Huw Edwards: Should the UK remain in a Customs Union?

The debate over ‘what kind of Brexit?’ seems to be reaching an important tipping point, with the Labour party now joining with pro-European Tories and the Confederation of British Industry in recommending one particular form of ‘soft Brexit’: namely, that the UK should remain in a Customs Union (or something similar) with the European Union. This proposal is now seen as anathema by the hard Brexiteers, and so within a few days Parliament may well be setting the course for UK negotiations, in one way or another.

A Customs Union with the European Union is not the full Single Market. As such, remaining in the Customs Union could be seen as a kind of Brexit-lite, particularly if combined with continued harmonisation in at least a large proportion of product standards.

At the same time, CU membership is a less close arrangement than Single Market or European Economic Area membership, which is seen as politically unpalatable in the UK due to popular resistance to continued freedom of labour movement.

The importance of the CU, and the reason it is seen as so important to many businesses, is because it means no tariffs between the UK and the EU, which simplifies border procedures (particularly important on the intra-Irish border). The CU provides freer trade with Europe than a Free Trade Area alone, because of avoiding the need for complex rules of origin, as Caroline Fairbairn of the CBI pointed out last week.[1]

To understand why some kind of successor trade deal with Europe is seen as so important: the EU currently accounts for over 50% of UK imports and 43% of our exports. However, including the other countries in the Customs Union, plus Switzerland (which has Customs Union on many items), over half of our exports go to Europe.

Arguments for Exiting the Customs Union

The main pluses of exiting the Customs Union are freedom to set our own external tariffs and freedom to negotiate our own trade deals with other parts of the World.

Freedom to set our own tariffs has certain attractions. EU tariffs, particularly on agricultural commodities and some manufactures, push up prices of certain goods in the UK. The UK could potentially declare lower tariffs on food imports, which would make the cost of living cheaper for families. However, it is likely that this would be resisted, as any cut in tariffs on foodstuffs would threaten farmers’ livelihoods.

Access to export markets is vital to our prosperity following Brexit. Cutting import tariffs unilaterally would leave the UK with little negotiating power to persuade other countries to cut tariffs, or reduce nontariff barriers on our exports. This means that the UK government is probably more attracted to the idea of retaining external tariffs, but then striking new trade deals with other countries, such as those in the Asia-Pacific region.

A difficult choice

This creates a difficult choice. If the UK seeks either to cut external tariffs or to strike its own trade deals with third party countries, then a form of trade barrier called ‘rules of origin’ would automatically apply to our exports to the EU.

We cannot have our own free trade agreements without having freedom of trade with the EU curtailed, at least to some extent. This is because we would need to introduce a load of new paperwork, and customs procedures likely to cost a lot in terms of manpower and time, in  order to avoid the UK being misused as a back door to the European Market. Part of the difficulty is that we do not currently know for sure how costly rules of origin actually are. There are relatively few studies, although evidence from North America suggests these are a real problem for exporters.

We also need to bear in mind that potential trade deals with other parts of the globe are unlikely to be easy to negotiate, especially if the deals cover the important parts of trade liberalisation, which are the reduction of nontariff barriers, rather than just tariffs. Such negotiations take a long time, and we would initially be running hard just to try and make up ground relative to the trade deals which the EU already has.

Running hard just to stand still

For example, the EU’s trade deal with South Korea was negotiated over several years, and came into force in 2011. This was a deep free trade deal, which opened up the Korean market to European exports. This deal resulted in a rise of 48 per cent in exports of goods to Korea from the EU as a whole between 2010 and 2013, but for the UK the increase was an even more spectacular 125 per cent. The reason this trade agreement led to such a jump in trade is that it was a deeper integration agreement, allowing for lower nontariff barriers as well as tariff reductions.

The evidence is now quite strong that deeper integration agreements are far more effective in increasing trade than tariff reductions alone. Yet deeper integration agreements are far more complicated to negotiate, as they require countries to agree on issues of goods and services regulation, legal conformity and health and safety issues.

As long  as the UK is serious about trading with other parts of the World, it will need to at least hold on to the gains from the EU-Korean deal, as well as the similar prospective deal with Japan, which was finalised at the end of last year, and in addition to those with Canada (which came into force last year), Mexico and Mercosur.

Even if the UK can match these agreements, which is a big if and likely to take many years, the gains are not necessarily very big. For example, despite the 125% rise in exports to South Korea, that country still accounts for less than 2 per cent of our total exports. Not big.

One alternative talked about is membership of the nascent Trans Pacific Partnership. This agreement was reaffirmed last month by many of its original signatories (but not the USA), and lowers non-tariff and tariff barriers to trade between Japan, Korea, Canada, Australia, New Zealand, Singapore and Malaysia, plus a few smaller economies.

One issue is that these countries together are not, in fact, very large as a proportion of the UK’s overall exports (just over 7 per cent of Britain’s goods exports in 2013). In addition, even though membership of TPP would assist Britain’s export potential, many of these countries already have (or are close to finalising) deeper free trade agreements with the EU as well, so TPP membership might well not provide much additionality  for British exports.

A further point, which applies to both the TPP and, even more, to the potential of trade deals with the faster-growing markets of China and India, is that trading more with lower income countries, rather than with wealthier countries such as the EU,  is likely to have a deleterious effect on income distribution within the UK.

This effect is well-known among trade economists: the effects of moving our relative goods prices towards those in the Asia Pacific region will be to have a magnified effect upon wage inequality. How this effect might stack up against the gains to poorer people from potentially cheaper food prices is something which would require detailed modelling: my instinct would be that we would end up with poverty considerably worsened, at least if we were replacing trade with relatively equal European countries with trade with highly unequal Asian and Latin American ones.

In addition, the more different countries are from ourselves (in terms of production specialisation and income levels), the greater the risk that a trade agreement could, in fact, be trade diverting (i.e., our trade with one poorer country would simply displace trade with someone else).

The American question

It has to be said that there is really only one outside market which has anywhere near enough size at present to be a credible substitute for UK-EU trade: that is the United States, which currently accounts for about 10 per cent of British goods exports.

The USA has, of course, been involved in two massive sets of deeper integration deals: the Trans-Pacific Partnership and TTIP, yet, under the more isolationist Trump administration, it has currently chosen to withdraw from both of them, at least for the present.

If TTIP were going ahead, this would, of course, provide a potential large trade boost for countries remaining within the European Union (although there have been serious concerns about some of the regulatory concessions involved). On the other hand, if the USA were in TPP, then that might make TPP membership for the UK an alternative means to improve access to the American market. However, the Trump administration is not playing ball with either TTIP or TPP.

While Donald Trump has made overtures to prominent UK Brexiteers, notably Nigel Farage,  there must be serious concerns about the kind of trade deal such an ‘America First’ president would ever offer to the UK, and there would surely be a great deal of political resistance in Britain, particularly over things such as meat and livestock standards, and safeguarding the National Health Service. So we should doubt whether Trump’s pro-Brexit views can really be a gamechanger.

Tentative conclusions

The tentative conclusions from this? Some commentators close to the Government seem very bullish about the UK’s trade potential with the rest of the world, to the extent that they would be prepared to forego the easier trade with the EU that would follow from remaining in a Customs Union.

It has to be said that, if Parliament does not overrule the Government on this issue, Britain will have its work cut out to stand still in terms of maintaining exports to the Rest of the World (without accepting a large depreciation in sterling), relative to what we could get with a closer, but less flexible, deal with the EU.

The rules of sensible management of change strongly suggest that we should be seeking to hold as much as possible of the trade advantages that we have, only giving up when we are asked for intolerable concessions, rather than throwing everything away and trying to negotiate from scratch.

In other words, start from Norway and work downwards, rather than starting from Canada and trying to work upwards. Nevertheless, some around the Government see things quite differently.

This Blog post was written by Dr T. Huw Edwards, leader of the TRANSIT research interest group and member of the Economics discipline group at the SBE. Huw can be reached on T.H.Edwards@lboro.ac.uk

You can watch an interview conducted with Dr. Huw Edwards regarding this matter by clicking on the link below

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