25 May 2017

CER: Why no deal would be much worse than a bad deal

[...] Were the UK to leave without a deal of any kind, EU tariffs would immediately be payable on imports from Britain. These average about 4 per cent, but vary hugely. British food exporters would face average tariffs of 14 per cent. British car exports, which have grown more rapidly than any other category of manufactured goods exports over the last ten years, would face a 10 per cent tariff. The UK would also have to impose tariffs on its imports from the EU: it would only be allowed to reduce tariffs to zero – as some eurosceptics have proposed – if it did so for all countries, not just the EU.

The imposition of tariffs would be massively disruptive, not least for the car industry, which relies heavily on components crossing borders many times before a vehicle is assembled. Car components would face a tariff of 3 per cent, but even that is enough to disrupt supply chains. The local content of a British-built car is just 40 per cent, with most of the rest being imported from the continent.

Britain would also exit the EU’s customs union, with the result that rules of origin would immediately come into force. Rules of origin are used to determine the national origin of a product, and hence whether tariffs need to be applied to it and at what level. The UK would face the EU’s common external tariff, so all British exports would face EU tariffs. But rules of origin are also used to determine EU anti-dumping measures, labelling and product standard requirements, and for the collection of trade statistics. The process would be time-consuming and costly, and many firms, especially smaller ones, would be unable to comply and would cease exporting to the EU.

Perhaps the most damaging aspect of ‘no deal’ would be that, outside the EU’s legal framework, many UK products would no longer be accredited for sale across the EU. [...] British-based financial firms would lose their passporting rights overnight, and mutual recognition of many regulatory standards would end. That would lead to a sharp fall in financial services exports, and acute legal uncertainty over contracts. Crucially it would affect the clearing and settlement of financial trades, especially of derivatives (futures, options and swaps), which are overwhelmingly centred in London.

Of course, ‘no deal’ would pose challenges for the EU too, and the largest of these could be financial. There has been a lively debate between central bankers about the financial stability risks to the UK and to the EU-27 from a sudden end to the operation of EU law in the UK.

UK officials say that the City of London is essentially the hedging capital of the EU. Continental banks use the City’s services to hedge against risks to their assets. They rely on short-term deposit financing, and lend out, long term, on fixed interest rates. They need hedging instruments to ensure that their short-term financing needs are met in the event that markets shift suddenly. If EU banks were cut off from the UK market, because the UK had left the EU and its clearing houses were not yet deemed ‘equivalent’ by the EU, derivatives trading would become more expensive and so hit eurozone banks.

Yet EU officials say that these fears are overblown. Banks can go to New York to clear derivatives, because the US’s regulation and supervision of clearing houses has been deemed equivalent by the EU. And eurozone banks would not be cut off from the UK market – the use of clearing houses in countries that do not have equivalence simply requires banks to set aside more capital. It would be a bit more expensive, but manageable.

Crucially, the EU has the power to contain the negative financial fall-out from the collapse of negotiations with the UK. If the UK walks away from the talks, the EU could grant the UK temporary equivalence in those forms of transaction that are critical to financial stability. For example, the EU could grant UK-based clearing houses temporary equivalence for a year, so eurozone banks could still clear and settle derivatives contracts in London. [...]

What would all this mean for the UK economy? British exports of goods and services would shrink very sharply. The hit to exports and to the attractiveness of the UK as a place to invest would in all likelihood provoke a sharp fall in the value of sterling, which could reach parity against the euro and possibly against the dollar too. Inflation would rise as the weakening of sterling and the imposition of tariffs boosted the prices of goods, in turn eroding disposable incomes and consumption. The result would be a deep recession, which would hit tax revenues and weaken the government’s ability to impart a fiscal stimulus to support the economy. The loss of investor confidence in the UK economy might present the Bank of England with the awful choice of either having to stabilise sterling by raising interest rates, or to stimulate the economy. [...]

Full publication on CER

© CER