A guide to trade agreements – the challenge facing Theresa May

Posted On: 
31st January 2017

Do you know your Regulatory Unions from your Customs Unions? As Britain prepares to embark on one of the most complex rounds of trade talks in history, Alan Winters offers a rough guide to trade agreements – and the obstacles the UK government will have to overcome

Liam Fox, Boris Johnson and David Davis leave 10 Downing Street

Trade Agreements are back in fashion. They will very probably dominate the next few years of domestic and international policy in the UK. As Theresa May sketched the agenda in her speech on Tuesday 17th January at Lancaster House, she pledged to not only pursue “a bold and ambitious Free Trade Agreement” with the European Union, but similar deals with non-EU countries around the world.

So what are they?

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Trade agreements come in many shapes and sizes, and this article sets out some of the options which will confront the British government as it sets off down this path.

The broadest trade agreement is the World Trade Organisation (WTO). This commits its 164 members to observe a number of rules of conduct in international trade, which are backed up by a pretty formal dispute settlement procedure. The WTO provides an even-handed multilateral framework for trade, but because it is so difficult to agree rules and trade liberalisations in such a large group of countries, there is obvious scope for groups of countries to get together to further liberalise their trade. These are the trade agreements that Mrs May has in mind.

Trade Agreements come in four basic flavours. Least ambitious are Free Trade Agreements (FTAs), which abolish tariffs on trade between the members provided that the goods concerned are genuinely produced in the exporting member country. Next, Customs Unions have zero tariffs inside and also a common external tariff on trade between any member and the rest of the world – this is what stops members from having their own trade policies.

The big attraction of a customs union is that you can abolish internal border controls. A big problem with FTAs is that because different members have different tariffs against imports from outside, third country exporters will choose to send their goods to the member country which has the lowest tariff and send it on duty-free from there, evading the other members’ tariffs.

To prevent this, FTA members have to maintain border controls between themselves to enforce so-called rules of origin to determine that goods are actually locally produced. This is obvious for simple goods like apples, but complex for, say, cars, where many of the components may come from outside the FTA.

In a customs union, on the other hand, every member levies the same tariff on outsiders and so trade deflection is no longer worthwhile. Abolishing border controls greatly speeds up and facilitates trade between members.

The third model is what the UK Trade Policy Observatory has come to call a ‘Regulatory Union’, in which regulations – such as the standards imposed on service suppliers, the means of certifying that goods meet required safety standards, competition rules and government procurement – are effectively harmonised so that something that can be sold in one member can automatically be sold in another.

This is a very deep level of integration and requires huge mutual trust and confidence in each others’ enforcement mechanisms. Australia and New Zealand have a pretty complete regulatory union, but the deepest example is the European Single Market, although even that is not absolutely complete (e.g. the rules for providing legal services have nationality elements in some EU countries). The EU Single Market depends heavily on the enforcement powers of the European Court of Justice.

The final flavour is a Common Market, in which not only are trade barriers abolished but also those on the movement of labour. There are some traditional unions with free movement of labour – e.g. The Nordic Passport Union – but again the largest such area is the European Union – which includes free mobility as part of the Single Market.

A regulatory union helps members to reap the benefits of a large market: large numbers of people and firms competing with each other and economies of scale, both of which stimulate efficiency. Free mobility reinforces this by allowing workers to move to where they are most productive.

Both the Single Market and the Customs Union cut the costs of trading within Europe, but they are distinct. The European Economic Area (EEA) involves the latter but not the former, with the result that there are customs formalities between, say, Norway and Sweden which slow trade down.

Likewise one can have a customs union which removes border formalities but still allow each country to have and enforce its own standards on goods and services. This was the EU in, say, the early 1980s, in which sales were fragmented into a dozen or so separate European markets each, potentially, with its own rules and testing.

Mrs May has correctly deduced that if we wish to reject the ECJ we have to leave the Single Market and if we want our own trade policy (rather than committing to have tariffs identical to the EU) we must leave the Customs Union. Thus the plan for the UK is to enter a world in which both sorts of trade costs exist between EU members and the UK; if there is no further deal,  this is likely to cut UK services exports to the EU by up to half and goods exports by a quarter.

Mrs May speaks bravely of a ‘customs agreement’ – which, you will notice, did not figure in the taxonomy of agreements above; neither I, nor she, knows precisely what it entails.

It presumably implies an attempt to make the waiting times and paperwork associated with crossing the border between the UK and the EU as small as possible. Based on New Zealand-Australia and USA-Mexico these costs can be reduced with a lot of cooperation and investment in hard and soft infrastructure, but they cannot be reduced to zero.

The Single Market is indivisible in European eyes, but the EU has signed trade agreements with several countries that give the partner enhanced access to the EU market in certain goods and services without Single Market membership. For example, the Korean-EU FTA has special clauses on financial services, electronics and vehicles.

If we can keep the atmosphere positive, there is no reason why the UK could not reach such an agreement with the EU, and probably on a wider set of sectors. But doing so will require good will and long negotiation and the British government needs to prepare itself for both.

It is the best that can be done for trade with Europe, but we have to recognise that it will increase costs substantially from what they are now and reduce trade volumes.

Striking trade deals with other countries is a partial substitute because it ought to boost trade with those other countries a bit. However, these agreements are unlikely to be very deep and effective – especially if we keep a deep arrangement with the EU, because if we share standards with the EU we cannot do so with others. And they too will take time to negotiate if they are to be substantive and advantageous.

While Mrs May has given us a slightly clearer picture of the UK’s future, the path to the sunny uplands of Brexit is both steep and rocky.    

Alan Winters is professor of economics at the University of Sussex and Director of the UK Trade Policy Observatory