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.
This document has been prepared for information purposes only, does not constitute an analysis of all potentially material issues and is subject to change at any time without prior notice. NatWest Markets does not undertake to update you of such changes. It is indicative only and is not binding. Other than as indicated, this document has been prepared on the basis of publicly available information believed to be reliable but no representation, warranty, undertaking or assurance of any kind, express or implied, is made as to the adequacy, accuracy, completeness or reasonableness of the information contained in this document, nor does NatWest Markets accept any obligation to any recipient to update or correct any information contained herein. Views expressed herein are not intended to be and should not be viewed as advice or as a personal recommendation. The views expressed herein may not be objective or independent of the interests of the authors or other NatWest Markets trading desks, who may be active participants in the markets, investments or strategies referred to in this document. NatWest Markets will not act and has not acted as your legal, tax, regulatory, accounting or investment adviser; nor does NatWest Markets owe any fiduciary duties to you in connection with this, and/or any related transaction and no reliance may be placed on NatWest Markets for investment advice or recommendations of any sort. You should make your own independent evaluation of the relevance and adequacy of the information contained in this document and any issues that are of concern to you.
This document does not constitute an offer to buy or sell, or a solicitation of an offer to buy or sell any investment, nor does it constitute an offer to provide any products or services that are capable of acceptance to form a contract. NatWest Markets and each of its respective affiliates accepts no liability whatsoever for any direct, indirect or consequential losses (in contract, tort or otherwise) arising from the use of this material or reliance on the information contained herein. However this shall not restrict, exclude or limit any duty or liability to any person under any applicable laws or regulations of any jurisdiction which may not be lawfully disclaimed.
NatWest Markets Plc. Incorporated and registered in Scotland No. 90312 with limited liability. Registered Office: 36 St Andrew Square, Edinburgh EH2 2YB. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and Prudential Regulation Authority. NatWest Markets N.V. is incorporated with limited liability in the Netherlands, authorised and regulated by De Nederlandsche Bank and the Autoriteit Financiële Markten. It has its seat at Amsterdam, the Netherlands, and is registered in the Commercial Register under number 33002587. Registered Office: Claude Debussylaan 94, Amsterdam, the Netherlands. Branch Reg No. in England BR001029. NatWest Markets Plc is, in certain jurisdictions, an authorised agent of NatWest Markets N.V. and NatWest Markets N.V. is, in certain jurisdictions, an authorised agent of NatWest Markets Plc. NatWest Markets Securities Japan Limited [Kanto Financial Bureau (Kin-sho) No. 202] is authorised and regulated by the Japan Financial Services Agency. Securities business in the United States is conducted through NatWest Markets Securities Inc., a FINRA registered broker-dealer (http://www.finra.org), a SIPC member (www.sipc.org) and a wholly owned indirect subsidiary of NatWest Markets Plc.