At long last, the UK has left the European Union (EU). But now tough and unpredictable negotiations lie ahead. In our view, the probability that they end in a negative short-term economic outcome is greater than 50%.
At 11 p.m. GMT on Friday, January 31, the UK formally left the European Union (EU). Thank goodness for that, many will say. Unfortunately, it isn’t quite that simple, as the UK and the EU still need to reach agreement on the shape of their future trading relationship.
Transition Phase Will Be Short
Now that the UK has left the EU, it has entered a transition phase during which it retains most of the rights and obligations of EU membership. This phase should last until December 2020, but may be extended for an additional two years if this has been agreed on by July 1. The only problem is that the UK government has passed a law to rule this out.
Many observers regard the enforced December 2020 deadline as a negotiating tactic on the part of the British government (since there is nothing to prevent it changing the law back again later). However, we are inclined to take Prime Minister Boris Johnson at face value on this. Extending the transition phase would be seen by Conservative voters as a huge betrayal, while the last thing Johnson can afford to do is start looking like his predecessor. This is exactly what will happen if he allows himself to be sucked into a never-ending negotiating vortex by the EU.
What Types of Deal Are Possible by Year-End?
Just about the only thing we can say with any certainty is that it will be close to impossible for the UK and the EU to reach agreement on a comprehensive trade deal covering goods and services by year-end. The best that can be hoped for is a limited agreement that would include a zero-tariff regime for goods, but with the UK leaving the EU’s customs union and with no provision for services.
While it’s difficult to be too precise about the shape of the future trade agreement, we can identify four broad scenarios:
1) No Deal/WTO Terms—No agreement, with the trading relationship between the UK and the EU defaulting to World Trade Organization (WTO) terms. While the government now has more time to plan for this outcome, it would still be disruptive and would probably push the economy into recession in late 2020/2021.
2) Limited Agreement—A zero-tariff regime for goods but with no agreement on services and the UK leaving the EU’s customs union. This would previously have been called a hard Brexit. It would be less disruptive than no deal but could still impair growth.