Five levers to tackle the economic shock of no-deal Brexit

10.2.19

www.politico.eu

Five levers to tackle the economic shock of no-deal Brexit

None of the weapons at the UK’s disposal comes without downsides.

It’s 11:01 p.m. in London on Friday, March 29 and it’s no deal. Britain will need to take immediate action to try to shield the economy from shocks, probably before markets open, on April Fools’ Day.

Here we take a look at some of the emergency levers that U.K. policymakers can pull.

Britain’s import-dependent economy has never looked so vulnerable in peacetime. An inflation bomb is set to explode. A diving pound and tariffs on key products from the EU such as food would hit consumers hard. Britain runs a hefty trade-in-goods deficit (of about £130 billion in 2016 and 2017), and sources about half of its food from abroad.

Policymakers will have to make hard choices on how to manage the currency — particularly on whether to hike or cut interest rates — when core elements of the economic model will be under fire. Markets have traditionally been tolerant of U.K. debt and deficit levels because the country was a prime venue for foreign direct investment from big companies such as Airbus and Nissan, but these are now in question.

As Bank of England Governor Mark Carney put it, Britain relies on the “kindness of strangers.” This has been drying up because the U.K. is becoming a less attractive investment destination outside the EU single market. Foreign direct investment more than halved to $15.1 billion in 2017, from $32.7 billion in 2015, according to U.N. figures.

Here’s our look at the five responses that the U.K. will need to consider. All have disadvantages.

1. Drop import tariffs to avoid big price hikes

If Britain leaves the EU without a deal, tariffs would be imposed on imports that used to come in freely from the EU. For example, Britain’s tariff on beef purchases would be around 40 percent.

To avoid food price inflation, Britain could lower or completely scrap tariffs on things such as food, car parts or medicines.

Catch No. 1: The World Trade Organization’s “most favored nation” principle dictates that these tariffs must be the same for all WTO members, unless you’re in a trade deal or in a regional bloc like the EU. This means not only French but also South American beef or cheese would come to Britain tariff-free.

Farmers would lose out, as cheap imports undercut their products. The government’s brutal calculation would have to be that farmers are far less important to the economy than supermarket prices for the whole population.

Trade Secretary Liam Fox told the U.K. parliament’s international trade committee on Wednesday that waiving tariffs to stimulate trade is a “possibility.” But the “full liberalization of tariffs … would certainly expose the U.K. to sudden competition in sectors to which it’s not currently,” Fox said.

Catch No. 2: By slashing tariffs, you have effectively gifted away your leverage in trade negotiations with other partners. They will already be shipping their goods tariff-free, they don’t need a deal. British tariffs may be down, but those of trade partners won’t be — putting British exporters in a difficult spot.

2. Use the Article 21 ‘nuclear option’

A hard-line solution would be to only lower tariffs to EU imports and ignore the WTO rules. Other countries would probably complain and launch WTO disputes, but Britain could fend them off by calling on Article 21 of the WTO rulebook, the infamous “national security” exemption, favorite of Donald Trump.

British Conservative MEP David Campbell Bannerman suggested this option in a Telegraph op-ed last month, saying the “national security” justification is possible because Britain would be “seeking to avoid security issues at the Northern Ireland border.”

Article 21 has long been a taboo in the trade world, but over the past one and a half years it has gained some dubious popularity as the United States, Russia and the United Arab Emirates invoked the exemption to justify questionable actions such as protective tariffs and border restrictions. The EU is a sharp critic of such steps and has warned that abusive use of Article 21 risks undermining the entire multilateral trading system.

Triggering this “nuclear option” would be risky for Britain too: “It would be an incredibly damaging way for the U.K. to start its new role as an independent member of the World Trade Organization,” said Dmitry Grozoubinski, a former Australian WTO negotiator. He warned that using such an “excuse for breaching most-favored nation rules” could backfire as Britain would likely use all the goodwill it would need in other talks, both bilaterally as well as at the multilateral WTO level.

3. Rates. Should I cut or should I hike?

Money is Britain’s supreme challenge. Many economists think the Bank of England will probably inject the markets with fresh money to try to prevent a meltdown. But this will also come at a cost for consumers, who will have to face higher prices.

Those looking to give the economy a shot in arm also reckon that the Bank of England would likely slash the base rate from the current 0.75 percent, accepting that this will exacerbate inflation.

Such a cut is not guaranteed, however. The Bank of England’s Carney has warned that businesses should not rule out an increase in the base rate. While this would help bolster the pound, a hike poses big challenges in the U.K., where mortgage debt is high and higher rates could create a housing crisis and sap household spending.

According to the Bank of England, Britain’s economic activity would fall by as much as 8 percent in the case of no-deal. The bank warned that in this scenario “output falls by more than it did in the financial crisis.”

One of the biggest immediate risks on Brexit day is that banks stop lending money to businesses or even to each other, out of fears that they won’t get their money back.

“Like at the moment when Lehman Brothers collapsed or 9/11, the central bank would certainly respond by injecting short-term liquidity,” said ING Chief Economist Carsten Brzeski.

In order to stimulate growth, the BoE may then want to use quantitative easing. “You will have to ask yourself how much you can stimulate without driving up inflation,” Brzeski said. “The pound will be weaker, so there will already be what we call imported inflation.” Further monetary loosening would make this worse.

Another of Britain’s vulnerabilities is that economists caution that a weak pound is not unadulterated good news for exporters. Many manufacturers insist they would prefer a stable to a weak currency because they are so dependent on imported raw materials and components.

4. Stop customs checks

Slashing tariffs will help soften the blow of higher food prices on consumers. But it won’t help businesses whose shipments are stuck in ports. Customs checks could lead to kilometers of trucks at highways and at the entrance to the Channel tunnel.

That will be one of the main costs of a hard Brexit, some economists say, in that it disrupts supply chains and ruins businesses that rely on just-in-time production. That’s why some businesses and pharmacies have started stockpiling supplies.

To avoid such a mayhem, the U.K. government could decide to wave through imports at its ports. It has already announced that it would do so for EU goods.

The risk of that is obvious: Suspend customs checks for too long, and Britain could become a smugglers’ paradise.

The EU may not do the same for U.K. exports coming in, meaning British exporters will struggle to get their merchandise into their biggest market.

The longer this situation persists, the more manufacturers would move their factories into the EU, meaning the U.K.’s trade deficit could widen.

5. Deregulate to become a fiscal paradise

This is the dream of hard-line Brexiteers like Jacob Rees-Mogg and Daniel Hannan. Once Britain leaves the EU without a deal, it could become a fiscal paradise, dropping taxes and deregulating its industry. This could attract investors as France and Germany show signs of pursuing a more protectionist model.

This is a longer-term solution, however, and will do little to resolve instant shocks.

The political risk is that deregulation could mean lowering standards on things like food safety, scrapping checks on dangerous chemicals, environmental protection, unemployment, or health benefits and consumer rights.

You can read the article as it originally appears by clicking here.

A ‘Managed No Deal’ WTO option using Article 24 of GATT can avoid raising tariffs or quotas

WTO imageIn the aftermath of Parliament’s rejection of the draft Withdrawal Agreement, there is a way forward for the Government which allows a smooth transition into a No Deal scenario after 29th March, if found necessary, and then allows the UK to negotiate its desired comprehensive Free Trade Agreement with the EU without having to impose tariffs or quotas in the interim. There is a mechanism to ‘manage’ a No Deal scenario; one that works within existing WTO rules, and that is not widely known about.

This is essentially an alternate transition or interim period, but within WTO rules without having to levy tariffs or (arguably) pay membership fees to the EU, but requiring some customs forms levied on the 7{6c073e6ddc991e32b987c2976a0494c1ef7e7c4976e02d56946b9937f4a8f0f4} of UK businesses (400,000 out of 5.7 million UK private registered businesses) that actually trade with the EU. This is the deal with the EU used by China, the USA, India, Australia and New Zealand for example.

These recommendations are based on my nearly ten years of experience as a member of the European Parliament’s International Trade Committee, working on EU trade deals such as those with Canada, New Zealand, India, South Korea, Japan and Columbia/Peru, and drawing on high level discussions I have had with senior trade representatives for the EU and the World Trade Organisation (WTO).

In the event of No Deal, there is a strong case to maintain preferential tariff and quota rates at zero between the UK and the EU for a limited period – thought to be around two years. There are a number of arguments for exemptions to what are termed ‘Most Favoured Nation’ (MFN) rules, which require the same treatment in terms of tariff rates and treatment between WTO members to avoid discrimination. They are:

1) It is to the advantage of fellow WTO members to minimise disruption between our two large markets, which would reduce knock-on impacts to their imports/exports to the UK or EU markets. WTO members have to show financial harm to justify objections to practices (or tariff schedules). Civitas calculate that £13 billion of tariffs would have to be levied on EU goods entering the UK and £5 billion on UK goods entering the EU Single Market if standard tariffs are levied under No Deal. This is one justification for keeping preferential rates of tariffs for a period whilst a full trade deal is finalised.

2) There are exemptions under National Security grounds such as over the issue of Northern Ireland, which the IEA have argued as a case for an exemption, but this is less appealing given its association with US and Russian cases for exemptions, such as over US tariffs on Chinese steel.

3) Exemptions to ‘Most Favoured Nation’ (MFN) rules under Article 24 of the General Agreement on Tariffs and Trade (GATT) 1947. This appears to be the most substantive argument. WTO rules state that preferential benefits, such as tariffs and quotas for goods which are more favourable than MFN treatment, may only be extended to another country if it is part of a customs union or a free trade area. The ultimate legal authority to grant such preferences is Article 24 of GATT , incorporated into the WTO regime when that body commenced operations in 1995.

Article 24 is helpfully the ultimate basis in international law for the existence of the EU itself as a preferential trading bloc, which grants preferential treatment to its members within the Customs Union.

If the UK accepts Donald Tusk’s offer of a free trade agreement along the lines of CETA+++ or what I propose as ‘SuperCanada’, then the UK and EU will be in the process of moving towards creating a free trade area – Tusk has offered a tariff and quota free deal plus services (whilst leaving the EU Customs Union) – so qualifies under this criterion.

There are two under-appreciated aspects of Article 24 which have direct relevance to our situation, and which provide reassurance.

Firstly, Article 24, para 3 states:

The provisions of this Agreement [i.e. the requirement to extend MFN treatment equally to all] shall not be construed to prevent:

(a) Advantages accorded by any contracting party to adjacent countries in order to facilitate frontier traffic

  • This has direct relevance to the position of Northern Ireland, and our adjacent country of Ireland. Some commentators have claimed that a sensitive and appropriate management of trade which respects and upholds both the letter and the spirit of, for example, the Good Friday Agreement would be in some form an unauthorised infringement of MFN treatment. That claim is clearly untrue.
  • There is also no obligation under WTO rules to erect a so-called “hard border” on 29th March. Government may continue discussions with our counterparts in Dublin to arrive at adequate and effective technological measures for the management of trade with minimal friction. You will have noticed the encouraging signs that the Irish Government already appreciates this fact. (See, for example, “Ireland has no plans for hard border after Brexit, says Varadkar”, from The Guardian of 21st December 2018)
  • We can expect that there will be considerable international sympathy for measures which support the situation in Northern Ireland, and hence a reluctance on the part of third countries to lodge objections. Although given the sensitivities this should not be stressed too heavily, such an exemption falls into ‘National Security’ related actions.

Secondly, Article 24 not only authorises member states to operate lower/zero tariff free trade agreements, it also permits them to offer lower/zero tariffs pre-emptively during the course of negotiations. The relevant provision, Article 24 para 5, is worth quoting at length, with emphasis added to the critical wording:

Accordingly, the provisions of this Agreement shall not prevent, as between the territories of contracting parties, the formation of… a free-trade area or the adoption of an interim agreement necessary for the formation of… a free-trade area; Provided that:…

(b) with respect to a free-trade area, or an interim agreement leading to the formation of a free-trade area, the duties and other regulations of commerce maintained in each of the constituent territories and applicable at the formation of such free–trade area or the adoption of such interim agreement to the trade of contracting parties not included in such area or not parties to such agreement shall not be higher or more restrictive than the corresponding duties and other regulations of commerce existing in the same constituent territories prior to the formation of the free-trade area, or interim agreement as the case may be; and

(c) any interim agreement referred to in subparagraph… (b) shall include a plan and schedule for the formation of such… a free-trade area within a reasonable length of time.

(A WTO declaration, the Understanding on the Interpretation of Article 24, 1994, clarifies that the ‘reasonable period of time’ in para 5(c) will generally taken to be no more than 10 years.) I estimate based on EU trade deals to date, that a UK-EU comprehensive Free Trade Agreement could take around two years, especially given the unique reality that the UK is starting from a convergent position with the EU, with zero tariffs and quotas and with our laws and standards currently harmonised.

  • If, before 29 March, the UK has reached an ‘interim agreement’ with the EU to pursue negotiations towards a comprehensive free trade deal, both sides would be permitted under WTO rules to continue with the present zero tariff/zero quota trading arrangements. There would be no disruption to the man or woman on the high street. No Deal would mean No Change, as the cost of goods would not go up.
  • In the present situation the ‘interim agreement’ would not have to be an extensive document running to hundreds of pages. The schedule of items covered by the negotiations would be all goods, as already envisaged in our discussions with the EU. The plan which the document sets out would have to amount to little more than a timetable for regular meetings and an ultimate deadline, some years hence, by which point negotiations will have to be concluded.
  • An ‘interim agreement’, then, need be little more than an agreement to continue talks – while also continuing zero-tariff and zero-quota trade on both sides – plus a deadline no later than 29th March 2029. I accept that the EU has so far declined to agree any deadlines (other than 29th March) but since the absence of a final cut-off point has been a major contributing reason for Parliament’s rejection of the Draft Withdrawal Agreement, perhaps the EU will now reassess that stance.
  • Whilst legal challenges at WTO level might be expected from an unhelpful member, the reality is that any such challenge is unlikely to get to the WTO ‘court’ – its appellate body – for at least two years and possibly longer, and only if that body finds the UK non-compliant would any compensating actions be authorised such as tariffs. This is within WTO rules, and if any challenges arise a fully compliant Free Trade Agreement should already be in place by the time any appellate body were to meet. The EU is now under extreme pressure from EU27 industry and commerce who enjoy a £96 billion surplus with the UK.
  • You will recall that the draft Political Declaration indicates the EU want to reach a comprehensive Free Trade Agreement with the UK on the basis of zero tariffs and quotas (see paras 17, page 5, and para 23, page 6) and extending to services (para 29, page 7). Those provisions are fully in line with numerous public statements made since the 2016 referendum by Donald Tusk, President of the European Council, and Michel Barnier, European Chief Negotiator – offering a CETA+++, or what I term a ‘SuperCanada’ trade deal, on 7th March 2018, 30th August and 6th October 2018.

It is significant that Heiko Maas, Foreign Minister of Germany, has already indicated a willingness to continue talks (see “Germany says EU ready to talk if UK rejects Brexit deal” on Reuters, 15th January).

Conclusion

This approach would continue the pre-29th March status quo in trading arrangements and patterns without interruption, justified by an explicit provision of the WTO regime. The possible grounds on which any third country could lodge an objection to this are extremely slight (unlike for schedule changes).

An ‘interim agreement’ would therefore be an important component of a ‘Managed No Deal’ outcome from 29th March. It permits trade between us and the EU to continue without tariffs or quotas under No Deal while creating a space for negotiations to be reset and recommenced on the basis of reaching a SuperCanada or CETA+++ trade treaty.

I urge the Government to now adopt this course of action, as it will mitigate the main impacts of a ‘No Deal’ Brexit and eliminate the task of having to assess and charge tariff rates on 19,753 MFN tariffs under the EU Customs Union, thereby substantially reducing friction at borders.

You can read this piece by David as it originally appears on brexitcentral.com here