U.K. starts new chapter after EU split

U.K. starts new chapter after EU split

  • It is strategic for the U.K. to have a trade deal with the EU given the short- and long-term negative effects of Brexit.
  • The deal will allow for tariff-free trade in goods, but there is uncertainty in financial services.
  • In our view, Brexit with a trade deal significantly reduces the chances of a rate cut in the near term.

The United Kingdom is the first country to leave the European Union (EU). The split, known as Brexit, has now been finalized, and a trade agreement between the two sides took effect at the start of 2021. We review the key features of the trade agreement and their potential implications for the country’s economy.

A look at Brexit

We expect negative medium- or long-term impact from Brexit on the U.K. via trade and investment channels. As part of the EU, the U.K. economy benefited from European and other international investments over the years. Compared with mainland Europe, the U.K. economy is more dynamic and flexible. In our view, it is easier to start and do business, its tax code is less punitive, and the legal and regulatory systems are more efficient and business friendly. For these reasons, some companies preferred to use the U.K. as a manufacturing and service hub for European clients. We believe that the Brexit referendum may have damaged the attractiveness of the country for some future investments.

The Brexit referendum may have damaged the attractiveness of the country for some future investments.

If a company’s business model is becoming less attractive due to Brexit, the firm would not likely invest in the U.K. even though it may choose not to reverse the initial investment. We would expect this process to be a slow bleed on the U.K.’s balance of payments and weigh on its growth potential by reducing aggregate spending and employment, all else being equal. A trade deal partially addresses this problem since businesses may maintain their production facilities or even increase their size as long as goods can flow freely across the borders.

inflation chart

Benefits of a trade agreement

Businesses are likely to attach higher risk to investing in the country when there is more uncertainty about the future. Given these near- and longer-term negative effects of Brexit, it was advantageous to have a free trade agreement with the EU.

The U.K.-EU Trade and Cooperation Agreement (TCA) is more than a trade deal. It is a first for establishing common standards in business subsidies, labor rights, law enforcement, digital trade, data exchange, and other areas. These provisions were put in place to address the sticking points during the negotiation process. However, they have potential to limit both sides’ flexibility.

The agreement allows for tariff- and quota-free trade in goods traded bilaterally between the U.K. and the EU. It sets out thresholds on the proportion of non-U.K. or non-EU inputs used in the production to qualify for tariff preferences. There are also product standards. All goods entering the EU will have to meet the organization’s standards, and vice versa. Still, businesses will face border checks and customs declarations. We expect that there will be some bottlenecks near the borders over the near term.

Services sector

The trade deal is in goods but not in services. Although the deal provides market access for services that goes beyond standard World Trade Organization commitments, U.K. service providers will lose their automatic right to offer services in the EU. The deal does not include any provisions relating to equivalence in financial services. U.K. financial service firms will be deprived of the passporting rights that allowed them to offer their services across the bloc. They have to establish a base in the EU.

Securing a trade deal on goods, while leaving out more competitive services, limits the damage on the government’s balance of payments.

The U.K. is a serviced-based economy. Although the U.K. doesn’t have any comparative advantage in goods, it does have some in services. The country contributes to price setting. Therefore, we do not expect the services business to be affected as severely as feared. Securing a trade deal on goods, while leaving out more competitive services, limits the damage on the government’s balance of payments. The trade balance has a deficit in goods but a surplus in services.

Central bank interest-rate policy

While it might be tempting to conclude that Brexit is over, the relationship with the EU will probably evolve over time. Some of the items that are not part of the TCA can be negotiated later. Unexpected or undesirable consequences of the agreement can also arise.

The deal mitigates some of the immediate economic costs of leaving the EU. That should reduce the likelihood that the Bank of England will cut the bank rate to negative in the near term. However, its main trade partner has a negative-interest-rate policy, so the BoE is likely to keep negative rates in its toolkit.


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