Peter Jones: Rocky road for Scottish exporters

There could be a drop in Scotland-rest of UK trade. Picture: Getty

Here’s a curious paradox about independence. If an independent Scotland created a really business-friendly environment which boosted the economic performance of Scottish companies, this could have counter-balancing adverse effects for companies trading with the rest of the UK. The net effect on the overall economy could well be zero.

This sounds unlikely, but it could happen because of something that international economists call “the border effect”. This has been intensively studied since John McCallum, a Canadian finance professor and politician, compared trade between Canadian provinces and between those provinces and adjacent US states in 1995.

He came up with the astonishing conclusion that Canadian provinces were 22 times more likely to trade with each other than with similar states on the other side of the US-Canada border.

Subsequent analyses, re-examining McCallum’s work and using different data, have found that his estimate was inflated and that the North America Free Trade Agreement, signed in 1994, has reduced the apparent border barrier effect.

But it is still there. Researchers now reckon that neighbouring states and provinces in the same country are about 4.5 times more likely to trade with each other than across the national frontier.

Why? The different Canadian and US currencies are a big factor because a business will have to cope with the cost of currency exchange, and the cost of hedging against exchange rate fluctuations. These costs don’t exist if the business just sells inside its own domestic market.

Other factors include differences in regulations which mean that everything from electrical goods to food products have to conform to different standards in each country, raising manufacturing costs. Add in delays caused by frontier controls aimed at preventing illegal immigration and smuggling, and business disinclination to trade across national frontiers becomes understandable.

On this side of the Atlantic, the EU’s single market and single currency are designed to eradicate these costs and delays. Have they succeeded?

In the EU context, the border effect is known as the home bias because the best way of measuring whether borders are a barrier or not is to look at how much buying and selling businesses within a country do with each other and compare that with the volume of trade they do with other countries.

The argument behind the creation of the European single market and the adoption of the euro was that, in trade terms at least, Europe would eventually resemble the United States of America, thus providing a big boost to European economic activity.

If that has worked out as intended, there ought to be no difference between inter-state trade versus intra-state business volumes inside America and Europe. But a 2011 study by the Centre for European Policy studies found that European states are three to four times more likely to trade inside their frontiers than across them when compared with the propensity of US states to sell to their neighbours.

So 60 years of European integration, including the adoption of a single currency, and still a long way to go before Europe can claim to have anything like the US single market.

The European Commission, aware of this failure of policy to produce expected results, has asked why. In a survey of businesses, a host of problems were cited. More than half of firms said they found difficulties in other European countries in tendering for public sector work, in raising finance, in getting licences, in having professional qualifications recognised, in getting contracts enforced, in getting a patent secured, and even in reclaiming VAT. Border effects are therefore real, significant, and hard to eradicate. They don’t exist to anything like the same extent in the UK home market, because there are none of the regulatory and other divergences listed by the EC report. But would they start appearing with independence?

Scotland cannot afford that they should. The recent report by Vince Cable, the UK business secretary, pointed out that Scottish exports to the rest of the UK in 2011 (excluding oil and gas) amounted to £45.5 billion, four times as much as Scotland exports to the rest of the EU, more than twice as much as is sold to the rest of the world, and comprising about 30 per cent of Scottish GDP.

And even if there was only a 1 per cent drop in Scottish exports to the rest of Britain, much bigger sales to elsewhere would be needed to compensate. Financial services, Mr Cable’s analysis said, would need a  7 per cent increase in sales elsewhere to compensate. The problems causing border effects in Europe and elsewhere suggest that would not be easy to achieve.

Would there be a drop in Scotland-rest of UK trade? A 2003 study by University of Maryland researchers for the World Bank found that trade between the Czech Republic and Slovakia fell after the “velvet divorce” which split Czechoslovakia in 1993. Slovak exports to the Czech Republic fell from $2.5bn in 1993 to $2.1bn in 2000. Czech exports to Slovakia fell similarly.

This loss in mutual trade was more than compensated for by a big increase in trade with the rest of Europe. This expansion was, however, mostly driven by foreign investors, led by Volkswagen.

The researchers argue that while the separation was “smooth and conflict-free” and agreements were put in place “to minimise the economic cost of unavoidable decline in mutual economic ties”, there were in each new state “different political dynamics and the pace of structural reforms have provided further impetus to divergences in regulatory regimes”.

And that, in a nutshell, is the strangely paradoxical problem that independence poses. Scotland would certainly have a “different political dynamic”, an element of which, according to Alex Salmond, would entail being more pro-business than the rest of the UK.

But if that also involves radically simplifying business regulation, it would mean any Scottish firm doing a lot of business south of the Border would soon have to cope with two sets of regulation where previously there was only one, adding to their costs.

It means, at the very least, that nuts and bolts of independence would have to be very carefully designed, otherwise there could be some damaging unintended consequences.