RaboResearch - Economic Research

Will COVID-19 force a Brexit extension?

Special

Share:
  • Markets and media are –rightly so– focused on everything that is related to COVID-19, yet the Brexit-clock ticks away in the background. The first real deadlines are nearing fast
  • There has been little progress in the negotiations, and the pressure on the UK government to ask for an extension of the transition period is building
  • The arguments to buy more time are compelling. But if Brexit was built entirely on rational arguments, the UK government would have already sought for such an extension by now
  • In this note, we’ll challenge the conventional wisdom and look for reasons why the UK government would not ask for more time
  • Once again, an eleventh hour decision appears to be the most likely. In the meantime, there is little choice but to take the government at its word that there will be no extension

The COVID-19 pandemic has brought the Brexit negotiations to an effective standstill, as political leaders in both the UK and the EU have to divert attention and resources from Brexit to dealing with the pandemic. In practice, the entire civil service has been put to the task of combatting the virus. Little progress has therefore been made since mid-March, when the virus really started its rampage throughout Europe. And whilst the talks on the future EU-UK relationship are still somewhere at the back of everybody’s mind, the topic has clearly lost its place on the front pages. But time is ticking and the already tight schedule has come under severe pressure. With just little more than a month remaining until the first real deadlines in June, this has everybody involved left wondering: will the British buy more time and ask for an extension of the transition period?

In this Special we’ll try to shed some light on this question; let’s first take stock of what actually has been achieved.

Little progress has been made…

In our 2020 Brexit outlook, we explained why we believe that any deal that will eventually be reached between the EU and the UK will have very limited potential and is just merely better than a no-trade-deal Brexit. While our ‘base case’ is still a free trade agreement on goods with only limited alignment on services, the eventual future relationship will clearly reflect that Brexit has been gradually defined in much harder ways over the recent years.

The EU and the UK published their negotiating mandates in late February. The UK’s says that there should be a “broad outline of an agreement” in time for the high level conference in June, which would be “capable of being rapidly finalized by September”. If not, then the UK would need to make up its mind whether its “attention should move away from negotiations and focus solely on continuing domestic preparations to exit the transition period in an orderly fashion”. The UK is threatening to walk away if there is no progress come June.

In mid-March, the UK and the EU exchanged their draft texts on how they view the future relationship (you can find the EU's input here, the UK’s draft has only been seen by officials). The EU’s text is clearly built on the political declaration and what has been communicated in a number of subsequent speeches; it therefore contains hardly any surprising elements.

The EU still proposes to establish a “free trade area in trade in goods" and wants a mutual commitment “to establish a favourable climate for the development of trade and investment between services”. The draft text therefore contains numerous articles to ensure that there will be ‘zero tariffs, zero quotas, zero dumping’. These also cover the already infamous level playing field commitments in areas such as state aid, competition, tax, workers’ rights, environmental protection and climate change.

The EU is seeking legally binding commitments –in some areas more stringent than in others but mostly with their own standards as a reference point– and sees an important role for the European Court of Justice. The UK has always rejected this, stating that it doesn’t want to go further than the commitments the EU agreed with countries like Canada, Japan and South Korea, despite the UK’s geographic proximity and the big volumes of UK-EU trade. Or, as Michael Gove said: “we will not be seeking to align dynamically with EU rules on EU terms governed by EU laws and EU institutions”. The EU’s draft text and all official commentary since confirm what is clear since this Brexit-deal was struck in October: there are big gaps on key points and no obvious solutions. Nothing much has changed, really.

With an economy in tatters, time already running short and no obvious way out, speculation about an extension to the transition period is therefore mounting.

Box 1: How can the transition period be extended?

The UK-EU Withdrawal Agreement states that the transition period will end on 31 December 2020, just eleven short months after the UK formally left the EU on 31 January 2020. The terms of the agreement explicitly allow a UK-EU Joint Committee to extend the transition period ‘once, for up to 1 or 2 years’, and only if this decision is taken before 1 July 2020. It also specifies that the UK would have to make extra contributions to the EU budget, effectively buying its way into a prolonged membership of the EU’s single market and its customs union.

The UK-EU Joint Committee oversees and monitors the application of the Withdrawal Agreement. It should ensure that both sides will be able to meet all the obligations that follow from this deal. It also has the authority to decide whether the transition period should be extended or not. This will be a joint decision; the committee has two co-chairs. The UK’s is Chancellor of the Duchy of Lancaster Michael Gove; the EU’s is European Commission Vice-President Maroš Šefčovič. Given that Gove is a senior cabinet minister and not an unelected official, the decision to extend will be seen as a political and not a technical one.

The UK government has repeatedly ruled out any extension to the transition period. To give this warning a little bit more credibility, it even legislated into the Withdrawal Agreement Act –the domestic law that implements the international treaty– its commitment not to agree to any sort of extension. In practice, this means that if the government would still want to buy more time, it would first need to make sure to repeal section 15A of this act. And in order to do so, the government would have to go to parliament, where it needs a simple majority. The very comfortable majority would suggest that the government wouldn’t run into any problems, yet there is a clear risk that such a move will antagonize the Brexiteers in parliament.

Moreover, it is not just a question of whether there will be an extension, but also how long it will be. The Withdrawal Agreement explicitly allows just one extension. It is a binding international treaty, so this should rule out creative ideas such as a rolling "pay-as-you-go" series of extensions, something similar to what we’ve seen during the Article 50 negotiations.

Finally, it’s worth pointing out that some legal experts argue that an extension of the transition period is possible after 1 July as well when both sides agree to retroactively amend the terms of the Withdrawal Agreement. They could then ‘simply’ change the end date. This could be something for consideration in the second half of 2020, perhaps if both parties get cold feet.

… so buying more time would be rational

There are plenty of compelling and straightforward arguments that call for more time. We list a few of these arguments, but note that the following list is far from exhaustive:

  • Time is already running short, and a comprehensive deal looks to be out of reach;
  • Government capacity should be fully diverted to dealing with the COVID-19-crisis;
  • Video conferencing is an imperfect substitute for physical meetings when negotiations are tough. Technical issues aside, it’s difficult to test the waters or identify potential ‘landing zones’;
  • The economy is suffering heavily from the fallout of the COVID-19 crisis; it appears insane to deal yet another blow to businesses and households;
  • Many firms, in particular small- and medium-sized enterprises, can’t properly prepare for either a no-trade-deal Brexit or a bare bones FTA with all sorts of trade frictions;
  • … and how on earth will both the UK and the EU governments get all the new customs arrangements in place on 1 January 2021?

It is therefore highly understandable that a consensus has formed that an extension is now the inevitable way forward. It is the most rational and sensible thing to do, after all. But if the foundations of Brexit were built on entirely rational arguments, it wouldn’t have taken place at all. Or, in any case, the UK government would by now have already sought for an extension.

Figure 1: Key Brexit-dates in 2020
Figure 1: Key Brexit-dates in 2020Bron: RaboResearch

At the same time, there are also some good arguments for getting a UK-EU deal done as soon as possible, rather than letting these discussions drag on into 2021 or possibly even 2022. These arguments are less obvious, and less based on a pure ‘homo economicus’ view of the world. Which is why we’ll discuss these in more detail.

But there are lots of reasons not to do it

Most analyses conclude that the government’s current refusal to extend the transition period is purely for domestic consumption. The government needs to be seen putting up fight after fight against Brussels, and by ramping up the pressures any eventual deal will seem a hard-fought victory. Yet fact remains that trading on the basis of a minimal FTA or even WTO terms would be far closer to the UK’s current vision of the future EU-UK relationship than to the EU’s. We should never lose out of sight that the government’s ambitions are really low.

It is also tempting, but ill-advised, to relate an extension of the transition period with the rolling extensions of the Article 50 procedure. Keep in mind that 2018 and particularly 2019 were dominated by fierce battles between the government and parliament over whether, when, and how Brexit was to be executed, because the Conservative government didn’t had the numbers in parliament. This forced both prime ministers to seek for ‘coalitions of the unwilling’ and to adopt mixed strategies that ultimately failed.

The opponent is weak

This situation has changed. The government has a very sizable majority in parliament, which should make sure that it is able to legislate any trade deal that it negotiates with the EU. In fact, a clause that initially set out a role for parliament in the negotiations had been removed from the Withdrawal Agreement Bill. Under a previous version of this bill, the government would had to regularly update parliament on its progress, while the latter would also have had a vote to approve trade treaties before the eventual ratification. These provisions are gone: the government has a big majority and no longer needs to appease Labour MPs, the DUP or the ERG’s Brexiteers.

The January decision to legislate the government’s commitment not to agree to any extension proposal (see also Box 1) showcased the shift in the internal power balance: the fate of this year’s negotiations will be decided by a few key players, rather than by parliament. And these don’t necessarily share the ‘homo economicus’ view of the world.

But not only the government’s domestic opponents are weak. The dynamics in Europe have changed, too. COVID-19 has exposed that there are still gigantic rifts within the European Union, whilst the 27 countries did a very good job speaking with one voice during the Article 50 negotiations. You could suspect that the UK now genuinely believes that there are cracks in European unity, which may widen if it has to negotiate under pressure. Keep in mind that trade deals eventually have to be ratified by all member states and several regional parliaments.

Brexit can’t dominate Johnson’s term

Prime Minister Johnson rose to power thanks to Brexit, but this also means that he has seen from up close how toxic and divisive this subject really is. There is very good reason to assume that he doesn’t want to get his entire term dominated by this; the energy that comes with it is not very positive and for large parts of his electoral base Brexit is already ‘done’. If the papers report that this issue lingers on and on, and that the UK even continues to pay into the European budget, he will have a hard time explaining. The government doesn’t even mention the ‘B-word’ in its recent communications and instead seeks to focus on its levelling up agenda, i.e. increasing public spending to narrow the north-south divide. In this agenda, Brexit only plays a minor role.

And on scorched earth…

Back to the economics. It is a generally accepted belief that a sudden change from an entirely open trading relationship to a very narrowly-defined FTA will lead to significantly higher trade frictions, which will have short-term economic repercussions and adjustment costs. We initially forecasted a modest 2021 recession based on these costs, but this was before the economic shock of the coronavirus overthrew all projections. We’re currently forecasting -6.8% GDP growth in 2020, followed by a 4.6% ‘recovery’ in 2021 (figure 2). This includes the effects of Brexit.

Figure 2: How to get away with Brexit?
Figure 2: How to get away with Brexit?Source: Macrobond, RaboResearch
Figure 3: Weak UK productivity is still a puzzle
Figure 3: Weak UK productivity is still a puzzleSource: Macrobond, RaboResearch

But as we argued in this column, the government strongly believes that the estimates of the long-term economic costs of an FTA-type of Brexit, which generally range from 3 to 7% of GDP, are surrounded by much more uncertainty as these are based on strong assumptions on productivity growth. The thinking is that reduced trade openness limits knowledge- or technological spill-overs and shields UK firms from international competition, but all estimates of productivity are very model-dependent. Indeed – if future productivity growth was really so easily predicted, you would also expect that last decade’s slump in productivity was widely forecasted. Instead, economists have been consistently too optimistic on UK growth, and it still is a puzzle today!

So even though most of the negative impact of Brexit would be spread out over the years to come, we did see a high risk of a shallow recession in the UK right after the two economic blocks would diverge. This recession would have hurt public opinion towards Brexit, that’s for sure.

One of the ideas that you can often read in pro-Brexit circles is that the expected hit of Brexit to trade and GDP will be barely noticeable on top of the massive shock due to the COVID-19 crisis (figure 2). Well, how ‘convenient’ is that! This is of course a very Machiavellian line of reasoning, but remember that the politics of Brexit have proven to be precisely that. And here’s another question with no easy answer: suppose that the COVID-19 crisis indeed passes at the end of the year, why would the UK government want to rebuild its economy within the realm of the single market, if it then still expects to leave it within the next year or so?

… grows a Magic Money Tree?

In our view, the UK was one of the premier candidates to explore the MMT’s world of economic policies, even as former Prime Minister May frequently lamented that there wasn’t a “Magic Money Tree that we could shake” to provide for the public services that the British people wanted.

Perhaps she couldn’t see the wood for the trees, as her successor has now clearly found one. In its response to the COVID-19 crisis, the HM Treasury clearly leans on the Bank of England to finance the rapid increase in the budget deficit. The Bank’s Asset Purchase Facility has already been increased from GBP 445bn to GBP 645bn in March, and if the economic fallout turns out to be bigger than initially estimated – and the deficit rises well north of 10% of GDP – a further increase of this facility looks likely. The path towards negative policy rates hasn’t really opened up, but the next logical step is that the Bank will try to exert even more control over the shape of the yield curve, following the examples set by the Bank of Japan or the Reserve Bank of Australia.

The Bank also agreed to a HM Treasury demand to directly finance the state’s spending, which is supposed to happen only incidentally or on a temporary basis. The clear coordination between their actions smacks of monetary financing, yet investors don’t seem to be bothered. Government bond yields have declined in lockstep with others and sterling has remained fairly stable – barring March’s volatility that was part of the global sell-off driven by shortages in dollar assets.

Figure 4: No UK-specific shock in long-term government bond yields
Figure 4: No UK-specific shock in long-term government bond yieldsSource: Macrobond
Figure 5: Trade-weighted sterling in line with previous years’ average
Figure 5: Trade-weighted sterling in line with previous years’ averageSource: Macrobond, Bank of England

The volatility in UK markets is not unlike in any other, and this could be interpreted as a tacit nod of approval of the governments’ ambitions. Private sector demand is being destroyed by the COVID-19 crisis, so any help from additional public sector spending is more than welcome. The paradigm has started to shift and investors have gradually come to accept that neoliberalism doesn’t have the answer to all problems – this in turn also implies that the market won’t be able to force the government’s hand in the Brexit negotiations as much as it would like.

Conclusion

Let us reiterate that an extension of the transition period would still be the most rational and preferred way forward. The economies of the UK and EU member states are already in dire straits; to throw a still very disruptive Brexit in the mix would clearly be an act of self-harm.

At the same time, there are also some strong indications that the UK government really believes that an extension of the transition period shouldn’t be entertained, even though some of these arguments really are Machiavellian.

Once again, an eleventh hour decision appears to be the most likely. And maybe both parties will look for yet another fudge in the second half of the year, perhaps in case of a second outbreak of COVID-19. In the meantime, however, there is little choice but to take the government at its word that there will be no extension to the transition period. Even though the current circumstances will make it very difficult to properly prepare for such a radical change in the EU-UK relationship, it’s better to be safe than sorry.

Share:
Author(s)
Stefan Koopman
RaboResearch Global Economics & Markets Rabobank KEO
+31 30 71 21328

naar boven