Brexit

Brexit proper, the UK’s departure from the EU’s single market a year ago, passed without major incident. Borders continued to work and lorries kept moving.

Yet beneath the surface, Brexit is reshaping patterns of trade. What happened at our borders is a metaphor for Brexit as a whole. There have been significant effects, but the most dramatic, and headline-worthy, predictions on both sides of the Brexit argument have not been realised.

In the event of a vote to leave the EU, the Treasury forecast an “immediate and profound economic shock causing a recession and a steep rise in unemployment”. The vote to leave was a profound shock, but a political one. Growth continued at a decent pace after the referendum, unemployment fell further and UK equities rose.

Nor has Brexit freed up “£350m per week for the NHS”, as the Leave campaign suggested it would. Indeed, with growth almost certainly weaker than it would have been otherwise, Brexit will have contributed to a deterioration in the public finances.

The effects of Brexit will be debated forever. Just trying to summarise some of the economic issues has resulted in this week’s briefing being at least twice as long as normal. But by and large, economists take the view that leaving the EU has meant more friction and greater economic distance between the EU and UK, and that means slower growth. While there’s no consensus on the scale of those losses, Brexit has had measurable economic effects.

In the wake of the vote, the pound fell by over 20% against the euro. A weaker pound raised UK import prices and inflation, squeezing consumer spending power. Uncertainty about the outcome of negotiations between the EU and the UK weighed on investment which has conspicuously underperformed relative to the pre-referendum period and to other major industrial economies. In a 2021 Bank of England paper, a group of Bank economists and academics estimated that Brexit has knocked off about 25% of the total level of UK investment.

So, it’s not hard to see why economists think Brexit has slowed UK growth, even if the magnitude of that effect is uncertain and, until the pandemic, the UK grew at roughly the same rate as the euro area.

The most obvious casualty of Britain’s departure from the EU – and, in economic models, the clearest source of damage to GDP – is trade. Just as reducing trade barriers boosts trade, so increased costs and frictions will dampen it.

In its economic modelling, the Office for Budget Responsibility (OBR) assumes that in the long term both total UK imports and exports will eventually be 15% lower than if the UK had remained in the EU. In turn, lower levels of trade, by reducing competition and choice, will generate a 4% reduction in long-run productivity in the OBR’s model.

Brexit has thrown sand into the gears of UK-EU trade. An Office for National Statistics survey of around 9,000 businesses revealed that in December two-thirds of UK exporters faced challenges selling abroad, up from 21% in December 2020. 80% of importers reported challenges with procuring foreign goods, up from 38% a year ago. Brexit-driven factors, including new paperwork and customs duties, rate as two of the three biggest problems for UK exporters and importers. Pandemic-driven factors featured lower down the list.

The second Alpha wave of COVID-19 coincided with the UK’s departure from the single market in January 2021 and has muddied the waters in assessing the effect of Brexit on trade. Perhaps surprisingly, since the referendum in 2016, and more so since January 2021, UK exports of goods to the EU have outperformed UK imports of goods from the EU. UK exports to the EU last December were about 8% higher than two years earlier, prior to COVID and departure from the single market; over the same period imports fell just over 4%. Both, however, are well below the peak seen in early 2019.

This seems especially odd given that exports from the UK have faced new EU customs checks and costs since last January, whereas the UK’s own, more onerous post-Brexit regime for imports from the EU only came into effect at the start of this month. UK businesses may have been better prepared for the new trading regime than their EU counterparts. With the EU accounting for 42% of total UK exports and the UK accounting for only 6% of EU exports, Brexit always looked likely to be a bigger deal for, and warrant greater investment from, the British.

As imports from the EU into the UK have faltered, imports from the rest of the world have filled the gap. This accelerates a reorientation of UK trade in goods and services away from the EU that has been underway for more than 15 years.

Just as one would expect, in the long term, Brexit is likely to weaken UK trade with the EU and boost it with the rest of the world. The UK’s ability to ‘roll-over’ many trade deals with the rest of the world that the UK benefitted from when it was in the EU is a good start (concern that a medium-sized economy like the UK would have trouble replicating existing terms post-Brexit have generally not been realised). But the most significant deals, such as those with India, the Trans-Pacific Partnership or the US, are distant prospects. Most economists, and certainly the OBR, believe that the UK’s losses from trade with the EU will not be recouped through increased trade elsewhere. 

The auto sector featured prominently in the debates about the impact of Brexit that followed the vote to leave. The sector’s worst fears have not come to pass. The eventual trade deal with the EU has averted a 10% tariff on automotive exports from the UK, a relief for manufacturers who were considering the sustainability of their UK operations in the event of a no-deal Brexit. UK manufacturers continue to export a majority of finished cars to the EU and data for the first half of 2021 show little evidence of a trade diversion from the EU to other destinations.  

Yet the sector hasn’t escaped new trade frictions and costs. A recent study by the Society of Motor Manufacturers and Traders shows that almost two-thirds of automotive firms have incurred significantly higher costs on dealing with the new trade regime.

Much of economic theory and economic modelling assumes ‘other things remain equal’. In the real world that is rarely the case. Since 2016, Brexit has been the dominant issue facing the UK corporate sector. Yet climate is becoming increasingly important, particularly after the UK government announced in November 2019 that it would ban new diesel and petrol cars by 2030. The government sees the creation of a British battery industry as being essential to the future of the auto sector and has set aside £800m to attract private investment (Nissan and, last week, Gigavolt have been the first two recipients of government funding). Few could have anticipated in 2016 the speed of the shift in UK policy towards the car industry.

Financial services are another Brexit-sensitive sector. The 'passporting rights' that allowed British firms to operate as if they were based in Europe have now gone. Almost immediately, Amsterdam's stock exchanges took over from London as the primary hubs for European share trading. By last February, London’s derivative-trading platforms had lost three-quarters of their euro trade volumes to Amsterdam and New York. Initial hopes of gaining 'equivalence' status – which would allow British businesses to continue serving European clients for various financial services activities – have faded.

According to research by the New Financial think tank, by last spring, British banks had moved roughly £900bn in assets (10% of the UK banking system) out of the UK. Insurance funds and asset managers are estimated to have moved more than £100bn in assets and funds. Asset managers have gravitated towards Dublin, banks have generally chosen Frankfurt and trading platforms, exchanges or broking firms have largely relocated operations to Amsterdam.

Despite these activities moving out of the UK, the jobs exodus by the time of the study had been significantly lower than expected. New Financial estimates that just 7,400 financial services jobs had moved from the UK to Europe since 2016, a fraction of the 1.1m people employed in the sector as a whole and well below the hundreds of thousands of jobs that some had feared the sector might lose. London’s attractiveness to a globally mobile workforce and sheer scale as a financial centre, remain significant advantages. The Economist recently observed that Frankfurt’s entire financial services sector employs fewer people than London’s fintech companies while the north of England exports more financial services than the whole of France.

The direction of UK financial services policy seems to have shifted from seeking convergence to actively diverging from the EU. In July 2021 the chancellor emphasised a pivot away from Europe and instead a “push for closer co-operation and more cross-border access with other like-minded financial centres in markets around the world”. Some reforms could also amend EU financial regulations that have attracted the most vocal criticism from the sector, such as Solvency II. The aim is to make it easier for firms to trial new technology and products, helping the UK carve out a niche in attracting innovative businesses.

The ending of free movement between the UK and the EU has been one of the most significant impacts of Brexit. One of the earliest effects of the Brexit vote was a drop in net migration flows from the EU, which fell by almost three-quarters between the referendum and the beginning of 2020. There was little effect on the numbers of EU workers who were already in the UK until the pandemic, which led to an exodus of low-skilled labour and reduced the number of EU-born people in the workforce by over 10%.

Brexit limits the supply of low-skilled EU workers by ending free movement. Sectors such as agriculture, food manufacturing, social care and hospitality, which are especially dependent on EU migrant labour, face the greatest challenges. The government has responded by making special concessions to ease skills shortages in the agriculture and social care sectors – extending an agricultural workers visa scheme for another three years allowing growers to recruit overseas workers during harvests and introducing a special visa for foreign care workers. 

Meanwhile, there has been a significant rise in non-EU migration since the referendum, with the number of non-EU workers in employment up by more than half a million (19%) helped by the relaxation of the cap on skilled worker visas for non-EU migrants.

The new skills-based visa system should make high-skilled jobs more contestable, by levelling the playing field between EU and non-EU labour. Inward migration will continue, but government policy implies a clear shift to the migration of skilled workers.

So how can we sum up the effects of Brexit one year in? The chaos and instant dislocation that some feared has not materialised. Extensive preparations by the government and the private sector helped. Systems have, by and large, coped. Huge disruptions – the vast lorry tailbacks (the port of Dover has attributed this weekend’s queues to a spike in freight traffic and not Brexit), recession, runaway inflation and so on – have not materialised. But Brexit has had economic effects. A weaker pound raised import prices. Brexit-related uncertainties weighed on investment. Importers and exporters have faced disruption and additional costs that show few signs of abating.

But more importantly, Britain’s economic focus seems to be shifting to the world beyond Europe. It is reflected in the trade and immigration data, and in the government’s push for greater co-operation with financial centres outside Europe.

Britain’s position in the EU changed and evolved over its near 50 years of membership. Leaving the EU is the start, not the end, of creating a new economic model. There are new opportunities and freedoms outside the EU. But the reality is that the decisions UK business and government face in seeking to improve economic performance are largely the same.

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https://www2.deloitte.com/uk/en/pages/finance/articles/covid-19-economics-monitor.html