Brexit: An Impossibly Complex Task for the UK’s New Trade Negotiators?

Chad P. Bown (PIIE)

September 7, 2016
Photo Credit: 
REUTERS/Toby Melville

On June 23, 2016, the United Kingdom (UK) held a referendum on whether to unwind its relationship with the European Union (EU). The UK populace chose “Brexit.” It was a clear vote against the status quo.

But by choosing Brexit, what was the UK actually voting for? The alternative was not on the ballot. To this day, what’s next remains uncertain. For while it is in the UK’s unilateral power to leave the EU, its new trading relations will be determined only through negotiations with dozens of other countries.

The UK now must bargain over issues that go well beyond the historical haggles between trade negotiators. Last century’s negotiators concerned themselves with reducing the size of the tariff on imports applied as goods crossed national borders. While tariffs remain important, today’s UK negotiators will soon find the discussions quickly turning to much more complicated issues. And because these upcoming negotiations are both complex and unprecedented, it will be years before the new terms of engagement are clear.

The negotiations will be tortuous for two key reasons:

First, the British economy has become heavily integrated with Europe’s. UK involvement in global supply chains and relatively open capital markets means small policy changes can have big effects.

Second, governance over the regulators of this economic activity was already in a state of flux. In external negotiations, for example, EU and US policymakers were already grappling with how to address global divergences in standards.

The UK’s Legal Starting Point

The UK must legally trigger Article 50 of the European Union treaty when it is ready to begin negotiations to terminate its current membership. Once the legal terms of the Brexit are clarified, everyone will know where to start negotiations over new relationships.

The most important new trade relationship that Britain must negotiate is with the EU. But it must also strike new deals with current EU free trade agreement (FTA) partners, and then prioritize across potential new FTA partners such as the United States, India or China.

Priority One: Determining the UK’s Future Relations with the EU

The most important task is for the UK to negotiate new terms with the other 27 member countries of the EU. This is not because of any legal imperative, but rather for basic economic reasons: Roughly half of its trade is with the EU. Pre-Brexit, this trade is being conducted with zero border taxes.

If the UK and EU were unable to hammer out a new free trade agreement, the new relationship would default to something much worse. Each would likely be treated under the terms extended to third countries via the World Trade Organization (WTO). Under WTO commitments, the UK and EU would be permitted to increase import tax barriers that are currently zero to an average of more than 5 percent.

The Auto Industry Angle

Trade taxes are especially important for the UK’s auto industry, which makes up 8 percent of UK exports to the EU. Without a new FTA, the EU could apply new import taxes that average 10 percent on incoming UK sales. Put differently, a UK-made car destined for the EU market would face a 10 percent cost disadvantage—simply because of the failure to negotiate a trade agreement—relative to the equivalent car produced in France or Italy. In a further blow, the UK would also face this tax disadvantage relative to cars sold in the EU but produced in Turkey, South Korea, and Mexico. These countries each have competitive auto industries and FTAs with the EU.

This underscores a second negotiating priority for the UK—new FTAs with current EU FTA partners. The UK currently trades duty free with these countries, and combined they receive another 14 percent of UK exports. Without new FTAs, most of those countries would impose even higher tariffs on UK exporters than even the EU market’s potential WTO-level, non-FTA tariff.

Robust foreign direct investment has been another underpinning for the UK auto industry’s competitive presence in Europe. Examples include Nissan’s plant in Sunderland and Ford’s manufacture of engines in Dagenham and Bridgend. Mini—owned by BMW—has a plant in Oxford that exports half of its cars to the EU. These UK facilities have survived as part of larger European supply chains. Equally important for UK auto exporters is thus their access to high-end inputs imported from suppliers in the rest of Europe. EU supply chains have extended northward because the UK applies zero import tariffs on key automotive components from Germany or Spain.

Beyond the zero-tariff relationship, active British involvement in these supply chains has been sustainable because of the UK’s integrated regulatory structure with the EU. Under the EU-wide regulatory system, a car part that meets the standard for a UK-produced engine or seatbelt has explicitly met the standard for full EU-wide authorization.

Leaving the EU means that this UK-EU regulatory relationship is also now up for renegotiation.

Leaving the EU means that this UK-EU regulatory relationship is also now up for renegotiation.

Regulatory Standards

Most all UK regulations of autos, foods, pharmaceuticals, medical devices, and consumer-safety products—as well as labor and environmental protections—have been conducted in concert with the EU. Why is this important, and what happens in the event of change?

Long before Brexit, trade negotiators worldwide were turning their attention to these regulations. The concern has been that a lack of regulatory coordination created unnecessary, unintentional, and economically inefficient nontariff barriers to trade. To emphasize the importance of the regulatory issue, consider the experience of two non-EU countries: the United States and Norway.

The United States has been intensively negotiating with the EU over a new trade and regulatory agreement called the Transatlantic Trade and Investment Partnership (TTIP) since 2013. The US and EU are both “high-standards” economies. Sometimes divergences in standards may be necessary due to important differences in local conditions. But all too frequently they have determined that the technical standards that each set individually ended up being unnecessarily incompatible. The problem is that a company in one market would have to undertake a costly modification or recertification to legally sell in the other market. In many instances, this divergence arose only because of a lack of coordination between regulators on each side of the Atlantic.

Will the UK claw back its regulatory authority, only to realize that the major players—including the US in addition to the EU—are doing just the opposite, as they seek to better align their standards and reduce these trade-barrier problems?

The “Norway option” is a now well-known potential template for future UK-EU relations. Norway has an FTA with the EU. However, unlike Turkey, Mexico, or South Korea, Norway also adopts most European Union directives (regulations) directly into its own laws. This streamlining of regulations—and other elements of participation in the European single market—reduces potential barriers to trade.

Like Norway, the UK has also been a long-time adopter of EU directives. The main distinction is that, as an EU member, the UK was able to influence the EU standards. The UK proposed and voted on legislation. It also served as part of other EU institutions—including the European Court of Justice—to strike down misguided regulations that others proposed. As a nonmember of the EU, Norway has had no political voice in setting those standards. This may also be true for Britain if it adopts the Norway option.

Overall, the US and Norway examples will give UK negotiators pause to reflect on the costs and benefits of regulatory independence versus regulatory cooperation.

Services and Passporting

A final negotiating sticking point involves services and the movement of people. Much of the backlash behind the Brexit vote was fueled by anxiety over inward migration. Yet free movement of EU citizens is one of the EU single market’s four freedoms, alongside goods, capital, and services.

Services are a major part of both the UK economy and its international trade. More than 40 percent of UK exports are in services, and roughly half of those are sent to the EU. And whereas the UK runs a sizeable trade deficit in goods, it has a substantial trade surplus in services. Exports of financial services, professional, scientific and technical activities, as well as information and communications services, are of sizeable importance for the British economy. EU membership has allowed a UK-based firm to establish a branch anywhere in the EU to offer legal, banking, insurance, or other financial services.

The UK or EU citizen employed as an automotive engineer can travel from any research and development facility on the continent to a UK plant. An information technology specialist can visit clients to troubleshoot hardware problems, unchecked by border controls applied to non-EU citizens. A British salesperson needing to attend a trade show in another EU country to meet new customers or to close a deal can do so unimpeded by visa requirements. All of this has allowed ideas and knowledge to flow more freely and improved the UK company’s competitiveness.

The EU’s legal commitment to the free movement of services and labor—while perhaps taken for granted—is rarely found in other trade agreements. An exception is the Norway option. But without a bilateral UK-EU agreement on services and free movement of labor, the legal commitments that the EU has made with the WTO would apply to UK service providers seeking to do EU business. And the EU’s WTO legal commitments for services are not nearly as generous as the status quo.

Long-term UK Options for Trade Agreements with New Partners

Only after the UK has settled its EU relationship will serious negotiations with other major countries be able to begin. Why?

Only after the UK has settled its EU relationship will serious negotiations with other major countries be able to begin.

Take the United States. US auto companies would like to increase their engagement with the UK. But if the barriers affecting 21st century trade are regulatory, US negotiators require knowledge of whose standards need to be met. And that depends on whether UK conditions continue to reflect EU regulations, or whether the UK makes the more drastic step of setting its own standards independently.

Whether the UK retains access to the single market for services and labor is also critically important. US- and Asia-based multinational companies have undertaken major foreign direct investment projects in the UK as beachheads for their EU-based sales. This strategy could change not only if the UK’s duty-free access to the EU market is dented, but also if UK-based staff cannot move freely around the EU.

Finally, in the immediate aftermath of the referendum, there was talk about the potential for the UK to quickly negotiate new FTAs with India, China, and Brazil. Because trade agreements require at least two partners, any such near-term deals are relatively unlikely. Historically, India, China, and Brazil have simply not negotiated comprehensive trade agreements with countries like the UK.

The Implications

Determining the UK’s new relations with the world will take time. Britain was completely unprepared for a post-Brexit future. Tellingly, one of the UK government’s first steps after the referendum was to announce it was seeking 300 new trade negotiators to staff up the role.

Unfortunately, there are important costs to an elongated process. This includes the uncertainty as to the terms of the UK’s future world engagement. Uncertainty makes firms hold back on investment, for fear that they will guess wrong. They make only short-term hiring decisions and limit long-term investments in people and training.

There is no guidebook for how this will play out. While the UK vote triggered the start of the process, many of the forces holding back resolution are now completely outside of Britain’s control. So much for any immediate-term payoff to the promise of new sovereignty!