Brexit: Outlook 2020

On February 3, the first working day after Brexit, Mr. Barnier and Mr. Johnson laid out two distinctive and competing visions of the future relationship between the European Union and the United Kingdom.

In his speech, Mr. Barnier delivered the EU’s negotiating objectives, which make it clear that the bloc wants to regulate the future relationship between the EU and the UK as much as possible. It wants to keep the UK within its universe of rules, using Brexit as a demonstration of its trade and regulatory powers. The process reflects the EU’s desire to be the regulatory hegemon: using the common market as leverage, it wants to set the rules and standards around which much of the world orbits. An important implication of this is that the moment the UK is given the option to diverge from EU regulations, the EU will treat the UK as if it already has diverged. This limits the potential of the trade agreement: don’t count on anything that is far-reaching.

And even though it will make little economic sense for the UK to deviate much from the existing rules, Mr. Johnson made just as clear that he doesn’t want to be forced to accept these rules in order to secure a trade deal. He argues that the UK is not leaving the EU to undermine labor or environmental standards, but that it wants to regain regulatory independence: the deal shouldn’t include regulatory alignment, direct jurisdiction of the ECJ or other ways of supranational control.

It is going to get rough. Doing a major trade deal from scratch in the little time that is available has never been seriously tried. Meanwhile, it also feels a lot like 2016/2017 again, with red lines being drawn everywhere. In this new phase of the Brexit negotiations, both sides are once again miles apart, in substance and in style. The EU is back at its most technocratic: alongside the (draft) negotiating directives it has released almost a dozen slidepacks with detailed information, and Mr. Barnier is beating up the British government with warnings of the “mechanical consequences” of its choice to cede its status as an EU member. Meanwhile, the UK has released a statement outlining a high-level approach as Mr. Johnson is threatening to walk away without a deal, selling a potential WTO no-deal Brexit as an “Australia-style arrangement”.

Is it possible to reconcile these differences within the 11-month deadline and agree on a trading relationship that is loosely based on the EU-Canada agreement? We do think so, but the route to this deal will be difficult. Yet unlike his predecessor, Prime Minister Johnson appears to have accepted that Brexit has its limitations and its economic consequences. If he and Mr. Barnier acknowledge that their two speeches are just starting positions, the Political Declaration still provides enough common ground for constructive negotiations.

A relatively benign scenario would then be a repeat of what we’ve seen in the autumn of 2019. Prime Minister Johnson talked a good game to his domestic audience yet folded on several issues (e.g. the Northern Ireland protocol) the broader public doesn’t really care enough about to fully grasp the implications. It’s mostly technical stuff, after all, and it did get Brexit ‘done’. However, it’s not likely that such a scenario will reduce uncertainty. The EU is likely to call the ‘Australian bluff’, while the influence of the Brexit purists can’t be underestimated. The negotiations are also not very ambitious. The gap between the targeted FTA or no trade deal at all is small: trade frictions will increase either way, and this will have its ramifications for economic output.

Indeed, over the recent years, Brexit has been defined in much harder ways.

The UK has formally left the EU on January 31. It is now a third country like any other country that is not an EU Member State and has lost its participation in the EU’s political and legal processes. But in effect there has been little practical change. The EU laws continue to apply in the United Kingdom during the transition period, which runs until the end of 2020 and allows the UK and the EU to negotiate the future relationship. But time is already running short. If the UK had left the EU as planned on 31 March 2019, there would have been 21 months to negotiate the future relationship. But the three extensions to the Article 50-process have eaten into that time: there are now less than eleven months remaining.

The UK-EU Withdrawal Agreement states that the transition period can be extended once, by either one or two years. A decision has to be taken by 1 July 2020 at the latest, by a Joint Committee composed of European officials and the UK Government. However, the UK domestic laws which implement the Withdrawal Agreement actually prohibit the government to agree to such an extension. Even though it seems that the prime minister has little appetite to spend more time than necessary on Brexit –he even carefully avoids mentioning the B-word– this legislation is mainly for domestic political consumption. The government still has the option to repeal this provision if necessary and only needs a simple parliamentary majority to do so.

Some legal experts argue that an extension of the transition period is possible after 1 July as well when both sides agree to retroactively amend the terms of the Withdrawal Agreement. They could then ‘simply’ change the end date (see Repasi (2019)). This could be something that will be considered in the second half of 2020, if it turns out that a no-trade-deal Brexit can’t be avoided otherwise. The prime minister isn’t inclined to do so, but may change tack if the expected supply chain issues start to surface and economic uncertainties intensify. We don’t think that Brussels will take such an initiative: their approach has always been more technocratic and they’re more likely to emphasize that both parties have signed up to this timeline in October 2019.

And what about ratification?

Time also needs to be reserved for ratification of the new EU-UK agreement, which is now scheduled for Q4 2020. It’s too early to tell how much time is needed, as this primarily depends on the breadth of the agreement. If it is an ‘association agreement’, which touches both on competencies exclusive to the EU and on competencies exclusive to its member states, it must be ratified by the European Parliament, the Council of the EU, and all 27 member states including some regional parliaments. This process is fraught with risks.

While the trade in goods is an exclusive competence of the EU, certain aspects of services trade, investment protection or intellectual property rights are shared with member states. This is one of the reasons why the EU-Canada CETA-agreement took almost a decade to negotiate, and even then it was initially being blocked by a regional government before it eventually passed (well, the Canadians now definitely know to locate Wallonia!).

It is also possible to “provisionally apply” trade deals before the entire ratification process is complete. If the Council of the EU and the European Parliament provide consent, a new EU-UK agreement could then come into force pending ratification by the individual member states. But this is limited only to those parts of the deal which fall under EU competence, e.g. the trade in goods but not the trade in services. Finally, it’s worth noting that there have been reports that some EU officials are "confident" that the future relationship deal won’t have to be approved by national parliaments, because it's likely to be an associated agreement with more EU-only content than national content (i.e. lots of focus on goods, and not as much on services). This all suggests that the scope of the upcoming EU-UK deal is rather limited.

It’s impossible to get everything sorted in eleven months. This is why the EU and the UK are likely to prioritise on what is absolutely necessary to do in 2020, and try to make as much progress as possible by June when leaders will meet to take stock. The ‘prioritised’ topics include a trade deal on goods, a security partnership, and access to UK fishing waters. The EU would like to negotiate these all in a “single comprehensive partnership agreement”, potentially linking separate issues. The UK, on the other hand, is of the opinion that the future partnership should be embodied in a “suite of agreements” with their own governance and dispute settlement arrangements “appropriate to a relationship of sovereign equals”. This would resemble the relationship that the EU currently has with Switzerland.

From a market perspective, attention will be mostly on what happens with the UK’s trade in goods and whether the government is able to reach deals (not only with the EU, but also the US or other countries). The stakes are high: in 2018, the UK exported GBP 345bn worth in goods as it imported GBP 487bn. Roughly half of the UK’s goods trade was with the European Union (GBP 171bn of exports vs. GBP 265bn of imports). The share of the EU in the UK’s total good exports has declined gradually over time, from c. 60% in 2003 to c. 50% in 2018, which is almost completely attributable to the rise of Asia (figure 2). Zooming in on UK-EU trade in figure 3, it can be seen that Germany is the biggest trading partner (GBP 103bn in bilateral goods trade), followed by the Netherlands (GBP 69bn), France (GBP 53bn) and Belgium (GBP 41bn). The UK runs a trade deficit on goods with 21 of the 27 EU member states, with Ireland being the most notable exception due to its economic structure and its geographical location.

The EU and the UK aim for a free trade agreement that allows for zero tariffs, zero quotas, and zero dumping. But this requires provisions to safeguard a level playing which ensures that competition between EU and UK firms remains fair, as both economies have to follow similar rules on the environment, labor rights, government subsidies and competition. The UK has already introduced new legislation to replicate the existing EU rules, so this should, in theory at least, not lead to any immediate problems after the transition period ends.

However, as these rules evolve, the EU has said to expect the UK to either keep up with EU regulations as they change over time (‘dynamic alignment’) or to at least commit to ‘non-regression’ of the existing set of rules. It will then provide access to its market accordingly, as the EU fears that its rules will otherwise be undercut by a ‘Singapore-on-Thames’-style UK. A dispute resolution body, not necessarily the ECJ, should enforce the deal in case either party is not upholding its end of the bargain. Whilst businesses with exposure to foreign markets would prefer to remain aligned, as this reduces trade costs, the government has a strong desire for regulatory autonomy – according to the foreign secretary, alignment “defeats the point of Brexit”. This is also why the government removed the level playing field conditions in the renegotiated Withdrawal Agreement, whereas it featured prominently in the version agreed by Theresa May.

Trade between the EU and the UK won’t be without frictions, even if a deal is reached. A number of checks and procedures will become necessary once the new EU-UK customs border is introduced. This creates costly delays, especially if there are bottlenecks and capacity constraints. Manufacturing firms which strongly rely on just-in-time supply chains are particularly vulnerable. Whilst the UK has the incentive to unilaterally simplify its own customs procedures, it doesn’t have control over the formalities that are required by the EU. Another source of costs for traders who want to export to the EU are the so-called rules of origin, as they will have to prove that their products are sufficiently Made in Britain to qualify for the 0% tariff rate. There is a clear risk that this is too cumbersome, leading firms to shift production either out of or into the UK.

But what about services?

While most of the Brexit-related discussion focuses on whether there will be an FTA that facilitates the trade in goods and that limits the disruption in the EU-UK manufacturing supply chains, the UK still mostly is a services-based economy (c. 80% of GDP). And a ‘bare bones’ FTA doesn’t do a whole lot to facilitate the international trade in services. Yet the stakes are high for the UK: unlike in goods trade, the country is actually a net exporter of services, such as financial, consulting, engineering or legal work (figure 4). The UK exported GBP 297.5bn worth of services in 2018, which amounts to 46% of its total exports. And the EU is by some distance the biggest trading partner: GBP 120.2bn of these exports were directed to the continent, whereas imports from the EU amounted to GBP 92.4bn, or 48% of total services trade (figure 5).

This is why the UK would like to have an FTA that covers goods and services. The Political Declaration states that the EU and the UK aim to “conclude ambitious, comprehensive and balanced arrangements on trade in services and investment in services and non-services sectors, respecting each Party's right to regulate”. Whilst this sounds positive, the UK government has been clear in its intentions to leave the common market. The explicit wish to escape the EU’s regulatory orbit implies that the UK will in turn have to accept that access to the EU’s market for services will be limited. This complicates the negotiations: it is likely that the EU will demand a hard guarantee that the provided services satisfy the bloc’s standards ex ante, as regulating and monitoring the quality of these services is relatively difficult due to its intangible nature. Unlike goods trade, services are not restricted by tariffs or physical border checks.

Free cross-border services trade will therefore require a deep level of sector-specific regulatory alignment. This myriad of regulations –on for example licensing, standards, quotas, professional qualifications, or work visa requirements– decides when and how services providers are allowed to operate in foreign markets. Financial services directly come to mind. It is certain that the current ‘passporting’ arrangement will end. The EU is then likely to insist that the UK has to decide whether it wants to obtain regulatory autonomy in one of its key industries, or whether it wants to maintain high quality access to the European markets through ‘equivalence’. The EU could offer reduced regulatory compliance, if it finds that a third country’s regulations are broadly equal to its own. But even then, as Switzerland can attest, it is not a very stable situation: the decision to grant regulatory equivalence can be withdrawn for any reason with 30 days’ notice. This is why the UK would like the EU to sign up to a “permanent equivalence” regime for financial services.

This regulatory uncertainty could gradually induce firms that currently provide services through ‘cross-border supply’ (i.e. selling a service abroad without a commercial presence in that country, see also here for the four modes of supplying services) to set up subsidiaries and comply with local regulations, almost without regard of the outcome of the trade negotiations. This is a costly affair, and only larger firms may decide that it’s worth it. Given the UK’s position as a net services exporter, the EU has already been very welcoming to these firms. It’s likely that we’ll see continued but gradual relocation of services activities, which is expected to have a negative impact on the UK’s services balance and, more broadly, on its economic potential.

While it is difficult to quantify the impact of these non-tariff barriers, it should be absolutely clear that there is an inverse relationship between the regulatory distance between the EU and the UK and the impact on services trade. In our view, market participants don’t fully appreciate the risks to the UK’s services-based economy, as the focus is mostly on whether a deal on goods is on the offing or not.

Another prominent feature in the early-stage negotiations will be the fishing sector. The UK has made this a negotiating priority, and the treatment of this sector will be seen as an early litmus test of whether the UK or the EU is winning ground in the talks. Given its relatively large coastline the UK has a substantial Exclusive Economic Zone, yet EU boats land 43% of all the fish (by value) in these waters, giving rise to criticism that EU fishermen benefit disproportionately from their access to British waters. The UK wants to ‘take back control’ over its own waters and to have the final word on which country is allowed to fish in it. Even though fishing and its related industries account for just 0.1% of UK GDP, the sector packs a far larger punch than this as the UK values its island identity highly. Many fishing communities also fit the description of the ‘left behind’, which have been targeted by the prime minister and helped him win the election. The Political Declaration sets out that any deal on fish should be in place right after the transition period, targeting to reach an agreement before 1 July 2020. This coincides with the deadline to extend the transition period or not, and fish may also become part of a ‘fish for finance’-deal that provides mutual access to both markets.

We have always held a quite bearish view on the impact of Brexit on UK economic activity. In an extensive study that we've published in October 2017, we found that the UK ended up in a recession right after the materialisation of Brexit due to a contraction in business investment and trade. The magnitude of the recession varied considerably in these scenarios, but the desired FTA excluding extensive customs arrangements is a relatively hard one (note that Brexit has been defined in much harder ways over the years). And although some recovery is expected after the initial negative shock, we are of the view that lower productivity growth will put the UK economy on a structurally lower growth path than we would have seen without Brexit.

Whilst the Bank of England –or any other central bank– will never explicitly forecast self-fulfilling recessions, the latest Monetary Policy Report did reveal that the MPC and its staff have taken a more negative view the UK’s potential growth as well. Now it is broadly clear what kind of Brexit is being targeted by the government, they have revised down their estimate for potential growth to just 1.1%.

The uncertainties about the economic outlook were elevated during 2019, and risk becoming entrenched. These have a particularly large effect on business investment, leading firms to delay investment spending until there is more clarity about the country’s future trading relationships. Even though recent survey evidence point to a pick-up in investment intentions after the decisive election, it remains to be seen whether this is the start of a new trend or short-lived post-election euphoria. We think it’s the latter, and remain fairly confident in our forecast of just 0.8% GDP growth this year, whilst seeing an elevated risk of a recession next year as the UK has to adjust to its new trading relationships.