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24 June 2020
As we near the end of June, the deadline for the UK to ask for an extension to the Brexit transition period is fast approaching. In this Macro Flash Note, Daniel Murray reviews recent developments and highlights potential paths ahead.
According to Article 132 of the 2019 EU-UK Withdrawal Agreement “the Joint Committee may, before 1 July 2020, adopt a single decision extending the transition period for up to 1 or 2 years”. However, UK Prime Minister Boris Johnson and his Cabinet have repeatedly stated their intention to exit the transition period at the end of this year regardless of the state of negotiations, with or without a deal. This was confirmed on 12th June when senior Cabinet member Michael Gove formally gave notice to the EU that the UK would not ask for an extension 1.
If reports are to be believed, a post-transition trade deal is far from being agreed. This is not surprising because it typically takes several years for countries to negotiate and ratify trade deals. For example, the Comprehensive Economic and Trade Deal (CETA) between Canada and the EU took seven years to negotiate and ratify. Even then it took some last minute political maneuvering to convince the Walloon regional parliament in Belgium to agree to the deal2. Despite the UK currently being fully aligned with EU rules and regulations there are known areas in which the UK government wants flexibility to deviate in the future. It was always a highly ambitious target to reach full agreement on a trade deal before year end.
What then are the potential paths that might be taken? One possibility is that the UK will leave without a deal at the end of the year, in which case trade between the UK and the EU would take place on ‘Most Favoured Nation’ terms set by the WTO.
A common misconception in this regard is that tariffs would heavily penalize trade between the UK and the EU. However, whereas the UK currently imports around 80% of its goods and services tariff free, that proportion might rise if the transition period ends without a trade deal having been agreed. For example, the temporary tariff schedule published by the UK government prior to the Withdrawal Agreement being passed anticipated that the percentage of goods and services imported without tariff would increase to 87%3. Furthermore, contrary to popular opinion, EU import tariffs are not particularly large on average – a little over 1% - although there are some goods such as cars for which the tariffs are higher (10%).
What would change is that companies would face an increase in the administrative and regulatory burden, adding significantly to non-tariff costs. This would result in an increase in prices for UK consumers and a loss of competitiveness for UK companies exporting to the EU. As about half of UK trade is currently conducted with the EU this would be a significant development. The OECD has estimated that non-tariff measures have an impact equivalent to a tariff rate of around 11% - about 10x the average EU import tariff - for companies exporting into the EU without a trade agreement (Chart 1). Areas other than trade would also likely be impacted such as the ability of UK nationals to live, work and study in EU countries and cooperation in security, scientific, medical and other research matters. It is hard to quantify the potential costs to the EU and UK economies of not reaching some sort of agreement by year end and a wide range of estimates exists. However, our working assumptions are that: (i) the costs would be non-trivial and (ii) the percentage hit to the UK economy would be greater – at least in the short to medium term – than the hit to the EU economy.
Chart 1. Tariff and Non Tariff Measures: Estimates for Selected Countries
Source: OECD Economic Outlook, Volume 2018 Issue 2
Given the undesirability of no-deal and the practical challenges to reaching a full trade deal in such a short space of time, what are the alternatives? To answer this question it is helpful to consider the main areas of dispute. These are summarised in Table 1.
Table 1. Main areas of dispute between the UK and the EU
The UK negotiators argue that the deal being sought is very similar to that agreed between the EU and Canada. The EU negotiators argue that additional safeguards are necessary because of the physical proximity of the UK to the EU and the current high degree of integration. Moreover, there is a concern among some member states that if the UK is granted too much freedom to deviate from EU laws it will try to undercut the EU to get a competitive advantage. Whilst both sides agree that there should be no hard border between Northern Ireland and the Republic, it is not clear how that can be achieved without a full customs union.
Possible solutions to all these sticking points exist subject to a degree of flexibility on both sides. After four unsuccessful negotiating rounds so far this year, the first glimmer of hope emerged last week when UK Prime Minister Boris Johnson and European Commission President Ursula von der Leyen held a virtual meeting following which both sides seem to have softened their positions. For example, von der Leyen subsequently said that the EU simply wants “predictability and guarantees” for its fishing industry whilst also acknowledging “the UK’s sovereignty in its own waters”. For his part Johnson said “I don’t think we are actually that far apart” and voiced his optimism that a deal could be reached relatively swiftly.
Whilst the PM’s leadership skills are being called into question regarding the government’s handling of the coronavirus crisis, his ability and willingness to forge a deal when all seems lost should not be underestimated. Any doubters should cast their minds back to the ease with which Johnson facilitated successful negotiation of the Withdrawal Agreement following a walk with Irish Taoiseach (Prime Minister) Leo Varadkar last October at a point when the talks seemed destined to failure. That Johnson did so despite the disapproval of the Northern Irish DUP4, with whom the UK government has a Confidence and Supply agreement, shows how he is prepared to sacrifice political allies with relatively narrow appeal in favour of more broadly supported policies.
Taking into account: (i) the terms agreed in the CETA as an example of what the EU is prepared to agree to (ii) recent softening on both sides following the Johnson-von der Leyen meeting (iii) the pain of no-deal at a time when the economies of both the EU and the UK are reeling from the coronavirus, indicates that there is a strong incentive to get some sort of a deal in place before the end of the year. Add to that Johnson’s deal-making flexibility together with the EU’s history of finding last-minute compromise solutions when it really matters – think Greek bailout or how the EU salvaged Irish support for the Lisbon Treaty in 2009 – and everything points to a negotiated resolution before year end.
That does not mean a full agreement will be in place. However, it would be straightforward for both sides to give some ground that allows a basic deal to be reached across a relatively narrow set of issues without compromising too much on core values. In reality the status quo would be preserved in many areas, to be negotiated in the months and years ahead. It would in effect be an extension without calling it such.
Whilst there is no guarantee that this solution will be reached, it is a face-saving possibility that would allow the leaders of the UK and the EU to return home each claiming victory whilst preventing the worst-case scenario.
1 See “UK formally rejects transition extension” Financial Times, 12th June, 2020.
2 See https://www.theguardian.com/world/2016/oct/27/belgium-reaches-deal-with-wallonia-over-eu-canada-trade-agreement and https://www.politico.eu/article/walloon-parliament-rejects-ceta-deal/
3 See “Temporary tariff regime for no deal Brexit published” 13th March, 2019.https://www.gov.uk/government/news/temporary-tariff-regime-for-no-deal-brexit-published
4 The DUP is the Democratic Unionist Party of Northern Ireland. Following the 2017 general election, the Conservative Party won the most number of seats in the House of Commons but failed to win an overall majority. Without going into a formal coalition, the DUP and the Conservatives entered into a Confidence and Supply agreement whereby the DUP committed to support the government on certain pre-agreed matters including votes of confidence, EU exit legislation, national security, the Queen’s speech, the Budget and finance bills.