Brexit update

May 3rd, 2018

Customs options

This week the UK government has been discussing the relative merits of two customs options:

1. A streamlined customs arrangement – which involves minimal customs checks and the use of new technology to enable as frictionless trade as possible - popularly known as 'maximum facilitation' or 'Max Fac'. This option would allow the movement of goods between the UK and the EU to be monitored and recorded, with traders paying duties on a monthly or quarterly basis, rather than paying duties on every shipment or service traded. This is the option currently favoured by ‘Brexiteers’.
2. A customs partnership with the EU – which involves the UK acting as a tax collector for the EU whenever goods enter the UK. If the goods are bound for the UK, and if the UK tariff is lower than the EU tariff, traders could claim any difference. This was the option reportedly favoured by Mrs May, although it remains unclear whether she still supports it following the Cabinet meeting this week.

The essential difficulty in moving forward is that while membership of the existing Customs Union has been ruled out as it would prevent the UK negotiating its own trade deals, no parties involved in the negotiations want to have a hard customs border between the Irish Republic (and EU member) and Northern Ireland (due to leave the EU with the rest of the UK).

While both options currently being discussed would provide some form of solution to the customs issue, and would allow the UK to negotiate new trade deals with the rest of the world, there is clearly much more work to be done in shaping out a detailed proposal - one that will, in the short term, unite members of Mrs May’s government and in the medium term one that has enough detail to form the basis of a trade negotiation.

March 19th 2018

Transition deal - key elements agreed

Key elements of the transition deal have been agreed in what has been called a ‘decisive step’ towards an ‘orderly withdrawal of the UK from the EU.

1. The transition period will last from the 29th of March, 2019, until December 2020.
2. Agreement has been reached on the status and rights of the 4.5 million EU citizens in the UK, and the 1.2 million UK citizens in the EU.
3. Crucially for the UK it will be able to undertake trade negotiations with non-EU countries during the transition period, and sign trade deals.
4. The main issue still to be resolved is the situation of the Northern Irish border, with the EU insisting that the deal will include a "backstop" option with Northern Ireland remaining in parts of the single market and the customs union should no other deal be agreed.

Read the full document

Previously:

Donald Tusk presents EU guidelines on UK trade relationship

Key points of Tusk speech

March 7th 2018

Mr Tusk re-stated that any free trade agreement (FTA) could not offer the same benefits as membership and cannot amount to participation in the Single Market.

The agreement would cover:

Trade

1. Trade in goods, which should be subject to zero tariffs and no quantity restrictions, and with appropriate rules of origin. Existing reciprocal access to fishing waters and resources should continue.
2. Customs cooperation, to preserve the regulatory and jurisdictional autonomy of the parties and the integrity of the EU Customs Union.
3. Trade in services, with the aim of allowing market access to provide services under host state rules - the UK will become a third country and the Union and the UK will no longer share a common regulatory, supervisory, enforcement and judiciary framework.

Other areas of interest to the Union, for example access to public sector markets, investments and protection of intellectual property rights.

Co-operation

1. Aviation - there would need to be an air transport agreement, combined with an aviation safety agreement, while ensuring a strong level playing field in a highly competitive sector.
2. EU programmes, such as those relating to research and innovation and of education and culture, any participation of the UK should be subject to the relevant conditions for the participation of third countries.
3. Guarantees to be in place to ensure a level playing field and prevent unfair competitive advantage that the UK could enjoy through undercutting of current levels of protection (involving state aid, tax, social, environment and regulatory measures and practices.)
4. Judicial cooperation in criminal matters should constitute an important element of the future EU-UK relationship in the light of the geographic proximity and shared threats faced by the Union and the UK.
5. Information - the future partnership should cover effective exchange of information, support for operational cooperation between law enforcement authorities and judicial cooperation in criminal matters.
6. Security - in terms of defence and foreign policy there should be no gap in the EU-UK cooperation as a consequence of the UK withdrawal from the Union.

Dispute settlement

The governance of the future relationship with the UK will have to address management and supervision, dispute settlement and enforcement, including sanctions and cross-retaliation mechanisms.

Previously

Mrs May sets out five tests for Brexit

March 2nd 2018

Speech by the UK Prime Minister, Teresa May

In her London speech today, (2/03/2018) Teresa May laid out the UK Government’s position on what it is looking for in terms of the UK’s future economic partnership with the EU.

She confirmed that real progress has already been made, but differences between the UK and the EU still exist. Mrs May went on to set out five tests to guide the UK in its negotiations:

1. That the future deal must respect the referendum result – to take control of laws, borders and money.
2. That any deal must endure – it must be sustainable.
3. That any deal must protect jobs and security. This can be done through a mutually beneficial economic relationship.
4. That any deal must be ‘consistent with the kind of country we want to be’ – namely, modern, outward-looking and tolerant.
5. That any agreement must bring the country back together, and make the union of countries stronger.

Mrs May went on to outline the nature of a new economic relationship which, she argued, should not simply be based on an existing model – not based on the Norwegian or Canadian models. Existing models, she insisted, do not provide the best way forward. Mrs May stressed that it was essential to build a new and deep relationship covering more areas than are covered in existing models.

In terms of the Irish border, she confirmed that the Belfast Agreement must be respected, and that physical border infrastructure is not something the UK wants – if the EU wants to create a hard border, then that is a matter for them.

In terms of 'taking back control' of laws, Mrs May confirmed that while ECJ judgements and case law will continue to be taken into account, the UK will no longer fall within the jurisdiction of the ECJ. In terms of regulations covering standards, Mrs May said that the EU should be confident that it will not be a 'race to the bottom' to remove them, and that UK standards should be at least as high as those in the EU.

Mrs May went on to re-state that the UK government did not accept the EU’s position that only an existing model can be applied. Trading relationships between the UK and the EU should be based on five key principles:

1. Reciprocal binding agreements to ensure fair competition.
2. An independent arbitration process in terms of upholding trade agreements and settling disputes.
3. The maintenance of an ongoing dialogue and regular consultations.
4. A new arrangement for data protection.
5. Maintain links between people of UK and EU.

Goods

The UK's position as a free trade advocate was, Mrs May argued, the key driver for the position that post-Brexit trade between the UK and the EU should be as free as possible, with trade at borders to be as frictionless as possible. She went on to clarify that while there was a commitment that the UK would ensure that laws are harmonised, they would not necessarily be identical, and stated that the outcomes of the laws can be agreed, if not the specific rules. Regarding European industry agencies, the UK could remain as associate members.

Mrs May confirmed that a new agreement on customs was essential to ensure mutually beneicial trade continues, with two options put forward:

1. Customs partnership – Where the UK applies the same customs rules, and rules of origins, and avoids the need for double checking if these goods are simply in transit from non-EU countries to the EU.
2. Customs arrangements – a streamlined system to keep trade flowing simply, where the UK implements existing schemes to allow trade flows, and creates new ‘trusted trader’ schemes when necessary.

Mrs May confirmed that agriculture, food and drink would require additional rules given the UK will leave CAP and the CFP. There was also a clear recognition by the UK government of the need for mobility of labour across Europe, and that mutual recognition of educational qualifications should continue.

Broadcasting

Mrs May stated that a special relationship covering broadcasting must be agreed, given that the UK provides over 30% of EU broadcasting. 

Financial services

She also confirmed that the UK was not looking for passporting rights, which are specifically related to the EU. London is the most important global financial centre with the UK having considerable responsibility for the stability of the UK financial markets –  many EU businesses rely on a flow of finance from the UK and a new reciprocal arrangement is required to ensure that capital mobility is maintained to the benefit of both the UK and the EU.

Previously

Trade barriers 'unavoidable'

Updated Monday 5th February, 2018

Michel Barnier, the EU’s chief Brexit negotiator, has stated that if the UK leaves the customs union, as the government has now confirmed, some barriers to trade will be ‘unavoidable’.

This comes at a time when Brexit negotiations are entering a critical phase covering the nature and length of the transition process, and the nature of the future trading relationship between the UK and the EU. The talks are set to continue all this week.

Previously

EU sets out its negotiating position

The EU has now made its position clear on the transition, or implementation, phase of the Brexit talks.

During this 2-year phase, which is due to end on 31^st December, 2020, the UK will continue to take part in the customs union, and Single Market. However, the UK will have to implement any new EU laws while having no involvement in the EU decision making process, which, according to Brexiteers puts the UK in the position of a ‘vassal’ state. Nor is the UK free to implement any new trade deals during this period with non-EU countries without the agreement of the EU.

Talks can move on to trade - but not just yet!

Despite agreement that sufficient progress has been made on the UK's 'divorce bill', and on the Irish border question, it is still unclear exactly when talks will start on Phase 2 - the trade talks. While preliminary talks may start in February, virtually all observers (See FT Report) expect the serious negotiations to commence in early March, 2018. All parties accept that Britain will leave on March 29th 2019, which means that talks must be concluded well before that date. 

Previous updates

European Commission President, Jean-Claude Juncker, announced this morning (Friday December 8th, 2017) that 'sufficient progress' has been made in the Brexit talks to allow negotiators to move on to discussions on the UK and EU’s future trade relationship. Critical to this was significant progress on the Irish issue, with a firm commitment that there will be no hard border. Talks involving all parties continued through the night, with agreement reached in the early hours of Friday. Provisional agreement on the financial 'divorce' settlement had already been made, with just the Irish border issue and the situation regarding citizens rights remaining.

As a result, sterling was up against most major currencies in early trading.

See also:

BBC news

Bloomberg.com

Previous reports

Divorce deal near to completion

Despite the absence of any official comment, it now seems probable that the UK and the EU are close to settling the first key element in Brexit talks – namely, the financial ‘divorce’ settlement.

The Daily Telegraph has reported that its sources have suggested that a figure of between €45bn and €55bn, depending on how the agreed methodology is calculated. The Financial Times says that the UK will assume liabilities ‘worth up to €100bn’ (£88bn), which would fall to less than half of this when adjusted for payments back to the UK. Of course, details of the settlement figure, what it relates to, and how and when it will be paid will not be made available quite just yet. It is likely that, to avoid appearing to have ‘won’ or to sound too triumphant, EU negotiators will not want figures released, given that the figure is very close to their initial assessment of net liabilities.

EU negotiators are likely to want to avoid causing any political embarrassment to the UK government, given that many its backbenchers would prefer a much smaller settlement. However, both Boris Johnson and Michael Gove – two leading pro-Brexit Cabinet ministers - have given Mrs May their support over the financial settlement, although adhering to the accepted principle that ‘nothing is agreed until everything is agreed’. Indeed, a final figure may not be known even after trade talks have finished, given that some of the UK’s financial liabilities relate to pension payments to EU officials, which are impossible to calculate ahead of time. What it does mean is that two further issues can now be moved into the spotlight – the question of the Irish boarder, and the position of EU and UK citizens, post-Brexit.

The Irish border issue

The UK government has already rejected the possibility of Northern Ireland remaining in the customs union, or the whole of Ireland forming a separate customs union. However, the UK government has said that it has actively looked to find 'creative solutions' which might eliminate the possibility of having a hard border between Ireland and Northern Ireland. What is clear that the precise nature of any border - hard or soft - will depend on any trade agreement that is negotiated.

Previous report

Background to Brexit

On June 23rd 2016, the UK voted to leave the EU - commonly known as ‘Brexit’. By July 14th a new government was in place, led by Theresa May, with Phillip Hammond as the new Chancellor. In the lead up to the referendum vote there was a broad consensus that Brexit was likely to cause a sizeable short term economic shock. This shock would, forecasters argued, be followed by a period of low growth, with fall-out adversely affecting the value of sterling, inflation, productivity and jobs.

The initial impact of Brexit on the financial markets stemmed from the uncertainty which followed this momentous decision - uncertainty about the short term impact on prices, jobs and growth, and about the kind of trading relationships that would emerge. Financial markets responded to this uncertainty in dramatic fashion, with the pound falling to a 30-year low against the US dollar, and stock markets around the world suffering considerable falls. There was a bounce back as the markets calmed immediately following the formation of the new government.

Sterling (daily spot rate against euro and US dollar)

Despite the Bank of England indicating that monetary policy would be loosened, interest rates were kept on hold at 0.5%, giving some room for manoeuvre later in 2016. The Bank of England’s MPC decided not to reduce rates immediately, until some hard evidence had become available regarding the impact of Brexit on the real economy.

Looking beyond the immediate shock, what is less certain is the medium and longer term impact of Brexit on the UK economy, given that, at the time of writing, there was no clear government policy on which ‘version’ of Brexit would eventually be adopted.

The main reason for the negative forecasts prior to the vote was the assessment that, while the benefits of remaining in the EU seemed clear, the benefits of leaving were far less clear, especially given the uncertainty about how Brexit negotiations would unfold. A consensus view emerged that the UK might find it difficult to compensate for the loss of the benefits that being an EU member bring. These include:

1. Tariff-free access to other member’s markets, which reduces the costs of trade, and creates trade between members
2. No customs check or controls on the movement of goods between EU members
3. A single market with common regulation creating a level playing field
4. Further access to 55 other markets through numerous EU-Free Trade Agreements (FTAs)
5. Common external tariffs on non-member imports

Add to these benefits, the fact that UK trade as a share of national income – trade openness - has risen to over 60% in the past decade, compared to under 30% in the years before the UK joined the EU, the economic case against Brexit, at least in the short run, appeared a strong one.

As the economic ‘dust’ settles, much will depend on the kind of trade agreements that will be reached, how resilient the UK economy is in the short term, and on how much time the negotiations will take to complete.

Trading scenarios for the UK after leaving the EU

The European Economic Area (EEA) scenario

The EEA (European Economic Area) scenario involves the UK leaving the EU, but continuing as a member of the wider EEA. The EEA includes the remaining 27 EU countries, together with the four European Free Trade Area (EFTA) states of Iceland, Liechtenstein, Norway and Switzerland.

EFTA was founded in 1960 as a counterbalance to the more politically focussed European Economic Community (EEC) as it then was, and included Austria, Denmark, Norway, Portugal, Sweden, Switzerland and the United Kingdom. In 1973, the United Kingdom and Denmark left EFTA to join the EC (as it had then become) and were followed by Portugal in 1986 and by Austria, Finland and Sweden in 1995. In recent years, EFTA has successfully concluded free trade agreements with North America and Asia. Supporters of this option have argued that the UK could, fairly quickly, become a fifth member of EFTA. However, in this scenario there would still be free and uncontrolled movement of labour into the UK, and a budget contribution to the EU, while at the same time EFTA-only members have no influence on EU trade rules in the future. There seems a consensus among analysts that this EU-lite option would put the UK at a significant disadvantage in terms of influencing the direction of the EU going forward.

An EU-UK Free Trade Agreement (FTA) scenario

This option would involve the UK negotiating a completely new free trade agreement with the EU, similar perhaps to that enjoyed by Canada. Clearly this would involve a lengthy negotiation period, perhaps with the EU reluctant to fast-track this kind of agreement.

The WTO scenario

The WTO scenario means that a country’s trade is subject only to the rules of the WTO club. If the UK adopted this approach - as some supporters of Brexit do - it would be subject to the Most Favoured Nation (MFN) rules of the WTO. The main principle of this WTO rule is that members should not be discriminated against and, in the absence of specific free trade agreements, all members should enjoy the same treatment as the most favoured country. Hence, if one member grants another member a special trade advantage, the same advantage should be conferred on all other members. Adopting this policy would, of course, mean that the UK would not have free access to the EU, and could not influence EU trade rules.

The Unilateral free trade scenario

The unilateral free trade scenario is a variant of the WTO scenario, where UK goods and services are faced with the tariff levels agreed through the WTO, but where the UK reduces its tariff levels on imports without any reciprocal reduction by trading partners. This is widely thought to be the least likely option following Brexit, although New Zealand and Singapore have successfully adopted this kind of approach. For example, Singapore has negotiated 20 free trade agreements with its 31 main trading partners.

The models used by key forecasters in the run-up to the referendum assumed the unilateral free trade approach to be the worst-case scenario. While unilateral elimination of tariffs gives away key ‘bargaining chips’ in future trade negotiations, some economists (especially those in the Economists for Brexit group) believe that the unilateral free trade route would lead to the greatest long term gains for the UK. This view is based on the belief that any form of protectionism distorts trade patterns to the detriment of all parties. However, Economists for Brexit and other 'free traders' recognise that the UK’s agricultural and industrial sectors are likely to be severely squeezed, as the lack of a comparative advantage in these areas will be exposed by unilateral free trade.

Other implications of Brexit

Impact on FDI

In terms of FDI, independent analysis by the Institute of Fiscal Studies (IFS) prior to the referendum vote, concluded that it is most probable that flows will fall after Brexit. This it likely to reduce productivity (given that productivity relies on the level of capital investment) which will have a negative impact on GDP. Lower FDI will have both demand and supply-side implications for all key macro-economic performance indicators, including growth, jobs and trade.

Less regulation

Given that the EU sets regulation in many areas, including the environment, health and safety, employment and financial services, exit from the EU is likely to lead to a reduction in the level of regulation. However, many analysts have concluded that the effects of this may be fairly modest given that the UK is a relatively unregulated economy compared with many others.

Impact on public finances

It is likely that there will be two different, and contradictory, effects of Brexit on public finances. Firstly, the positive mechanical effect, which means that leaving the EU will strengthen the public finances in the short term as a result of a fall in net contributions of the order of £8bn a year - the gross contribution of £18.8bn, less the rebate and the return back of funds from the EU budget. However, a second and stronger negative effect, the national income effect, suggests that the possible fall in GDP as a result of Brexit will weaken public finances, as tax receipts fall and spending increases. Whatever the impact, there is likely to be a significant delay in its effect given that the mechanical effect will only happen once the UK ceases to make payments to the EU, which may well not be until at least 2018/19.

The digital economy

Research suggests that, apart from the US, web users are highly inward looking, generating a strong home-bias in favour of local online suppliers and internet providers, suggesting that trading in the digital world is both less open than we might believe, but also dominated by US based companies. While the internet should reduce ‘economic distance’ between countries, the home-bias effect may well counteract this. With its many languages, different cultural preferences, and inward looking approach to the digital economy, many doubt that the EU is best placed to cope with the new realities of a digital world. Although the EU has made some progress in liberating the digital market-place, many feel that the UK should adopt a much more outward looking approach.

One view is that once the UK has ‘cut loose from its orbit’ around the EU it can connect more closely to the US, which dominates the digital economy, and where the ‘economic distance’ between the UK, US, Canada, Australia and other English speaking nations is much smaller than between the UK and the EU. The same may be said of the emerging power-houses of China and India, and indeed many see Brexit as a considerable opportunity for the UK to have a much closer relationship with these two countries.

The financial sector

Perhaps the single biggest unknown is the impact of Brexit on the UK’s financial sector. In the early days after the Brexit vote many were claiming that the UK would suffer irreparable damage, and certainly shares in UK banks were some of the worst to suffer - along with those of house-builders.

The UK is a dominant player in global financial markets, and has the largest market share of EU business in financial services - double that of France and Germany. How Brexit negotiations unfold will be highly significant to the UK’s financial sector.

Perhaps the most important aspect of Brexit for the UK’s financial services is the potential loss of so called ‘passporting rights’. This relates to the ability of banks and other financial institutions in one EU state to conduct business in another one. As a member of the EU, national banks and financial institutions do not need to obtain licenses in each country. It is certainly too early to tell exactly how Brexit will affect financial services at the global level, and in terms of the UK and the EU.

Farming

The impact of Brexit on the UK’s farming sector is also likely to be considerable, given that over 50% of farm income in the UK comes from CAP support. However, until new trade deals have been negotiated, and the UK government has made its position clear on subsidies, the overall impact on farming remains unknown.

New policies

As well as introduce a new outward looking approach to trade policy designed for the post-Brexit era, many see Brexit as an opportunity to develop a whole new range of domestic policies. Many argue that the UK has neglected its industrial base, and its infrastructure, and it is time to develop a new industrial policy for the post-Brexit age. This could also be said for technology policy and innovation.

See also:

Gravity theory of trade