How Not to Do Trade Deals

Swati Dhingra and Nikhil Datta

About half of Britain’s trade and investment is with the EU, and currently, as members, we implement almost the same standards for products and services. One of the few concrete things stated in the government’s white paper on Brexit was its intention to establish UK trading schedules – including import tariffs and quotas – at the World Trade Organisation, replicating ‘our existing trade regime as far as possible’. If no trade deals were struck with the EU after Brexit, the EU and UK would need to charge each other the tariffs they charge other WTO members. The average tariff rate is low – around 1.5 per cent – but some products attract higher tariffs. Cars, for example, incur a 10 per cent tariff, which the head of European manufacturing at Nissan stated would be a ‘disaster’ for the UK industry.

Tariffs also have an effect on the price of food. The pound’s loss of around 10 per cent of its value after the Brexit referendum may have benefited certain export industries and increased the number of tourists coming to the UK, but food price inflation – which until Brexit had been negative – contributed to overall inflation hitting its highest level in four years, at 2.9 per cent. Food price inflation has a significant impact on living standards, especially for those on lower wages who spend a larger proportion of their income on food. Evidence from the Resolution Foundation suggests the real wages of around 40 per cent of the workforce are falling, so many people are already feeling worse off. Agricultural products imported into the EU have very high tariffs: meat can be as high as 84 per cent, dairy produce up to 74 per cent and grains 63 per cent. Since 71 per cent of the UK’s agricultural imports currently come from the EU, if no new trade deal is reached, UK food prices are likely to rise even higher. And UK farmers will also suffer, since the current annual figure of €16.1 billion of agricultural exports from the UK to the EU is bound to drop.

Hard Brexiters often see leaving the EU as an opportunity to drop tariffs completely, which could reduce prices for British consumers. When it’s no longer a member of the customs union, the UK would be free to set its own tariffs, or could unilaterally decide to abolish them. But tariff levels are an important bargaining chip: if the UK drops its import tariffs without getting reciprocal access to foreign markets, it would be hard for prices to fall enough to make up for the job losses incurred in industries that would face competition from imports. Since tariffs are higher in manufacturing, higher job losses would be likely in areas of the UK that are already in economic difficulty.

The customs union binds all members to charge the same common external tariffs, so ensuring that members don’t import goods from outside the trading bloc using lower tariffs, and then export them into the single market, bypassing other members’ tariffs. Goods exported to the EU from Norway and Iceland, which are members of the single market but not the customs union, have to go through customs checks to ensure that the goods were indeed (largely) made there. The cost of complying with customs checks is estimated to amount to about 8 per cent of the value of an import, with almost all this the result of the extra paperwork. Even firms that already meet the necessary standards will have to bear these compliance costs. Since the EU has one set of ‘rules of origin’ that applies to members of the single market outside the customs union – Iceland, Liechtenstein and Norway – and to those with Free Trade Agreements, like Switzerland, the current situation of Norway can be used to assess the impact that these checks could have on trade. A survey by the Swedish National Board of Trade of almost a thousand businesses found that Norway ranked top along with Russia as a problematic trading partner: 70 per cent of those companies which found trade with Norway problematic singled out ‘incredibly cumbersome’ customs handling and rules.

Such rules would have a severe effect on the UK car industry, since 56 per cent of the cars made in the UK are currently exported to the EU. The UK supply chain is highly integrated with the EU, with some car parts crossing borders about forty times. As a result, car makers and the government would like a sector-specific trade deal, that keeps the tariffs on cars and car components at zero and counts components from EU countries towards the rules of origin. But the UK and the EU can’t sign a deal that removes tariffs on cars and no other sector. To prevent countries cherry-picking and discriminating against other members, the WTO only recognises bilateral trade deals that cover almost all forms of trade between the signatory countries. A zero tariff deal for the car industry is therefore unrealistic.

Firms that operate tight production schedules and have complex supply chains, such as the car industry, depend on parts passing through customs quickly and easily. Both Nissan and Jaguar Land Rover operate a ‘just-in-time’ supply chain: for some components they keep available only the amount of stock used in a two-hour period. Even very brief customs disruptions could effectively halt production in plants that produce two cars every minute.

To pre-empt this problem, the UK could increase the number of customs staff it employs. HMRC is woefully understaffed compared to similar sized countries and totally unprepared for the extra work involved in being outside the customs union: the UK has about 5000 customs staff while Germany employs more than 35,000. The UK will also need to open British versions of EU regulatory agencies. The cost of setting up a UK version of the European Aviation Safety Agency has been calculated as £400 million over a decade, and this is just one of almost forty agencies. It’s possible that some EU regulators will continue to be used by the UK, but this would mean the UK would be answerable to the European Court of Justice, and this was expressly ruled out in the white paper and in Theresa May’s recent statements.

Many of those lobbying for Brexit saw the supposed ability to cut red tape as a key element of ‘taking back control’. But signing any trade deal involves giving up some amount of sovereignty. As a WTO member, the UK agrees to bind its tariffs to rates agreed with other members and to respect the judgment of the WTO’s dispute settlement body.

To sustain trade volumes at current levels requires trade deals that keep non-tariff barriers low by reducing divergences in standards and streamlining conditions imposed on foreign operators. Enforcing similar policies across markets effectively turns a free trade area into a single market where goods and services can be provided with the assumption that they meet the necessary requirements. Countries trying to make a trade deal have to agree on similar sets of standards and oversight policies that can be mutually recognised. If partner countries have similar preferences over standards, it’s much easier to make trade deals without giving up much sovereignty. For instance: the UK gives up some sovereignty when it applies the EU’s Toy Safety directive. But the loss is small because the safety concerns of UK consumers are similar to those of EU consumers. Following a common standard also enables UK businesses to sell goods in the EU without additional verification, and this reduces the non-tariff costs of trade to businesses. For some sectors, including food processing and pharmaceuticals, the value of applying similar standards is that it lowers the risk of cross-contamination from batches intended for a different market and ensures that all businesses are treated equally.

There won’t be much change to start with in the regulation of many products that currently carry the ‘CE’ (Conformité Européene) marking, and the UK could make a mutual recognition agreement with the EU covering electrical goods, machinery and medical devices, as countries such as Australia, Canada and the US have done. In the longer term, however, if UK standards diverge from EU ones, British businesses may have to produce two different product lines, one for the UK and one for the EU; this would be costly and reduce competitiveness.

A larger problem is trade and foreign investment in the services sector, which makes up 80 per cent of the UK economy. There are no tariffs on services: non-tariff barriers are the main hurdle. Access to the single EU aviation market, for example, requires a company to have its headquarters and majority shareholdings located within the EU, so that the EU can have regulatory oversight on safety. This could have an impact on companies such as easyJet, which recently announced plans for a new business, easyJet Europe, that would have its headquarters in Vienna. Even if the UK is recognised by the EU as having an equivalent regulatory regime, it could be cost-effective for some firms to relocate if the UK doesn’t keep pace with changes in EU regulations. The government’s recent position papers give no detail on how mutual recognition agreements will accommodate future changes in EU rules. Estimates of the ‘trade cost equivalent’ on services thanks to non-tariff barriers range from 8.5 to 47.3 per cent for trade between the US and the EU. The UK could expect to see some of these costs applying to its trade with the EU after Brexit.

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As tariffs and the cost of non-tariff barriers rise, studies based on detailed customs data estimate that UK-EU trade will fall by between 13 and 40 per cent, depending on the level of market access negotiated. Brexit supporters are banking on outside trade deals cushioning this fall. Discussions of reawakening trade with the Commonwealth, striking deals with developing nations and strengthening the trade relationship with the US are common. With Britain on its own, the argument goes, it will be easier to strike deals, as bilateral agreements should be more straightforward than a deal between 29 countries.

But trade deals, even between two countries, take time and diplomatic resources. Which deals should the UK prioritise and what should they look like? The most discussed contenders are a new deal with the EU, deals with China and India, populous, quickly developing nations, and with the US, whose GDP is almost the same size as the EU’s.

It would be sensible to prioritise a trade deal with the EU. Countries have always traded the most with their biggest, closest neighbours. This is by far the most reliable fact about international trade and holds true no matter which set of countries, time period or sector (goods, services, e-commerce, foreign investments) is looked at. Given that the EU is within swimming distance from the UK, has a population of more than 500 million and a GDP of almost $20 trillion (double that of China), an equivalent replacement is effectively impossible. EU standards on goods and labour are more acceptable to British people than those in the US, China and India, even if Jacob Rees-Mogg told the Treasury Select Committee last year: ‘We could say, if it’s good enough in India, it’s good enough for here … We could take it a very long way.’ But if we want trade deals that reduce non-tariff barriers without compromising domestic standards, it will be harder to achieve with the US, China, India et al than with the EU.

Currently, 3 per cent of UK exports and 7 per cent of imports are with China, so trade with China would have to increase ten times to get anywhere near the levels we have with the EU. The economy most like the UK’s to have a deal with China is Switzerland. The deal took nine negotiation rounds and around four years of talks. Swiss tariffs on Chinese industrial products, shoes and textiles were removed immediately, whereas Chinese tariffs on Swiss exports are being dismantled in some cases over a 15-year period, while other sectors like machinery and chemical products are keeping their tariffs. As a report by Lalive, a Swiss law firm, makes clear, the agreement ‘is more favourable to Chinese exports’, and a survey conducted by the Swiss Chamber of Commerce two years after its introduction concluded that ‘the FTA is not very attractive.’ In that survey, 89 per cent of respondents claimed that the agreement had had no clear effect so far, and that the biggest problems they faced were red tape, time delays and customs officers’ lack of knowledge. The deal did cover services, but didn’t really extend the already existing WTO services commitments. The most recent Swiss embassy report noted that service exports from Switzerland to China shrank by 0.3 per cent in 2015, dropping 1.3 per cent from the year before, during most of which the agreement wasn’t in force. The Swiss are not inexperienced in negotiating deals, so it seems unwise to expect a UK-China deal to create an export market that will replace the EU market.

Despite all this a UK-China deal could still lower costs of goods for UK consumers, but deep integration with a country like China, where labour is cheap and abundant and which has very different standards of safety and environmental regulation, is likely to hurt British blue-collar workers – the people who voted for Brexit. To avoid this the UK could insist on worker protection and consumer rights in its trade deals with developing countries. It could insist on social clauses in trade agreements that include the monitoring of safety standards, as the US has done with its Better Factories Cambodia project. But getting countries like China to agree to such clauses would be very difficult.

Similar concerns on the quality of regulations would arise in a future trade deal with India, which was the first stop on May’s Global Britain tour late last year. It might seem that Brexit would make a bilateral UK-India deal easier to accomplish because one obstacle that arose in EU negotiations with India would be removed: the UK, unlike the EU, may be happy to reduce tariffs on agricultural products from India. A deal with India is popular partly because UK trade with the subcontinent has been dropping. At the moment less than 2 per cent of UK exports go to India so, again, even substantial growth wouldn’t make a huge difference to export volumes.

UK businesses would like access to the Indian market in service industries such as law, insurance and finance. In January 2016, the UK reached an agreement on opening up legal services and infrastructure investments in India for UK businesses. But the Indians wouldn’t be keen on deep liberalisation in other sectors, like financial services, without getting reciprocal access for services that matter to India, such as information technology. This was a major sticking point during the EU-India negotiations, and May’s refusal as home secretary to reform visa rules for students and skilled professionals from India stalled EU-India negotiations as early as 2010. Since the Brexit referendum, the May government has if anything hardened its rhetoric on visas. A new trade deal is therefore not going to be as straightforward as it seemed before the prime minister’s visit to India.

While increasing trade with China and India wouldn’t go far towards making up for loss of trade with the EU, increased trade with the US might be thought to get us nearer plugging the hole. But here too there are problems. First, since import tariffs for both the EU and the US are already low (1.6 per cent), any expansion in UK-US trade would need a lot more regulatory harmonisation. There are some simple ways of reducing non-tariff barriers which the UK and the US could pursue: extending mutual recognition of technical standards and expanding labelling for food products. But many of these barriers reflect a clear difference in the two countries’ preferences. Regulation is aimed at ensuring quality, whether of employment, environment or of a product. Dropping the regulations preventing the import of hormone-fed beef or chlorine-washed chicken from the US may not be something the UK wants to do. Another hurdle to harmonisation with the US is the difference in the way new products are regulated. The precautionary principle in EU law, which has no counterpart in the US, holds that in the absence of scientific consensus, the burden of proof of the safety of a new product is on the company wanting to introduce it. US law, however, asks government agencies to show that a product is unsafe, rather than requiring companies to prove that it is safe, before it enters the market. It’s highly unlikely that the UK could get the US to switch to a precautionary policy and so a new trade deal that reduces non-tariff barriers would therefore mean abandoning that principle and following the US approach.

Another hurdle, probably the biggest one, is the investor rights that the US demands in deals with trade partners. Typically, the US insists on an investor state dispute settlement (ISDS) mechanism to settle disagreements between US firms and host governments. The ISDS gives foreign firms the right to bring claims against national or regional governments if they feel they have not been given fair and equitable treatment. The Calgary-based, Delaware-registered company Lone Pine Resources, for instance, has claimed damages for potential losses from the Quebec government’s moratorium on fracking. Although a decision is pending, this case has become the poster child for the ‘excessive’ powers that ISDS gives foreign firms, allowing them to undermine national and local government sovereignty, especially in socially sensitive policy areas like the environment, natural resources and public health.

The UK currently has about £250 billion worth of investment from the US, so any investment-related clause would have far-reaching implications for firms, workers and consumers. There is little evidence to show that ISDS clauses increase economic activity. An LSE study concluded that they expose the state to political costs, without providing much economic benefit. In a trade deal with Australia, however, the US accepted an agreement which settles such disputes within the domestic court system. Following the Australian example, the UK could try to improve on the agreement that the EU was negotiating with the US, which proposed less transparent ways of resolving disputes with foreign companies.

Counting on future trade deals with countries like China, India and the US to replace our existing economic ties to the EU is wishful thinking. We would be better off pursuing these deals as a long-term strategy. If the UK negotiated an interim arrangement like the one Norway has, outside the customs union but in the single market, we would buy a few years to negotiate better trade deals outside the EU. But such deals won’t do much to revive the stagnating wages of those who voted for Brexit.