7,000 trucks backed up in Kent due to customs delays. Shortages of food and medicine supplies. Widespread social disorder. These were only some of the potential consequences of Brexit outlined in the government’s worst-case scenario planning.
The reality has been much more anodyne. Significant port disruption has been avoided. Food and medicine continue to flow unimpeded. And the economy is booming as Covid-19 restrictions are unwound: Retail sales surged through April, unemployment is falling, and the composite PMI hit a record high in May.
“Despite the Trade and Cooperation Agreement being settled at the eleventh hour, and anecdotes of challenges at the UK border, high-frequency data suggest these have mostly been teething problems and the drag on Q1 GDP looks to have been relatively modest,” say analysts at Goldman Sachs.
Over the coming quarters, the UK is seen growing faster in sequential terms than most European neighbors, spurred by its swift vaccine rollout and ample fiscal support. And in the longer term, British growth prospects also compare favorably to those of the EU, despite a tighter migration policy and a host of new trade frictions thrown up by the UK-EU FTA.
“A successful vaccine rollout, stable politics, aggressive policy support and a solid global backdrop set the stage for at least two years of rapid recovery,” predicts Kallum Pickering, senior economist at Berenberg.
“[In the long term] we still expect [the UK] to outperform many western European economies due to continued growth in labour supply [and a] leading position in several service sectors,” says Andrew Goodwin, chief UK economist at Oxford Economics.
Six months on from Brexit then, to the untrained eye the UK economy appears to have emerged relatively unscathed. So what exactly has changed?
- Out with the old, in with the new
While a headline-grabbing breakdown at border control was avoided, EU trade data has still made waves: Exports and imports to the continent plunged 41% and 29% respectively in January, with sectors such as textiles, food and cars particularly hard hit. There are mitigating circumstances—much of Europe was in lockdown at the start of this year, and some pullback was always likely following stockpiling in late 2020—but the data still suggested firms were struggling to digest the new rules.
Goods flows to and from the continent bounced back notably in February–April. Yet British companies still paid billions of pounds in avoidable tariffs in the first quarter. And even those which managed to dodge levies faced hefty amounts of new red tape.
“Since early January, some of the early sticking points appear to have been worked through. For instance, major hauliers have resumed UK-EU deliveries, having in some cases paused services in response to a significant percentage of consignments arriving without the correct paperwork,” says James Smith, economist at ING. “However, there are signs that firms are still struggling. […] So while some of the initial disruptions has since cleared, it’s likely that the effect of the new UK-EU relationship will take time to ripple through the economy.”
Trade with the rest of the world has been rosier. Imports from non-EU countries were up year-on-year in Q1—the first quarter since records began that inflows of goods from non-EU countries were higher than those from the EU. China has surpassed Germany as the UK’s biggest import market. However, the pandemic’s distortionary effect makes it too soon to say if this will prove a temporary trend, or a more permanent rewiring of supply chains.
On one hand, trade with Europe will certainly see a cyclical recovery as economies emerge from their Covid-19-induced slumber and companies grow more adept at navigating red tape.
However, further short-term disruption is likely when the UK finally introduces comprehensive import checks in 2022. Moreover, relations with Brussels are enduring a rocky post-divorce period, amid heightened tensions over everything from the Northern Ireland protocol to fishing rights. With political goodwill in short supply, a meaningful deepening of the trading relationship currently seems a distant prospect.
Consequently, the government has moved swiftly to search for other alliances. In early June, it announced a trade deal with Australia—the first substantial pact to be negotiated entirely from scratch. The plethora of other agreements reached in recent months amounted to little more than the rolling-over of the UK’s previous trade terms as a member of the EU.
Bigger fish are in the crosshairs. The UK has formally begun talks to join the CPTPP—a Pacific-Rim commercial agreement worth around 13% of world GDP. And London also recently said it would begin prepping for trade negotiations with India—slated to begin in the autumn. The extent to which the UK is able to deepen access to non-EU markets will be key to whether there is an enduring shift in trade away from the EU towards the rest of the world.
Regardless though, there are some things that no amount of trade deals with fast-growing Asia-Pacific markets will offset. Geographical proximity, cultural similarities, firms’ intimate knowledge of the others’ markets and the sheer size of the EU economy mean it will remain a key partner for the UK.
Plus, economic gains from strengthening ties with non-EU countries could be fairly limited in any case. The UK already has bilateral agreements in place with most CPTPP members for instance, and does relatively little trade with Australia and India. Even an FTA with the United States—the biggest of all post-Brexit prizes, albeit currently a remote one—would only boost long-run exports by 0.7%–1.3% according to government modeling.
- The crown slips
The reversal in fortunes was swift. Within a month of the UK-EU FTA coming into force at the start of this year, London had already lost its title as Europe’s largest share hub to Amsterdam, as trading in EU-listed firms moved overseas. Around EUR 9.2 billion of shares were traded on Dutch exchanges each day in January, against EUR 8.6 billion in the British capital.
The swaps market tells a similar story. Pre-Brexit, London held close to a 40% market share in euro swaps. In the last few months, that figure has plummeted to around 10%, as trillions of dollars of trading have moved to venues in the EU and U.S.
These are direct consequences of the lack of provisions for the services sector—responsible for around 80% of British GDP—in the new commercial relationship with the continent, which has led to the UK being largely shut out of the bloc’s financial markets. But London’s leading light was already waning well before Brexit: Since the vote to leave the EU in 2016, the City has lost one trillion pounds in assets and thousands of jobs, mainly to rival European financial centers.
“At this stage it is not clear whether these moves are the beginning of a trend whereby the UK loses more people and assets over the next few years, or a sunk cost that has been paid and a new interdependent relationship will emerge going forward,” say analysts at Goldman Sachs. “In part, the outcome will depend on the eventual deal the UK reaches with the EU, and on how stringent the EU will be at implementing the rules. There is a risk that the EU will try to build on these moves and attract more business functions away from London, with the objective to build up a number of strong financial centres within the EU.”
For now, the more pessimistic scenario seems to be bearing itself out. Negotiations with Brussels to secure equivalence for UK financial companies, which would enable them to operate in the EU, have stalled; the bloc’s financial services commissioner recently stated there is “no rush” to grant such terms. And the ECB is piling on pressure for firms to accelerate plans to relocate more staff and business activities to the Euro area.
With hopes of securing broad market access fading, the British government is shifting focus from mirroring European regulations towards a more bespoke approach aimed at positioning London to compete against other global financial centers, such as New York or Hong Kong. The chancellor recently pledged to shake up the stock market listing regime for instance, in a move aimed at carving out a greater slice of the pie for the capital in fast-growing areas such as fintech and green finance. In June, a government task force recommended overhauling the MiFID II and Solvency II regulations, and making it easier for pension funds to invest in early-stage companies.
Such changes could take time to bear fruit, and even then may fail to fully offset the lack of equivalence. Without doubt, London’s incredibly deep talent pool, favorable time zone and strong legal system will ensure it remains a potent force in world finance in the years to come. Yet New York and Hong Kong are world-beating banking hubs in large part because they act as conduits to the American and Chinese markets; without similar access to the EU, London would be missing a key competitive edge.
- Every cloud
Brexit may have put a dampener on the UK’s external sector and blunted London’s financial prowess. But other post-divorce developments have been more positive. According to the Bank of England, the number of companies reporting Brexit as a key source of uncertainty has fallen sharply so far this year. PMI data shows business expectations are at a record high. And companies’ investment intentions returned to positive territory in April—marking the best reading in over two years.
The ebbing impact of Covid-19 has undoubtedly played a role in boosting sentiment. But greater clarity over future trading relations with the EU has likely helped. As a result, prospects for capital spending in the quarters ahead are finally looking up, following several years during which Brexit cast a pall over firms’ willingness to invest.
It is the changing attitude of the government though that represents the biggest upside potential from Brexit. Divorce from Europe has led to a newfound urgency in boosting productivity, which has long lagged behind other major economies.
The 2021 budget introduced a range of measures, from a “super-deduction” tax incentive to stimulate private investment, to a scheme aimed at upskilling SMEs and the creation of a national infrastructure bank. The visa system is being revamped to encourage more high-skilled migrants, and technical education is being overhauled.
Earlier this year, Downing Street announced the creation of a new research agency funding “high-risk, high-reward scientific research” modelled on the highly successful DARPA in the U.S. The government aims to raise R&D spending from the current 1.7% of GDP to 2.4% of GDP by 2027, while overall public investment over the next few years is set to be the highest since the 1970s.
For sure, many of these measures will take time to bear fruit. Their long-term impact is still unclear. And some targets may not be met: The Higher Education Policy Institute recently suggested the 2.4% objective for R&D was optimistic for instance. Yet, coupled with firms’ spending on process automation and digitalization as a result of the pandemic, they still have the potential to boost productivity in the years ahead.
As analysts at Goldman Sachs comment: “A potential silver lining to Brexit is that we are now in a situation where both political pressures and economic needs are pulling in the same direction. If the government is able to successfully implement policies that can spur business investment, create new jobs, and re-skill and retrain workers, then there is the potential to mitigate Brexit headwinds and boost the post-Covid recovery.”