costly restrictions in the transport, finance and telecoms sectors, including restrictions and regulatory barriers which hinder foreign market entry and competition (van der Marel 2016). Furthermore, and perhaps more importantly, existing rules have been designed to address the exportation of services as a final activity from a national firm and not as an intermediate input in the context of multiple suppliers and locations (Stephenson 2012). The current trading rules for services found within even the newest regional agreements or at the WTO, are therefore being rendered irrelevant by the role played by services within global value chains.

So where does this leave the UK as it seeks to capitalise on new and diversified opportunities in the trade in services with economies such as Canada?  A number of possible policy approaches will need to be considered.

First, any new trade agreements the UK seeks to negotiate should address services trade in greater breadth and depth than has traditionally been the case, reflecting the more recent achievements under CETA and the TPP.  The UK should ensure that they achieve more comprehensive coverage of the new issues discussed above which recognise the role of services in global value chains, as well as that of technology and information, flows in the provision of services. Ensuring new areas such as e-commerce are covered alongside provisions on domestic regulation and commitments to achieve regulatory cooperation is essential.

Second, any trade agreements negotiated on services market access should be based on a negative list approach, covering all services unless explicitly indicated.  Additionally, they should seek to allow for fewer exemptions and restrictions than for example under CETA, particularly in sectors where the UK has a comparative advantage such as management consulting and financial and R&D services. They should also be seeking to restrict regulations which raise costs and affect sectors where services are important inputs such as transport, telecoms and financial services.

Third, because traditional trade rules do not fully recognise the reality of cross-border service activity in which services act as important intermediary inputs in global value chains, the UK must consider other complementary policy levers for reducing regulatory barriers to service market access. To this end, the UK should seek sectoral, regional and multilateral cooperation initiatives with the goal of achieving coherence in regulations and avoiding bottlenecks in GVCs.  Such cooperation initiatives might take the form of ‘supply chain councils’ (Hoekman 2014) or regulatory councils modelled on CETA’s Regulatory Cooperation Forum (van der Marel 2016).

Our next post will look in some detail at how the opportunities of trade in services can best be addressed in the context of global cities and the extent to which a focus on cities might help address some of the challenges raised in this blog.

This post represents the views of the author and not those of the Brexit blog, nor the LSE. The authors gratefully acknowledge financial support from the ESRC under the recent international Knowledge Synthesis Grant competition on Understanding the future of Canada-UK trade relationships, grant number 872-2018-0018. Our work has drawn heavily on excellent research assistance by Angelina Borovinskaya.

Saul Estrin is Professor of Management at the London School of Economics.

Christine Cote is Senior Lecturer in Practice at the Department of Management (LSE).

Daniel Shapiro is Professor of Global Business Strategy at the Beedie School of Business, Simon Fraser University, and co-editor, Multinational Business Review.

Bibliography
Alaveras, G. and Martens, B. (2015). International Trade in Online Services. SSRN Electronic Journal.
Castellani, D., Jimenez, A., & Zanfei, A. (2013). How remote are R&D labs? Distance factors and international innovative activities. Journal of International Business Studies44(7), 649-675.
Christen, E. (2017), Time Zones Matter: The Impact of Distance and Time Zones on Services Trade. World Econ, 40: 612-631
Eaton, J. and Kortum, S. (2018). Trade in Goods and Trade in Services. In: Ing, L. Y. and Yu, M. World Trade Evolution: Growth, Productivity and Employment. 1st Edition. Routledge.
Egger, Peter H. and Larch, Mario and Staub, Kevin E. (2012) Trade Preferences and Bilateral Trade in Goods and Services: A Structural Approach. CEPR Discussion Paper No. DP9051.
Freeman, R. and Pienknagura, S. (2018). Heterogeneous effects of trade agreements across product types | VOX, CEPR Policy Portal. [online] Voxeu.org.
Head, K., Mayer, T. and Ries, J. (2009). How remote is the offshoring threat? European Economic Review, 53(4), pp.429-444.
Hellmanzik, C. and Schmitz, M. (2016). Gravity and international services trade: the impact of virtual proximity. European Economic Review, 77, pp.82-101.
Hoekman, B. (2015). International Regulatory Cooperation in a Supply Chain World. in Redesigning Canadian Trade Policies for New Global Realities. Edited by Stephen Tapp, Ari Van Assche and Robert Wolfe. IRPP.
Kandilov, I. and Grennes, T. (2012). The determinants of service offshoring: Does distance matter? Japan and the World Economy, 24(1), pp.36-43.
Miroudot, S., Sauvage, J. and Shepherd, B. (2013). Measuring the cost of international trade in services. World Trade Review, 12(04), pp.719-735.
Sauvé, P., Roy, M. (2016). Research Handbook on Trade in Services. Edward Elgar Publishing, Incorporated.
Stephenson, Sherry. 2016. Trade Governance Frameworks in a World of Global Value Chains: Policy Options. E15 Expert Group on Global Value Chains. Geneva: International Centre for Trade and Sustainable Development (ICTSD) and World Economic Forum
Van Der Marel, E., & Shepherd, B. (2013). Services trade, regulation and regional integration: evidence from sectoral data. The World Economy36(11), 1393-1405.
Van Der Marel, E. (2016) The Potential to Enhance Canada’s Services Trade in CETA, TPP and TiSA in Redesigning Canadian Trade Policies for New Global Realities. Edited by Stephen Tapp, Ari Van Assche and Robert Wolfe. IRPP.
Walsh, K. (2008). Trade in services: Does gravity hold? Journal of World Trade, 42(2), 315–334.

Just how wrong is the Brexiteer view of an anti-market EU? Ask Canada or Australia

Just how wrong is the Brexiteer view of an anti-market EU? Ask Canada or Australia, write Craig Parsons and Benedikt Springer. Brexiteers have frequently characterized the EU as a regulatory nightmare that impedes Britain’s traditional commitment to global openness and free trade. Well-informed observers generally know this is implausible—the EU is built around deep “single market” liberalisation, and promotes free-trade deals worldwide—but even experts rarely realize just how much the EU stands out for cross-border openness. In many ways, the Single Market now has fewer interstate barriers than the national markets of Canada, Australia, or the United States. Canadian and Australian moves to liberalize their own markets have been directly inspired by the EU model.

One of the salient (though secondary) themes that led to Brexit presented the EU as a straitjacket on Britain’s vocation of openness. In this view, free trade is an invention of the Anglo-Saxons—practiced most purely by the British and their progeny in the United States, Canada, Australia—that the Continentals have generally obstructed. As British tabloids have reported for decades, and as the Ur-free-marketeer Margaret Thatcher came to believe in her later years, the EU is a stifling “super-state”: a bureaucratic, mostly anti-market entity bent on regulating the curvature of bananas and encouraging fraudulent over-production of olive oil. As Theresa May put it in January 2017, “the British people […] voted to leave the European Union and embrace the world.”

This image fits awkwardly with the primary theme behind Brexit: that the EU forced Britain to be open in undesirable ways. Opposition to free movement of people across European borders was the leading edge of the movement. Analyses of the Brexit vote tend to highlight what sociologist (and then-LSE Director) Craig Calhoun described as an anti-openness “mutiny against the cosmopolitan elite.” Brexit appealed especially to less educated, less skilled, and older people who felt threatened economically or culturally (or both) by cross-border flows.

Despite their contradictions, only the marriage of these themes delivered the Brexit baby. Some especially compelling support for this interpretation comes from Dominic Cummings, the maverick political prodigy who orchestrated the Brexit campaign. His frank 20,000-word account emphasizes the contingency of the outcome, and also that any chance for “Leave” depended on combining the “mutiny” with respectable, market-friendly Tory leadership. Immigration and threats to the National Health Service were the winning issues with voters, but many middle-class voters baulked at identifying with Nigel Farage. Though the “Go Global” frame itself was a “total loser” electorally, its traditional-Tory feel helped established figures like Michael Gove and Boris Johnson become the faces of the coalition—and to claim that they carried the mantle of Mrs. Thatcher in so doing. Brexit would restore British sovereignty so it could both control its borders and return to its free-trade vocation.

CC0 Public Domain

This blog post argues that the “Go Global” theme was extraordinarily misleading. Many observers have made similar points, both with respect to the EU and Britain’s options outside it. Certainly, the EU has some questionable regulations and subsidies, but it is built around a project of deep liberalization. It actively promotes free-trade deals around the world, with more leverage and success than Britain could possibly achieve on its own. To fully grasp just how wrong is the Brexiteers’ view of an anti-market EU, however, this post briefly compares the EU to the internal markets of Anglo-Saxon federations. Though not even many EU experts recognize it, the EU’s Single Market has surpassed the United States, Canada and Australia in removing internal barriers to exchange. What’s more, substantial recent steps in liberalizing the Canadian and Australian internal markets were unambiguously propelled by the EU model.

Take the latter point first. In 2014 Canada and the EU signed a Comprehensive Economic and Trade Agreement (CETA). Given the many barriers to interprovincial trade (of which more below), it led to business complaints that Canada-EU trade would now be freer than intra-Canadian trade. The Canadian Senate produced a major report titled “Tear Down These Walls: Dismantling Canada’s Internal Trade Barriers,” and in 2017 the provinces and federal government signed a Canadian Free Trade Agreement (CFTA) to open up trade in goods and services, recognize each other’s professional licenses where possible, and end interprovincial discrimination in public contracts and subsidies. Australia went through a similar process twenty years earlier. It was not so directly spurred by negotiating with the EU, but was explicitly and constantly presented as an effort to redress declining Australian competitiveness by imitating the EU’s “Single Market 1992” initiative.

Canadian and even the more advanced Australian efforts still leave more barriers in place than we see in the EU, however—and their legal commitments to open interstate exchange are far weaker. The US case, meanwhile, has stronger legal commitments to open interstate commerce than Canada or Australia, but still much weaker than the EU, and essentially zero political interest or legislative activity to address interstate barriers. The following tables provide a quick and crude summary of this complex terrain, looking first at legal and political principles (Table 1) and then at salient areas of regulatory rules as they stand (Table 2):

Table 1 highlights that the Anglo-Saxon federations do not require much openness from their states. They generally ban explicit or purposeful discrimination against other states’ people or firms, but have little problem with regulations that only have the effect of impeding interstate commerce while pursuing some other announced goal. The EU, meanwhile, puts a severe burden of proof on all state rules to specifically justify any impediments they raise to interstate exchange or mobility.

If Australia and Canada have now both recognized that their legal principles long permitted “far too many unnecessary regulatory and legislative differences…that prevent the free flow of people, goods, services and investments between provinces/territories” (as the Canadian Senate’s report put it), that recognition has not actually altered their legal standards for openness. Their internal liberalization has been entirely voluntary on the part of the states—using what the EU would call “intergovernmental” mechanisms—thus confirming the states’ authority to back off from openness if they wish. Indeed, the Canadian Supreme Court reconfirmed this principle in the widely-followed “Free the Beer” case decided in April 2018. It held that New Brunswick’s limit on buying beer from other provinces was acceptable despite the constitution’s provision that any province’s goods “be admitted free into each of the other provinces” (section 121). As one lawyer said after the decision, “[Internal liberalization] is going to have to be negotiated by the provinces rather than decreed by the Supreme Court.”

Why the Anglo-Saxon federations have been relatively uninterested in internal market barriers, and the EU so obsessed with them, is a big question that we’re researching now. We’ll try to elaborate in future posts—including arguing that the reasons why the most pro-market American politicians (like outgoing House Speaker Paul Ryan) ignore substantial barriers in their interstate commerce are much like the reasons why Tory free-marketeers dislike the EU. (Both concern opposition to federal authority that trumps—if you will—their desire for economic openness).

For the moment, though, the takeaway is just that Brexiteers would be well advised to consider how strange their characterizations of the EU will sound to their Anglo-Saxon brethren in the Antipodes or the Great White North. In the same time period that anti-EU Thatcherites developed the notion that the EU obstructed true economic openness, pro-market politicians in these other polities concluded that they had to imitate the EU more to reach that goal.

None of this is to say that the EU is a model of economic rationality, or that we personally endorse the EU’s strict requirements for interstate openness. But the EU’s commitment to interstate openness is unambiguously stronger than any other large polity in history, and it has encouraged similar openness elsewhere.

This post represents the views of the author(s) and neither those of the LSE Brexit blog nor of the LSE.

Dr Craig Parsons, Professor of Political Science, University of Oregon.

Dr Benedikt Springer, Policy Analyst, Oregon Bureau of Labor and Industries and Hatfield Resident Fellow, Portland State University.

The regulation of unfair trading practices after Brexit

tom verdonkThe effect of Brexit on unfair trading practices (UTPs) has been largely overlooked, yet it could be very significant – especially in agriculture. Tom Verdonk (KU Leuven) looks at whether the regulations could diverge and what impact that would have.

With the UK’s imminent withdrawal from the EU, the EU’s motto “United in diversity” has clearly taken a hit. While the motto is generally used to refer to European cultural diversity, it could equally apply to some legal domains. One legal area in which EU Member States have shown to be united in diversity is the domain of so-called laws on unfair trading practices between businesses (UTPs), which refers to a wide variety of business-to-business practices that deviate from good commercial conduct and are contrary to good faith and fair dealing.

UTPs tend to occur in vertical relationships (i.e. between a supplier and a buyer) characterised by an inequality of bargaining power. Similar to abuses of dominance, UTPs are often imposed unilaterally by a larger undertaking on a smaller one, though a firm does not have to be dominant in the competition law sense. The asymmetrical relationship between two undertakings itself is seen as a facilitator for the imposition of harmful practices at the expense of the smaller firm.

Consequently, almost all Member States have taken legislative and/or regulatory initiatives addressing UTPs. Without rules to tackle UTPs, they fear UTPs will impede the functioning of markets, as they can result in the misallocation of resources and (disproportional) exclusionary and exploitative conduct, at the expense of SMEs and, ultimately, consumers. But approaches of Member States are far from uniform. The beginning of the end of this divergence may, however, soon commence, as the Commission recently proposed legislation in this area. Interestingly, the UK Government was for a long time one of the Commission’s main critics, arguing against any attempt to harmonise rules on UTPs. Among other reasons, it did not recognize the added value of EU rules on top of its own system.

Compared to other fields of law that deal with the protection of markets and their participants, the impact of Brexit on the regulation of UTPs has been virtually overlooked, arguably due to the absence of common rules on UTPs (as of yet). Nevertheless, this field should not be ignored, as the sector-specific scope of the draft EU legislation on UTPs could have profound effects on some important UK and EU markets in the post-Brexit era. Therefore, this article explores the development of regulation of UTPs in the EU and the UK, highlights interesting elements from these systems, and shares some thoughts on how Brexit may impact the future development of this legal domain.

Developments in the European Union

Apart from the Late Payments Directive and the Directive on misleading and comparative advertising, there are no EU rules on UTPs between businesses. The lack of common rules is surprising in itself, because EU law has a prominent, if not leading, role in many adjacent areas of law and policy, such as competition law, consumer law, and agricultural policy. Despite the absence of common rules on UTPs, almost all Member States have implemented laws, regulations and administrative provisions to specifically address UTPs. General (contract) law is not seen as an adequate solution, since smaller parties like SMEs may be reluctant in seeking redress before civil courts for fear of retaliations (known as the “fear factor”).

Approaches of Member States come in all shapes and forms, but can essentially be divided into two groups. In the first group Member States have stretched the scope of competition law beyond the boundaries of the abuse of dominance prohibition, as laid down in Article 102 TFEU. As Member States are not precluded under Regulation 1/2003 from implementing stricter national competition laws with regard to abuses of dominance, some have introduced the concepts of abuses of superior bargaining power or economic dependence (e.g. France and Germany). In the second group (representing the vast majority of Member States), on the other hand, Member States have chosen to implement legislation outside the scope of competition law. These rules aim to govern contractual relations between suppliers and buyers, sometimes specifically addressing the food supply chain. Typically, rules on UTPs in the area of business-to-consumer protection have been extended to business-to-business transactions. In addition to the above approaches, many self-regulatory mechanisms, again often with a focus on the food supply chain, have been launched, such as the EU-wide Supply Chain Initiative.

In response to the fragmentation within the EU in the regulation of UTPs and in contract law in general, harmonisation attempts have been made but have also proven to be very difficult. An exemplary project from recent times in that regard was the rejected Common European Sales Law, which aimed to introduce a single set of contract law rules that would stand as an alternative to national contract law of Member States in both business-to-consumer and business-to-business transactions.

However, recent initiatives could turn the tide. In April 2018 the European Commission proposed two pieces of legislation that aim to tackle UTPs between businesses: a proposal against UTPs in the food supply chain and a regulation to ensure fairness of platform-to-business trading practices in the online platform economy. Particularly, the first initiative sparked discussion, because it would – if adopted – introduce a minimum level of protection for suppliers active in the food supply chain against UTPs of buyers across the EU, prohibit a number of UTPs (of which some, only if not agreed in clear and unambiguous terms), and have each Member State designate a competent enforcement authority with the power to apply fines.

Another interesting aspect of the proposal is its legal basis, which was found in one of the key objectives of the EU’s Common Agricultural Policy (i.e. “to ensure a fair standard of living for the agricultural community”). As a result, agricultural policy and EU regulation of UTPs have become closely intertwined. Currently, both proposals have been submitted to the European Parliament and the Council, and are still under debate. If adopted, they would introduce EU rules on UTPs, albeit with a sector-specific and limited substantive scope.

Developments in the United Kingdom

Within the debate on EU rules on UTPs, the UK Government has always been a fierce opponent of any European intervention. Some of its reasons against harmonisation were of a more general nature and included its scepticism towards the incorporation of concepts like “good faith” and “fair dealing” into the UK’s common law system (and the legal uncertainty they, accordingly, could create within the system), the inadequacy of contract law in dealing with abuses of economic dependence, and the risks associated with interfering in the business-to-business freedom of contracts, particularly the increased likelihood of overprotection. Based on these arguments, the UK Government expressed its support for a sector-by-sector approach through national initiatives. That way, certain market failures could be targeted specifically, allowing interventions to be beneficial or at least neutral in their impact, in both the short and long term.

Despite its sector-specific focus and minimum harmonisation character, the UK Government also expressed concerns over the Commission’s draft Directive on UTPs in the food supply chain. Its main concerns were the lack of flexibility for Member States and the costs of the increased remit of a regulatory authority. Instead of harmonising the rules on UTPs, the UK Government considered Member States themselves to be in the most appropriate position to legislate. This allows them to take into account the specific, domestic market conditions, as the UK does, according to the Minister for Agriculture, Fisheries and Food, within its already existing system addressing UTPs.

Currently, the UK does not have general (statutory) rules on UTPs, but it does have a system to tackle UTPs in the UK groceries supply chain. The Groceries Code Adjudicator (GCA) monitors and enforces compliance with the Groceries Supply Code of Practice (GSCOP), which aims to ensure fair and lawful treatment of direct suppliers by the UK’s ten largest supermarkets. The GSCOP applies only to supermarkets with a turnover in sales of groceries in the UK exceeding £1billion, which currently are: Aldi, Asda, Co-operative, Iceland, Lidl, Marks & Spencer, Morrisons, Sainsbury’s, Tesco, and Waitrose. Under the GSCOP these supermarkets must comply with a variety of obligations when dealing with their suppliers, including the use of written contracts, and refrainment from retrospective supply arrangements and pay delays. If a supermarket does not comply with the GSCOP, a supplier is able to involve the GCA. The GCA then has the power to arbitrate, investigate and fine a supermarket. In February of this year, the UK Government decided not to extend the remit of the GCA following a consultation. Although the consultation identified UTPs in the UK groceries supply chain, the Government concluded that “there is no clear evidence of systematic widespread market failures.”

Similar to the EU, regulation of UTPs in the UK cannot be considered in isolation from agricultural policy. While UK’s withdrawal from the EU will also place it outside the CAP, a link between UK agricultural policy and regulation of UTPs will probably continue to exist. A new Agriculture Bill was introduced by the Government into Parliament in September of this year. Among other provisions, the draft bill includes a provision that gives the Government the power to make regulations “for the purpose of promoting fair contractual dealing by the first purchasers of agricultural products (…) in relation to contracts they make for the purchase of agricultural products from producers.”

Post-Brexit prospects

Brexit may serve as turning point for EU regulation of UTPs, as proponents of harmonisation of laws on UTPs lose a critical Member State. To a great extent, this will also depend on the success of the proposed Directive on UTPs in the food supply chain. If adopted and positively evaluated in the (near) future, the Directive could reinvigorate calls for further integration and perhaps even for general EU laws on UTPs between businesses, similar to the provisions and instruments of EU consumer and competition law. Ironically, despite its opposition against EU laws on UTPs, the UK’s withdrawal from the EU will not provide its government an opportunity to shirk from participating in debates on the desirability of laws on UTPs. In fact, despite Brexit, laws on UTPs could affect the UK in a number of ways.

Firstly, following Brexit, UK-based businesses conducting business with EU-based businesses would still have to comply with the applicable laws on UTPs in Member States in some cases. If the draft EU legislation were to be adopted, UK-based buyers active in the food supply chain buying from EU-based suppliers would have to comply with the implemented obligations of the draft Directive, and UK-based digital firms targeting the EU market would have to comply with the terms of the draft Regulation. Given the great uncertainty regarding the Brexit scenario(s), it is difficult to assess how Brexit could impact laws on UTPs during the transition period. According to the current draft EU27/UK Withdrawal Agreement, the UK would remain bound by all existing and new EU regulations throughout a transition period, which is currently scheduled to end on 31 December 2020. Hence, if the Directive and/or the Regulation were to be adopted before or during the transition period, the UK would still be bound by the adopted legislation on UTPs for a while. Accordingly, on the basis of that scenario it is unlikely that divergence in laws on UTPs between the UK and the EU27 will arise in the short term.

However, the impact of Brexit on regulation of UTPs in the long term is less straightforward. Divergence in legislation could eventually arise if the EU27 would decide to further integrate laws on UTPs. If the laws on UTPs were to be adopted and positively evaluated a few years after implementation, this could pave the way for the expansion of the scope of the rules or the introduction of similar rules in other supply chains. In those instances, it remains to be seen whether the UK will follow suit. Also, the UK itself may decide to diverge from the EU’s approach to UTPs, because Brexit provides the UK an opportunity to tailor its legislation and regulation to the specific conditions of its domestic markets, such as the agricultural market. Given the close relationship between regulation of UTPs and agricultural policy, divergence between EU and UK agricultural policies may play a significant role in this as well.

On the other hand, it remains to be seen whether the EU27 will actually continue to harmonise rules on UTPs. The path that eventually led to the draft Directive was scattered with obstacles, hardly surprising after various failed attempts to harmonise European private law. Reaching consensus on the way forward will – without the UK – not be a walk in the park all of a sudden for the remaining Member States. Furthermore, in response to the undesirability of any divergence between the UK’s and EU’s approach to UTPs, (some) convergence or coordination may be deemed necessary. The desirability of cooperation in this area may specifically be relevant in the agricultural sector, given the significant cross-border agricultural trade between the UK and some Member States of the EU27. After all, the UK is currently far from self-sufficient in agricultural production and the EU is the UK’s single largest trading partner in agri-food products, accounting for 60% of exports and 70% of imports, as also recognised in a House of Commons report on Brexit and its impact on the UK’s food and farming industry.

Either way, it is clear to parties on both sides of the Channel and the North Sea that discussions on UTPs legislation are not done yet. In the EU, current discussions on the draft UTPs legislation in the European Parliament and the Council reveal that there seems to be general support for the draft Directive (though some call for an extension of its scope). Similarly, the consultation on the GCA and the new Agriculture Bill indicate strong support for extension of rules on UTPs in the UK from a variety of stakeholders, including agricultural trade associations. Therefore, it is more likely than not that following Brexit debates on the desirability and scope of laws on UTPs will remain on the political agendas of the UK and the EU27.

This post represents the views of the author and not those of the Brexit blog, nor the LSE. It first appeared at European Futures.

Tom Verdonk is a PhD candidate in Law at the Institute for Consumer, Competition & Market at KU Leuven. His research focuses on the economic regulation of agricultural inputs markets, taking into account competition laws, intellectual property and agricultural policy.

Pushing the BoE to the limit: what a no-deal Brexit will mean for UK exchange and interest rates

The absence of a trade agreement between UK and EU will yield further depreciations of the pound relative to leading currencies, explain Michael Ellington and Costas Milas. This will then lead to a sharp cut in the Bank of England’s policy rate and to another round of quantitative easing. In other words, a no-deal Brexit will push the Bank of England to the limit.

Prime Minister Theresa May has warned “it’s either my [Chequers] deal or no deal”. With betting odds implying a probability of 62.5% on no deal being reached before April 1st 2019, one way of looking at the impact of such an outcome is to consider its consequences in terms of an economic policy uncertainty shock. There are good reasons why policy uncertainty affects the economy. Policy uncertainty motivates agents to delay investment and hiring decisions, and so leads to a decline in investment employment and total output. Further, under these conditions, monetary policy becomes less effective. This is because agents tend to postpone decisions until more precise information becomes available, and this cautiousness makes them less responsive to changes in the economic environment, including the interest rate. Last but not least, credit rating agencies respond by downgrading the credit profile of countries hit by rising policy uncertainty.

We measure economic policy uncertainty based on articles from The Times and The Financial Times regarding policy uncertainty. We count the number of articles containing the terms uncertain or uncertainty, economic or economy, and one or more policy-relevant terms. Following from the EU Referendum result, policy uncertainty recorded an unprecedented spike in June 2016 (see Figure 1). Since then, policy uncertainty has somewhat receded; nevertheless, it remains elevated compared to its pre-2015 levels.

Source: http://www.policyuncertainty.com/index.html

In new research we assess the impact of economic policy uncertainty on the effective exchange rate and interest rate differentials between the UK and our main trading partners (namely the Euro area and the US) prior to, during, and in the aftermath of the EU Referendum. This is done in the context of so-called time-varying models which are flexible enough to track the changing nature of key economic variables over time.

Two key results emerge. First, the influence of a policy uncertainty shock to the interest rate differential between the UK and our trading partners had been more persistent and contractionary in the run up to the referendum. For a given value of our trading partners’ policy rate, a shock to economic policy uncertainty a year before the referendum remained prominent 20 months after the shock was observed. Second, the depreciation of the sterling effective exchange rate was substantially more persistent and contractionary in June 2016 than the year prior to and following the vote. In June 2016, a shock to economic policy uncertainty caused the exchange rate to depreciate by 15.8% in the year after the shock occured. Notice that in the year after the referendum the actual sterling depreciation was 9.3%.

Our results highlight the importance of economic policy uncertainty for monetary policy stance as well as for exchange rate movements. What our findings also emphasise is that, in order to hinder the influence of policy uncertainty, the UK needs to agree on a trade deal prior to its departure from the EU.

Mark Carney has warned MPs that “[f]rom a monetary perspective, we would look to do what we could to ease that [no-deal] scenario but there are limits to what we can do,”. Under the assumption that the impact of an economic policy uncertainty shock during June 2016 is a ‘best-case’ scenario of what might happen to monetary policy stance and exchange rates, the absence of a trade agreement looks set to yield further depreciations of the pound relative to leading currencies, together with a sharp cut in the Bank’s policy rate and another round of quantitative easing. Loosening the monetary policy lever through quantitative easing will also look to hinder possible downgrade pressures on the UK’s national debt, something that will most certainly be transmitted to the private sector. In other words, a no-deal Brexit will push the Bank of England to the limit.

The above draws on the authors’ longer paper available here. This article gives the views of the authors, and not the position of LSE Brexit, nor of the London School of Economics and Political Science. It first appeared on LSE British Politics and Policy. Featured image credit: Pixabay (Public Domain).

Michael Ellington is Lecturer in Finance at the University of Liverpool.

Costas Milas is Professor of Finance at the University of Liverpool.

 

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