Dave Leggett provides an assessment of the latest developments following the UK’s referendum result to leave the EU.

It is probably true to say that it has been a tumultuous ten days for the UK, economically and politically, since the referendum result. There is, however, a growing sense that we are just at the beginning of a process that could take years to sort out. The decline to sterling on June 24th was an initial reaction. Stabilisation of the currency since reflects the simple fact that traders are unsure where to go with sentiment as the UK government reacts to a situation it did not expect. Uncertainty is still the word that best sums up the overall position, in terms of the economic impacts ahead and the terms of the UK’s departure from the EU (and, crucially, trade arrangements). Things may become a little clearer when we have a new prime minister in September, as a UK government negotiating position for the talks with the EU is finally arrived at. David Cameron’s resignation, by the way, means that the new prime minister will be chosen from the ruling Conservative Party without resort to a general election (though there is some speculation that an election could follow).

Article 50 ‘trigger’

David Cameron’s final significant act as prime minister was to say that it would be for his successor to invoke Article 50 of the Lisbon Treaty (think of it as the EU’s constitution), that implements a strict two-year timetable for negotiations to determine the exit terms for a member state leaving the EU. This initially bought some time – a few months – because a new prime minister needs to be elected by The Conservative Party.

What had looked like a straightforward administrative step to formally start exit negotiations has, however, become more strategically significant because it appears that it is in the UK government’s hands to determine when it is invoked and the resultant timeline may be crucial to the eventual outcome and how favourable, or not, the terms are for the UK. For example, some UK politicians have said it would be a good idea to have informal discussions with the EU before pressing the button, to maximise the chances of getting a good deal once the clock starts ticking. Another consideration is the political landscape in the rest of the EU. If there are elections coming up, there could be an incentive to ‘punish’ Britain in order to make anti-EU political movements or parties less attractive to voters (there are elections in France next year).

That has led to plenty of speculation on when Article 50 would actually be invoked, with some suggesting it may not be until next year. Obviously, much will also depend on the attitude of the EU which, while it cannot force the UK government’s hand, may start to apply pressure. On the UK side there is also the realisation that an extension to the two-year period can only happen with the unanimity of all 27 other member states. If that is not there, then the UK is out after the two-year period expires, likely with no free trade deal done. That is another reason not to rush things, from the UK perspective.  

Another point is that the EU is sticking to the line that there can be no informal negotiations until Article 50 is invoked. The UK side would like to have discussions – see the lay of the land – before that ticking clock actually starts; the EU is saying a firm no to that. That said, politicians like to talk and it is hard to imagine there won’t be some probing of positions and discussions of scenarios in the weeks and months ahead – both publicly and more discreetly. We have already seen plenty of media coverage fed by remarks from politicians across Europe and we can expect to see more. And the EU, too, has to develop a negotiating stance and react to the UK’s position. There are bound to be differing views that need to be distilled into a concerted EU line or position.

Status of the two-year exit negotiations

The status of the negotiations themselves is an intriguing one. We are, let’s remember, in uncharted territory. The UK is an EU member state that is the first to leave. It has free trade with the EU now, meets EU standards and wants to negotiate a trade deal that continues that (as opposed to the more usual practice of the phasing down of tariffs and actions on standards and regs). The EU’s Trade Commissioner, Cecilia Malmstrom, has said that the two-year negotiation period triggered by Article 50 is for the UK to leave the EU and that it does not cover a trade deal. A trade deal, she said, can only happen when the UK is outside of the EU. That will have caused concern on the UK side because it suggests that after two years the UK will be subject to WTO with tariffs before a years-long negotiation on a free trade deal can even start. Technically, that appears to be the case. In practice, the two sets of negotiations can happen in parallel. The trade deal is important enough for negotiations to take place during the two-year period with some kind of fix so that a trade deal comes into effect just as the Article 50 negotiations terminate. Well, that’s one way it could go, but we are in new territory with much of this. The trade deal could take much longer than two years to do. Much depends on the political will to do a deal. And the UK’s position here is that of one country wanting to leave a club consisting of another 27 countries. The mood of those 27, and especially some of the bigger members, will be crucial, and that could change in the months ahead. There’s not a lot of sympathy for the UK position right now, but there is a broader political canvas at work and the factors that provoked the UK ‘out’ vote in the referendum are present in other countries across Europe, too.

Single market access or free trade?

The future of the trading relationship between the UK and the EU is at the heart of things. Could the UK continue to have access to the single market as many in the UK’s business community would like? Or would a free trade deal – that would likely exclude services, an issue for London’s international banks – be more likely?

The automotive sector in Britain has made its preferences very clear. It would like the UK to continue to be inside the single market, to enjoy tariff-free and unhindered trade with the EU (in effect, as now). That would be along the lines of the deal that Norway has with the EU. The big difficulty here is that in return for single market access, Norway pays into the EU Budget and has to accept freedom of movement of labour with the EU. High levels of immigration in Britain were a defining issue in a referendum that voted to leave in order to control intra-EU immigration (well, the distinction with immigration into the EU may have been lost on some voters…). Norway also has no say in the drawing up of EU regulations that it must slavishly observe. One strand of UK opinion on the Leave side has argued for the retention of single market access alongside concessions or limits on migration. Would the EU countenance that? Thus far, it has looked unwilling to concede on freedom of movement and that was also something on which David Cameron failed to get much change out of Brussels in his UK deal ahead of the referendum. And the trouble is, the EU has to think about precedents and the attitudes of other member states. In the end, the trade deal has to be ratified by all 27 member states. It is likely to be a tough one for the negotiators, but Germany’s Chancellor Angela Merkel has been fairly consistently saying the UK should not be allowed to “cherry-pick” benefits without costs. It’s hard to imagine business-as-usual trade with a special concession on movement of people for the UK on top.

If not single market access, how about a free trade deal? On the plus side, a free trade deal would mean that tariff-free trade in goods continues. There’s also no freedom of movement stipulation, because Britain would be outside of the single market. However, a free trade deal is less attractive to the UK side because it would likely not include services and London’s position as an international financial centre would be harmed by the loss of so-called ‘passporting rights’ that allow UK operating banks to trade freely across the EU. A free trade deal would also take time to negotiate (Canada is on 8-years and counting) and some estimates suggest it could take as long as five years to conclude. If that’s true, the UK either gets an extension to its two-year Article 50 status or has to fall back on the WTO. That would mean tariffs on goods shipped from the UK to the EU and the UK would have no alternative but to impose reciprocal tariffs (eg 10% on cars, 5% on components) in the other direction. It would, therefore, not be in the interests of either side to go to that situation as economic growth would be dented on both sides. If it does happen though, there could be a significant incentive to invest in components manufacturing in the UK to avoid tariffs on supplies to UK-based vehicle manufacturers.

On balance, some form of free trade accommodation is looking like the most likely basis for a compromise deal. It could come with some extra elements borrowed from the single market (‘free trade plus’). Which brings us to non-tariff barriers. Unless the UK is in the single market, this potentially becomes an area of concern with aspects such as ‘mutual recognition’ and rules of origin. The single market is designed to facilitate free trade as easily as possible. Outside of that, potentially, compliance costs for companies rise as traded parts or vehicle sub-systems require more auditing to establish origin and allow free circulation (it might mean having to go down to Tier 2 and Tier 3 parts). Cross-border customs controls could also be more onerous, but all of that is potentially on the table for negotiation. How long will it take to sort out? If the political will is there, the gloomier predictions may be confounded. The UK is in the single market, so is complying with EU rules and standards; it’s really not as complex as, say, Canada. And the UK does have a big trade deficit with the rest of the EU. The political will to do a deal, though, may not be evident for several months yet. 

Economic impacts and automotive volumes

What will the economic impact of the current uncertainties be? It is still too early to say with great confidence, but it looks likely that the UK economy will take a significant hit. Economists at Morgan Stanley say that a cumulative 1.5 percentage points will be taken off the UK’s growth rate in 2016 and 2017. That will bring the UK economy close to recession. Growth could also halve in the euro area, they say. UK interest rates stand at 0.5% and the Bank of England is focused on supporting the economy and the financial sector. That historical interest rate low is likely to make its way close to or down to zero and there is really nowhere to go from there. The Bank of England will also engage in quantitative easing to inject liquidity into the economy and support activity. It will be interesting to see how much export lift for the UK economy comes from the fall of sterling thus far.

What about the car market? The UK car market has surged in recent years and last year’s 2.6m tally was a record. In recent months it has shown signs of easing back. Expect it to decline in the coming months and show a fall in 2017 as the economy slows. A decline of 5-10% in 2017 looks likely on current economic assumptions. The exchange rate and a recovering European market will ease flows of cars from the continent – prices of cars in Britain could start to edge up; certainly the drive to sell cars in Britain will ease now that the exchange rate is less favourable.

UK car production, however, is rising. So far this year (to the end of May), UK car production is up by 13.6% to 738,516 units. Buoyant export demand and favourable product cycles are providing a boost. Car sales in Western Europe are up by almost 9% this year and heading for 14.1m units, a very respectable total. UK car manufacturing is well placed for now and nothing will change in the short- or indeed medium-term, in terms of sourcing. There could be some softening of volumes though as demand from the UK market eases.

LMC Automotive says its latest base forecast for the UK light vehicle market is for sales to fall 15% to 2.55m units in 2018 (versus 3.0m units in 2015). However, it says a decline of 410,000 units on its previous (pre-referendum) forecast for the UK light vehicle market to 2018 will be felt across Europe. Indeed, according to its latest analysis, German plants will see the greatest downward volume adjustment, losing some 130,000 units compared to the previous base case (with 50,000 units lost in the UK).

Auto industry positions

The auto industry continues to call for free and unhindered trade. The UK auto sector’s position is that it wants to stay in the single market. The feeling is that staying in the single market is the best way to secure output and employment as well as attract future investment. Outside Britain, the auto industry is also saying that it would like tariff-free trade to continue. The statement by the VDA early on, suggests an awareness in Germany of the importance of not disrupting trade in either direction between the UK and EU. I expect we will be hearing a lot more in the coming months about the differences between full single market access and the conditions that come with a free trade deal. 

For the time being, the focus is very much on the economy, what that means for demand and also on the trading relationship between the UK and EU and how the wind is blowing for the lengthy negotiations that lie ahead. The auto industry will be little impacted for now, but head offices will be looking for likely economic/trade scenarios for 2018 and beyond. And they will frame their longer term manufacturing and sourcing strategies accordingly. Prolonged uncertainty will undoubtedly deter investment. Many firms are locked in on investments for the next five or six years out. However, the longer the uncertainty on trade relationships continues, the more likely it is that an an Asian or US firm looking to invest in Europe eventually marks down the UK (competitive ‘gateway to Europe’, maybe not so strong a case now – interesting move by the UK Treasury to consider slashing corporation tax…) because of its possible position outside of the single market and with higher transaction costs on international trade. It would take some doing to compensate a 10% WTO tariff on European car shipments from the UK by pulling other competitive levers. My guess is that central and eastern European countries are particularly well placed to benefit from any shift of automotive investment away from the UK over the next 15-20 years; they are fundamentally low-cost, inside the single market and with rising local demand (motorisation still relatively low). UK or Poland for that new plant (yes, there’s a potential irony there)? It’s in the UK’s economic interest to do a trade deal quickly and remove uncertainty, restore confidence in the long-term outlook for manufacturers already here. It is also in Europe’s interest to contain the economic fallout that threatens the whole region (the eurozone could potentially have another financial crisis if economic growth slows and the problems of EU economic integration, national bailouts and sovereign debt are far from put to bed).  

There is also a global perspective to bear in mind. Expect to hear more about the UK’s future trading relationships with other parts of the world. It’s potentially an opportunity (a US-UK bilateral free trade deal, for example, might be easier to do than one with a 27-country bloc) but, there again, it is also subject to uncertainty (would the US talk to the UK before it concluded an EU deal, which could be years away?). The UK also lacks the expertise and civil service infrastructure to move quickly right now, as trading relationships have been handled in Brussels (it’s a good time to be a trade and treaty lawyer in London). One hope is that free trade around the world gets a shot in the arm from multi-lateral free trade deals like the Trans-Pacific Partnership (TTP) and Transatlantic Trade and Investment Partnership (TTIP). The TTP is on an open source style platform and the UK could possibly apply to join; it might provide a template for more trade deals. Could international OEMs start to view their UK car plants – take Honda in Swindon with the Civic, as an example – in a more globally sourcing way? The UK could be a driver in liberalising international trade and find a position that is more globally orientated, but it certainly can’t afford to ignore the considerable opportunities in the countries next door with whom it does most of its trade and has been sharing trade regulations and manufacturing standards for decades. Will common sense eventually prevail?

UK car production, model and make, 2015

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