Small and short-lived Brexit bounce to boost Irish GDP in 2020 but…

… unclear UK position may mean sentiment sours as year progresses

Even if trade deal reached, Irish growth outlook dimmed for2021 and beyond

Weaker outlook raises awkward questions about stance of Irish fiscal policy and scope for giveaways.

Analysis by Austin Hughes, Chief Economist, KBC Bank Ireland

Today, Friday, January 31st, the UK will leave the EU ‘in word if not in deed’. There may be political fanfare in Britain including the launch of a new commemorative coin and a light show from Downing St. However, the vast majority of businesses and households in the UK and in Ireland, in common with the rest of Europe, will see no practical changes at least until the agreed transition period finishes at the end of this year. Until then, the UK will be treated as though it were an EU state and EU law will continue to apply in the UK.

As a result, there will be no immediate constraints on trade and travel. So, January 31st is not an immediate pivot point for the UK or Irish economies. At the margin, the removal of the immediate threat that the UK might crash out of the EU could prompt a small and temporary ‘Brexit Bounce’ in sentiment and spending in the UK and Ireland. This is an important element in the upgrade of our 2020 GDP forecast for Ireland to from 3% to 4% which we made towards the end of last year.

If the very short-term economic impacts are likely to be limited and perhaps even positive, the longer-term consequences seem set to be substantial and clearly negative. In a sense, stronger growth in 2020 may ‘borrow’ from growth in future years. Major uncertainties could return before long and even an orderly outcome entailing the delivery of a free trade agreement between the UK and EU still implies a major fracture in Irish economic ties with its near neighbour. We tentatively estimate that this change will shave about 0.5% to 0.8% per annum off Irish GDP growth for a number of years. As a result GDP growth may dip close to 2% in 2021 and 2022. The paragraphs below outline the ‘geopolitical’ drivers of this expected growth slowdown.  

A different but still difficult UK stance means the path to a trade deal could be painful

A major problem in talks on the withdrawal agreement was difficulty in establishing a coherent and consistent British negotiating position because of problems reconciling sharply divided positions on Brexit within the British parliament and the broader UK population. For many different reasons, the very decisive outcome of the recent British general election  may also pose problems for the upcoming negotiations on the future relationship between the UK and EU.

The Conservative party,  previously weakened by its position a minority government, now has a very large 80 seat majority significantly because of its election  promise to ‘get Brexit done’.  The election outcome appears to reflect the extent to which UK voters were fed up with the drawn-out exit process. The recent election result also makes it likely that the UK will prioritise a speedy clean break with the EU over the more patient but protracted efforts  to reach a comprehensive agreement.

A second influence is that the recent election has changed the complexion of the UK parliament with Brexiteers now firmly in charge. The UK team negotiating with the EU will be more inclined to believe that, outside the EU, the UK will have enhanced scope for independent policy-making that will deliver greater opportunities for British business, offsetting the costs of more limited access to the EU single market.

A final important influence is the absence of any dramatic adverse Brexit impact thus far on UK households. While economic growth has slowed markedly in recent years, the latest data show unemployment at 3.8%, average earnings at 3.3% and inflation running at 1.3%. A supportive policy mix, a more competitive exchange rate and the fact that post-Brexit impacts have yet to be felt mean that many UK consumers now see earlier dire warnings of dramatically poorer economic conditions as unfounded ‘project fear propaganda put forward by pro-remainers.

In reality, the UK is facing a challenging economic outlook with the Bank of England yesterday revising down its growth and inflation forecasts and suggesting it may ease policy further. However, this caution and the evidence of forward looking indicators such as chronic weakness in business investment or softness in the housing market have attracted little attention among the population at large. 

For these reasons, there are significant risks that the UK approaches upcoming negotiations with the  speed with which a deal is reached prioritised at the expense of the substance of the deal and with more emphasis on the rather uncertain benefits rather than the real costs of UK divergence from the EU.

In the same vein, the suggestion that the UK might seek to copy and paste much of the EU’s recently concluded trade deal with Canada appears consistent with a willingness to run such risks as well as hinting at a failure to appreciate how differences in distance and depth of economic ties might make the Canada deal a poor blueprint for an agreement between the UK and EU.   

Complicating matters further is the UK’s ambition to simultaneously conclude trade deals with a range of other countries, with some suggestion that a mooted deal with the US would enhance the UK’s bargaining position vis-à-vis the EU. However early indications that Washington would look unfavourably on a proposed digital tax in the UK and Huawei’s involvement in the roll-out of 5G in the UK point towards the scale of problems the UK may face to quickly realise its stated ambition to become ‘a champion of free trade’ .  

For these varied reasons,  early indications of the UK approach to negotiations with the EU hint at difficult discussions to come and an ongoing risk  that the UK might crash out of the EU at the end of this year. Such worries could become particularly pronounced around mid-year when initial agreements on areas such as fisheries and financial services are scheduled to be completed. Although the withdrawal agreement allows an extension of the transition period for up to two years, the provision recently entered into UK law that the British government cannot agree to any extension means this is most unlikely to happen.

A limited trade deal will be difficult but is not impossible

On the evidence of previous EU trade deals, an eleven-month timeframe looks entirely inadequate to reach agreement with the UK. However, given the extent of existing linkages and commonalities, it might be possible to make sufficient progress on the broad outline of a meaningful if limited agreement to allow some form of fudge delivering  a provisional deal and creating a ‘technical implementation period’ beyond the end of 2020.  These constraints suggest that any trade agreement will probably be ‘narrow and shallow’ and primarily focussed on trade in goods, with limited progress likely on trade in services and possible difficulties in concluding definitive arrangements in areas such as security and data.

Significant obstacles to  delivering even an outline of a very basic trade deal between the UK and EU suggest that Brexit concerns are likely to remain a large and threatening cloud hanging over the British and European economies in the year ahead. Even if these obstacles can be overcome, the sort of free trade deal now envisaged by the British Government is likely to have serious negative impacts on UK economic activity and by extension on the Irish economy over time.

A weaker UK outlook has important and awkward  implications for Irish fiscal policy

The UK Treasury has estimated that  ending frictionless trade in goods and significant curbs on trade in services between the UK and EU could leave UK GDP about 7% lower than in a no Brexit scenario -an amount equivalent to the cumulative growth in the UK economy in the four year period from 2016 to 2019.

The fact that this might not happen all at once does not markedly diminish the risks in this regard. Between the nominal Brexit date of January 31st and the likely effective departure date at year end when the transition period concludes, significant gaps between political rhetoric and economic reality in the UK could be painfully exposed.

In turn, those gaps may have major implications for the stance of Irish fiscal policy and the scope to implement the wide-ranging spending and tax proposals now being put before the Irish electorate.  Although a softer growth trajectory might argue the merits of some fiscal support in 2021 and beyond, it may also mean a material shortfall in the budget arithmetic currently underpinning proposals on public spending and taxation. Striking the right balance on fiscal policy is likely to be the key domestic determinant of the stability and strength of Irish growth in coming years.