13 January 2021

There are no winners in Brexit, or so they say. In the recently agreed EU-UK Free Trade Agreement (FTA), the United Kingdom was able to “regain control” of its immigration policy, to maintain tariff-free access to the EU Single Market (for now at least), to regain the ability to negotiate independent trade deals with third parties, and to enshrine the supremacy of its legal decision-making — all key Brexit motivations. But, this came at a high cost. Brexit’s impact on UK productivity, investment, labour force growth, and trade will leave UK GDP 10% smaller than it would have been otherwise during the next generation. And, even though the Irish border will remain open, the customs border established in the Irish Sea will impose new costs on the Northern Ireland.

Meanwhile, the European Union was able to preserve the integrity of the Single Market, and to establish costly disincentives for other countries tempted to follow the UK’s lead. Moreover, as the recent Deal reduces economic uncertainty, business investment should begin to recover. Future bilateral trade, however, will be lower than it would have been otherwise. But, the costs of more restricted commercial links will be less severe for the European Union than for the United Kingdom. Indeed, exports to the UK represent less than 10% of the EU’s foreign sales, whereas UK exports to the Single Market exceed 40% of the nation’s external trade.

On the other hand, however, the Republic of Ireland’s crafty diplomacy (combined with the EU’s willingness to strongly back the interests of one of its smallest members) may allow the Emerald Isle to emerge as a victor from the Brexit saga (both in absolute and relative terms). To be sure, the EU-UK FTA will impose additional costs on Ireland, and many important questions remain unanswered. But, as the dusts settles, I believe Ireland has the potential to become an important European manufacturing hub; attracting large-scale foreign investment in the wake of the UK’s decision to leave the European Union. Achieving this outcome, however, will require that Ireland implement domestic reforms to further improve the attractiveness of its business climate for overseas investors (not much can be done about the climate itself!).

Brexit: Bullet Dodged, But Not Without Costs

Given its’s extreme vulnerability to Brexit, Ireland was able to convince other EU members to prioritise the “Irish Issue” during Brexit negotiations. Although Ireland’s dependence on the British market has declined dramatically since joining the European Union, the Chart above illustrates that nearly 35% of Irish goods imports come from its larger neighbour.

Moreover, the Chart above highlights specific sectors are especially vulnerable. In particular, farm products represent 30% of Irish exports to the United Kingdom, and nearly 50% of Irish agricultural sales world-wide are destined to GB. Much of this agriculture trade occurs with Northern Ireland. Chemicals are also an Irish export. On the other hand, even though Ireland is not a huge exporter of manufactured goods, nearly 60% of this sector’s foreign sales are part of UK-linked supply chains.

Therefore, the new FTA’s continuation of tariff/quota-free trade in goods between the UK and EU and the maintenance of an open Irish border have dramatically reduced Brexit-related trading risks. Nevertheless, the UK’s departure from the EU customs union will result in higher non-tariff barriers. The tables above illustrate the costs involved are potentially substantial in some key sectors, e.g. agriculture, cars, and certain service areas. Moreover, higher tariffs are still possible in the future (limiting the UK’s access to the Single Market), if GB’s regulatory regime diverges from the EU’s.

Critically, trade in services was not included in the FTA. Again, the Chart above underscores Ireland’s vulnerability relative to other EU members. Indeed, the share of Irish services destined for the United Kingdom exceeds that in goods sectors. And, Ireland enjoys a bilateral surplus with the United Kingdom in this vital economic segment. EU-UK service sector negotiations will continue, but clearly Ireland is not out of the woods.

FDI: Displacing the UK as North Atlantic Hub?

So, while Ireland may have averted the worst-case scenario, Eire (along with other EU members) will experience a Brexit-related net economic cost from diminish prospects for trade in goods and services. These costs, however, may be offset if Ireland is able to establish itself further as a North Atlantic trading hub: displacing the United Kingdom as an investment destination offering unfettered access to the EU’s Single Market.

Ronald Davies (et al) have identified the factors influencing the selection of foreign direct investment destinations in Europe (Chart above). For non-EU investors, access to the Single Market, low corporate taxes, and language are most important. Per capita GDP in the host country is less important, especially if the destination is regarded primarily as an export hub. EU investors also value these factors, but also prefer destinations close to home.

As the United Kingdom can no longer assure investors reliable long-term Single Market access, Ireland appears an attractive alternative (a low-tax, English-speaking host country). The Chart above illustrates the United Kingdom has relied more heavily than Ireland on FDI inflows from other EU nations. It’s easy to image EU firms shifting manufacturing supply chains towards Ireland over time: where they already have a strong presence. Likewise, Swiss investors may well increase their Irish stake, especially in the healthcare/pharma industry in which Ireland enjoys many advantages.

The United States, however, is likely to be the big prize. The Chart above indicates the European Union is the largest recipient of American FDI, with the Netherlands, UK, and Ireland accounting for nearly 75% of the inflows into the region. Again, motivated by the desire to gain Single Market access, it’s easy to imagine American firms diverting future investments from the UK to Ireland, especially given the deep existing relationship existing between the USA and Ireland. From an Irish perspective, the USA is by far the largest provider of FDI (accounting for about 33% of total inflows). The following Chart also illustrates the enormous impact of US FDI inflows on Ireland’s local economy.

From a sectoral perspective, Ireland already has succeeded in attracting considerable FDI inflows in technology (largely from the USA), which should continue. In Brexit’s wake, financial and business services are likely to benefit from relocation from London. Meanwhile, manufacturing exports represent a remarkably small share of Irish output and sales abroad (Chart below illustrates Irelands export mix). Over time, I anticipate EU firms may redirect their extensive manufacturing supply chains from the UK towards Ireland — potentially another leg in Ireland’s post-GFC recovery story!

Attracting FDI Requires Domestic Reforms

Ireland confronts numerous domestic policy challenges; successful resolution of which will both help attract FDI inflows and ensure maximimum benefit from these investments. (This section benefits greatly from the OECD’s recent Ireland surveys. Sometimes my job is to read things you don’t have time to get to! I will highlight issues briefly — using numerous charts — but each topic merits careful consideration).

Infrastructure: The following Chart illustrates that the quality of Ireland’s infrastructure lags other EU nations, including leading alternative FDI destinations.

Productivity Gap: Even though many advanced economies have experienced subpar labour productivity growth in recent years, Ireland confronts specific problems. Reflecting its two-tiered economy, labour efficiency levels are much higher in foreign-owned firms, whereas productivity improvements have been negligible in locally-owned enterprises (Chart below).

High levels of regulation, especially for start-up businesses, often stifle entrepreneurship and productivity gains.

Significant skills shortages are emerging, as the educational system is not adequately training workers (both young and adult) for the jobs created in the dynamic economic sectors. Educational reforms are required.

Demographics: Good news, bad news. Encouragingly, Ireland continues to enjoy solid population and labour force growth, especially compared to many European rivals. However, the future fiscal burden of Ireland’s aging population is amongst the OECD’s largest.

Covid: Of course, the pursuit of long-term ambitions will require the Covid pandemic is brought under control. While all western democracies continue to struggle, Ireland has fared somewhat better than many countries, the United Kingom in particular.

Climate Change: After the Covid crisis passes (soon, hopefully), climate change will top the international policy agenda. Unfortunately, Ireland’s Green House Gas (GHG) emissions per capita are Europe’s third highest. The Chart below illustrates how far Ireland is lagging other countries in achieving the EU’s target of reducing emissions by 55% by 2030.

Ireland confronts numerous specific climate challenges. Actually, overall energy efficiency is relatively good, and the utility sector is successfully shifting away from the most carbon-intensive sources of power. However, Ireland still lags in the use of renewable energy, and remains highly reliant on fossil fuels (more akin to China than Sweden). Ireland’s transport system is highly reliant on motor vehicles, as rail and public transport options are limited. Adoption of electric vehicles is low.

Ireland’s large agriculture sector complicates mitigation efforts, especially in the methane-emitting dairy and grazing industries.

Confronting this extensive array of policy challenges will be complicated by the enormous fiscal impact of the Covid crisis. I suspect tax increases are inevitable, especially as Ireland’s tax burden is comparatively low.

Strategic Considerations

• Brexit will hit the United Kingdom hardest: GDP will be 10% smaller than would have been possible over the next 20 years.

• The negative implications for EU-27 countries will be far less significant — perhaps a 2% headwind over a generation.

• After the Covid crisis ends, Irish GDP growth could average 3% annually during the next decade — twice the pace in the EU-27 and United Kingdom. The Netherlands may emerge as a Brexit beneficiary also.
• I do not expect Northern Ireland will enjoy the same FDI inflows the Republic will experience, although the open border will limit Brexit’s economic costs. Brexit may lead both Scotland and Northern Ireland to re-consider the relative merits of the two unions — UK versus EU. Scotland’s May parliamentary elections will be noteworthy. In Northern Ireland, meanwhile, the nation will both celebrate its centenary and conduct its first national census in a decade during 2021. The population census may record the region’s first Catholic majority (Chart below). I believe serious consideration of a united Ireland remains a generation away. Hopefully, and as I suspect, future consideration of this contentious issue will be based on economic consensus, rather than sectarian allegiances.

• For those living around Pittsburgh, Pennsylvania, please visit my pub Mullaney’s Harp and Fiddle in the Strip District. Enjoy our hospitality, and support local small businesses during the pandemic!