Archive for the ‘Economics of Brexit’ Category

Mission impossible: calculating the economic costs of Brexit

Much of the 2016 referendum debate focused on the costs involved in a potential Brexit. The ‘fatalists’ claimed that the losses would be huge and felt immediately after the UK had taken the decision to leave the EU. As time progressed, a more ‘moderate’ view prevailed postulating that the costs would not be instantly perceptible, but would crystallise only over the medium-run. However, according to Eddie Gerba (LSE), the reality is much more complex and the degree of uncertainty in estimating the true economic costs has been much higher than any of the sides in the debate were ever willing to admit.

As a matter of fact, estimating the costs surrounding a future stochastic event (or structural break) is as easy as predicting next year’s weather. Financial mathematicians know this matter better than anyone. Considering that there has not been a previous exit from the European Union (nor in any highly integrated economic area), estimating the full costs was never going to be possible. The attempts that were made prior to the referendum involved many and heavy assumptions, including strong premises regarding the reaction of the other economies and trading partners within the EU, and beyond. Moreover, the issue involves a multitude of aspects beyond those strict trade-related, such as productivity and competitive edge, labour mobility, education, firm complementarity across borders, macroeconomic interdependence, (macroeconomic) policy alignments, financial interdependence, financial market flexibility, financial innovation, liquidity, systemic risks and financial stability, or prudential policy effectiveness.

CC0 Creative Commons

Yet despite this cloud of uncertainty, there are some insights from the literature that we can use to make the challenge more manageable, specifically when it comes to the macro-financial aspects at the heart of Brexit. The first and maybe most obvious is the competitive edge of the financial services sector, and the status of London as a financial ‘hub’. There has been a lot of discussion on the potential costs from the loss of a privileged access to EU financial markets (the so-called EU passport). While that is true, and there may be some considerable (opportunity) costs from that, the bigger cost is the lost opportunity to take part (and advantage of) the EU’s banking and capital markets union. In particular, the flexibility, innovation, unique regulation, and privileged access to financing and counterparties from the other EU member states would have been highly beneficial for the UK financial system.

That said, we must remember that the ‘Big Bang’ in the UK financial system occurred during the mid-80’s, and well before the EMU, integration of capital markets, and the opening up of financial markets in the rest of Europe. Relocation of European (investment) banks and other financial institutions to London was, at large, prior to any of those events. Moreover, the competitive advantage of the UK financial sector goes much beyond the EU market access. Not only is there a level of expertise and specialisation in market financing in London that is not comparable to any other European city, but there is a well developed global stock market (the other LSE), a whole network of legal services and juridical expertise to support financial transactions and services, a renown higher-education system with strong links to the City, and a physical-technological infrastructure that backs the hub. Considering that it took quite a long time to build and cultivate these components, it is hard to imagine that simply because of an exit (or a rearrangement in the relation between the UK and EU), financial institutions will relocate to other European destinations where some (or all) of these components are lacking. That is why there is little evidence for many of the costs related to the ‘end of the UK dominance’ in financial services that has sometimes been claimed.

Another important aspect of the divorce is the issue of macroeconomic costs. Roughly speaking, the more synchronized the business cycles, the higher is the cost of a divorce since many adjustments will be required to break that harmony. Moreover, the sources of volatility will be similar in that case, which will require policy alignment to counter them. As a result, the divorce will be costly as this alignment of policies will be broken. However, the recent empirical literature has shown that UK regions are less synchronized with the Euro Area than the rest of the European Union (Bandres et al, 2017, Barrios et al, 2002). Moreover, the first study shows that amongst the regions of EU-16, the majority of the UK’s (and in particular England’s) is synchronized with those of Sweden and Finland only (Figure 1). Considering this, the macroeconomic costs, including those of policy misalignment may be very limited.

Figure 1: The clusters in the synchronicity of the business cycles across EU-16 regions. The colours represent the different clusters. As can be seen, the majority of the UK regions are clustered into those of Sweden and Finland (cluster 4). See Bandres et al (2017).
Source: Banco de Espana Working Paper No. 1702.

The area that has possibly received the most attention in terms of economic costs of a Brexit is related to trade, and the disintegration from the common goods-and labour market (I leave services aside since the level of integration in services remains very low). A priori, the costs of a divorce seem to be highest here. On the demand-side, the costs arise from a loss of access to a major consumer market with more than 300 million consumers, as well as from a potential drop in foreign direct investment (FDI). On the supply side, the costs originate from a break in supplier relations, cease in access to skilled workforce, and a drop in productivity spillovers and human capital exchange. The magnitude of the costs, however, is not clear since it depends on a number of factors. First and foremost, it is contingent on the exit trade deal (and bill) that the UK will reach with the EU. Currently, there is a high uncertainty regarding this (or any other form of) deal. Hence, not much can yet be said on this aspect.

Secondly, it will depend on the ability of the UK to redirect the trade flows towards new partners, new deals, and new multilateral agreements in order to compensate for some of the losses generated from the EU divorce. Finally, the cost will greatly depend on the ability of UK to innovate. Because, as history has shown, the economies that best survive structural breaks are those that adjust and innovate. And to do that, you need to look firmly ahead and have a flexible production sector that can quickly switch to new partners and trade models. In this regard, Germany’s quick adjustment in export strategy during the Great Recession might be the inspiration that is currently required.

Whatever the outcome of the negotiations, it will take quite some time before we know the extent of the final Brexit bill. At the moment, all the efforts should be devoted to envisioning a new model for the UK beyond the EU. Because the ability to adapt to the new ‘normal’ will be the decisive factor in tipping the balance between the success or failure of a Brexit, beyond the short-term costs that are inevitable in any structural breakup.

This article gives the views of the author, not the position of  LSE Brexit or the London School of Economics. 

Eddie Gerba (PhD) is a Distinguished Affiliate at the CES Ifo Institute in Munich. He is also a Visiting Fellow at the European Institute and has previously held the position of Fellow in Macroeconomics there.

Keeping zero tariffs is good economics, but the EU’s political interest matters too

Tariffs are a key element in any trade deal negotiated between the EU and the UK. Ozlem Taytas Ozturk (LSE) explains why and writes that while a zero tariff arrangement is in the economic interests of all the business sectors involved, the final deal may be swayed by politics. The EU may impose some tariffs in order to discourage non-EU countries from seeking a better deal with the bloc, and discourage restless members from leaving.

Because the UK is currently a member of the EU’s Single Market and customs union, there are no tariffs applied in its bilateral trade with the EU. This has enabled both parties to develop supply chains and fragment their production processes across the Single Market for more than 40 years. The UK also applies the Common External Tariff (CET) on imports coming from other countries outside the Single Market.

As the second phase of Brexit approaches, the UK and the EU will negotiate a prospective trade deal which is expected to enter into force after the transition period ends in December 2020. What will happen to tariffs in the context of this deal? Which option seems most favourable for both parties?

The negotiations will have to address tariffs. The sectors most affected by the UK’s exit from the EU are motor vehicles, chemicals, pharmaceuticals, machinery, electronics, food and drinks, because these are the most important sectors in EU-UK trade. All of these sectors in the UK and the EU would like to maintain their current tariff-free access to the other’s market.

Tariffs are important because of the complex value chains between the EU and the UK. This means multiple imports and exports of goods between these two parties throughout the production process. Tariffs on intermediate goods would therefore have a cumulative effect on final costs, to the disadvantage of producers and consumers. Failing any agreement between the EU and UK the default would be WTO tariffs. While the average WTO-bound tariffs are very low for the EU, they can be significantly higher for some products (WTO 2017). Therefore, it is important to make sure that they do not create an additional burden.

It is easier to measure the total costs of imposing tariffs on the bilateral trade between the EU and the UK compared to other regulatory measures. Given that both parties are developed economies and have low levels of Most Favoured Nation (MFN) tariffs in general (WTO 2017), other trade costs associated with non-tariff barriers and customs procedures are likely to create more hurdles in the forthcoming negotiations. However, this does not mean that tariffs do not have any significant impact. On the contrary, they may be an important bargaining tool, especially to get concessions in other areas.

The continuation of zero tariffs seems to be the best scenario for both parties – whether as an EEA member, in a customs union or a comprehensive free trade agreement (FTA) such as a CETA+ deal. Each of these models poses a number of difficulties for at least one of the parties. Nevertheless, taking into account the stated positions of both sides, the most probable option would be an FTA with zero-tariffs for all sectors.

Reverting to WTO rules and MFN rates is the worst-case scenario and the least efficient in welfare terms. Obviously, given that the starting point of these negotiations is no tariffs at all, introducing MFN rates to the bilateral trade would be a serious setback. Furthermore, under WTO rules the UK will lose its competitive advantage in the EU vis-à-vis the other 67 FTA partners of the EU. This poses a significant threat, and is a major reason for the UK to avoid this option.

It is clear that from the economic point of view, continuing the status quo is the best option for tariffs, but political aspects are also important. First, the EU may want to discourage its remaining 27 members from toying with the idea to leave the EU in the future. Thus, the EU may decide to impose some tariffs, even though it is not meaningful or desirable for both parties in economic terms.

Second, as mentioned before, the EU may want to use tariffs as a bargaining chip for the rest of the agreement. In this context, in exchange for allowing zero tariffs, the EU may limit the market access in trade in services or introduce some restrictive measures for customs procedures or other non-tariff barriers in their bilateral trade with the UK. The UK may also regard this as an effective negotiation strategy. The scope and content of FTAs are shaped by precedent. The EU will therefore be aware that offering more to the UK is also likely to be followed for demands from its other trading partners for equivalent access.

Finally, the EU may have difficulty satisfying the sometimes conflicting demands of individual member states. While member states with a close trading relationship with the UK would like to be close to the status quo, others may favour more EU tariffs on UK exports.

Overall, a bespoke deal like CETA + seems to be the most likely outcome of the negotiations. Although both sides are probably willing to accept zero or near-zero tariffs, the final outcome depends on other issues too.

This post represents the views of the author and not those of the Brexit blog, nor the LSE. A fuller analysis is available here.

Ozlem Taytas Ozturk is a master’s student in international political economy at LSE.

Clean break? Why the Sanitary and Phytosanitary framework matters

nazli uysalAfter Brexit, Britain wants to be able to diverge from the EU’s Sanitary and Phytosanitary frameworks so as to negotiate new trade deals. But to sell into the Single Market, the UK will have to continue to meet EU standards. Nazlı Gül Uysal (LSE) examines how the government has tackled this conundrum.

Trade in agri-food between the UK and the EU is a vital part of the Single Market and has been central to the Brexit debate. The issue of Sanitary and Phytosanitary (SPS) frameworks remains an important yet under-discussed aspect of this trade.

On the day of Brexit and until the end of any transition period, the UK’s SPS regulations are identical to those of the EU and enjoy full recognition in the Single Market. After Brexit the UK will – if it wishes – be able to develop its own SPS framework, which includes measures intended to protect human, plant and animal health. Here, the fundamental trade-off Britain faces between regulatory autonomy and access to the Single Market will be crucial: While diverging from the EU’s SPS framework might facilitate new trade agreements with third countries, it will put an end to the regulatory harmony between the UK and the EU, given the EU’s uncompromising stance in this area. This means SPS measures will act as non-tariff (technical) barriers to trade, causing costs and delays. To minimise disruptions in agri-food trade and establish as comprehensive a partnership as possible, any prospective free trade agreement (FTA) would have to establish a formal framework for equivalence, or mutual recognition of conformity assessments.

To what extent will the UK choose to diverge from the Single Market’s SPS standards? As some argue, having the option to develop its own SPS measures following its departure from the EU offers an opportunity for Britain to move away from “non-tariff protectionism” and promote agri-food trade with countries often hindered by stringent EU standards. This could facilitate new FTAs that help reduce the UK food and agriculture sector’s dependence on the EU. However, it is doubtful whether the potential benefits of such agreements would offset the substantial losses from disrupted EU trade. Widespread concern remains that any divergence from high EU standards will mean lowering the UK’s SPS standards. Oft-cited examples include imports of hormone-treated beef and chlorine-washed chicken from the US; both have been banned in the EU since the 1990s on the grounds of the Community’s (contested) “precautionary principle.”

Even if the modified UK standards are not “lower” per se, any amendment after Brexit will essentially mean the UK’s SPS measures are no longer harmonised with (i.e. identical to) those of the Single Market. Consequently, administrative procedures such as customs checks and certification requirements for products – as well as production facilities – will be necessary in order to inspect whether imports comply with the EU’s standards. These costly procedures are likely to cause delays, which the Lords EU select committee has warned  “…would have a particularly strong negative impact on the agri-food sector, where products are often perishable and food supply chains are highly integrated across the UK and the EU.” For frictionless trade in agri-food to continue, it will be necessary to establish SPS measures’ equivalence, accepting each other’s (different) measures as equivalent; or mutual recognition, recognising each other’s conformity assessment procedures as equivalent.

Equivalence or mutual recognition would be in the interest of both sides, as they help minimise potential costs and delays. However, they are only possible if regulatory cohesion is preserved in essence, which limits the actual scope for divergence. The highly interdependent supply chains, salient business and consumer interests – as well as the particular fragility of the situation in Northern Ireland – further complicate the picture, making the prospects of divergence appear even more unfavourable.

As the implications emerged, both sides have made their positions known and found common ground regarding the undesirability of “no deal” – i.e. trade on WTO terms with rather rudimentary arrangements that would incur substantial costs. Theresa May has said the UK government aims for a ‘new, deep and special partnership‘ that goes beyond the existing “models” of EU trade agreements. In emphasising Britain’s shared commitment to high standards on the one hand, and the possibility of employing different means to achieve them on the other, May hinted that the UK will seek a balance between regulatory autonomy and market access as it tries to ensure trade with the EU is as frictionless as possible.

The draft guidelines put forward by the President of the European Council Donald Tusk suggest the EU’s preference, too, is to establish as close a partnership as possible. However, the guidelines underline that this partnership is likely to be limited in its scope, given the stated UK positions. The EU envisions an FTA that addresses the issue of SPS measures and decides the level of Single Market access based on the extent to which the UK’s substantive rules are aligned with EU standards, as well as whether the mechanisms to ensure proper implementation are adequate.

The Comprehensive Economic and Trade Agreement (CETA) with Canada – the EU’s most extensive FTA to date – has been put forward as a potential model for the prospective UK-EU FTA. But the British side has repeatedly rejected this model on the grounds that a CETA-style agreement would still mean a significant restriction on the pre-existing level of market access between the UK and the EU.

While CETA does establish specific rules for equivalence, streamlines approval processes, and facilitates cooperation through its Joint Management Committee for SPS measures, it nevertheless lacks mechanisms for harmonisation or mutual recognition of standards. Therefore, a CETA-style agreement based on voluntary cooperation would still entail significant additional costs and slash the level of market access both parties currently enjoy.

A bespoke agreement that goes further than CETA could certainly address the SPS issue by providing a formal framework to minimise disruptions due to post-Brexit modification of regulations. Moreover, given the UK is already fully compatible with EU standards – unlike Canada – it could be reasonable to put more emphasis on how future regulatory divergence will be assessed, rather than equivalence, as MEP David Campbell Bannerman suggests in his “SuperCanada” UK-EU comprehensive agreement proposal.

Thus, equivalence and mutual recognition of conformity assessments will be key to minimising disruptions in agri-food trade after Brexit. While a bespoke FTA agreement would seem to suit both sides, achieving it will be challenging.

This post represents the views of the author and not those of the Brexit blog, nor the LSE.

Nazlı Gül Uysal is pursuing a dual master’s degree in International Public Management and International Political Economy between Sciences Po Paris and LSE.

Outside the Single Market, what kind of deal can Britain’s services sector hope for?

john catalfamolaura artsProfessional and business services account for more than a tenth of the UK economy. Leaving the single market means it will no longer enjoy the passporting rights that give the financial sector smooth access to EU markets. John Catalfamo and Laura Arts (LSE) look at the limited options available to Theresa May as she tries to reconcile Brexiters’ demands for regulatory autonomy with the need to negotiate access to the Single Market.

One of the most economically significant and complex aspects of the post-Brexit EU-UK free trade agreement (FTA) negotiations is that of services. While negotiations over trade in goods can vary in complexity from simple tariff rates to full regulatory convergence, services negotiations are invariably complicated, requiring sector-by-sector negotiations over the specific “behind the border” regulations and requirements that affect the provision of services. The future of EU-UK trade in services is not only an intricate endeavour, but cuts to the heart of one of the central political issues of the Brexit referendum and the debate currently happening inside Theresa May’s government: how much regulatory autonomy should the UK be willing to defer to the EU in return for market access to the European Single Market?

Services in the UK economy and in EU-UK trade

As a services-oriented economy, the UK runs a large trade surplus in services with the rest of the world (4.7% of GDP in 2016). With financial services, the country is the world’s leading financial exporter in terms of net flows, with $95bn in financial exports in 2014 and UK financial institutions can currently do business elsewhere in the EU without setting up a subsidiary by way of EU “passporting rights” that give them access to EU markets. Over 5,400 British firms rely on passporting rights to bring in £9bn in revenue every year.

lunch hour london

Lunch hour in London SE1, 2014. Photo: Henry Hemming via a CC BY 2.0 licence

The professional and business services (PBS) sector is another major part of the UK services sector. It accounts for over 11% of the British economy, employing almost four million people, and 36 of the top 50 UK law firms have offices in 25 of the 27 EU Member States. In 2015, over £20bn (32%) of the UK’s PBS exports went to the EU, and it imported over £15bn. Given the size of these cross-border flows, access to both the EU and third markets for services is critical for the British economy.

Services and the Single Market

The intra-EU provision of services is a critical component of the Single Market (SM). Given that the EU and its SM is as much a political project as an economic one, and that part of its resilience is the preservation of benefits for its members, the EU has established that it will not let the UK “cherry pick” the parts of the SM to which it wants access, and those from which it will diverge. At the same time, Theresa May announced in January 2017 that the UK would leave the SM, ensuring a “clean” Brexit, while maintaining the “freest possible trade” with EU countries.

Given the logic of a single regional hub for most of Europe’s financial transactions, financial services and PBS providers in both the EU and the UK stand to lose significantly if the UK’s access to the EU markets is revoked or obstructed, as this would lead to substantial transaction costs and other inefficiencies.

For the European financial system, retail banking is less likely to be affected by Brexit than wholesale banking, as it is less cross-border in nature. Within wholesale banking, over the counter (OTC) products and corporate lending and deposits are most likely to be affected, as they depend on recognition of equivalence under MiFID II or access to single passporting rights. Other products – such as payments, advisory services, and exchange traded products – are less vulnerable.

The key tension May’s government must balance is between regulatory autonomy and market access. On one side of the debate are those who benefit greatly from market access to the services SM. On the other side are the “hard” Brexit supporters who emphasise the importance of British regulatory autonomy and trade negotiation authority. Yet these two options are mutually exclusive. Full access to the SM necessitates a degree of regulatory convergence. Likewise, prioritising regulatory autonomy would mean foregoing the single market in services.

Possible post-Brexit frameworks

For financial services and PBS, the UK’s future trade relationship with the EU depends on whether it will remain in the SM or not. If it decides to leave, it will have potential options. It can either secure a mutual recognition agreement with the EU, in which specific services sectors would be reviewed by a committee set up through the agreement to determine the commonalities of the parties’ regulatory regimes. Another option is equivalence, which is a unilateral determination by the EU that a third party’s regulatory regime is equivalent to EU regulations. The EU retains the authority to revoke equivalence at its own discretion with only 30 days’ notice. If the EU and UK fail to reach any sort of agreement for services, trade in services would revert to WTO rules, in which the UK’s access to the single market would be that of any other third (non-EU) country that does not have a free trade agreement with the EU that covers services.

WTO rules

An outcome in which WTO rules dictate the EU-UK trade relationship would be the most extreme example of regulatory autonomy with limited market access. The UK would be completely unburdened from the EU’s regulatory authority, but it would lack any preferred access to the SM. No major stakeholder has advocated this position.

CETA

The Comprehensive Economic and Trade Agreement (CETA) substantially integrated the Canadian and EU markets, but it would represent a significant downgrading from the access that the UK currently enjoys. While CETA liberalised some trade in services, it contained a wide array of carve-outs and exceptions, and while the UK could potentially trade in PBS under the auspices of equivalence, the Commission could rescind equivalence at its own discretion. For financial services, a CETA-style agreement would not give the UK single passporting rights – meaning that it would lose its ability to do business in all EU member states without establishing subsidiaries or proving equivalence.

CETA+

A CETA+ agreement would likely fall somewhere between EEA membership and a CETA-style agreement. The ‘plus’ could imply improved coverage of services, particularly financial services. Under such an agreement, the UK could try to secure mutual recognition that covered professional qualifications and licensing for various sectors from its inception. But any deepening of services commitments under a CETA-Plus agreement would trigger unconditional Most Favoured Nation (MFN) clauses in the EU’s other FTAs covering the market access aspects of cross border services and investment (such as CETA). However, this unconditional MFN may not apply to any EU-UK mutual recognition agreements.

Customs Union membership

Customs union membership has been discussed as a post-Brexit option for goods, but without an FTA covering services it would revert trade in services to WTO rules. The customs union provides for a common external tariff and no internal barriers to trade in goods, but nothing for services. Given how important PBS and financial services are to the British economy, UK negotiators are unlikely to favour this option.

EU Association Agreement

The association agreement between the EU and post-communist Eastern European countries like Ukraine offers the latter an opportunity to begin the regulatory convergence process with the EU, as the first steps to membership. As such, the nature of the EU-UK relationship is fundamentally different: while an association agreement aims towards regulatory convergence, the UK aims for managed divergence away from EU regulations. However, unlike European Economic Area (EEA) membership, an association agreement not only demands applying EU rules, but also depends on the EU granting equivalence for them. In addition, the party must agree to adopt any future SM services regulations immediately – which would likely defer more regulatory power to the EU than the hard Brexit supporters could stomach.

EEA membership

An EEA agreement would be the most minimal shift from the UK’s current position as a member of the EU, and it is the framework under which Norway, Liechtenstein and Iceland operate. EEA countries have access to the SM for services but are outside the customs union and have the opportunity to negotiate their own FTAs. However, these countries must adopt all SM regulations into their national laws and are not given a seat at the table when the regulations are devised, acting as ‘rule takers’ rather than ‘rule makers.’ May’s January 2017 speech probably ruled out EEA membership for the UK, as it clashes with her aim of a “clean” Brexit.

Conclusion

Options like EEA membership, WTO rules, and standalone customs union membership are unlikely to garner much support from relevant stakeholders. Either they give too little market access for services (WTO rules or a customs union) or they defer too much regulatory authority to the EU (EEA membership). A CETA, CETA+, or an association agreement might placate the different factions within the UK while offering a palatable option for the EU. However, MFN clauses in the EU’s existing FTAs mean that concessions to the UK would translate into matching concessions to all the EU’s FTA partners. While both sides are now seriously considering the merits of CETA or CETA+, equivalence and mutual recognition are still major stumbling blocks.

This post represents the views of the authors and not those of the Brexit blog, nor the LSE.

John Catalfamo (@John_Catalfamo) is a Masters student in International Political Economy at the LSE.

Laura Arts is a Masters student in International Affairs in the joint degree programme with the LSE and Peking University.

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