Written evidence submitted by Scottish Centre on European Relations (TFI0028)

Written Evidence to Scottish Affairs Committee Inquiry ‘Scotland and Brexit: Trade and Foreign Investment’

Dr Kirsty Hughes, Director, Scottish Centre on European Relations

Overview

As Brexit talks enter what should be their last few weeks of negotiations on the withdrawal agreement and political declaration on the future relationship, uncertainty levels remain high. There is uncertainty over the nature of the deal, whether it will be ratified at Westminster, what will happen if it isn’t ratified and whether there could still be a ‘no deal’ outcome[1].

If there is a deal which is also ratified at Westminster (and by the EU27 and European Parliament), then there will be certainty that the UK will leave the EU next March. However, there will then remain major uncertainty over the nature of any future trade and security relationship with the EU, when that may be agreed and ratified and whether it will or will not lead to sufficiently frictionless trade that the Northern Ireland backstop, which would have to have been agreed for a deal to go ahead, would instead kick in at the end of 2020 (for an indefinite length of time).

If there is no deal or any deal is rejected at Westminster, uncertainty will deepen and the UK will probably face a major political and economic crisis. How this is resolved, whether with a further EU referendum, a general election, further negotiations with the EU (hard to envisage at this stage) is entirely unclear: if Westminster cannot agree on a way forward, the political crisis would deepen. If there were a general election or further public vote, there would be a need to request an extension to Article 50.

This degree of uncertainty inevitably has substantial economic and political impacts. UK growth has already slowed considerably in the last two years with the IMF now predicting only 1.4% growth for 2018. FDI inflows into the UK in 2017 were 90% lower than in 2016[2].

A new British Chambers of Commerce survey also shows that 67% of Scottish firms in their sample (about 200 businesses) had not done any risk assessments on the impacts of Brexit compared to 62% of firms across the rest of the UK. Uncertainty over Brexit also comes out as the most important factor for these Scottish firms when considering whether or how much to export and import. These results are troubling and suggest businesses are struggling to plan ahead given levels of Brexit uncertainty.

The major political divisions across the UK – both in terms of public opinion in Scotland and Northern Ireland still supporting a ‘remain’ scenario and with deep divisions in England – look likely to continue if Brexit goes ahead. When there is next a general election, the goals of the future UK-EU trade relationship could change substantially so debate over these options will continue. This will add to economic and political uncertainty. It is hard to foresee a new UK-EU trade deal being agreed and ratified before the next general election in 2022 (if there isn’t one before then).

This uncertainty does not bode well for future trade and foreign direct investment (FDI) options and outlook for Scotland or the rest of the UK. It is also the case that any trade negotiations with other third countries are unlikely to proceed quickly unless and until the shape of the future UK-EU relationship is clear.

If the Irish backstop includes an indefinite period where the UK stays within a customs union with the EU, this will also impact directly onto whether and when the UK can agree any future trade relationships with third countries.

Scotland’s options for promoting trade and FDI after Brexit (if it goes ahead) all depend, therefore, on the nature of the deal, and the degree and range of uncertainty that it and the rest of the UK faces. This means planning for a range of uncertain scenarios which in itself consumes resources and makes adjustments by the range of government departments, businesses, organisations and individuals that are all impacted by Brexit extremely difficult.

Impact of Brexit

There have been many studies done of the likely impact of Brexit on GDP and on trade and FDI depending on the nature of the future UK-EU relationship. Most of these predict negative impacts[3]. Both Scottish government and UK government estimates are very similar in terms of overall impact on GDP growth. The Scottish government estimates[4] staying in the EU single market would reduce future growth, in 2030, by 2.7%; a Canada-style free trade deal would lower growth by 6.1%; and in a WTO scenario growth would be 8.5% lower (UK government figures respectively are 2.5%, 5.5% and 9%).

Estimates by the National Institute of Economic and Social Research, focusing on trade flows, suggest that in a Canada-style free trade deal, UK-EU goods trade could fall by 35% and services by 61% – and in a WTO outcome, goods could fall 58%[5]. The NIESR study assesses whether new trade deals elsewhere in the world could counter this fall in trade, and finds that it only has a very modest impact. Overall, the study finds a fall of 30% in total UK world trade if it moves to a WTO relationship with the EU and a fall of 22% if it moves to a free trade agreement with the EU.

Recent economic research has found that services trade, like goods, is strongly impacted by distance (as well as by non-tariff barriers)[6] suggesting the goal of increasing services trade beyond the EU will not be an easy one to fulfil (even before considering the greater difficulties in negotiating trade deals in services, and the interconnections between goods and services trade). In research for a report by the Institute for Global Change Institute, the NIESR also found that compared to a ‘soft’ Brexit, in a Brexit on WTO terms, GDP would be 4.9% lower by 2030 – with services accounting for 2.1 percentage points of that lower growth and goods only 1.1 percentage points (and migration and other factors also lowering future growth)[7]. For a Chequers’ style deal, they find GDP growth 4.1% lower.

The challenge for Scotland and the whole UK, for goods and services trade and FDI, is therefore one of damage limitation. Trade will also be affected by what happens to existing EU trade deals with countries around the world. Even if these trade deals are successfully rolled over during transition, they will eventually need full renegotiation. The UK, as a much smaller trade partner than the EU, will have much less bargaining clout than the EU and so may not anticipate getting equally good deals.

What Sort of Future UK-EU Trade Relationship?

A ‘Soft’ Brexit: The Scottish government has made clear, that if Brexit goes ahead, it would want to see a ‘soft’ Brexit of the UK staying in the EU’s single market and customs union. Economically, this would be the least damaging option. It would mean that the UK faced neither tariff nor non-tariff barriers to trade and FDI with the EU. However, over time, with the UK no longer having a full voice and vote and participation in EU institutions, it would seem inevitable that UK and Scottish interests will not always match with those of the EU27 and decisions on regulation and trade will be taken that will in some areas not be beneficial to the UK and Scotland.

This democratic deficit will impact on the economy but will also have political impacts – the UK will be a rule-taker and will have given up sovereignty rather than sharing it. If the UK is to stay in the single market and customs union, then it would clearly be politically and democratically preferable to stay in the EU.

A Free Trade Deal: Under the UK government’s current Brexit policies and red lines, any future trade deal, however deep and special, between the UK and EU is likely to mean new barriers to trade – especially non-tariff barriers between the UK and EU. This will make it particularly challenging to attract FDI to Scotland and the UK, as the UK will no longer be an attractive location for companies wishing to be within the EU’s single market; the UK will no longer be a gateway to the EU. It will also act as a brake on trade.

Customs Union and an Irish Backstop: If, as part of an Irish backstop, there is provision for an indefinite customs union between the UK and EU, this will reduce frictions due to absence of tariffs and absence of checks on rules of origin. This will help the goods but not services sector. However, the Chequers proposal of the UK remaining in the single market for goods, with full regulatory alignment and hence no checks on regulatory compliance, has been rejected by the EU for a range of reasons[8] (whether some version of close alignment resurfaces in the deal is an open question). If the UK was allowed to be in something close to the single market for goods, there would again be a substantial democratic deficit, and a major hit for services in being excluded.

For that period where the Irish backstop kicks in (if it does), there will, even with a customs union, be major negative economic impacts on both Scottish and UK goods and services sectors due to non-tariff barriers. The extent to which Northern Ireland will gain economically by remaining in the EU’s customs territory and single market for goods (if that is what transpires) is an open question but the Scottish government is right to be concerned that any such deal, while strongly desirable in terms of protecting the Good Friday Agreement, could divert FDI away from Scotland to some degree. However, any special deal for Scotland whereby it could have a differentiated deal, staying in the EU’s single market and customs union, looks impossible at this late stage in the talks.

Timing and Scottish Government Involvement: Timing is uncertain in terms of how long any future UK-EU relationship will take to be negotiated. The EU’s chief negotiator, Michel Barnier, has suggested 10 major strands of that negotiation should start in April 2019. Talks are likely to take several years, with longer to then ratify any deal. Whether there will be provision in the withdrawal agreement to extend the transition period (rather than let the Irish backstop kick in as effectively a quasi-second transition period) is an open and important question.

Current structures for consultation between the UK government and devolved administrations do not look adequate in terms of Scottish interests in both the future UK-EU relationship and other trade negotiations. New provisions for participation and consultation are clearly needed, as proposed by the Scottish government and others. However, if EU-UK talks do begin next April, then there needs to be rapid discussion of, and agreement on, new structures. How any such structures relate to processes and structures for agreeing UK common frameworks will also be a key question. There may be a clear risk that UK government decisions on trade deals will pre-empt the functioning of processes to agree common frameworks and pre-empt devolved decision-making.

Labour as the main UK opposition party has said that it would aim to agree a permanent customs union with the EU. If Labour came to power at a general election while trade talks were under way, it would be anticipated these talks would then change substantially. A very different approach to the future UK-EU relationship may also need a different approach to consultation and participation structures for the devolved administrations. Hence uncertainty – both political and economic – will continue to impact on all preparations and policy options.