Brexiting in times of Covid-19

Executive Summary

 

• A (partially) done Brexit deal. As expected, the EU and the UK reached a very last-minute compromise on Brexit, just seven days before the EU exit day. The deal is more advantageous than other FTAs as it offers zero tariffs for goods. However, non-tariff barriers could amount up to +10% due to the exit from the Customs Union. The transition period we expected due to the lack of customs declaration preparation on the UK side has been confirmed until the end of June 2021, while financial services and data adequacy are still waiting for an “equivalence status” from the EU, which could take longer than just six months. 
• How is Brexiting in times of Covid-19 different?  

• First, demand remains low and volatile because of the renewed tight sanitary restrictions. In the short term, the “hard lockdown”, notably in the UK, will worsen the contraction of private consumption and investment. This should keep trade disruption low at least until Spring 2021, buying time for the UK and EU governments to pursue more infrastructure investments to reduce the time spent at the border. However, for UK exporters, Brexiting in times of Covid-19 could prove even harder because of the below-normal demand coupled with a +10% increase in non-tariff barriers. We forecast UK exporters to lose between EUR13.5bn and EUR27.3bn over the year (vs. EUR10bn for EU exporters in H2 2021) due to weak demand, higher bureaucracy and not much competitiveness from the sterling (-3% in 2021). This would translate into 0.6% to 1.1% annual loss in GDP. The top five hardest-hit sectors would be mineral and metal products, machinery and electrical equipment, transport equipment, chemicals and textiles.
  
• Second, the “rule of origin” is likely to require supply-chain changes for a sectors such as wood, electrical equipment, metals, chemicals, pharmaceuticals, computer and electronics, transport equipment (incl. automotive) and machinery and equipment, given their high dependency on foreign inputs. The good news is that the Covid-19 crisis has already pushed many companies to rethink their supply chains and look for more domestic suppliers. In our recent supply chain survey, the share of UK companies looking for domestic suppliers is higher compared to peers (35% vs. 17% in Italy). When asked about the reasons for considering changing the location of their suppliers, 35% of UK companies surveyed mentioned reducing delivery delays and better managing inventories among the top three reasons, vs. 21% on average in other countries.
• Third, the impact of the Covid-19 crisis on prices could alleviate some of the upside impact of Brexit on some of goods in 2021. For UK importers, the trade disruption has been delayed to July 2021, when we expect import prices of goods to rise by +2% to +5% due to the additional paperwork and longer transportation time. These costs might be reduced by (i) the mutual recognition of “Trusted Trader Schemes”, (ii) the infrastructure investments the UK government will make to facilitate customs checks and (iii) the low pressure on prices due to disrupted demand amid the Covid-19 crisis. 
  
• Fourth, pushing further with “smart industry” in the UK would be hard in times of Covid-19. The incoming labor force was already impacted in 2020 by the sanitary restrictions and Brexit will accentuate this, notably for EU workers, given the need for work permits. The total number of EU workers going to the UK has fallen by -15% since the 2016 referendum. Future labor shortages will put upside pressures on wages and make the substitution with domestic suppliers difficult.
  
• Fifth, the Covid-19 crisis provides some leeway for policy support to absorb the negative impact from Brexit, but we expect GDP to remain -2% below pre-crisis levels at end-2022. We expect additional spending of around GBP100bn (or 5% of GDP) on (i) infrastructure at the border and (ii) a VAT cut to limit the loss of purchasing power and the rise in inflation starting in H2 2021. However, the renewed strict lockdown until mid-February is expected to keep the UK in recession in Q1 (-5.5% q/q) as the closure of schools for six weeks will cut GDP growth by more than -3pp, while the closure of non-essential shops and the hospitality sector could cost -2.6pp. Hence, we keep our below consensus forecast of +2.5% for GDP growth in 2021, followed by more than +7.0% in 2022.

A (partially) done Brexit deal

After four and half years, three Prime Ministers and two general elections, Brexit finally took place on 31 December 2020 at 11pm. However, the deal with the EU is far from complete due to the lack of time for preparation, and lingering uncertainty has resulted in some disruption at the borders since 01 January 2021: many small firms have suspended EU imports and exports as they wait to see what Brexit-related changes would mean, according to the UK Federation of Small Businesses, and about one in five trucks have been turned away at channel crossings, partly because of Brexit paperwork, according to the UK Road Haulage Association.

On goods, as expected, no tariffs will apply if the level playing field conditions and rule of origins are respected (see Figure 1). Indeed, if the UK moves too far from EU rules, notably regarding subsidies – which have increased over the past few years, see Figure 2 – and if the EU considers that this distorts trade and harms its businesses, a ‘”rebalancing mechanism” can unilaterally apply. This would mean tariffs are likely to be imposed in a similar way as the EU and the US implemented bilateral tariffs following their Airbus-Boeing dispute at the WTO. Financial services and data adequacy are still awaiting for equivalence from the EU and fall under a “temporary fix” of six months.

Cooperation on foreign policy, security and defense will be reduced below current levels, along with provisions for transport, energy and civil nuclear cooperation. Mobile roaming, mutual recognition of professional qualifications, access to legal services, digital trade and public procurement are other areas where cooperation will be downgraded. Indeed, both British and EU professionals wanting to practice abroad will need to get their qualifications officially recognized. Furthermore, while the EU and the UK have agreed not to require visas for travel, the free movement of people will end. That means EU citizens going to the UK, and vice-versa, will be subject to border screenings and no longer be able to use biometric passports to cross swiftly through electronic gates.

Figure 1 – The Brexit deal in short

Figure 2 – Number of harmful state interventions, i.e. number of domestic subsidies 

How is Brexiting in times of Covid-19 different?

For UK importers (and consumers), an immediate trade disruption has been avoided thanks to the six-month transition period for customs declarations. This protects EU exporters from losses at least in H1, but could translate into EUR10bn of export losses in H2 2021.

With a lack of preparation at the border (50,000 customs agents needed, 250 million customs declarations needed per year for trade with the EU) leading to longer transportations costs , as well as extra-paperwork and bureaucracy, we expect non-tariff barriers to reach a maximum of +10% on product value for imports coming from countries such as France, Germany or Spain, as they were part of the Customs Union and the Single Market, and around +5% on imports coming from Norway, a member of the Single Market but not the Customs Union. However, the UK government has decided to give a six-month grace period (until 30 June) for customs declarations for UK companies to allow time for preparation. This should allow for a status quo on import prices of goods in the UK. Beyond July 2021, these costs might be reduced by:

(i) The mutual recognition of “Trusted Trader Schemes”, which will reduce the amount of paperwork required for such traders.
(ii) The infrastructure investments the UK government will make to facilitate customs checks.
(iii) The bilateral cumulation of origin between UK and EU goods, allowing for most manufactured goods to irreversibly acquire EU or UK-originating status even when their composition includes products from the other party, with limited exceptions.
(iv) The mutual recognition of product certifications (eg. for organic products) and Good Manufacturing Practice (eg. for medicinal products), which avoids a double inspection of manufacturing facilities by the UK and the EU.  

We initially forecasted that EUR18bn of EU exports could be lost in the first year following Brexit (see our recent report). The six-month transition period is expected to halve these losses to less than EUR10bn. Germany (EUR2bn), the Netherlands (EUR1.2bn), France (EUR0.9bn), Belgium (EUR0.7bn) and Italy (EUR0.6bn) would continue to be the hardest hit – even if the losses represent less than 0.5% of their total exports.

Companies producing wood, electrical equipment, metals, chemicals, pharmaceuticals, computer and electronics, transport equipment (incl. automotive) and machinery and equipment will need to readapt their supply chains, given their high dependency on foreign inputs.

For UK exporters, the “rules of origin” under the Brexit deal are more convenient compared to other FTAs. UK companies exporting to the EU will have to prove that their goods are produced in the UK by a certain determined share (in most of cases 55-60%). This compares to 80% for CETA and 90% for WTO terms. In addition to this more favorable threshold, traders can self-certify the origin of their goods. Mitigating this risk was important as around 150,000 UK companies trade exclusively with the EU. However, for some goods, there could be a rotation needed into a higher share of UK-produced goods. For example, the average car made in the UK purchases 44% of its components from UK suppliers. However, the proportion of this actually made in the UK is somewhere between 20% and 25%. All in all, foreign inputs for some products such as wood, electrical equipment, metals, chemicals, pharmaceuticals, computers and electronics, transport equipment (incl. automotive) and machinery and equipment go beyond 45%. The companies producing them will need to readapt their supply chains in order to avoid tariffs (see Figure 3).

Figure 3 – Foreign value added content of gross exports as a% of gross exports of final products

To finish, some manufacturers will have to face another layer of red-tape beyond having to simply verify compliance with the rules of origin for the sake of applying preferential tariffs. For one thing, the EU Dual-Use Regulation, whereby the EU controls the export of goods used for both civilian and military purposes, no longer applies in Great Britain. The latter will call for the UK exporters of such goods to acquire special licenses in order to keep selling in the EU. Second, the UK having officially left the European Single Market announces a growing divergence between both sides when it comes to the agreement regarding goods standards, calling for standards compliance verifications at the border, and thus additional trade frictions such as rigorous sanitary checks on agrifood products, for example. However, the TCA warns against any unfair subsidy to trade from one of the two parties by making it a justified ground for retaliation from the other party, notably through tariff application. In this case, lower social, labor or environmental standards with the aim of unfairly boosting trade competitiveness could be perceived as such, and call for the agreement’s provision to apply. Therefore, deviation between the UK and the EU as the former regains its sovereignty over product standardization should be cautiously undertaken and thus limited.  

The exit from the Customs Union would be equivalent to between EUR13.5bn and EUR27.3bn of annual export losses for UK companies.

Taking into account a rise in non-tariff barriers equivalent to +10% due to controls at the border for UK exporters, and two scenarios for the GBP/EUR: -3% in 2021 (our baseline) and stability, we forecast UK exporters would lose between EUR13.5bn and EUR27.3bn in 2021. The top five hardest-hit sectors would be mineral and metal products, machinery and electrical equipment, transport equipment, chemicals and textiles (see Figure 4).  

Figure 4 – Expected UK export losses per year by GBP/EUR scenario  

The services surplus is likely to shrink in the absence of mutual recognition and the UK’s financial model will need to evolve away from “classical financial products”.

Until now, the UK has had a high surplus in services trade (see Figure 5), which will be reduced by the fact that there is no mutual recognition of professional qualifications, which limits the provision of services to the Single Market by, for instance, business and financial firms. For financial services, after losing the passporting rights to offer services across the EU, cross-border business moves to an equivalence regime  by which the EU grants permission on a case-by-case basis. For central clearing of derivatives contracts, for example, equivalence has already been conceded for the next 18 months, given the heavy reliance of the EU financial system on UK central counterparties (CCPs). For the UK, much is at stake: a quarter of the financial services sector’s annual revenue comes from business related to the EU. EU business is particularly important in banking and investment, with over 40% of UK exports in these areas heading to the EU. Looking at other equivalence systems (Switzerland, US, Japan), we understand that the process can be laborious, as each financial activity needs to be screened by the EU. In addition, the equivalence status can be withdrawn unilaterally, at any time, by the EU, as was the case for Switzerland equity securities, which lost their right to be traded on stock exchanges in the EU in summer 2019. In 2015, the European Court of Justice found data equivalence with the US to be invalid following a challenge by an Austrian citizen through the Irish High Court. A new – more restricted – equivalence decision was put in place by the EU shortly after this. Thus, to avoid the uncertainty of the equivalence regime, most London-based financial services providers set up subsidiaries within the EU and moved capital (but not many jobs) into the EU in order to continue to service their EU clients.

The end of free movement will also affect the UK’s transportation services, whose exports to the EU stand at close to EUR1bn. The deal has allowed the recognition of each other’s licenses and permits, allowing drivers to cross multiple countries (to a maximum of two journeys inside the EU). However, it has reduced cabotage rights (the deal gives drivers the right to stop only once, for drop-off / pick-up, in the EU against three time before).

Figure 5 – Current account balance decomposition, GBPmn

Figure 6 - UK balance of payments (latest data point Q3 2020), GBPbn 

The Covid-19 crisis provides some leeway for policy support to absorb the negative impact from Brexit, but we expect the UK’s GDP to remain -2% below pre-crisis levels at end-2022.

Starting on 01 July 2021, when the Brexit deal will be fully enforced on the UK side, we expect import prices to increase by close to +5% following the rise in non-tariff barriers (+5 to 10% depending on the product) and the -3% GBP depreciation against the EUR (see Figure 7). However, these forecasts could change depending on the size and speed of the UK government’s policy response. We expect spending of around GBP100bn (or 5% of GDP) on (i) infrastructure at the border and (ii) measures to limit the loss of purchasing power and the rise in inflation starting in H2 2021. The rise in import prices is equivalent to GBP5bn for consumption goods (see Figure 7). The government has two options: (i) cut the VAT tax rate (around -1 to -2pp) or (ii) subsidize part of the increase as usually done for energy imports. The BoE will continue to remain very accommodative until the end of 2022 after having announced an increase of  GBP150bn of QE purchases last November, which should continue to support the increase in bond sovereign issuances.

The renewed strict lockdown until mid-February is expected to keep the UK in recession in Q1 (-5.5% q/q) as the closure of schools will cut GDP growth by more than -3pp while the closure of non-essential shops and the hospitality sector could cost -2.6pp. Hence, we keep our below consensus forecast of +2.5% for GDP growth in 2021, followed by growth of more than +7.0% in 2022 (Figure 8). In the medium run, productivity trends will be key for potential growth. Lower migration from the EU, which accounted for 4.6% of the total UK active population in 2019 (see Figure 9), is likely to reduce headline GDP growth along with lower levels of inward investment. Overall, Brexit could result in an average reduction in the long-term level of GDP of 4%.

Figure 7 - Increase in import tariffs by type of product (% and GBPbn)

Figure 8 – UK forecasts

Figure 9 – Total EU and non-EU nationals working in the UK, % of active population