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The Brexit deal came in time for Christmas – but was it the gift UK businesses & markets hoped for?

15 January 2021

Ross WalkerChief UK Economist

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Theo Chapsalis, CFAHead of UK Rates Strategy

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Paul RobsonHead of G10 FX Strategy

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Other insights

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Trade in goods

The UK-EU Trade & Cooperation Agreement (TCA) is, as expected, largely confined to trade in goods – zero tariffs, zero quotas on qualifying goods. To qualify for tariff-free access, British goods will need to meet Rules of Origin (RoO) requirements – some sectors are exempt and UK manufacturers are able to ‘cumulate’ (both UK & EU components count towards the RoO threshold). A 12-month grace period on some aspects of RoO declarations will give business some breathing room to obtain supporting documentation from suppliers.
 
The agreement does not secure broad mutual recognition and instead seeks to minimise technical/ regulatory divergence via the adoption of international standards and streamlined compliance processes. This means British goods entering the EU will need to comply with EU law (and vice-versa) so many goods will face two sets of conformity assessments, thereby adding costs to business. While the deal requires new customs declarations & paperwork for GB & EU trade, a ‘trusted trade scheme’ will allow for a simplified process for eligible businesses.
 

How will UK corporates & markets adjust to the post-Brexit landscape? Listen to our latest episode of On Point on Spotify or YouTube to find out.

Trade in services

Other than limited provisions for airlines, hauliers, and telecoms providers, services are largely absent from the deal – with layers of complexity stemming from national variations within the EU. The services provisions do include a ‘Most Favoured Nation’ (MFN) clause which, in principle means that, were the UK or EU to give more favourable services terms to a third country in future, those terms would automatically extend to the UK/EU.
 
For financial services, the agreement amounts to a ‘no deal’ outcome. EU financial passporting has gone and the once hoped for ‘enhanced equivalence’ is proving elusive. Fortunately the sector had prepared for this outcome: around 8,000 financial services jobs and £1.2 trillion of assets have been relocated from the UK to EU centres since 2016, according to EY.
 
Instead, the UK & EU have agreed to establish a framework for regulatory co-operation, and negotiations on financial services equivalence are to begin imminently with a view to reaching a deal in some form by March 2021. The EU agreed to extend the current arrangements for euro-denominated derivative clearing, but this appears aimed at buying time to construct rival infrastructure. Still, for the fund management sector, uncertainty persists around the extent to which ‘delegation’ is permitted.
 

How will the end of the transition period affect the way companies in the UK and EU access financial services? Click here to learn more.

Level Playing Field (LPF), competition & taxation

As for LPF, the TCA’s provisions fall short of EU demands for the UK to align with EU law but go beyond those in the EU’s trade deal with Canada, and the EU subsidy regime will no longer apply in the UK. The TCA defines subsidies along with common principles on processes and exemptions, and makes specific provisions to deal with any dispute – if a dispute cannot be resolved by consultation, independent arbitration is an option, and each party can impose remedial measures if either assesses the rules to have been breached.
 
Both sides have committed not to lower existing overall standards of labour and social protection vis-a-via trade and investment (‘non-regression’ agreement), and have the right to take countermeasures – tied to harm caused to trade – if the other side has engaged in unfair practices. Tying any countermeasures to harm to trade may limit how these provisions are used, but this still creates uncertainty over where divergences might arise (and what retaliatory action might ensue).
 
The TCA sets out common principles around competition policy, and provisions on taxation are very limited (essentially confined to not lowering standards below what has been agreed in the OECD) – neither are subject to dispute resolution. But the deal also includes a ‘rebalancing mechanism’ – to allow adjustments to be made in response to policy divergences over time from the agreed baseline, which could allow tariffs to be imposed and even (in extreme cases) a reversion to WTO trading terms.

Surveys suggest corporate resilience may be an issue

Are corporate finance decision-makers prepared for this new post-Brexit reality? Two surveys recently published by the Bank of England (BoE) give rise to some concerns. Around one-third of UK firms say they are not prepared for post-Brexit trading arrangements – 4% say they are not prepared at all, with 33% only partially prepared: border delays, new bureaucratic requirements and regulatory compliance are the factors identified as likely to have the most negative impact (see below).

Chart 1: Brexit preparedness

Source: Bank of England, NatWest Markets

Chart 2: Brexit problems

Source: Bank of England, NatWest Markets

The sharply negative ‘confidence’ balance suggests capex and hiring could be hesitant through early 2021, while ‘indirect’ factors such as confidence may end up weighing more heavily on GDP than specific and theoretically temporary issues (eg, IT systems needed to adapt). Nevertheless, the BoE estimates UK GDP will be reduced by 1% point in Q1 2021, principally through weaker trade and supply-chain disruption.

Manufacturing & financial services to take a hit in the medium & long-term

Short-term economic disruption will be a key focus for markets & policymakers in early 2021 – but a bigger, almost existential, question remains unanswered: what is the UK’s post-Brexit economic vision?
 
Historically, the UK provided a relatively low-tax, business-friendly base from which global corporations and financial institutions could access the world’s largest single market – the effectiveness of which can be gaged by the country’s out-sized share of foreign direct investment (FDI). But this has fallen dramatically since the 2016 referendum, with the UK government’s estimates showing financial services and manufacturing among the hardest-hit sectors – 7% and 8% lower output, respectively, over 15 years vs. staying in the EU (see below).

Chart 3: Foreign direct investment (FDI) flows into the UK, £bn

Source: Office for National Statistics, NatWest Markets

Chart 4: Brexit impact, % change over 15 years 

Source: UK Government, NatWest Markets

Brexit could shift the balance on Sterling

The impact of Brexit on the currency largely depends on the supply-side economic effects – on productivity and inflation – and whether the TCA leads to a change in the balance between the current account balance and its sustainable level (as well as relative growth).
 
Our analysis suggests the TCA has lowered Sterling’s expected long-term equilibrium by one standard deviation vs. our estimated pre-Brexit equilibria (1.48 for GBP/USD and 0.82 for EUR/GBP) – driven by additional bureaucracy around international trade, less efficient supply chains, and restrictions of free movement of labour. But our models also suggests the currency is overvalued (by around 10%), consistent with the long-term trend – which suggests a higher sustainable current account deficit position than we estimate: it hints that international investors have been comfortable to fund (via asset purchases) the current account deficit at current exchange rates.
 
Brexit has potential to shift this balance, both through making the current account deficit larger and lowering portfolio and FDI inflows; given the historical nature of UK FDI and the glaring absence of services (the UK’s dominant export) from the TCA, this look likelier than not.
 
Additionally, we don’t believe there will be a significant reallocation of global FX reserves towards Sterling post-Brexit; the currency’s share of (allocated) global FX reserves has been stable since the 2016 referendum and wasn’t obviously reduced because of it.
 

A game-changer for UK rates & inflation-linked debt: macro takes the driving seat

The dynamics of the gilt market are far from static, and the Brexit deal appears to have beckoned an important structural shift.
 
For the past two years, Retail Price Index (RPI) swaps, used to hedge against the risk of inflation, have traded at a premium – due largely to some combination of uncertainty around “no deal”, the introduction of tariffs and a sharp depreciation in the currency. But that’s now a thing of the past, and we think the sensitivity of the UK inflation market to politics will diminish as macro moves into the driving seat.
 
That said, the interplay between post-Brexit trade dynamics and the coronavirus pandemic will likely send inflation lower. Light inclusion of services into the TCA may translate into weaker near-term inflation given fears over damage to that (sizeable) part of the economy. And if the second UK lockdown in November was any guide, the third lockdown currently in place (notwithstanding additional support measures) also favours weaker inflation via sharply reduced retail spending.
 
For questions on this article, get in touch with your NatWest corporate & institutional representative or contact us here.

 

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