The Known Unknowns: A New Set of Trade Relations for a Post-Brexit World

By Shannon Togawa Mercer
Thursday, September 15, 2016, 7:44 AM

Brexit minister David Davis’s address in Parliament last Monday on the state of Brexecution met mixed reviews. The speech promised an outline of the U.K.’s strategy for what comes next, but Davis delivered what at least one news outlet has called an “astonishingly empty statement,” and what one Labour Party Member of Parliament, Emily Thornberry, described as just “more empty platitudes from a government that continues to make it up as it goes along.”

Davis did, however, say one uncontroversial thing: Naturally, people want to know what Brexit will mean.” If you were waiting with bated breath for “The Plan” to materialize out of a cloud of Leave campaign rhetoric, as I certainly was, you probably found little comfort in Davis’s synthesis statement: “Simply, [Brexit] means the U.K. leaving the European Union. We will decide on our borders, our laws and taxpayers' money.” Even now, more than a week later, Davis has informed British lawmakers that his department, perhaps appropriately dubbed “Department X,” is still determining exit aims and strategy.

So we may have to wait a while to learn the specifics of Tory Brexit strategy, but, as I mentioned in my last Brexecution article, there are a bunch of what Donald Rumsfeld would call “known unknowns” about the future relationship between the EU and the U.K. In the next few installments of the Brexecution series, I will outline a few of the substantive foci of the coming negotiations. In this piece, I’m going to outline several of the myriad trade issues that the U.K. and EU negotiators will have to sort out to make Brexit a reality. There are a lot of them: What kind of access will the U.K. have to the European single market? How might the U.K. reshape its relationship to the WTO, and what about all those free trade agreements to which the EU on the whole is party, but not the U.K. on its own? What about agriculture and fisheries? And what about financial services, which is one of the big things that makes London tick? For that matter, what about aviation?

Davis and Prime Minister May have emphasized the importance of maintaining the freest possible trade relations between the U.K. and EU. Recently, Davis said that it is unlikely that the U.K. will leave the EU without a trade deal. In other words, the U.K. will seek to avoid plunging directly into tariff barriers similar to those the EU applies to third countries (Most Favored Nation, or “MFN” treatment) under the auspices of the World Trade Organization (WTO). Currently, 44 percent of the U.K.’s exports go to the EU. And 12.6 percent of the U.K. GDP is linked to EU imports. With that level of integration, any shift from a zero tariff barrier to higher rates could shock the system. If you’re interested in more detail on the potential trade outcomes for the U.K., specifically the prospective tariff rates compared to current export volumes of a variety of goods (in my case, I found potato chips and orange juice particularly interesting), the Wall Street Journal published a number of handy interactive infographics back in June.

So the U.K. will, as a preliminary matter, want to maintain access to the European Economic Area (EEA). While early in the process Davis suggested that it is improbable that the U.K. will remain in the single market, May has made it clear that he was expressing his personal opinion and not that of the government. Continued membership in the EEA will likely reduce the U.K’s ability to limit migration. The EEA is a group of all EU member states plus Norway, Iceland and Liechtenstein from the European Free Trade Association (EFTA) within which the four freedoms of the EU (free movement of people, goods, services and capital) are also guaranteed. This relationship is governed by the European Economic Area Agreement (EEA Agreement). The U.K., if it so desires, would have to rejoin the EFTA under the EEA Agreement and then join the EEA afterward. Alternatively, association agreements could be drawn up. This could be addressed in negotiations.

Relatedly, the U.K. will have to decide how to approach its new status with respect to the World Trade Organization (WTO); sort out its strategy regarding existing and future bilateral and multilateral Free Trade Agreements (FTAs); negotiate a position on agricultural and fishing rights and the movement of products; and, in the realm of services, the movement of financial services and the necessary regulation surrounding that.

The status of the U.K. in the WTO is of the utmost importance to the future of the British economy. The U.K. will want to regularize its position within the WTO, addressing the disentanglement of tariff schedules from the EU, dividing trade quotas, looking into agricultural support agreements, and contemplating other agreements it may not have benefitted from under the EU umbrella (such as FTAs and the Government Procurement Agreement, for starters).

Currently, the U.K. is a member of the WTO in its own right but falls under the umbrella of the EU customs union commitments. The U.K. also currently enjoys zero tariff barriers within the customs union. It cannot negotiate its own trade deals. If withdrawn from the EU, the U.K. will need to both re-negotiate schedules with all 161 members of the WTO and decide whether it wants to negotiate a special agreement with the EU such that goods and services are subject to more favorable terms than those the EU imposes on third-party countries. If the U.K. exits the EU without such an agreement, it will be subject to the EU’s general tariff barriers which can reach heights of 20 percent on animal products and over 10 percent on fish, fish products, cereals, sugars, fruit, vegetable and plants.

But the U.K. is damned if it does and damned if it doesn’t on this point: Negotiations for a new tariff schedule with the WTO will be excruciating line-by-line negotiations. And upon Brexecution of a free trade agreement with the EU, U.K. exporters will take on cumbersome measures to comply with the separation. For instance, complying with the EU’s rules of origin may result anywhere from 4 percent to 15 percent in overhead costs. There is also the question of whether third parties will want to rebalance their tariff schedules with both the U.K. and the EU.

The U.K. will also be concerned with FTAs to which the EU is already a party. EU competence agreements will cease to apply to the U.K. once it has withdrawn. The EU is currently party to 22 different bilateral and regional agreements involving trade, and three agreements incorporating into the customs union both Turkey and those world trade powerhouses Andorra and The Most Serene Republic of San Marino. The U.K. will have to evaluate whether it wants to maintain the advantages gained through these agreements and then, if so, negotiate its own bilateral agreements with each country or region.

The work doesn’t stop there. The EU is currently mid-negotiation with around 38 countries and regions, the most prominent of these negotiations being the Transatlantic Trade and Investment Partnership (TTIP) between the EU and the U.S. The U.S. has expressed a declining interest in a deal with the EU if that deal doesn’t include the U.K. That’s unsurprising given that the U.K. accounts for around 25 percent of the goods and services that make their way to the U.S. annually. Strong U.S. interest in safeguarding a trade relationship with the U.K. could bode well for any separate deal the U.K. contemplates after its exit. Recently, President Obama reflected on a meeting with May, ensuring that the U.S. would look to prevent “adverse effects” to the U.S.-U.K. trade relationship by “consulting closely” with the U.K. during Brexit negotiations. That said, in another report about last week’s G20 summit in China, Obama said that the U.S. will prioritize trade negotiations with the Pacific and the EU over a new U.K. agreement. The true extent of the U.S.’s support for the U.K. in its navigation of new trade deals remains something of a wild card. On the other hand, some countries are less opaque in their attentions: Australia, for example, has eagerly recognized its opportunity to get an early start on the trade action with the U.K.

Here’s a problem: the U.K. doesn’t really know how to negotiate trade deals any more. The U.K. Department of International Trade hasn’t had to negotiated its own trade deals in more than 40 years. For that reason, it has actually expressed a willingness to hire foreign trade negotiators to help in the ensuing discussions. Where are the U.K.’s trade mercenaries coming from? Funny you should ask. New Zealand, a country particularly experienced in trade negotiations as of late (see TTP and Chinese negotiations), has offered to send some of its negotiators to assist. Furthermore, Sir Jeremy Heywood has spoken with experts in the private sector (Earnst and Young, KPMG, McKinsey to name a few firms) to seek out their expertise in preparation for negotiations. That said, there is still significant worry around the U.K.’s relative lack of trade negotiation experience.

Another big issue will be protecting trade and production in agriculture, which will be vital to the U.K.’s stability post-Brexit. Currently, the U.K. is a beneficiary of the EU Common Agricultural Policy (CAP), a system of agricultural regulations which includes subsidies and programs aimed at rural development. British farmers received £2.4 billion in 2015 from the CAP program. Between 2014 and 2020 British farmers are being given access to a £4 billion of funding for rural development projects.

This is a big deal; it translates to roughly 55 percent of the U.K.’s total income from farming. Without a special deal with the EU, U.K. farmers will lose CAP subsidies. Removing CAP subsidies would “devastate British farming” according to Meurig Raymond, the President of the British National Farmer’s Union (NFU). A consultancy called Agra Europe predicts that the loss of CAP subsidies would lead to a crash in land prices and that 90 percent of British farmers would be out of jobs. Some policymakers, including the farming minister and Brexit proponent George Eustice, believe that the U.K. will be able to continue providing the subsidies domestically. He has suggested that Brexit would lead to an £18 billion dividend that could be used to replace the CAP subsidy. Switzerland and Norway have both developed their own versions of CAP and provide even more support to their domestic farmers. On the other hand, the House of Commons library supports the prediction that Brexit will reduce farming incomes in Great Britain.

The bottom line is that without access to the EU single market and without special arrangements made for trade, the U.K. might be facing an average 14 percent tariff on agricultural products and potentially a 36 percent tariff on dairy products. WTO director Roberto Azevedo has predicted that U.K. exporters could face £5.6 billion in increased duties on goods if no deal is made. These hikes would lead to first-order consequences, higher prices for consumers and lower revenue for farmers, and all sorts of second-order economic consequences for the U.K.

Then there’s the fish. Under the current arrangement, Brussels administers fishing grounds even within the 200 nautical mile radius (in Maritime Law, the Exclusive Economic Zone) around Great Britain. The EU Common Fisheries Policy (CFP) gives all EU fishermen equal access to EU waters. Currently, more than a third of the fishing fleets operating in the southwest coast of the U.K. are foreign owned. British fishermen were torn during the referendum, as economic incentives differ greatly depending on their location and market: Scottish ports sell much of their salmon, shellfish and lobster to EU countries, thus benefitting from the lack of tariff barriers. Some British ports, however, primarily sell to domestic markets, meaning that they would benefit from less competition and higher tariff barriers on imports. The former EU fisheries commissioner, Maria Damanaki, is skeptical of those who say the U.K. will withdraw from the CFP altogether. She cites the integration of the British sea with Irish and other European seas as creating an interdependency which necessitates cooperation.

Perhaps the most economically worrisome component of the U.K.-EU relationship is the future regulation of financial services. Some analysts predict that London will remain the center of the European financial services industry. That said, other commentators, including the French Prime Minister, Manuel Valls, report that firms based in London are making plans to relocate to Dublin, Amsterdam, Frankfurt and Paris. While Barclays has reported that it will not move jobs outside of the U.K., HSBC and JP Morgan have hinted at moving thousands of jobs elsewhere.

Much of British financial regulation is derived from EU directives and regulations. In fact, the U.K. will have to be particularly careful of regulatory gaps once EU treaties no longer apply. If the U.K. desires, and is able to negotiate, maintaining its membership in the EEA and thus the single market, much of the regulation of financial services will stay the same. That said, Travers Smith, a London law firm, predicts that the U.K. will not end up staying in the EEA because, as mentioned above, that will also require the U.K. to keep its borders open for the free movement of people.

A think tank, New Capital, hypothesizes that there could be a regulatory backlash to Brexit involving the EU changing policies and regulations which advantage the U.K. For example, the European Central Bank could relocate Euro clearing houses from London to European cities; the U.K. currently houses the largest Euro foreign exchange transactions market, exchanging around a trillion Euros per day). In order to avoid this type of conflict, the U.K. will need to negotiate its relationship with the EU and financial services regulation very carefully, paying close attention to how many EU regulations it will maintain and for how long in order to preserve sustainable levels of freedom for personnel and services. The U.K. Financial Conduct Authority (FCA), the main regulatory body for finance in the country, has established an internal Brexit unit to address any changes which may take place as a result of negotiations. Likewise, the City of London Corporation has hired twenty to twenty-five new staff members to focus on regulation.

U.K. participation in the energy and aviation markets may also require further negotiation. The European Energy Union Strategy project began in 2015 to regulate and strategize around EU energy supplies. The EU decided to build an Energy Union later that year; it will also be in charge of climate policy. The Energy Union is aiming to create 10 percent electricity interconnection amongst member states by 2020. The European Commission suggests that interconnection may lead to more affordable energy prices, a more secure energy supply, more sustainable development, and decarbonizing energy sources. If the U.K. wants the benefits of integration, it will have to negotiate an agreement to be a part of the proposed system.

Likewise, the EU single market applies to aviation as well. Member states’ airlines can operate within the EU with the same air traffic rights and without capacity, frequency or pricing restrictions. The Single European Sky is the current EU legislative framework for the EU aviation market. The U.K. may look to negotiate an agreement to maintain, or transition from, these rights, although the Brexit vote has already had an impact: Ryanair, Europe’s largest airline, has reduced plans for growing its fleet in the U.K., opting to station more planes in the EU.

These topics are only the tip of the iceberg. Trade negotiations alone will take on titanic proportions. The U.K. will have to negotiate free trade deals all over the world while simultaneously negotiating with the EU. This would be a substantial task even if the U.K wasn’t already en route toward the icy wall of asking for EEA access without free migration. Donald Tusk has predicted that the negotiations may take five years to complete, but the U.K. has more than just this to tackle. Most recently, Guy Verhofstadt, the European Parliament’s lead Brexit negotiator, posted on Twitter that the UK will have to accept free movement of citizens if it wants access to the single market. Clearly, immigration and national security will also pose large challenges for the newly assembled U.K. negotiation team. My next post will continue to explore the waters ahead for May, Davis and the intrepid travelers of H.M.S. Department X.