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Equant Analytics June Trade Outlook

Article 50: time to take a strategic look at trade

Almost as soon as the dust settles after the UK election, the Article 50 process to negotiate the UK’s exit from the EU will start. The UK so far has relied on a conciliatory Europe led by a Germany that was genuinely saddened by the loss of its like-minded Anglo-Saxon ally and therefore more likely to drive the bloc towards compromise. The G7 and NATO summits at the end of May, and the inauguration of President Macron have changed all that. Europe is finding a new assertiveness on the global stage. This was articulated by Chancellor Merkel in her Munich speech; she argued that the US and the UK could no longer be relied upon and that Europe must find its own voice to promote its own interests. And while much of the rhetorical anger in the speech may simply be attributed to electioneering, it serves as a wake-up call to the UK. Europe will have its own strategic interests when it starts the negotiations and the UK would do well to be aware of what these are.

Trade is political and this makes it strategic – that is, something that can be used as a tool to promote national or regional interests in economic or foreign policy terms. In this, EU negotiators will be keen to protect Europe’s economic and energy security as well as increasingly focused foreign policy interests.

The EU’s top ten export and import trade flows by sector with the UK are automotives, machinery (including computers), pharmaceuticals, electrical equipment and oil and gas (Figure 1). The top fifteen trade flows by sector add optical, photographic and medical equipment, plastics and aerospace. These are not just the top trade sectors for the EU as a whole; they are also among the top sectors for Germany, France, the Netherlands, Italy, Belgium and the UK.

Given that Europe exports to the UK some 85% more than it imports from the UK, it has been assumed that the cards are stacked in the UK’s favour. However, trade “wars” are reciprocal: one side imposes tougher arrangements and the other retaliates. As these are the top sectors for the UK as well, and as Europe is the UK’s largest export destination for each of these sectors, it will be important to bear in mind that the symbiotic relationship in these sectors are because of Europe-wide supply chains. Everyone will lose without some compromise.

Figure 1: Top 15 trade flows by sector between EU and UK (exports and imports, 2016, US$ bn)
Source: Equant Analytics, 2017

The second thing to note is just how concentrated this trade is. The top ten flows account for 53% of Europe’s trade with the UK. Add in plastics, optical and medical equipment and aerospace (the 11th and 12th largest flows and in the top five for Germany, France and Italy) and the top flows account for over 60% of Europe’s trade with the UK (Figure 2).

Again, the dominance of exports to the UK is clear – the top four sectors are all exports to the UK and constitute over 31% of Europe’s trade with the UK. Again, however, the importance of Europe-wide supply chains is critical. The UK is a large export market for German cars and automotive components, but this is because the UK is a major location within Europe for the manufacture of German cars. While this may appear that Germany is more dependent on the UK than the other way around, the UK’s exports of cars to the US has grown at an annualized rate of 9% and to China at an annualized rate of 13% over the past five years. This is not all attributable to German manufacturers, but there is no doubt that this has had an influence.

Figure 2:  Share of EU trade with the UK, top fifteen sectors, 2016 (%)
Source: Equant Analytics, 2017

Finally, the EU 27’s trade is 73% correlated with the value of the euro since 1998 suggesting that it is a trade-based currency rather than a speculative one. Its trade with the UK is slightly weaker at 70% but this is still substantial. (Figure 3). The euro is the world’s second largest trade finance currency and its position and strength can therefore be seen as a function of the strength of Europe’s trade. This is a quite distinct function for the euro and explains why Germany in particular has been keen to hold the Eurozone together: the euro’s economic importance is in trade and as supply chains develop across the region, this becomes more rather than less important. Just as is the case for Europe, a stable euro for the UK ensures that prices within the supply chains into which UK businesses are woven are also stable.

Figure 3:  EU 27 exports to UK vs euro-usd spot price, 1998-2016
Source:  Equant Analytics, 2017

Elections distort rhetoric and there is anger in Europe about the UK’s bellicose tone which, along with Trump’s visits at the end of May provoked the response from Angela Merkel that former allies could no longer be trusted and that Europe would have to go it alone. The danger is that rhetoric becomes entrenched on both sides after the election in the UK because there is still a long way to go before the German election. This would be a negotiating mistake on the part of the UK. Europe’s and the UK’s trade is almost symbiotic because of the importance of supply chains. Policy makers on both sides would do well to remember this.