Brexit: it’s only the beginning (of more misery)

Economic opinion

Despite optimistic Brexit sounds, we argue that Brexit will continue to be a major source of uncertainty causing economic damage to the European economies. The combination of UK political turbulence, strategic trade policy considerations and structural damage to the UK economy is likely to cause Brexit troubles to cast a lasting shadow on the European economy.

My kingdom for a deal

The crooked path to Brexit continues to take us into uncharted territory. In large part, the related difficulties are the result of deep and widening internal divisions within the UK (also see KBC research report). While an exit agreement now looks possible, and maybe even probable, it is still far from certain. Nearly a full year ago, we were in a broadly similar situation. An initial exit deal was agreed by the EU27 with Theresa May, but she was unable to get it ratified by the British Parliament.

Boris Johnson, the current UK Prime minister, has had comparable problems getting parliamentary approval for his renegotiated deal with the EU. As a result, the EU has allowed a flextension, meaning that the UK should leave the EU by January 31, 2020 at the latest.

It ain’t over yet

Unfortunately, we may now just be approaching the end of the beginning rather than the beginning of the end in relation to Brexit. We believe that Brexit will remain a major source of uncertainty, affecting the European economies in a negative way throughout 2020 and likely beyond. In this opinion we put forward three arguments for this view.

A first reason is an unclear and unhelpful domestic UK political situation. The British government has lost its majority in the British Parliament, and, as a result, it has lost about a dozen important parliamentary votes. However, reflecting a popular mood which is entirely fed-up with the lack of progress on Brexit, Boris Johnson has presided over a sharp increase in the Tories’ standing in opinion polls through his signaled determination to ‘get Brexit done’. This has led him to take a gamble and to call an early general election (not scheduled until 2022) which, with the agreement of opposition parties, will take place on December 12.

Although it is generally expected that the Tories will be returned to power with a clear majority, opinion polls have given several seriously misleading signals in recent years both in relation to the general elections of 2015 and 2017 and in relation to the Brexit referendum itself. In spite of the UK’s ‘first past the post’ electoral system, two of the past three general elections have produced a hung parliament and the UK political establishment is having notable difficulties operating in this environment. While the Conservative party is likely to canvas on the basis of the current deal, the newly established Brexit Party may propose a cleaner cut with the EU, while the Liberal Democrats will propose a second referendum. Labour, the main opposition party, reflecting deep internal divisions that are weighing on their electoral prospects, have not yet formally decided, but may back a second referendum. So, while unlikely, the possibility of another ‘people’s vote’ on Brexit can’t entirely be ruled out, making the path to Brexit remain shrouded in fog.

Trade and trouble?

Even assuming Johnson’s strategy works and produces a decisive parliamentary majority to get the new Brexit deal ratified, there is a second, potentially far more important source of uncertainty. The current deal is focused on the withdrawal agreement, a temporary arrangement to avoid the UK crashing out of the EU and causing major economic damage. The future long-term relationship between the UK and the EU is only vaguely outlined in an accompanying Political Declaration. It remains to be seen how that document’s good intentions will translate into a detailed trade agreement between the UK and the EU27, as well as broader agreements on investments, regulatory cooperation, migration and labour mobility rights.

It should be emphasised that the main difference between the May deal and the Johnson deal is that the UK will now withdraw from the European customs union (albeit with a special status for Northern Ireland). Hence the transitory situation will be one of a free trade agreement between the UK and the EU27, while the default option – if no permanent deal can be agreed – is the WTO most favorite nation tariff rates. While the withdrawal agreement avoids WTO settings for now, if these were activated in the future, they would cause substantial and wide-reaching economic damage.

Some believe that the new Johnson exit deal prevents a default WTO option forever. However, that’s wishful thinking. Although the newly revised Political Declaration confirms the ambition to conclude a free trade agreement with zero tariffs and quotas between the EU and UK including guaranteeing a level playing field for fair competition, this commitment is not legally binding. One should rather expect a trade-off within the (future) British government between reaching a comprehensive trade agreement with the EU and concluding various comprehensive trade agreements with other trading partners that would limit future integration with the EU.

Although the EU is by far the largest British export destination, British exports are relatively diversified geographically. The Leave camp has always advocated that signing favourable trade deals with other countries would be a key benefit of leaving the EU. A related British ambition to build an extensive global trade network is likely to trigger tensions with the EU. The latter is afraid of a ‘tariff (and tax) haven at the Thames’. Moreover, this British trade policy strategy may distort ongoing trade negotiations, not least between the EU and the US. Although the UK would never benefit more from a favourable trade deal with the US than with the EU, the US may try to use the UK as a backdoor to the European single market via its UK connection and this may make the US less inclined to sign a significant trade deal with the EU, potentially increasing the prospect of a US-EU trade conflict.

Uncertainty weighing on economic performance

Thirdly, as uncertainty surrounding the Brexit process continues, the British economy will be harmed. While there hasn’t been a dramatic crash, UK growth has slowed markedly because of pronounced Brexit related problems in some areas. Although consumer spending remains positive on foot of a still strong job market, there has been a marked slowdown in the property market. Substantial difficulties are evident on the corporate side with capital spending by companies falling in five of the past six quarters on uncertainty and expectations of slower future growth. Similarly, uncertainty over future trading links, coupled with the importance of imported components in UK exports, has meant that weakness in Sterling hasn’t translated into any marked reduction in the UK’s large external deficit which was a worrisome 4.6% of GDP in Q2 2019.

There is little expectation that a UK-EU27 trade deal can be concluded quickly and, on current indications, any future agreement might be quite limited and thereby act as a long-lasting and material constraint on UK growth. Such an outcome would also dampen EU growth prospects. For these varied reasons, there are grounds to believe that the Brexit ‘cloud’ will continue to darken the European growth outlook and remain a complicating factor in political discussions for some considerable time to come. While recent developments suggest a Brexit ‘blowout’ may be avoided, at very best, it may put a slow puncture in European growth prospects in coming years.

Disclaimer:

All opinions expressed in this publication represent the personal opinions of the author(s) at the date stated therein and are subject to change without notice. KBC Groep NV makes no warranties as to the extent to which the scenarios, risks and forecasts proposed reflect market expectations, nor as to the extent to which they will actually materialise. All forecasts are indicative. The data in this publication are general and purely informative. The information cannot be considered as an offer to sell or buy financial instruments. Nor can it be considered as investment advice, investment recommendation or "investment research" within the meaning of the law and regulations on the markets in financial instruments. Save the express prior and written consent of KBC Groep NV, any transfer, sale, distribution or reproduction of the information, publication and data is prohibited, regardless of form or means. KBC Groep NV cannot be held liable for the accuracy or completeness of the information or for the direct or indirect damage that would result from the use of this document.

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