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No deal or light deal? Policy issues after Brexit

The clock continues to tick down one negotiations between UK and the EU. Bot parties are trying to  bridge their differences in order to finalise an agreement on trade that will take effect from 31 December 2020, when the UK leaves the EU’s single market and common customs regime. “No deal” still remains a prospect, but a “light deal” could still be salvaged. We look at some of the issues

Where are at

October had long been presented as a crunch month for talks.  Both sides recognise that any deal reached will need to be ratified in time to be implemented by  31 December 2020.  This will require action by the UK Parliament, the governments of the 27 EU member states and in some cases their parliaments, and the European institutions, i.e. the European Council, the Commission and the Parliament. In the event, UK Prime Minister Boris Johnson and EU Commission President Ursula Von der Leyen agreed,  via teleconference, that talks should extend to the end of the month.

Negotiators will go in total secrecy into what has been termed a negotiating “tunnel”, or perhaps more appropriately a black hole, from which no information could emerge while the final details were hammered out.  For the UK side, the issue in the very short time remaining would then be to get this deal through Parliament before pro-Brexit forces on the Conservative right wing had time to derail it.

Sore points

Trade negotiations are for the most part complex, technical affairs. But they inevitably involve a handful of high profile flashpoints. One of these is fisheries. The political heat to economic significance ratio here is particularly skewed to the former, since fisheries accounts for around 0.1% of UK GDP. The politics reflect the concentration of fishing activities in the UK, and long-held grievances by the UK fisheries sector that EU membership increased EU shipping fleets’ access to UK waters much more than the other way round. The EU’s position has accordingly been to try and maintain the status quo, or something like it.

Moreover, given the EU’s position, the UK has long sought to hold fisheries as a bargaining chip to be bartered for gains elsewhere. Financial services was one of them. Concessions from the EU on state aid rules are another, and these now loom as perhaps the most contentious of sticking points.

In a state on state aid

State aid rules deal with the use of financial support to businesses. The reason the EU developed these rules was to avoid wasteful financial competition between its members states and to avoid distortions to competition and trade within the single market. Somewhat ironically in the present circumstances, the UK was one of the driving forces behind these rules. The main thrust of state aid rules is to allow financial support for very specific reasons, and only if the public benefit is material enough to outweigh the detriment to competition and trade.

The UK’s initial reluctance to countenance a continuation of the EU state aid regime was largely presented as a matter of principle: on leaving the EU, the UK should be left to decide its own approach. The unspoken subtext was that, on the historical evidence, the UK was unlikely to adopt an approach that was very different in practice to that of the EU. A future trade agreement would not require what in the UK’s view were intrusive provisions (with references to the role of the ECJ a red flag).

Two developments may have altered the calculus. Politically, the Conservative Party’s win in at the December 2019  General Election heralded a move towards a more interventionist industrial strategy as part of the new government’s “Levelling Up” agenda. The advent of the covid-19 pandemic further stimulated an appetite for intervention, for both immediate and longer term purposes. That concern is shared by EU member states: France, for example, recently unveiled a 100 billion Euro recovery package, which has a number of elements that target sectors (e.g. clean technologies in transport, digital technologies) that are also targeted by the UK.

Is reliance on WTO subsidy rules really to the UK’s advantage?

The dispute over state aid rules  has thus become a proxy fight over industrial policy rivalry in key technologies and industries for the future. The UK’s view is that it would prefer to rely entirely on WTO rules on subsidies. The latter are in some ways less constraining: services do not fall within their purview, and they do not kick in ex-ante i.e. there is no formal approval process that needs to be passed before a financial package is enacted.

The main discipline comes from the possibility that trade partners can take action against subsidies if they demonstrate that these subsidies cause adverse effects to their domestic industry. By action we mean imposing countervailing duties i.e. temporary tariffs that negate the harmful effects on domestic industry of the subsidy, or a claim via the WTO’s dispute settlement mechanism. If this mechanism found against the subsidising country, the latter would need to amend its measure or face retaliation. The narrow scope of remedies mandated by the WTO, coupled with a paralysis of its appeals function, further weaken enforcement and hence how far these rules may bite.

While this might prove attractive to advocates of a more activist industrial policy, there are also grounds for caution. For a start, both sides can play this game, and it is unclear that it is really in the UK’s interest to enter into a subsidy war with the EU.

Secondly, the narrower scope of the WTO rules can also play against the UK. Under WTO rules, what a partner needs to do is to demonstrate that a subsidy is specific to an industry and has caused adverse effects on domestic industry. There is no provision to balance detrimental effects to trade with wider policy objectives. To take a specific example, UK subsidies for the development of the Airbus A350 XWB were cleared under EU state aid rules, but were deemed  by a WTO dispute settlement panel to be in violation of WTO rules because they created adverse effects on the United States. It is not too difficult to imagine that the EU could launch a similar case against the UK in sectors where the industrial strategies of both parties create the possibility for rivalry.

Rules can help smaller parties

It could therefore be in the UK’s interest to agree to a regime that does have more explicit balancing properties between trade effects and other objectives, in the way state aid rules do. If agreed with the EU, that could help to manage some of the possible challenges that might come the UK’s way from the EU in the future, for example on in matters of “green industrial policy” in sectors such as transport.  Moreover, because the UK has established procedures for evaluating spending in a way that conforms to “balancing” it might be better placed than other EU countries to meet the requirements. More broadly, this approach could open the scope for a cooperative approach to industrial policy that leverages each party’s strengths and reduced the scope for wasteful competition.

It is often the case in commercial diplomacy that in an asymmetric bilateral relationship, an agreement on common rules that are equally constraining benefits the smaller party. The UK could consider the wisdom of this. In return, the EU could explore mechanisms that manage state aid, but which leave out some of the more contentious aspects such as references to the ECJ

The vexed issue of rules of origin

The battle around industrial policy is largely a battle around global value chains, such as electrical vehicles. In this battle, rules of origin are a key weapon. These rules determine when goods are eligible for duty free treatment e.g. within a free trade agreement. A lot of trade happens within value chains with inputs moving across borders for processing and assembly. An exporter that uses a lot of imported inputs needs to show that a sufficient degree of transformation has taken place on its territory (that it has originating status) to be eligible for any duty free treatment to be offered to it. Rules of in FTAs are usually designed in such a way that inputs sourced within the parties to the FTA can count towards the determination of originating status.

The issue came into focus for the UK when it concluded a new FTA with Japan to replace the one it had before, as a EU member state, with Japan. How would imports of Japanese intermediate goods – say inputs into vehicle production – be treated by the EU  if used in UK manufacturing processes. When the UK was part of the common customs territory, that question did not arise. But under the new arrangements, it is not enough for the UK to have agreed rules of origin with Japan and the EU; all three parties need to agree on the rules. That remains some way off. It points to the fact that fragmentation in the UK’s relationship with one of its major markets does not aid the UK’s global supply chain ambitions.

“Light deal” over “no deal”

With time running out, it seems the best parties can hope for is a relatively slimmed down deal. One that includes a mechanism on state aid could be in the interests of both sides, and could clear the way for further agreements on matters like rules of origin. Both parties have a clear interest in not adding to economic turmoil in these turbulent times associated with the Covid-19 pandemic

A “light deal” could also perhaps open prospects for more substantial negotiations on matters such as services trade, which have long been the missing link in these negotiations.



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