How Labour’s trade strategy could improve UK-EU relations

Four years after Brexit, its impact on the economy and the political landscape continues to unfold. The EU-UK Trade and Cooperation Agreement may have avoided tariffs, but most trade between the two blocs is now subject to non-tariff barriers. These barriers, including extensive paperwork and checks, complicate and inflate the cost of trade. This is a fixed cost that significantly impacts small and medium-sized enterprises in particular. The adjustment process - how businesses, both in the UK and elsewhere, adapt to the new rules - is far from complete. Even so, Brexit has hardly been discussed in the current UK election campaign. The Conservatives’ silence on what was once their flagship policy is a tacit acknowledgment of its shortcomings. Conversely, Labour’s mantra of “stability is change” can only be interpreted as a veiled critique of what Brexit has done to the country’s economic and social fabric.

Labour is very likely to take the reins of government after July 4. The economic landscape they will inherit is far from rosy, marked by tepid growth, flat real wages, high debt levels, overburdened public services, lacklustre investment, and a pressing housing shortage. While Brexit cannot shoulder all the blame, it certainly hasn't helped. Labour's economic strategy, dubbed Securonomics, proposes an active role for the government in addressing these challenges. The strategy is underpinned by three pillars: stability, investment, and reform. The emphasis on stability means Labour will not stir up controversy by attempting to undo Brexit. Nonetheless, even within the confines of the party's red lines and the logical constraints imposed by a green industrial policy, there are still many ways to improve the UK’s relationship with Brussels.

In this report, we look into the current state of UK trade and offer our perspective on Labour’s trade strategy vis-à-vis the European Union.

The impact of Brexit on UK trade is difficult to unravel. The data has been volatile, with the effects of the pandemic and the war in Ukraine muddying the waters. The figures for 2023, marking the third year since the Brexit deal was finalized, provide a first clear look. Starting with the trade deficit: at -1.2% of GDP, the deficit is actually smaller than it was on average between 2015 and 2019. If we look at trade openness, defined as exports and imports divided by GDP, which many economists believe leads to improved productivity and higher incomes, we see that there has been a relative decline in the UK’s openness (still at 63.5%) relative to the OECD’s average (61.2%). This relative decline started in 2020, as shown in Figure 2.

Economists predicted that increased trade barriers with the EU would negatively impact the UK’s trade with it. However, the data show resilience. Figure 3 illustrates the share of the EU in the UK’s foreign trade. Although the EU’s share is gradually declining, reflecting its smaller share in world GDP, it has been stable post-Brexit. It remains the largest source of trade for the UK, particularly in goods imports. The gravity equation in international trade remains a robust empirical finding: the flow of trade between two countries is proportional to their economic size and inversely related to their distance from each other. The EU will always remain the UK’s largest trading partner. But this relative stability could also reflect the UK’s delay in implementing border checks on EU imports, meaning many of the trade frictions have not yet fully come into effect.

The UK’s goods exports, both to the EU and the rest of the world, continue to languish. While a decline in goods trade was anticipated, non-EU trade in particular has been affected to a surprising extent. Figure 4 shows an international comparison of goods exports as a share of GDP, highlighting the UK's notably poor performance. Furthermore, by the end of 2023, goods exports volumes had plummeted to levels seen in the early 2010s, experiencing a significant 12.1% contraction after Brexit. This far exceeds the decline observed in comparable countries. It is particularly true for exports of high-value goods that are part of extensive pan-European supply chains, such as chemicals and automobiles.

On the other hand, the UK continues to excel in services trade. This often goes unnoticed, as services trade is elusive and challenging to grasp. Unlike manufacturing, services output is less dependent on foreign demand. In 2023, exports accounted for 32.3% of manufacturing turnover, with sectors such as machinery, pharmaceuticals, and computer, electronic, and optical equipment being over 50% reliant on exports. In contrast, exports constitute just 17% of turnover in services industries (Figure 6).

The strength in services exports is intriguing, especially given that the Brexit deal is relatively light on this. Growth is primarily driven by the expansion of “other business services”. Globally, the UK’s lawyers, management consultants, and accountants are particularly in favor. Several factors contribute to this performance. Firstly, global trade in services, where the UK holds a comparative advantage due to its high education levels, language, geographical location, and regulatory environment, has grown faster than global trade in goods. Secondly, the UK is less reliant on the EU for services exports compared to goods exports. Instead, there has been particularly strong growth in these exports to the US, possibly due to US firms outsourcing work to the UK thanks to a cheap sterling. Finally, digitalization has made trading services easier and less dependent on physical proximity, although this also leads to inadvertent noncompliance with the new EU-UK trade rules. Also note that two sectors within services have underperformed: financial services and transport services. Financial services, which are heavily regulated, saw many UK-based providers establishing operations in the EU to serve mainland Europe. Transport services, including road haulage and shipping, also lagged behind. Both relative declines can be traced back to Brexit.

Under the previous paradigm of increasing international integration, the UK’s reliance on services exports to earn its foreign exchange didn’t seem that much of a problem. Global value chains were stable and the sectoral structure of global trade was expected to shift toward a greater emphasis on services anyway. However, in this era of geoeconomic fragmentation, where supply chains are being used as a geopolitical tool, maintaining a robust manufacturing base is essential.

One of the main advantages of Brexit has been regaining the UK’s ability to conduct an independent trade policy, aligned with the government’s domestic objectives. Signing as many free trade agreements (FTAs) with non-EU countries as possible and tilting toward the Indo-Pacific were central to the post-Brexit trade strategy of “Global Britain”. Notable are deals with Australia and New Zealand, as well as the UK’s membership of Asia-Pacific’s CPTPP. Negotiations with India are ongoing, but have reached an impasse as India seeks more on visas and social security, while the UK wants greater market access. Labour is committed to reaching a (probably very modest) FTA with India, but fresh impetus from both sides seems to be required. Its economic impact will be marginal, but it would help to diversify the import supply options available to UK businesses.

That said, the United States and China, which jointly account for about a fifth of UK trade, were seen as the two key prizes when Brexit was sold to voters. The US has clearly signalled an FTA isn’t on the table. Its economic policy is now all about self-sufficiency entwined with national security, enforced through domestic protectionism and industrial policies. The increasingly global trend of friend-shoring, de-risking, or even the decoupling of supply chains – in other words, the practice of moving supply chains away from sources deemed potential national security risks – makes a trade agreement between China and the UK unimaginable.

Three red lines, three ambitions

It’ll be up to the new government to formulate a new trade strategy, particularly in relation to the EU. Labour’s stated plans on EU-UK relations are very modest, as they seek to balance demands from UK businesses with their own desire to increase the competitiveness of the UK without reopening a can of worms. Labour’s caution manifests in its ambitions starting with three red lines: no single market membership, no customs union, and no freedom of movement. This is required to preserve autonomy over product and services regulation, including Labour in the City, its trade relations with other countries, and immigration.

Labour has also outlined three positive ambitions in speeches and its campaign. These are securing a veterinary – or sanitary and phytosanitary (SPS) – agreement to facilitate trade in agri-food products, ensuring mutual recognition of professional qualifications to allow regulated professions to practice in the EU and vice versa, and advocating for short-term visas that facilitate touring artists. The election manifesto repeats these, but says little else, lacking detail and enthusiasm. It’s clear why Labour is opting for such a reserved approach, but even so, the manifesto does not indicate that trade will be a major priority. Securonomics is focused inward.

Veterinary agreement

The most significant ask is a EU-UK veterinary agreement. Such an agreement, which could supplement the existing EU-UK Trade and Cooperation Agreement, focuses on recognizing, aligning, or harmonizing each other’s regulations and standards aimed at protecting human, animal, and plant life or health. This would reduce or remove the need for SPS checks for food and agricultural products, which is now an important source of trade friction. The UK has just started checking and inspecting some agri-food goods coming in from the EU. This was put off a number of times because the government was worried about border hold-ups and increased prices for consumers. Full border controls started immediately in January 2021 for products coming into the EU from Great Britain.

The essence of an SPS agreement is quite simple: the UK agrees to follow EU rules for food, agriculture, and health standards. This means that food products moving between the EU and UK would meet the same criteria, eliminating the need for health inspections and very extensive paperwork at the border. This puts British farmers on more equal terms with their EU counterparts. It should also reduce lorry queues and supply chain issues, benefiting non-agrifood producers as well. Additionally, it would eliminate most border checks between Northern Ireland and the rest of the UK, addressing a complex political issue.

Trade talks, especially when Brexit is involved, are politically delicate. The specifics of a veterinary agreement will significantly influence the smoothness of these negotiations. A Swiss-style deal, where the UK maintains a close and evolving regulatory relationship with the EU, would be most suitable for such a close trading partner. This arrangement eliminates almost all physical checks on animals and food products, while retaining some paperwork checks. It would probably mean that the EU will require London to accept European Court of Justice oversight to resolve any disputes. This might not sit well with some voters, and the headlines will write themselves, but it is not one of Labour’s red lines. Meanwhile, the EU, recalling the difficulties of previous Brexit negotiations, will reject any signs of a UK “having its cake and eating it too” attitude.

What else?

The Conservative government has shown willingness to bear higher trade costs to keep open the option of regulatory divergence, but have seldom pursued actual divergence from EU regulation. Given the UK’s ongoing compliance with “legacy” EU rules and its current hesitation to change course, it would be logical for the UK to continue following EU business regulations to maintain the level playing field. If the Labour party sticks to its credo that stability equals change, it should work closely with business and industries to identify areas where continued alignment with EU standards is advantageous. It also shouldn’t be afraid to pinpoint sectors where diverging from EU regulations could be strategically significant. However, we’re not seeing this.

The UK has relative strengths in sectors such as chemicals, pharmaceuticals, and medical devices. If Labour commits to remaining aligned with EU industrial regulations, it could help unlock new investment. This alignment could even be done unilaterally. It would reduce costs, as businesses wouldn’t have to comply with two different regulatory regimes, even though they would still need to demonstrate compliance at the border. That said, the EU’s past dealings with other European countries indicate a willingness to open its markets in exchange for stronger regulatory influence and a larger Single Market. And despite a growing trend of protectionism in Brussels, aimed at crafting an industrial strategy for Europe’s future competitiveness, this task would be more manageable with the UK’s continued participation in European supply chains than without.

There are many other avenues that also need to be explored. We consider two more: carbon taxes and rules of origin. Both the EU and the UK are set to introduce their own carbon border adjustment mechanisms in 2026 and 2027, respectively, but have similar net zero targets. Aligning the UK’s regime with the EU’s would make it more manageable to meet these targets and the associated carbon budgets efficiently. The EU-UK Trade and Cooperation Agreement commits both parties to consider linking their carbon pricing schemes. Therefore, Labour may decide to advance the UK CBAM to 2026 and to formally link the UK ETS with the EU ETS. We would also expect Labour to explore membership in the Pan-Euro-Mediterranean Convention on rules of origin. This customs union agreement includes the EU, other European countries, and almost all the countries around the Mediterranean. Accession would be advantageous for UK companies active in supply chains with these other countries and would help British exports qualify more easily for tariff exemptions under the EU-UK Trade and Cooperation Agreement.

The EU-UK relationship is a multi-faceted engagement, involving many stakeholders. We don’t expect major high-level announcements, but a number of smaller agreements would still be beneficial.

Brexit is unfolding like a slow puncture. While economic growth has been tepid, trade data show no signs of an immediate crisis. This allows Labour to be cautious about Europe. It worries that if it talks too much or too positively about the EU, those who voted Leave in 2016 or voted for the Conservatives in 2019 will be reminded of their identity and vote Reform or Conservative again. Labour’s ability to win the July 4 election is due partly to Starmer’s concessions to populist demands, both in rhetoric and policy. This means there is only room for rather inconspicuous but meaningful adjustments to the Conservatives’ Brexit deal.

The implication of Securonomics is that Labour will try to reshape the economy to support national priorities, even if it means imposing or maintaining barriers to production, trade or finance that would otherwise be considered inefficient by global market standards. Protectionism could therefore be a feature of Labour’s economic policy, even as they don’t want to label it that way. We harbour doubts about Labour’s readiness for a major transformation in UK-EU relations.