Secret Economist January 2021

Deal done

The news from the UK and EU trade talks has ebbed and flowed over recent days and weeks. At one point the prospects of a deal looked dead in the water, while talks were abandoned on more than one occasion. Indeed, the UK went as far as to ramp up its preparations for a no deal Brexit. This included telling supermarkets to stockpile ahead of anticipated disruption to the food supply chain.

It would seem though that a deal has been agreed, albeit at the last minute of the discussions, or rather on Christmas Eve. 

The ratification process ought to be straightforward in terms of getting sufficient support both from the government backbenches and the opposition, with no deal being the alternative.


So what are key elements of the deal?

First and foremost, this is a free trade deal, so has no tariffs or quotas, on goods imported or exported to and from the European Union as of 1st January 2021, replacing the transition arrangements that were in situ post the UK formally leaving the EU on 31st January 2020.

There are to be additional security and safety checks at borders, as well as additional paperwork, in the form of customs declarations, which could delay delivery of goods to and from the EU. However, the UK and EU will recognise each other’s Authorised Economic Operator schemes (AEO) which will allow AEO-approved firms to move goods more seamlessly between economies.

There are no clear long-term arrangements for financial services. However, the vast majority of banks and financial firms have already made provisional new working arrangements across jurisdictions in advance of the changes, as an agreement on services always looked unlikely. There are some indications that the UK financial services sector will have access to the EU market under a system of ‘equivalence’, but that can be withdrawn with as little as 30 days’ notice.

On fishing, the UK has won back its fishing waters, but will allow for a step down in access to those waters over a 5½ year period, which will see the EU’s quota reduce by 25% over that period. At the end of this period, there will be additional negotiations over future access.   

On state aid, the UK government can set its own subsidies for domestic businesses/sectors. However, the EU can contest any state support in UK courts, and, according to the Financial Times, impose tariffs to counter the effects of trade-distorting subsidies (with an ‘undefined’ arbitration system in place also). Although the agreement mentions taxation, it is surprisingly thin (given the almost 1300 pages it runs to) on any dispute resolution mechanism if the one party materially diverges on taxation versus the other. This might be very interesting given the ongoing debate over the taxation of digital industries, for example.

The UK and EU are able to set their own rules on environmental standards, employment laws etc, but again material divergence versus the other economy can result in tariffs being imposed.

On travel, visas will be required for stays longer than 90 days, and UK students will no longer participate in the EU’s Erasmus scheme to study abroad (with the exception of Northern Irish students, whose participation in the scheme will continue, funded by the Republic of Ireland government). For the rest of the UK, study abroad will be replaced by the Turing scheme.


What are the economic implications?

A trade deal with the EU will be supportive for both the UK and EU, since it removes any additional negative impacts from a no deal Brexit, which could have taken an additional 5% from UK GDP, and up to 1% from EU GDP. 

The impact on labour markets is less clear. With the deal making no provision for the free movement of labour on either side, then it will be down to both economies to determine what rules they will introduce in order to manage migration. In the UK’s case, they have outlined a points-based migration system, applicable on a worldwide basis, which will afford the same opportunities to those in Europe as those outside of the continent. Will this prompt a reduction in the numbers of jobseekers from Europe? The data from migration over the last 18 months suggests that is what is already happening, although the level of migration from the rest of the world to the UK has increased to fill the gaps thus far. 

Will inward investment into the UK be negatively or positively affected by the changes? The UK government has signed 62 free trade deals with countries around the globe, although many of these simple replace the existing deals these countries had with the UK under the EU. 

For monetary policy this also removes some of the worst possible outcomes for both the UK and EU. It is now much less likely that the UK will move to negative interest rates or indeed require hundreds of billions of pounds in additional quantitative easing from the Bank of England. As for the Eurozone, this could alleviate some of the deflationary risks around lower demand for goods, again reducing the need for further monetary loosening from the European Central Bank. 

That is not to say that the central banks won’t loosen further, but the demand for it won’t be driven by a no deal Brexit on trade.


What are the implications for the FX markets?

On the face of it, the announcement of a deal is supportive for the pound, but clearly the markets had priced in a high degree of certainty that a deal would be done. Therefore, the additional impetus for a rally from here against the likes of the euro and US dollar will be limited.

I am sceptical over the additional upside for the pound against the euro and US dollar over the coming months. This is because for the first few months, at least, there is still likely to be significant upheaval for businesses as they adapt to the new systems around trading with our neighbours on the continent. Indeed, each setback might in fact erode some of the hard-won strength we’ve seen in the British pound as the optimism over the deal has grown. Moreover, this may prove to be an opportune moment for those that have bought the pound in recent months to sell it, having benefited from a rally, particularly against the US dollar. Over the first few months of 2021, we could see GBP/USD heading back below $1.30, and GBP/EUR back beneath €1.09.

Perhaps the optimism over the UK-EU trade deal has been superseded by the developments over Covid-19. With the UK heading for increasing restrictions over a larger chunk of the population into the New Year, and Europe also suffering an elongation of restrictions and lockdowns, 2021 is set to get off to a difficult start, which may be reflected in a weaker euro and pound against safe-haven currencies such as the Swiss franc, Japanese yen and US dollar

After the teething problems are over, I’m optimistic that the new relationship between the UK and European Union can prove mutually beneficial, and we should all be mightily relieved that a compromise has been reached. 2021 should, given the positive news on UK-EU trade and COVID vaccines, be much improved the further into the year we get.

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The views and opinions expressed in this article are those of the author, The Secret Economist, and do not represent moneycorp or any affiliated entity.

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