RaboResearch - Economic Research

Brexit: Living apart together


  • The EU and UK’s Trade and Cooperation Agreement has been concluded. Both parties ended up with the sort of deal that was expected it would end up a year ago
  • The negotiations were defensive: the UK restored its sovereignty, the EU protected the integrity of its Single Market. Both parties succeeded, making this a thin deal
  • It is the first ‘trade deal’ in recent history that raises barriers instead of lowering them. We don’t expect this to lead to another economic shock on top of the pandemic, but these barriers do lead to lost EU-UK trade, missed opportunities, and lower structural growth
  • Rather than a messy divorce, the TCA marks the start of a complex relationship in which the UK and the EU will have to learn to live together separately. This won’t be without frictions
  • The government has failed to come up with a coherent economic strategy post-Brexit, a gap which should be filled in the next few months
  • Even though the deal was concluded, sterling didn’t materially appreciate. This suggests that the deal is a Pyrrhic victory; the ‘sunlit uplands’ are far away
  • The near-term prospect of negative Bank rate has diminished, but this may resurface if the economy suffers from the adverse side effects of ‘long Covid’ and ‘long Brexit’

A kabuki dance…

After little less than a year of negotiations, the United Kingdom and the European Union reached an agreement on their future relationship, which goes by the name of Trade and Cooperation Agreement (TCA). The TCA removes all tariffs and quotas and avoids the alternative of having to resort to WTO rules, making it highly significant, and for certain (agri-)sectors and manufacturing industries very much worth having. That said, it is also the first major agreement in recent history in which trade barriers were raised instead of lowered. This should immediately curb any enthusiasm.

The entire process felt much longer than just eleven months, and this was mostly because the broad outlines of this agreement had already been plainly visible since the start of the negotiations. Most importantly, the UK government already decided in 2019 not to seek membership of either the Single Market or the Customs Union, thereby making sure that any agreement would always lead to a rupture of the economic ties between Britain and Europe.

The two negotiating mandates, which were published in February last year, showed that the trade parts of this agreement would be heavily focused on goods and be minimal on services, even as the United Kingdom is seen as to having a comparative advantage on the latter. A direct comparison of these two mandates revealed that there were some pretty big gaps on level playing field, deal governance, and fisheries. It was to be expected that one or more political interventions would ultimately be needed to bridge these gaps. For all their hard work, David Frost and Michel Barnier simply didn’t have the mandates to conclude the agreement.

This suggests that the deal could have been done even faster. After all, the UK and the EU ended up with the sort of deal that everyone thought they would end up with. Much of what happened since September seems to be a kabuki dance for the benefit of domestic audiences. Several crises, such as the one over the Internal Market Bill or the lapse of made-up deadlines, were manufactured in order to leave the final few compromises until the very last moment: the real 31 December deadline.

This political theatre has minimized the possibilities for scrutiny, both in Europe and in the United Kingdom. The European Parliament is being presented with a fait accompli, as the TCA has been provisionally applied before lawmakers are given the opportunity to scrutinize and decide whether to provide consent. Their deadline is set on 28 February. The House of Commons, meanwhile, had to consider the implementation of the TCA less than two days before it was to be applied, which is so ridiculously late in the day that a disruptive Brexit without a trade agreement was the only real alternative. This scrutiny was therefore of limited use and implies frail democratic support (figure 1) in spite of the 521-73 vote in the Commons. There is a great irony behind this, as Brexit was purportedly a democratic exercise to ‘take back control’.

Figure 1: British views of the European Union reached a historic high in 2020
Figure 1: British views of the European Union reached a historic high in 2020Source: Pew Research Center
Figure 2: Without the TCA, the recovery from the pandemic would have been even slower
Figure 2: Without the TCA, the recovery from the pandemic would have been even slowerSource: RaboResearch

… or catenaccio?

The deal is a triumph for those in favor of a hard Brexit. The exit of the Single Market and the Customs Union, the avoidance of any oversight from the European Court of Justice, and even the departure of programs such as the EASA or Erasmus+, makes this so. The agreement does, however, respect the major red lines of both parties, while it accomplishes to secure zero tariffs and zero quotas. This is what both sides wanted, it’s what they got, and the importance of it shouldn’t be trivialized. Our latest estimations suggest that UK GDP growth would have been 2.2 points lower in 2021 if the TCA hadn’t been concluded (see figure 2), which would have led to an even slower recovery from the pandemic than we currently project. We now forecast GDP to grow 3.9% in 2021. This is already below consensus, but the current nationwide lockdown may lead to yet another downward revision.

Both the UK and the EU have employed catenaccio tactics. In football, catenaccio implies a strong focus on defense, with the aim to neutralize the offense of the opponent and to prevent them from gaining goal-scoring opportunities. The result is that teams score little, but risk even less. This negotiation was also all about the protection of the core defensive interests: for the UK this has been to restore its "sovereignty", or at least the government’s narrow interpretation of what sovereignty entails, and for the EU this has been to protect the "integrity” of the Single Market, which refers to the four freedoms that govern the internal movement of goods, persons, services and capital. These interests were red lines and therefore had to be defended at all costs.

Figure 3: Unlike in goods, the UK is a net exporter of services to the EU
Figure 3: Unlike in goods, the UK is a net exporter of services to the EUSource: ONS Pink Book, RaboResearch

Many of the UK’s offensive interests, which could be seen as concessions in the EU’s market, were dropped in the negotiations or not achieved due to (self-imposed) time constraints. A few of the most prominent are the absence of a deal on financial services, the lack of meaningful provisions for other services providers which will now face a myriad of sector- and member state-specific restrictions, the lack of equivalence on sanitary- and phytosanitary measures, the lack of diagonal cumulation with third countries[1], the limited mutual recognition in relation to conformity assessments,[2] or the lack of actual guarantees of mutual recognition of qualifications. Other costs that will arise are, inter alia, a variety of customs declarations, differing VAT regimes, new audits to prove that rules of origin requirements are met, border delays that disrupt just-in-time processes, or visas for workers. These are just examples of the numerous non-tariff barriers – or outright red tape – that are the direct result of Brexit. This discourages EU-UK trade and has a harmful effect on the UK’s potential.

In short, and this is a point worth repeating, a free trade agreement does not at all lead to free trade. This makes the TCA an extremely ‘thin’ or ‘skinny’ deal in light of the pre-existing interconnected web of relations between the European Union and the United Kingdom. All the additional frictions that were not here before will result in a reorientation of trade flows: for UK traders, non-EU markets will become relatively more attractive, for EU traders, non-UK markets will become relatively more attractive. This short Sky News video illustrates this point well.

Figure 4: The EU’s relative importance as a UK goods export destination has declined
Figure 4: The EU’s relative importance as a UK goods export destination has declinedSource: ONS Pink Book, RaboResearch
Figure 5: The UK exported GBP 318bn worth of services in 2019; the EU is the biggest receiver
Figure 5: The UK exported GBP 318bn worth of services in 2019; the EU is the biggest receiverSource: ONS Pink Book, RaboResearch

The EU has got its way

The catenaccio tactics have served the EU particularly well. The tariff-free trade of goods is more important for the EU than for the UK, since the EU is the one with a big surplus in goods trade (GBP 96.7bn, or 4.4% of UK GDP, in 2019). On services, where the United Kingdom is a growing and large net exporter (GBP 46.3bn, or 2.1% of UK GDP, in 2019), there are new barriers that make life significantly more complicated for its businesses.

The dialogue to facilitate services trade further (incl. financial services) will continue, but has to do without the pressure of a sharp deadline. This makes it likely that the terms will be set by the EU and its member states, for the simple reason that the UK depends much more on the EU for its trade than the other way around. So much for sovereignty.

Two flash points

Rather than a messy divorce, the TCA marks the beginning of a new but complex relationship in which the United Kingdom and the European Union will have to live apart together. In order to manage this relationship, an entirely new institutional infrastructure under the flag of the Joint Partnership Council is being set up. This joint council will act as a port of call for any issues between the UK and the EU or its member states and consists of more than two dozen specialized committees and working groups, each focusing on a specific area of the agreement. For brevity, we’ll focus on level playing field and fisheries, two potential flash points in the years ahead.

Level playing field

The level playing field involves policy areas such as labour rights, environmental standards or the state’s capacity to dole out subsidies to specific sectors or businesses. The level playing field was the thorniest issue of these negotiations. Eventually the EU and the UK found a compromise that respected each other’s red lines but ensured a wide economic and regulatory distance.

The UK has negotiated away the EU’s initial demand that it effectively had to follow all new EU regulations (‘dynamic alignment’) and to allow jurisdiction of the European Court of Justice. It did eventually settle on ‘non-regression’, which is a commitment to not lower existing standards on several policy areas (e.g. labour, environmental or social standards), and on a mutual domestic state aid regime. If one party is a little too generous with its subsidies to a specific sector or business, and after consultations this still results in a dispute between the EU and the UK, this should then be resolved via arbitration. If the arbitration panel finds that the agreement is indeed violated, the complaining party is permitted to take counter-measures such as tariffs. These don't have to be imposed on the same kind of goods or service that caused the breach of the agreement, but have to be proportional. This is called cross-retaliation – a key EU ask.

Above this is an arrangement that is called a “rebalancing mechanism”, which is the forward-looking component of the level playing field provisions. If either the EU or the UK finds that there have been “significant divergences” across the level playing field, so this has a very wide scope, and that this divergence also has a significant impact on bilateral trade and investment, “rebalancing measures” in the form of tariffs can be imposed after arbitration. This works both ways. Finally, it’s worth noting that if these rebalancing measures are deemed unjustified or excessive, the other party can in turn take countermeasures. This entire structure makes EU-UK trade a very political matter, which raises the risk of an acrimonious trade relationship. This risk is real: the government is already seeking to change regulations in the UK to support growth.

If this eventually leads to a series of tit-for-tat retaliation measures, the EU or the UK can trigger a review of the trade agreement from 2025 onwards. Such a review might lead to a suspension of some parts of the TCA, or even a termination of the entire deal with just twelve months’ notice. This means that the threat of no-deal hasn’t really vanished, especially not if the two parties in this agreement decide to set course on diverging paths.


The compromise is that the EU’s catch in the UK EEZ is reduced by 25% over five and a half years. The underlying assumption in the deal is that, from 2026 onwards, the quotas would then remain unchanged even as there is scope for annual negotiations. If one side withdraws or reduces access “compensatory measures” can be taken “commensurate to the economic and societal impact of the change in the level and conditions of access to waters”. This suggests that if the UK “takes back control” of its waters after 2026, as the government promises, the EU would simply seek to apply hard compensatory measures. These could take shape as tariffs on fish imports from the UK, which on top of the already-existing and cumbersome health checks would be a heavy price for control of the UK waters.

No return to stability

The stability of the TCA is a big issue for any future investment in UK assets. At this point, there are still many questions left unanswered, but one stands out: is the UK government able to provide international and domestic investors with any long-term reassurances on continued tariff-free access to European markets?

That remains highly uncertain. The process of the past eighteen months has showed that the current government prioritizes sovereignty –some would say isolationism– over the economic interests of businesses and households, whilst failing to admit that this decision has real adverse consequences that carry real economic costs. The trust-eroding obfuscation of such realities will have long-term repercussions on the country’s standing. It also leaves you wondering about the confidence-building measures the government might put in place to convince investors of a more welcoming environment to do business in a post-Brexit UK. This should be on the top of the UK’s domestic and foreign policy agenda for this year.

But will they? The Conservatives, its MPs and its voters alike, are strongly divided on the matter of sovereignty versus prosperity. Most of its economic policies are shaped by an uneasy coalition of nationalist voters in areas such as Brexit and liberal globalists in other areas. Illustratively, there has been a lot of political bluster and bravado in the EU-UK negotiations, but the existing EU deals with third countries such as Japan or Mexico were rolled over successfully, and without much fuss. This contradiction is also reflected in the fact that this exercise of protectionism is being sold as a shift towards rather than away from free trade, even though the level of UK exports and imports will eventually tell a different story. Finally, it’s also the reason why the UK government avoided debate on this deal in Parliament and why the HM Treasury’s last externally published impact analysis is more than two years old and effectively shelved. The analysis projected a -4.9% to -6.7% hit to long-term GDP, which can be seen as a 15-year timeframe.

Even though it’s surprising that this coalition has been able to hold it together for so long, the internal division is persistent. The culture war, and Brexit as one of its symptoms, has served Prime Minister Johnson and many Cabinet members or other Tory MPs well. As the promised ‘sunlit uplands’ of Brexit will instead be obscured by clouds, it is a starry-eyed ideal that the blame games towards EU institutions will end now Brexit has been ‘done’. As soon as the UK decides to diverge from EU regulations in order to ‘make a success’ of Brexit, which would then trigger the divergence mechanisms, the row with the EU simply flares up again. While the Tories might not pocket electoral wins on this platform forever, the benefits of this strategy aren’t fully consumed.

We can already surmise how this would play out. When the Conservative ERG’s legal advisory committee gave their blessing to the TCA, they noted that (emphasis ours): “Our overall conclusion is that the agreement preserves the UK’s sovereignty as a matter of law and fully respects the norms of international sovereign-to-sovereign treaties. The ‘level playing field’ clauses go further than in comparable trade agreements, but their impact on the practical exercise of sovereignty is likely to be limited if addressed by a robust government. In any event they do not prevent the UK from changing its laws as it sees fit at a risk of tariff countermeasures, and if those were unacceptable the Agreement could be terminated on 12 months’ notice.”

The potential flashpoints ahead of the next general election are already visible. The UK will have the ability to diverge from the existing EU standards and/or to close its fishing waters from 2026 onwards, even as this comes at the cost of tariffs (and the ‘benefit’ of a row with the EU). We’ve been here before: the desire to increase the economic and regulatory distance with the EU will be set against the economic consequences of such a decision.

If the regulatory divergence and the possible tariffs create persistent imbalances, the TCA could be renegotiated on all of its terms. This will be possible from 2025 onwards. This is just one year after the scheduled date of the next general election. The campaigns are already writing themselves years in advance.

Disunited Kingdom

Since the eruption of the financial crisis of 2008, the United Kingdom has experienced a continuous period of instability interrupted by brief periods of relative calm. One of the strongest arguments for Brexit was that it would deliver a positive shock to the British state at the expense of already strained relations with the European Union. From this perspective it remains odd that a coherent government strategy on how the economy and society should evolve in the post-Brexit world remains absent. Moreover, the government is eager to talk about ‘levelling up’ and ‘building back better’, but fails to explain how being inside the EU prevented the implementation of these agendas. One of the structural shortcomings of the economy is indeed inequality, but this should be tackled with domestic policy levers, such as taxes, regulation and public spending.

The government hasn’t come up yet with a strategy that uses Brexit as a catalyst for change and to leverage the country’s comparative advantages. In fact, the minimal provisions on financial or professional business services suggest the TCA does the opposite. Some sectoral agreements could eventually be added to the overall framework of the TCA, but this is likely to happen only if the EU sees the need to do so. It is reasonable to expect that the EU would want to onshore as many of these high-skilled, well-paying (and taxable) activities as possible.

The UK government could counteract this by focusing more on industrial strategies, but this has to go much deeper than three-word slogans or recycled promises. It also can’t simply expect the market to get the hint if these slogans aren’t backed by concrete policy actions. This requires a stronger and more proactive role of the state, but then again it begs the question whether this government is fit for purpose to take up this role after years of austerity and extreme partisanship.

Especially in times of radical uncertainty –that is, right now– it pays dividends to have a sharply formulated strategy and steer the country in a specific direction. The green agenda is a prime candidate for this. The COP26 is scheduled to be held in Glasgow from 1 to 12 November and this provides a platform to restore some of the UK’s soft power. It would make sense if the government decides to ramp up its agenda on clean tech, de-carbonization and net-zero emissions, and seeks public–private partnerships to leverage these policies. We also wouldn’t be surprised if the Bank of England gets more closely involved in order to ensure that finance towards these projects is cheap and plentiful.

Finally, we could see that the British efforts towards the desired US-UK trade deal could take the spotlights, as this is regarded by one of the holy grails of Brexit by Conservative MPs. Over the past year, lots of work on this prospective deal has already been done, but the thorny issues surrounding financial services, agricultural goods (‘chlorine-washed chickens, ‘GMO’s’) and pharmaceuticals or healthcare (‘don’t touch the NHS!’) are as of yet unsolved. These are some major hurdles, and not particularly popular with large parts of the electorate. The economic benefits of a US-UK trade deal are small, highlighting again that large-distance trade deals are more about politics than economics. Moreover, the Biden administration has already made it clear that new trade deals are not a foreign policy priority and that he will focus on rebuilding the US relationship with the EU first, which is complicated enough.

Drifting apart

Even though an extended period of stability would be really welcome to the economy of the United Kingdom, it doesn’t seem likely. Crises like these don’t have neat beginnings and endings and people will continue to demand ‘change’ relative to the status quo. For this reason it is entirely reasonable to expect that Northern Ireland and Scotland will continue to actively question the benefits of the union, even more so as the devolved nations have been kept out of the Brexit talks against their wishes. The union was already fractured to start with, but the combination of Brexit and Covid-19 has clearly exposed and likely even widened these rifts.

The arguments around Scottish independence are therefore again gathering pace. The regional parliamentary elections will be held in May and the Scottish National Party will run on a platform of holding a second independence referendum. If the SNP does well, and this is to be expected, it is likely to claim that it has gained a new mandate for Scottish independence, arguing that the facts on the ground have changed significantly since the previous referendum. Prime Minister Johnson will therefore be pressed for a second vote, but even as he denies this, or employs more heavy-handed tactics to suppress this sentiment, the rift between Scotland and ‘England’ would widen even further. This will be a very important theme in the next few months.

The impact of Brexit on the economy and society of Northern Ireland has been profound. A (probably) unintended result from leaving the EU’s Single Market is that the UK internal market has shrunk in size. As agreed under the Northern Irish Protocol, customs checks will take place in the Irish Sea rather than on the land border between Northern Ireland and the Republic of Ireland. This means that Northern Ireland de facto remains within the regulatory spheres of the European Union, which over time are set to diverge from the UK. This will result in a deepened economic relationship with the Republic of Ireland than before Brexit. We can already see a first sign of this: the Irish government has promised to fund an Erasmus+ scheme for students from Northern Ireland, allowing them to continue to take part in the study abroad scheme.

Moreover, recall that the Withdrawal Agreement states that, in four years’ time, the UK must provide the Northern Ireland institutions the opportunity to decide whether or not the provisions from the Northern Ireland Protocol should remain in place. If consent is not given, the protocol will cease to apply after two more years. During this period, the EU-UK Joint Committee will make recommendations on alternatives for avoiding a hard border and protecting the Good Friday Agreement. It’s impossible to say where this would end up.

The early months of 2021 will continue to be dominated by the aftermath of Brexit and Covid-19, but the risk of an existential crisis is material. As such, there is a lot of pressure on the government to show the quick gains from the breakaway from the European Union. This explains the immediate reach-out to UK businesses and the swift start with vaccinations.

Double-dip recession

As we surmised in the spring of last year, the devastating impact of the Covid-19 crisis and its distorting effects on the regular flow of economic data provide the perfect cover to implement radical changes to international trading arrangements. Unfortunately, the governments of the United Kingdom have lost control over the virus and new lockdowns have been announced. This will lead to a double-dip recession this winter.

Figure 6: This is not a curve, but a straight line
Figure 6: This is not a curve, but a straight lineSource: Macrobond
Figure 7: The pressure on UK health care has surpassed the first wave
Figure 7: The pressure on UK health care has surpassed the first waveSource: Macrobond

The so-called trifecta or unholy trinity of risks has been a recurring theme since last summer. These are the very impractical realities of Brexit, the ‘on-off’-nature of the Covid-19 restrictions until at least Easter, and the (looming) rise in unemployment. We initially forecasted GDP to grow 1.3% q/q in the first quarter of this year, which would only partially make up for the -3.4% q/q we pencil in for the last quarter of 2020, but even this is looking increasingly unlikely given the uncontrolled trajectory of Covid-19. A consecutive quarter of negative GDP growth appears ever more realistic instead, even as GDP already is at a low base. The economy will probably still bounce back this spring as the vaccine-driven recovery kicks in, but our projections indicate that it’ll take at least until June 2021 before GDP is back at its October 2020 level. We expect that this setback will be fully ascribed to the new strain of Covid-19, and not the erratic and inconsistent Covid-19 policies of the government, let alone the trade frictions and the slowdown in investment that are the direct result from Brexit.

The recovery should pick up from May onwards, thanks to a more complete roll-out of the vaccines in the critical age groups. The outlook for the second half of the year is better. We currently project growth of 3.9% in 2021 and 5.4% in 2022, and expect GDP to be back at pre-pandemic levels from mid-2023 onwards (see again figure 2). One would guess that the government would try to direct the narrative towards the ‘sunlit uplands’ of Brexit, but in reality this rebound will be technical as large parts of the economy open up. Our projected rate of recovery in the UK is slower than in other major European economies apart from Spain.

Figure 8: The economy of the UK could suffer from ‘long-Covid’ and ‘long-Brexit’
Figure 8: The economy of the UK could suffer from ‘long-Covid’ and ‘long-Brexit’Source: RaboResearch forecasts

It’ll also be very difficult to achieve the “Roaring Twenties”-forecasts as currently set out in the Bank of England’s Monetary Policy Report; the Committee projects growth of 7.25% and 6.25% in 2021 and 2022 respectively. This has never looked very feasible, so we expect another round of downgrades on this front when the MPC publishes new forecasts in the first week of February.

What about sterling?

The TCA failed to give the pound much of a lift versus most of its peers. The consensus was that a thin deal would eventually be struck, so didn’t came as much of a surprise. And even though the deal brought relief to some manufacturing and farming sectors, services was left mostly out in the cold. Another reason for the lack of upside in the pound is that the past few weeks brought additional Covid-19 related restrictions, which could potentially last until Easter. Finally, the credibility of Prime Minister Johnson has been hit by a series of policy U-turns over the last year. Markets don’t like these types of headwinds, but our central view is that the pound can make up some ground versus the euro, in line with an expected rebound in UK growth in the second half of the year. However, the coming months could still bring plenty of hurdles for the pound. Our forecast for the end of the year stands at EUR/GBP 0.87.

Finally, the risk of a Brexit without a trade agreement was closely associated with the risk of negative policy rates. The market’s speculation on an official foray into the world of negative rates isn’t likely to subside anytime soon as, after perusing the details in the agreement, traders find out that the Brexit-deal isn’t very ambitious or impressive at all.

Figure 9: The TCA failed to give the pound much of a lift versus the euro
Figure 9: The TCA failed to give the pound much of a lift versus the euroSource: Macrobond
Figure 10: Money markets are pricing in a 10 bps rate cut in August
Figure 10: Money markets are pricing in a 10 bps rate cut in August Source: Bloomberg, RaboResearch

Within the Bank of England’s MPC, which comprises nine members, there’s however a distinct division between the internal and the external members on the suitability of negative interest rates. The internal members focus more on the risks of this policy, whilst the external members place more emphasis on the potential expansionary effects. This division is likely to stay, although we expect that the ‘hawks’ (relatively speaking!) remain in the majority. This division is actually quite convenient for the MPC, as they collectively have an interest in keeping the market guessing. This helpfully anchors money market rates or short-term swaps below or close to Bank rate, without the MPC actually having to cross the Rubicon.

We remain reluctant to forecast any changes to Bank rate in 2021, even as we think that market speculation on negative rates will persist. For now, we judge that the costs of negative rates outweigh its benefits. This trade-off may change, however, especially if and when the low-hanging fruit of the vaccine-driven recovery has been picked, fiscal policy starts to retrench as policymakers focus on the public purse, and the economy effectively gets stuck in a low-growth/low-inflation environment. But that’s a discussion for 2022 onwards.


[1] The rules of origin requirements in the TCA could have allowed for diagonal cumulation with a third country with which the EU and the UK both have an FTA, such as Japan. This would have made it possible to use inputs originating from Japan in UK products and sell these products to a customer in the EU as if the inputs were from the UK, no matter how much value was actually added to it in the UK. This would have been particularly helpful for manufacturers in long and complex supply chains.

[2] Goods made in the UK will have to comply with EU standards (and the other way around), and therefore need to be tested, certified and inspected. Mutual Recognition Agreements provide for recognition of these processes between the EU and the UK and reduce technical barriers to trade. 

Stefan Koopman
RaboResearch Global Economics & Markets Rabobank KEO
+31 30 71 21328

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