The Economic Consequences of a No-Deal Brexit


What Is a No-Deal Brexit?

With the Dec. 31, 2020, deadline for a trade agreement between the European Union and United Kingdom approaching, the risk of a “no-deal Brexit” is mounting. When the U.K. initiated Brexit—its exit from the EU—on Jan. 31, 2020, the Withdrawal Agreement provided 11 months for negotiating a new trade relationship and extended U.K. participation in the EU single market and customs union during the transition. If no deal is reached by the deadline it will trigger what is called a no-deal Brexit. In this case the U.K.-EU trade relationship will be governed, by default, by the trading rules of the World Trade Organization (WTO).

The sudden switch to WTO rules would greatly increase tariffs and other trade restrictions, raise the cost of goods, and complicate regulations, greatly increasing financial and administrative burdens for companies. A no-deal Brexit will greatly impact the U.K., causing an estimated 8.1% reduction in its gross domestic product (GDP) after 10 years.

What Does Trading Under WTO Rules Mean?

Under WTO rules, tariffs on transactions between two WTO members are subject to the WTO’s most-favored nation (MFN) rule, which requires a member to grant all other WTO members the same lowest tariff that it imposes on a particular imported goods or services. Both the EU and U.K. have tariffs and other trade restrictions on MFN nations, so trade between the U.K. and EU would suddenly be subject to a whole host of new trade barriers, not only tariffs. Examples of nontariff barriers include quotas and customs checks for compliance with various regulations. As an EU member, U.K. goods did not require customs inspections at the border of other EU countries.

An exception is that two WTO countries can enter into a bilateral trade agreement to grant each other preferential rates lower than those required by WTO rules. This is why a deal is so important; without a deal, the U.K. and EU can’t just lower tariffs and nontariff trade barriers with each other, as they’d have to do the same for all other WTO nations. If a deal is reached, it could reduce, or even avoid entirely, the higher tariffs associated with a no-deal Brexit.

U.K. costs under WTO rules will extend beyond trade with the EU, as Brexit will end U.K. trading rights under EU agreements with 72 other countries. The U.K. has reported reaching new agreements with only 12 countries. So, in effect, it will not just be losing one deal, but dozens. It may also have trouble getting them back as external trading partners will have to evaluate Brexit’s effect on their relationships, product sourcing, and international locations for operations and financing, which may impact the terms of these new agreements.

Nontariff WTO rules also will apply to EU-U.K. trade. WTO environmental, labor, and social standards may prove less stringent than the EU standards, which the U.K. currently meets. However, the cost of services will likely rise due to the cost of complying with now-differing sets of rules.

What Will the Overall Economic Effect Be?

The cost to the U.K. economy of these new trade barriers would be substantial. Approximately 90% of U.K. goods exported to the EU would be subject to tariffs. It is estimated that the U.K.’s GDP and per-capita income will decrease by 3.3% to 4.0% over 10 years.  When including estimates of indirect impacts, that reduction rises to a range of 7.6% to 8.1% in U.K. GDP and per capita income. For the EU, the direct costs of a no-deal Brexit will reduce GDP by 0.7% over 10 years. Even if a tariff-free EU-U.K. agreement is achieved, Brexit’s indirect costs would still reduce U.K. GDP by at least 1% and EU GDP by at least 0.2% after 10 years. A U.K. government study estimated that, with a no-deal outcome, paperwork alone would cost businesses £15 billion ($20.1 billion) annually.   

How Will This Affect Specific Sectors?

Trade in Goods:

The trade barriers, new regulatory hurdles that would come with a no-deal Brexit, won’t be evenly distributed; they’ll hit some sectors much harder than others. The new trade barriers are particularly concerning to the agricultural sector and the automobile industry, in addition to the manufacturing sector more broadly. 

While the EU’s average MFN tariff rate on goods is 3.2%, tariffs on some U.K. products will be significantly higher. Average EU tariffs on imports will be 11.1% on agricultural goods, 15.7% on animal products, and 35.4% on dairy products. EU tariffs can reach 189% on some dairy products and 116% on animal products. U.K. tariffs on agricultural products will average about 16% and, in particular, are designed to protect the domestic beef, lamb, poultry, and pork producers.

For U.K.-made cars sold in the EU, the tariff would be 10%, totaling £5.7 billion annually and increasing the average price for a U.K. car sold in the EU by £3,000. More than 30 automobile makers, including the Honda Motor Co. (HMC), Toyota Motor Co. (TM), and Jaguar Land Rover Ltd. (part of Tata Motors Ltd. (TTM)) face not only substantial tariffs but also logistics issues because customs checks at borders are likely to slow cross-channel transport.

Trade in Services:

Services, including financial services, account for more than 80% of the U.K.’s GDP and professional and technical business services, and financial services constituted more than half of its services exports to the EU in 2019.  Travel services are the largest EU service exports to the U.K.

Of specific concern is the effect of a no-deal Brexit on the financial sector, due to the size of this sector in the U.K., and the complexity of the regulations governing it. Separate U.K. and EU regimes for banking and financial services will increase operational and regulatory costs. Without a new agreement, U.K. firms will no longer benefit from EU “passporting” privileges that permit a firm authorized by one EU member to operate in the others without seeking additional authorizations. In 2016, when U.K. voters pass the “Leave” referendum, approximately 5,500 U.K. firms held passporting rights. Without these rights, U.K.-based financial firms would need to get authorization to conduct most activities in each of the 27 EU member states separately, substantially increasing the difficulty of operating in EU markets. 

The EU has proposed allowing U.K. firms to enjoy rights similar to passporting if they meet EU “equivalence” requirements. That means the EU would recognize U.K. regulations governing a set of activities of finance if they are deemed to be equivalent to EU standards and regulations for the same activities even if the U.K. rules do not exactly match the EU rules. However, even this equivalence is only available in the areas of investment banking and insurance, no equivalence rights are offered for retail banking and reinsurance. EU legal action would be required to expand the allowable areas for equivalence decisions.

One area that shows the difficulty of this issue are central counterparty clear houses (CCPs). CCPs are clearinghouses for European derivatives trading similar to the U.S. derivatives clearing organizations (DCOs). The EU announced some temporary EU authorizations and the European Securities and Markets Authority (ESMA) will permit three U.K. CCPs to operate in the EU beginning in 2021. The U.K. will continue its “permissions” regime for three years. 

Due to the difficulty of the jurisdictional issues and the uncertainty of their resolution, U.K.-based banks are establishing foreign legal entities and moving personnel to the EU, with Germany, Ireland, the Netherlands, and France as the most common destinations. JPMorgan & Chase Co. (JPM), for example, is moving approximately $230 billion (200 billion euros), almost 10% of its total balance sheet, from the U.K. to its Frankfurt, Germany subsidiary; 200 London-based bankers will move to Paris, Frankfurt, Milan, and Madrid. Goldman Sachs Group Inc. (GS) and Morgan Stanley (MS) also are reported to be moving employees and setting up operations in the EU. In Feb. 2019, repurchase agreement (repo) dealers and two clearing houses in London and Paris moved almost all euro-denominated repo clearing from the U.K. to France; now almost all repos in euros are cleared in EU CCPs.

The Irish Protocol

One particularly difficult issue in the Brexit negotiations is the Irish Protocol adopted with the Withdrawal Agreement preserves an open border with no controls or tariffs between Northern Ireland, part of the U.K., and the Republic of Ireland, an EU member. This open border is intended to preserve the peace established by the 1998 Good Friday Agreement between two groups in Northern Ireland: republicans who wished to unify the two territories into a single Irish nation and unionists who wished Northern Ireland to continue as part of the U.K. This peace agreement ended the long period of violence known as “The Troubles.” Because a key point of the peace agreement was opening up and demilitarizing the border, any border regulation or control between the two areas could jeopardize the agreement and renew violence. 

Under the Irish Protocol, the U.K. would collect EU tariffs at the U.K. border situated in the Irish Sea on imports from Great Britain into Northern Ireland that are considered at risk of being transferred to the Republic. If any EU tariffs are paid on imports from Great Britain that are not transferred into the Republic but remain in Northern Ireland, they will be refunded. Trade between the Republic of Ireland and the rest of the EU will continue to be free of tariffs and regulations. After four years and at intervals thereafter, Northern Ireland will have the right, but not an obligation, to end the Irish Protocol. 

Where Things Stand

Despite the COVID-19 diagnosis of a lead EU official, negotiations continue without in-person meetings. Recent threats by British Prime Minister Boris Johnson to override portions of the Withdrawal Agreement, including the sensitive Irish Protocol, have raised further potential issues. The purpose of the Prime Minister’s threat against the Irish Protocol is uncertain, but unlikely to cause any change. The EU insists that the Irish Protocol’s observance is a treaty obligation. Moreover, U.K. disregard of the Irish Protocol would damage its own interest: the U.K. is seeking a trade agreement with the United States where leaders of both political parties have stated they will bar an agreement if the open Irish border is threatened. However, the U.K. House of Lords’ opposition blocked the PM’s proposal, somewhat reducing tensions.

Outstanding issues include the allocation of British North Sea fishing rights to EU countries. Although fishing is minor part of the EU economy, this issue is politically significant in Denmark, Belgium, the Netherlands, Ireland, Germany, and especially France. Also unresolved is the extent of permissible government subsidies for business for which the U.K. has sought expansive latitude. For a time the prospect of an agreement was severely threatened by the Prime Minister submitting to Parliament a proposal to disregard the Irish Protocol. The U.K. proposal would re-establish a border between the areas of Ireland. Faced with strong opposition by EU members, and especially by the United States, whose politicians threatened that violating the Irish Protocol would bar any U.S.-U.K. trade agreement, the Prime Minister announced that the U.K. would comply with the Irish Protocol.  

To some extent, financial markets have already priced in a no-deal Brexit; therefore, if a deal is struck, stocks may rise. However, because of the significant, negative impact of the COVID-19 pandemic on the U.K. and world economy, the short-term effects of a no-deal Brexit may be hard to disentangle from the effect of the pandemic.

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