Brexit – it all boils down to trade deal and tariffs

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By: Sakthi Prasad -- Content Manager

28 June, 2016

Brexit – it all boils down to trade deal and tariffs
BLOG

With additional inputs from Vinu Prasanna -- Senior Domain Lead and Mohit Handa -- Senior Research Analyst

brexit eu eurozone procurement

On June 23, Britain voted to exit the European Union (EU) – a process known as “Brexit” – sending shockwaves around the globe.

Quantifying the impact from Brexit is anything but easy considering the magnitude of factors that are involved in the process.

“As so often in these unprecedented big bang events, headline estimates of a quantified economic impact on the Eurozone and individual countries should be taken with a pinch of salt,” analysts at the Dutch bank ING wrote in a research report. (http://beroeinc.co/290r50P)

To be sure, the process of leaving the EU is no cakewalk. The referendum is not legally binding, and some politicians are suggesting a parliament vote before formally invoking Brexit. Also, with Scotland and Northern Ireland voting to remain in the EU, confusion prevails as to what’s in store in the coming days and months.

Britain needs to trigger Article 50 of the Lisbon Treaty, putting in place a two-year timeline for formal talks. So it seems unlikely that the country will leave the Union before 2018 at the earliest.

Arduous process of trade and tariff negotiations will begin once Article 50 is invoked. And it’s anybody’s guess as to what a future trade deal between UK and EU would look like.

John Forrest, the head of international trade at law firm DLA Piper, told the Guardian newspaper that UK will simply be required to negotiate a single deal with the 27 remaining EU states under the EU’s common commercial policy. “It will definitely not be on a country-by-country basis. The EU maintains a single harmonised customs border and the UK will simply negotiate with the EU the continued terms of trade with the EU,” he told the paper. (http://beroeinc.co/29aDXC8)

At this critical juncture, it is pretty tough to imagine what would happen to bilateral trade and investments between EU and UK – the country has a deficit with the EU in goods, but a surplus in services.

An organization called Open Europe has predicted that eight industries in goods and services sector – Automobiles, Chemicals, Aerospace, Machinery, Food, Beverage and Tobacco, BFSI and Professional Services – faces medium to high risk of disruption in case Brexit is operationalized. (http://beroeinc.co/290r5y8)

The EU’s average tariff has fallen in recent decades and the cost of being outside the EU’s customs union has fallen, as a result of which many non-agricultural products may not face much change in tariffs. However, tariffs remain high for several goods.

For example, about 35% of UK exports to the EU are in sectors where the EU imposes high-tariffs such as cars, chemicals, clothing, food, beverages and tobacco. These sectors would face tariff barriers in case Britain does not sign a favorable trade deal with the EU.

Goods

% exported to EU (approx)

Trade deficit/surplus (in bln pounds)*

Potential EU Tariffs

Risk of Disruption

Chances of similar EU access

Cars

35%

(-14)

10%

High

High

Chemicals

57%

(-8)

4.60%

High

Medium to High

Aerospace

45%

2.6

No Tariff

High

High

Machinery

31%

(-5.5)

1.7%-4.5%

Medium

High

Food, Beverage and Tobacco

61%

(-17)

Average >20%

High

Medium to High

Services

     

 

 

Financial Services

41%

16

Various market access regulations

High

Low

Insurance

18%

4

Various market access regulations

Medium

Medium

Professional Services

30%

(-2)

Various market access regulations

Medium

Medium

Source: Open Europe; * Includes imports

ING said in its report that besides tariffs, UK would have to deal with non-tariff barriers if it leaves the EU. Examples include product standards, anti-dumping legislation and labelling standards. Many studies show that this issue is a bigger trade obstacle than tariffs, which have been reduced steeply over recent decades.

However, independent macroeconomic research company Capital Economics said that Brexit would not be as catastrophic as it is imagined.

The worst-case Brexit scenario would be one in which Britain failed to negotiate a free trade agreement with the EU. “Such an outcome might result from the Union playing hard ball in order to discourage any other members from leaving or, alternatively, Brussels might demand too high a price – such as the continued free movement of labor – for Britain to agree,” the firm said in a report. (http://beroeinc.co/29aEhkl)

Capital Economics said that even if Britain fails to get a favorable trade deal, British exports to the EU would only face common external tariff, as the country’s trade with Europe would be governed by the most-favored nation (MFN) rules – also known as “WTO option”. In this option, British goods and services would attract same tariff as the EU charges other non-member countries.

The Centre for Economic Performance (CEP), which describes itself as a bipartisan research organization, said that after Brexit, the UK would become an independent player in trade negotiations. This means that the country would need to negotiate trade deals not only with the EU, but also with the rest of the world, and may look to lower tariffs below that of the EU in order to gain a favorable trade position. However, there is limited scope for further tariff reductions and lowering of nontariff barriers, according to CEP. (http://beroeinc.co/297cB2O)

If Brexit is operationalized, Britain has a choice of following Norway, Switzerland or WTO models.

OPTIONS BEFORE UK AFTER BREXIT

MODELS

PROS

CONS

EEA (European Economic Area) – the Norway model

Belong to the Single Market.

Able to negotiate trade deals independently of the EU

Required to implement Single Market policies, but have no representation in setting the rules of the Single Market.

Bilateral agreements – the Swiss model

Free trade in goods and free movement of people with the EU.

Able to negotiate trade deals independently of the EU.

Bilateral agreements require Switzerland to adopt EU rules, but Swiss have no representation in EU decision making

EFTA (European Free Trade Association)

Free trade in goods with the EU.

No obligation to contribute to the EU budget.

Goods exported to the EU must meet EU product standards. 

WTO (World Trade Organization)

Able to negotiate trade deals independently of the EU.

Not required to adopt EU economic policies and regulations.

Trade with EU subject to MFN tariffs and any nontariff barriers that comply with WTO agreements.

Source: Centre for Economic Performance (CEP)

Pointers for Procurement Organizations:

Now comes the big question: what are the pointers for procurement organizations amidst all this flux? It’s a safe guess that Brexit may not happen at least until 2018. What happens after that is anyone’s guess.

1)      For those businesses in UK or EU and are negotiating with suppliers on the opposite territory, it is better to refrain from signing long-term deals when contracts come up for renewal in the next few weeks or months. As of now we are in open waters and don’t know yet what course will eventually be charted by the policymakers.

2)      Renewal of existing contracts can also face some turbulence since there may be some confusion as to what legal framework needs to be adopted.

3)      Large outsourcing contracts by UK companies may slowdown given that businesses may want to adopt a wait and watch approach until policy situation becomes clear. However, it is better to keep communication channels open with preferred list of suppliers.

4)      As a plan B, procurement organizations can scout for suppliers from alternate regions, especially if the raw material or service is critical to one's business.

5)      In case Brexit is fully operationalized, there is a risk that pound may lose some of its value. This may boost exports of UK machinery and services – however, import of services and goods can become relatively expensive. It’s better to invoice in U.S. dollars instead of pounds in case the currency becomes volatile.

6)      Businesses that are looking to expand their operations face a dilemma on two fronts: should they buy up office space in the UK or the EU? And what about allocation of staff considering that passport-free travel might potentially end when Britain formally leaves the EU?  London office-property values may fall by as much as 20 percent within three years of the country leaving the EU as some businesses may choose to relocate, Bloomberg reported, citing data from Green Street Advisors LLC. This can be a good buying opportunity for those who want to expand in London. It’s better to hedge one’s bet and wait for clarity on the policy front before signing large real-estate or staffing deals at least for the next quarter or so.

7)      For those businesses that may have to move staff from UK to the EU and vice versa because of regulatory constraints, now is the time to open negotiations with relocation service providers. Movement of thousands of staff across the channel can be a daunting task and may need careful planning and budgeting.

8)      Logistics and warehousing can have a high impact as custom costs, paper work and waiting times across the channel is bound to go up once the divorce is finalized. And fuel price may go up in UK if pound continues to lose its value. Also, large multinational corporations may move their warehouses from UK to Europe and vice versa in order to honor quick deliveries. This may result in an overall increase logistics and warehousing costs.

Now let’s look at the impact on select macro indicators:

Secondary Trade: The stock markets in UK will experience volatility. However, in the long run stocks will be driven by overall economic and business conditions and not on a single event.

Commodity: Commodities will be impacted on account of strengthening or weakening of currencies and broadly follows the overall demand/supply dynamics. The U.S. dollar is expected to strengthen against major currencies until uncertainty over Brexit ends. And since commodity prices, at times, tend to react to the value of dollar, it could lead to price swings.  This could have a cascading effect wherein commodities can be pricier for other currencies, leading to weak demand.

Currency: The euro and the pound are expected to weaken globally. The pound is expected to face new challenges as questions linger over the inherent strength of the UK economy. The euro already has weakened since the 2008 recession as the continent continues to battle high debt load. There could be new structural changes to the Euro in the coming decade.

Labor Movement:  The EU framework provides for mobility of labor. If Britain were to formally exit the EU there would be shortage of workers in the country, and wages can artificially increase in the short- to-medium term. The flip side is that the country will have complete freedom to restructure labor laws, which could be more conducive for the domestic economy.

The Brexit referendum has surely opened up the Pandora’s Box. And we will be closely watching all developments.