Brexit will hold back the recovery - Capital Economics
UK Economics

Brexit will hold back the recovery

UK Economics Update
Written by Ruth Gregory
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We assume that a slim trade deal will be agreed by the end of this year and that a big step change in the UK-EU relationship will be avoided. But with the chances of a “no extension, no Brexit deal” rising, the risks to the UK’s economic recovery are on the downside. Either way, Brexit is one reason why the economic recovery in the UK is likely to be more sluggish than in many other countries.

  • We assume that a slim trade deal will be agreed by the end of this year and that a big step change in the UK-EU relationship will be avoided. But with the chances of a “no extension, no Brexit deal” rising, the risks to the UK’s economic recovery are on the downside. Either way, Brexit is one reason why the economic recovery in the UK is likely to be more sluggish than in many other countries.
  • 1. How much time is left? Having left the EU on 31st January 2020, the UK is now five months into the status-quo transition period. After the formal notification by the UK government on Friday that it will not extend the transition period beyond the end of the year (although it could change its mind at a later date), the two sides have until 1100 GMT on 31st December 2020 to negotiate a deal.
  • In fact, it has been suggested that everything needs to be concluded by 31st October so that all 27 EU members have time to ratify the deal. (See Table 1.) But we doubt the 31st October is a hard deadline. It’s possible that only parts of any agreement will require full EU ratification. Indeed, if the arrangement is judged to be a “mixed agreement” then all EU27 members need to sign it. Mixed agreements usually involve areas like transport, energy and security. If it 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. So some parts of the agreement could be signed more quickly than others.
  • And if we’ve learnt anything from the past few years, it is that Brexit deadlines are made to be broken! So if a deal is reached, we suspect it will not be confirmed until the eleventh hour, perhaps in November, or at an EU summit on 10th-11th December. (See Table 1 again.)
  • 2. What’s possible by the end of the year? The UK and EU positions continue to differ significantly on the issues of the level playing field, fisheries, access for financial services and the governance structure of an agreement. And neither side seems about to soften its red lines. To recap, the UK is aiming for zero tariffs/quotas on goods, easier access for services and financial services, as well as the chance to diverge from the EU’s regulatory standards. The EU is happy to give the former two, as long as the UK gives up the latter. Arguably the EU’s 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.
  • Of course, lots can, and will, change. The two sides have agreed to accelerate talks over the five weeks to 31st July. (See Table 1 again.) And behind the tough rhetoric, there are some signs of movement. Michel Barnier has recently dropped hints that a compromise on the level playing field is possible. Meanwhile, a high-level meeting between Prime Minister Boris Johnson and European Commission President Ursula Von Der Leyen today may inject fresh political impetus. Even if this fails to move the talks on, with Johnson surprising everyone by agreeing the Withdrawal Agreement in October last year, a last-minute deal is not out of the question.
  • 3. How does the coronavirus crisis change things? Failing to extend the transition period by 1st July does not rule out the two sides agreeing that they need more time later. Even so, the pandemic is likely to have hardened the UK government’s resolve not to extend the transition period. After all, an extension ties the UK into making continued contributions to the EU’s budget. And with the EU recently announcing a joint €750bn Covid-19 recovery fund with funds being pooled and disbursed, the UK government may fear it could be on the hook for any additional EU spending.
  • The coronavirus crisis has also changed the perception of the economic costs of Brexit. Compared with the pandemic-induced 25% peak to trough fall in GDP, our expectation of a 1% hit to GDP resulting from a no deal Brexit, is miniscule. Even the Bank of England’s “doomsday” no deal Brexit scenario of an 8% fall in GDP, which it devised to stress test the banks, is small in comparison. This has led to some speculation that the government may now be more willing to accept a no deal outcome if talks fail this year. And if anything, the costs of a no deal Brexit might be lower due to the lower trading flows after the pandemic. Some have suggested the coronavirus crisis would conveniently hide the true costs of Brexit.
  • Even so, with many firms struggling to cope with the pandemic, the additional costs of administrative burdens and more uncertainty would be unhelpful. Meanwhile, Brexit is clearly not a priority right now and businesses may not have the time nor the resources to prepare. Even if the costs do prove to be far smaller than those after the coronavirus lockdown, they will hinder the UK’s recovery from the crisis compared with other countries. What’s more, with interest rates already very low, there is now less scope for monetary policy to step in to support the recovery than would have been the case without the coronavirus.
  • 4. What is the most likely scenario? It is possible, but not particularly likely, that the UK government agrees to extend the transition period later in the year. We’d put the probability of this at around 10%. (See Table 2.) Equally, there is a real chance that the UK and the EU fail to reach a deal by the end of 2020. This might particularly be the case if the EU sticks to its line on the level playing field and refuses to consider multi-year renegotiations on fishing quotas and access to waters and the UK doesn’t back down. We think the chances of this have risen to 30% and that this would lead to some hit to GDP, up to a maximum of 1%.
  • But we think that the most likely scenario (we’d put the chances at about 60%) is some sort of fudge or compromise which results in the bare bones of a deal being agreed by 31st December. This would involve a slim trade in goods deal, while the status quo is maintained on many other issues, such as services and financial services, until deals in those areas can be sorted after 2020. Or this may mean that the negotiations are concluded this year, but time is set aside to implement the deal – an extension of the transition period in all but name. Either may suit Prime Minister Boris 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. This would mean it would take an extra year or two to get everything done. And it could involve a short-term hit to GDP ranging from around zero to 1%, depending on how comprehensive the deal is.
  • Our base case. At the start of the year, we had assumed that there would be a fudge that prevented a major step change in the UK-EU trading relationship at the end of the year. (See here.) In the spring, with the negotiations shelved due to the coronavirus and momentum shifting behind an extension of the transition period, we had thought it a little more likely that the government would back down and opt for an extension. But given the UK government’s formal rejection of an extension on Friday, our base case is now that a slim trade in goods deal is concluded by the end of the year, with the status quo for services and financial services maintained until a later date.
  • How will Brexit influence the markets? Sterling will continue to be buffeted by some negative news on Brexit in the coming months, as the negotiations drag on throughout the year. If there isn’t a deal by 31st December 2020, sterling could drop significantly, possibly to $1.15 or a bit below. However, if we are right in thinking that there will be some sort of deal by the end of the year, then we think sterling will pull back to $1.35, up from $1.25 at present.
  • How will Brexit influence the recovery? The economic recovery from the coronavirus is going to be long. And Brexit only adds to the existing uncertainties and will hold back investment. Even if there is a deal, there may be some disruption at the turn of the year. And if there is a no deal, then Brexit will act as a bigger drag on economic growth. So whether a deal is agreed or not, Brexit will probably prove a further hurdle in the UK’s long road to recovery.

Table 1: Timetable to Track Progress

Date

Event

15th June

Meeting between Prime Minister Boris Johnson and President of the European Commission, Ursula Von Der Leyen.

19th June

EU Council Meeting

29th June – 31st July

UK-EU weekly talks

1st July

Deadline for transition extension.

15-16th October

EU Council Meeting.

31st October

UK/EU deal to allow for ratification?

10-11th December

EU Council Meeting.

31st December

UK transition period ends.

1st January 2021

New UK/EU relationship begins.

Table 2: Brexit Outcomes & Probabilities

Brexit Outcome

Probability

Deal by 31st December 2020*

*May include “implementation” period

60%

Delay*

*A formal extension of the transition period either by 1st July or later in the year

10%

No Extension, No Deal

30%

Total

100%


Ruth Gregory, Senior UK Economist, +44 7747 466 451, ruth.gregory@capitaleconomics.com