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“Hard Brexit” Q&A: What We Know So Far and Key Transmission Effects to Watch

Puzzle of the European Union flag missing a piece that reveal the United  Kingdom flag

Despite British Prime Minister Boris Johnson’s hardline stance on Brexit, the risks of the United Kingdom (U.K.) leaving the European Union (EU) without a deal appear to be fading for now. The shift in sentiment comes after British Members of Parliament (MPs) passed a bill this month that essentially blocks the U.K. from exiting the EU on October 31 without an agreement. Market expectations for a deal next month have also been rising, and many analysts expect the Brexit deadline to be extended into next year. That said, the chances of a hard Brexit are far from eliminated, with concerns likely to resurface when the next potential deadline approaches. Given the various moving parts, we have decided to take a step back and review some frequently asked questions and key transmission effects of a hard Brexit.

Where do the negotiations currently stand? What could happen next?

Negotiations between the U.K. and the EU remain at an impasse after the deal brokered by former U.K. Prime Minister Theresa May was rejected three times by Britain’s Parliament. The deal, commonly referred to as the “withdrawal agreement,” set out the terms for a post-Brexit transition period during which the U.K. and the EU could negotiate a trade arrangement. The 585-page deal outlined the rights of U.K./EU citizens living abroad, the U.K.’s financial settlement with the EU, among other details, and gave the U.K. until December 2020 to negotiate trade deals with other countries. A major point of contention with the deal, however, is the Irish backstop—a clause put in the treaty that keeps the U.K. in the EU customs union until a free trade agreement (FTA) is signed, preventing a hard border after Brexit.

With the EU and the U.K. unable to find a solution on the Irish backstop, the two parties remain in stalemate. Boris Johnson has threatened to pull the U.K. out of the EU with or without a deal by October 31. However, earlier this month a new U.K. law came into effect which requires the government to ask the EU for an extension until January 31 if the two sides cannot come to an agreement by October 19.

As for next steps, Johnson’s government will continue to try to reach a deal with the EU before the deadline. If indeed he is forced to ask for an extension, the EU is likely to grant one, meaning the Brexit decision continues to be kicked further down the road. It is also highly likely that the U.K. parliament will have fresh elections once the U.K. exit is delayed, but the different outcomes may not be so market friendly: Either the Conservative Party increases power and prospects of a no-deal Brexit rise, or a surprise victory by the Labour government could result in more anti-business policies. A hung parliament could just cause more delays to Brexit and more uncertainty.

  • The likelihood that the UK and EU agree to another Brexit extension before a deadline of October 31 has risen; however, the probability of a hard Brexit at some future date is far from eliminated.
  • In a hard Brexit, UK-EU trade would revert to WTO rules, meaning higher tariffs and a loss of preferential market access.
  • In the financial markets, the British pound would likely fall. In the short term this could give a boost to internationally-exposed UK companies, but in long run the impact from weaker economic growth/less demand
  • would eventually outweigh the benefits
  • U.S. companies with a large corporate presence in the UK could begin to reassess their long-standing strategy of using the UK as a key production and export hub.

What does a “hard Brexit” mean?

In the case of a hard Brexit, all trade between the U.K. and the EU would be subject to the World Trade Organization’s (WTO’s) Most Favored Nation rules, meaning higher tariffs. Additionally, those rules dictate that any tariffs that the U.K. applies to the EU, or vice versa, would have to be applied to all other WTO members unless a trade agreement exists between the two parties. Losing preferential market access to the EU would be a significant loss for U.K. businesses. Indeed, 46% of the U.K.’s exports in 2018 went to EU27 countries, and 53% of the U.K.’s imports came from the EU, according to data from the U.K. Office for National Statistics.

Non-tariff barriers would also rise. These include increased regulatory and compliance costs, rules of origin, customs inspections, and less harmonized product standards. Delays at the U.K. border and associated import costs could eventually be passed on to consumers in both the U.K. and the EU. According to a study by the Central Bank of Ireland, U.K.-Irish border delays could increase by 90% (+4.5 hours of border wait times) if the U.K. were to leave the EU customs union1 That 90% increase in delays translates to a 9.6% decline in total U.K.-Ireland trade, according to the report. Of all the nations in the EU, Ireland is most at risk in terms of Brexit.

In addition, the U.K. would lose access to many of the trade agreements it had been a part of as an EU member. According to the UN, the EU has about 40 trade pacts granting EU member states preferential market access to roughly 70 countries. While the U.K. has secured the continuation of many of these trade deals after it leaves the EU, there are still several deals (representing about 10% of the U.K.’s total exports) for which the U.K. does not have an agreement to “roll over” the current deal after Brexit.2 The ability of the U.K. to quickly negotiate trade deals with new markets and roll over their existing trade deals will be a key determinant in how much global trade will be disrupted after Brexit. Suffice it to say, however, trade negotiations are nothing if not glacial.

What could be some of the options for the U.K.-EU relationship in the longterm?

In general, the U.K. and EU must choose between a “soft” or “hard” Brexit. However, beneath the surface, there are many different options for the path forward:

  1. Remain - The U.K. stays in the EU, and continues to be a member of the EU single market, customs union, and EU institutions. Until an exit plan is formally agreed upon by all parties, this option continues to be on the table and could be achieved through a second referendum.
  2. Single Market - This allows the free movement of goods, services, people and capital across EU-U.K. borders. The U.K. would leave the EU’s political structures (Parliament, Commission, Council), meaning the U.K. must abide by EU rules without a voice in what those policies are. Also, the U.K. must abide by “rules of origin,” or demonstrate that the majority of a product’s components actually originates in the U.K., and it cannot strike deals with other countries.
  3. Customs Union - Goods trade between the U.K. and EU remains tariff-free and with fewer border checks. The U.K. would have to apply the EU’s common external tariff for all trade with countries outside the EU, meaning the U.K. would be unable to make trade deals with other countries and would have to follow EU product standards and trade regulations.
  4. Negotiate Free Trade Association (FTA) with EU - There are various styles of FTAs the U.K. could have with the EU. Specifics of a deal would ideally be negotiated during a transition period. The recently enacted EU-Canada CETA (Comprehensive Economic and Trade Agreement) eliminates tariffs for 98% of products, though a few industries remain highly protected (agriculture, financial services), and border checks are not eliminated. Another option would be to remain a member of the European Free Trade Association (EFTA), like Switzerland. While an FTA seems like a valid option for the U.K., it’s important to remember negotiations take time. It took years for Canada and the EU to come to a final agreement and for all countries to ratify the deal. Also, the many different EU member states have various conflicting priorities when it comes to trade and protecting local industries, which makes negotiations with the EU especially difficult.
  5. Hard Brexit (No Trade Deal) - U.K. trade with the EU would revert WTO rules, leading to a rise in tariffs and non-tariff barriers to trade. The U.K. would be free to set its own trade policy, as well as its own immigration policy, but lose preferential market access to the EU.

Where would the pain of a hard Brexit likely be felt first?

The most immediate effects of a no-deal or hard Brexit would be felt in the currency markets, with the pound likely to fall sharply on expectations for lower potential growth in the U.K. economy after Brexit. After the referendum in June 2016, the pound fell more than 13% versus the dollar in just two weeks. The recent push by British MPs to delay the Brexit deadline into January 2020 has helped the pound to recover some of its recent losses, though the pound still trades near multi-decade lows versus the dollar. That said, the chances of a no-deal Brexit are far from eliminated: In the case of a sudden, no-deal Brexit, the pound would sink against both the U.S. dollar and euro on expectations for a significantly weaker U.K. economy versus the rest of the world.

What could a weaker pound mean for the British economy?

In general, a drop in the pound would lead to higher inflation in the U.K., as a weaker currency makes it more expensive for businesses to import intermediate and final goods. Higher tariffs would also have an initial effect of raising prices for consumers. Higher price inflation erodes the spending power of consumers, squeezes real household incomes and ultimately reduces overall consumption levels and rates of real gross domestic product (GDP) growth. According to research from the London School of Economics, the rise in inflation that occurred after the 2016 referendum is estimated to have cost the average household £404 a year by June 2017.3

How could U.K. business activity be affected?

In the short term, internationally exposed U.K. businesses could benefit as a weaker pound inflates overseas revenues and makes exports more competitively priced in foreign markets. For instance, since the pound started weakening again last year, the more internationally focused FTSE 100 index4 has outperformed the more domestically oriented FTSE 250 by 400 basis points (Exhibit 1). However, in the long run, a weaker U.K. economy, declining demand from abroad, less growth in the labor force, and the additional costs of reorganizing supply chains, higher tariffs and increased customs inspections would more than offset the benefit of a cheaper currency. Losing access to the EU single market or customs union would be a significant challenge for U.K. manufacturers who have long relied on open borders and complex global supply chains to increase efficiency and boost profitability. Industries most likely to be effected by the increase in tariffs include agriculture, motor vehicles, processed food and apparel/textiles.

Exhibit 1: Falling Pound Favors More Internationally-Exposed Companie

Chart detailing the exchange rate between the pound and U.S. Dollar

The FTSE 100 Index represents the 100 largest companies listed on the London Stock Exchange. These tend to be more internationally focused. The FTSE 250 consists of the 101st to 350th largest companies listed on the London Stock Exchange. These companies tend to have less foreign exposure than the FTSE 100. Source: Bloomberg, total returns. Data as of September 20, 2019. Past performance is no guarantee of future results. Performance would differ if a different time period was displayed. Short-term performance shown to illustrate more recent trend.

What’s more, high levels of uncertainty and weaker confidence among the U.K. business community would likely cause companies to pause investment and rethink hiring plans. Large declines in capital investment dragged down economic growth in the second quarter this year, with GDP growth contracting for the first time in seven years.

What impact could a hard Brexit have on foreign investment?

Brexit uncertainty has already led to visible changes in European foreign direct investment (FDI). First, the incremental spend on new investment by multinational companies since the Brexit vote has increasingly been directed toward the EU continent (EU27), as businesses look to diversify their global presence away from the U.K. According to a Financial Times database of cross-border investment, new capital invested in the EU27 countries rose 43% in the three years to Q1 2019 (compared to the prior three years), while the U.K. experienced a 30% drop. Additionally, the average spend per project in the U.K. has declined from $45 million in 2015 to $27 million in 2018— another sign that Brexit risks have made companies more cautious in allocating large capital investments toward the U.K.

Second, the Brexit referendum has caused companies currently located in the U.K. to shift their operations to other destinations. According to research by the London School of Economics, the Brexit vote caused a 12% increase in the number of new investments made by U.K. firms into the EU, while causing the number of new EU investments into the U.K. to decline by 11%.5 While this represents a significant swing, the investment exodus would likely accelerate in the event of a hard Brexit. In the financial services sector, for example, companies have created contingency plans outlining how they would shift their operations after the UK officially leaves the EU. As of June 2019, 41% (91 out of 222) of financial services companies tracked by Ernst and Young have publicly stated they will move some of their business and/or staff from the U.K. to Europe due to Brexit and will bring with them an estimated £1 trillion of assets. Major auto and technology companies in the U.K. have also been among those announcing plans to move their operations out of the country citing Brexit uncertainty.

What do we think all of this means for economic growth in Europe and the rest of the world?

The costs of Brexit are expected to be much more severe for the U.K. than the EU27. According to the latest data from Eurostat, U.K. exports to the EU make up over 13% of U.K. GDP, while EU27 exports to the U.K. are less than 3% of EU27 GDP. However, the eurozone economy is hardly immune to the effects of Brexit. According to the International Monetary Fund (IMF), a hard Brexit could cause EU real GDP to decrease by as much as 0.6% by 2021.6 Uncertainty surrounding Brexit and a drop in the pound this year reduced U.K. demand for foreign products, adding to the eurozone’s economic slowdown. For instance, Germany’s exports to Britain declined by 21% in Q2 2019, contributing to a 0.1% fall in GDP for the quarter.7 Some of the countries most exposed to U.K. trade include Belgium (goods exports to the U.K. represent 7% of Belgium’s GDP), the Netherlands (6.5%) and Ireland (5%).8 While a weaker European economy can have spillover effects into other regions, the IMF predicts that the overall effects of a hard Brexit on the rest of the world are relatively minor. Weakness in the EU and U.K. economies would account for the majority of the decline in global GDP (-0.2% by 2021) caused by a hard Brexit, according to the IMF’s projections.

Exhibit 3: The Transmission Effects of a “Hard Brexit”

Transmission
Channel
Likely Outcome/Consequence
Currency (FX)
  • Pound weakens vs. the dollar and euro.
  • Consequences include: inflationary effect for Britain; inflation sqeezes real incomes and purchasing power; threatens profitability of foreign companies (e.g., U.S., German businesses) selling goods to the U.K...
Trade
(goods/
services)
  • Tariffs increase, as U.K. trade with EU reverts to WTO rules.
  • Non-tariff trade costs would rise, reflecting the emergence of a customs and regulatory border between the U.K. and the EU. Delays at the border could arise, despite the preparatory measures, which would raise import costs for firms and households in the U.K. and to a lesser extent in the EU.
  • Non-EU trade: U.K. to lose access to FTAs it had been a member of as part of EU. Tariffs revert to WTO rules. Future of trade depends on ability of U.K. to negotiate and roll over trade deals with countries outside the EU.
Foreign
Direct
Investment
  • Expect further relocation announcements (companies shifting operations from U.K. to EU)
  • U.K. FDI in Europe to increase in short run. Over long run, expect longer term trend of deglobalization/more local investment and automation.
  • U.S. FDI flows into U.K. should slow over the long term as Britatin loses free market access to EU.
Macroeconomic
Growth
  • Recession for U.K. (IMF forecasts U.K. real GDP to be 3.5% lower by 2021 in no-deal scenario).
  • A no-deal Brexit would also push EU economic growth down, but expect less damage for EU27 than for the U.K.. Effects on other regions are negligible.
  • In the long term, higher tariffs and nontariff barriers reduce the efficiencies of global firms and reduce the potential output for both the U.K. and EU. Stricter immigration policies also may cause lost potential output over the long term.
U.S. Global
Earnings
  • Short term, a weaker pound from hard Brexit could pressure U.S. global earnings.
  • Long term hit to global earnings as multinational supply chains become less efficient with higher tariffs and non-tariff bariers to trade. U.S.-U.K. new free trade and/or investment deal, however, is source of potential upside, but expect uncertainty during a long negotiation period.

Sources: Chief Investment Office; International Monetary Fund. Data as of 2019.

What could be the implications for U.S. multinational companies?

Britain’s departure from the EU puts at risk corporate America’s massive FDI stake in the U.K. The U.S. corporate presence in Britain, importantly, is premised in large part on the territory’s membership in the largest, wealthiest and most important foreign market in the world to U.S. companies: the European Union. For decades, the U.K. has served as a strategic gateway or bridge to the EU for U.S. firms, with American companies very much at home in a country that boasts a large and affluent market, a shared language, and a similar business and legal architecture to the United States.

Geography has also certainly helped matters. Perched at the rim of continental Europe, the U.K. offers easy access to Europe at large and has long served as a jumping-off point for U.S. firms desiring deeper access to the various markets of the EU. Indeed, while the bulk of U.S. foreign affiliate sales in the U.K. are for the local market, the exportpropensity of U.S. affiliates in the U.K. is hardly inconsequential. While outranked by nearby Ireland, U.S. affiliate exports from the U.K. to other non-U.S. markets still totaled over $140 billion in 2017 (Exhibit 4). On a standalone basis, what U.S. affiliates export from the U.K. each year is greater than the total exports of most nations.

Exhibit 4: Corporate America’s Export Platforms*

Corporate America’s Export Platforms

*Goods and services sent abroad by U.S. foreign affiliates from host country to other non-U.S. countries.

According to various different metrics depicted in Exhibit 5, the United Kingdom is a key hub for the global competitiveness of U.S. firms. The output of U.S. affiliates in the U.K. totaled $180 billion in 2017, about the same as the entire GDP of Ukraine or Hungary. U.S. affiliate sales in the U.K. were almost double sales of U.S. affiliates in China.

Exhibit 5: Operations of U.S. Foreign Affiliates in the U.K.*

  Billions of $&     % of Global Total     Rank    
Total Assets 5,574 20.0% #1
Value Added (Output of Affiliates) 180 12.7% #1
R&D 6 11.3% #2
Capital Expenditures 18 9.2% #2
Foreign Affiliate Sales 644 10.3% #1
Employment (thousands of employees) 1,473 10.2% #2
Manufacturing (thousands of employees)     308 5.7% #4

*Data for Majority-Owned Foreign Affiliates, 2017. Source: Bureau of Economic Analysis. Data as of August 2019.

In short, leveraging Britain’s and the U.K.’s access to the EU has been a profit-generating strategy for U.S. multinationals for decades and one of the main reasons corporations decide to base their operations in the U.K. Since 2000, the U.K. has accounted for 8% of cumulative global foreign affiliate income, a proxy for global earnings, and for 15% of total income earned in Europe.

This strategy, however, is now at risk as the U.K. crafts a future outside the EU, and as U.S companies rethink their global supply chains to account for higher trade and investment barriers in the U.K. Delays at the border, higher tariffs, non-tariff barriers to trade and more protected labor markets, in the end, would make U.S. foreign affiliates less productive and potentially reduce the returns to capital for U.S. companies operating in the U.K.

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