What to expect as the UK negotiates its future relationships - Capital Economics
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What to expect as the UK negotiates its future relationships

UK Economics Focus
Written by Paul Dales
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As the negotiations over the UK’s new relationship with the EU will be arduous and long, business investment probably won’t rise much this year as firms will worry about the risk of there being something similar to a no deal on 31st December 2020. But if that risk is ruled out by the UK and EU adopting a piecemeal approach and putting in place at least some new arrangements this year and maintaining the status quo elsewhere, then business investment could come back to life in 2021.

  • As the negotiations over the UK’s new relationship with the EU will be arduous and long, business investment probably won’t rise much this year as firms will worry about the risk of there being something similar to a no deal on 31st December 2020. But if that risk is ruled out by the UK and EU adopting a piecemeal approach and putting in place at least some new arrangements this year and maintaining the status quo elsewhere, then business investment could come back to life in 2021.
  • Even though both the UK and the EU will be aiming for a “Canada plus, plus” arrangement, there is a lot to do in the 11 months between the UK leaving the EU on 31st January 2020 and the status-quo transition period ending on 31st December 2020, which Johnson has said he won’t extend.
  • Both sides will need to solve three key trade-offs. The first stems from the EU’s greatest fear and Boris Johnson’s greatest hope that Brexit will allow the UK to become more competitive in global markets. While the EU wants to prevent this by ensuring that there is at least a balance between the ease of access the UK has to EU markets and the extent of EU rules it must follow, Johnson wants easy access as well as the ability to diverge from the EU’s rules.
  • The second trade-off pits detail against time. If the UK wanted a relationship as close as full EU membership or as distant as operating on WTO terms, that could be arranged very quickly. But something like Canada, plus, plus will be harder and will take longer. This tight timetable may force the UK to give up some ground.
  • The third trade-off brings in the US as the UK also wants a trade deal with America. In theory, the differences in regulatory principles and standards mean the closer the UK moves to the US the further away it must be from the EU. But in practice, just like Canada, the UK can have deals with both. Talking to the US could influence the UK-EU negotiations by either making it harder for the UK and the EU to reach a deal or by forcing the EU to fear that America’s exports to the UK will undercut its exports.
  • The recent relative shifts in negotiating power mean that the chances of the two extreme outcomes by the end of the year are higher than most investors assume. The UK government’s large majority in Parliament and its greater conviction in Brexit could mean either everything falls into place or the UK walks away and accepts WTO terms.
  • But some sort of fudge that prevents a step change in the UK-EU relationship at the end of this year is more likely. A piecemeal approach could involve deals in some areas (such as goods) being agreed this year and the status quo being maintained in others (services) until deals can be sorted after 2020.
  • This would be good for the economy as it would rule out something like a no deal on 31st December 2020. If there were also a clear road map for the next stages, then perhaps businesses would conclude the chances of any sudden changes in the relationship after 2020 are lower too. That means business investment may be able to rise more rapidly in 2021 and beyond. This is one reason why we believe GDP growth will beat the consensus forecast by accelerating from 1.0% this year to 1.8% in 2021.

What to expect as the UK negotiates its future relationships

This Focus is an adapted version of a presentation given at the Capital Economics UK Forecast Forum held in London on 21st January 2020.

There’s little doubt that the biggest economic and political event of the year is the negotiations over the UK’s future relationship with the EU, which will kick off in earnest after the UK leaves the EU on 31st January. This Focus highlights the hopes of both sides and the likely conflicts, considers if the UK can have a deal with both the EU and the US, outlines what we think is actually possible by the end of the year and assesses how it will all influence the economy.

The end of the first phase

It’s well known that as uncertainty over the outcome of the first phase of negotiations over the terms of the UK’s exit from the EU increased, the growth of business investment and overall GDP slowed. (See Chart 1.) Uncertainty has eased after December’s general election result ruled out a no deal Brexit on 31st January 2020. But the key issue for the rest of the year is whether the second phase of negotiations about the UK’s future relationship with the EU reduces uncertainty further, keeps it where it is or pushes it higher again.

Chart 1: Business Investment & Uncertainty

Source: Refinitiv

The start of the second phase

Those negotiations need to cover areas as diverse as the economic, security and institutional relationship and areas as detailed as the 13 separate topics within the economic partnership. (See Table 1.)

The two topics highlighted in red in Table 1 are more important for political reasons than economic ones. In particular, the EU wants to keep alive its fishing communities by allowing them to continue using UK waters. But the Prime Minister, Boris Johnson, will want to give something back to the UK’s northern fishing communities who turned their back on Labour to vote for him in the election. And assisting the Scottish fishing industry could help tie Scotland to the UK too. This will be an area of contention.

But the other 11 areas of the economic partnership are more important for the economy. We focus on those highlighted in blue, namely the negotiations over the new arrangements for the trade in goods, services, financial services and the commitments to compete on a level playing field.

Table 1: UK/EU Economic Partnership

1. Goods.

8. Mobility of people.

2. Services.

9. Transport.

3. Financial Services.

10. Energy

4. Digital.

11. Fisheries

5. Capital.

12. Global cooperation

6. Intellectual property.

13. Level playing field for competition.

7. Public procurement.

Source: HM Government

What do both sides want?

The EU wants the new relationship to be “as close as possible”. But it says there must be a balance between the access the UK has to EU markets and the extent of the laws and obligations it must adhere to. As all countries have access to EU markets, what it really means is the ease of access that can be reduced by tariffs, quotas and checks at the borders for goods and rules and regulations for services.

The EU won’t want the quality of goods and services in its Single Market to decline. But arguably its biggest aim is to ensure that Brexit doesn’t allow the UK to tilt the playing field in its favour by using tax, labour, environmental and state aid policies to become more competitive and to undercut it.

As for the UK, Johnson has said it will leave both the EU’s Single Market and Customs Union and will no longer allow free movement of people. But he also wants easy access to the EU’s markets and he views the ability to diverge from the EU’s regulations and level playing field as Brexit’s greatest prize. And he wants all this done before the status quo transition period ends on 31st December this year.

That 11-month transition period is very short compared with the average three and a half years it has taken the EU to negotiate other recent trade deals. The EU/Canada deal, for example, took more than five years. (See Chart 2.) So there is a lot at stake and not a lot of time.

Chart 2: Time to Negotiate EU FTAs (Years)

Source: Institute for Government

That’s why negotiations will focus on replicating and tweaking current trade templates. The closest relationship would be something similar to full EU membership. (See Table 2.) The green ticks show this provides tariff-free, friction-free access to EU markets for all goods and services and gives passporting rights to financial firms, all in exchange for meeting every EU regulation and level playing field condition.

Table 2: Templates for UK/EU Relationship

Source: Capital Economics

The rules of the World Trade Organisation (WTO) are at the other end of the spectrum. The red crosses show this would mean that the UK’s goods and services trade with the EU would be subject to tariffs and customs checks, UK financial firms would not be able to sell as easily to the EU, but the UK would be free to ignore all EU regulations.

This is the default option if the EU and the UK can’t reach any agreements by 31st December 2020. This is not quite the same as the “no deal” that everyone has been talking about in recent years. That’s because the Withdrawal Agreement has put in place arrangements for things like the financial settlement, citizens’ rights and the treatment of Northern Ireland. But it would be similar in other ways as there would be step changes in the UK’s trading relationship with the EU and in other areas too. This is why people talk about the risk of a no deal having shifted from 31st January to 31st December 2020.

The middle of Table 2 shows two other options. The free-trade agreement between the EU and Canada, or CETA, provides tariff-free, friction-free trade for goods and very few regulations or level playing field responsibilities. But the access for services is only a bit easier than WTO rules and access for financial firms isn’t any easier at all.

That’s why Johnson wants to go further and has talked about a “Canada plus, plus” deal, which provides easier access for services and financial services. As the EU previously offered such an arrangement to Theresa May, this is what both sides will aim for. But to achieve it they will need to solve three key trade-offs.

Key trade-offs

The first is the trade-off between ease of access and extent of obligations. (See Chart 3.) The EU’s principles suggest the UK should sit anywhere on the blue line. If it wants the easiest access to EU markets, it must accept full regulatory and level playing field requirements, just like an EU member in the top right. If it wants no such regulatory burden, then it must accept access with more frictions, like someone on WTO terms in the bottom left. Canada and Canada plus, plus are somewhere in between, but the key point is that their arrangements are proportional.

Chart 3: Trade Off 1 – Access Versus Obligations

Source: Capital Economics

If anything, because the UK poses a greater competitive threat to the EU than Canada, the EU might want to tie it to more regulation relative to access by forcing it to sit in the red area. In contrast, Johnson wants the UK to have easier access relative to its regulatory burden, so he hopes to land somewhere in the green area.

This is going to be an almighty tussle as the EU’s greatest fear of being undercut is set against the Johnson’s greatest hope of becoming more competitive.

The second trade-off is between the extent of the relationship and the time taken to agree it. Unlike the first trade-off, this is not proportional and looks more like a bell. (See Chart 4.) That’s because the UK and the EU could easily agree a very distant WTO relationship or a very close EU member relationship as those rules are already in place. Anything else, such as Canada plus, plus, is harder and will take longer.

This means that Johnson’s pledge not to extend the transition period beyond 31st December (he’s even written it into law!) plays into the EU’s hands as to agree Canada, plus, plus in just 11 months might require the UK to concede some ground.

Chart 4: Trade Off 2 – Detail Versus Time

Source: Capital Economics

The EU-US trade-off

The third trade-off brings in the US. Both Johnson and President Trump want a UK-US trade deal. Johnson wants to send a signal that Britain is open for business and he would like to secure easier access for UK businesses to America’s services, financial services and government procurement markets. Meanwhile, Trump wants easier access for American businesses to the UK’s agricultural, food, car and pharmaceutical markets.

The real trade-off is due to the regulatory differences of the EU and the US, which means the closer the UK moves to the US the further away it needs to be from the EU. (See Chart 5.) This is mostly due to principles as the EU’s regulatory regime requires producers to prove they are not causing harm while America’s requires regulators to prove that they are causing harm. One approach is not necessarily better than the other. It just makes it hard for the UK to satisfy both regimes.

This is also exacerbated by well-known differences in standards in some areas. For example, America’s hormone-fed beef and chlorinated-washed chicken cannot be sold in the EU. Some think this is good as it ensures higher health standards, while others think it prevents productivity gains.

Chart 5: Trade Off 3 – EU Versus US

Source: Capital Economics

This trade-off doesn’t mean the UK can’t have a trade deal with both the US and the EU. The bits in red on Chart 6 show that Canada has managed it via CETA and USMCA, which used to be called NAFTA. (See Chart 6.) The blue bits show how in theory the UK could replicate that. It just needs to decide whether it wants to be closer to the EU or the US as somewhere in the middle probably won’t work.

Chart 6: Solution to Trade Off 3 – EU Versus US

Source: Capital Economics

In practice, Johnson and Trump may not be able to agree a deal this year. It would need to be approved by Congress anyway. And of course, Trump may not be President after November’s election.

But just talking to the US could alter the dynamics of the UK’s negotiations with the EU. If the UK considers opening its market to America’s chlorinated chicken, then perhaps a deal with the EU becomes harder. But it could work the other way. If tariffs and barriers between the UK and the US come down at the same time as they go up between the UK and the EU, American exports to the UK could suddenly undercut the EU’s exports. This fear may prompt the EU to concede more in negotiations to keep the UK close.

Shifts in cooperation and negotiating power

The outcome of these three trade-offs depends on the willingness of each side to cooperate and their negotiating power, both of which have changed since the first phase of negotiations. The government’s large majority in Parliament and its greater belief in Brexit means the UK has more power than before. This time the EU can’t rely on British MPs to rule out a no deal.

The EU will dogmatically protect the Single Market and its level playing field. And the short timeframe plays into its hands. But it may want to prevent the UK from drifting towards the US. And while in the first phase of negotiations the EU may have dragged its feet partly because it hoped the UK would decide to remain in the EU, with that option gone the EU may now be a bit more constructive.

What’s possible by the end of the year?

Those changes could mean the chances of the two more extreme outcomes by the end of the year are higher than most appreciate. There could be an upside surprise if the EU concedes more ground and all aspects of the new UK-EU relationship fall into place by the end of the year. The UK and the US may also agree the bare bones of a deal.

This would be the best outcome for the economy in the near term. While businesses would have to adjust to the new arrangements, the reduction in uncertainty would allow business investment to rise rapidly next year.

But there could be a downside surprise if the EU sticks to its line on the level playing field and if the UK doesn’t back down. In that case, Johnson is more likely than Theresa May ever was to walk away, resulting in few agreements and the UK trading with the EU on WTO terms. That would be the worst outcome for the economy and would cause some disruption in the near-term.

The fudge

But while we think that the chances of the all or nothing options are both higher than widely accepted, something in between is more likely. Usually with trade deals, nothing is agreed until everything is agreed. But on this occasion, there may be a piecemeal or step-by-step approach.

The first step could be to conclude some deals this year, perhaps on goods, fish and security, as well as arrangements on how to manage divergences in regulation rather than outlaw them. The second step could be to maintain the status quo in other areas, such as services and financial services, until deals in those areas can be sorted after 2020.

This could suit Johnson as he wouldn’t need to officially extend the transition period and could say he has agreed a trade deal with the EU (in goods anyway) and is on track to strike other deals.

It could be good for the economy too. Admittedly, agreeing deals in areas likes goods and fish and leaving services and financial services to later caters to the EU’s comparative advantages and neglects the UK’s. And it could also leave the UK without much leverage in later negotiations.

But this would rule out something like a no deal on 31st December and may even mean the risk of anything like that at a later stage diminishes. With Johnson having surprised everyone by agreeing a Withdrawal deal and then surprising everyone by agreeing a trade in goods deal, people may conclude it won’t be long before he gets deals on services and financial services too.

This outcome would mean it would take an extra year or two to get everything done. But eventually, we assume that the UK would end up with something like a Canada plus, plus arrangement with the EU.

The timetable

Some key dates will help judge progress. (See Table 2.) If both sides start well by agreeing what to talk about and in what order by 1st March, then that would be a good sign. But if they stumble at the very first fence, then it would be an omen that the going is likely to be heavy for the rest of the time.

Sometime in June there needs to be a “high level” meeting to assess progress. And both sides will have to decide by the end of that month whether or not to extend the transition period. We believe Johnson will decline the offer, although we suspect he could always extend it at a later stage if he changed his mind.

It has been suggested that everything needs to be concluded by the end of November so that all 27 EU members have time to ratify the deal before the transition period ends on 31st December 2020. Whether full ratification is required depends on some legal technicalities.

If the arrangement is deemed to have “exclusive competence” then only the European Commission needs to sign it. That traditionally means areas like the customs union and competition rules. However, if it is judged to be a “mixed agreement”, then all EU 27 members need to sign it. Mixed agreements usually involve areas like transport, energy and security.

It may be the case that some parts of a piecemeal agreement require full ratification while others could be signed off more quickly. Either way, the lawyers will probably argue about this right from the start with the UK hoping most (or all) of it can be deemed “exclusive competence”.

Table 2: Timetable to Track Progress

Date

Event

31st Jan

UK Leaves the EU.

1st Mar

UK/EU agree negotiating mandate. Negotiations start.

June

UK/EU high level meeting to assess progress.

30th Jun

Last date to extend transition period.

1st Jun

Aim to conclude fisheries and financial services deals.

3rd Nov

US Presidential election.

End Nov

UK/EU agreement concluded to allow for ratification.

31st Dec

UK transition period ends.

1st Jan

New UK/EU relationship begins.

Source: Capital Economics

How will it influence the economy?

With firms at least knowing there won’t be a no deal at the end of January 2020, business investment may start to rise again this year. But the trade-offs I highlighted earlier mean that the negotiations won’t be easy or smooth and will probably go down to the wire. With there being a risk of something like a no deal on 31st December 2020, business investment may not rise by more than 0.5% this year.

But in a piecemeal approach that eventually rules out a no deal at the end of this year and reduces the chances of something similar later, then a gradual fading of Brexit uncertainty could allow business investment to grow by 2.5% in 2021. (See Chart 7.) That wouldn’t be high by historical standards, but it could mark the start of a stronger period for investment.

Chart 7: Business Investment & Uncertainty

Sources: Refinitiv, Capital Economics

Conclusion

This all leads to four conclusions. First, the chances of everything being arranged this year or nothing being arranged are probably higher than most people have assumed. Second, by ruling out a no deal on 31st December 2020 a piecemeal approach could be good for the economy. Third, as the negotiations will be tough and will probably last all of the year, business investment won’t rise much this year. Fourth, but business investment could finally start to make some decent gains next year.

Overall, Brexit uncertainty will probably continue to hold back the economy this year, but the handbrake may start to be released next year. This partly explains why we expect that after growing by just 1.0% this year, GDP will beat the consensus and rise by 1.8% in 2021.


Paul Dales, Chief UK Economist, +44 20 7808 4992, paul.dales@capitaleconomics.com