Trade and foreign direct investment‐related impacts of Brexit

• Date: 01 January 2020
• Published date: 01 January 2020
• DOI: http://doi.org/10.1111/twec.12859

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World Econ. 2020;43:2–32.

wileyonlinelibrary.com/journal/twec

Received: 17 August 2018

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Revised: 5 August 2019

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Accepted: 15 August 2019

DOI: 10.1111/twec.12859

ORIGINAL ARTICLE

Trade and foreign direct investment‐related impacts

of Brexit

María C.Latorre1

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ZoryanaOlekseyuk2

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HidemichiYonezawa3,4

1Universidad Complutense de Madrid, Madrid, Spain

2Deutsches Institut für Entwicklungspolitik, Bonn, Germany

3ETH Zurich, Zurich, Switzerland

4Statistics Norway, Oslo, Norway

Funding information

German Federal Ministry for Economic Cooperation and Development; Spanish Ministry of Economy and Competitiveness,

Grant/Award Number: ECO2016‐78422‐R

KEYWORDS

Melitz, monopolistic competition, Multinationals, trade in services

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INTRODUCTION

The potential impact of Brexit has attracted much attention since the referendum in 2016. UK's de-

parture from the EU was due in March 2019, two years after invoking article 50 of the Lisbon Treaty.

However, the UK's Parliament has rejected the Withdrawal Agreement negotiated by the then‐prime

minister of UK Theresa May, who has ended up resigning. As a result, much uncertainty still sur-

rounds what the future relationship between the UK and the EU will be. With this background, we

address the following questions in this paper: Which side (UK or EU) will be more harmed? Will the

UK or EU be able to recover much of its lost trade after Brexit in other regions of the world? Who

wins in that trade with third nations? What is the role of UK and European multinationals as well as

multinationals in UK and EU?

Modelling a disintegration process constitutes a rather uncommon analysis.1 However, the economic

effects of Brexit have been broadly studied and reviewed (e.g. Busch & Matthes, 2016; Chang, 2018;

Fernández‐Pacheco, Lopez, & Latorre, 2018; and Latorre, Olekseyuk, Yonezawa, & Robinson, 2019).

The consensus is that it will generate an asymmetric negative outcome in which UK will lose more than

1 As the last decades are characterised by the deepening of economic integration and the fall in barriers to trade and FDI,

studies tend to investigate integration processes (e.g. Latorre et al., 2018; Ortiz and Latorre, 2017; Latorre and Yonezawa,

2018). Some scarce exceptions, however, can be found in the analysis of disinvestments (Gómez‐Plana and Latorre, 2014), of

FDI decreases during the crisis (Latorre and Hosoe, 2016) and of Crimea's annexation from Ukraine (Olekseyuk and

Schuerenberg‐Frosch, 2018).

This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and reproduction

in any medium, provided the original work is properly cited.

© 2019 The Authors. The World Economy published by John Wiley & Sons Ltd

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LATORRE ET AL.

the Rest of the European Union (REU, henceforth). This paper analyses the impact of two dimensions of

Brexit, namely trade and foreign direct investment (FDI). It aims at quantifying its effects on a sectoral

and aggregate level for several regions, with a focus on potential effects on foreign multinationals in

services and productivity impacts in manufacturing. We use a numerical simulation model with 21 sec-

tors, 11 regions and 4 factors of production, which incorporates a Melitz (2003) structure in manufac-

tures and foreign multinationals operating under imperfect competition in services. This combination

has not been previously attained in a multiregional framework, to the best of our knowledge.

Our analysis provides original estimations of Brexit impact and contributes to the literature along

three broad fronts. First, with respect to the mainstream analysis in international economics (e.g.

Costinot & Rodriguez‐Clare, 2014), we incorporate more simultaneous features of real economies.

These include multiple sectors, regions and factors of production; trade imbalances; intermediates

with demand structures reflecting actual data; sector‐specific tariffs as well as nontariff bar riers

(NTBs) to trade and FDI; multinationals operating in services' sectors; and a competitive selection of

heterogeneous manufacturing firms.

Second, modelling productivity differences across firms within sectors and firms' selection to bi-

lateral markets is an appropriate approach accounting for the features of real economies (e.g. Bernard,

Jensen, Redding, & Schott, 2007). Most of the previous studies on Brexit neglect this point by apply-

ing an Armington perfect competition setting (e.g. Aichele & Felbermayr, 2015; Ciuriak et al., 2015;

Dhingra et al., 2017; Ottaviano, Pessoa, Sampson, & Reenen, 2014). Since the debated equivalence of

welfare impacts of trade among Armington, Krugman and Melitz structures suggested by Arkolakis,

Costinot, and Rodríguez‐Clare (2012) holds only in a very restrictive setting (see, e.g. Akgul, 2017;

Balistreri & Tarr, 2017; Costinot & Rodriguez‐Clare, 2014), most of the analyses of Brexit with the

Armington setting could be considered as a lower bound impact.

Third, we additionally incorporate multinationals in services into the path‐breaking numerical sim-

ulation model of Balistreri, Hillberry, and Rutherford (2011) with the full Melitz structure in several

sectors. Given the particularly intense specialisation of UK economy in services, such as finance, in-

surance, telecommunications and business services, an analysis of mode 3 provision of services (i.e.

through foreign affiliates sales) is of high relevance. Moreover, our sensitivity analysis illustrates that

dropping the FDI barriers and monopolistic competition among heterogeneous firms (i.e. similar set-

ting to Ottaviano et al., 2014 and Dhingra et al., 2017) would generate an underestimated Brexit im-

pact by approximately 50%.2

Our results suggest that the UK experiences much more sizeable losses in its welfare, foreign

trade, production, average industry productivity, wages and capital remuneration than the REU

does. A hard Brexit (i.e. reversion to WTO rules) would reduce welfare in the UK by −3.17% (in

REU by −0.59%), while the impact of a soft Brexit (e.g. a post‐Brexit arrangement similar to

Norway) would be about a half of the negative impact of the hard one in both regions. We also

observe higher welfare losses along the extensive margin for the UK illustrating the fact that the

UK loses many imported varieties (produced by highly productive European firms) with low prices

and high quantities, while the new domestic varieties are produced by firms with lower productivity

and therefore at high prices and small quantities. Indeed, the results for average productivity of

domestic firms in the UK confirm this with a decline by up to −2.27% in several manufacturing

sectors such as textiles, chemicals, motor vehicles and electronics. Thus, less productive firms enter

the British market due to increased protectionism and reduced import competition. Moreover, our

2 While the magnitude of Brexit impact quantified by Ottaviano et al. (2014) and Dhingra et al. (2017) is comparable with our

results, note that their policy assumptions of Brexit are different from ours. Specifically, they incorporate missed future

opportunities of further EU integration, which generates the lion's share of losses accounting for more than half of the total

effect. In contrast, we incorporate the FDI barriers, which lead to one third of the welfare loss.