As the differences between a Brexit deal and a no deal are not as big as they once were, the economic costs of a no deal have diminished. The bigger risk is that relations between the UK and the EU deteriorate to such an extent that both sides start to unravel the agreements already put in place. So what really matters now is not whether there is a deal or a no deal, but what type of no deal it is.
- As the differences between a Brexit deal and a no deal are not as big as they once were, the economic costs of a no deal have diminished. The bigger risk is that relations between the UK and the EU deteriorate to such an extent that both sides start to unravel the agreements already put in place. So what really matters now is not whether there is a deal or a no deal, but what type of no deal it is.
- A lot of the recent analysis about what’s going to happen when the transition period ends on 31st December 2020 and the UK’s new relationship with the EU begins in earnest has been about trying to work out if there’s a going to be a deal or a no deal. This is impossible to call and misses two bigger points.
- First, the differences between a deal and a no deal are not as big as they were immediately after the EU Referendum in June 2016 and just before the original Brexit deadline of 29th March 2019. That’s partly because leaving the EU’s Single Market and Customs Union makes this Brexit a relatively “hard” one. But it’s mostly because a lot of arrangements have already been put in place.
- Indeed, the Withdrawal Agreement laid down the terms of the break-up, both the UK and the EU have made substantial progress in granting financial services equivalence and the UK has replicated the bulk of the trade deals it had with non-EU countries via the EU.
- In a no deal in these circumstances (a “cooperative no deal”), the pound may fall from $1.29 now to $1.15, inflation may rise to a peak of 3.7% and GDP in 2021 as a whole may be only 1.0% lower than if there were a deal. And in this situation, financial services equivalence would probably be granted in 2021 and, if necessary, the UK and the EU would probably rollover any temporary arrangements in the future.
- The second point that is often missed is that there are many different types of a no deal. The real risk is that the UK and the EU completely fall out. The UK could override part or all of the Withdrawal Agreement, the EU could respond by starting legal proceedings and few measures could be implemented to mitigate the disruption on 1st January 2021.
- In such an “uncooperative no deal”, the pound may fall to $1.10, inflation may rise to a peak of 4.1% and GDP may be 2.5% lower in 2021 as a whole than if there was a deal. The acrimony would probably continue beyond 2021 too, which may lead to fewer agreements in the future and the expiry of any temporary measures.
- Relative to the 26% slump in GDP endured during the COVID-19 crisis, any hit from a no deal would be small. But the pandemic does mean there is less scope for policy to respond. Even so, we suspect the Chancellor would loosen fiscal policy by about £10bn (0.5% of GDP) and target it at those sectors hit hardest. And the Bank of England would probably prop up demand, most likely through more gilt and corporate bond purchases rather than negative interest rates.
- We agree with most other economists that Brexit will probably reduce the economy’s potential growth rate in the long run. But we differ in expecting all of that drag to be offset by an increase in productivity growth triggered by the digital revolution. If anything, by forcing technology to be adopted more widely, the pandemic means this rise in productivity growth could happen sooner than we previously thought.
Brexit – deal or no deal is not the big issue
With just three months to go before the transition period ends on 31st December 2020 and the UK’s new relationship with the EU begins on 1st January 2021, this UK Economics Focus acts as a one-stop shop for all things Brexit and explains how the COVID-19 pandemic has changed the situation.
It starts by laying out what has been done, what has not been done and what may happen during the last leg of negotiations. It then highlights how a deal and different types of no deal may influence the financial markets and the economy in the short run and the possible policy response. It ends with some brief comments about the long-run influence of Brexit.
What has been done?
It may feel like it happened much earlier (and COVID-19 means that it happened in a very different world), but it was only eight months ago that the UK left the EU on 31st January 2020. Given that the UK declined the EU’s offer to extend the status-quo transition period beyond 31st December 2020, that “political” Brexit will be followed by the “economic” Brexit at the end of this year.
And by comparison, this will be a relatively “hard” Brexit. That’s because the government decided to leave the EU’s Single Market and Customs Union in order to gain the freedom to set its own migration and trade policies, and to end contributions to the EU budget and the oversight of the European Court of Justice. So the aims are all done and dusted.
The terms of the divorce are also in the bag as they were laid out in the Withdrawal Agreement, which was passed into UK and EU law in late January and needs to be put into practice by 1st January 2021. Amongst other things, it covered three key areas. First, citizens’ rights. It guaranteed rights of residence, access to social security (healthcare, pensions and welfare), and employment protection for UK nationals living in the EU and EU nationals living in the UK.
Second, the financial settlement or “divorce payment”. Rather than the exact amount, the Withdrawal Agreement specified the method used to calculate the value of the UK’s remaining financial obligations to the EU as well as a payment schedule. In March, the OBR estimated that the total cost could be £32.9bn (1.5% of 2019 GDP) spread, but front-loaded, over 45 years.
Third, the Northern Ireland protocol. This established a legal mechanism that enshrined into law the principles of avoiding a hard border on the island of Ireland, protecting the all-island economy and the Good Friday Agreement, safeguarding the EU’s Single Market and ensuring that Northern Ireland remains in the UK’s customs territory and benefits from any new trade deals the UK strikes.
In practice, this means that the UK has to apply EU rules and checks in Belfast on goods moving from Great Britain to Northern Ireland if there is a chance they will enter the EU, but doesn’t need to if the goods are likely to stay in Northern Ireland. And for goods going from Northern Ireland to the UK, the UK needs to complete EU export formalities in Belfast.
On top of the terms of the divorce, quite a lot has been decided on those aspects of the future relationship that were deemed outside the scope of the formal UK-EU negotiations.
Financial services is one such area. The UK will leave the EU’s passporting regime, which allows financial institutions in one EU country to operate in any other EU country without requiring extra authorisation. In theory, that means EU financial institutions won’t be able to serve their UK customers and UK financial institutions won’t be able to serve their EU customers.
But in practice, the UK has passed legislation putting in place a temporary passporting regime that allows EU financial institutions to continue to operate in the UK while they are in the process of securing full UK authorisation. And although the EU has not done the same, the risk of disruption has been minimised by UK institutions transferring their EU clients to their subsidiaries in the EU that are covered by the passporting regime.
What’s more, these temporary measures won’t be necessary should the UK and the EU grant “equivalence” to each other’s financial services, which permits access as it assumes regulation and supervision standards are the same in both jurisdictions. The UK has completed its assessment of EU standards. The EU has not and doesn’t intend to in a number of the 40 areas of financial services in question until 2021. But given that UK and EU financial institutions currently follow the same EU rules, it would be a surprise if the EU didn’t eventually grant equivalence in the remaining areas. In any case, this would primarily affect EU households and businesses rather than UK ones.
Admittedly, while financial services passporting lasts for as long as you are in the EU, financial services equivalence can be withdrawn at a moment’s notice. So the new setup won’t be as stable. And in July 2019, the EU withdrew equivalence of Switzerland’s stock market. (See here.) But the EU was a bit taken aback by the Swiss retaliation of banning the trading of shares in Swiss companies on EU exchanges. There’s not much to gain from the EU entering a similar tit-for-tat battle with the UK.
Taken all together, the Bank of England summed it up nicely in its August Financial Stability Report when it said “most risks to UK financial stability…have been mitigated”.
The UK has also made a lot of progress in replicating the 40 trade deals with non-EU countries that it benefited from as an EU member. In total, these trade deals cover about 11% of all UK trade. 20 of those deals have been replicated, which includes the one concluded a few weeks ago with Japan. They cover about 8% of all UK trade. At the same time, the UK has replicated EU mutual recognition agreements, which certify if a product meets the specified legal requirements, for Australia, New Zealand and the US.
So because the UK is leaving the EU’s Single Market and Customs Union, the consequences of Brexit for good or for ill (depending on your standpoint) will be greater than if there were a “softer” Brexit that involved a closer relationship with the EU. But the Withdrawal Agreement, the temporary financial services passporting regime, progress on financial services equivalence, and the rollover of the bulk of the EU’s third-party trade deals mean that many crucial agreements are in place. That means a no deal now is less worrying than feared immediately after the 2016 EU Referendum and ahead of the original 29th March 2019 Brexit deadline when there were no agreements on those issues.
What’s not been done?
Of course, the bulk of the future relationship has yet to be agreed. The aim of both sides is to reach a comprehensive agreement across a wide range of areas that includes zero tariffs and zero quotas on trade in goods. Ahead of the formal negotiations that began in March, the UK and the EU laid out eleven areas that needed to be addressed:
- Trade in goods.
- Trade in services and investment.
- A level playing field for open and fair competition (i.e. state aid).
- Energy and civil nuclear cooperation.
- Mobility and social security coordination.
- Law enforcement and judicial cooperation in criminal matters.
- Thematic cooperation (cybersecurity, migration).
- Participation in Union programmes.
- Horizontal agreements (aviation etc.) and governance.
Since then, eight formal negotiating rounds have been and gone. It’s been reported that a lot of progress has been made on many of these issues, but that there are still large gaps between the two sides on four issues; the level playing field (state aid), fisheries, judicial and law enforcement, and governance (dispute settlement mechanisms).
The sticking points of judicial and law enforcement and governance mainly come down to the EU insisting that the European Court of Justice has some role, while the UK wants it to have no oversight whatsoever. The issues of fisheries and the level playing field are arguably harder to solve.
With fisheries, the EU wants its current access to UK waters to continue indefinitely, the current quotas to stay fixed and severe punishments for the UK if it blocks access to UK waters. The UK wants to negotiate access to waters on an annual basis, wants to change the quotas and wants the ability to withdraw EU access to UK waters if the annual negotiations fail. In short, the EU wants to maintain the status quo, while the UK wants more fish and more control.
This issue is more important from a political point of view than an economic one as fishing accounts for less than 0.1% of the UK economy. The EU wants to keep alive its fishing communities by allowing them to continue using UK waters. This is such a big issue for the EU that its Chief Brexit Negotiator, Michel Barnier, said after 1st round of negotiations in March “Let me be clear once again: a trade and economic agreement with the UK must include a balanced solution on fisheries”. In other words, without a deal on fish, there’s no deal on anything.
But the UK government is adamant that it wants to give something back to the UK’s northern fishing communities who turned their back on Labour to vote for Boris Johnson in the 2019 election. And assisting the Scottish fishing industry could help knit Scotland to the UK too.
As for the level playing field, this pitches the EU’s biggest fear against the UK’s biggest hope. The EU is worried that Brexit will allow its large and close neighbour to lower regulation standards, lower competition standards, lower taxes and use state aid all to undercut EU businesses. To prevent that, it wants the UK to abide to more restrictions on these issues than it had insisted in trade deals with Canada and Japan. It believes if the UK wants more access to the EU than Canada and Japan (i.e. zero tariffs and zero quotas on all goods) it must have tighter rules on the level playing field.
The UK views access and restrictions as separate issues and doesn’t want to be subject to the jurisdiction of the EU’s institutions that oversee regulation and competition. But most importantly, the UK government views its ability to alter regulation, competition policy, taxes and state aid as the main benefit of Brexit as it would allow it to reshape the UK economy to achieve its political aim of “levelling up” the regions.
What is the current state of negotiations?
The negotiating process has gradually become more frustrating for both sides. At the end of the 1st round of formal negotiations at the start of March, Barnier said “I think that an agreement is possible – even if it will be difficult.” At the same time, the UK’s Chief Negotiator, David Frost, said “we are going to get a good conclusion in negotiations this year”.
But the COVID-19 pandemic set back negotiations and the mood has soured in recent months. After the 7th round of negotiations in August, Barnier said “an agreement between the UK and the EU seems unlikely”. By the end of the 8th round in September, he said “the EU is intensifying its preparedness work to be ready for all scenarios on 1st January 2021.” So it seemed to write-off the chances of a deal.
And tensions have exploded since then as the creation of the UK’s Internal Market Bill appears to have reduced the trust between the two sides.
This Bill has two aims. First, it aims to prevent new barriers to trade being established within the UK. In essence, it takes away powers (such as deciding on state aid) from the devolved nations of Scotland, Wales and Northern Ireland and hands them to the UK government. This is designed to ensure that any legislation created by the devolved nations doesn’t undermine the UK’s internal market.
The second aim is more important when it comes to Brexit negotiations as it overrides some parts of the Withdrawal Agreement relating to Northern Ireland. The Internal Market Bill would mean that if the transition periods end without a deal, then customs checks would not need to take place on goods moving between Great Britain and Northern Ireland. And the UK would be free to apply state aid law based on its interpretation and not on the EU’s. (The Withdrawal Agreement says that EU state aid law can be applied to anything that influences trade between Northern Ireland and the EU.)
The UK government says this is necessary to protect the Good Friday Agreement as it ensures that Northern Ireland’s economy is treated the same as Great Britain’s economy. But the EU says that the Internal Market Bill threatens the Good Friday Agreement as if there are no customs checks between Northern Ireland and Great Britain, then they will have to happen between Northern Ireland and Ireland, which is prohibited.
The EU says that the Internal Market Bill breaches an international treaty. The UK doesn’t deny this and Brandon Lewis, the Northern Ireland Secretary, stated in Parliament on 7th September that the Internal Market Bill “breaks international law in a very specific and limited way.”
In response, the EU set a deadline of 30th September (which expired yesterday) for the UK to cancel the aspects of the Internal Market Bill that would override the Withdrawal Agreement. It has said it is willing to take legal action if it doesn’t and it has taken the first step by sending a letter to the UK noting its grievance.
Boris Johnson has also set his own deadline of 15th October. If a deal hasn’t been done by then, he said the UK would walk away and focus on a no deal. And previously the EU has said that a deal needs to be agreed by 31st October to leave enough time for it to be ratified by the end of the year.
So the UK and EU are still far apart on a number of issues, there’s not a lot of time left and the UK’s threat to break the Withdrawal Agreement has raised tensions.
This means the 9th and final round of formal negotiations, which began on Tuesday 29th September, are crucial. And it is encouraging that the mood music seemed a bit more positive going into these negotiations. The EU has said that it is willing to start working on a joint draft of the legal text of the treaty, which it has previously insisted it would not do until there was broad agreement in all 11 areas. In exchange, the UK is expected to be more constructive in talks on fisheries and state aid.
The hope is that enough progress can be made this week to allow senior negotiators to enter what has been called a “tunnel” of negotiations or “submarine talks”, from which the negotiators don’t emerge from/come up for breath from until an agreement is in place. The idea is that agreement could then be presented at the European Council summit on 15th-16th October for EU heads to sign off. Table 1 highlights this timetable and some other key dates.
How will it play out?
At this stage, it seems very unlikely that the two sides will agree to formally extend the transition period and continue negotiating next year. Never say never with Brexit, but that ship appeared to sail when Johnson wrote into law that there would not be an extension and the EU’s 30th June deadline for extending came and went.
Table 1: Key Brexit Dates
9th round of negotiations began
EU deadline for UK to cancel Int. Market Bill
Johnson deadline for deal to be reached
EU Council Meeting
Deal deadline to allow time for ratification
Transition period ends
1st Jan 2021
New UK/EU relationship begins
1st Jul 2021
UK due to start implementing border checks
Source: Capital Economics
It is possible to envisage the UK and the EU finding solutions on the remaining areas and reaching a deal. It shouldn’t be too hard for the EU to concede that fishing quotas don’t need to remain exactly as they are now forever. And the UK could agree for the quotas to be revised gradually over time rather than immediately.
With regard to the level playing field and state aid, there’s scope for the UK to agree to non-regression clauses that stipulate standards won’t be weakened. And the EU may be willing to accept that the UK’s own supervisory bodies will be sufficient to maintain standards. That’s especially the case when the UK has historically used state aid much less than other EU countries.
The UK is unlikely to accept jurisdiction of EU courts. But setting up an independent arbitration committee, which is common in other trade agreements, would be a possible compromise. Similarly, the agreement could involve non-regression clauses on issues like the environment and workers’ rights. The UK doesn’t want to bind its hands, but it has no plans to unravel the current regulations in these areas.
Of course, both sides could have made similar compromises some time ago. But it is possible that the COVID-19 crisis has strengthened the desire of both sides to reach a deal. After all, with UK and EU businesses having been hit hard by the pandemic, the last thing governments want to do is saddle them with more disruption and set back their recovery.
And given how far Boris Johnson’s approvals ratings have fallen during the pandemic, he’s in desperate need of a political win. A deal would allow him to say he managed to “get Brexit done”. A deal would also go some way to quelling the rise in support for another Scottish independence referendum, which would surely soar after a no deal.
It may be the case that by coming to agreement in some areas this year, the status quo can be maintained in areas until a final agreement can be reached at a later date. And/or there might also be an implementation period of something like six months to allow businesses to prepare for and get used to the new rules. This would amount to an extension to the transition period by the back door and would be more likely if a deal is pulled out of the bag late in the year when all seemed lost.
Equally, it is very easy to see how a no deal could happen. The EU has insisted right from the start that the UK can’t have its cake (zero tariff, zero quota access to EU markets) and eat it (no requirement to follow EU rules on the level playing field). And the UK has been adamant that it needs to be able to set its own rules as it sees fit.
You could also argue that the COVID-19 crisis may have strengthened the resolve of both sides. As the pandemic is reshaping all economies, the EU will be worried that the UK will sacrifice some rules and regulations to give it a competitive advantage.
At the same time, the pandemic may have increased the UK’s desire to use state aid and competition policy to do exactly that. Johnson’s government always wanted to embrace technology and “level up” the regions. Arguably now is a good opportunity to take advantage of the changes that are underway and reshape the economy. As such, the UK may dig its heels in on the level playing field and state aid.
The pandemic may have also highlighted to the government its ability to be flexible and nimble when it comes to fiscal and monetary policy. It has spent a huge sum on its COVID-19 support schemes and it’s probably quite pleased that it doesn’t have to pay some of the EU’s costs too.
Finally, the pandemic may have put the potential economic costs of a no deal into perspective. Both sides may have simply concluded that compared to the 15-25% fall in GDP endured by most economies during the COVID-19 lockdowns, the relative fallout from a no deal would be a walk in the park. In fact, it has been suggested that the pandemic is a good opportunity to “hide” the effects of a no deal as it will be hard to establish what’s due to the pandemic and what’s due to a no deal.
It’s simply impossible to know what is going to happen. But for what it is worth, we have attached a 0% probability to a formal extension of the transition period (obviously it’s higher than zero but we don’t think it is very likely at all), something like a 60% chance of a deal (which may include an implementation period) and a 40% chance of a no deal. (See Table 2.)
Table 2: Capital Economics Brexit Probabilities
Delay (An extension of the transition period)
Deal by 31st December 2020 (May include implementation period)
No Extension, No Deal
Source: Capital Economics
So in our view, it’s not far off 50-50. But we think that Johnson’s desire to secure a political win and the EU’s hope that it can avoid a no deal are enough to give a deal the edge. We wouldn’t be surprised, though, if a deal was not agreed by Johnson’s 15th October deadline or by the EU’s 31st October deadline. Instead, a deal may come out of nowhere in November or December just when a no deal looks most likely.
How would a deal affect the markets & economy?
If there were a deal, we suspect the pound would strengthen from $1.29 now (€1.10) to around $1.35 (€1.13). That’s because the markets have been pricing in some chance of a no deal which, by resulting in more trade barriers, is assumed to lead to slower economic growth and lower interest rates for longer. If you take that out, then the pound should be higher.
The trajectory of the pound from now until that point will be determined by the noises coming out the negotiations. If it becomes clear that the negotiations are going well, then the pound will probably strengthen before a deal is reached. If, however, the negotiations appear to be going nowhere, the pound would probably weaken until there is a development that suddenly makes a deal more likely.
A deal would be a double-edge sword for the FTSE 100. A stronger pound would reduce the overseas earnings of the companies in the FTSE 100. But a deal would improve the prospect for their domestic earnings and could raise their valuations. These two factors may offset each other. Indeed, our forecast that the FTSE 100 will rise from 5,900 now to 6,300 by the end of the year is mostly based on our assumption that the sectors hit hardest by the pandemic will regain ground.
For domestically focused indices, such as the FTSE 250 and the FTSE Local, we suspect the boost to domestic revenues from a deal would more than offset the drag from the stronger pound, resulting in bigger rises.
As for the economy, a deal would obviously cause less disruption than a no deal, but it may still affect activity in two main ways.
First, as the UK is leaving the EU’s Customs Union, even if a deal means there are no tariffs to apply, for the first time since 1973 goods flowing between the UK and the EU will be subject to customs checks. This is bound to slow down the flow of trade until officials and businesses get used to the new system.
Admittedly, the UK government has said that it will not impose full customs controls on imports from the EU for at least six months until 1st July to allow firms to acclimatise to the new arrangements. But the EU has said that it will impose full customs checks from day one. That may mean the UK’s exports to the EU are disrupted by more than its imports from the EU. That could reduce the contribution net trade makes to GDP growth in Q1 of next year. And some businesses will have to wait longer to receive the imported components they need.
Second, the uncertainty over whether or not there will be a deal may alter the timing of some economic activity. Until they know what is happening one way or another, some businesses will continue to postpone investment decisions in the coming months. Even if a deal is reached, businesses may want to wait to see how it works in practice. As such, business investment in Q4 of this year and Q1 of next year will probably be fairly soft even if there is a deal.
It’s possible, though, that the same uncertainty prompts some businesses to bring some activity forward. This is certainly what happened ahead of the previous two main Brexit deadlines of 29th March 2019 and 31st October 2019. Stockbuilding added 1.3 percentage points (ppts) to the quarterly rate of GDP growth in Q1 2019 before subtracting 1.8 ppts in Q2. (See Chart 1.)
Chart 1: Manufacturing PMI & Inventories
Sources: Refinitiv, IHS Markit
That said, the pandemic probably means there will be less stockbuilding this time for two reasons. First, many firms may have burned through their cash reserves and might not have the ability to build up significant amounts of stock. Second, many firms may decide it’s best to conserve cash rather than tie it up in stock. After all, what is the point in having the shelves full if there is another lockdown or demand remains extremely depressed?
Beyond the end of this year and the start of next year, a reduction in uncertainty associated with a deal may mean that some of the investment postponed in recent months takes place. Consumer confidence may rise a bit too, which may mean that households are a bit more likely to spend.
However, most of what happens to GDP growth, the unemployment rate, inflation and the policy set by the Bank of England depends on the evolution of COVID-19 and the restrictions the government puts in place to control it rather than the effects of a deal.
Taken together, we suspect that they will result in GDP not returning to its pre-pandemic level until the second half of 2022, the unemployment rate rising from 4% to a peak of 7%, inflation being stuck closer to 1.5% than the 2.0% target and the Bank of England launching an extra £100bn of Quantitative Easing (QE) in November and a further £150bn next year. (See here.) Those forecasts provide a useful “baseline” that we can use to illustrate how things could be different if there were a no deal.
What type of no deal?
It’s common for people to talk about a “no deal” as if there is a pre-agreed fallback option. But in reality, there are many different possible types of no deal which all carry different economic implications.
Perhaps the slimmest no deal would be one where the EU and UK put in place arrangements on seven of the 11 areas of negotiations that they agree on and agree to disagree on the four areas where there are still gaps. We wouldn’t rule this out. But right from the start the EU has emphasised that there are plenty of crossovers and interaction between the 11 different areas. So we suspect it’s more likely to insist on an all or nothing approach.
Contrary to the popular perception, a deal and no deal are not as far apart as they once were. Table 3 shows there are a lot of similarities between a deal and two possible types of no deal, a “cooperative no deal” and an “uncooperative no deal” which we talk about in more detail later.
In any deal or no deal, customs checks and formalities will be required for goods crossing the border. And in all situations, authorisation of standards gained in the UK will no longer count in the EU, the UK no longer benefits from the trade deals the EU has with some non-EU counties and UK financial institutions lose their passporting rights, although as we noted earlier the potential disruption in all three of these areas has been largely mitigated. So at this stage, the real difference between a deal and a no deal comes down to three factors; tariffs, any measures the UK and EU put in place to mitigate the potential disruption and whether or not the Withdrawal Agreement remains intact.
In all types of no deal, tariffs will be applied on the UK’s exports to the EU (making them less competitive in EU markets) and on the UK’s imports from the EU (making them more expensive for UK buyers). The EU will apply its Common External Tariffs on the UK’s exports to the EU. This will be particularly onerous for some sectors whose exports to the EU will be subject to tariffs of 10.0% for cars, 11.1% for agricultural goods, 15.7% for animal products and 35.4% for dairy.
And if the UK were to apply WTO tariffs to all imports coming from the EU, then we estimate that the average import tariff when weighted by trade flows (including those from non-EU countries some of which are already subject to tariffs) would rise from just under 1.0% now to almost 3.5%.
But the UK can choose what tariffs to apply to imports from the EU, as long as it applies those same tariffs to imports from all other countries that it doesn’t have a trade agreement with. And in February, the UK published its “UK Global Tariffs”, which we estimate are consistent with a weighted average tariff of 2.5%. That’s higher than the 1.0% in the current situation, but not as high as the 3.5% that would result if the UK used WTO tariffs. (See here.)
The political backdrop will largely determine what happens to the other two factors and ultimately what a no deal looks like.
Table 3: Possible Characteristics of a Deal & No Deal
UK Authorisation applies in the EU
EU FTAs include UK
Financial Services Passport
Tariff-free UK-EU Trade
Mitigation (Trade Facilitation, Side Agreements)
Withdrawal Agreement Upheld
Cooperative No Deal
Uncooperative No Deal
Source: Capital Economics
In a “cooperative no deal”, the UK and EU don’t find a compromise but work together to make the end of the transition period as smooth as possible. That could involve the full implementation of the Withdrawal Agreement (the UK would have to cancel or change the terms of the Internal Market Bill), the implementation of other arrangements, such as the temporary passporting regime, and some temporary mitigation measures to reduce disruption to trade at the borders. Both the UK and EU could use a “light touch” when applying the new customs processes and requirements. (See Table 3 again.)
As well as minimising the initial disruption, a cordial working relationship would limit the long-term influence of Brexit as the UK and the EU would probably continue to gradually put in place long-term agreements and rollover temporary arrangements if necessary.
Alternatively, if the negotiations end in acrimony, perhaps because one side refuses to compromise on some key issues and/or the UK refuses to back down on the Internal Market Bill, there could be an “uncooperative no deal”. This could be different to a cooperative deal in three main ways. First, while the UK may do all it can to minimise the initial disruption (it has already said it will be lenient in applying new customs rules for the first six months), the EU may not. Applying new customs rules to the letter of the law would exacerbate the initial disruption at the ports.
Second, some of the arrangements that have already been put in place may be unravelled. That could include the Internal Market Bill overriding some parts of the Withdrawal Agreement or the bulk of the Withdrawal Agreement (probably excluding citizens’ rights) being reversed. The EU may respond by to the breaking of the Withdrawal Agreement by starting legal proceedings, which could lead to sanctions and fines. At the same time, the previous judgements on financial equivalence could be reversed. Third, such a fallout could also lead to less cooperation in the future, which could prevent the rollover of temporary arrangements. (See Table 3 again.)
There are many grades of no deal in between the two we have chosen to highlight. But the key point is that the financial market and economic consequences of a no deal will be different depending on what type of no deal it is.
How would a no deal affect the financial markets?
Whatever type of no deal it is, it will be felt in the financial markets first. Indeed, if the markets get wind of the increasing chances of a no deal, then the bulk of the reaction would probably take place before a no deal on 1st January 2021.
It will probably be felt most in the pound. Indeed, bad news on Brexit tends to weaken the pound as it is assumed it will weaken the UK’s long-term growth prospects and result in monetary policy being looser than otherwise. That’s why the pound fell by 17% on a trade-weighted basis after the EU Referendum result in June 2016 and why it has fluctuated with the changing chances of a no deal ever since.
The relationship between the pound and the chances of a no deal Brexit in 2019 implied by betting markets (which back then would have been without the Withdrawal Agreement), suggests a 100% chance of a no deal could have caused the pound to fall to around $1.05 (€0.90). (See Chart 2.)
Chart 2: 2019 No Deal Odds & $/£
Sources: Refinitiv, Oddschecker
The pandemic has weakened the relationship this year. But at face value, a 100% chance of a no deal (this time presumably with a Withdrawal Agreement) could prompt the pound to fall from $1.29 now to $1.00 (€1.10 to €0.83). (See Chart 3.)
Chart 3: 2020 No Deal Odds & $/£
Sources: Refinitiv, Smarkets
It’s possible that the pound could fall to $1.00-$1.05 if there’s a no deal, especially if it is an uncooperative one. After all, the pound weakened to $1.15 in March during the rush for dollar liquidity at the height of the COVID-19 crisis.
But there are two reasons why a smaller fall may be more likely. First, with interest rates already at rock bottom in both the UK and the US, there is less scope for interest rate differentials to move against the pound. In early 2019, the interest rate differential was already fairly wide as US rates were 2.0% and UK rates were 0.75%, and that gap would have probably widened after a no deal.
Second, the large 17% fall in the trade-weighted index after the EU Referendum was partly because the pound was probably already overvalued. But as it is probably a bit undervalued now, the downside is now smaller. (See Chart 4.)
Chart 4: $/£ PPP & Actual Exchange Rate
As such, in a cooperative no deal, we suspect the pound would fall to around $1.15 (€0.96), which would be a decline of about 11% on a trade-weighted basis. In an uncooperative no deal, it may decline to about $1.10 (€0.92). That would be a 15% fall on a trade-weighted basis. In both situations, we suspect the pound would start to rebound once the worst of the economic effects pass in 2021. (See Table 4 below.)
Just like with a deal, a no deal would also be a double-edged sword for the FTSE 100 as the overseas earnings of its constituents would be boosted by the weaker pound but their domestic earnings would be reduced by the weaker economic outlook. At the same time, the valuations gap that opened between the price to earnings ratio of UK equities and those elsewhere since the EU Referendum in 2016 would probably be sustained. (See Chart 5.)
For the FTSE 100, the boost from the lower pound will probably offset the drag from lower valuations to leave the outlook for the FTSE 100 much the same whether or not a deal is reached. The FTSE 100 could then continue to rise in line with global equity prices as the effects of the COVID-19 crisis fade. (See Table 4.)
Chart 5: Stock Market 12m Forward PE Ratios
But for the FTSE 250 or FTSE Local, which are less exposed to the benefits of a lower pound and more vulnerable to the domestic hit, the effect will be unambiguously negative. This would be a repeat of what happened after the EU Referendum in 2016. (See Chart 6.) The situation for the FTSE 100 is likely to be broadly similar if the no deal is cooperative or uncooperative.
Chart 6: FTSE Local & FTSE 100 (23 Jun. 2016 = 100)
Table 4: Deal & No Deal Financial Market Forecasts
Cooperative No Deal
Uncooperative No Deal
Cooperative No Deal
Uncooperative No Deal
10-Year Gilt Yield (%)
Source: Capital Economics
How would a no deal affect the economy?
The influence of a no deal on the economy depends on what you assume is the “baseline” or the counterfactual and what type of no deal you are talking about. For example, the influence of a no deal compared to what may have happened if the UK stayed in the EU would be larger than compared to the “hard” and slim trade deal that is the option now. And as we have already said, it is important to distinguish what type of no deal it is.
Our analysis compares the cooperative and uncooperative no deals to the “baseline” of the deal we described earlier. In this section we focus on the influence in the short run. We talk about the long-term influence a bit later.
We can get a sense of the rough impact of a no deal by looking at the various ways in which it would affect economic activity, namely through the influences on trade, consumer confidence, household incomes and business investment.
In both types of no deal, the UK government will mitigate trade disruption by phasing in new border requirements gradually over six months. The EU has said it will impose them immediately. Even so, and despite the pandemic, it appears that businesses are better prepared now than they would have been if there had been a no deal on 29 March 2019.
The Port of Calais and Euro Tunnel say they have the necessary infrastructure in place. Ahead of the original Brexit deadline in 2019, the UK government thought that “50-85% of Heavy Goods Vehicles travelling via the short Channel Straits [would not be] ready for French customs”, which implied that 15-50% were ready. According to the Bank of England’s Decision Maker Panel, 60% of businesses are now ready and only 5% are not at all prepared. (See Chart 7.)
Even so, there will almost certainly be some delays at the borders. In a cooperative no deal, “trade facilitation” measures, such as trusted trader schemes, and some leeway for firms getting to grips with the new requirements on the EU side as well as on the UK side could help to keep trade flowing. After all, on 1st January 2021, the UK’s product standards will be aligned with the EU’s. In an uncooperative no deal, the EU may impose onerous documentation and physical checks leading to longer delays at the borders.
Chart 7: % of Firms that Trade with the EU that are Prepared for Brexit
Sources: Bank of England DMP
Given that the UK runs a trade in goods deficit with the EU, any reduction in exports due to disruption would probably be offset by a bigger fall in imports. The impact on net trade and GDP may therefore be positive! But this disruption to trade would still be detrimental due to the impact on supply chains.
About 56% of UK imports from the EU are intermediate goods that are used as inputs in UK production. The importance of components from the EU is highest in the manufacturing sector, where 16% of components are imported from the EU and make up 10% of the output of the UK manufacturing sector itself. (See Chart 8.) Within manufacturing, chemicals and car manufacturing are even more reliant on imports from the EU.
Chart 8: Imports of Intermediate Goods & Services from the EU, 2014
Sources: World Input-Output Database, Capital Economics
It’s impossible to predict with any confidence the extent of the disruption to supply chains. But in the extreme case of a 30% reduction in UK-EU trade, then as 10% of inputs to UK production are imported from the EU, that might prevent 3% of economic activity occurring.
The hit would be smaller if the reduction in trade is not as big and/or if firms have built up stocks of imported components. The disruption to trade will probably be short-lived too. For example, the rebound in activity after the strikes that closed the Port of Calais for three days in July 2015, which resulted in 4,600 lorries being parked over 30 miles of the UK’s motorways, meant that it hardly showed up at all in the exports and imports data. (See Chart 9.) And the plunge and rapid rebound in imports and exports during the COVID-19 crisis illustrates how quicky activity can get back to normal.
If in a cooperative no deal trade flows are disrupted for a month, that might reduce annual GDP in 2021 by about 0.2%. If in an uncooperative deal trade is disrupted for four months, it may cut it by 1.0%.
Chart 9: Monthly Goods Trade (£bn, Excluding Oil & Erratics)
Sources: Refinitiv, Capital Economics
Just like after the EU Referendum and ahead of the previous Brexit (“Article 50”) deadlines, a no deal Brexit would probably reduce consumer confidence. After the EU Referendum, the economic outlook balance of the GfK measure fell by 10 points. (See Chart 10.) That’s roughly consistent with lower consumer spending reducing GDP by 1.5%.
But confidence bounced back quickly after the EU Referendum and we suspect it would repeat that pattern after a no deal. If the fall in confidence lasted one month after a cooperative no deal and fed through into consumer spending, it could take off 0.1% from 2021 GDP. If it lasted three months after an uncooperative no deal, it would subtract 0.3% from 2021 GDP.
Chart 10: Gfk Consumer Confidence
The impact on households’ real incomes would last longer. As we explained earlier, the government’s no deal tariffs could result in the average (when weighted by trade flows) import tariff rising from 1.0% to around 2.5%. That would raise the level of import prices by 1.5%. At the same time, the fall in the pound would push up import prices in sterling terms by a further 11% in a cooperative no deal and a further 15% in an uncooperative no deal.
When taken together, we estimate that would result in CPI inflation rising from a peak of 1.9% in December 2021 if there were a deal to a peak of 3.7% in a cooperative no deal and to 4.1% in a uncooperative no deal. (See Chart 11.) In each of 2021 and 2022, inflation would be 0.9 ppts higher in a cooperative no deal and 1.1 ppts higher in an uncooperative no deal.
Chart 11: CPI Inflation (%)
Sources: Refinitiv, Capital Economics
If everything else were the same, that would leave households with less money to spend on other items. In other words, the growth rate of real incomes would be 0.9 ppts and 1.1 ppts lower respectively. That could lead to a similar-sized falls in the growth of consumer spending, which would reduce GDP growth by 0.5 ppts and 0.7 ppts respectively in each of 2021 and 2022.
Given its high import content of about 30%, higher import prices will also make business investment more costly. The extra uncertainty may also mean businesses don’t want to invest as much. We estimate that a rise in the cost of imported capital goods would reduce the real spending power of businesses by about 2% in a cooperative no deal and by about 5% in an uncooperative one. Given that business investment makes up a bit less than 10% of GDP, that would reduce GDP by 0.2% in a cooperative no deal and by 0.5% in an uncooperative one.
In total, we estimate that a cooperative no deal could reduce the average level of GDP in 2021 by around 1.0% while an uncooperative no deal could reduce it by about 2.5%. (See Table 5.)
Table 5: No Deal Impact on 2021 GDP (%)
Hit to real household income
Lower business investment
Source: Capital Economics
Note that the figures in Table 5 are the differences in the level of GDP between the no deal outcomes and the deal outcome in 2021 across the year as a whole. The initial hit to GDP in Q1 of 2021 would be larger, but some of that would be recouped later in the year. The largest drag on activity comes from the hit to households’ real incomes. And that effect lingers into 2022 too.
Chart 12 compares how the path of GDP could be different in the deal and no deal situations. Three points jump out. First, in every situation the initial hit to activity is much smaller than during the COVID-19 crisis. Second, just like in the COVID-crisis, activity rebounds quickly. Third, GDP doesn’t get back to is previous path by the end of 2022 after a no deal as in 2022 the hit to real household incomes is still being felt.
Chart 12: GDP (Q4 2019 = 100)
Sources: Refinitiv, Capital Economics
What would policymakers do?
In any no deal situation, we think policymakers would respond by loosening fiscal and monetary policy further to support the economy.
Admittedly, the amount of policy space has been depleted by the pandemic. Interest rates have already been cut from 0.75% to 0.10%. And the Chancellor has already spent about £220bn in 2019/20 (10% of GDP) on various emergency COVID-19 measures. By August, public sector net debt had risen to 102% of GDP.
What’s more, there would probably be a resurfacing of the old debate over whether a no deal would be mainly a shock to demand (due to trade frictions reducing the appetite for UK exports, uncertainty limiting spending and rising inflation squeezing households’ real incomes) or supply (due to delays at the borders and disruption to supply chains).
If a no deal were to reduce both demand and supply by a similar amount, then there would be no extra slack in the economy, scant downward pressure on inflation and no need for the Bank of England to loosen monetary policy. In that situation, any discretionary fiscal loosening would just raise inflation rather than support demand.
And if the OBR decided that Brexit weakened the economy’s potential rate of growth, then more of the budget deficit would be judged to be structural rather than cyclical, which would further limit the Chancellor’s room for manoeuvre.
However, our view is that the decline in demand would last longer than the reduction in supply. (See here.) And it is telling that ahead of the original 29th March 2019 Brexit deadline, the majority of members on the Bank of England’s Monetary Policy Committee (MPC) had come round to a similar view.
And even if policymakers are unsure at the time what’s happening to demand and supply, it makes sense for them to err on the side of caution by loosening policy. That’s exactly what they did in the midst of the COVID-19 crisis earlier this year.
What’s more, the lesson from past global downturns is that economies struggle to recover and inflation is hard to generate. And the MPC need not worry too much about a sterling-induced rise in inflation leading to permanently higher inflation. Despite CPI inflation rising to 3.1% in November 2017 after the pound fell by 17% after the EU referendum in June 2016, inflation was back below the 2% target in 2019. So the Bank may judge that it’s safer to risk having a bit more inflation in the near term than a longer and/or deeper downturn.
The Bank would certainly quash any financial market dislocation triggered by a no deal with more QE, just as it did during the COVID-19 crisis. It’s a bit less clear what else it could do to support demand But we suspect it would favour a package of targeted measures rather than the use of a single instrument. That would mimic the strategy used after the EU Referendum and earlier this year. (See Table 6.)
Table 6: Bank of England Policy Packages
EU-Referendum (August 2016)
Bank Rate cut
From 0.50% to 0.25%
From 0.75% to 0.10%
Corporate bond purchases
Other Credit Easing
Term Funding Scheme
Term Funding Scheme for Small and Medium Sized Enterprises
Covid Corporate Financing Facility
Decrease in cost and rise in volume of loans in other currencies.
Source: Bank of England, Capital Economics
An immediate cut in interest rates from +0.10% to below zero seems unlikely for two reasons. First, by January, the systems necessary to implement negative interest rates effectively may not yet be fully in place. Second, the Bank thinks that negative interest rates are more effective when an economic recovery is well underway rather than when the banks are still worrying about future loan losses, which will still be the case come January whether or not there is a no deal.
Instead, we suspect the Bank would favour more QE. Based on our view that a cooperative no deal would perhaps widen the output gap by up to 1% of GDP, policy may need to be eased by the equivalent of just over a 50bps reduction in interest rates. Based on the Bank of England’s estimates, this could be equivalent to around £75bn of extra QE. About £65bn of that could be extra purchases of gilts and about £10bn additional purchases of investment grade corporate bonds.
The Bank may also consider bolstering the Term Funding Scheme for Small and Medium Sized Enterprises (TFSME) and/or its Covid Corporate Financing Facility lending scheme to help those businesses hit hardest survive the period of economic disruption.
Even if there’s a deal, we think the Bank will expand QE by £100bn in November and by a further £150bn by the end of 2021. So if there’s a cooperative no deal, some of the £150bn of QE we expect in 2021 may just happen earlier or perhaps the Bank would eventually have to expand QE by around £225bn in 2021.
In an uncooperative no deal, the Bank may need to do more sooner. What’s more, if that were to mean the economy was still struggling towards the end of 2021, that might be when the Bank of England decides to reduce interest rates below zero.
The prospect of more QE and the possibility of negative interest rates explains why we think gilt yields would probably be a bit lower (perhaps around 0.05%) than if there were a deal (perhaps about 0.15%). (See Table 4 earlier.) If the Bank of England did actually cut interest rates below zero, gilt yields would be lower still.
Meanwhile, there are two reasons why we think that the Chancellor would continue to prioritise supporting the economy over trying to put the public finances on a sustainable path. First, low gilt yields mean there is no pressure for the government to reassure the markets. Second, keeping firms afloat and households in jobs reduces the combined long-term fiscal costs of a no deal and the pandemic.
As such, after a no deal the Chancellor may unveil a discretionary fiscal loosening perhaps worth about £10bn (0.5% of GDP). This would probably be targeted at the industries and workers hit hardest by a no deal, such as car and food producers whose exports to the EU would be subject to higher tariffs.
Since extra capital spending would take time to get off the ground, any fiscal package may also include some increases in current (i.e. day to day) spending, such as raising the number of HMRC customs agents. There may also be some help for households suffering from reduced spending power inflicted by the higher rates of inflation. Cutting the standard rate of VAT from 20% to 18% would help. But that would cost £13bn per annum. A temporary 1 ppt cut in income tax would be a cheaper alternative as it would cost about £4.5bn per annum.
The long-term impact
The main message is that in the short run the difference between a deal and a no deal is not that large. It is only if there is an uncooperative no deal that the difference becomes more striking. The same is probably true in the long run.
We agree with most other forecasters that on its own Brexit will probably have a downward effect on the UK’s potential growth rate in the long run. We already know the government wants to reduce net migration into the UK by setting up a skills-based points system. This will probably exacerbate the trend since the EU Referendum of lower net migration from the EU and higher net migration from non-EU countries. But the net effect will probably be a reduction in total net migration, which would reduce the growth rate of the labour force.
It is possible that the pandemic adds to that downward pressure on net migration, not least as it may discourage international students and migrants who previously would have found jobs in the hospitality and tourism sections.
Brexit is also likely to have a small downward impact on productivity growth. It is well established that lower trade barriers lead to faster productivity growth, so the increase in trade barriers between the UK and the EU triggered by Brexit should have the opposite effect. When taken together, slower growth of both the labour force and productivity may reduce the economy’s potential growth rate by something like 0.3 ppts a year.
That said, we have always thought that the digital revolution would eventually lead to a surge in productivity growth. The pandemic has probably brought this forward as firms have been forced to adopt new technology faster than they otherwise would have done. We suspect this effect will be powerful enough to offset the drag on both labour force growth and productivity growth from Brexit. That’s why we think that in 10 or 15 years’ time, the UK economy will probably still be able to grow by something like 1.6-1.7% a year.
Is this the end?
Bringing all of this together, there’s no way of knowing if there’s going to be a Brexit deal or a no deal. But given that a lot of arrangements have already been made, the gap between the economic consequences of a deal and a no deal are not as big as they once were. That said, it is crucial to acknowledge that there are different types of no deal. And an uncooperative no deal could result in many of the existing arrangements being unravelled.
Whatever happens at the end of the year, it’s probably the case that Brexit doesn’t end there. At some point, the UK government will need to establish its post-Brexit policy. And the pandemic has arguably dealt a blow to its ability to achieve a low-tax, high-investment economy.
What’s more, we suspect that the next big development will be a renewed push for Scottish independence. That would especially be the case if there is a no deal. We wouldn’t rule out a move towards Irish reunification either.
Developments in both of these areas will influence the economic performance of the UK. The post-Brexit policy and the state of the Union are topics for future work that we will return to in due course.
Paul Dales, Chief UK Economist, +44 7939 609 818, email@example.com
Ruth Gregory, Senior UK Economist, +44 7747 466 451, firstname.lastname@example.org
Thomas Pugh, UK Economist, +44 7568 378 042, email@example.com
Andrew Wishart, UK Economist, +44 7427 682 411, firstname.lastname@example.org
Bradley Saunders, Research Economist, +44 7712 516 902, email@example.com