Back on the Brexit rollercoaster: buckle up for a bumpy ride

What’s happening with Brexit?

The UK and European Union (EU) resumed Brexit negotiations over the summer but made limited progress. The political drama and posturing that accompanied the proceedings look certain to persist in the coming weeks.

It appears the UK intends proposing domestic laws to weaken its Withdrawal Agreement commitments on the border between Ireland and Northern Ireland. This would be a backward step for negotiations and could provoke a sharp reaction from the EU. Moreover, it will reignite the issue of governance. This appeared almost to have been settled. However, it will flare up again if the Johnson government signals genuine reluctance to honour existing treaty obligations.

Despite this latest development and fractious talks in prospect, our base case is still for the UK and EU to initially achieve a narrow free trade agreement (FTA). Nevertheless, this would mean a big increase in barriers to trade between the UK and EU, compared with pre-Brexit. Sectors reliant on smooth cross-border supply chains, and the services sector in general, would be most affected.

Table 1: Possible trade deal outcomes between the UK and EU

Scenario Definition
Narrow FTA

Zero tariffs, zero quotas on goods, with exclusions for highly regulated sectors

Customs checks at borders

Services sector access based on WTO terms

Full discretion over EU migration in UK and vice versa

No Deal Brexit

UK exits EU transition period without trade agreement

UK and EU trade on WTO rules, resulting in different tariff levels for different sectors, and services unprotected

Customs checks at borders

Full discretion over EU migration in UK and vice versa

Broad FTA*

Zero tariffs, zero quotas on all goods, with mutual recognition on some regulatory issues

Customs checks at borders

Some enhanced services sector access including transport - potentially also financial services

Discretion over EU migration in UK and vice versa but possible allowances traded off in negotiations

Customs Union

Zero tariffs, zero quotas on goods across most industries

No customs checks at borders

No guarantee for services sector but likely modest access

Some labour market agreements likely but much more limited than current

Norway Plus

Zero tariffs, zero quotas on goods across most industries

No customs checks at borders

Wide services sector access in exchange for regulatory alignment and budget contributions

Labour market freedom, with EU assurances on emergency brake

What issues are at stake in the trade talks?

The current economic turmoil resulting from Covid-19 has not greatly altered the underlying dynamics of the UK/EU trade talks. Access to the EU market will be traded off against the degree of regulatory discretion that the UK seeks to retain. The EU’s priorities are protecting the integrity of the Single Market and limiting ‘regulatory dumping’ by the UK.

In the goods sectors, our base case is for a zero-tariff, zero-quota deal. This will require some alignment on issues such as competition, state aid, environmental and labour standards.

State aid has become very contentious. The UK is keen to avoid restrictions on its domestic regime and post-Covid restructuring plans. It is clear the UK government envisages its long-term orientation as being outside the EU’s regulatory orbit. However, it has also just confirmed it will recognise European goods standards (the ‘CE’ mark) until at least 2022. The process of regulatory unwinding may be slow. Nevertheless, the UK’s long-term ambition to diverge will restrict the scope of any FTA.

Service-sector access will be much reduced compared with the days of EU membership. In July, the European Commission signalled it may not recognise UK regulations in key financial services such as trading and investment banking. Indeed, there are signs that EU capital market regulators are developing a somewhat protectionist mind-set. So, UK market access may become more limited over time. Regarding professional services, the EU has signalled that licensing, recognition of qualifications and regulatory alignment allowing cross-border services trade are all beyond the likely scope of an initial FTA.

What happens when the transition period ends?

The short-term economic effect of a narrow FTA is likely to vary by sector. It will depend on the importance of regulations and customs checks in the production and distribution chain. The UK’s readiness on the ground will also be an important factor. There are signs from Whitehall and from industry that preparations on customs and logistics are behind the curve. This includes Dover and the Irish/Northern Irish border.

The government is also having to focus on the ongoing public health and economic challenges of Covid-19. So there is little time to close the preparedness gap. If there is no deal this autumn, we can expect major short-term disruption to trade flows in both directions. Sectors that benefited from MFN tariffs* under EU membership are vulnerable (see Chart 1).

*MFN tariff - a ‘most favoured nation’ tariff is the lowest possible tariff that one country will charge another.

Chart 1: Average EU tariffs

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Where do we go from here?

Overall, a landing zone is visible for a UK/EU FTA. However, the path to reach such a deal is paved with political pitfalls, with a ‘no-deal’ outcome lurking around every corner.

Yet three key reasons have surfaced to suggest a deal will be done. First, there is mounting pressure from the Scottish National Party for another Scottish independence referendum. Second, businesses are just starting to return to normal after lockdown. Third is the growing dissatisfaction with the government over its policy choices.

We believe the UK is less willing - and, crucially, less able - to embrace ‘no deal’ than No10’s media briefings would suggest.

On balance, we believe Prime Minister Johnson remains incentivised to make a deal by 1 January 2021. Indeed, in our view, the UK is less willing - and, crucially, less able - to embrace ‘no deal’ than No10’s media briefings would suggest.

The October EU Summit is a vital moment for presenting any potential deal. As with many such negotiations, political drama is often needed to get things over the line. Therefore, Brexit talks are likely to go down to the wire. With the timetable tightening, we reiterate the possibility of an implementation period running into 2021. This would allow both sides more time to prepare. But, without agreement, a 'no-deal' Brexit would undoubtedly provide a further headwind to what is already shaping up to be a long and difficult recovery.

Broad FTA*
*Free trade agreement

Editorial image credit: LMPC / Contributor via Getty

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Risk warning

Risk Warning

The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.