The UK may be setting the stage for a slow erosion of its competitiveness, as a hard Brexit increases risks for its intellectual capital, which is key to power innovation, productivity and the UK potential to grow.

As the UK prepares to begin negotiating its exit from the EU, the business focus has been on trade, financial flows and whether the UK will continue access to the single market. What’s missing from the Brexit debate is a discussion on the risks for intellectual capital, especially in case of a hard Brexit, says Carmen Nuzzo, senior European economist at Morgan Stanley.

In a recent report, Nuzzo tackles the complex question of how, depending on the terms of the UK negotiations, a hard Brexit may carry negative implications for the UK’s wealth of intellectual capital, particularly research. Today, the UK is increasingly investing in sectors that require, in addition to skilled human capital, other intangible assets, such as intellectual property rights, research and development capabilities, software, as well as public and private research networks, on top of hardware, such as real estate, factories or machinery. In short, intellectual capital is a key input to power innovation, productivity and the UK’s potential to grow, in a world where economies are increasingly knowledge-based and service-oriented.

UK Intangible vs. Tangible Investments

Source: UK Government's Intellectual Property Office, Morgan Stanley Research

Nuzzo argues that part of what makes the UK economy so dynamic is its ability to draw talent from all over the world—to its universities, research labs, engineering programs, and large multinational firms with far-flung global operations and opportunities, as well as small business entrepreneurs and ambitious startups.

They are attracted by well-functioning institutions, less red tape, regulatory transparency, the advantages of the English language, and access to investors and open financial markets. Indeed, the World Economic Forum in its recent competitiveness ranking lists the UK among the top three countries in the world for “the most technologically-ready” economy, quality of scientific research institutions and management schools, strong intellectual property rights, and at the very top for foreign ownership of companies.

This business-friendly environment, combined with investment in research and development, which is skewed toward high-tech manufacturing and knowledge-intensive services, has given the UK a comparative advantage, not only in financial services but also in sectors such as pharmaceuticals, chemicals, aerospace, transport equipment, information and communication technology, as well as other business services.

To sustain its place on the world economic stage and to finance its large current account deficit, however, the UK needs to continue to attract foreign investment, including talent, Nuzzo argues. Brexit has introduced many uncertainties: “Will an EU departure result in less red tape or an increasingly regulated environment?” Nuzzo asks. “Will it undermine the UK's tech-hub status and its status as an attractive center for research, startups and foreign investment? What will happen if it loses EU research funding? What are the consequences for research capabilities if limits to high-skilled migrants are set, or obstacles to EU-born high-skilled labor working in the UK are introduced?”

Investment in Tangible vs. Intangible Assets Varies by Sector

2014 data
Source: UK Government's Intellectual Property Office, Morgan Stanley Research

These are open but momentous questions when the UK is expected to trigger Article 50 of the Lisbon Treaty by the end of the first quarter, 2017, officially kicking off negotiations to exit the EU. So far, the rhetoric seems to point to a hardline approach, with Prime Minister Theresa May asserting national control over key issues, such as immigration.

Restricting the free flow of people poses the greatest risk to intellectual capital, Nuzzo says. “Limits to the entry of high-skilled migrants are a significant threat to the UK labor force, especially to the UK's research capabilities,” she says, “more so even than the potential loss of EU research funds, of which the UK is one of the largest EU recipients.”

To be sure, any such new limits will not come overnight. “The UK is not facing a crisis today but risks a slow erosion of its competitiveness,” Nuzzo warns. Health and tech research, for example, two areas in which the UK excels, requires years, even decades of investment by institutions, both public and private, and by teams of talented scientists, engineers, coders, and so on. Will such investment remain robust amid uncertainties over funding, higher bars for work or residency status? 

UK R&D Spending Skews Toward High-Tech Manufacturing & High-Knowledge Market Services

The manufacturing and market services are classified using the International Standard Industrial Classification (ISIC) Rev. 3. High-tech manufacturing includes pharmaceuticals (ISIC 2423), office, accounting and computing machinery (ISIC 30), radio, TV and communication equipments (ISIC 32), medical, precision and optical instruments, watches and clocks (ISIC 33), aircraft and spacecraft (ISIC 353). Medium-to-low technology industries include all the rest. High-knowledge market services include post and telecommunications (ISIC 642), financial intermediation (ISIC 65-67) and some knowledge-intensive business activities (ISIC 72-74), including computer and related activities (ISIC 72). Low-knowledge market services include all the rest.
Source: OECD, Morgan Stanley Research

For more Morgan Stanley Research on the outlook for the UK economy, ask your Morgan Stanley representative or Financial Advisor for the full report, "Brexit: Let's Talk About Intellectual Capital” (Oct 12, 2016). Plus, see our full Brexit coverage and more Ideas.