Morning Commentary: The Hidden Costs of Brexit

A daily summary and commentary of events and factors that affect the global markets, with a particular emphasis on the foreign exchange markets.

The Hidden Costs of Brexit Share this story: Andrew Kositkun Foreign Exchange Head Trader

The U.K. technically left the EU back in January 2020, but on Jan. 1, 2021, the U.K. also exited the transition period, ushering in a new era of EU and U.K. trading.  The U.K.–EU breakup was unique in many ways, including how trade negotiations went. Instead of discussing ways to lower trade barriers, the EU and U.K. were negotiating over how much to increase them, with the final result being a skinny deal relative to what the U.K. operated under with EU membership.  The fact that there will be no headline tariffs or quotas on U.K.–EU trade does provide relief for manufacturers and retailers. However, a range of non-tariff trade barriers have been reintroduced as the U.K. transitions from seamless trade, unimpeded by customs formalities and so on, to trade facing additional bureaucracy. Moreover, the biggest costs could turn out to be the invisible ones, such as opportunities between the EU and U.K. that would have previously been pursued but are no longer viable. While this is a vast oversimplification, it is likely that higher U.K.–EU trade barriers will result in a structural reallocation in the U.K. away from higher value-added traded services to lower value-added domestic production.  Looking ahead, there are many things that could shift Brexit’s economic calculus up or down. The three most notable ones to watch are as follows:  U.K. regulations: The U.K. will now be free to choose its own regulations, possibly to its advantage, as it should be nimbler without the need to establish consensus with other EU members. Of course, U.K. officials are as prone to poorly designed regulations as their EU counterparts.  Ongoing negotiations: The two sides are currently negotiating financial services equivalence and will be negotiating and renegotiating access to each other’s markets for years to come. The Brexit deal allows for either side to reimpose tariffs in retaliation to regulatory changes that distort completion, with the entire deal to be reviewed in five years’ time.  U.K. political risks: The Brexit vote exposed large differences among the countries in the U.K. For example, Scotland voted heavily in favor of remaining in the EU. Polls show majority support for Scottish independence, with the Scottish National Party retaining a very strong lead in voting intentions ahead of the May Scottish elections. This makes U.K. breakup risks something worth tracking.  On a broader level, Brexit and the cost of forced trade decoupling illustrates some lessons that can be applied to other scenarios, such as the U.S.–China trade war. For example, in 2019 the U.S. imported goods equaling 11.8% of GDP and exported goods totaling 7.6% of GDP. Using a simple accounting framework, the elimination of goods trade would add more than 4% to U.S. GDP.  Of course, economics and accounting are two different subject matters. If the U.S. were to eliminate trade, it does not have the capacity to make most of the goods it imports. Even if the U.S. were to build the needed infrastructure, higher labor costs would make production more inefficient. Therefore, a better option to forced decoupling and reshoring production, from an economic point of view, could be to push for a gradual shift from China to other U.S. allies with low labor costs. From what we have seen from the Biden administration thus far, this could very well be the strategy utilized.  HERE ARE THE KEY NEWS STORIES FROM OVERNIGHT: Vice President Mike Pence will not invoke the 25th Amendment, leaving impeachment the only path left to remove President Donald Trump. The House is expected to move forward with impeachment proceedings tomorrow. As for the Senate, it currently is on recess until Jan. 19 so will have to convene a special session to hold an impeachment trial.  Yields in the U.K. and continental Europe have followed U.S. yields higher, albeit at a slower pace. This means nominal interest rate differentials are widening in favor of the U.S., supporting the U.S. dollar.  Bank of England Governor Andrew Bailey has pushed back against negative rates, noting there are “lots of issues.” Nevertheless, market-implied pricing suggests negative rates as early as May. The next Bank of England meeting is Feb. 4, when further details around the negative rate debate should emerge.  News reports suggest that Japan’s government will declare a state of emergency for the Osaka, Kyoto and Hyogo prefectures as early as tomorrow. With the greater Tokyo area already in a state of emergency, this new order would put a large portion of the country under lockdown.

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