Hard-Brexit Uncertainties Stretch Well Beyond Financial Services

Much guesswork surrounds the consequences of a hard, or no-deal, Brexit - the possibility that the United Kingdom will leave the European Union on March 29 without an agreement for a smooth transition. No deal means that the U.K. becomes a third country with the EU, its biggest trading partner. Lacking an official free trade agreement, the two sides suddenly switch to World Trade Organization rules.

Apart from limited temporary authorizations, businesses in the U.K. would face many of the same challenges that existed before the EU single market emerged more than 20 years ago, and tariff barriers and other challenges it hasn't faced since joining the EU in 1973.

“Which is why a transition period of at least two years is really important, because it allows the EU and U.K. during that period to agree on all the things they don't want to lapse, without disrupting them in the meantime,” explained Dorothy Livingston, a leader of Herbert Smith Freehills' Brexit focus group and chairman of the Financial Law Committee of the City of London Law Society.

“An Imperfect Situation”

“If we drop out suddenly and all these things fall away,” Livingston said, “we're left with an imperfect situation that definitely would risk substantial disruption to trade in both goods and services.”

Impeding the withdrawal agreement is the so-called Irish backstop. The provision was designed to prevent a “hard” border between Northern Ireland, a part of the U.K., and the Republic of Ireland, which will continue as an EU member. The U.K. government has been unable to garner sufficient support for the agreement from members of Parliament wary of lingering obligations to the EU, and continuing negotiations in London and with the EU have failed to break the impasse.

Recognizing the stakes, the U.K. last August published extensive instructions on preparing for a no-deal Brexit and has followed up with significant legislation. The European Commission (EC) launched a more streamlined “Contingency Action Plan” last November. On December 19, the EC stated that it had adopted all the legislative proposals and delegated acts announced in the action plan, and that any remaining items would be ready by February 15 “to allow for a vote in competent committees.”

Livingston said on February 12, however, that much of the relevant EU legislation was still being debated and not in the statute book.

Seeking Reciprocity

A number of the EU measures depend on U.K. reciprocation. Livingston said the U.K. measures will almost certainly hit that mark and may go further. The U.K.'s European Union Act 2018 provides for the continuation of a large portion of EU law, adapted to U.K. needs.

A transition deal before the deadline would mean that the legislative provisions would not have to come into force until the end of the transition period. During the transition, the two sides could rely on continued cooperation arrangements.

Absent a Brexit deal, both sides provide temporary solutions on paper, but there are real-world dimensions that are expected to be challenging to resolve even with a multi-year transition period. A sudden exit without any transition, Livington said, could result in significant disruptions.

Real-Economy Risks

The financial services industry has received significant Brexit-related attention, given its business and economic importance. Livingston said that the U.K. has established a “temporary permissions regime,” enabling a French or German bank branch to continue operating in London for up to two years if it applies for U.K. authorization. But the EU has done little on that front, with the EC's contingency plan limited to providing temporary authorizations focusing on derivative transactions.

Many U.K.-based banks and insurance companies fortunately have EU offices and the proper licenses, Livingston said, and many more are making those arrangements to avoid disruptions to customers.

“The only question is, if they haven't completed the process by March 29, will they be given temporary authorization to operate?” the Herbert Smith Freehills regulation and trade expert said, adding that local regulators may not be able to process requests in time.

Other industries face bigger challenges. The EC's contingency plan provides U.K.-controlled airlines with 12-month authorizations to fly across the EU and make stops. However, it restricts cabotage - the transportation of goods or persons between two places in a country. So depending on the final EU legislation, U.K.-controlled airlines may no longer be able to drop off passengers or cargo in an EU airport, pick up more to fill the plane, and travel to another EU destination.

Transportation Hubs

Airlines are working to minimize disruptions, Livingston said, noting that London's Heathrow Airport is routinely ranked as the busiest airport in Europe, with significant traffic into the EU.

Road haulage and border controls are also likely to suffer from a no-deal.

“If we get a transition of two or more years, the intention is to sign a new trade agreement in that period, and so a lot of these problems would never arise,” she said. “But if we drop out at the end of March with nothing, then there are relatively limited measures in place.”

Livingston noted that the EU's contingency plan would effectively permit a limited amount of road haulage by U.K. carriers into the EU for a period of nine months, but it also restricts cabotage for trucks. A U.K.-based trucking company can now direct a vehicle to Paris to deliver half its load, fill the truck back up, and transport the new load to Milan. If there is no deal, the truck would have to travel half empty to Milan or head home from Paris, leaving the Paris-to-Milan leg to an EU operator.

Vehicles will need international permits from the European Conference of Ministers of Transport (ECMT) to replace U.K.-issued EU permits. These have to be applied for in the preceding calendar year, so it is now too late to get one for 2019, Livingston said, and the EU proposal appears to address only the gap before 2020 permits could come into force.

In industries such as trucking, where many businesses are not large and may have limited resources, a no-deal is more likely to cause disruption, Livingston said. She added that the U.K. had announced it intended to permit road haulage with comparatively few restrictions on cabotage, provided the EU reciprocates.

“Which means the U.K. may move to operate no more than a mirror image of the EU proposal for EU road haulers,” Livingston said.

Corporate Supply Chains

The EC's limited solutions in areas such as transport are ultimately likely to affect large companies as well, notably auto makers and others with just-in-time manufacturing processes, and retailers relying on just-in-time supply chains.

Livingston said the U.K. has, for example, taken steps to continue to allow Spanish produce certificates that have been acceptable until now to still be accepted. The EU's agricultural industry, however, is more protectionist, so British certificates for Welsh lamb, a significant U.K. export, suddenly would not be accepted. “It will have to be re-inspected and go thorough phyto-sanitary tests, and it might be held up at the ports for ages,” she said.

More commercially damaging, Livingston added, would be the high rates of customs tariffs on some agricultural products - upwards of 50% for sheep meat, for example.

Port Inspections

In fact, ports may be another point of disruption. French ports have traditionally been ports of entry for U.K.-EU trade, but not inspection points for agricultural products coming from outside the EU.

“The French have produced legislation [in mid-January] with a view to managing this situation, including new investment in inspection facilities,” Livingston said. “It's not clear that all the continental ports take a similar approach, and some will be better equipped to deal with new checks than others.”

In addition, she said, duties must be paid on automobile parts and other supplies, whichever direction they are moving in. The U.K. has set up a “trusted supplier” scheme in which paperwork is handled off-site and doesn't hold up traffic.

Even if U.K. imports run smoothly, delays to exports at some continental ports could result in significant delays for returning trucks, disrupting supply chains. Simple checks that add 15 minutes to truck or container stays in port can have knock-on effects that cause a backlog.

“So the U.K. has been busy turning parts of Kent into potentially lorry parks, should they need them.” Livingston said,

Type Approvals

If there is no deal, EU type approvals issued by the U.K. for typically more sophisticated goods such as automobiles, medicines and medical devices - indicating they meet certain EU standards - will not be accepted after March 29.

“A lot of manufacturing businesses have been running around getting EU type approvals in continuing EU countries where they do business that may have originally been issued in the U.K.,” Livingston said.

She added that multinational corporations may already have most of the necessary type approvals for their business in the EU, or have taken steps to get them. Small and mid-size businesses with fewer resources, however, may have been counting on a transition period to complete the task. Given that they are vital links in larger companies' supply chains, the challenges they face will likely ripple through the U.K. and EU economies.

“One would anticipate there to be a whole lot of unexpected problems if we crash out of the EU at the end of March,” Livingston said. Problems that “with the best will in the world people haven't been able to address.”