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Brexit: The UK Decides Not to Let It Linger

06 July 2020   |  

In June, Brexit hit a rather inauspicious milestone, marking the four-year anniversary of the vote to split from the European Union but with little to show for it practically: While the UK has separated in spirit, it remains economically linked to the EU. However, with the UK Cabinet Office confirming that EU trade talks would not extend through next year, the breakup now has a firm date. What remains less clear is how trade will flow between the two regions moving forward.

Trade discussions, complicated by COVID-19’s rise, have proved delicate. Without a deal, the UK and EU will use much more restrictive rules dictated by the World Trade Organization (WTO). Such a hard Brexit would drastically increase tariffs on goods, financial services, insurance, telecom and intellectual property, among other things. EU car imports would include a 10.0% tariff, dairy products would average 35.0% and non-agricultural products would have an average tariff of 2.8%. Overall, the Rand Corporation estimates such a move would reduce UK GDP by 5.0% over the next 10 years. Conversely, the UK’s initial post-Brexit tariffs and quotas schedule eliminates all tariffs under 2.5%. Nearly half (47.0%) of all products would have zero tariffs.

The rub for the UK is it still wants to operate within the single market while operating independently of the EU’s broader regulatory framework (and negotiating its own trade deals with other countries—more on that later). Meanwhile, the EU wants to continue trading profitably with the UK but needs to disincentivize breaking away lest other union members follow in the UK’s footsteps.

Trade negotiations often come down to leverage. And for now, the EU seems to have the advantage given it remains the larger economy—even with the estimated 16% of GDP lost from the UK’s departure. The UK also relies from a trade perspective on the EU more than the other way around. More than half (51%) of UK imports came from and 43% of exports went to the EU in 2019.

That said, for many individual countries, Britain is a large market as a percentage of total exports (Exhibit 1)—including Ireland, the Netherlands, Belgium, Denmark, Spain, France and Portugal. Ireland also imports meaningfully from the UK—which means it faces the greatest potential adjustment.

Exhibit 1: Percentage of Individual Countries’ Exports to the UK, 2018

Source: Observatory of Economic Complexity, as of 2018.

And there are considerations beyond both trade and the EU: Britain has long-served as the EU’s financial center, including for lending activity. Many banks that operated in the EU through Britain have set up satellite offices in other EU countries to avoid post-Brexit disruption. Lending will likely be limited without a deal.

Then there are the non-EU relationships—like with Japan, which has proven an important potential UK trading partner (Exhibit 2).

Exhibit 2: Largest Non-EU Trading Partners (2018) and Y/Y Percentage Change

Source: UK Department for International Trade, as of February 2020.

Currently, trade between the two countries accounts for £29 billion. The UK government estimates that could increase by £15 billion with a deal. But Japan has said for such an agreement to pass its parliament before the end of the year, the two sides must agree to terms by the end of July. Japan’s chief negotiator, Hiroshi Matsuura, recently warned the UK both sides would need to “limit their ambitions” for a deal to get done in time.

A similar hurdle lies in coming to an agreement with the US, which is further complicated by the upcoming November elections and the UK’s relative inflexibility in US negotiations until it strikes a truce with the EU.

All told, the UK doesn’t need more roadblocks hindering its post-COVID recession recovery—though failing to ink a deal with the EU could certainly serve as one.

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