A good but not a great Brexit deal

Economic opinion

An eleventh hour trade deal between the EU and UK avoids further damaging the near term economic outlook but the Brexit story is far from finished and remaining risks highlight the fragile nature of global economic relations at present.  

In what has become something of a tradition in important European matters, a ‘last minute’ trade deal between the EU and UK was agreed in late December, long after multiple deadlines had been missed and well past the timeframe needed to guarantee that the formal exit of the UK from the EU would proceed smoothly. Indeed, so late in the day was agreement reached that the deal has been applied on a provisional basis on the EU side pending more formal approval by the European parliament in coming months.

Assessing all the potential implications of the minutiae of a 1246 page legal text is not possible in this note. Instead, we offer some broad comments about the economic implications of the agreement reached between the EU and the UK. The most important point is that a deal was reached. This means that we avoided the real and substantial threat of additional economic dislocation and difficulty from the sudden imposition of tariffs and other major impediments to trade and transport at a point when all European economies are already facing severe challenges. This is no small achievement.

The capacity to strike a deal that sets future relations between the EU and UK on a positive footing rather than risking a potential trade war represents a notable achievement given the understandable preoccupation of policymakers with the catastrophic impacts of the Coronavirus through most of 2020. However, equally problematic for the talks has been the complex nature of the Brexit process itself that meant negotiations on the future relationship between the EU and UK could not be straightforward. 

There are few precedents for the Brexit negotiations. Most trade talks centre around efforts to strengthen economic ties between countries to deliver shared benefits. Instead, in this instance, both parties attempted to minimise their share of inevitable losses. The Brexit talks also attempted to disentangle deep and complicated ties stemming from the UK’s 48 year membership of the European family. The Brexit ‘divorce’ had to take account of not only the economic fallout but broader political considerations such as the implications for the Northern Ireland peace process or, more generally, the integrity of the European Union.

Another important consideration was that the ambitions of the EU and UK in concluding a deal was very different. For the EU, protecting the clear benefits of membership of the single market was the central consideration and this produced a coherent and consistent position on contentious issues. Importantly, and in contrast to some UK expectations, the EU 27 managed to maintain a united front through the negotiation process that markedly strengthened its bargaining position.

For the UK, a Brexit referendum that divided the country had emphasised the less easily defined goals of ‘taking back control’ and gaining ‘sovereignty’. This led to confusion and changes in the UK negotiating position.  In this respect, a key lesson from the Brexit talks that may spill over into difficulties in the future economic relationship is the importance of clarity of objectives and mutual trust.

To the extent that the UK has indicated a desire for future divergence and the recent negotiations have been marked by misgivings on both sides, the emphasis may be on protecting current positions rather than promoting further progress. A range of mechanisms would allow either side to counter any measures taken by the other that are seen to have ‘material’ impacts on trade or investment. Coming years could see several further twists in the Brexit story as the EU and UK move in different directions. As the UK roadmap has yet to be drawn, precisely how troublesome future policy shifts may prove remains uncertain.        

A second important lesson (that may offer some comfort in terms of the risks outlined above) is that economic size and strength matter. While it is possible to point to several aspects of the EU/UK deal that saw significant concession made by the EU such as those around dispute resolution mechanisms and the lack of dynamic alignment on standards, the reality is that the deal limits damage to trade in goods where the EU enjoys a significant surplus vis-à-vis the UK while it markedly weakens conditions for trade in services where the UK has a surplus (and which represents some 80 per cent of UK economic activity).  Piecemeal and temporary measures including upcoming talks on the prospect of ‘equivalence’ approval for some financial services activities point towards notably more restricted and uncertain access for UK firms to the EU marketplace for services.

A third important lesson that may be drawn from the Brexit deal is that it is symptomatic of a generally more unstable global climate for trade and investment. While it has taken a very difficult three and a half years to arrive at an agreement on the future relationship between the EU and UK, the deal itself can be terminated by either side at any time once twelve months’ notice is given. Moreover, a full review of the agreement is to be undertaken in 2025 and every five years thereafter. There will also be ongoing assessments of various aspects of the relationship including an annual consultation on fisheries and, as well as regular reviews, a potentially significant vote in Northern Ireland on the NI protocol in 2024. So, while the Brexit deal takes away short-term uncertainty, longer term questions will persist.     

The delivery of a limited Brexit deal is substantially preferable to a ‘cliff edge’ no deal outcome for the EU and, particularly, for the UK  economy. The UK’s Office for Budget Responsibility (OBR) recently cited a range of studies suggesting that British GDP would be 2 percentage points lower in the event of a no deal than in the case of a free trade agreement along the lines recently concluded. However, according to the OBR, these studies also suggest that over time UK GDP would be 4 percentage points lower, even with a free trade deal, than if Brexit had not taken place. In the context of a roughly 11 per cent pandemic-driven drop in UK GDP in 2020, these estimates suggest that Brexit will add significant additional pain to an already  troubled economic picture for the British economy. 

Even with the trade deal just reached, there will be significant friction in goods trade between the UK and EU reflecting a substantially increased administrative burden of documentation and regulatory checks. In addition, the UK’s position as a leading exporter of services has been undermined by restrictions and uncertainty around its access to the EU marketplace.  Finally, broader uncertainty around the future path a more ‘independent’ UK economy might take is likely to diminish its attractiveness as a gateway for Foreign Direct Investment and could also act as a constraining factor on domestic business capital spending.

In turn, these difficulties will spill over into poorer market growth for the UK’s key EU trading partners at a particularly inopportune time. The UK’s decision not to fully operate customs checks for six months and a range of temporary concessions by both sides, such as a twelve month grace period before ‘rules of origin’ documentation, will provide a very limited offset. Similarly, there may be some partial compensation in time with the expected migration of FDI from the UK to other European countries. The adverse impact on Euro area GDP is likely to be modest, particularly in comparison to the trauma resulting from the coronavirus. However, the reality is that more difficult access to a UK market that will be notably weaker than if Brexit had not occurred will be problematic for many European businesses in the year ahead.    

To conclude, there is much to be grateful for that a trade deal between the EU and UK has been agreed as it avoids a ‘cliff edge’ deterioration in trade prospects and the risk of further damaging ‘tit for tat’ measures along the lines of US-China tensions in recent years. However, the limited nature of the deal reached and the potentially divergent path the UK economy may take in future years is a strong reminder of the fragile state of international economic relations at present. In turn, this points to the need to prioritise further European integration as well as structural reform to underpin the outlook for EU economies in the years ahead.   

Disclaimer:

Any opinion expressed in this KBC Economic Opinions represents the personal opinion by the author(s). Neither the degree to which the hypotheses, risks and forecasts contained in this report reflect market expectations, nor their effective chances of realisation can be guaranteed. Any forecasts are indicative. The information contained in this publication is general in nature and for information purposes only. It may not be considered as investment advice. Sustainability is part of the overall business strategy of KBC Group NV (see https://www.kbc.com/en/corporate-sustainability.html). We take this strategy into account when choosing topics for our publications, but a thorough analysis of economic and financial developments requires discussing a wider variety of topics. This publication cannot be considered as ‘investment research’ as described in the law and regulations concerning the markets for financial instruments. Any transfer, distribution or reproduction in any form or means of information is prohibited without the express prior written consent of KBC Group NV. KBC cannot be held responsible for the accuracy or completeness of this information.

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