While the UK officially left the EU on January 31, the country still remains in the EU’s customs area and single market until the end of the year, effectively masking the real economic impact of such a decision for the time being.
During this period, the UK and the EU were expected to agree on a future trade arrangement to commence on January 1, 2021. Negotiating a whole new trade deal in less than a year was already ambitious – the advent of COVID-19 added another cause for delay on top of what was already a daunting political task.
The terms of the UK’s departure from the EU were legally enshrined in the Withdrawal Agreement. Most of that was negotiated by Theresa May’s government. But after Boris Johnson replaced her as prime minister in July 2019, he negotiated some changes to it. Included therein was a specification that if the UK felt more time was needed for the negotiations, it could request a two-year extension to the transition period, which would give the sides until December 2022 to negotiate a deal. But that request, which had to be formally made by June 30, never actually arrived. As a result, Brexit was back in the spotlight in the past few weeks, despite the very unusual times of the pandemic, and is likely to remain so in the coming months.
It is fair to say that progress in the Brexit negotiations has always been sluggish at best. Added to this, COVID-19 has restricted the negotiations in terms of physical movement but also mental movement.
The crisis has commanded vast amounts of attention and resources that otherwise might have been directed towards the EU-UK talks. In effect, after four rounds of negotiations, there are still significant disagreement between the EU and the UK over many of the fundamental aspects of a trade deal.
At the root of the problem is the same fundamental issue that has plagued the discussions for the last four years. The UK wants to regain control – to become fully sovereign – setting its own rules and regulations overseen by British courts. However, the EU is not willing to grant significant access to the single market without guarantees that standards will not be undercut to gain competitive advantage.
If an agreement cannot be reached by December 31, then tariffs and full border checks will be applied to UK goods travelling to the EU. Aside from trade, many other aspects of the future UK-EU relationship will also need to be decided during the transition. These include issues related to law enforcement, data sharing and security, aviation standards and safety, access to fishing waters, supplies of electricity and gas and licensing and regulation of medicines.
Lately, the impact of Brexit has been put into a different context as a result of the dramatic economic effects of COVID-19. This has prompted many to think that an extension of the transition period was more likely than not. In effect, the pandemic shock has made British firms more vulnerable and less able to cope with further economic disruption. There is also a non-negligible risk of a second wave of infections later this year, which could disrupt or delay negotiations and/or the ratification process of any deal.
On June 15, Prime Minister Johnson took part in a virtual meeting with European Commission president Ursula von der Leyen and European Council president Charles Michel. Though neither side was willing to back down, they agreed to “inject new momentum” into trade talks, setting a new deadline for the end of July. The reportedly positive mood following the meeting suggests that both sides still believe in the mutual benefits of a trade deal and that there is room for compromise.
On its part, the EU states that October 31 is the real deadline as member states will need time to ratify the agreement. Unlike the Withdrawal Agreement, the trade deal will require unanimous backing, which raises the risk of hold-outs.
In effect, the pandemic is exacerbating differences within the EU 27. Fiscally well-off countries such as Germany have been able to flood their economies with aid and development funds, while countries such as Italy that were already strained financially, are struggling to pay for necessary economic rebuilding. To conclude a trade deal with the UK, the EU 27 will need to find common interests and work together. However, right now, economic pressures are seen driving them further apart.
The pandemic shock has made British firms more vulnerable
Concluding and ratifying a deal between the UK and EU in less than six months looks extremely ambitious, therefore, considering that EU trade agreements typically take several years to negotiate and ratify. Nonetheless, the base scenario depicted by various research houses and political commentators, remains that of a partial trade deal to be agreed by the end of the year, with potentially add-on deals agreed in subsequent years.
With fragile recoveries on both sides of the English Channel and disruption of long-distance supply chains in particular, a deal looks to be in the clear interests of both sides, and many still think it is feasible if the political will is there. Given the lack of available time, however, the agreement is likely to focus on the sectors that are of the highest priority for both sides.
If both sides fail to agree on even a partial deal, then we can expect to see tariffs being applied to the flow of goods heading in both directions, potentially raising prices and reducing demand. This would be synonymous of a ‘hard Brexit’. Both sides would suffer, though the impact on the UK would be larger, given that 45 per cent of the UK’s goods and services exports go to the EU, compared with 13 per cent of EU exports going to the UK.
There could also be significant ramifications for financial firms, since the UK would lose its passporting rights, i.e. its ability to serve EU clients from the UK. Advocates for a hard Brexit argue that a clean break would allow the UK more flexibility in negotiating future trade deals with other trading partners, although any benefit from these agreements would still only be seen once these trade deals had been implemented, which is often a lengthy process.
There is no doubt that leaving the EU’s single market at the end of the year will bring costs to the UK. But camouflaged by the pandemic’s effects and mitigated by the huge upswing of debt-fuelled government spending, Brexiters may argue there is no better time to bite the bullet. According to an article published on Bloomberg, the coronavirus pandemic is forecast to hit the UK’s GDP by over 13 per cent this year, while the economic impact of Brexit has been estimated to result in foregone growth of eight per cent of GDP over a 15-year period. This was described as “a drop in the ocean” for analysts at Schroders compared to the impact from the coronavirus lockdown.
From a markets’ point of view, we believe the Brexit issue may not receive too much attention until the autumn, when crunch time approaches. However, by the start of the fourth quarter, as the end of year deadline approaches, we expect both sides to be in full swing, trying to extract the most concessions. In the end, we expect pragmatism to prevail and some solution to be found, at least on the most pressing issues.
While it is important to note that this outcome is anything but certain, it is important that investors are mindful of the significant risks associated with this event. In particular, sterling may be particularly volatile and, with almost 80 per cent of revenues coming from abroad for the FTSE 100 Index, this will also have implications for the equity market, since a stronger sterling could put downward pressure on earnings and vice versa should sterling fall, all other things being equal.
However, caution is warranted against relying too heavily on a rally in the FTSE in the event of a hard Brexit, as a disorderly Brexit would be likely impact both UK and EU activity negatively, depressing some of the overseas earnings that matter to UK companies.
This article was issued by Stephen Borg, head of wealth and fund management at Calamatta Cuschieri. For more information, visit www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.
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