United Kingdom: Brexit strategy agreed, but proposals will struggle for support at home and in the EU
On 12 July, the government set out a White Paper on the future UK-EU relationship, which it hopes will form the basis of negotiations over the Withdrawal Treaty that are supposed to conclude by October. The UK proposes a free trade area for goods, a much less ambitious agreement covering services, and a hybrid customs arrangement which would enable an independent trade policy. Such an agreement would likely lower the UK’s potential growth rate substantially compared to under continued EU membership. However, the EU is unlikely to accept the paper in its current form, and there is also no clear majority in the British parliament in favor of the proposals.
The White Paper spells good news for the manufacturing sector; the UK and EU would share a common rule book and there would be no customs checks at the border, protecting supply chains. However, the UK’s dominant services sector—which accounts for around 80% of GDP—would fare worse, with the government openly acknowledging that “there will be more barriers to the UK’s access to the EU market than is the case today”. In particular, financial services—an area where the UK has until now enjoyed a strong competitive advantage—would likely suffer. The government will make no attempt to replicate current passporting rights, which allow financial firms based in the UK to offer services to the rest of the EU. Such a deal would likely significantly dampen potential growth. According to Kallum Pickering, Senior Economist at Berenberg, “UK potential growth would fall to 1.5-1.7% from +2.0% inside the EU.”
However, the proposals are unlikely to survive in their current form, as several aspects of the paper will raise objections from the EU. Chief among them is the planned customs arrangement, which would see the UK collect tariffs on behalf of the EU for goods destined to the bloc, while simultaneously setting its own tariffs on goods destined for the UK. Such an agreement is unprecedented, would be of great technical complexity, and has so far been flatly rejected. The EU is also likely to take a dim view of the government’s attempts to cherry-pick—remaining in a single market for goods, but not for services, labor and capital; and continued participation in certain EU agencies, for instance. Furthermore, subsequent amendments approved by the House of Commons, touching on areas such as customs arrangements and the Irish “backstop” agreement, will make it even harder for the EU to give the green light.
Economists at ING state: “The EU will almost certainly say no, but Brussels may seek to strike a balance when communicating this. A UK government breakdown is not in the EU’s interest, so it will be wary not to completely destroy the fragile cabinet truce and risk May’s position as PM.”
Along with the EU’s likely reservations, support from the UK parliament—which will vote on any final Brexit deal agreed with the EU—is far from guaranteed. Many pro-Brexit Conservative MPs are unhappy with the proposals, as evidenced by the recent resignations of Brexit Secretary David Davis and Foreign Secretary Boris Johnson, as they consider the UK would remain too closely tied to the EU. In addition, the Labour Party, which advocates membership of a customs union, is unlikely to throw its weight behind the White Paper. A recent legislative defeat for Prime Minister Theresa May in parliament over post-Brexit medicine regulation, which saw several Conservatives rebel against the government, highlights the fragile parliamentary situation.
To gain the backing of the EU while avoiding a hard border in Ireland, the UK will likely need to become more closely aligned with the EU than envisaged in the White Paper. This is the view of analysts at Nomura: “The final agreement with Brussels (assuming, as we do, that there is one) could potentially see Brexit become even softer than what has been proposed.” Economists at ING strike a similar tone: “We suspect it is probably only a matter of time before the UK accepts that it will stay in a customs union in full after Brexit.”
Such a shift in position would be politically unpalatable for right-wing Conservatives and could trigger a leadership bid against Theresa May, potentially leading to snap elections. However, the adoption of some form of customs union would boost the chances of Labour Party support—particularly if the alternative was crashing out of the EU without a deal.
With the government’s current proposals still unworkable, it is increasingly likely that a withdrawal treaty will not be agreed in October as currently envisaged. The longer the wait for a deal, the less time national parliaments will have to ratify it, the more UK investment will be dampened, and the higher the risk of a no-deal Brexit, which would likely cause severe economic disruption.