The Art of the No Deal

With three weeks to go before the critical EU summit, Mrs May’s range of Brexit options are narrowing. They could even narrow to nothing.

The Never-ending Story

It is now two years since that extraordinary referendum result, and even ardent Brexiteers are sick and tired with the snail’s pace of progress and the tedious intricacies of our disentanglement from the EU. Two years in and we still don’t know what the post-Brexit trade architecture will look like. But we may find out at the EU summit on 29^th June. (Or not, as the case may be).

Where we are now

In recent weeks, Mrs May has reduced the menu of choices on our future trade relationship with the European Union post-Brexit to just two. Namely: a customs partnership; or maximum facilitation (the latter inevitably abbreviated in media parlance to Max Fac).

Under a Customs Partnership – supposedly the preferred option of the Prime Minister – Britain would collect tariffs on imported goods and then would pay them over to the EU. This is what happens now given our membership of the EU, though currently the EU reimburses us with a ten percent administration fee. But, once out of the EU, the UK would be a third party country. As such, it is unlikely that the Europeans would authorise an outsider to collect revenues for them (even though the UK is widely regarded as having integrity in such matters). So it is unlikely that the EU would agree to this, anyway. Liam Fox, the Trade Minister, admitted last Friday[i] that the cabinet committee looking at the partnership deal had met only once – and David Davis, Brexit Minister, is said to be implacably opposed.

Maximum Facilitation is a proposal to minimise “friction” at the borders, while still retreating from the Customs Union and the Single Market. It is basically being out of the Customs Union while behaving as if we were still in it – which the French have signalled (frantic shoulder-shrugging, here) is impossible. It would involve filing submissions, presumably electronically, each time a consignment of goods crossed over the UK-EU border at Dover, or wherever. Large exporters and importers would be pre-approved to participate under a trusted trader scheme.

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In a hearing to the Treasury Select Committee on 22^nd May, Jon Thompson, Chief Executive of HMRC, told MPs that Max Fac would cost British businesses up to £20 billion a year in additional administrative costs. This turned out to be a back-of-a-fag-packet calculation which had no supporting HMRC research. It is just based on the notion that there would be around 200 million cross-border consignments, each of which would carry administrative expenses of £100 on average.

This is not just disingenuous but fatuous. Thanks to the HMRC (and the EU) businesses already have to employ armies of bookkeepers, payroll managers and VAT clerks – latter day digital bean-counters – all supported by not-cheap software products such as those produced by Sage PLC (LON:SGE), the market leader.

The additional cost of new software and manpower per consignment is likely to be marginal. And, remember, this is not a cost to the taxpayer but rather to importers and exporters who would be likely to pass it on in their prices. Recent fluctuations in the value of Sterling and in the price of diesel will have been much more significant to businesses’ bottom-lines than the cost of automatically uploading a report to HMRC – as employers must do every time they pay salaries these days under Real Time Information (RTI).

“No progress”

Whatever the merits of either option, the word is that there has been no progress in the Brexit negotiations since March. There is a growing body of opinion – expressed by both prominent Leavers and Remainers – that the 28^th June summit will be a car crash – no doubt with negative consequences in financial markets.

On Wednesday (6^th June), Mrs May revealed at PMQs that the government’s white paper on the form of trade post-Brexit would not be released before the summit (contrary to what Mr Davis had said previously).

Then we learnt that there is to be a temporary customs arrangement (TCA), according to which the transition period could be extended beyond 31^st December 2020 in Northern Ireland until such time as the full agreement as to the UK’s departure terms are finalised. At first this CTA was described as having indeterminate length; next we learnt from the Downing Street website that the government expects it to last one additional year – so until 31^st December 2021…

But if this flexible so-called backstop (horrible word) becomes reality, then why would the EU bother to finalise a free trade deal at all? As this article goes live it seems unlikely that Mr Davis will resign immediately, as was rumoured on Thursday morning – an action that would have triggered a full-scale political crisis. Monsieur Barnier is no doubt following events in London with wry amusement.

The case against the existing Customs Union

The Customs Union goes right back to the Treaty of Rome (1957), the founding pact of (what is now) the European Union. The Single Market – the uniformity of regulations on goods (though not services) – in contrast, was a much later confection. This came into effect in 1992. Ironically, the Single Market was championed by the government of Mrs Thatcher (before the Iron Lady saw the light, concluding that Europe is fundamentally unreformable).

Under the Customs Union, all EU member states levy tariffs on goods imported from outside the EU in accordance with EU trade deals, and pay them over to Brussels. All trade policy is monopolised at EU level, so member states, per se, do not have a say on how much these tariffs are.

The idea that membership of the Customs Union is essential to Britain’s economic well-being – Labour’s current policy, as articulated by Sir Starmer – is absurd. Such a customs union is designed to stimulate trade between its members: but also to restrict trade between such members and third parties.

In 2016, the UK ran an overall trade deficit of about £40 billion. Our trade deficit with China was £26 billion, but our trade deficit with the EU was a lamentable £80 billion. Please note that, in contrast, we ran Germanic trade surpluses of £33 billion with the USA and £30 billion with the rest of the world. We even scored a £1 billion trade surplus with the ever-toiling Japanese. In fact, since about the beginning of this century, we have greatly improved our trade balance with the USA and Japan, even as that with the EU has irreversibly declined.

One possible explanation for this is that our trading arrangement with the EU is unequal. A single market pertains for goods but not for services (which generally carry much greater value added). The UK’s comparative advantage (in the sense first defined by the classical economist, David Ricardo) is in value added services, not manufacturing. For the Germans, it is the reverse. So we pay for the Germans’ comparative advantage while they do not buy into ours.

Further, if Britain were to remain a part of the existing Customs Union, as Labour now seems to desire, then we would have to abide by every letter of new EU regulations without having any say over their formulation. We would become a rule-taker. Sure, there is no point in changing regulations for its own sake and it would be in Britain’s interest to maintain broad regulatory alignment – which the UK has already committed to do under the December accord.

But it is likely that we may wish to amend and indeed tighten regulations, as we see fit. I, for one, am strongly in favour of tighter standards of animal welfare and I would like us to have the right to ban the import of meat which has been reared or slaughtered inhumanely. But we would not be permitted to impose such higher standards on the rest of the EU were we to remain in the existing dispensation.

Finally, the Customs Union forbids us from coming to bilateral trade arrangements with our friends. Unlike many Brexiteers, I have never been keen on a bilateral trade agreement with the United States. Our American friends would inevitably drive a hard bargain. And we don’t need their agricultural produce, either. I have always, however, been an enthusiastic advocate of a Commonwealth free trade agreement between old friends and partners (who speak English and use English common law). I’ll have more to say on this shortly.

The trope of the Irish border

The UK and the Republic of Ireland are close trading partners. But only about one twentieth of Irish exports to the UK cross the border on the island of Ireland. The overwhelming majority of Irish exports to the UK (mostly agricultural goods) go from Dublin to Holyhead or from Rosslare to Pembroke. Much of Ireland’s exports to the EU go from Rosslare direct to Cherbourg and Roscoff in France, or by air freight.

The actual border between the six counties of the North and the 26 counties of the South arose because the South broke away from the UK nearly 100 year ago. (Though the Irish government now wishes to deny the UK the freedom to break away from Europe). When you cross that border you change from Pounds to Euros; you also move from 20 percent VAT rate to 23 percent. There can never be total regulatory alignment between separate jurisdictions if both of those jurisdictions are sovereign nations. That is the problem, the EU does not recognise sovereignty.

An analogue to the Northern Irish border is that between Norway and Sweden – or indeed the Swiss border, given that Switzerland is entirely surrounded by the EU. Here, rational and amicable neighbours have worked out border regimes which work perfectly well.

Regrettably, Monsieur Barnier has used the callow threat of a resumption of violence in Ireland as a wrecking measure, even though trade relations did not feature in the Belfast Agreement (1997). He is assisted by Irish Taoiseach Leo Varadkar, who is running scared of Sinn Féin. The latter party, meanwhile, has paralysed Northern Irish politics – purposefully, by withdrawing from the power-sharing agreement at Stormont, precisely because they perceive Brexit as an opportunity for Irish republicanism to advance.

Peer pressure

Next Tuesday, 12^th June, the House of Commons will review the amendments made to the Brexit Bill by the House of Lords. This will afford the House the chance to have their say on the Customs Union, amongst other matters. There will even be an amendment calling on the government to join the European Economic Area (EEA) along with Norway. The EEA is of course, subject to freedom of movement – though Switzerland has been contesting that since their referendum of February 2014. Meanwhile, the Norwegian Prime Minister, visiting London, has come up for air to say that Norway would not accept Britain in the EEA on privileged terms.

Labour’s stance on the Customs Union/Single Market is highly equivocal and, as Sir Starmer has admitted, opinion within the parliamentary party is fragmented. But Labour’s dream is to defeat the government by uniting with the Tory Remainers to tie Mrs May’s hands at the June Summit. Labour now (according to The Times[ii]) wants the softest of soft Brexits. There is probably a one in five chance that they will cripple the government’s negotiating strategy next week.

Not nice people

A reader’s letter to the Daily Telegraph recently went viral. Mr Burne of Wokingham wrote that “[w]e are not dealing with nice people…[t]hey have cheated the Southern European states by pretending that their strictures were for their own good.”

David Davies recently accused the EU of posturing and point-scoring in the breakdown of talks on security issues post-Brexit. Brussels is now threatening to shut out British firms from the €10 billion Galileo satellite navigation system because they could not countenance sharing sensitive information with a third party state. Brussels has also ruled out Britain’s continued involvement in the European Arrest Warrant extradition system.

The UK has been involved in the Galileo programme since its inception in 2003. Mr Hammond has suggested that if the UK is excluded from Galileo, which provides an alternative to the USA’s GPS system, then we shall just have to go it alone with our own system. This could actually be an opportunity for BAE Systems (LON:BA) – on which more soon. Others have pondered the efficacy of partnering with Australia, which recently launched its own space programme.

Actually, this is not really about Britain and Europe; it is rather about our one thousand year war with France…

The agenda

Brexit will not even be at the top of the agenda at the European summit.

The summit will be attended by Italy’s new Eurosceptic, populist government. Although Italian government bond yields have attenuated after a spike during the Roman political shenanigans last week, the Eurozone is faced with higher interest rates, and therefore borrowing costs. The yield on Italy’s 2-year bond fell by 73 basis points to 1.26 percent on 1^st June, the day the new government was sworn in. But inflation is rising across the Eurozone, partly due to rising oil prices. Eurostat reported that inflation in the Eurozone was 1.9 percent in May – up from 1.2 percent in April. Higher inflation will put pressure on the ECB to end its stimulus (bond-buying) programme.

Then there is the little matter of the incipient trade war with the United States. As we know, the Trump administration has imposed tariffs on imports of European steel and aluminium and Europe is responding in kind. On 7^th June the EU announced plans to impose tariffs on US$2.8 billion of US products in retaliation.

The fact that the EU is singing the praises of free trade in this context suggests that they are unlikely to impose tariffs on British exports post-Brexit. Instead, additional frictions on UK-EU will be of the non-tariff kind.

Mrs May’s prisoner’s dilemma

There may be a need to compromise, but any whiff of capitulation on 29^th June will not go unpunished. The problem for Mrs May is that she has insufficient political capital to just walk away. (This being of course a negotiating tactic: just as Mr Trump seemingly walked away from the talks with North Korea – for about 72 hours). But if she does not walk away, she risks signing up to a deal that Leavers abominate, putting her own survival in doubt.

Failure to prepare properly for a no-deal scenario has made this tactic more risky. In particular, the reaction of the British public, whipped up into a commotion by the mainstream media (especially the BBC), makes this a potential disaster for a not particularly popular minority government whose slender majority in the House of Commons depends on the socially conservative DUP.

A leaked report[iii], drawn up for Mr Davis by the Cabinet Office, thinks that the downside scenario of a no-deal endgame could be “disastrous”. It foresees critical shortages of food, fuel and medicine within days – and the port of Dover (and the M20 which feeds it) in meltdown. For Brexiteers, however, this is just the latest manifestation of Project Fear.

There is still a hard core of Tory Brexiteers who maintain that, come 30^th March 2019, the UK could just switch over to WTO rules and be done with it. Britain, they say, could throw open its borders to EU goods without imposing tariffs: the EU would be shamed into reciprocating. Mr Grayling, Transport Secretary, has already said that the UK would waive all customs checks at Dover. The Germans, who are concerned about uninterrupted automotive exports, might just go along with this. The French, however, have already said there would be “very frequent checks” on trucks containing foodstuffs. This, cumulatively, could result in gridlock along the M20 where the Highways Agency is already constructing a new lorry park for anticipated repetitions of Operation Stack.

To give Mrs May and Mr Davis their dues, they did reach a relatively favourable accord on the “Brexit bill”. That well-known Anglophobe, Herr Verhofstadt, initially indicated that the figure would be more than £60 billion, but, as per the agreement of 7^th December last year, we are told it will be in the £35-£39 billion range. The Europeans know that if there is no deal, then they won’t get their money – and that would have massive repercussions for their 2020-25 budget cycle.

Some commentators have reflected recently that Mrs May – who was technically a Remainer, though she refused to participate in the 2016 referendum campaign – probably wanted a Soft Brexit all along. So, all that talk about citizens of nowhere was designed to get the Tory die-hard Brexiteers behind her. We shall probably never know for certain. Even Mrs May’s memoirs are unlikely to elucidate entirely.

And even if there is agreement at the summit about the future shape of trade relations – even if Max Fac is accepted by the Europeans (unlikely) – come October, Mrs May will be required to hand over a cheque for nearly £40 billion in exchange for a putative free trade deal, the details of which will remain obscure.

Last year, during the first phase of the election campaign, I described Mrs May as the Downing Street Sphinx. No one seemed to know what she really thought about anything. If there is no deal at the forthcoming summit, and if there is little tangible evidence of a plan for what happens on 30^th March next year without a deal – and bold leadership towards that end – then, as Bismarck said about Napoleon III, she will be a sphinx without a riddle.

But, as Bismarck also said, politics is the art of the possible. Resolving Brexit definitively will probably take a dog’s lifetime, not a mouse’s. Clear-headed investors should have expected a protracted period of disharmony and, very likely, dislocations in supply chains and, thus, market turbulence. The London market and the Pound will remain subdued for some time. On the other hand, there will also be opportunities.

As Kipling told us: “If you can keep your head when all about you [a]re losing theirs and blaming it on you…You’ll be a man my son.” Or even a very resilient lady Prime Minister

[i] Reported in the Sunday Times, 03 June 2018, Revealed: plans for Doomsday no-deal Brexit.

[ii] Onn BBC R4’s Today Programme, 01 June 2018.

[iii] Lead story, 06 June 2018.