UK's Brexit proposal pleases nobody but is an important step forward
The proposal seeks a softer Brexit for exporters of goods, but a hard Brexit for services.
The publication of the UK government’s white paper outlining its approach to Brexit marks a significant and long overdue step towards the UK leaving the European Union.
Negotiations with the European Commission have largely been on hold since the initial outline of the withdrawal agreement last November as the UK government could not agree on the direction of travel with regards to the customs union and single market access.
However, with time running out, Prime Minister Theresa May has pushed a softer version of previous Brexit plans with the agreement of the majority of her cabinet.
The so-called “Chequers agreement” overrode the position of the Secretary of State for Exiting the EU David Davis, forcing him to resign in protest. Following him was hard-core Brexiteer Boris Johnson (former Foreign Secretary), who is seen as a potential leadership challenger to May.
While softer than expected, the government’s white paper is still harder than what most consider as a soft Brexit and harder than EEA membership. Key features include:
- A free trade agreement for most goods including agri-food, with common rules on standards but with the ability of the UK parliament to diverge should it choose to.
- A new Facilitated Customs Arrangement, which would remove the need for customs checks and borders, but would require the UK and EU to charge the correct customs tariffs for goods travelling through one zone and heading for another.
- The ability for the UK to agree separate trade deals with other countries/regions.
- No free trade agreement for services, with the freedom to diverge on regulations. This is likely to lead to some loss of access to EU markets.
- End of free movement of labour. Reciprocal travel visas for tourism, short-term business travel and study.
- Ongoing participation in EU agencies such as the European Chemicals Agency, the European Aviation Safety Agency and the European Medicines Agency.
- A commitment to a common rulebook on state aid, keeping UK state aid at similar low levels to the past.
- A commitment to high environmental and climate change standards.
- Commitments to explore options for agreements for road transport, rail, energy, a civil nuclear relationship, maritime and aviation travel.
- The end of the jurisdiction of the European Court of Justice in the UK, but with an institutional framework taking the form of an Association Agreement between the UK and EU. This would be overseen by joint committees for dispute resolution.
Overall, the proposal looks like it sits somewhere between the Canada trade deal and the European Free Trade Association (EFTA), also known as the Swiss option.
With services making up 80% of UK output/GDP, and more than half of the UK’s exports, we are disappointed that the government has not pushed for a free trade agreement in services.
The government is right to highlight that only 38% of UK services exports are to the rest of the EU, and that the single market in services is far from complete. The government also argues that freedom to have regulatory divergence is important to maintain high standards and to grow the UK’s services exports elsewhere in the world.
While the paper does not specify any particular areas where divergence is required, we think that the government is anticipating a tightening of financial services rules, including the wider use of a Tobin tax (transactions tax) which the UK has opposed over the years.
Reduced market access for financial services
The government accepts that its position is not to replicate the “passporting” of financial services, and has now also dropped the proposal of mutual recognition of rules. Instead the white paper states “The decision on whether and on what terms the UK should have access to the EU’s markets will be a matter for the EU, and vice versa.”
It is clear that market access for the UK financial services firms will be materially lower, as the paper states that the government “…acknowledges that there will be more barriers to the UK’s access to the EU market than is the case today”.
For many financial services firms, especially investment banks, this is the hardest form of Brexit they could face. Initially, enhanced regulatory equivalence could keep the status quo going. The real danger comes from a possible change in rules on whether business can be done in the EU, but with risk management and hedging to still be done in the UK. If rules diverge materially, then business will certainly be lost to mainland Europe.
It is worth highlighting the importance of financial services to the UK economy. In 2017, the financial services sector employed 1.1 million people in the UK, 3.2% of all jobs.
It contributed £119 billion to the UK economy (6.5% of total economic output) with £23 billion or 19% directly attributed to the UK’s net trade in financial services with the EU.
Lastly, the sector is estimated to have contributed £72.1 billion in tax in 2017, or 11% of government receipts. Damaging financial services will not only lead to the loss of high value-added jobs, but also hurt public finances and public spending.
As for asset managers, they rely on the EU’s so-called “delegation” regime, which allows funds to be domiciled and regulated in an EU country, while being actively managed from outside the EU. The white paper has no mention of these rules, which in any case need not be affected by Brexit.
EU will push back on some proposals
Moving on to trade in goods, the pursuit of frictionless trade is admirable, and crucial for the preservation of the Northern Ireland peace deal. However, the practicality of the Facilitated Customs Arrangement proposal is highly questionable, and will leave the party with higher tariffs open to fraud. This will be one of the areas of contention for Brussels.
The end of the free movement of people (a divergence from the Swiss option) will be another as the EU will argue that the UK is “cherry picking”, and that the EU’s “four freedoms” (goods, services, capital and persons) are indivisible.
The European Commission is likely to push back and attempt to water down some of the white paper’s proposals, but it may also compromise on some areas that were previously seen as red lines.
Brussels will also demand additional annual payments to the EU budget in exchange for the level of access the UK has proposed. This is not currently being discussed, and will certainly anger Brexiteers, despite similar arrangements being in place for Switzerland and Norway.
Westminster split could lead to a cliff-edge Brexit
The reaction in Westminster to the proposals has been poor. The majority of Brexiteers are outraged, referring to the proposals as “the Chequers fudge” and the “…death of the Brexit dream”. Even US President Donald Trump has criticised May’s approach.
The problem for the prime minister is that the cabinet reflects a divided country on this issue. 48% of those that took part in the referendum voted against Brexit, and while some are now content with leaving the EU, the majority want a soft Brexit, which would include access to the single market and free movement of labour.
Meanwhile, Brexit supporters are split on these issues, but a worryingly large number are happy to see a “no-deal” or “cliff-edge” Brexit happen, as they argue that this would be the easiest and quickest route out of the Union. Moreover, they argue that this would allow the UK to negotiate from a clean starting position with the EU and the rest of the world.
Brexiteers complain that the UK will become a satellite state of the EU, being forced to be a rule taker without having any influence over how those rules are made. Of course, without offering an alternative solution their complaints only serve to highlight the benefits of the status quo.
Brexiteers are also being short-sighted. If they truly believe that the country agrees with their vision of a hard Brexit, then they should back the current proposal as it stands, then seek to change the relationship in the future. The current proposal sets out a Swiss-style arrangement, where most new rules introduced in Brussels will require either a bilateral agreement or a vote in parliament. This offers parliament the ability to reject a proposal from Brussels, though the consequences of such action may be the loss of the ability to trade in some areas.
The risk going forward is that the prime minister loses further support from both sides of the debate, potentially leading to a leadership challenge or even a general election. This would almost certainly delay Brexit proceedings, but could even lead to a cliff-edge Brexit at the end of March 2019.
Progress welcome but much uncertainty remains
For investors, progress from the UK side has to be welcomed, as the high level of uncertainty is paralysing businesses. Current infighting in the government is a concern, which is being reflected by a depreciation in sterling in recent days.
Compared to the current arrangement or a soft Brexit such as being a member of the European Economic Area (EEA), the proposal introduces a risk that at any point in time, a UK government could reject or even withdraw from an agreement, affecting trade and business. Clearly, this is negative for long-term investors who will demand an additional premium to compensate for such risk.
Finally, it’s worth noting that the white paper has tied the “Withdrawal Agreement” from the end of 2017 to the framework for the future relationship currently being discussed, “The UK and the EU have also been clear that ‘nothing is agreed until everything is agreed’”. Even at this late stage in the negotiations, and with clearly no majority in parliament to back a no-deal Brexit, the government still maintains the pretence.
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.