27 May 2020
L. Alan Winters CB is Professor of Economics and Director of the UKTPO. Mattia Di Ubaldo is a Research Fellow in the Economics of European Trade Policies, and Palitha Konara is a Senior Lecturer in International Business at the University of Sussex. Both are Fellows of the UKTPO.
COVID-19 and Brexit may appear as independent shocks but, in fact, they are interrelated. First, as the UKTPO and many others have argued, because COVID has disrupted the preparation for and conduct of negotiations on the future UK-EU trading arrangements, the UK government should ask for an extension to the transition period. This would allow the UK and EU to work out details of mutual cooperation that will be beneficial on both sides of the channel.
Second, COVID and Brexit, in either its ‘No deal’ or its FTA form, are linked in a more direct and more harmful way – company debt. COVID is creating a mountain of debt and this will make the already difficult job of adjusting to Brexit more difficult.
The re-introduction of trade frictions with the European Union and with countries where the UK has not managed to strike Trade Continuity Agreements will require a major re-orientation of UK exports. That, indeed, is the logic of seeking new trade agreements. To quote last week’s statement on a UK-Japan Free Trade Agreement (FTA), ‘‘More trade is essential if the UK is to overcome the unprecedented economic challenge posed by Coronavirus. It can give us security at home and opportunities abroad – opening new markets for business, …..”
Expanding exports to make up for those lost in the EU was always going to be a challenge and it was never really clear that the Government understood this – think of the argument in 2017 between Liam Fox as Trade Secretary and ‘lazy’ industry that, he said, did not want to export. But post-COVID it will be even more difficult. As we document below, the evidence shows that
While the government has done everything it can to support UK business through the COVID crisis, it has not taken on every expenditure they have; for example, it pays only 80% of the salaries of furloughed staff up to £2,500 a month, so firms have to make their own arrangements for the rest, and it will reduce its support before demand gets right back to normal. To help firms cope with the inevitable cash short-falls, the Government has introduced several schemes to make it easier for them to borrow. Hence, COVID will leave firms much more heavily indebted than they or the government expected – see, for example, this article by Bo Becker, Ulrich Hege, Pierre Mella-Barral.
The result of these debts will be that firms will be even less able than before to experiment with new products or in new markets. In fact, as they emerge from the lockdown, facing imminent restrictions in their traditional EU markets, many may well just give up on exporting altogether. Any government that actually believed that ‘trade is essential …to overcome the unprecedented economic challenge posed by Coronavirus’, would not be hurrying to close nearby markets that firms understand, but making every effort to keep them open.
Breaking into new markets is an expensive and risky operation, which only the most productive firms can afford to undertake.
There is a lot of evidence[1] about the large costs that firms have to incur when taking their products abroad. These costs range from simple things like packaging to more complex tasks such as establishing marketing and distribution channels, accumulating information on foreign demand, and learning about the formalities involved with crossing a border (i.e customs).[2] Furthermore, the largest fraction of these entry costs is unrecoverable should a firm change its mind: if serving a foreign market turns out not to be profitable, the investment made to enter it is gone. In addition, entry costs appear to be proportionately larger for small firms, possibly because they have to rely on fewer contacts and smaller distribution channels. Small firms, and those with shallower pockets in general, are thus at quite a disadvantage.
Compounding the high costs, exporting is risky. Many new exporters drop out of the export business very rapidly: they often start by selling small quantities to a single neighbouring country, and yet almost half of them stop exporting within a year.[3] The survivors typically increase their presence in their current destinations, and the more successful ones also expand into other markets. Because firms are so uncertain about their exporting profitability ex-ante, they prefer to “test the water” in order to learn about their likelihood of success.[4] That is, they invest resources on the chance, not the certainty, that things will go well.
The first new market is therefore a special one, where firms discover their general ability as exporters. For most firms most of the time, the first new market is the closest one[5], both geographically and in terms of preferences, where information is likely to be greater, entry costs lower and the likelihood of succeeding higher.[6] It’s your neighbour. For the UK, our neighbour is the EU, but now that the UK has left the EU, costs of exporting will increase, and its value as a “testing-ground” for new exporters is weakened.
As exporting involves extra costs – to enter a foreign market – and a considerably longer cash conversion cycle compared to domestic sales, it is more challenging for financially constrained firms either to start exporting or to sustain/expand their export activities. Many studies have found that exporters are less financially constrained than non-exporters and among these, company debt is the most widely used measure of financial constraint.[7] Some argue that the relationship runs only from exporting to financial health (which is perfectly reasonable),[8] but more recent and better specified studies find that the main relationship runs from financial health to exporting – that is, that firms enjoying better ex-ante financial health are more likely to start exporting. [9]
Company debt has been found to be a key financial constraint that decreases the chances of export expansion to new destinations.[10] And research also suggests that increasing company debt reduces the survival chances of firms that enter into exporting. In fact, it finds that increases in the share of debt have a stronger negative effect on a firm’s survival probabilities for export starters than it does for non-exporters.[11]
As financially constrained firms may face difficulties in financing the recurrent costs of maintaining their market presence, several studies also find that firms with higher levels of debt have a higher propensity to exit from exporting, and there is evidence that this effect was particularly pronounced for the 2007-2009 financial crisis period.[12] Given that substantial reinvestment is required to re-enter an abandoned export market, firms exiting from the export market during a crisis are unlikely to re-enter again, particularly during the immediate aftermath of the crisis.[13] Thus crisis-led exits can lead to permanent reductions in the number of exporters.
Brexit was never going to be good for exporting; COVID-19 has made it worse.
[1] For example, see: Das, S., Roberts, M.J. and Tybout, J.R., 2007. Market entry costs, producer heterogeneity, and export dynamics. Econometrica, 75(3), pp.837-873. https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1468-0262.2007.00769.x
[2] Sunk entry costs for Colombian manufacturers of leather products, knitted fabrics, and basic chemicals have been estimated to be at least $344,000 in 1986 U.S. dollars.
[3] Eaton, J., Eslava, M., Kugler, M., Tybout, J., 2008. The margins of entry into export markets: evidence from Colombia. In: Helpman, E., Marin, D., Verdier, T. (Eds.), The Organization of Firms in a Global Economy. https://www.hup.harvard.edu/catalog.php?isbn=9780674030817
[4] Albornoz, F., Pardo, H.F.C., Corcos, G. and Ornelas, E., 2012. Sequential exporting. Journal of International Economics, 88(1), pp.17-31
https://www.sciencedirect.com/science/article/pii/S0022199612000220
[5] Lawless, M., Firm export dynamics and the geography of trade (2009) in Journal of International Economics, 2009, vol. 77, issue 2, 245-254
[6] Distant markets, in fact, tend to be served only by the largest and more productive exporters. See Albornoz et al.
[7] Wagner, J., 2014. Credit constraints and exports: a survey of empirical studies using firm-level data. Industrial and Corporate Change, 23(6), pp.1477-1492. https://academic.oup.com/icc/article-abstract/23/6/1477/2912381?redirectedFrom=fulltext
[9] Manole, V. and Spatareanu, M., 2010. Exporting, capital investment and financial constraints. Review of World Economics, 146(1), pp.23-37. https://www.researchgate.net/publication/225233349_Exporting_Capital_Investment_and_Financial_Constraints
[12] Görg, H. and Spaliara, M.E., 2018. Export market exit and financial health in crises periods. Journal of Banking & Finance, 87, pp.150-163. https://www.sciencedirect.com/science/article/abs/pii/S0378426617301899
[13] Görg and Spaliara (2018) find that only about 21% of exiters re-enter export markets during their period of observation.
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