Brexit has arrived. What now?

30 January 2020

wiiw expert Michael Landesmann discusses how the next stage of negotiations is likely to develop.

By Michael Landesmann

What changes immediately after 31 January? Not much, as until 31 December 2020 the United Kingdom will still be in the EU single market (with its four freedoms), will remain in its customs union, will continue to pay into the EU budget, will still have to apply EU regulations and will also remain under the legislative oversight of the European Court of Justice on issues relating to compliance with EU law. However, the UK will no longer participate in the decision-making processes of the EU, including decisions on the next financial framework or on foreign and security policy.

The UK can start to negotiate trade deals, to come into force after it leaves the single market – in the first place with the EU itself, but also with other trading partners. Most prominent among the latter will be an agreement with the US, but the UK will also need to negotiate deals with the many partners with which the EU has trade agreements. Some of these might already be at an advanced stage of preparation – with New Zealand and Australia, for example – as (non-official) talks have taken place over the past few years. However, the full content of these deals will be linked to whatever the UK negotiates with the EU, which will continue to be the UK’s largest trading region. The shape of the UK-EU trade deal will also determine important constraints that will apply to the UK in its negotiations with other trading partners.

The main challenge: regulatory divergence

The main issue in the negotiations with the EU will be the extent of ‘regulatory divergence’ (the extent to which the UK will maintain ‘regulatory alignment’ with the EU). This is a central issue, as ‘tariff- and quota-free trade’ (although prominent in public discussion) is, in a context of relations between advanced economies, somewhat secondary to compliance in standards and other regulations that determine whether a country can access other markets. The EU has an evolved complex system of technical standards and regulations (notably in industries such as pharmaceuticals and chemicals, but also in cars, medical equipment etc), as well as a range of regulatory bodies that supervise and enforce such standards and regulations. The EU is often described as the world’s ‘regulatory superpower’.

UK ministers – such as the Chancellor of the Exchequer, Sajid Javid, speaking at the World Economic Forum – have said that the UK after Brexit will no longer be a ‘rule taker’. It will insist on its ‘sovereign right’ to set its own standards, and its businesses (as well as banks and other financial institutions) will be supervised by its own regulatory bodies. However, the UK’s access to the EU, its most important market, will continue to depend on obeying EU rules and regulations. It is therefore in the UK’s interest not to have to produce to separate technical standards for the domestic market and its main export market. Although most UK firms are small and produce predominantly for the domestic market, the interests of the country’s large and exporting firms will prove decisive in this respect.

The extent of continued ‘regulatory alignment’ or ‘regulatory convergence’ will be central to the negotiations with the EU on an FTA. The issue is likely to be dealt with on a sector-by-sector basis, in view of differences in the relative importance of UK exports to the EU and in the dependence on cross-border production linkages. The car and aerospace industries, and probably also telecommunications, will be in the vanguard of those pushing for very close regulatory alignment. The financial sector, in contrast, will opt for a high degree of ‘regulatory independence’, according to a recent statement by the outgoing governor of the Bank of England, Mark Carney. This is because of its complex nature: some segments of the financial sector look forward to the significant potential of securing new trading relationships with other markets and seek to develop a strong presence in other financial hubs, such as New York, Hong Kong and Shanghai; other parts of the financial industry that rely on close ties with the EU have already shifted some of their operations into subsidiaries on the continent that will be fully compliant with EU laws and regulations.

Nonetheless, the UK’s insistence on ‘regulatory sovereignty’ means that, even in industries that favour high regulatory alignment (for example the food industry, which sells most of its exports to the EU), the EU will need to grant ‘equivalence’ of UK regulations and standards. This is common in trade agreements between the EU and other trading partners, such as with Switzerland in the area of financial services. However, it can be unilaterally cancelled if the EU considers that a country no longer complies with its standards and regulations. The power to revoke ‘equivalence’ can be used as a bargaining chip. One recent example of this came when the EU stopped recognising trading on the Zurich stock market in order to exert pressure on Switzerland in negotiations over a more streamlined bilateral relationship.

A daunting list of other issues to be resolved

Recognition of EU environmental and labour standards, as well as the extent of state aid to industries, will be important factors in the UK-EU negotiations. This insistence on a ‘level playing field’ is not always part of an EU trade agreement, at least for countries such as Canada or South Korea. However, EU negotiators will argue that the UK is a large economy in the immediate neighbourhood of the EU, which therefore cannot allow ‘unfair competition’. The EU will not want the UK to provide an environment, through looser regulations and lower environmental and labour standards (or distorting state aid provisions), that gives UK-based firms a competitive advantage. This will be an important issue in the negotiations. Access to ‘tariff- and quota-free trade’ will depend on substantial UK compliance with such standards and state aid rules, which will therefore mirror parts of the EU’s single market and competition policy.

Other issues will also complicate the UK’s trade situation after Brexit. For instance, when the UK reaches an FTA with the EU, and UK firms sell products that contain inputs from third countries (such as South Africa, with which the UK might have its own FTA), these companies will have to comply with ‘local content’ requirements, i.e. prove that at least 55% of the value of the product originates in the UK. This will add additional costs.

Furthermore, there will in effect be a ‘hard border’, as goods will require physical random inspection to assess whether they comply with EU standards. These checks will be particularly frequent in industries that require health certificates (such as products of animal origin).

Another issue will be EU recognition of professional qualifications of UK-qualified personnel. As recognition of qualifications comes under the aegis of individual member states, this would have to be negotiated on a country-by-country basis, although the EU could play a co-ordinating role.

The UK has been preparing in the pre-Brexit period by creating its own regulatory bodies. For establishing ‘regulatory equivalence’, there will have to be a dialogue between EU and UK regulators. The negotiating strengths will vary in different areas. For example, in areas that relate to the eurozone’s ambition to form a ‘capital markets union’, an important voice for UK regulators would be very much in the EU’s interest, as the EU alone would not represent a capital market with a global scale.

An interesting point is made by Sam Lowe from the Centre for European Reform (CER) in London that the costs of deciding on the principle to gain ‘regulatory sovereignty’ will be front-loaded (Lowe: “the additional costs associated with choosing to diverge are large; the relative costs of actually diverging are smaller”). Even though, in practice, the UK might not want to diverge from EU product standards very much, as EU standards are recognised globally, the fact that the UK claims the right to set its own standards in itself creates significant costs.

A further issue is the duration of negotiations: the general expectation is that there will only be a ‘rump agreement’ by December 2020 on goods, financial services and fisheries, and that the EU will insist on a certain sequencing of negotiations. Furthermore, the UK’s trade negotiation capacities are limited, and this will affect parallel negotiations with a number of trading partners in its attempts to replace existing EU agreements when the UK finally leaves the ambit of the EU’s customs union.

Two additional complications

There are two further problematic issues that will come into sharper focus this year. First, the impact of Brexit on regional imbalances in the UK. Boris Johnson speaks about ‘levelling up’, but this will be more difficult in the post-Brexit environment as the UK’s northern regions rely more heavily on manufacturing, the food industry and fisheries, for which, in each case, the Brexit process creates disproportionate difficulties. These difficulties arise in manufacturing because of the importance of cross-border production linkages; for the food industry because it is highly reliant on EU markets, and hence recognition of food standards is particularly important; and for fisheries because fishing rights in UK waters are politically a highly contentious issue. All of these areas will require much negotiating skill, a pragmatic approach that will have to overcome political sensitivities, and also compensation for producers in the northern regions for the impact of higher trade friction. The last of these would require heavy investment in infrastructure, upgrading of skills, supporting research and other similar measures. We shall see whether the political will is there to provide for these in the coming years.

The second additional complication is migration policy. Migration was one of the key factors underlying the pro-Brexit vote in the 2016 referendum. The government has therefore declared that it will take control of ‘migration policy’. From what has emerged so far (see also the recently published report by the independent Migration Advisory Committee, MAC), it looks likely that the government will opt for a modified form of an Australian-style points system (with the aim of attracting highly qualified workers, and particularly those in short supply in the UK), as well as paying attention to specific job market impacts (setting a pay threshold for those with a job offer). The MAC is, of course, aware of the trade-offs inherent in any migration policy set-up: for example, a policy skewed towards the highly qualified does not cover the need for social care workers, or for labour in agriculture and food processing, sectors that rely heavily on migrants. In addition, the very successful university sector will become less attractive if students from the EU have to pay the same fees as those from non-EU countries and if possibilities for post-study employment are significantly reduced.