UK-EU trade negotiations are assumed to drag on beyond the end of 2020 with either an extension of the transition period or a political fudge that has the same effect. This would prevent trade frictions from being introduced while talks are ongoing, according to the latest research report from Oxford Economics.
However, a 30 percent chance that talks break down, leaving the UK and EU to trade under WTO rules from 2021. The UK government’s apparent determination not to extend the transition period and its desire to avoid making commitments that might limit its ability to conclude trade deals with other partners make this a tangible risk.
Should talks break down, the UK and EU would experience much of the short-term disruption that we have previously outlined regarding the impact of a no-deal Brexit. Tariffs would be levied on goods imported from the other party.
In addition to tariffs, UK-EU trade will be subject to non-tariff barriers (NTBs). The reintroduction of customs controls will increase the administrative burden on traders, while UK exports to the EU will also be subject to additional NTBs related to regulatory issues.
In the event of a such a “no-trade-deal Brexit,” UK GDP would be 1.6 percentage points lower at the end of 2022 than in our baseline forecast. On an annualised basis, this corresponds to UK GDP being £37bn lower by Q4 2022 than would have been the case if our baseline view was fulfilled, the report added.
The damage to EU countries would be much smaller, although Ireland would also be hit hard.
"We also expect that financial markets would react negatively, with sterling depreciating by a projected 5 percent against the dollar in late 2020, and a smaller drop of around 3.5 percent against the euro, reflecting the notion that eurozone growth prospects would also be slightly softer under this scenario," the report further commented.
Equity prices would also be hit with our model suggests that UK equity prices would drop by around 4.5 percent relative to baseline by the end of 2021.
Mitigating the impact on the UK economy would be looser policy settings. However, the prospect of weaker growth in potential output is likely to limit how much fiscal and monetary policy would be loosened.
The experience of the various Brexit deadlines in 2019 suggests there would be considerable volatility at the end of 2020 and start of 2021. Wary of supply-chain disruptions from the new trade frictions, firms would take precautionary action to build up stocks and clients would front-load orders.
"We would expect this to result in swings in inventories, exports, and imports similar to the build-up to the initial March 2019 Brexit deadline. The subsequent, temporary, downturn in activity could be exacerbated if, as in 2019, motor manufacturers opt to schedule their annual shutdowns for the period that has the highest risk of supply-chain disruption," Capital Economics added.
The imposition of tariffs and introduction of NTBs would weigh significantly on both exports and imports from Q1 2021, although sterling depreciation would mitigate some of the damage to exports while adding to the drag on imports.
But while the weaker pound would offer some support to GDP growth by helping boost net trade, the experience of 2016-2017 suggests that the negative impact on consumer spending from higher inflation would more than offset that. This effect would steadily take hold through 2021. Business investment is likely to be hit hard, both via lower demand and the UK’s reduced attractiveness as a base for European production.
Although looser policy settings provide some support to activity, more than offsetting that are the dampening effects on consumer spending from higher inflation and weaker employment growth, as well as ongoing weakness in business investment and exports.
Meanwhile, the hit to industrial production would be much larger than the damage to GDP. This reflects the larger increase in trade barriers to goods trade than to services exports, that a greater portion of manufacturing output is exported, and the impact of lower business investment, Capital Economics further noted in the report.