Tuesday, 25 October 2016

What might Brexit mean for UK manufacturing?

The question of how UK manufacturing will fare post-Brexit is often presented in the somewhat simplified terms of a transactional relationship between UK manufacturers and EU markets. ‘Leavers’ contend that because the EU sells more goods to the UK than the UK sells to it, we will have the upper hand in negotiations.  But that position overlooks the nature of modern manufacturing, which today relies on complex networks of companies, scattered across the globe, all dependent on each other to produce finished goods and services.
In order to unpick how much UK manufacturing depends on access to the EU Single Market we need to consider the issue from three different but connected perspectives: the manufacturing trade environment, the impact on foreign direct investment, and the importance of manufacturing value chains and networks.
In terms of trade, the UK has run a deficit since 1998, largely caused by a deficit in traded goods. According to the Office of National Statistics, the 2015 deficit was around 6.9% of GDP, although this is partly offset by a surplus in services, resulting in a balance of -2.1% of GDP. Clearly the devaluation of the pound in the immediate aftermath of the EU referendum may have a positive impact on exports - UK exports are currently around 20% cheaper than they were pre-referendum - which makes UK goods more affordable and appealing to international markets. However, the impact of this devaluation is likely to be short-lived. Already there is evidence of inflationary pressure affecting imports used by UK manufacturers. As price increases flow through supply chains, the cost of finished goods will also increase, offsetting competitive advantage gained through a weak pound. In the long term, the way to address the UK’s deficit is through trade - ensuring that we export more than we import - and for that we require access to international markets, both in Europe and beyond.
In recent years, the UK has been very good at securing foreign direct investment, but the Japanese Government, in its letter to the United Kingdom and European Union, challenged any assumptions that this would continue untroubled by Brexit. The letter, delivered just before the G20 meeting, was remarkably explicit, raising five substantive issues that would deter future investment: uncertain trading conditions, additional customs duties, inability to access services and make financial transactions seamlessly across Europe, inability to access workforces with the right skills, and the need to deal with different sets of regulations and standards in the UK and the EU. The Japanese Government’s warning was stark: “Japanese businesses with their European headquarters in the UK may decide to transfer their head-office function to continental Europe if EU laws cease to be applicable in the UK after its withdrawal”.
As commentators have noted, the Japanese letter makes it clear that the UK is not just negotiating with the EU over Brexit, but it also has to strike a deal that satisfies the requirements of other international trade partners. Failure to do so will isolate the UK further from the international community and runs the risk that future foreign direct investment will be more difficult to secure.
The third issue is that of global supply chains. Today’s manufacturers do not operate within the boundaries of a single country.  To describe a manufacturer as British – in competition with, say, its US or German or Japanese counterparts – is somewhat misleading.  Competition in modern manufacturing takes place between interdependent groups of firms, often from different countries, that share knowledge and collaborate with one another to produce goods and deliver services. Raw materials are typically sourced in one location, intermediate inputs (such as parts and components) are produced in another and then exported somewhere else for further processing and/or assembly into final products. And it’s not just supply chains that function across boundaries: the knowledge-intensive aspects of manufacturing such as R&D, design and professional services are similarly geographically dispersed.
For manufacturers to be competitive they need access to high quality production ‘inputs’. These inputs include not only components, systems and specialised services but also workers, finance and even infrastructure, many of which are imported from abroad. Data from the OECD shows that a considerable proportion of UK exports rely on UK manufacturers first bringing in inputs from abroad, processing them and then exporting them.  In 2011 the content of UK exports that had been previously imported was around 23%, and that figure appears to be higher than for the other major EU manufacturing economies.
Conversely, over half (52.5%) of UK manufacturing domestic value added is driven by foreign final demand, and a significant proportion of what the UK exports are not final goods, but products and services that are further processed by another country before reaching the consumer. Of the UK’s total exports of domestic value-added in 2011, 63.7% were not final goods.
So the picture complex. The assumption that the balance of trade deficit strengthens the UK's hand in Brexit negotiations only holds if the factories using these imports are confined to the UK. If the tariffs on importing intermediate goods become too high, however, there may come a tipping point where it might be more competitive to move some activities (and factories) to the EU.
While uncertainty remains over what Brexit actually means, it is clear that the impact on manufacturing will be significant. For manufacturing to thrive and prosper we need an agreement with the EU that is open, transparent and enables international trade, investment and knowledge to flow with ease. Anything less runs the risk of damaging the long-term health of UK manufacturing.
Professor Andy Neely, Head Institute for Manufacturing, University of Cambridge
Dr. Carlos López-Gómez, Head of Knowledge Exchange, Policy Links, Centre for Science, Technology & Innovation Policy (CSTI), University of Cambridge