The UK is hurrying towards the exit but may not be sure where it is going

Economic opinion

On Friday, January 31st, the UK will leave the EU ‘in word if not in deed’. There may be political fanfare in Britain including the launch of a new commemorative coin and a light show in Downing Street. However, the vast majority of businesses and people, both in the UK and across Europe, will see no practical changes at least until the agreed transition period finishes at the end of this year. Until then, the UK will be treated as though it were an EU member state and EU law will continue to apply in the UK. The longer term perspectives for the UK economy remain unclear and most likely less promising given the enormous economic and political challenges the UK will face. Moreover, Brexit is likely to remain a cloud above the European economies.

Not a pivot point but the start of a challenging process

January 31st will not be an immediate pivot point for the UK or its partner economies in the EU. At the margin, the removal of the immediate threat that the UK might crash out of the EU could prompt a small and temporary ‘Brexit Bounce’ in sentiment and spending in the UK and, to a lesser extent, in its key trading partners in the EU.

If the very short-term economic impacts seem limited, the longer-term consequences could be substantial. January 31st 2020 marks a momentous date in what has already been a long and twisting path to Brexit. The UK will pass the point of no return and can no longer seek to stop the Article 50 exit process. It will no longer have a voice in EU decision-making. After a tortuous divorce process stretching over three years, the UK will seek to negotiate within at most eleven months, what Boris Johnson has indicated should be a broad free trade agreement with the EU covering goods and services, and cooperation in other areas. This appears, at best, hugely ambitious (See KBC Economic Opinion of 31 October 2019).

A major problem in earlier talks was sharp divisions on Brexit within the British parliament and the broader UK population. For several reasons, the very decisive outcome of the recent British general election may also pose problems for the upcoming negotiations.

The Conservative party, previously a minority government, now has a very large 80 seat majority significantly because of its election promise to ‘get Brexit done’. UK voters seem fed up with the drawn-out exit process, making the UK likely to prioritise a speedy clean break with the EU over the more patient but protracted efforts to reach a comprehensive agreement.

A second influence is that the recent election has changed the complexion of the UK parliament with Brexiteers now firmly in charge. The UK team negotiating with the EU will be more inclined to believe that, outside the EU, the UK will have enhanced scope for independent policy-making that will deliver greater opportunities for British business, offsetting the costs of more limited access to the EU single market. 

A final important influence is the absence of any dramatic adverse Brexit impact thus far on UK households. The latest data show unemployment at 3.8%, average earnings at 3.3% and inflation running at 1.3%. A supportive policy mix, a more competitive exchange rate and the fact that post-Brexit impacts have yet to be felt mean that many UK consumers now see earlier dire warnings as unfounded. Forward looking indicators such as chronic weakness in business investment or softness in the housing market have attracted little attention. 

For these reasons, there are significant risks that the UK approaches upcoming negotiations with speed prioritised at the expense of substance, with more emphasis on the benefits rather than the costs of divergence from the EU, and with a continuing difficulty understanding how the EU’s strategic imperatives and economic scale would influence the shape of those negotiations. 

In the same vein, the UK Government’s decision to incorporate measures in British law that prevent it seeking any extension to the transition period may not achieve the intended goal of strengthening its bargaining position. As a result, early indications of the UK approach may hint at difficult discussions to come and recurrent threats that the UK might crash out of the EU at the end of this year. 

Complicating matters further is the UK’s ambition to simultaneously conclude trade deals with a range of other countries, with some suggestion that a mooted deal with the US would enhance the UK’s bargaining position vis-à-vis the EU. However, early indications that Washington would look unfavourably on a proposed digital tax in the UK and Huawei’s involvement in the roll-out of 5G in the UK point towards the scale of problems the UK may face to quickly realise its stated ambition to become ‘a champion of free trade’ . 

Economic reality may clash with political rhetoric

For the EU’s part, Commission president Ursula Von der Leyen spelt out the principles and priorities informing its negotiating stance with the UK very clearly in an early January speech in London, noting ‘...our partnership cannot and will not be the same as before…The more divergence there is, the more distant the partnership has to be. We will work for solutions that uphold the integrity of the EU, its single market and its Customs Union. There can be no compromise on this.’

Clear differences in the approaches signalled by the UK and EU, and the current political mood in Britain make it unlikely that the UK and EU will extend the transition period beyond the end of the year. This also means that any trade agreement will probably be ‘narrow and shallow’ and primarily focussed on trade in goods, with limited progress likely on trade in services and possible difficulties in concluding definitive arrangements in areas such as security and data. 

So is a deal technically impossible? On the evidence of previous EU trade deals, an eleven-month timeframe looks entirely inadequate to reach agreement with the UK. However, given the extent of existing linkages and commonalities, it might be possible to make sufficient progress on the broad outline of a meaningful if limited agreement to allow some form of fudge delivering a provisional deal and creating a ‘technical implementation period’ beyond the end of 2020. 

Reaching such an outcome would depend critically on the extent to which the EU is satisfied that the UK will respect a ‘level playing field’, entailing commitments in a range of areas including state aid, social and employment standards, the environment and relevant tax matters. Recent rhetoric from the UK emphasising its intention to avoid alignment is not encouraging, but some creative emphasis on commonalities might overcome this obstacle if the insurmountable task of delivering a line by line trade deal within a reasonable timeframe is to be avoided. 

Significant obstacles to delivering even an outline of a very basic trade deal between the UK and EU suggest that Brexit concerns are likely to remain a large and threatening cloud hanging over the British and European economies in the year ahead. Even if these obstacles can be overcome, the sort of free trade deal now envisaged by the British Government is likely to have serious negative impacts on UK economic activity over time. 

The UK Treasury has estimated that ending frictionless trade in goods and significant curbs on trade in services between the UK and EU could leave UK GDP about 7% lower than in a no Brexit scenario -an amount equivalent to the cumulative growth in the UK economy in the four year period from 2016 to 2019. The fact that this might not happen all at once does not markedly diminish the risks in this regard, even if it sustains claims that a bright alternative future for Britain is now coming into reach. Between the nominal Brexit date of January 31st and the likely effective departure date at year end when the transition period concludes, significant gaps between political rhetoric and economic reality in the UK could be painfully exposed. 

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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