The United Kingdom left the European Union at the end of January. Given that 2020 is a transition period, however, Britain for now will only cease to be involved in the EU’s decision-making process. No immediate economic changes will happen — it will remain in the EU’s customs union and single market until the end of this year.
The question is what will happen in and after 2021. British Prime Minister Boris Johnson asserts that he will sign a free trade agreement with the EU by the end of this year and will not extend the transition period through 2022 as allowed under an agreement with the EU. This means that if the FTA is not concluded by the end of December, Britain and the EU will impose regular tariffs beginning next year on goods imported from each other.
An U.K.-EU FTA will eliminate tariffs on automobiles, but a 10 percent tariff will be imposed in the absence of a free trade deal. If an auto plant in Britain imports parts and components (such as steel and electronic devices) worth 50 percent of the finished products from the EU and then ships the vehicles to the continent, a 10 percent tariff on vehicle parts will push up the manufacturing cost by 5 percent. The 10 percent duties on vehicle imports to the EU will effectively raise the tariffs to 15.5 percent.
That will be a big blow to auto manufacturing plants in the U.K. Japanese automakers that have plants in Britain would be forced to reconsider the sites of their manufacturing operation. All eyes will be on the upcoming free trade negotiations between Britain and the EU.
EU officials have already indicated that level playing field must be secured — that tariff-free access to the single market will not be provided unless Britain promises to adopt labor and environmental regulations equivalent to the EU’s — or that it would be difficult to wrap up the talks with the U.K. since it took four years to conclude the free trade negotiations with Japan. Behind such remarks are believed to be the EU’s intensions to keep the U.K. in check as a competitor. Some top leaders of member states say that the EU with its larger economic scale should be able to take the upper hand over Britain in the talks.
As for financial services, there is a system called single passport in which a company that has been licensed to run its business in any single country within the European economic area (which includes the EU) can operate in any other parts of the area. That system has prompted many financial institutions to locate their European headquarters in London, where the City is located. A question going forward is whether the EU will allow the U.K. to remain in the system.
But is Britain really in such a weak position? In goods trade, the EU registered a surplus of £94 billion with Britain in 2018. It is the EU that wants to maintain free trade with the U.K.
Concerning the level playing field argument, the EU cannot press a sovereign state to continue to abide by EU rules into the future. That’s why Britain opposed the “backstop” plan that was agreed on between former Prime Minister Theresa May and the EU. Conversely, the reciprocity principle will dictate that the EU would not be allowed to ease its regulations more than the U.K. does.
But is that acceptable to the EU? It would be unfair for the EU to demand anything from Britain that it has not demanded of Canada or Japan. As for the euro-financing business, large numbers of financial institutions have already moved their European operation bases from London to the continent. In that sense, Brexit has already taken place.
The EU is in a weaker position on some issues. Fishermen from EU member countries like France, the Netherlands and Denmark catch 42 percent of their total regional haul within Britain’s fishery waters. Fisheries industries matter politically because they are an important part of the region’s economy. So far, catch quotas were assigned to each of the member states under the EU’s common fisheries policy — in other words, by Brussels.
From now on, the British government will allocate annual quotas to each country based on its estimate of the resources in its fishing waters. The EU will be in a position to make requests to Britain. Unless the EU comes to an agreement by the end of this year, the catch quotas for EU member states could potentially be cut to zero in 2021 and onward.
According to an accord made between the U.K. and the EU last year, the two sides are to reach a conclusion on the financial services and fisheries issues by the end of June. June is also the deadline for making a decision on whether to extend the negotiations beyond 2020 — an indication that negotiators on both sides believed the financial services and fisheries issues will determine the course of the whole talks.
Should the EU take a hard stance toward the U.K. on the financial services issue, Britain can do the same vis-a-vis the EU on the fisheries issue. Clever negotiations may enable the U.K. to control the talks. If both Britain and the EU really want to avert a no-deal Brexit, they should hold intensive talks so they can come to an agreement by the end of the year.
A failure to conclude an FTA, on the other hand, will not necessarily be a bad thing. From the viewpoint of international economics, a customs union and a free trade agreement to eliminate tariffs on imports solely from a particular country has a demerit called the trade diversion effect. In the absence of such trade agreements, a nation imposes uniform tariffs on imports from all other countries, and it therefore imports from the country that can supply the goods at the cheapest cost worldwide. But when it concludes a free trade agreement with another, it will convert to tariff-free imports with the partner in the agreement. From the importer’s standpoint, it will be a problem buying more expensive goods just because they’re tariff-free.
Britain’s departure from the EU means that it no longer has to buy EU wheat, which is more costly than American or Australian wheat. That means a loss for EU members like France, which have so far been able to export their costly products to Britain. The trade diversion effect will be reinstated if the U.K. concludes an FTA with the EU. But that will disappear again if Britain signs an FTA with the United States or joins the TPP-11, of which Australia is a member.
Such a trade diversion effect has so far not come up for public discussion because the customs union enabled consumers to buy the goods at low cost, and probably because people at large did not realize that tariff revenues have been lost.
Meanwhile, the need for border control and customs procedures will not change either in a Brexit accompanied by an FTA or in a no-deal Brexit. It was argued that a no-deal Brexit would make the customs procedure more time-consuming and supply chains between Britain and continental Europe would be damaged. But that would not change if mutual tariffs are eliminated by concluding a free trade agreement.
The backstop plan was aimed at keeping Britain within the EU customs union to avoid a border control between Ireland and Northern Ireland because one would become necessary under a free trade agreement.
Either a customs union or an FTA will mean the application of lower tariffs than those promised under the World Trade Organization rules. One important difference between the two is that under an FTA, each of the participating countries will impose different tariffs on imports from non-member countries. For example, country A and country B — both parties to a free trade agreement — may impose a 100 percent and 1 percent tariff, respectively, on beef imports from non-member states.
Since mutual tariffs will be zero among participants in the FTA, the tariff on beef from country C — a non-member — imported to country A via country B will be 1 percent, making it difficult for country A to protect its domestic beef industry. To prevent this, beef imported tariff-free to country A must be proven to have originated from country B through a certificate of origin. To trade goods at zero or low tariff through an FTA, border control will be necessary to examine whether the traded goods meet the rules of origin.
Under the EU single market, food and industrial product standards have so far been unified. But if Britain is to create its own standards following its departure from the EU, the imports must be screened at the border control to see whether they meet the standards of each country or group.
A failure by Britain and the EU to reach agreement by the end of 2020 should not be considered a grave problem. Tariffs will be temporarily reinstated in 2021, but that should disappear if they can agree on an FTA, for example, in 2022.
Even without a U.K.-EU free trade agreement, Britain can implement an FTA with Japan beginning in 2021, when it leaves the EU customs union. The same goes for an FTA with the United States. The U.K. will become free to conclude a free trade deal with countries with which the EU does not has an FTA. Britain is interested not only in an FTA with Japan but joining the TPP. Britain’s departure from the EU may reduce its influence in the global community, but in economic terms Brexit will not be an entirely bad deal.
Kazuhito Yamashita is research director of Canon Institute for Global Studies and a senior fellow of the Research Institute of Economy, Trade and industry.