Authors: Paul Gretton, ANU; David Vines and Anne Williamson, Oxford University

The outcome of the Brexit referendum has imparted a drastic shock to the UK economy. The United Kingdom must choose between three options as it seeks to refashion its international trade relationships.

The first option is for it to seek to avoid a protectionist outcome by reversing its decision and remaining in the European Customs Union and European Single Market.

Under a second option, it can withdraw into a more protectionist environment, in which it leaves the Customs Union and Single Market but forms market access agreements and free trade areas (FTAs) with other countries. This second option is the preferred UK government policy at present.

The third option would be for the United Kingdom to leave the Customs Union and Single Market, and reduce its tariffs and liberalise its own borders, in an attempt to open up its trade with the rest of the world.

The economic costs to the United Kingdom of withdrawing from the Single Market and the Customs Union will be large. The EU accounts for half of Britain’s exports. It is true that EU tariffs are (for the most part) very small, apart from textiles and clothing, heavy industry (including motor vehicles) and agriculture. But losses will still accrue to the United Kingdom, if the United Kingdom and the rest of the EU both close their markets to each other’s goods and services. In particular, the costs of leaving the EU will extend beyond being subject to tariffs—the United Kingdom will lose access to the EU’s financial market openness and the EU’s regulatory architecture in many industries such as pharmaceuticals and air transport.

If the UK does not reverse its decision to exit, which of the other two approaches would be least costly?

The preferred UK government policy at present is to negotiate FTAs with other countries and to negotiate a new agreement with Europe (the second option). But the gain from these actions is likely to be extremely small for two reasons. First, negotiating bilateral agreements is time-consuming and the costs of doing so are high. Second, the agreements­—even any new agreement with the EU—will inevitably include productivity-sapping regulations that are designed to enforce preferential rules of origin. Partly because of this, the take-up of negotiated market-access preferences will only be partial.

Furthermore, the EU already has free trade agreements with countries that make up another 17 per cent of the United Kingdom’s export market—such as South Korea, Canada, Singapore, and the countries within EFTA, and is at present seeking additional agrements with other countries. Thus the United Kingdom’s planned negotiations of new agreements with other countries may do no more than maintain the status quo, rather than leading to new opportunities.

With the United Kingdom contributing only about 3 per cent of gross world product, it is unclear how powerful the United Kingdom would be in any FTA negotiations. Negotiating partners are unlikely to want to take the United Kingdom as a standard-setter. A hub-and-spoke system with the United Kingdom at its centre is extremely unlikely.

Might unilateral liberalisation (option three) combined with domestic reform efforts be an alternative way of mitigating the negative effects of Brexit? Under this policy, the United Kingdom would open its borders to Europe and elsewhere. It would seek to increase its trade with the most rapidly growing parts of the world, particularly the Asia Pacific region. At the same time the United Kingdom would foster productivity improvements at home.

Since overall tariff levels are low, unilateral liberalisation would not make much of a contribution to offsetting the trade costs of exiting the EU. Unless combined with substantial domestic productivity-improving domestic reforms—which would be difficult to achieve—any liberalising moves by the United Kingdom would not greatly offset the wider costs of exiting from the EU Single Market.

Further, efforts to liberalise the UK economy would need to be gradual in industries that are highly dependent on government assistance, and which will lose access to the European market. This is particularly the case for some agricultural and manufacturing activities, including in the textiles and clothing industry and in the heavy manufacturing sector, including motor vehicles. In short, the domestic gains from option three are likely to be small.

Seeking greater economic integration in the Asia Pacific may also prove to be harder than it seems. Any difficulties faced by the United Kingdom in accessing the economic opportunities available in this region would not be helped by new regional mega-agreements, such as the Regional Comprehensive Economic Partnership and the revamped Trans-Pacific Partnership (the TPP 11), which are much closer to preferential agreements. They would also not be helped by perceptions of globalisation in some countries in the region—in particular China—that are cast mainly in terms of access to foreign markets rather than the opening up of domestic markets.

The Irish border issue is also critical. If the United Kingdom carries out the government’s preferred option (the second) a hard border will need to be established between Northern Ireland and the Republic of Ireland, potentially endangering the Good Friday peace agreement of 1998. A hardening of the border will also be needed to be established if option 3 is pursued. In December 2017 the UK government announced that it would maintain an open border between Northern Ireland and the Republic of Ireland. It is hard to see how this will be done without the United Kingdom remaining a member not just of the European Customs Union but also the Single European Market, potentially forcing the United Kingdom back to option one.

Even if the British government does get round the Irish hurdle, it will be important for the United Kingdom to avoid an elementary mistake. That is, it would be odd if the United Kingdom sets aside membership of the Customs Union and Single Market in order to pursue partial liberalisation of trade with only a small number of other trading partners outside Europe. The unilateral opening up of the United Kingdom’s trade with the rest of the world is unlikely to be a way of squaring this circle.

In recognition of the nature and scale of the choices facing the United Kingdom, there is a need for a national policy review institution in which proposed reforms to the United Kingdom’s trade and domestic policy can be assessed according to their potential impact on the national interest. At present, the United Kingdom does not have a forum in which these issues can be clearly discussed.

Paul Gretton is Visiting Fellow at the East Asian Bureau of Economic Research and an Associate of the Centre for European Studies at The Australian National University.  

David Vines is Emeritus Professor of Economics and Emeritus Fellow of Balliol College at Oxford University, and Research Fellow at the Centre for Economic Policy Research, London. 

Annie Williamson is an MPhil student in Economics at Oxford University.

Many of the issues raised in this article were discussed at a meeting on Brexit and the United Kingdom’s trade choices, convened by the Centre for Economic Policy Research and held at the National Institute of Economic and Social Research in London on 7 February 2018. A report of these discussions can be found here.

This article appeared in the most recent edition of East Asia Forum Quarterly, ‘Trade wars and Asia’.