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Rocky road ahead: bare bones trade deal or WTO Brexit?

After all the efforts to avoid a disorderly Brexit, it now looks as though that’s exactly what may happen. An extension of the transition period seems to have been ruled out – and there are only six months left to negotiate a new trade agreement. Will economic rationality win out in the end, with the two sides agreeing a ‘bare bones’ deal?

The situation is deadlocked. The end of June is the deadline for extending the transition period – the period during which the current EU rules continue to apply to the relationship between the United Kingdom and the European Union (EU) – by up to two years. Talks between the EU and the UK have been going on since February but no progress has been made. Recently, the British side seems to have been moving towards the position that, in the context of the coronavirus crisis, there is “not much to lose”. The thinking appears to be that the additional economic damage caused by the failure to secure a trade deal would not be noticed in the deep coronavirus recession that is about to engulf the country.

Talks with the EU are now going to be held at the highest level on a weekly basis, starting in July. The aim is to have a trade agreement in place by the end of the year. However, the British government has repeatedly refused point-blank to countenance any extension of the transition phase and this now appears to be completely off the table.

Sticking points: level playing field, fishing, EU law

This leaves six months to prevent a WTO Brexit. Union Investment believes a bare bones trade agreement is still possible. However, the hurdles to be overcome by then are considerable, for two reasons.

Firstly, time is pressing. The EU’s chief negotiator, Michel Barnier, has already stated that a deal must be agreed by the end of October to allow time for it to be ratified before the end of the year. And British officials are even demanding that the trade agreement be wrapped up by the summer.

Secondly, even after three months of negotiations, the central sticking points remain unchanged: the European demand for a level playing field, the issue of fishing in British waters and the primacy of the European Court of Justice (ECJ) in the interpretation of European law are the main points of contention between the UK and the EU.

If no trade agreement, even a rudimentary one, can be agreed, there is a risk that the UK will leave the EU on WTO terms at the end of 2020. This will result in a multitude of tariffs and trade restrictions, but also the loss of rules for ‘non-tariff trade barriers’, i.e. product standards and safety and sanitary regulations, for example in the food sector. The minimum standards of the World Trade Organisation (WTO) would then apply. This would be a ‘hard Brexit’ – a scenario that the EU and the UK have previously worked hard to avoid.

At this stage, the question of the specific content of a potential trade agreement remains completely open. It is conceivable, however, that the negotiations between the EU and the UK could result in a solution to the issue of tariffs.

Risk of economies of scale being lost

WTO rules are not uncommon: they apply between countries that do not have a free trade agreement. However, they can be supplemented by additional bilateral agreements – as in the case of the US and the UK. Britain would lose direct access to the single European market in the event of a ‘hard WTO Brexit’ and trade with the EU would involve considerably more red tape. Customs declarations, export licences and tax issues would result in significantly higher costs, especially for smaller companies. Businesses would also have to deal with different national regulations and product standards, thus losing the economies of scale they enjoyed when the UK was part of the single market. British industry would be particularly badly hit, but the trade sector would also suffer. And there would also be financial losses for companies within the EU27, as it would cost more to export to the UK. In the recent discussions regarding the EU coronavirus recovery fund, Belgium and Ireland have already warned of the danger of a WTO Brexit coming on top of the economic shock caused by the pandemic.

So both sides have an economic interest in not allowing the negotiations to fail completely. The relevance of this can be seen in the close economic ties that exist between the UK and the EU. In 2018, for example, 45 per cent of British exports went to the EU, compared with only 19 per cent to the United States.

UK trade by region

UK trade by region
Source: Office for National Statistics.

Risk of complete schism

However, there is a high risk that the UK will dig its heels in and that Prime Minister Boris Johnson, with a clear parliamentary majority behind him, will seek to break free from the EU completely. A significant number of Brexit supporters believe that a shake-up of Britain’s global trade relations could work to the advantage of the British economy and be particularly successful in attracting innovative industries. The Johnson government has already decided to significantly increase research funding in advanced mathematics, for example.

The EU, on the other hand, insists on regulatory alignment and a level playing field, i.e. it wants to prevent a softening of the existing regulations in a deal with the UK. It is also unclear what role the European Court of Justice (ECJ) will play in disputes between the UK and EU. This, incidentally, is also a factor in the stalled negotiations on a framework agreement between the EU and Switzerland. Against this background, the Bank of England believes there is a real risk of a no-deal Brexit and has instructed British banks to prepare for this eventuality.

Overall, businesses on both sides of the Channel are facing a situation of continuing legal uncertainty which is dampening growth. In the UK, a failure of the trade talks would hamper the recovery of the British economy once the coronavirus pandemic has been brought under control, and could cause the tide of public opinion to turn. However, the position within the British government seems to be hardening. Ministers appear to be consciously accepting the economic damage of a WTO Brexit and hoping that the negative effects can be buried amid the current coronavirus chaos. Coupled with the upheavals caused by the pandemic, this means huge uncertainty for the UK’s economic outlook.

Gross investment in plant and equipment of various countries

Percentage change year-on-year
Gross investment in plant and equipment of various countries
Source: Macrobond; as at 26 May 2020.

In conclusion, Union Investment’s experts expect that economic reason will prevail in the end and a rudimentary trade agreement will be thrashed out. However, given the limited time available and the wide gulf between the negotiating partners, there is still a real danger of a WTO Brexit. Even if a rudimentary trade agreement were to be reached, companies can expect new checks and controls and a lot more bureaucracy. If Johnson remains on his current course, the risk is that all the work that has gone into securing an orderly exit from the EU since the referendum will have been in vain.

 

As at 15 June 2020