What effects will Brexit have on Estonia?

The Brexit Trade Agreement (TCA) leaves questions unanswered

Four and a half years after the Brexit referendum, the wait is finally over: Great Britain has left the internal market and the customs union of the European Union and broken away from a political and economic agreement that had been in effect since 1973. It is replaced by a last-minute commercial agreement that provides clarity in some areas but leaves others in the dark. So what Brexit will ultimately mean in practice remains to be seen.

In the tenth edition of our weekly series, the two Brexit experts from T. Rowe Price Quentin Fitzsimmons and Tomasz Wieladek provide an overview of the current state of affairs and their assessments for the future.

What has happened since our last issue?

After months of tough negotiations, Great Britain and the European Union agreed on a Trade and Cooperation Agreement (TCA) on December 24 to regulate their trade and security relations after Brexit. The contract was on the brink for a long time, as the negotiations have stuttered again and again since the official exit on January 31, 2020 - accompanied by fierce mutual accusations by the two parties. Even if most observers had expected an agreement of whatever kind, a no-deal scenario threatened the stock exchanges until the end.

However, at the time of the referendum, the result would have been described as a “hard Brexit”. The Duty Free Trade Agreement means that products that are wholly manufactured in the UK or the EU will not be charged any new taxes. However, the “Rule of Origin” clause also means that UK companies may be subject to VAT and import duties when exporting goods containing components made outside the UK or the EU. Aside from the customs issue, other barriers to trade will also increase as trade between the UK and the EU is subject to a number of new rules, controls and bureaucratic hurdles. The UK government estimates that companies will have to fill out an additional 215 million customs declaration forms when importing or exporting goods, which is likely to cause significant delays in ports like Dover.

- Quentin Fitzsimmons, Fixed Income Portfolio Manager

While some of the new rules will change trade in goods in the long term, the main burden, namely the cost of businesses adapting to the new trading conditions, is likely to be temporary pressure. More worrisome, therefore, is the fact that the agreement leaves out many services, which constitute a significant proportion of UK exports. For example, the area of ​​legal advice is regulated, while British financial service providers, for example, will in future have to trust that Brussels will award them the "equivalence" in order to offer their services as before in EU countries (an equivalence agreement establishes that the regulations of a third country are equivalent to those of the EU, so that the companies may operate in the other legal system).

The UK and the EU want to have a letter of intent on regulation and cooperation in the financial services sector by March. However, it should only set out the procedures for future action. Presumably, the European Commission will only grant equivalence after it has examined and assessed all regulatory differences. In addition, it has a considerable economic self-interest in granting equivalence only in areas in which either London enjoys significant competitive advantages or for which there is no adequate substitute in the EU. Ultimately, it seems unlikely that British financial service providers will have the same access to the EU market as they did before Brexit.

Until the relevant decisions have been made, the financial services industry is practically a no-deal. However, according to calculations by the London administrative authority, this accounts for 10.5 percent of all UK tax revenues. At the same time, around 40 percent of UK financial services provided abroad are in the EU. However, we also see an opportunity for areas in which no equivalence is granted. The British government can then deviate from the EU requirements at its own discretion and increase competitiveness without fear of customs consequences from the monetary union.

What's next?

In many areas, trade will remain subdued as long as the corona restrictions are in place. At the same time, many British companies replenished their stocks before December 31, and the British border authority apparently does not want to apply the new customs regulations until June 2021. These factors will initially mask the consequences of the UK's withdrawal from the internal market and the customs union, so that the longer-term regulatory effects of the Brexit agreement will only become fully apparent once the corona pandemic is finally behind us.

From today's perspective, there is an estimated 70 percent clarity about how the trade in goods will work in the long term. However, once all the open issues are resolved, some companies may ultimately conclude that trading cross-border is too costly for them.

In the service sector, negotiations on market access are likely to continue for some time. It remains to be seen how far the Memorandum of Understanding between the EU and Great Britain will go in March - if it comes about. However, Brussels is likely to be hesitant with further equivalence agreements, which is why it could take a while before there is clarity for cross-border financial services.

An extraordinary change - and an opportunity

In the short term, the economic outlook for Great Britain depends primarily on the costs of the switch to Brexit and the further course of the corona pandemic. Despite the higher stockpiling, the restricted movement of goods and people due to the pandemic, and the relatively loose border controls, the adjustment costs in the manufacturing sector should be clearly felt in the first quarter of 2021, which should put gilt yields and the pound under pressure.

The abolition of the EU law could increase working hours in the UK

The working time directive resulted in fewer hours worked per week

As of December 31, 2019.
Source: OCED / Haver Analytics.

At the same time, the UK is making significantly faster progress in vaccinating its population than the euro zone, which is why it should be able to lift the restrictions sooner - provided that no new, vaccine-resistant virus mutations are found. If the UK can ease restrictions three to four weeks earlier than the eurozone, the pound should see a boost against the US dollar. At the same time, gilt yields are likely to rise by spring as investors turn to riskier investments.

- Tomasz Wieladek, International Economist

The UK's exit from the EU marks a historic change in the trade regime and it will be a long time before a new economic equilibrium is achieved. The barriers to trade explained are likely to burden the UK gross domestic product in the medium term. At the same time, however, positive impulses could also be released if the government knows how to use its new regulatory freedom wisely. She would have various options for doing this.

- Quentin Fitzsimmons, Fixed Income Portfolio Manager

First, it could deregulate those areas of the economy that are not covered by the Brexit agreement. For example, the British government could abolish the bonus cap for banks that applies in the EU. Significantly higher variable remuneration, which is paid in addition to a correspondingly lower fixed salary, could be reduced more in the event of a crisis, which in turn would reduce the need for tax-financed rescue measures. Even if, as with any financial reform, excessive deregulation could lead to stronger boom-bust cycles, this risk is mitigated by the fact that the British regulatory apparatus established after the global financial crisis pays close attention to every reform and stress tests the financial system for its resilience to check out.

A second option would be to reduce the British implementation of EU regulation to the minimum standards. This would increase competitiveness without triggering retaliatory tariffs related to a level playing field. For example, the EU Working Time Directive requires a minimum of four weeks of paid annual leave for full-time employees, while the UK implementation requires 5.6 weeks (four weeks plus all UK public holidays). Reducing vacation time by one week per year - for example by partially paying off vacation time or increasing working hours by one hour per week - could increase potential UK GDP by 2 percent when the reform was introduced in 1998). Of course there will be political opposition to such changes in the labor market, but it is precisely such reforms that will help the economy the most in the medium term.

- Tomasz Wieladek, International Economist

Third, the UK government could use the post-Brexit political momentum to drive other economic reforms, such as those related to the UK planning system. The resulting stronger housing construction and lower costs could trigger a positive supply shock and increase the need for construction workers, which is expected to support construction wage growth across the UK.

Uncertain future

It remains unclear how Brexit and economic reforms will affect UK potential GDP growth over the long term. The consequences of the trade interruptions, which depend on various factors, such as the new legal framework for the offerings of British financial service providers in EU countries, are also unclear at the moment. At the same time, the impact of reforms on productivity growth will depend primarily on the depth, breadth and political acceptance of such reforms.

Even after the corona pandemic, the trade conflicts will continue to weigh on British GDP for some time. However, if the UK government takes full advantage of its new regulatory autonomy, while leveraging post-Brexit political momentum to reform certain areas of the economy, it could have a significant positive impact on potential GDP growth. The next two to three years will show whether this will succeed. Any indication that the UK is taking this path is likely to steepen the gilt-yield curve and strengthen the pound against the euro in the medium term.