Brexit Outlook: Down to the wire

Brexit is a fact of life. But even for those most affected, remarkably little of the daily routines has actually changed because of it (… unlike some other thing that has happened in 2020). This potentially creates a false sense of security, as the status quo ends on 31 December. Governments have launched awareness campaigns, urging businesses and households to ‘get ready for Brexit’. But even at this stage, it is far from clear as to what they should prepare for. Since the talks are likely to go down to the wire once more, it might take another two months before clarity arrives.

The Withdrawal Agreement ushered in Brexit on 31 January 2020. But only a few aspects of the UK’s future after Brexit were actually enshrined in this agreement. The three most prominent were:

The Withdrawal Agreement covers only a small part of the future EU/UK relationship. Some other contentious issues were put off for another day and shoved into the non-binding Political Declaration. While this document sets out a framework for this new relationship, in reality it just serves as a reference point in the negotiations. The EU tends to accuse the UK for walking back on the pledges it made in the declaration. It sees these pledges as hard ones, as the declaration was inextricably linked to the Withdrawal Agreement, an international treaty. At the same time, we have to keep in mind that there has since been a UK general election, and, as a consequence, a different government with evolved ideas on Brexit and what it means to be a sovereign state.

The negotiations on the future relationship started in earnest in early-February with two sharply contrasting speeches –in substance and in style– by chief negotiators Mr. Barnier and Mr. Frost. The latter emphasised the benefits of being a sovereign state, saying that “we believe sovereignty is meaningful and what it enables us to do is to set our rules for our own benefit”. The British government believes that it will be easier to adapt to a rapid-changing world as an ‘agile’ sovereign state than as part of a slow-moving union of 28 member states. It also sees the new EU-UK relationship as one of ‘sovereign equals’. Mr. Barnier, however, attempted to tone down these aspirations as he warned that such a set-up would have serious ramifications for EU-UK trade. He said that “A third country, the United Kingdom, will not dictate the conditions of access to our market for British goods, services, data or for workers and businesses … We remain sovereign. This is my mandate.” Or, more bluntly: the EU’s single market has a much bigger economic weight than the UK’s could ever dream of, so … bonne chance!

This battle for sovereignty is being fought on the seas and on the level playing field.

Fish fights

One area in which the United Kingdom believes it has the most leverage over the European Union is fish. The EU mandates its negotiator Barnier to “avoid any economic dislocation” for the EU’s fishing fleet, whilst the British believe that any arrangement similar to the status quo would mean that they would again be the one losing out. There is a strong belief that the fishing industry was ‘sacrificed’ in 1973, when the UK agreed to share access to its waters in order to join the European Economic Community (the predecessor of the EU). Official government data show that EU-based fleets land about eight times as much fish in the UK’s waters as the British fleet does in EU waters.

The fishing industry may be just a drop in the ocean in terms of GDP, contributing just 0.12% to it, but it remains a potent symbol of the British ire with the EU. Rightly or wrongly, it’s therefore entirely logical that the UK government believes it can improve on the existing deal: it wants the new agreement to provide for annual negotiations on mutual access to each other’s waters. The catch however is that this will effectively create a rolling source of UK leverage over the EU, with a recurring risk of a sudden dislocation to the EU’s fishing fleet. Mr. Barnier simply doesn’t have the mandate to accept such a proposal. Instead, he seeks a long-term solution that provides a certain degree of regulatory certainty to the EU’s fisheries, even as such a solution may eventually lead to a gradual rebalancing of the fishing quotas in favour of the UK. The UK government could then sell such a compromise as a win, as it will take back control over its waters.

Keeping a level playing field

Conversely, the European Union appears to have the upper hand in deciding on which field it would like to play the great game of international trade. The Political Declaration states that such a level playing field entails the ‘robust commitments’ to stick to agreed common high standards on issues such as environmental protection, workers’ rights, taxation and state aid, predominantly to prevent distortions of trade and competition. Furthermore:

In so doing, [the UK and the EU] should rely on appropriate and relevant Union and international standards, and include appropriate mechanisms to ensure effective implementation domestically, enforcement and dispute settlement.

The two different sides of The Channel have different interpretations of what is ‘appropriate’. The EU’s negotiating mandate states, for instance, that these guarantees should also be robust over time. This is called ‘dynamic alignment’ and would effectively mean that the UK has to adhere to new EU rules and regulations if it wants greater access to its markets. However, such an arrangement would imply that the UK would be a rule-taker, which does not sit particularly well with the concept of sovereignty. It would also tie its hands in FTAs with other countries.

There have been signals that the EU has watered down the most stringent demands, making it all the more likely, however, that it will require ‘non-regression’-clauses. This would still imply that both parties commit to uphold the current, existing set of shared regulations. The EU evidently sees a clear risk that the UK government wants to use the disruption of Brexit, and possibly Covid-19, as a platform to deregulate the economy and to increase its competitiveness. As such, it remains concerned that the UK will position itself as a low-cost rival – right across The Channel.

Throwing off the yoke of the Brussels bureaucracy?

For the UK, dynamic alignment or non-regression is particularly problematic in the area of state aid. We argued here that it is conceivable that the UK wants to adopt a more interventionist industrial policy –also in light of the country’s dramatic productivity numbers– in order to boost local production and consumption and to provide strategic industries the space and shelter to expand. In its approach to the EU-UK negotiations, the government states that it plans to create its own regime of subsidy control and that the trade deal should merely include an obligation on both parties to notify the other every two years on the subsidies that are granted. Whilst this goes beyond the notification requirements set by the WTO, it does create the risk of politically-loaded conflicts and/or punitive tariffs down the road.

The UK government has yet to publish a blueprint of its subsidy regime but appears to be split. Any progress in the negotiations will be difficult –if not impossible– until this blueprint sees the light of day. And even then, a trade agreement is only realistic if this regime broadly resembles the EU’s rules, which the UK of course has helped to develop over the years.

A closely related source of contention is the role of the European Court of Justice. The EU wants to set the rules and standards around which much of the world orbits, and sees the ECJ as its enforcer. The UK, however, doesn’t accept an EU court that dictates the legal boundaries of its economic policy. As it sees the future EU-UK relationship as one of two sovereign equals, it proposes to set up a dispute resolution mechanism that settles disagreements through political engagement, or eventually through punitive tariffs if the other side doesn’t hold up its end. It appears that the UK has successfully argued that ECJ oversight is indeed too big of an ask. Again, Mr. Barnier recently signalled flexibility. Yet the EU has every reason to be wary that the UK will eventually try to deregulate. After all, Brexiteers have insisted for years and years that one of the main goals of Brexit was to throw off ‘the yoke of the Brussels bureaucracy’.

Nobody can predict with any precision where and if the UK and the EU will find their ‘landing zone’. But some things are certain. Trade barriers will rise considerably, regardless of whether a trade deal is struck or not. European and British companies that once traded freely in each other’s markets will have to cross newly-erected barriers. This costs both time and money.

There is only so much a trade deal can achieve, let alone the aspired simple free trade agreement. There will be customs checks carried out at the EU-UK border, goods that cross borders will have to satisfy rules of origin requirements to qualify for tariff-free entry, and trade will continuously be subject to the threat of anti-dumping measures and countervailing duties.

This all means that businesses, in particular small ones, may decide that it’s not worth the effort to trade overseas. For some of those, the adjustment to a new FTA could be just as frustrating as an adjustment to WTO standards. Moreover, large firms that are currently intertwined in international supply chains may (eventually) find out that it is much easier to produce in the EU or in the UK and then simply sell only the final product into the other market. It is reasonable to expect that trade and investment between the EU and the UK will decline considerably over time.

The aspired FTA doesn’t help services – at all

While most of the Brexit-related discussions focus on whether there will be an FTA that facilitates trade in goods and that aims to limit disruptions in pan-European manufacturing supply chains, we have to keep in mind that the UK still is a services-based economy (c. 80% of GDP). It is also a net exporter of services to the EU and other countries. The aspired FTA does little, if anything, to facilitate the international trade in services.

That said, one important but admittedly intangible benefit of negotiating constructively and eventually coming to agreement on a trade deal in goods, is that this could eventually serve as a springboard for various ‘side deals’. For instance, the EU still has to decide whether it will allow UK financial services providers to do business on its markets (a decision they had expected to make before July 1). The EU makes these decisions unilaterally and does so if it judges that (a part of) the UK’s regulatory regime on financial services is ‘equivalent’ to the European regime. In theory, such a decision has little to do with an FTA on goods. It’s an entirely different process. In practice, however, a harmonious EU-UK relationship could do wonders. Another example: as the UK leaves the pan-European GDPR regime and becomes a third country, UK businesses will need an EU ‘adequacy decision’ that allows them to work with personal data of EU individuals. Without such a decision, UK businesses will face a lot of additional red tape in the form of additional and bespoke contracts that allows them to freely receive personal data of EU individuals.

Trade in intangible services remains overshadowed by trade in tangible goods in the debate, even as the EU is a major market for UK-based services providers. These businesses will inevitably face increased regulatory costs, insurmountable barriers even. This is likely to continue to lead to a reallocation of services production away from the UK and into EU member states. That said, an FTA on goods could ultimately provide a platform on which a deeper relationship can eventually be re-build (… if the political reality changes).

The next official round of negotiations starts in the week of 7 September, but any form of significant progress can’t reasonably be expected as long as the UK government won’t publish the details of its domestic subsidy regime. Even as these delays raise the suspicion that Prime Minister Johnson hasn’t really made up his mind yet, it is more likely that the strategy to sit tight until the very last moment is a deliberate one. Because the longer he waits, the less time there is available for domestic scrutiny of what is a very complex and difficult to comprehend legal text. This is also what happened in October 2019, and it allowed the prime minister to ram a deal through Parliament even as it crossed several of his ‘red lines’, e.g. the Northern Ireland Protocol.

The mandates of Barnier and Frost don’t click and political intervention appears necessary to make things work. It is therefore likely that the talks will go down the wire once more. But even if you assume that the EU doesn’t make any further meaningful concessions on level playing field, it’s still possible to spot a ‘landing zone’ for a deal: the UK is granted some easy-to-communicate wins on fishing quotas, but gives in on some of the more complex and ‘technocratic’ issues such as state aid, even as this could ultimately be seen as a strategic mistake. That said, it remains uncertain whether there will be enough time to conclude a deal before or at the crucial European Council summit of 15-16 October. It is therefore possible that an extra summit even needs to be called in the second half of October or early-November, but this has its limits as some time is needed for legal work and eventually ratification (see also here).

After December 31

The entirely different nature of the future EU-UK relationship will immediately change the way EU and UK businesses trade in each other’s markets. As time is already running short, calls for another implementation phase that follows on the transition period may grow louder. There have been reports suggesting that officials are looking at ways on how to incorporate such a phase into the future relationship agreement, if such an agreement is indeed agreed at the last minute.

It is, however, difficult to see how such a phase-out period would really be of any help, as a lot of the envisaged changes in the EU-UK trading relationship are rather binary. There really is no halfway house in filling customs declarations, in performing sanitary- and phytosanitary controls and other checks, or in proving that the traded goods comply with rules of origin. It is either being required, or it is not. The implication is that there will always be some sort of cliff-edge.

An implementation phase will be politically difficult to achieve as well. Even though additional time would allow both sides to continue talking and improving on the deal beyond the 31 December deadline, the optics of it could be pretty bad. The UK government may try to argue that an implementation phase is an entirely different beast than a formal extension of the transition period, but there’s a very sizable group of Tory MPs that would love to punch holes in this. And the government would be a particularly easy target if an implementation phase comes with the typical EU-strings attached, such as requirements to continue paying into the EU budget or to remain subject to EU laws. Therefore, the scope for phase-out periods seems to be limited to some loose ends here and there, rather than to the broader structure of the deal.

The Europeans have indicated that they’re willing to make some significant concessions, but these haven’t yet been met by British reciprocity. Instead, the Johnson government appears to play the same game as it did in 2019. It threatens to walk away with no trade deal, even in the midst of a pandemic, and hopes that EU leaders (i.e. Merkel or Macron) will ultimately intervene to protect their already-hurting export industries. Last year, Boris Johnson conceded at the very last moment. This may happen again, in particular on state aid, and it remains our base case.

Having said that, a no-trade-deal Brexit won’t be as disruptive as a 2019 no-deal Brexit would have been. Especially not from a relative point of view: trade barriers will be erected anyway. Yes, it is true that even the simplest of FTA’s will produce some better-looking economics, but the politics of no-deal may be better if such an FTA ties the UK to the EU rulebook forever. Also, the expected short-term hit to trade or GDP will be barely noticeable on top of the current crisis. Keep in mind that the cost of Brexit has always been through a slow burn of an increasingly distanced economy that sees less productivity growth than had otherwise been the case, as we detailed here. In fact, we expect that UK GDP will grow by 4.4% in 2021, even as this merely reflects (an incomplete) recovery from the sharp slowdown in the second quarter of this year. Such figures provide the perfect shelter for a no-trade-deal Brexit.

Ultimately, the talks boil down to the trade-off between regulatory autonomy and the ability to have deep international trading relationships. Since this UK government puts sovereignty at the centre of how it sees Brexit, the scope for any agreement remains very limited.

Financial markets remain relatively sanguine in the run up to the new Brexit deadlines and sterling has fared relatively well against both the dollar and the euro, although the better tone in recent data has simultaneously pushed back on fears of a negative policy rate. That said, short-dated implied volatilities remain within bounds as well, signalling that investors remain at ease. Even then, unless the status quo alters in the weeks ahead, we would expect EUR/GBP to be pushed higher in the run-up to these deadlines. We see risk of move to 0.92 on a 2 to 3 month view if an EU-UK compromise remains elusive.

We would also expect businesses to increase their stockpiling efforts ahead of 31 December. However, the pandemic has already left its mark on their cash reserves, while consumer and business demand is expected to remain relatively muted as unemployment will rise over the course of the autumn and winter. Finally, stockpiling hasn’t exactly been a winning strategy in 2019, so a larger share of businesses may simply wait and see what eventually happens.