Renegotiating of Trade Agreements and Firm Exporting Decisions: Evidence from the Impact of Brexit on UK Exports

07/03/2018

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Meredith Crowley, Oliver Exton, Lu Han | Institute for New Economic Thinking, University of Cambridge

Abstract

The renegotiation of a trade agreement introduces uncertainty into the economic environment. In June 2016 the British electorate unexpectedly voted to leave the European Union, introducing a new era in which the UK and EU began to renegotiate the terms of the UK-EU trading relationship. We exploit this natural experiment to estimate the impact of uncertainty associated with trade agreement re-negotiation on the export participation decision of firms in the UK. Starting from the Handley and Lim˜ao (2017) model of exporting under trade policy uncertainty, we derive testable predictions of firm entry into (exit from) a foreign market under an uncertain ‘renegotiation regime’. Empirically, we develop measures of the trade policy uncertainty facing firms exporting from the UK to the EU after June 2016. Using the universe of UK export transactions at the firm and product level and cross-sectional variation in ‘threat point’ tariffs, we estimate that in 2016 over 5200 firms did not enter into exporting new products to the EU, whilst almost 4000 firms exited from exporting products to the EU. Entry (exit) in 2016 would have been 5.1% higher (4.3% lower) if firms exporting from the UK to the EU had not faced increased trade policy uncertainty after June 2016.

Introduction

Nearly all global trade – 98.2% in 2016 – takes place under the import tariff commitments of the World Trade Organization (WTO). Regional trade agreements such as the European Union (EU) and the North American Free Trade Agreement (NAFTA) establish even more stringent tariff commitments which govern the 63% of EU exports to other EU members and the 50% of NAFTA exports to other NAFTA members. While numerous studies have quantified the importance of multilateral and regional trade agreements in increasing trade, more recent theoretical and empirical contributions (Limao and Maggi (2015), Handley and Limao (2015), and Handley and Limao (2017)) have emphasized that trade agreements increase trade between signatories not only by lowering tariffs but also by reducing uncertainty over future tariff schedules. Although countries commit to future tariff rates when they sign trade agreements, renegotiations of tariff and other commitments have been routine over the last 60-70 years (Hoda, 2001). A common thread in post-war renegotiations has been that the threat point or fall back position is the status quo – tariffs would be kept at existing levels if negotiations were to collapse. However, recent renegotiations including the Korea-US FTA in Spring 2018, the NAFTA renegotiation of 2017-2018, and the UK-EU post-Brexit trade relationship start from the position that tariffs could increase to levels above existing commitments if negotiations break down. In this paper, we examine how firm participation in foreign markets changes under the renegotiation of an existing trade agreement. Among countries that are already in a free trade agreement or customs union, the switch to a ‘renegotiation regime’ creates uncertainty about the level of tariffs in the future and a non-zero risk of tariff increases. In the Handley and Limao (2017) model of exporting under trade policy uncertainty, during a renegotiation in which tariff hikes are possible, two forces act upon a firm’s entry decision: an increase in uncertainty about future tariff rates generates a pure risk effect which raises the real option value of waiting to enter foreign markets while the non-zero probability that higher ‘threat point’ tariffs could materialize if negotiations breakdown raises the mathematical expectation of future tariffs which, in turn, lowers the expected returns to entry. The main contribution of this paper is to analyse how firm entry into and exit from foreign markets changes when existing tariff-free trading rights could be revoked under a trade agreement renegotiation. We present new evidence of the impact of a switch to a renegotiation regime in the context of Brexit, when the British public unexpectedly voted to leave the European Union in a referendum on 23rd June 2016. Using the EU’s World Trade Organization schedule of tariff commitments, we compile granular ‘threat point’ tariffs that British firms exporting to the EU would face if the renegotiation were to break down. We implement a generalized difference-in-difference strategy to estimate the impact of switch into a renegotiation regime on the growth in the number of UK firms entering (exiting) the EU market in in 2016 relative to 2015 (first difference) with different Harmonized System products (second difference) that face different threat point tariffs during the renegotiation period. Our results show that the switch to a renegotiation regime, characterized by substantial threat point tariffs for some products, decreases firm entry into and increases firm exit from exporting to the EU. The impact is largest for products facing higher threat point tariffs, suggesting that UK firms placed positive probability on the likelihood that negotiations could collapse and leave some firms facing substantially higher tariffs on exports to the EU. On average, across all products, a 1 percentage point increase in the threat point tariff decreases (increases) the growth rate of entry (exit) by 1.1 percentage point (0.5 percentage point). We explore possible non-linear responses with discrete categories of threat point tariffs and find that ‘extreme’ threat point tariffs of more than 15% ad valorem are associated with a 25.3 percentage point decline in the growth rate of entry while products with ‘high’ threat point tariffs from 10% up to 15% experience a decline in the growth rate of entry of 12.3 percentage point. We conduct a partial equilibrium aggregation exercise to calculate the number of missing entrants into (exiters from) the EU from the UK as a result of the switch to the renegotiation regime post-Brexit. This exercise estimates that 5,221 firms did not enter into exporting new products to the EU in 2016, whilst 3,850 firms exited from exporting products to the EU in 2016, in response to the uncertainty and tariff risk associated with renegotiation of the UK-EU trade agreement. Overall, entry into (exit from) the EU would have been 5.1% higher (4.3% lower) in 2016 relative to a counterfactual of zero tariffs on all products and no uncertainty about future tariff rates. While previous research has examined trade policy uncertainty (Handley and Limao (2015), Handley and Limao (2017), Pierce and Schott (2016), Crowley, Song, and Meng (2016)), ours provides the first empirical evidence on increased uncertainty from renegotiation of an agreement between freely trading partners. With declining support for globalization among many groups in society, more countries face the prospect of trade agreement re-negotiations and the uncertainty over policy that they bring. We show that our findings are the result of the switch to the renegotiation regime and are not driven by product specific global demand shocks or supply chain disruption. We implement a generalized triple difference comparing entry and exit to the EU in 2016 relative to 2015 (first difference) across over 8500 products (second difference) relative to non-EU countries (third difference). The triple difference provides evidence that the impacts of the switch in trade policy regime are causally driven by the risk of future tariff increases. Estimates of the decline in the growth rate of entry for products with higher ‘threat point’ tariffs are larger in the triple difference specification relative to our baseline difference in difference over time and across products. This suggests that the phenomenon of trade deflection (Bown and Crowley, 2007) – in which firms shift export sales from destinations that have raised tariffs to those which have not – extends to the extensive margin with firms shying away from entry into destinations that might raise tariffs in favour of markets with more stable trade policy.

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