Brexit May Be Taking a Toll on the UK Economy

Prior to the Brexit referendum, we published a piece outlining the complexities involved if Britain chose to leave. Suffice to say, Brexit happened and most of those issues are yet to be worked out in any serious manner.

Simply put, Brexit negotiations are currently in a state of paralysis. Ever since UK Prime Minister Theresa May invoked Article 50 at the end of March 2017, starting the two-year countdown to Brexit, negotiations between British and European Union (EU) officials have more or less gone sideways, with only a brief respite in December 2017. From afar, it looks like they are talking past each other , with the British refusing to hear the several ways in which the EU has said “No” to core proposals put forward by the former.

While it would be straightforward to give a report about the current state of affairs, we believe there is value in rewinding a bit to see how things developed up to this point. That will provide some context in understanding why negotiations are at a standstill, and how things may proceed from here.

An agreement on the divorce bill

After six rounds of negotiations, there was positive news in December 2017. The EU and the UK put out a joint progress report about the conclusion of phase 1 of the negotiations (the divorce phase) and agreed to move ahead to phase 2, dealing with transition details and the future relationship.

The EU had initially put forward three contentious issues to settle during phase 1: the bill for Britain’s exit from the EU, freedom of movement and rights for EU citizens, and the Irish border question.

The first of these has been settled to a reasonable degree – the UK will pay between 35 and 39 billion pounds to the EU as part of the exit settlement.

The EU also deemed that “sufficient progress” had been made on the other two, and agreed to a transition period that would last through December 2020 i.e. twenty-one months after official exit on March 29, 2019 (though UK Prime Minister Theresa May had requested a full two years of transition).

There was concern that the EU would demand satisfactory resolution on all three core issues, especially the Irish border, before even agreeing to a transition period. So the joint report was good news from the UK’s perspective, especially for businesses who would otherwise face a regulatory cliff edge at the end of March 2019.

Yet, even at the time, there were several reasons to dampen some of the optimism.

Brexit, but not really

In addition to the size of the Brexit bill, the UK made significant concessions to get a joint agreement, which was further codified as a conditional withdrawal agreement on March 19, 2018.

Prime Minister May and Brexit supporters have repeatedly claimed that Brexit would allow the UK to take back control of its money (what it pays to the EU), borders and laws. Nonetheless, during the transition period, the UK will continue to pay into the EU budget and abide by EU rules, including the free movement of people. At the same time, they will have no representation in EU institutions, meaning they will have no formal influence in any new rules and regulations. Furthermore, the UK will have to accept the primacy of the European Court of Justice (ECJ) with regard to the rights of EU citizens.

Brexit was also supposed to give the UK’s fisheries industry a lot more independence. A disproportionate system of quotas have granted French fishermen rights to fish about 84% of local species, and as little as 9% to the British. This, along with other restrictions, led British fisherman to believe that leaving the EU would improve things – prime beneficiaries of “taking back control”. However, the UK has now agreed to remain in the common fisheries system at least until 2021. There is also the possibility of remaining in it for good, as part of the price of securing a new trade deal with the EU.

Many UK officials believe the twenty-one month transition period is not long enough to deal with all the massive structural changes that need to be made to customs and immigration, not to mention the creation of new regulatory agencies (which are currently handled at the EU level). So the UK wanted a sunset clause in case it needs a possible extension of the transition period – but this was rejected by the Europeans.

In an apparent concession by the EU, they would tell non-EU countries to treat the UK as it were a member of the union while transitioning. At the same time, the UK would be free to negotiate trade deals with non-EU countries during this period.

Yet the reality is that trade deals take a long time to negotiate, especially the services component (which is crucial to the UK). Moreover, it remains to be seen whether other countries will even begin negotiating trade deals with the UK in a serious manner without knowing the final shape of the UK-EU trade relationship. The US might, given its size – though its trade team is currently busy on several other fronts. It is hard to see how the UK can receive more favorable terms in a US-UK trade deal than it did as part of the single market, or with any other country for that matter.

After close to a year of negotiations, all the UK achieved was to keep things more or less the same for another twenty-one months after official Brexit. The transition deal simply extends the period of uncertainty and there is no sense of what the UK-EU relationship will transition towards, especially since considerable hurdles remain in place.

Related: What to Expect in Light of the Chronicle of Fed Tightening

Not quite a done deal

An important caveat in the December agreement is that the transition arrangement is not guaranteed, and is dependent on successful conclusion of a full withdrawal deal. Right at the top of the report it says:

Nothing is agreed until everything is agreed”

Among key sticking points to a successful withdrawal deal are a future framework for trade and a dispute resolution mechanism for future trade relations. Soon after the agreement was put together, Michel Barnier, the EU’s chief negotiator, warned that the most difficult part of the negotiations was only starting. He also said “ no way” to Prime Minister May “cherry-picking” the best pieces of existing trading models between EU and non-EU countries, and securing a bespoke trade deal.

These issues could perhaps be resolved if one side backs down sufficiently. Even then, a particularly thorny, and related, problem would remain: how to deal with the border between the Republic of Ireland (an EU member) and Northern Ireland (part of the UK).

The Irish border question

EU single market rules require its members to check if goods entering through their borders are compliant with EU rules. Non-compliant goods are restricted. This is because once goods enter through one member state it can circulate freely within the single market without further checks.

So if the UK exits the single market, the border between Northern Ireland and the Republic of Ireland will essentially become a hard border between the UK and the EU i.e. one that will require checks and controls.

However, the UK and the Republic of Ireland are bound by the terms of the Good Friday Agreement , which came into force in 1999 and ended decades of sectarian conflict in Ireland. Amongst the agreement’s provisions is that there are not to be intrusive checks at the border between Northern Ireland and the Republic of Ireland.

This was reaffirmed by the UK and the EU in December. The joint report states that the Good Friday Agreement must be protected in all its parts and that the UK recalls its commitment to the avoidance of a hard border, including any physical infrastructure or related checks and controls. It goes on to say (article 46):

The commitments and principles outlined in this joint report will not pre-determine the outcome of wider discussions on the future relationship between the European Union and the United Kingdom and are, as necessary, specific to the unique circumstances on the island of Ireland. They are made and must be upheld in all circumstances, irrespective of the nature of any future agreement between the European Union and United Kingdom.”

In other words, the UK has committed to avoiding a hard border irrespective of what happens between the UK and the EU vis-a-vis a final deal and transition arrangements.

Since Prime Minister May is insistent on leaving the single market, the EU has effectively put the onus on Britain to find a mutually agreeable solution to this problem. If not, the Europeans have proposed their own default backstop.

The EU backstop for Ireland

The EU has proposed a sea border between all of Ireland and the rest of the UK, meaning that Northern Ireland alone will be in full alignment with the EU. The EU has actually fleshed this out in fair detail, arguing that they had to prepare for the eventuality that the UK does not deliver.

For all practical purposes, this would make Northern Ireland more a part of the EU than the UK, and Prime Minister May has emphatically rejected it, saying that no prime minister could ever agree to such an option. This is also anathema to the ruling coalition in Britain, which includes the Northern Ireland’s dominant party, the Democratic Unionist Party (DUP).

So in effect, the Prime Minister wants no hard border between Northern Ireland and the Republic Ireland, nor a sea border, but also wants to leave the EU’s single market.

At the same time, the UK committed to a backstop in December. So either they renege on that agreement or find a new solution that squares the circle, one that is also acceptable to the EU.

Related: A Closer Look into China’s Pace-Setting GDP

EU rejects UK proposals

In a bid to overwrite the EU backstop, Britain presented a couple of solutions in March 2018:

A “Customs partnership” – which involves the UK collecting duties on behalf of the EU.

A “Highly streamlined customs arrangement”, or “max-fac” (maximum facilitation) – which makes use of technology (yet to be developed) to avoid cumbersome border checks. The UK would police its border as it were an EU customs border, but then track imports to apply different tariffs depending on final destination – the UK or the EU.

With one of these in place, the UK was hoping to reject membership of the single market. They proposed loose regulatory equivalence across the border initially, with the option for future divergence (which the EU has rejected as unworkable).

British negotiators were repeatedly made aware of EU skepticism towards British plans for the border over five rounds of technical negotiations in Brussels. Finally, at an April meeting, EU officials gave the UK’s lead Brexit negotiator “ a detailed and forensic rebuttal ” that made clear that none of the UK’s proposed customs options would work, dismissing them as “magical thinking”.

After the meeting, Donald Tusk, the European Council president, warned that without a solution on the Irish border, the UK risked leaving with no agreement and no transition arrangements.

Is a customs union the solution?

A majority of Britain’s House of Lords, its upper house of Parliament, recently voted to call on the Government to explore the possibility of remaining in a customs union with the EU. The latest reports also suggest that Britain will tell Brussels it is prepared to stay tied to the customs union beyond 2021, despite objections from pro-Brexit cabinet members. This is Prime Minister May’s new backstop to avoid a hard Irish border.

However, there is considerable confusion as to the difference between the single market, a free trade area and a customs union. So it would be useful to unpack the difference between these, especially within the context of the EU.

Single market

The single market includes the free movement of goods, services, people and capital (the four freedoms). There are no quotas, tariffs or taxes on goods and services moving across borders. The same rules, regulations and standards (non-tariff barriers) apply across the area.

Norway, Iceland and Lichtenstein are not EU members but are part of the single market i.e. the European Economic Area (EEA).

Free trade area (FTA)

A free trade area simply eliminates tariffs or quotas on goods, and sometimes services, between the countries signing onto the agreement (like NAFTA). It particularly does not include free movement of people.

Free trade negotiations can take years to negotiate. The Canada-EU trade deal, the Comprehensive Economic and Trade Agreement , which eliminates 98% of tariffs on industrial goods between Canada and the EU, saw five years (2009-2013) of negotiations and another two years of ratification by European capitals and Ottawa. It is still only provisionally applied, subject to no adverse opinion from the European Court of Justice in response to a request from Belgium.

It is important to note that members of an FTA are free to impose their own external tariffs on goods originating outside the FTA. Under NAFTA, goods can move freely between the US and Canada (or with preferential tariff treatment). Yet both countries can apply different tariffs and quotas to goods from say, China. So if Chinese steel faced a 50% tariff in the US, and zero in Canada, a Chinese exporter could simply export steel duty-free to Canada, and then to the US. To prevent this, the US has to carefully monitor rules of origin for steel flowing in from Canada, so that Chinese steel is not masked as Canada’s own production.

In order to eliminate rules of origin tests at a border, countries would need to harmonise external tariffs through a customs union.

A customs union

A customs union is formed when countries agree to apply a common system of tariffs to goods from outside the union – the common external tariff (CEF). Clearing customs in any one of the member countries will permit the good to be shipped to anywhere else in the union without further tariffs (assuming they are also part of a free trade area).

Turkey is a member of a customs union with the EU and has also signed a free trade agreement with it (the European Free Trade Area – EFTA). At the same time, this has not eliminated the need of a hard border between Turkey and the EU.

On the other hand, Norway is part of the European single market but not the customs union. So it has border checks to prove rules of origin (at its border with Sweden) – it is fairly efficient but again, not frictionless by any means.

More than just customs

As the graphic below illustrates, the European Union is both a single market and a customs union. Moreover, the single market is both a free trade area and a regulatory union – the former eliminates the need for collecting tariffs, while the latter, most importantly, enforces compliance with non-tariff regulations like rules for safety and standards, packaging, etc. The customs union ensures compliance with rules of origin, preventing third-country goods from being masked as the exporting country’s own production (which would have less hurdles).

It is this combination that allows for completely frictionless borders between EU member countries.

The problem with just being part of the customs union is that non-tariff barriers do not go away and so it does not eliminate the need for a hard border. This is especially important with respect to the Irish border since the largest exports from Northern Ireland to the Republic of Ireland are ‘ Food and Live Animals ‘ (31% of the total in 2016). When Britain exits the EU, the Irish border becomes an external EU border and a huge body of EU law that governs the movement of animals and products of animal origin will automatically apply .

Moreover, the UK cannot simply harmonise customs and regulatory rules for certain goods and sectors – checks would be required to see if a good crossing the border falls in that category or not, which is hardly frictionless.

Neither can the UK hope for a ‘customs fudge’ from the EU on the Irish border issue. The EU is a member of WTO and hence, when it comes to border controls, it cannot discriminate amongst non-EU countries with which it does not have a unique deal.

Only membership in the single market can completely eliminate non-tariff barriers. So Prime Minister May’s latest conceptual proposal to keep UK within Europe’s customs structure would need to go much further. As Irish Prime Minister, Leo Varadkar, put it during a recent meeting with the British Prime Minister, they “need details in black and white”, and that:

Any move on customs would be welcome but I think I need to be very clear – that avoiding a hard border between Northern Ireland and Ireland is about more than customs”

However, being part of the single market effectively means the UK will have to continue paying into the EU budget, accept free movement of people and more or less be a rule-taker from the EU. The EU is also bound by a mutual treaty to enforce protections within the single market, and any legal recourse ultimately lies at the European Court of Justice. Ergo,the UK will have to accept this court as the binding authority. Brexit supporters would find this a hard pill to swallow since the primary argument for leaving the EU was to regain sovereignty and control over immigration.

A crisis brews amid political maneuvering

As we discussed at the top of this piece, EU negotiators offered the British a brief respite in December 2017 when it agreed to a transition period and stepped away from demanding resolution on core issues (like the Irish border). It is unlikely they will do so again since time is running out. Yet the two parties cannot even agree on a timeline at this point.

The EU wants a workable proposal by the end of June, when the next European Council summit is scheduled, and warns of a crisis if this does not happen. However, the UK is pushing for an October deadline, insisting that the border issue cannot be resolved without knowing what the future trading relationship will be. Note that the EU has been asking the British for their views on what this future relationship will look like but is yet to get a response.

Ultimately, in addition to all the Brexit related logistics and negotiations, which would be hard under the best of circumstances, a key problem is that Prime Minister May lost her majority in last year’s elections. It left her politically weak, and unable to dictate terms even within her own cabinet, which is deeply divided. As a result, we have seen multiple proposals and trial balloons floated by London, only to be rejected by Brussels since none of them really prove viable. This almost appears to be by design, i.e. an attempt by Prime Minister May to get the Brexit supporters within her cabinet to recognize that the UK has limited options.

In any case, the UK and the EU will have to conclude a full withdrawal deal by October in order to have it ratified across various European capitals by March 2019, assuming there are no legal wrinkles that will have to sorted out at the European Court of Justice. If not, we will see a ‘no-deal Brexit’, i.e. Britain crashing out of the EU without any deal, and all the chaos that entails.

A final Brexit deal, or even a ‘no-deal’ Brexit, will also have to pass the UK parliament. If Prime Minister May loses this vote, thanks to a divided Conservative party that she nominally heads, there is a chance of having yet another election before the end of 2018.

Economic impact is already being felt

The constant maneuvering and resulting confusion keeps introducing ever more uncertainty into a fraught process and has already cast a shadow on the UK economy. While other developed countries like the US have seen economic growth accelerate over the last year, UK GDP growth has slowed to levels last seen in 2012 – the economy expanded just 1.4 percent in the first quarter of 2018, due to a manufacturing slowdown and contraction in construction. Mark Carney, the governor of the Bank of England, estimates that each British household is £900 worse off after the Brexit vote (though Brexit supporters dispute this).

Uncertainty is also causing problems on the other side of the English channel. The Port of Rotterdam, Europe’s largest and a key conduit for British goods, is delaying expensive investment on new port infrastructure in the hope that a deal can be reached. Significantly more bureaucracy would be needed even with a free trade agreement in place. Nevertheless, they are clearly preparing for a ‘no-deal Brexit’. Roel van’t Veld, the Dutch ministry of finance’s Brexit and customs adviser, recently said:

We started collecting the statistics and they are rather frightening. Trading between Southend and Rotterdam will be as trading between Rotterdam and Morocco, and people have to realise that. We have a huge number of companies that have no idea what trading outside the EU means. We have 35,000 companies trading with the UK who have no knowledge of customs. They are not known in our system.”

EU agencies have also begun advising businesses that the UK would become a third country when it leaves the union in March 2019. Ironically, the UK has objected to this, saying that EU preparations for a ‘no-deal Brexit’ are tantamount to asking businesses to comply with regulatory rules by relocating to the continent, without referring to Britain’s goal of achieving a transition period and a future trade deal.

It is impossible to predict what will happen, whether the UK and the EU finally reach a deal or not. The fact that the UK committed to avoiding a hard border in Ireland, with no physical infrastructure, does not leave it many options – something the Europeans apparently recognize but not the British. So realistically, any future relationship will be one that resolves the Irish border question in a manner acceptable to all parties: the UK, the EU and even the Republic of Ireland. Of course, we could get a transition period that keeps getting extended, even though the Europeans have currently rejected this idea.

In the meantime, we will be keeping a close eye on events unfolding at the next European Council meeting in June.