Deloitte-uk-shoes-brexit-blog

COVID-19 has monopolised the business headlines for the last three months. But now, with the negotiations stepping up a gear and the transition set to end by December, Brexit is moving back into the limelight.

The UK left the legal structures of the EU on 31 January, entering a transition period which lasts until the end of this year under which most arrangements, including on trade, continue as before. The negotiations now taking place will determine the future relationship between the UK and the EU.

The UK is seeking tariff and quota-free access for its goods and would like the free trade agreement to match the best around in services. In particular, the UK wants financial services to operate under ‘equivalence’, allowing many UK financial products to be sold into the EU.

In return the EU wants the UK to accept the so-called level playing field – EU rules on state aid, competition policy, the environment, support for industry and employment. Retaining access to UK fishing waters is another EU priority. Fishing is a small industry, but one that has intense emotional resonance for maritime nations.

The EU insists that the UK cannot enjoy full access to EU markets without accepting the rules and the jurisdiction of the European Court of Justice in interpreting them. This tension between trade access and rules plays out in many trade negotiations, for instance over the UK’s scepticism towards US exports of chicken cleaned in chlorinated water or, more generally, over state subsidies.

The UK appears deeply reluctant to be a rule taker in its dealings with the EU. The UK’s chief negotiator, David Frost, has said that the UK is leaving the EU precisely in order to break free from EU rules.

This pull between, on the one hand, the UK’s desire for a free trade agreement and, on the other, the EU’s insistence on a level playing field, lies at the heart of the impasse between the two sides.

The UK and the EU have now both ruled out extending negotiations by the deadline of the end of this month. Achieving a later extension is legally cumbersome and seems, for now, unlikely. The EU says that a deal must be reached by 31 October, though this seems ambitious. While the EU has a history of taking negotiations to the line, the need for 27 member states to ratify a deal suggests a deal will need to be struck by mid-November at the latest.

Without a new trade agreement the UK would default to World Trade Organization (WTO) rules. Northern Ireland would remain aligned to EU rules on industrial goods and agriculture to prevent a hard border on the island of Ireland and regulatory checks would take place between Northern Ireland and the rest of the UK.

This outcome was envisaged in the withdrawal agreement signed by both sides and the UK government is keen to stress this would not, strictly speaking, constitute a ‘no-deal’ Brexit. The withdrawal agreement does contain some minimal provisions explaining how trade would be handled on day one if there is no new agreement.

Defaulting to WTO rules would be disruptive for both parties and would mean the most distant form of economic relationship between the UK and EU. Both sides have an interest in securing a deal and may, yet, make concessions. The EU’s fishing nations could, perhaps, drop their aim of maintaining existing fishing quotas while the UK might accept existing, but not future, employment and environmental legislation.

But after four rounds of talks the gap between the two sides seems as wide as ever. Given that a deal would need to be struck within six months, a WTO outcome, or what has been called a ‘thin agreement’ are very real possibilities. A thin deal would likely be a zero-tariff, zero-quota deal with adjustments that might, for instance, ease non-tariff barriers for certain sectors or allow mutual recognition of some technical standards. But it would still be a significant step down from current trading arrangements.

If the UK were to revert to operating on WTO terms it would be bound by the ‘Most Favoured Nation’ (MFN) principle. Under this both the UK and the EU cannot offer any trading advantage to the other that they are not willing to offer to any other country. The only exception to MFN rules is where countries have a free trade agreement.

Under a WTO outcome tariffs would be levied on UK exports to the EU at an average of 4.3%, with some goods, particularly on agricultural goods and cars, subject to much higher rates. The EU does not levy tariffs on services, but non-tariff barriers, such as the loss of mutual recognition of professional qualifications, would weigh on trade.

The UK has proposed an import tariff schedule which would take effect next year and would apply to all countries with which the UK does not have a trade agreement. In the absence of a trade deal the schedule would cover EU imports. 87% of UK imports by value would be tariff-free, up from about 80% today. UK consumers would find the price of some EU imports rising and those of some non-EU imports falling.

Trying to estimate the economic effects of different varieties of Brexit has been a speculative business at the best of times. But with the pandemic likely to generate huge swings in activity, disentangling the impact of Brexit from other factors will be almost impossible. In a normal quarter the UK economy might be expected to grow by around 0.4%. We expect quarterly growth to run at around ten times this rate in the second half of this year and the first half of next as activity recovers from the lockdown slump. Were a full lockdown to be reinstated the profile of growth would be more erratic still.

There are arguments for ‘getting on’ with Brexit. Some believe the disruption from Brexit is best coped with at the same time as business adjusts to the post-COVID world. Reduced levels of trade, travel, migration and tourism in the wake of the pandemic would reduce the economic impact of Brexit, simply because there is less activity to disrupt. The huge amount of policy stimulus coming from central banks and governments will, the argument runs, help the UK economy through the Brexit transition.

Yet the two shocks, from the pandemic and Brexit, could amplify one another. The pandemic has stretched many businesses. Coping with social distancing, uncertainty, sub-par demand and then Brexit could be too much for some. Moreover, the sectors disrupted by a post-Brexit trading regime will not necessarily overlap with those affected by the pandemic. Those which have fared relatively well up until now such as the pharmaceutical and financial services sectors, could be caught in the turbulence.

The moment of truth on Brexit is approaching. With concessions and will, a trade agreement could yet be struck. But from where we stand today, an exit on WTO terms looks a very real possibility.