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How are Covid-19 and Brexit affecting the products that UK firms trade?

 The pandemic and the UK’s departure from the European Union present twin challenges for domestic firms engaged in exporting and importing. The extent to which they adapt their product mixes in response to changing economic conditions shapes trade and output growth.

Firm-level decisions in response to shocks like coronavirus play a key role in determining the overall impact on the aggregate growth of trade and output. Firms choose what goods or services to export, how much to export and to which foreign markets they sell – and these decisions can have big overall effects.

Firms’ reactions vary depending on the nature of the economic shock. For example, the way a firm changes its behaviour may depend on whether a shock is perceived as temporary or permanent. Firms find it more costly to adjust their production processes in response to a temporary shock. This means that the perceived duration of a crisis is an important consideration when analysing the effects on international trade.

UK firms are currently facing two shocks simultaneously: Covid-19 and Brexit. These shocks differ in their nature and in perceptions of their likely time horizons. Recent research and data analysis can be used to infer how UK businesses are adjusting the range of products they trade in foreign markets during this twin shock.

The range of products traded is known as a firm’s ‘product trade portfolio’, and it can include both the number of outputs exported and the number of inputs imported. Although most of the focus is on how firms are adding and removing products – what is known as ‘product churning’ – analysis can also be applied to firms’ choice of export destinations.

What is the latest picture for UK firms’ product mix?

Individual UK firms, on average, exported and imported only around eight products each in 2016 – see Figure 1. But when splitting by firm size, the data show that larger enterprises tend to sell more products abroad and purchase more inputs compared with firms with 250 employees or fewer (Office for National Statistics, ONS, 2018, using HM Revenues and Customs, HMRC, trade data).

Figure 1: UK firms’ average number of goods traded, 2016

Source: HMRC, ONS; ONS calculations; Own elaboration.
Note: Excluding wholesale and retail industries; goods counted as number of 4-digit commodity codes.

Firms’ product mixes also vary considerably across sectors – see Figure 2. For example, manufacturing firms from sectors such as transport equipment, pharmaceuticals, chemicals and mining generally exchange wider varieties of products. The finding that larger firms on average trade in more different products is seen across all industry categories.

Figure 2: UK firms' average number of goods traded by industry, 2016

Source: HMRC, ONS; ONS calculations; Own elaboration.
Note: Goods counted as number of 4-digit commodity codes.

We can also look at the number of products traded by destination – see Figure 3. On average, UK firms trade fewer products with the European Union (EU) than with the rest of the world across all firm sizes. But it should be noted that data on EU trade are limited by the exclusion of firms trading below an official threshold, which may conceal a higher actual number of products traded with the EU.

Figure 3: UK firms' average number of goods traded by destination, 2016

Source: Own elaboration on ONS data.
Note: Excluding wholesale and retail industries. Goods counted as number of 4-digit commodity codes.

Available data have some key limitations. They don’t allow analysis of firms’ product mixes over time, nor do they distinguish across industries, and they do not consider firm characteristics. Further, figures are not recent enough to identify the effects (if any) of Covid-19 or Brexit on firms’ product portfolio decisions in the foreign market.

Nevertheless, it is useful to revisit how firms have reacted to past crises and to assess the preliminary effects from these two new shocks, while bearing in mind their different natures.

Covid-19: a temporary shock or longer-term transformation?

The pandemic and associated lockdown policies have disrupted industries worldwide, starting with China, which is a major supplier to the rest of the world. Nevertheless, when the virus spread more widely, closures all over the world hit supply chains even harder, including those with links to China (Baldwin and Freeman, 2020).

One early evaluation of the global effects of Covid-19 is that the pandemic should not yet be seen as evidence of an era of ‘deglobalisation’ (Antras, 2020). This may be a consequence of firms viewing Covid-19 as a temporary crisis, after which the ‘global value chain’ will gradually return to its usual form. In light of this, the study argues that most of the responses in the early stages of the pandemic have taken the shape of firms trading smaller volumes of their products, rather than by adding or removing products from the market.

The study warns, however, that it is not yet clear if Covid-19 will be a temporary shock, since international business travel – which is key for global production networks – is likely to be disrupted in the medium run. In addition, increasing income inequality between firms arising from differential capacities for staff to work from home may deepen the length of this crisis, affecting firms’ trading activities.

This preliminary conclusion is in line with studies looking at past crises. For example, during the Great Recession of 2008-09 and accompanying trade shocks, trade mostly fell due to cheaper and smaller quantities being sold by firms, rather than firms dropping products, leaving destinations or exiting the market (Behrens et al, 2013). This evidence was found for the small and open economy of Belgium, where there is wide data availability.

Similarly, Danish firms responded to the 2008-09 recession mainly by trading fewer existing exports and imports (Abreha et al, 2013). A similar study of Japan, however, finds that surviving manufacturers added and dropped products in the transition out of the recession (Bernard and Okubo, 2016). This body of work gives a first hint at how firms respond to an arguably temporary shock like Covid-19 – by trading less of their existing product portfolio, rather than seeking alternatives.

Why do firms react like this? It should be noted that trade between firms, as opposed to trade with final consumers, accounts for the vast majority of world trade flows and determines trade shares between countries (Bernard et al, 2018; Eaton et al, 2018). Firms are so strongly connected with each other that it is costly for them to shut down links with existing partners and search for alternative ones. As a result, these links react sluggishly to trade shocks, as seen in Chile during the Great Recession – where output losses would have been 30% lower with totally flexible production networks (Huneeus, 2018).

Similarly, evidence for France shows how shocks that cause increases in uncertainty reduce the formation of new firm-to-firm relationships involving products with high partner search costs (Martin et al, 2020). Again, these links remain active, but with smaller volumes of the same products, rather than dropping or replacing them with others.

Brexit: an uncertain permanent shock

Unlike Covid-19, Brexit is generally seen as a permanent shock that makes trade between the UK and Europe more costly. This is despite the zero tariffs on most goods, as negotiated in the latest deal – mainly because of an increase in ‘red tape’, and trade in services becoming more difficult and costly. Some studies predict that the long-run economic costs to the UK economy will be two to three times larger than those from Covid-19 (Van Reenen, 2020; Sampson, 2020).

Research on permanent trade shocks shows that changes in firms’ product mixes are pervasive. For example, this pattern was seen following gradual institutional and managerial reforms in China (Söderbom and Weng, 2012). Also in China, the reduction of export tax rebates – a clear increase in trade costs – caused firms to drop least competitive products (Han et al, 2015).

Economic theory predicts that an unexpected input tariff rise makes firms renegotiate with initial suppliers or find replacements (Grossman and Helpman, 2020). Hence, it is reasonable to expect long-run adjustments in UK firms’ product portfolios in the EU market. Brexit may cause UK firms to drop their least competitive products.

Studies of the short-term effects of Brexit on the performance of UK firms highlight the high degree of uncertainty caused by the referendum. This persistent uncertainty is shown to have delayed adjustments in UK firms’ investment decisions (Bloom et al, 2019). As a result, the 11% fall in investment caused by Brexit took three years longer than expected.

Estimates for 2016 show that around 5,300 UK exporters decided against entering the EU market with new products, and over 5,400 exporters pulled products from the EU (Crowley et al, 2018). But these decisions did not have a large aggregate impact (under £3 billion) relative to total UK exports to the EU (£139 billion in 2016).

What else do we need to know?

After discussing the nature of both shocks and the experience from previous crises, it would be reasonable to expect a stronger impact of Brexit on firms’ product mix decisions. With the data, this might translate into a lower number of products being traded with the EU.

But much more information is required to draw firm conclusions. Access to UK firm-level trade data is essential for analysing how firms’ export product portfolios have evolved over time and to explore the determinants of these changes. Indeed, this article echoes previous calls for the need for real-time data on businesses in order to study their dynamics in light of shocks (Dhingra and De Lyon, 2020).

Of equal importance for any serious analysis of firms’ export decisions in the context of the two shocks is to consider differences across sectors, as observed in Figure 2. It is clear that some industries are more exposed to trading with the EU and the permanent effects of Brexit, while others are more affected by the temporary pandemic-related lockdowns.

Indeed, industries such as transport activities, electrical equipment and textiles – where business volumes in April 2020 did not decrease dramatically due to Covid-19 ­– are those most exposed to the negative impacts of Brexit. Conversely, industries such as printed publications, metal and food – which have been most affected by Covid-19 – tend to be less exposed to Brexit uncertainty (De Lyon and Dhingra, 2020).

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Author: Manuel Tong, NIESR
Photo by Tyler Casey on Unsplash
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