31 July 2018

Before a short pause in Brexit negotiations began last week, the European Commission seemed poised to shoot down key aspects of the UK’s Chequer’s proposals. Initially, the Commission had cautiously welcomed the government’s plan – however, over two successive interventions, the EU’s chief Brexit negotiator, Michel Barnier, has taken aim at UK proposals for future UK-EU trade in goods.

A lot of focus has been given to Barnier’s dissection of the UK’s Facilitated Customs Arrangement (FCA) plan. Last Friday he warned, “The EU cannot and the EU will not delegate the application of its customs policy, of its rules, VAT and excise duty collections to a non-member who would not be subject to the EU’s governance structures.” Some suggest this has killed off the Prime Minister’s plan altogether, given the FCA model relies on UK authorities ensuring goods intended for the EU market pay the EU tariff at British borders. However, the EU may instead be zeroing in on questions of governance and enforcement – if this model is to stay afloat, the EU is likely to push for a continued role for the Commission and the ECJ in supervising and managing the UK’s commitments.

However, less attention has been given to Barnier’s recent statements on the economic feasibility of proposals for a UK-EU free trade area in goods. Following a meeting of the EU27 Europe ministers to discuss the UK White Paper, he questioned whether it would be economically possible to separate trade arrangement for goods and services:

By definition, the “common rulebook” for goods would not concern services, on which the UK wants to be free to diverge. When we know that 20 to 40% of the value of products that we use every day is linked to services, how could we avoid the unfair competition which European businesses would face [from UK goods manufacturers]?

The broad point on the indivisibility of the EU’s four freedoms – goods, services, capital and people – is not new: the institutions and member states have held this line since the referendum vote. However, this has not often been put forward in purely economic terms – in part because the economic argument is weak.

Barnier’s point is that even if the UK stays fully aligned with EU rules and regulations on goods in order to achieve frictionless trade, its freedom to diverge on services could allow it to become a regulatory competitor by the backdoor. This, he would say, is because a range of services are needed in the manufacture of any good – from the design and engineering of a product to accounting and legal services provided to manufacturing firms. If the UK deregulates in any of these areas after Brexit, UK firms would be able to sell goods into the EU at more competitive prices that European manufacturers, while benefiting from the same barrier-free trading arrangement. This would undermine the EU’s level playing field.

So how important is the British service industry to the UK manufacturing sector? First, it is important to note that services can be linked to goods in two main ways: either they are necessary elements in the creation of a good – known as services inputs; or they are sold as packages alongside a product – service outputs. The Commission’s argument has centred on service inputs – for example, the design of a product, or the transport services need to move component parts from one site to another – given this is where it perceives the greatest threat. I will try also to address the question of services outputs – for instance, repair contracts sold with engines, or maintenance contracts sold with computers. EU businesses may have something to gain in this area after Brexit.

UK service inputs are not quite as valuable to manufacturing exports as the EU suggests

Barnier risks overstating his point when he warns the EU could face unfair competition on 20-40% of the value of UK goods exports. According to the latest OECD data, around 37% of the gross value of UK manufacturing exports came from service inputs in 2011. But services supplied by UK businesses accounted for only 21.3% of the value of goods exports. What’s more, this figure has declined, albeit marginally, in recent years – in 2000, UK services accounted for 24.3% of the value of British manufacturing exports.

On the other hand, services provided outside the UK are becoming a more important – 12.2% of the gross value of UK manufacturing exports came from foreign services in 2000, compared to 15.8% in 2011. This reflects the integration of British manufacturing into global value chains, and increased off-shoring of different parts of production. Of course, the EU cannot claim “unfair competition” from the value added by non-UK services in the future, given these were never subject to the EU’s regulations.

The UK already has flexibility to deregulate in services, given the Single Market is services is incomplete

This brings us to the more fundamental flaw in Barnier’s argument: the UK – like other EU member states – already has a good degree of regulatory freedom in many service industries. This is because the EU Single Market in services is not fully developed.

For instance, the UK primarily produces and exports high tech industrial goods such as cars, airplane parts, pharmaceuticals, and computers. The services most linked to the manufacture of these goods – engineering, consulting, market research, accounting (according to ONS input output data for 2014) – are regulated largely at the national, rather than EU, level. The EU doesn’t have the perfect regulatory playing field it claims to have – the UK already has freedom to deregulate in key services sectors while Britain is a member state. This would remain the case under the Chequers proposal. The EU competitive environment arguably faces greater threat from UK deregulation in areas such as social and employment law, taxation or state aid – but the government has made strong post-Brexit commitments to maintain the status quo in these areas, which the EU has welcomed.

One key exception to this argument is financial services, where the EU single market is well developed. Financial services account for much of the services inputs that go into producing high tech goods such as cars and airplanes. Under the Chequers model, the UK could in theory move away from the EU’s strict banking regulations, for instance by relaxing capital requirements and allowing banks to offer manufacturers access to cheaper capital. But it is worth putting this into perspective: according to ONS data, financial services accounted for 3% of the total output of the British car manufacturing industry in 2014 (in price terms), and 4.6% of the total output of aerospace.

What’s more, recent reports have shown that an important share of the value of high tech manufactured goods comes from services contracts that are “bundled” with products – aftercare, repair and maintenance packages – rather than services inputs. Indeed, repair and maintenance services account for around 9% of the total output of UK aerospace manufacturing in price terms – over double the value of financial services. Given much of this is provided locally, rather than supplied cross-border, the EU could stand to gain here post-Brexit. If the costs to UK service providers of establishing themselves in EU markets rises, this creates new opportunities for local businesses to supply contracts on UK goods sold to the EU. On the other, the EU might choose not to restrict FDI from the UK, given this creates jobs and generates tax revenues.

The link between goods and services is even more pronounced in Swiss exports, but the EU still agreed to a preferential deal in goods

However, the EU may say that these arguments miss the point – even if services are not fully regulated at the EU level now, the Single Market will develop further. The real economic risk of offering the UK a frictionless deal in goods without requiring a level regulatory playing field on services would materialise in the future. Despite EU-level services integration having proven stubbornly difficult to achieve, this is a fair point.

But this has not prevented the EU from striking “goods only” deals with non-EU countries before. The clearest example of this is Switzerland, whose agreement on goods with the EU “results in a de facto situation which is hardly different from the EEA in industrial goods” (according to a recent OECD report), but which has limited agreements in services.

The value added by domestic services to manufacturing exports is notably higher for Switzerland than for the UK – OECD figures show 28.8% of the gross value of Switzerland’s manufacturing exports in 2011 came from domestic services, compared to 21.3% for Britain. The EU may argue this was not case at the time it concluded its bilateral agreement on goods – but data shows that Swiss services accounted for 29.7% of the gross value of its manufacturing exports in 2002, when the Swiss-EU ‘Bilaterals I’ package was introduced. If the interrelation between goods and services wasn’t an insurmountable obstacle to the Swiss agreement in goods, why should it prevent a similar agreement being reached for the UK?

The simple answer is that the economic argument alone would not rule out the Chequers plan for goods; the EU has strong political incentives to sell the four freedoms as ‘all or nothing’. However, past deals have shown that the EU can be flexible on this when it wants to be – Ukraine’s association deal with the EU approaches free movement of goods, but does not include free movement of people; Switzerland has achieved quasi-free movement of goods and essentially accepts the full free movement of people, but does not have a similar arrangements for services or capital. Is it really impossible for the EU to find a similar degree of flexibility when renegotiating its relationship with such a close economic and strategic partner as the UK?