The Gravity Model of Trade (http://www.nber.org/papers/w19285) is one of the more robust models in economics. It is based on the observation that levels of trade between countries depend on the size of the economies and the inverse square of the distance between them. Double the distance between a pair of countries and the potential for trade falls to a quarter. The gravity model is persistent over time as it is includes geography which does not change. Growth rates in GDP and exchange rate shifts come and go. Responding to them is an opportunistic tactic. The gravity model shows the strategic targets for increased trade.
While it is obvious, that say, shipping costs and delays influence the attractiveness of goods sold at a distance, services also often follow the gravity model. Intellectual property monopolies such as design rights to ARM chips or Liquid Crystal Displays may seem free of distance but even in such a case time zone differences and the trouble and expense of intercontinental flights can be a factor in encumbering sales effort. Often services are a face to face business. Differences in time zones and long travel times erode the opportunity to deliver services from a remote base. Tokyo, Hong Kong, Singapore, Dubai, New York and Chicago compete with London financial services at least partly due to time zones and distance to travel to meet clients. That said, there is a bias in service exports to English speaking countries, especially the US and also to the EU. This could also be a bias to developed countries which have larger service economies anyway.
The G20 is a grouping of countries that represents 85% of World GDP. Confining this analysis to the G20 captures the all significant opportunities without cluttering the presentation. The UAE and Iran are not in the G20 although on some measures they are bigger than the smaller members such as Argentina.
The EU and the USA are so dominant that the post Brexit question comes down to the UK’s ability to increase exports and decrease paperwork and regulations to the USA more than the likely losses to the EU. It’s an exciting challenge.
The next chart shows the countries lost in the corner. The trend line is the same as for the previous chart.
The Russian Anomaly Is the UK underperformance in Russia due to post Crimea and Donbass sanctions? There were EU sanctions against individual members of the Russian elite and Russian counter sanctions against EU food suppliers.
It is not.
In 2016, after the oil price crash, Germany, also in the EU, outsold Britain by a factor of 5.5 times in goods selling a similar mix of products to that of the UK. Germany is a bigger economy, closer to Russia and has significant a population with Russian language skills but not enough for a 5.5 times out performance. France outsold the UK by a factor of 2.4 and Italy by 2.2. France did sell even more relative to the UK in previous years but lost significant trade in 2014 due to Russian counter sanctions in food and the failure to deliver an aircraft carrier. UK, Germany and Italy were less affected. The UK competes better in selling services but goods still predominate in the Russian case. However, success in exporting media, financial and legal services from London does not excuse this underperformance in manufactures. Britain outside the Home Counties deserves some support and attention from government.
Based on experience in assisting British firms to enter the Russian market by investment or export, Volga Trader can make the following observations about British underperformance. One is a lack of ambition by British firms. The EU and USA are vast markets. Why go further?
Often, Russia is included in Europe for purposes of sales management. The European Sales Manager, with an incentive programme that emphasises one year performance is in charge. Unlike the EU, Russia is a real foreign country and there are regulations and customers procedures to fulfill. These take time and money. 9 documents is ordinary. Sales managers whose other experience is the EU, where “export” involves changing a line in a VAT return may find this forbidding.
Building a real business in Russia is typically a 3 year assignment. The rewards are usually good. Because of the barriers to entry competition is less and prices are often higher than the EU. The Russian competition authority estimated 25% higher in consumer goods. Volga Trader’s direct experience with UK firms in Russia suggests a reluctance to invest in setting up a sales operation other than seeking to find an importer/distributor in the current year already engaged in the same trade and so already selling a competitor’s products. Building an exclusive team takes time and money middle sized British firms will not spend to develop a distributor in the same way as German firms seem to.
The graph shows above trend performance in English speaking countries. The UK may have particularly bad language skills for the three leading opportunities; Russia, China and Turkey. This is solvable. The UK contains many immigrant communities, including Russians from the Baltic countries (at one time the cleaner in Volga Trader' office block was an ethnic Russian history teacher from Lithuania), Chinese from Hong Kong and recently arrived Turkish immigrants. These groups tend to get pushed into low-level jobs or self-employment. It would be of advantage to the country if they could be offered training programs to make them commercially useful to British exporters. Although they do less skilled jobs, in terms of their own qualifications they are not always unskilled.
Also, implementation consultancies like Volga Trader can help firms cope with finding partners, language problems, local regulations, testing to local standards, customs documents and so forth. Russia need not remain impenetrable. If necessary we can provide an interim management team to prove the market. We can maintain our commitment past the stage where the local UK trade delegation must give up.
Harmonization of regulations is improving. Russian belongs to the Eurasian Economic Union. There is a customs union already operating and a single market with regulations harmonized to European Union standards in construction. Otherwise, since 2012, Russia trades with the world on WTO terms. The Russian economy will grow. Russia still has very large Sovereign Wealth funds. In a speech to the Federal Assembly President Putin announced major spending plans for these funds. He plans a 7% growth rate in the next two years well ahead of the world average. Huge infrastructure and housing projects will take place. Social spending on healthcare may double. The economic content was rather overshadowed by the announcements of new types of missiles.
The UK has an attractive food market that could be used to influence concessions by Russia in areas of British interest.
Bridgend, the UK office location of Volga Trader has examples of export potential. The post Brexit survival of the Ford Bridgend Engine plant. Ford has a substantial operation in Russia that could accept Bridgend engines instead of expanding its existing engine plant in St Petersburg which builds smaller engines. Without a trade deal, to remove Russia’s rules of origin provisions, St Petersburg could expand (wages are much lower) and threaten Bridgend (more reliable infrastructure) in third markets. Russian electronic assembly is weak although product design skills exist in the country. Sony Bridgend has an electronic assembly plant a truck drive away from Russia with far lower reject rates than Chinese competitors. Low tariff access can open this market too.
This discussion has focussed on the potential for British exports. This is 18th Century Mercantilism. Imports matter too. They are not a matter of charity. They reduce prices in the importing country. Trade opportunities with Russian flow two ways. Russia is the world’s largest exporter of wheat, barley and sunflower oil products. Post Brexit tariff reductions, given the modest distances involved, Russian grains are likely to be very competitive in the UK market. Also. Russia is already an exporter of chicken (not chemically washed) and becoming one in pork. Russia may yet deliver the food price reductions sought by Free Trade advocates without the regulatory compromises involved with supplies from the US. In principle, Russian regulations concerning GMO’s or chemically washed chicken meet or exceed EU standards. Having Russia as a potential trading partner, reduces US bargaining power to force US regulatory standards in food products during future trade negotiations. With a Russian alternative, UK agriculture can preserve its export potential to Europe by maintaining regulatory standards. Russia is a major producer of other raw materials and semi processed metals whose prices influence long value chains. Russia’s European culture means that services such as media production for example, Masha and the Bear, also have value.