A quickie divorce

21 October 2016

At 1.00am this morning, Theresa May took the five minutes allotted to her at the end of the dinner at the Brussels summit to point out that the UK remains in the EU until the Article 50 notice runs out. She had previously expressed her wish that the UK should continue as a good friend and responsible partner to our continental neighbours. Regardless, her audience remained silent. Later in the day, Brussels saw its authority collapse with the breakdown of last-ditch talks on free trade with Canada (CETA), though this could yet be resolved by dint of the EU's customary drama-queen finale. This piece sets out how the Premier may act as the good friend to the EU she wishes to be, by letting it off prolonged Brexit negotiations so that it is free to turn to its many other problems.

This is best accomplished with the measures on which I touched last week in A summary departure”, for the Adam Smith Institute. Despite the inelegance of “quickie divorce”, the phrase serves as a catch-all for policies to minimise uncertainty, respond to volatility in financial markets and abate the risk of deferred recruitment or investment on the part of industry. It does so by providing an early and definitive framework for commerce, finance and industry; and paving the way for prompt discussions with other trading partners. The specifics of the proposals stem from another central policy objective: avoiding favourites in particular sectors.

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First we look at services, where the timetable of international negotiations presents the UK with an immediate opportunity to gauge the EU’s intentions. This stems from the Trade in Services Agreement (TiSA), currently in opaque (and apparently desultory) negotiations in Geneva between twenty-three members of the World Trade Organisation, accounting for seventy percent of world trade in services. As a precondition for any negotiations with the EU, the UK should give it thirty days to sponsor the UK’s independent status at these talks.

This matters to the UK but should not be any skin off the nose of our neighbours. Its response to this request will serve as a touchstone of its inclination to act positively. If not, the UK should walk away at the end of the notice period. This would invoke powers taken under the Great Repeal Act for HMG to exercise its rights under the Vienna Convention on Treaties to abandon Article 50 talks for lack of a serious intent to engage by the other side.

If Brussels responds positively, the UK should then chart a course which recognises the chequered path to free trade in services.

Barriers to trade in the field are regulatory. The EU’s approach has been “harmonisation”, universally seen as heavy-handed, indeed one of the most unpopular aspects of its acquis. Even so, it has yielded some fruit in transport and financial services.

Otherwise, many European services remain shielded from international competition, in particular those provided directly by governments or otherwise heavily regulated. These include broadcasting, education, energy, environmental, healthcare, postal and transportation services.

By contrast, the UK has led the way in deregulating (eg) energy, environmental, postal and rail services. This has opened them up to continental entrants without similar opportunities for UK firms across the Channel.

Given these complexities, not to say disparities, the UK’s best course is the easily understood position of the status quo ante. Our negotiators should also make clear their alternative to the adjudicatory role of the ECJ on trade disputes. The intended solution caters for domestic sentiment, conforms to best practice and creates no new bureaucracy. This would be binding arbitration in London under the laws of England, universally seen as the gold-standard for resolving international disputes.

As this offer is silent on freedom of movement, it is likely to be seen as the “cherry-picking” against which so many EU voices have been raised. This means that the UK needs to take pains to ensure that its fall-back position, reciprocity, is fully understood by the EU member-states and commercial organisations most likely to be affected.

If the EU becomes militant about financial services post-Brexit, then by the same token the UK will look anew at the positions of the French insurer, AXA, and banks, BNP Paribas and Soc Gen; as well as the threadbare champion of German finance, Deutsche Bank. In other sectors, UK will regard itself as at liberty to revisit the unreciprocated access to UK markets enjoyed by Dutch, French and German state-owned transport franchisees, respectively NS, RATP and DB; the French state-owned energy franchisee, EDF; and the French shareholder-owned supplier of services to British local authorities, Veolia. In addition, the UK will be in a position to exercise untramelled tax sovereignty to lift tax burdens, as briefly mentioned below.

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We now turn to trade in goods, where a zero-tariff regime makes increasing sense. Full disclosure: I have always warmed to the principle of free trade but have also always accepted that it smacks of utopianism. As events are turning out, zero tariffs are emerging as the most elegant solution all round. They should be combined with an invitation to the EU to reciprocate, to address the concerns of integrated supply-chains and manufacturing exporters in general. If this invitation drives a wedge between Brussels and its constituent exporting nations, I expect our negotiators will be able to staunch their salt tears.

To remind ourselves of the underlying economics, zero tariffs reduce costs for our manufacturers and consumers. The politics give such a regime the additional benefits of

relieving both sides of the unrealistic burden of line-item negotiations;

taking the high ground in the international community; and

showing as much support as is reasonably possible to noisy lobbyists from (eg) financial services or car manufacturers; and placing the burden on them to lobby the EU.

This too would probably be regarded as cherry-picking. Happily, should the EU decline to reciprocate, a zero-tariff regime represents its own fall-back position. International manufacturers in the UK will be able to source universally, free of duties. They will then have to balance the undoubted gravity effects of the proximate European market with the UK’s other attractions, including any newly emerging relief in the tax regime.

Critics of this policy may fairly point out that it has only been taken up by the two city-state entrepôts of Hong Kong and Singapore, suggesting that it has little application to major economies. This bald statement is correct as far as it goes, but its conclusion doesn’t follow. The overall level of EU tariffs is 5.3%. This is 180 basis points above world levels which are around 3.5%. Both are well below any reasonable test of materiality. It is also not at all clear which UK sectors need the protection of tariffs.

We sometimes hear that a zero-tariff regime would deprive the UK of bargaining cards in FTA negotiations. The facts are against this. Singapore has a network of FTAs encompassing almost twice the GDP of those achieved by the EU on the measure most flattering to the latter, including agreements with (eg) the ASEAN group, EFTA, China, India, Japan, Korea and the US; plus an agreement with the EU itself, which the latter has not been able to ratify. Hong Kong has FTAs with (eg) the ASEAN group, China and EFTA. We are also told that zero tariffs would deprive the UK of penalties for dumping. This is hard to understand as nothing in such a regime would cause the UK to relinquish its rights in such matters.

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We now reach the final element in a quickie divorce: the financial settlement. The concept of a payment is to crystallise and defray all other outstanding matters, specifically the UK’s share of pension and other future obligations, balanced by its share of buildings and other tangible assets. Last week, we threw out that this would be a one-off payment in the single billions. We have heard of no reason to alter this.

Any periodical payment is intended to cater for specific programmes - the example we chose was the Erasmus scheme of student exchanges - the UK might continue to find valuable. (Parenthetically, why are top British universities so keen on shunting their students off for a year at less distinguished European academies, whose demoralised faculties are most notable for trying for jobs here?) Once again, we threw out that this might be a periodic payment in the hundreds of millions. Here too, nothing has come up to change our views.

Since we raised this last week, there has been an almighty ration of media guff. This means that it now falls to us to dispose of the barmy notion that the UK might be bulldozed into periodical payments for passporting financial services. Let’s go through the figures. The City estimates that the tax contribution from financial services is £66.5bn of which it hints that twenty percent might be at risk, either from the loss of passporting or other disruptions.

As it happens, international banks do pay around one fifth (yes, twenty percent) of total taxes sourced from the City, but only a fraction of their activities benefit from passporting into Europe. The scheme is intended to protect consumers, whereas City institutions largely deal with each other or leading commercial or industrial corporations.

In addition, international banks are but one of the City’s activities: others include the UK-based banks providing consumer, industrial and mortgage lending; as well as non-banking activities, including asset managers, currency dealers, hedge funds, life and general insurance and private equity; together with professional services including actuaries, fintech, law and risk-management. Almost none of this is vulnerable to the loss of passporting.

If, moreover, the international banks concerned are European, they benefit from passporting into the UK, reversing the balance of arguments on the topic.

Most UK collective investment vehicles operate via the Channel Islands, Dublin or Luxemburg, rather than using their passport from London. This tells us that they place more value on a low-tax regime than any reductions in overheads stemming from passporting. Once again, this opens the way for the UK to revisit its tax regime to make the balance more attractive.

Since passports were introduced the growth of UK financial exports to the EU has barely improved. Meanwhile, UK financial exporters sell without passports to their two largest markets, Switzerland and the US.

Finally, City institutions will adjust. They will find new sources of revenues, to serve as the wherewithal for future tax receipts under whatever regimen then applies.

No-one knows what the right figure for the sums at risk might be, but it is well under 20% of the total of tax revenues originating in the City. To see how ludicrous such talk is, let’s try a thought experiment about something which the soft Brexit crowd would see as valuable to the UK. Wouldn’t it be interesting to hear what the EU would charge for full participation in the pertinent aspects of EU decision-making on financial services - what it calls its “comitology”? But to make this worthwhile, participation would have to extend to a UK veto on regulations affecting the City, with dispute-resolution under the binding arbitration described above. At this point we simply have to wake up from the pipe-dream, which has only served the purpose of reminding us of the limit of what a financial settlement can achieve.

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The thrust of this approach is that it is unrealistic to expect too much from prolonged (let alone detailed) negotiations. Whether drama-queen finale or outright car-crash, the CETA debacle tells us that Brussels will find it close to impossible to develop a position which commands its members. Its negotiators will be discouraged from offering any kind of flexibility to the UK, for fear concessions are demanded elsewhere. Most of all, the EU has so much else on its plate that it would be delighted to do without the distraction of Article 50 negotiations carrying on till the second quarter of 2019. The UK has no reason to make things unnecessarily tough for our neighbours. A quickie divorce eases the position for them and cultivates desirable conditions for us: reducing uncertainty at home and overseas, making the best of the EU’s own market and accelerating new departures in international trade.