Post-Brexit trade tensions ramp up the tail risks for the UK and EU

The G7, as usual, contained much talk and little in the way of concrete proposals, with Brexit teething troubles seemingly overshadowing the bigger global issues.

The spike in tensions between the EU and its former member are nothing new.

The Brexit deal was never a complete solution, as the Northern Ireland protocol aptly illustrates, and arguments between the various political and trading partners have been – and probably always will be – a defining feature of European relations.

The Irish border crisis is resolvable, but entrenched positions are raising the prospect of arbitration, legal action and possibly even trade barriers. Adopting pragmatism to find mutually beneficial solutions is, after all, not always a key feature of the politicians’ guidebook.

Most Euromoney Country Risk (ECR) survey experts are not yet factoring in the prospect of a trade war as a notable risk.

For example, Monica Bertodatto, a European expert and associate director at Deutsche Pfandbriefbank AG (PBB), echoes the views of other contributors by saying that the Northern Ireland protocol does not really have the potential to escalate to the level of a fully-fledged trade war, such as that between China and the US since 2018.

However, a trade war is, and indeed always was, a tail risk clouding the investor climate, which was dealt another blow by the pandemic.

European risks have been increasing on a five- and 10-year trend basis, with analysts steadily marking down the continent after the banking and sovereign debt crises, the Brexit issue and now Covid 19.

The UK, ranked 31st in Euromoney’s global risk table, has seen its score fall sharply. All of the main EU countries have followed similar trends, with double digit 10-year score declines for Belgium, France, Italy, Luxembourg and Spain.

The Brexit problem, in any event, was never completely resolved, and the thorny issue of checks on goods moving between Britain and Northern Ireland remains.

Complicating matters, the UK will neither accept adhering to the EU’s food standards nor anything that undermines the Belfast Good Friday Agreement.

The EU is seen as too inflexible, while the UK position casts doubt on its respect for international agreements. One wonders whether and how a compromise can be found.

Economist Bruce Morley, a lecturer in the macroeconomics and finance research group at the University of Bath, is one of many contributors to the ECR survey who spells out the consequences should it occur.

“If a trade war started between the UK and the EU, in the short term it would adversely affect both sides, particularly the UK and Ireland, although as the EU has a substantial trade surplus with the UK, it would affect EU exporters and UK importers the most,” he says.

He sees a trade war – with tariffs imposed – increasing the risk of inflation, which is already rising. It would be worse, too, for the UK, which is dependent for much of its food on EU supplies, although the exchange rate would invariably determine by how much.

Sovereign risk expert Norbert Gaillard of NG Consulting concurs, saying that higher tariffs would “mechanistically lead to inflation risk”.

“Considering the goods and services involved, one could expect a price hike in the following sectors: insurance and financial services, packaged medicaments, gas turbines, computers, cars, vaccines, oil and gold,” he says.

He also thinks an all-out trade war is unlikely. If anything, higher tariffs are more likely in specific, symbolic sectors. The UK might target European wines, for example, as Donald Trump did in 2019.

There is the potential for trade wars and political differences well into the future 

 - Bruce Morley, University of Bath

A trade war would invariably weigh on risk factors.

“A global trade war as well as specific protectionist measures involving financial services would reduce economic growth in the EU and the UK, and affect country risk ratings,” adds Gaillard.

A trade war would also impact on budget deficits in the short run for the UK and the EU, warns the University of Bath’s Morley.

“This is worrying, given the debt/GDP ratios are high for both, with the UK approaching a 100% debt/GDP ratio following the measures to reduce the negative impacts of the pandemic,” he says.

From Europe’s perspective, if a trade war developed, Ireland, Belgium and the Netherlands would be especially affected, notes NG Consulting’s Gaillard.

“The Irish economy is systemically dependent on the UK,” he says. “The first import partner for Ireland is the UK ­[accounting for more than 30% of all Irish imports]. Many Irish firms and financial institutions are strongly connected to British financial institutions.

“The profile of Belgium and the Netherlands is different, as both countries have a significant trade surplus with the UK. Higher tariffs would weaken the export position of both countries.”

PBB’s Bertodatto adds that in the case of the UK-Ireland relationship, the impact would be more localized and possibly subject to some mitigating factors.

“There could be a substitution effect between trade partners on the Irish side, so that UK counterparties would lose market share in favour of EU ones over the medium term,” she says.

“Similarly, UK imports from Ireland would follow the same pattern as all other EU partners, but in this case a substitution effect would be harder because of proximity reasons.”

Bertodatto believes the application of tariffs would depend on a mutual or symmetric trade policy, which would unlikely escalate to a China-US level and therefore not become a driver of inflation on either side.

“Most of the disruptions would instead affect the timeliness of the transits across the border in both directions, but with time some of the bottlenecks that are being experienced right now would be resolved,” she says.

A trade war would not benefit either side politically, either. It would probably entrench positions, especially regarding recent changes in Northern Ireland’s Democratic Unionist Party, which now has a new leader, adds Morley.

“The problem seems difficult to resolve, as the border is going to be either between Northern Ireland and the Irish Republic, which the EU opposes, or the rest of the UK and Northern Ireland, which the UK opposes,” he says.

“In the short term, there will be continued negotiations. This will increase uncertainty over future trade relations, which will have an adverse effect on financial risk, potentially undermining asset markets – although given the US dollar weakness, currently, it probably won’t cause the euro or pound to fall excessively.”

Morley warns: “The room for manoeuvre is limited for both sides, so even if a decision is reached, it is unlikely to satisfy both sides and will continue to be problematic for years to come. So, there is the potential for trade wars and political differences well into the future.”

If the UK sticks to its position by not implementing the Northern Ireland protocol, it could damage London’s reputation and undermine the ‘Global Britain’ project, notes Gaillard, expounding the recently aired views of UK diplomats.

Bertodatto, meanwhile, believes that in terms of UK unity, the disagreement on Brexit “has already accentuated existing regional fractures and the Northern Ireland protocol might just risk adding to a process already in place”.

The risks of investing in the UK and its main EU trading partners eased after the Brexit deal, notwithstanding the Covid crisis – which once again shone the spotlight on Europe’s shaky macro-fiscal metrics, with economic growth undermined, unemployment higher and fiscal balances depleted by the pandemic.

In the ECR survey, the UK’s total risk score worsened in the second half of last year, but it rebounded in Q1 2021, and at a faster pace than the EU average, which also improved.

The previous year saw volatility, with economic risk increasing as the lockdowns weakened Europe’s economies, while political risks initially declined.

Scores for factors such as government stability, institutions, transparency and policymaking improved at first in the wake of the crisis, as governments responded quickly and effectively with lockdowns and extraordinary financial support for vulnerable groups.

With economies reopened, economic prospects have improved, and with the hit to labour markets not as bad as originally feared, UK and EU analysts upgraded their economic risk scores.

UK political risks also improved, with the notable exception of corruption, given the suspicions surrounding inflated and preferential treatment concerning Covid public procurement contracts.

For now, analysts are not prepared to overreact to the post-Brexit trade issue,

There is some political brinkmanship going on, but all parties will ultimately seek common ground to avoid the serious social and economic consequences from a prolonged dispute.

As a consequence, few experts would be prepared, just yet, to argue there is a notable risk of inflation or weakening of other macroeconomic variables as a direct consequence.

However, as some have pointed out, the threat of a trade war had seemed highly unlikely after the two sides reached a post-Brexit trade agreement, and with Boris Johnson eager to preserve the integrity of the UK, the Northern Ireland situation has become an intractable nut to crack.