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Free trade agreements

EU–UK Trade and Cooperation Agreement: Averting disaster and creating opportunities

Published 05 January 2021

The new EU-UK Trade and Cooperation Agreement have averted the worse potential outcomes from Brexit and both parties have achieved their political objectives. The success or failure of Brexit from a UK perspective will depend on its ability to use the agreement to main its role in European wide value chains and its ability to deepen the UK’s trading relationship with the rest of the world.

On Christmas Eve 2020, the United Kingdom (UK) and the European Union (EU) concluded their negotiation of the agreement that will govern their future trading relationship, at least for the time being. Although legally the UK left the EU a year ago, a transition agreement (that effectively meant nothing changed) was in place throughout 2020, so 2021 will be the first year in which Brexit has meant anything from an economic perspective. The new agreement, formally known as the EU-UK Trade and Cooperation Agreement, sets out the terms under which the UK and the EU will trade going forward.

While the UK was a member of the EU, and during the transition period, the UK traded with the EU as part of the European Single Market and the Customs Union. These terms facilitated probably the smoothest possible trading relationship: trade was tariff free, customs procedures were non-existent, and non-tariff barriers to trade negligible. Partly as a result of this frictionless trade regime and partly due to geography, the EU is the UKs largest trading partner, accounting for about 47% of total trade in goods and services. In monetary terms the relationship is one of the largest in the world, with bilateral trade in goods alone totaling EUR512bn in 2019 and total trade being EUR720bn. The UK is the second largest destination for EU exports after the United States and is more than 50% more important than China in value terms. It was therefore important for both parties to strike a deal that would facilitate the continuation of this important economic relationship, and the agreement largely achieves this within the context of two preconditions: a) the UK electorate’s expressed desire for a return of sovereignty and b) the EU’s desire to preserve the integrity of the single market and the customs union.

These preconditions help to explain why this free trade agreement – perhaps uniquely - degrades an existing relationship between two parties, rather than deepen it through the removal of barriers. The yardsticks against which the success of the agreement is measured therefore are twofold: 1) not the degree to which economic welfare is enhanced, but rather the degree to which economic damage is limited and the improvement the deal delivers over and above the baseline of operating under WTO rules. And 2) the degree to which freedom of action afforded by the agreement can be translated into welfare enhancing policy going forward. With this in mind, the agreement should be thought of as the first attempt to develop the post-Brexit economic relationship and not the final word on it. There are gaps that need to be addressed and it is likely the framework will evolve over time. It is heartening, however, that there appears to be a willingness on both sides to make the economic exchange work.

Probably the most important aspect of the agreement is that each side will enjoy tariff and quota free access to the other’s market for the trade of goods. Furthermore, under the new agreement the rules of origin (ROO) allow for content produced by either trading partner to be treated as local when it comes to qualifying for the preferential (zero) tariff regime. This bilateral cumulation should go some way to protecting the cross-channel value chains that have been established in recent decades.

While the new regime is a big improvement on basic WTO most favored nation (MFN) terms it will still produce some trade friction due to customs formalities and, potentially, non-tariff barriers as well as ROO compliance. Nevertheless, the agreement creates a less favorable environment than existed while the UK was in the single market. The key questions are: how great will these frictions become over time and what is the size of the welfare loss that will materialize as a result?

The UK Trade policy observatory (UKTPO), working without full access to the final agreement, have modelled the impact of the FTA relative to a base case of continued EU membershipi. They conclude that bilateral trade between the UK and EU will fall, over the medium term, by close to 30% relative to the baseline, with EU exports falling slightly more than UK exports in percentage terms. Given the asymmetry of the goods trade, this implies a meaningfully larger monetary loss to the EU albeit spread among a much larger economy. Trade diversion is the major consequence of the introduction of friction to the trading relationship with Asia being the biggest beneficiary in terms of replacing lost EU exports to the UK. In terms of GDP, the study concludes that the UK economy will be about 4.4% smaller in the medium term than would otherwise be the case, versus a 5.5% shrinkage under WTO terms.

But does this analysis paint too pessimistic a picture? The UKTPO study makes various assumptions about the costs of trade friction that may prove to be too high. For example, they assume customs formalities cost 2% of the value of the consignment. A number of studiesii suggest that 1% may be more appropriate and some large UK firms with deep experience of exporting around the world claim the costs amount to no more than a few basis points. In addition, the UKTPO study attributes a 3.5% cost to ROO compliance. Clearly, the cost will be industry specific but the more complex the supply chain, broadly speaking, the higher the value of the consignment – autos for example – and so again this may well prove conservative. A drop in these frictional costs from the assumed 5.5% to 2% would be the equivalent of removing all the tariffs again (a 3.5% drop in trade costs) leaving a more modest welfare gap to be closed by other means.

There is, of course, much more to the EU-UK economic relationship than the trade in goods. Overseas visitors, 70% of whom come from the EU, spent GBP28bn in the UK in 2019. Similarly, EU countries dominate the destinations of choice for UK residents traveling abroad. UK residents spent GBP67bn while overseas in 2019. Visa free travel for up to 90 days should leave the tourist and business travel industry largely unimpacted but the financial services industry is not well covered by the existing deal as it stands. The performance of financial services sector in the UK going forward will perhaps be a key test of whether the regulatory freedom that departure from the EU has brought about can be put to good use.

The agreement means that the worst potential outcomes from Brexit have been avoided and both parties have achieved their political objectives. Arbitration of disputes will not be carried out by EU institutions and the level playing field provisions permit regulatory change, albeit potentially at the expense of incurring proportionate costs. The success or failure of Brexit from a UK perspective will now depend on its ability to use the agreement to maintain its role in European wide value chains and its ability to deepen the UK’s trading relationship with the rest of the world.



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Stewart Paterson

Stewart Paterson is a Research Fellow at the Hinrich Foundation who spent 25 years in capital markets as an equity researcher, strategist and fund manager, working for Credit Suisse, CLSA and most recently, as a Partner and Portfolio Manager of Tiburon Partners LLP.

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