The imbalance of UK-EU Trade and its Consequences

The problem is due to the Union itself because within a Union the National effort cannot be kept within the Nation.

The Current Position of UK- EU Trade

The Graph below summarizes the current trading position with the EU:

The data shows that UK Trade is performing far better outside the EU than within it and constitutes grounds for an immediate re-examination of the UK-EU trading relationship. The data also shows that there is probably a systemic problem in UK-EU trade. Why is the UK-EU trade balance so bad?

The value of UK exports to non-EU countries is now considerably in excess of the value of exports to the EU:

However, exports to the EU are only failing to grow, not declining massively. So what is going wrong with UK-EU trade, why is there such a huge deficit? The answer lies in a large growth in imports from the EU:

The reason for this growth in imports is that, as a result of financial, non-trade transactions, UK consumers have been provided with a large excess of Euros to spend on EU goods. This will be discussed in the following sections. The Office of National Statistics has described this use of overseas funds to buy imports:

"In every year since 1998, the UK has borrowed from abroad to finance its continuing current account deficit. This has resulted in inward investment (UK liabilities) exceeding outward investment (UK assets)." Pink Book 2014, Part 2

However, since the Eurozone crisis this should be reworded: "The UK has financed its current account deficit using the inward investment that it has received".  This provides a more accurate summary of the same phenomenon and allows us to deal with it.

The Consequences of Economic Union

If the UK were part of a full economic union any benefit from trade would rapidly percolate out of the UK into the rest of the union in the same way as it percolates out of London to Surrey or from Scotland to England. In an economic union the effort of UK exporters will not necessarily enrich the UK because it will be distributed into other parts of the union. The UK is currently in a partial economic union with the EU and is experiencing the first effects of distributing its national effort elsewhere. The movement of money to the centre of a country is called "Regionalisation", the UK is becoming a region of the EU and this is being made obvious because the UK has a separate currency from the Euro (the EU national currency). This process could be beneficial to pan-European enterprises but UK MPs and the UK Government must decide whether the process is beneficial to the people that they represent.  

Excess Foreign Investment and the Balance of Payments

Foreign investment in the UK is excessive when it greatly exceeds UK investment abroad and when the excess flow of foreign funds into the economy has a significant effect on the purchase of imports.

Foreign direct investment alone now totals about £1000 billion in the UK (£1trn see Government Article below) and there have been large inward flows in portfolio investments etc. Is foreign investment in the UK excessive and how is this affecting the economy?

The UK has the peculiar status of having its own, major currency within the EU. This allows EU investors to hedge against the Eurozone crisis within the relatively safe, legal framework of the EU. As a result there has been a large inflow of foreign investment into the UK with about 50% coming from the EU and 50% from the rest of the world. As the investment flows into the economy, it provides a high availability of foreign exchange to purchase imports. This investment always creates liabilities for profits, interest, dividends and other payments (the Primary Income deficit) and in the case of EU investments this has created an annual bill of about £40 billion. The net result of excess imports and a Primary Income deficit is a chronic Balance of Payments Current Account deficit with the EU:

 The annual Current Account deficit with the EU is now routinely over £100 billion (5.8% of GDP) and is responsible for nearly all of the UK Current Account deficit. This deficit is “financed” by continuous, high flows annually of foreign investment money: the UK is paying off a revenue deficit by acquiring liabilities. The flow of foreign currency for investment raises the value of sterling which has led to an increase in imports from the EU and this has created the large deficit in the trade of goods with the EU. The UK displays the typical profile of an overvalued currency with the expected rise in imports and a fall in exports:

Calculations of the real value of the pound show that it has been very overvalued as a result of foreign investment.  Foreign investment entails the exchange of billions of Euros etc. for pounds, creating a demand for pounds and hence increasing the value of the pound.

(Post referendum update: Fortunately the EU Referendum has finally adjusted the pound back to its correct, trading value, a change that started in 2014 as the Eurozone economies improved. The direct, trading value of the pound (PPP) with investment effects removed is given by the green line in the graph below:

As Euros flow into the UK the exchange rate for the pound increases whilst the underlying value of the pound (the value without an inflow of Euros) declines as the trade deficit widens.  The economy appears rosy on the surface whilst it is rotting within.  See Note 2 below.)


Not only has foreign investment elevated the pound, making imports cheap and UK exports expensive,  the large inflow of imported goods and the management of foreign investment has distorted the UK economy, favouring services over the production of goods.  This in turn has decreased the offering that the UK can make in the general international trade in goods. The growth in the relative importance of services is shown below:

The EU Single Market is "Regionalizing" the UK. Does the UK really want to be a region of the EU specialising in Financial Services?

The net effect of the flow of excess foreign investment into the UK economy is largely negative. It distorts the balance of industry and services in the economy and favours imports rather than exports. This potential negative effect of foreign investment is well known in the economics literature and the UK is an example of the negative effects outlined by Jože Mencinger (2008) in his seminal paper on the effect of foreign investment on the current account balance in New Member States of the EU. Unlike the New Member States of the EU, the UK has no need of excess foreign investment (See Will Hutton's article http://www.theguardian.com/commentisfree/2015/mar/08/selling-off-britain-ownership-crisis-debate and also see Note 1 below

 

It is conventional to blame UK exporters for the current account deficit but the deficit is clearly due mainly to imports and has resulted from structural problems related to the flow of money between the EU and UK. The net result is that the UK is distributing its financial surplus to the EU by purchasing goods. This huge import of EU goods undermines British companies in those areas of production, areas that are popular in the EU, and so probably damages the ability of UK producers to export to the EU.

Why are Euros flowing into the UK? It is because the UK has very different economic policies from the Eurozone.  It is a better place for Eurozone companies to invest for growth.  However, although this is good for Eurozone finances it is terrible for UK citizens because the investment employs imported Eurozone citizens and exports the profits.  The UK gets the overcrowding and disruption and the Eurozone gets the benefit.

The problem of excess foreign investment is probably costing the UK economy about £50 billion to £60 billion per annum, this being the loss in industrial volume due to the imbalance in trade (half the current trade deficit with the EU) plus an estimate of the amount that could be recouped from the global primary income deficit. The EU has a wide range of directives concerning the management of a country's accounts that ensure the free movement of money and restrict any action. This means that the problem can only be tackled by leaving the EU and copying and improving on the measures taken by independent countries such as Switzerland which have had similar problems with excess investment.   This need to manage capital flows means that the UK must leave the Single Market and adopt a Free Trade Agreement with the EU like South Korea and many other countries.  Any "Single Market" agreement would simply perpetuate the current problems, it would only be suggested as a re-entry into the EU by the back door.  The objective should be, in the long run, to balance the current and financial accounts independently whilst increasing the volume of trade in the current account.

Note 1: The Benefit of Foreign Investment in the UK

Surely foreign investment is beneficial? There is a great deal of confusion about foreign investment that results from its effects in underdeveloped countries versus its effects in developed countries.

When incomes are low and unemployment high the provision of work and wages is a real bonus and sending profits and dividends overseas to compensate foreign investors is a small price to pay. However, when incomes are high and unemployment is low the inward flow of excess foreign investment provides a transient excess of foreign exchange that finances imports, imbalancing the economy, and creating a long term liability for payment to overseas investors of profits, dividends etc. This liability means a commitment to the long term sharing of the wealth of the UK economy with wealthy people overseas rather than focussing it in the UK. Furthermore, if unemployment is low the foreign investment creates a demand for labour from overseas. This all benefits the industrialist, foreign shareholder and migrant worker but not the individual UK citizen or the long term health of the economy and country. The Government should be representing the long term interests of the UK citizen rather than the interests of the general population of the EU, industrialists and foreign shareholders.

In the best case of foreign investment in the UK, that used to create employment rather than currency speculation etc., there are yet more problems. The creation of 100,000 jobs in the UK, which has only 5% unemployment, will simply pull in 50-100,000 workers from overseas. The net effect for the wealth of the country as a whole is negative in the long run because it creates a large primary income deficit, as detailed above, and, of course, no change in income per head of population, a large population growth and overpopulation. It is this illusory growth in GDP, the growth that results from excess foreign investment in a developed country, that constitutes much of the “gains” for Trade and Industry described in reports that favour remaining in the EU. 

The extent to which the GDP of the UK is being transferred overseas is clear when GDP is compared with Net National Disposable Income, the proportion of the Gross Domestic Product that is retained in the UK.

The upper line in the above graph is the headline figure for GDP and the lower is the actual value of this GDP for the citizens of the UK. The difference between the curves is largely due to remittances abroad to foreign investors.  The graph above also shows that UK wages are being kept low by free movement of labour, it is amazing how corporate PR has managed to portray free movement of labour in the EU as a wonderful benefit for individuals when it is about low wages.

It is not generally realised that much of foreign investment in UK industry is investment by foreign, state owned enterprises. The ownership of property is equally suspect According to the Financial Times:

"At least £122bn of property in England and Wales is held through companies in offshore tax havens ......  Nearly two out of three of the 91,248 foreign-company owned properties in England and Wales are held via the British Virgin Islands and Channel Island structures."

So the British are paying profits and dividends to EU governments and rents to tax evaders. The wonders of foreign investment...

Nearly two out of three of the 91,248 foreign-company owned properties in England and Wales are held via the British Virgin Islands and Channel Island structures. - See more at: http://www.taxresearch.org.uk/Blog/2014/08/01/tax-haven-ownership-of-uk-property-might-cost-2-billion-year-in-tax-avoidance/#sthash.znFX95Gh.dpuf

Nearly two out of three of the 91,248 foreign-company owned properties in England and Wales are held via the British Virgin Islands and Channel Island structures. - See more at: http://www.taxresearch.org.uk/Blog/2014/08/01/tax-haven-ownership-of-uk-property-might-cost-2-billion-year-in-tax-avoidance/#sthash.znFX95Gh.dpuf

Nearly two out of three of the 91,248 foreign-company owned properties in England and Wales are held via the British Virgin Islands and Channel Island structures. - See more at: http://www.taxresearch.org.uk/Blog/2014/08/01/tax-haven-ownership-of-uk-property-might-cost-2-billion-year-in-tax-avoidance/#sthash.znFX95Gh.dpuf

The improvements in Trade and Industry that would truly benefit the UK are gains in productivity and hence higher pay for the existing population; although these might seem to be difficult to achieve, perhaps restrictions on migration rates to, say, 300,000 a year might have the desired effect by limiting the availability of low cost labour, but this is impossible within the EU.

Note 2:

Over the years the Bank of England has tried to lower the value of the pound.  As a member of the EU the only major tool at its disposal was to increase the supply of sterling but this was insufficient to counteract the over-valuation of the pound due to foreign currency inflow because increasing money supply without increasing production has adverse effects on the economy.

Summary

Why the Balance of Payments and Trade are so bad and how this affects the UK is covered in detail above but here is a summary for those in a hurry:

The UK has a vibrant economy and an independent currency. The Eurozone economy is flat and the euro is under perpetual threats.  EU Investors choose to invest in the UK because it is governed by EU rules and connects seamlessly to the EU economy.  The UK is selling off its industry and property at a huge rate.  This sale creates a liability for profits, dividends and rentals to be paid overseas on a huge scale.  The largely state owned companies that invest in the UK buy British companies and pay corporation tax in their home country. They use many suppliers from their own countries and hence cause an increase in imports. Their business investments also pull in large numbers of EU workers to keep wage rates down and because the UK has low unemployment.  The UK is unable to stop the large haemorrhaging of funds to the EU because of controls on the movement of money, it cannot stop the flow of workers because of free movement of labour and cannot affect the preferential purchase of imports from the EU because of free trade.  The EU investor can take away their profits to the EU without hindrance and without making significant investments that benefit UK citizens. The EU investor can even sell up and take away their original investment or relocate it without difficulty.  Any increase in GDP due to EU investment is exported to the EU and does not benefit the UK - this is what the "current account deficit" actually means.

The net effect is that the UK is allowing EU companies to operate enclaves in the UK that are owned by, and benefit, the Eurozone but which use the UK economic environment to prosper. The only answer is to leave the EU, especially the Single Market which allows the flows of capital and labour that cause the damage.

 

Other Structural Problems

There are also lesser factors that affect UK-EU trade. Perhaps the most important of these is the way the Eurozone was created in the Maastricht Treaty. Norman Lamont has described the problem:

"At Maastricht, one of the Germans’ main objectives was to secure a “no bail-out” clause to joining a single currency, because they were worried about the large indebtedness of Italy. But the logic of currency union is that the strong countries should assist the weaker ones."

This means that the Northern European countries in the Eurozone can use a currency, the Euro, that has a lower exchange rate than might be expected from their economic performance. These countries can take the benefit of this rate without paying the social costs in Southern Europe. Any future Free Trade Agreement with the EU would need to address this obvious inequity. The UK should not be a party to such exploitation.

See:

Lamont. Daily Telegraph http://www.telegraph.co.uk/finance/financialcrisis/8771090/Norman-Lamont-Its-not-just-the-euro-its-the-European-Union-that-needs-rethinking.html

Growth

The EU has been a region of low growth for the past decade. Almost all assessments of the benefit of the EU for UK Trade and Industry either assume that the EU will return to growth or that the UK will grow at the same rate as is currently the case within the EU after leaving. Independent assessments of the growth potential of the EU such as that of the IMF, disagree that the EU will return to growth:

Growth of EU GDP %

Graphic from Wikipedia: The Economy of the EU.

(The latest IMF estimates for Eurozone growth are even more pessimistic – see https://www.imf.org/external/pubs/ft/weo/2015/01/weodata/index.aspx ).

Furthermore, on leaving the EU the UK economy would be expected to grow more strongly if managed as well as many other independent, developed economies.

Tariffs

When the UK acceded to the EEC in 1973 it joined a customs union. The objective was to remove the tariffs on trade. Tariffs in the 1970s were frequently over 10% on a wide range of goods. In recent years there has been a considerable, global, reduction in tariffs due to the work of the WTO and there have been bilateral agreements between the EU and much of the rest of the world. The Free Trade Agreement (FTA) between the EU and Canada and the FTA between the EU and South Korea remove almost all tariffs. A similar FTA is about to be signed between the EU and Japan. The UK pays over £11 billion a year to avoid EU tariffs. Canada etc. pay nothing. The saving consequent on leaving the EU will be at least £11 billion per annum when other factors such as rebalancing the economy are taken into account, this is a huge subscription for enjoying Free Trade with the EU.

It should be noted that if the UK remains in the EU the forthcoming FTA between the EU and Japan will leave UK manufacturers of Japanese cars without a tariff advantage. 

Complex areas of trade, such as the trade in Wines and Spirits, can also be the subject of FTAs. As an example, the agreement between the EU and Canada on wines and spirits protects Geographical Indications etc. as well as removing tariffs. This means that areas of trade such as the Scotch Whisky industry can continue to trade with the EU without extra cost. 

That the EU would not urgently seek an FTA with the UK if the UK were to leave the EU is unimaginable given that the UK takes £225 billion of EU goods imports per annum and exports only £140 billion in return (See Table 2 in ONS “UK Trade 2015” http://www.ons.gov.uk/ons/dcp171778_413031.pdf ). However, the total cost of tariffs on exports to the EU and the world, even if the UK had no bilateral agreements, has been calculated at only £7.4 billion (“Change or Go” - see below) which is about £4 billion less than the amount paid to the EU avoid tariffs.

Although tariffs are now small it would suit the UK to have a period of tariffs against EU goods so that UK exporters can recover. It is permissible under WTO rules to refund tariffs paid by UK exporters when exporting to the EU (the refund could be financed by import tariffs on EU goods), this may provide the advantage needed for recovery.

See also:

The EU-South Korea Free Trade Agreement http://trade.ec.europa.eu/doclib/docs/2011/october/tradoc_148303.pdf

The EU-Canada Comprehensive Economic and Trade Agreement http://ec.europa.eu/trade/policy/in-focus/ceta/

The Agreement between the EU and Canada on Trade in Wines and Spirits http://ec.europa.eu/world/agreements/SummartOfTreatyAction.do?step=0&treatyId=292

Also See:

“The Swiss Trade Surplus Unveiled” by George Dorgan (2012) http://snbchf.com/swiss-macro/2012-sm/swiss-trade-surplus-balance/ ).

Government Article. “UK wins a record number of investment projects and maintains position as top investment destination in Europe” https://www.gov.uk/government/news/uk-wins-a-record-number-of-investment-projects-and-maintains-position-as-top-investment-destination-in-europe - although the Swiss are tearing their hair out about excess Eurozone investment the UK government seems to be unaware of the problem.

Jože Mencinger (2008). THE "ADDICTION" WITH FDI AND CURRENT ACCOUNT BALANCE. INTERNATIONAL CENTRE FOR ECONOMIC RESEARCH WORKING PAPER SERIES. Working Paper No.16/2008. http://servizi.sme.unito.it/icer_repec/RePEc/icr/wp2008/ICERwp16-08.pdf

Liquidity swap agreements

First published 9/12/15