Vol. 40 No. 21 · 8 November 2018

What would it be like?

Swati Dhingra and Josh De Lyon on the realities of a No Deal Brexit

2866 words

More​ than two years after the referendum, there is still a possibility that the UK will fail to reach a withdrawal agreement and an agreement on future relations with the EU. If a deal cannot be reached by 29 March next year, when the UK will cease to be a member of the EU, the consequences will be severe; many of them will also follow if a withdrawal agreement is reached but not an agreement on future relations.

Aggregate economic impact. Credible reports, including those by the government and the LSE’s Centre for Economic Performance (CEP), predict that the long-term impact of No Deal on the UK economy would be a permanent reduction of output because barriers to trade – tariffs, border costs and regulatory divergence – between the UK and the EU would be higher. The estimate is that by 2030, UK GDP will be between 3 and 8 per cent lower than it would have been had the UK remained in the EU. These studies judge that the cost to the UK economy of a No Deal Brexit would be greater than that of every other possible option. It is difficult to quantify the short-term effect because the changes would be so abrupt and volatile, but substantial disruption is inevitable.

Local economic impact. The CEP estimates that, on average, No Deal would lower the long-term gross value added in local authorities by 2 per cent every year, compared to 1 per cent under a soft Brexit. This figure takes into account reduced trade as a result of higher trade barriers, but does not take into account the effect of firms relocating outside the UK. Places like London and Aberdeen that rely heavily on service industries are expected to be hardest hit by reduced trade. Northern areas, for example towns such as Burnley and Barnsley, that are less reliant on services trade with the EU, are likely to see smaller negative effects. Even though the immediate negative impact will be smaller, areas outside the South of England and urban centres may find it considerably more difficult to adjust because they are poorer to start with. That was one lesson of the financial crisis: London and the South-East were hardest hit, but they recovered much more strongly than less affluent areas.

The value of the pound. On referendum night, the pound plummeted when the result became clear. It was the biggest depreciation in any of the four major currencies since the collapse of the Bretton Woods system in the 1970s – bigger than Black Wednesday or the financial crisis. Since the referendum, the value of the pound has changed in line with the likelihood of No Deal. Whenever it seems more likely that the UK will leave without a deal, the value of the pound falls. The Bank of England’s Monetary Policy Committee recently stated that there has been an ‘increase in perceived downside risk to the exchange rate’ among City traders as a consequence of the increased probability of No Deal. If a deal isn’t reached, the pound is likely to take a further hit.

Prices. Inflation has already risen as a direct result of the referendum. The annual rate of Consumer Price Index (CPI) inflation has been above 2 per cent since February 2017; in the year preceding the referendum it remained under 0.5 per cent. This increase has been driven by the fall in the value of the pound, which has made imports more expensive. In the case of No Deal, barriers to trade would increase sharply, causing the cost of imports to rise further. Many imports are of parts needed for production taking place in the UK, so the cost of production and therefore prices would also rise.

Real wages have returned to negative growth as a result of the higher price of imports. New research from the CEP shows that businesses have responded to more expensive imports by cutting back on wages and the education and training of workers. This trend is likely to continue under No Deal because cost pressures on businesses would rise further.

Investment, in particular foreign direct investment (FDI), is expected to fall if no deal is reached. The CEP estimates that FDI would fall by about 20 per cent, which could reduce UK GDP by about 3.5 per cent a year, compared to expected levels if EU membership continued. The UK’s role in the global economy and its market access abroad would be unclear. Most important, the UK would lose access to the EU Single Market, which businesses often cite as their most important reason for investing in the UK. Many businesses have stated that they will move their offices or headquarters abroad if the UK and EU do not reach a deal. Toyota, for example, says it will end production at its Derbyshire plant for an indefinite period, and EasyJet has already announced that its new European headquarters will be in Austria.

Government finances. It is likely that the UK’s credit rating would be downgraded following a No Deal Brexit, though recent evidence suggests that this wouldn’t significantly affect the government’s ability to borrow. There would be structural changes to government revenue and to the budget. The UK would stop making fiscal contributions to the EU and would be able to generate some revenue by imposing tariffs on imports. However, reduced business activity and lower wages would reduce domestic income, and this is expected to be much more significant than the net fiscal savings, which amount to less than 0.5 per cent of GDP.

Monetary policy. Real wages are falling and No Deal is likely to exacerbate this trend. The governor of the Bank of England, Mark Carney, has said that the Bank ‘would look to do what we could to ease that scenario but there are limits to what we can do’. Another round of quantitative easing could be used to stimulate the economy. But as Silvana Tenreyro of the LSE, a member of the Monetary Policy Committee, noted, inflationary pressures could make it difficult to return to lower interest rates. The only certainty here is that under No Deal, Brexit would be the key factor in UK monetary policy.

Industrial policy. The government has issued 105 technical papers on how to prepare for No Deal. They include advice to businesses on exporting and importing from EU and non-EU countries, since firms will face new administrative burdens. The government has stated that it will transpose the EU’s state aid rules (these make it illegal for EU countries to give help to some companies and not others) into UK legislation to ensure that subsidies do not undermine competition and burden taxpayers.

Trade rules with the EU. Under World Trade Organisation rules, each member must grant ‘most favoured nation’ market access, and charge the same tariffs, to all other WTO members. The only exceptions are that preferential market access can be given to developing countries and to those that have signed free-trade agreements. Consequently, trade with the EU would be subject to the same tariffs, customs checks and regulatory checks that the UK and EU currently impose on third countries such as the US, China and Brazil.

Tariffs. UK exports to the EU would face the same tariff rates as any other country with which the EU does not have a trade agreement. In sectors such as agriculture, these tariffs are very high; in others they are quite small. The UK could choose its own tariff rates for imports but it would not be able to grant preferential treatment to the EU unless a trade agreement were reached.

Non-tariff barriers. The EU has a system of mutual recognition of standards and regulations. This means that member states must allow goods that are legally sold in another member state to be sold in their country. Without a deal, customs and regulatory checks would be required for trade between the UK and the EU-27. The cost of sticking to these rules would be high for businesses and government. For example, non-tariff barriers between the EU and the US are estimated to add 20 per cent to the cost of goods and services.

Trade flows with the EU. Barriers to trade between the UK and EU will inevitably rise and there is complete consensus among economists that this will lower the volume of UK-EU trade. Estimates suggest that it could fall by as much as 40 per cent under No Deal, and the fall probably won’t be offset by increased trade with non-EU countries. It is thought this will reduce UK output by 2.7 per cent in the long run.

Trade agreements. After it leaves the EU, the UK will be able to negotiate its own trade agreements. It will have more flexibility in its negotiating position but it will also lose the clout of belonging to the largest trading bloc in the world – its bargaining power will be reduced. The economic gains from new trade agreements with non-EU countries will, it is estimated, be substantially outweighed by the economic costs of separating from the EU. This is unsurprising since the UK’s volume of trade with the EU is large, relative to other countries. Exports to China and India, for example, make up less than 5 per cent of UK exports. These would need to rise by 400 per cent as a result of new trade agreements to make up for the expected reduction in exports to the EU under No Deal. The UK would also lose the trade agreements it holds through its EU membership. The EU has trade agreements in place or partly in place with 82 countries, from countries with large economies like Canada, to smaller developing economies like South Africa, Ghana and Peru, plus pending agreements with 22 countries and negotiations with a further 21, including China and India.

Customs authority. A quarter of a million small businesses will be asked to start making customs declarations. The UK will also need to add to its five thousand customs staff. HMRC has said that, in the case of No Deal, it will need to double that number; more than 1100 new customs staff have already been hired.

Ports. Dover in particular is likely to be heavily affected, since almost all the goods that move through it are heading to or from the EU. Currently, as few as two lorries out of 180 are checked. Research suggests that an extra two minutes spent at the border by each vehicle could more than triple the queues on nearby major roads to 29 miles, resulting in almost five-hour delays. In anticipation of this, a recently leaked local government report outlines plans to turn a 13-mile stretch of motorway into a lorry park and goods holding area in an attempt to ease the gridlock, and suggests it could be in use until ‘2023 at the earliest’.

The Irish border. A No Deal Brexit would cause serious concerns over the peace and stability of Northern Ireland. Currently, membership of the EU Customs Union and Single Market helps to ensure frictionless trade across the Irish border. No Deal would mean a hardening of the border, probably involving a physical manifestation – such as cameras or border infrastructure. There is very little support among the public in Northern Ireland for No Deal.

Supply chains. Many businesses, particularly in manufacturing, depend on complex cross-border supply chains and ‘just-in-time’ parts delivery. Increased trade barriers, uncertainty over delivery times and having to comply with multiple sets of regulations would be costly to these firms, which might decide to restructure or to relocate their supply chains or production plants. Notable examples are aerospace firms such as Airbus, major car manufacturers such as Nissan, Toyota, Jaguar Land Rover, BMW, Ford and Vauxhall, and car parts suppliers such as GKN. They operate on short delivery and production schedules, with parts often delivered less than an hour before they’re used – a system designed to maximise efficiency.

Regulation and laws. In the event of No Deal, MPs will have to pass between eight hundred and a thousand new statutory instruments through Parliament in a matter of days on urgent matters such as safety certificates for airlines and instruments that enable financial contracts to be enforced. Given the short timeframe, it is likely that many of these will be drafted directly from EU law.

Migration. No Deal could affect both UK citizens living in the EU and EU citizens in the UK. The future of EU citizens living in the UK would be relatively secure because the main provisions of EU law on the freedom of movement of people have been incorporated into UK law. They would continue to have the right to live and work here unless the government changed the legislation. As regards future flows of migrants between the UK and the EU, each state would be able to determine its own rules.

Services. The UK’s hugely important exports of services (R&D, legal services, administrative and support services etc), which exceeded the value of services imports by £111.5 billion in the year leading up to May 2018, would suffer. The OECD suggests that, on average, EU barriers to services trade with non-EU countries are four times greater than the barriers within the Single Market. Cuts in wages and training are already most pronounced in the service industries that have suffered disproportionately from the fall in sterling because of their greater reliance on international supply chains.

Financial services. Financial firms would lose passporting rights, which allow them to trade in EU countries without regulatory barriers, making it much more difficult for them to sell financial products to EU-based companies. This would also affect companies from countries such as the US, which use UK offices to sell to EU markets. The result may be a contraction in the UK financial sector. J.P. Morgan, for example, plans to move at least four thousand of its 16,000 UK staff abroad; its commercial banking will move to Luxembourg and its investment banking and markets business to Frankfurt.

Car industry. As many as 56 per cent of the cars made in the UK are exported to the EU. Crucially, the car industry depends on constant supplies of parts, often from producers in the EU, for ‘just-in-time’ production. Honda, for example, uses 350 trucks to carry two million components to its Swindon plant every day. Any increased uncertainty in delivery times as a result of customs delays and higher trade barriers would be hugely costly to the car industry and is predicted to result in a drop in UK production of 12 per cent.

Retail companies such as supermarkets, medical supply networks and online outlets also depend on ‘just-in-time’ supply of goods and would be similarly affected by No Deal.

Agriculture. About 70 per cent of the UK’s agricultural imports – representing about 30 per cent of total consumption – come from the EU and 60 per cent of its agri-food exports go there. EU tariffs on agricultural goods from non-member states are as high as 84 per cent on meat, 74 per cent on dairy and 63 per cent on grains. Once outside the EU, the UK could unilaterally reduce these tariffs to keep food prices low at home and to promote its development agenda. But this would expose local farmers to cheaper imports. UK farmers could face a shortage of workers: a large proportion are EU nationals. Special visas for agricultural workers would be needed to cover the immediate shortfall.

Fisheries. After No Deal, the UK would no longer have to comply with the Common Fisheries Policy. The likely impact is mixed: UK vessels dependent on access to other member states’ waters or, more important, to EU markets would suffer; those fishing primarily in UK waters who sell to the domestic market might benefit.

Aviation. Brexit in any form will be disruptive for airlines, but a failure by the UK and the EU to reach an agreement would leave the industry in chaos. There is no WTO safety net in aviation because the sector has its own system of regulation. In Europe – the UK’s biggest market – the EU has created a regulatory order that combines liberal access to international markets for airlines with high safety standards and advanced passenger rights. The EU has also negotiated bilateral agreements with countries including the US and Canada, so the rights of UK airlines to serve these markets are regulated by EU agreements.

The NHS and the pharmaceutical industry. First, there is the prospect of delays in access to medical supplies. This is particularly important for products that are not currently produced in the UK, such as human insulin. Second, the UK would no longer be part of the EU drug approvals process. Third, the European Health Insurance Card (EHIC), which gives the right to access state healthcare in another member country, will cease to apply, meaning that people travelling to the EU after Brexit would be strongly advised to have medical travel insurance.

Energy and the environment. Many long-term environmental policies depend on co-operation between countries to avoid cross-border leakage – production leaving areas that have strong environmental regulation for countries where regulation is weak. The European Union (Withdrawal) Act 2018 incorporates EU environmental regulations into UK law, so the UK will continue to be bound by international environmental commitments in the event of No Deal.

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