Media  Global Economy  2019.01.29

Consequences of rejecting the draft Brexit agreement - Will a no-deal withdrawal be harmful in every aspect?

The article was originally posted on Webronza on January 13, 2019
Will a hard Brexit allow the UK to recover tariff autonomy?

The UK Parliament voted down the draft Brexit agreement that British Prime Minister Theresa May had reached with the EU. The UK is set to withdraw from the EU on March 29. This withdrawal is on course to be without a deal or a hard Brexit.

Let me first explain what a hard Brexit will entail.

The UK now belongs to the customs union and single market called the EU. This customs union is designed to impose a common set of tariffs on imports from other countries outside of the EU and no tariffs on internal trade in the EU. The single market, on the other hand, is designed to unify the standards for products so that goods are distributed freely or smoothly within it. It is also designed to harmonize or unify individual countries' policies in the EU as a whole so as to prevent gaps in competitive conditions from appearing due to differences in regulations or protective policy between countries (see "For those who want to understand Brexit").

A hard Brexit means a complete separation of the UK from the EU.

The withdrawal from the customs union will allow the UK to impose tariffs on Japan, the US, and other countries independently from the EU. At the same time, as the remaining 27 EU countries, including France and Germany, will become "foreign countries" like Japan and the US, tariffs will be levied on exports from the UK to France or Germany and vice versa.

What will the tariff levels be like?

All GATT/WTO members have submitted a schedule of maximum tariff levels for different items, known as a "schedule of concessions," to GATT/WTO. The UK might return to the schedule of concessions it submitted before 1973, when it joined the EU. Yet that will be unlikely for three reasons. First, the internationally recognized tariff nomenclature is different now. Second, new items have emerged since then. Third, the then GATT and the present WTO are different legal entities.

Accordingly, the schedule of concessions that the EU has submitted to the WTO will be applied as the schedule for the UK for the time being. Of course, it will be possible for the UK to partly amend this schedule and resubmit it to the WTO since the UK and the EU will constitute different customs territories. The UK will be at liberty to reduce the tariff rates listed in the schedule (from ten percent to eight percent for autos, for example) of its own accord and submit the schedule thus amended to the WTO.

If the UK wants to raise tariffs on certain items it wants to protect (e.g., color TV), it will be able to resubmit the schedule in this way after negotiating with major exporting countries (e.g., Japan) and reducing tariffs on other items (e.g., automobiles).

In relation to the WTO, the UK will not be able to raise tariffs higher than the levels agreed to with the organization. Yet it will be free to apply lower tariffs than the levels of commitment it has made to the WTO while leaving such commitment levels intact. (Take Japanese tariff on beef for example. Japan's schedule of concessions states that the maximum tariff level on imported beef is 50 percent, but Japan is currently applying a tariff of 38.5 percent.)

Due to its membership of the EU's customs union, the UK has not been at liberty to decide on tariffs; it has followed the decisions of the EU as a whole. A hard Brexit will allow the UK to make its own decisions on tariffs.

As such, the UK will be able to strike a free trade agreement (FTA) with Japan and the US regardless of the EU. Since Japan has concluded an FTA with the EU, which includes the UK, it will be easy for the UK to sign an FTA with Japan. In fact, both Japan and the UK are in hope of the latter's participation in the TPP 11.

Also, the UK may not face so much difficulty in striking an FTA with the US as the EU did in its FTA negotiations with the US. A US-EU FTA called TTIP has not been concluded after lengthy negotiations when Barack Obama was US president. This was due in large part to the non-tariff barriers (standards and regulations) and agricultural issues unique to the EU.

Under the current draft Brexit agreement, the UK will maintain a de facto customs union with the EU. Because the EU--not the UK--will have the authority to determine tariff levels, the UK will not be able to strike an FTA on its own. This is why US President Donald Trump criticized the draft Brexit agreement.

Furthermore, independence from the single market will allow the UK to establish its own standards on food and industrial products and implement its own policies on issues such as the environment and competition law, both independently from the EU. In short, the UK will be also able to recover economic sovereignty in many aspects including tariffs.

Sovereignty will be recovered in relation to the WTO as well. The UK will be able to speak on behalf of itself when its legislation is in dispute at the WTO. Under the current arrangements, even when legislation specific to an EU member state (e.g., the UK) is at issue, European Commission officials are engaged in the WTO dispute settlement procedures on behalf of that member state.

Moreover, even if a non-member state of the EU challenges subsidies or regulations in France or the EU as a whole and takes countermeasures such as higher tariffs, the UK will no longer be the target of such countermeasures.

Damage due to a hard border

Leaving the customs union and constituting a customs territory independent from the EU will require the UK to implement strict border controls (a hard border) in relation to not only non-EU members, but also Ireland and other EU members (just as Japan put customs in place for trade with other countries).

British Prime Minister Theresa May and other EU leaders came up with a draft Brexit agreement that will virtually retain the UK within the EU's customs union and single market--a state of affairs that cannot be described as Brexit. This was because Mrs. May did not want to set up a hard border between Ireland and Northern Ireland. This weak point must have been taken advantage of by wily and veteran negotiators of the European Commission, which wanted to retain the UK within the EU.

To an outsider like me, the draft Brexit agreement looks as if the tail called "hard border avoidance" thrashes the body called "Brexit." For those who experienced the Northern Ireland conflict, however, avoiding a hard border must have been an overriding imperative.

Yet, a hard Brexit will inevitably entail a hard border. The UK will have to face the political cost of a possible recurrence of the Northern Ireland conflict.

The UK will have to face the economic cost as well. Higher tariffs will impede UK exports to the EU market. This can be avoided if the UK strikes an FTA with the EU. If the UK and the EU impose different tariffs, however, they have to provide proof of origin for their respective exports. This will in turn necessitate a hard border (see "What is the only solution to the Brexit problem?").

Avoiding such a state of affairs will require UK to forfeit the right to set its own tariffs. This will make it impossible for the UK either to strike a different FTA --independently from the EU--with countries with which the EU has concluded an FTA or to have FTAs with the other countries. Suppose, for example, that the UK signs an FTA with the US (which has not concluded an FTA with the EU) and remove tariffs on American wheat. In that case, American wheat will flow into the EU market freely via the UK, unless the EU, which has concluded an FTA with the UK, calls on the UK to prove that wheat eligible for no or preferential tariff under the FTA has originated from the UK by way of a hard border (customs clearance).

This is only part of the story. Even if the UK accepts such inconvenience, it will have to check food and other products at its border to see whether they comply with British standards, which may differ from EU standards and vice versa. A hard border will be necessary in this regard as well.

At any rate, the need for customs clearance on a hard border, a hitherto unnecessary procedure that involves inspecting the goods and examining related documents, might significantly hinder logistics. This might in turn exclude the UK from EU-based supply chains. Unable to procure parts smoothly from Continental Europe, Japanese automakers might have no choice but to pull their operations out of the UK.

Advantages of leaving the customs union

International economics teaches us that a customs union or FTA that imposes no tariffs on trade with specific countries has a disadvantage known as "trade diversion effect."

The trade diversion effect can be explained by the following example. Suppose that the unit wheat price is 300 yen in the US, 600 yen in France, and 1000 yen in the UK. When the UK imposes a tariff of 400 yen, British consumers buy American wheat, the cheapest of all, for 700 yen. If the UK reduces wheat tariffs to zero in relation to France in the face of the customs union with the EU, British consumers will buy French wheat for 600 yen. The fact remains, however, that American wheat is cheaper than French wheat. The unit amount of 400 yen in tariffs that British consumers will pay will go into British government coffers as customs revenues; it will not be a cost for the British economy. Yet the UK will have to pay more to import wheat.

Generally speaking, there will be a shift in imports from the cheapest supplying country in the world under a unified tariff arrangement to a member country of a customs union that entails no tariffs. The importing country will have no choice but to buy expensive imports instead of cheap ones. (International economics describes this phenomenon as a deterioration in the terms of trade (the ratio of exchange in prices between exports and imports).) This is what the trade diversion effect is all about.

The UK's withdrawal from the EU's customs union will obviate the country's need to buy EU-produced wheat, which is more expensive than American or Australian wheat. This will have a negative impact on France and other EU member states that have enjoyed the benefit of exporting their product to the UK at a higher price. If the UK signs an FTA with the EU, the trade diversion effect will reemerge. This effect will disappear again if the UK strikes an FTA with the US or joins the TPP 11, which includes Australia.

Detesting a hard Brexit like the plague?

As discussed above, a hard Brexit has advantages as well as disadvantages.

If the UK wants to avoid a hard Brexit at any cost, however, there will be only two options: to rescind the withdrawal notification to the EU and hold a snap general election or to have another national referendum (see "What is the only solution to the Brexit problem?").

The EU may be ready to wait; it prefers the UK's continued EU membership or the draft Brexit agreement to a hard Brexit.

It's up to you, Theresa!

(This article was translated from the Japanese transcript of Dr. Yamashita's column in "Webronza" on January 13, 2019.)