Ever since the burgeoning of international trade in the post-war era, economists have sought to understand the fundamental factors that drive it.
One surprising finding was that trade is largely determined by the same two features that govern the physical world – mass and distance – as captured in an equation that mirrors Newton’s universal law of gravitation. This gives rise to the so-called ‘gravity model’ of trade1.
The model predicts that bigger economies which are closer together will trade more with each other. That’s particularly intuitive for trade in goods: the greater the distance goods need to travel, the higher the trade cost, which in turn reduces trade flows.
However, for services, like accounting and finance, which do not have to be physically transported, one might argue that their intangible nature makes them less susceptible to the forces of economic gravity. So, given the growing importance of services in global trade flows, do the lessons of the gravity model still hold true?
Our latest research suggests that they do. Using a new experimental dataset from the ONS on UK services and exports, and controlling for a number of factors2, we find that distance matters as much for services as it does for goods.
Doubling the distance between the UK and a trading partner is associated with a 41% decrease in the value of services exports. The effect on goods is only slightly stronger. Doubling the distance would decrease the value of goods exports by 44%.
So what might these findings tell us about the UK’s approach to negotiating future trade relationships?
Services exports: A great British success story
The UK is the world’s second largest exporter of services after the US. From tourism and transport, to financial, business, creative and cultural offerings, the UK’s services exports combine to generate a trade surplus equivalent to 7% of GDP3.
Many of these services, as our gravity models would predict, head to both closer and larger economies like the US and the EU, as the map below shows.
How the world map would look if the size of each country’s land area were scaled to the size of UK services exports to these countries
It’s clear, therefore, that focusing on services as part of the post-Brexit trade negotiations with the EU and other geographically proximate (and larger) economies would play to the UK’s strengths.
A one-size-fits-all approach doesn’t work
A deeper analysis of individual sectors shows that the influence of distance on trade can vary significantly depending on the type of service provided. Sectors that tend to be sold as part of – or embedded in – goods, such as construction and repair services, are weighed down by gravity. At the other end of the spectrum, the UK’s cultural exports, such as music and performing arts, fashion, films and TV, are examples of services exports that have strong global appeal, not just in geographically proximate markets.
Perhaps even more surprising is how trade in sectors like financial and professional services – which conventional wisdom might suggest would defy the forces of gravity as they are often delivered digitally and remotely – appear to be inhibited over greater distances.
This suggests that networks, close collaboration and relationship building – all of which are hampered over longer distances – can be crucial when it comes to demand for these services. The UK’s time zone between the East and West has helped it secure its position as a global financial services hub. Its proximity to Europe, and the fact that it’s a member of the EU Single Market, has also helped it to serve as the primary gateway to European markets for leading US and Asian financial institutions.
A one-size-fits-all approach to trade negotiations, where the same sector emphasis is applied in negotiations with different countries and regions, is therefore unlikely to work.
So while much of the Brexit debate so far has focused on securing the seamless flow of goods between the UK and the EU, the next stage of negotiations with the EU must focus on services.
Understanding which services ‘travel well’ and which do not, will serve the UK well as it steps up its efforts to deepen trade links with other countries beyond the EU, whatever the outcome of Brexit.
Read more of our research here. For more Brexit insights, go to pwc.co.uk/brexit.
