News in Charts: Brexit and the lessons of comparative advantage

Roughly 200 years ago David Ricardo hypothesised that trade between economies works most efficiently when each country specialises in the goods and services that they are relatively better at producing — a theory subsequently known as Comparative Advantage. These gains are likely to be strongest when countries trade with others that have very different specialities.

Based upon these ideas, Fathom’s proprietary RiCArdo tool utilises detailed trade data to uncover an economy’s ‘revealed comparative advantage’ (i.e. which sectors an economy appears to be relatively better at). Unsurprisingly, the tool reveals that the UK’s comparative advantage lies in the financial, insurance and pension services sectors. But RiCArdo allows us to go further than that. By comparing each country’s revealed relative specialisms, we can see where the most efficient trading relationships could be struck.

On 1 January the UK entered into new trade agreements with 62 non-EU countries.[1] These agreements primarily served to replicate the previous agreements that the UK was party to while a member of the EU. Collectively, they cover approximately 13% of all UK goods exports in 2019. These agreements, coupled with the UK’s new post-Brexit trade deal with the EU, mean that close to 60% of the UK’s goods export market was covered by new trade deals at the start of the year.[2] However, since the 62 new agreements largely replicate what was already in effect and trade with the EU is now subject to higher barriers than before, the UK will still have seen an increase in trade frictions.

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As stated above, the gains from trade are usually largest when trading with countries that have substantially different specialisms. The chart below attempts to capture this by comparing the UK’s revealed comparative advantage (RCA) in 20 key sectors with that of various other countries. The best trading partners from a Ricardian perspective are those whose specialisms are most negatively correlated with the UK’s.

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The view this casts on Brexit is rather mixed. On the one hand, the specialisms of most European economies suggest significant benefits from a close trade relationship since their specialities, as implied by their RCAs, are the least similar to the UK’s (i.e., there is a strong negative correlation with the UK’s sectoral specialisms). Assessed on this basis, Italy, Poland and the Czech Republic appear to be near-perfect trading partners for the UK. However, on the flipside, the bloc’s two largest economies — Germany and France — appear to have largely similar specialisms to the UK (mainly services-oriented sectors).[3]

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Of course, the UK government intends to sign additional trade deals on top of those already agreed, with membership of the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP) close to the top of the agenda. Even with the USA’s decision pull out of talks, the CPTPP remains one of the largest blocs around the world, equating to roughly 10% of global GDP.  If the US were to perform a volte-face on this issue, the trading bloc would be substantially larger than the European Single Market. Reassuringly for UK policymakers, the RCA data suggest that most members of the CPTPP appear well suited to a trading relationship with the UK, with trade entrepôt Singapore and future joiners Peru and Brunei being the main exceptions.

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Outside of the CPTPP, data from Fathom’s proprietary RiCArdo database suggest that other Asian economies such as China, South Korea and Taiwan should all be prime targets for trade deals. Interestingly, and perhaps not by coincidence, these countries are also at the epicentre of tensions in the US-China technological supply chain. By contrast, the similarities between the US and UK economies suggest that a transatlantic trade deal might be less beneficial than many believe.

To find out more about Fathom’s RiCArdo tool and how it could help you, or to subscribe to the database, please contact us: enquiries@fathom-consulting.com.

[1] UK trade agreements with non-EU countries – GOV.UK (www.gov.uk)

[2] In addition, trade deals with four other countries — Albania, Canada, Jordan and Mexico — are due to take effect later in the year.

[3] There are one or two sectors which stand Germany and France out from the UK. In the case of Germany, it is primarily autos manufacturing and the production of machinery; in France, it is the production of food/drink and, to a lesser extent, the tourism industry.

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