Trade in services and Brexit

Services account for around 80% of the UK economic output and 46% of UK exports, and this share has been growing over time. The UK is the world’s second largest exporter of services by value and is generally viewed as a world leader in many service activities such as financial services. Taken as a single entity, the EU is the UK’s largest export market for services, accounting for 41% of all service exports.

While the UK discusses its future relationship with the EU, the future of services trade has received less attention in the public debate than trade in goods. At the same time, it is clear that any potential change in the terms of trade with the EU will affect many sectors of the economy and will impact on many UK businesses. While large companies have capacity to adapt, small and medium sized enterprises might be less equipped to cope with those changes.

Complexity

Services sectors cover a broad range of activities. Professional and business services, combined with financial services, account for a half of UK services exports, but cross-border trade takes place in many more areas, from tourism and travel, transportation by road, sea, air and rail, telecoms and IT, to broadcasting, film, culture, (higher) education, construction and retail.

Trade in services is complex and different from trade in goods. Services can be traded in various ways – across the border (online or through other channels), in person (when a consumer travels to the supplier or the supplier goes to the client), or through a subsidiary company abroad.

Unlike goods trade, services are not restricted by tariff barriers and border checks. Instead, national regulations - on licensing, quotas, professional qualifications and immigration - decide when and how foreign providers are allowed to enter a market. Such non-tariff barriers are complex and hard to assess as they vary by sector and by activity. Behind-the-border requirements and regulations can make selling services in another country difficult.

To boost trade in services, countries remove restrictions or align regulations. Often governments have to accept that their freedom to regulate may be restricted as a result. This can complicate the negotiation of trade agreements.

Market access

The UK’s exposure to services trade means that any major change of the terms of cross-border trade will affect businesses in many sectors across the economy, although some will have to adapt more than others. While services imports are very significant both for UK consumers and for businesses that rely on imported services inputs into UK production, the substantial role of services exports in the UK economy tells us that access conditions to foreign markets will be crucial for UK services.

Single market

Although many barriers still remain in the EU, the single market is the most integrated area for trade in services in the world. Companies and individuals are free to establish and run a business from anywhere in the single market; they can provide services from their ‘home’ Member State. Consumers can buy services in or from a Member State other than the one where they live. Member States have regulatory powers, but their rules generally may not discriminate or prohibit access to their market. Freedom to provide services is supported by free movement of people, cross-cutting as well as sector-specific rules on mutual recognition of professional qualifications, and common rules on data.

Draft Political Declaration on the future relationship

The UK is due to leave the EU on 31 January 2020. During the transition period which will start then, the UK will negotiate its future trading relationship with the bloc. The UK and the EU have set out in their Political Declaration on the future relationship that their trade partnership could have a comprehensive free trade agreement at its core. In relation to services and investment both have an ambition to go well beyond the current commitments under the WTO and existing free trade agreements of the EU with third countries. At the same time, the UK will leave the single market for services in order to pursue regulatory autonomy and independent trade policy. How this new balance in UK-EU relationship will evolve for trade in services is largely open.

A free trade agreement with the EU?

In free trade agreements, countries can make commitments on liberalisation of services. Most recent agreements such as the EU-Canada deal CETA and EU-Japan agreement attempt to go deeper than GATS but do not provide the level of access which is available to EU members in the single market. To establish a relationship on services with the EU which is closer than any existing free trade agreement can offer, the UK would have to seek enhanced regulatory cooperation with the EU on issues such a mutual recognition, free flow of data and business travel. Equivalence arrangements would have to be agreed for financial services.

Leaving without an agreement

If, by the end of the transition period, the UK and EU fail to reach an agreement, the UK will become a ‘third country’ to the EU for the purpose of services trade. Trade with the bloc will follow the rules of the General Agreement on Trade in Services (GATS) of the World Trade Organisation (WTO). In addition, UK businesses will face rules set by individual EU Member States; a few common EU rules and protections will apply. For some, it would be a major shift.

WTO General Agreement on Trade in Services
The WTO trading system provides a broad global framework for continued liberalisation of trade in services rather than setting compulsory rules. The GATS sets the baseline for liberalisation of services trade: it prohibits discrimination between members, and mandates national treatment of foreign providers, as well as transparency and objectivity of national regulations. Members commit to opening markets in specific sectors.

In fact, country policies are more liberal towards foreign service providers than their commitments under GATS would suggest, but countries can back down on such policies more easily if their commitments are not supported by a trade agreement.

Economic impact

Leaving the EU will change the economic relationship between the UK and EU. The nature of the future UK-EU trading relationship will be crucial in determining Brexit’s impact on the UK services sector. The crucial question is thus how much divergence there will be between the UK and EU. The greater the divergence, the higher barriers to trading become and the costlier it will be for UK companies who export to the EU to meet EU rules (and for EU companies trading with the UK). By maintaining a close relationship between UK and EU standards and regulations, the UK would, however, limit its freedom to change its regulatory systems and other areas of economic policy.

A number of studies have attempted to estimate the potential economic impact of Brexit. While it is difficult to measure non-tariff barriers (NTBs) and their impact, economic research generally finds that:

• (i) the closer the future UK-EU trade relationship is, the smaller the increase in trading costs are; and,
• (ii) in turn, the smaller the negative impact on trade volumes (exports and imports).

Possible reductions in trade costs with non-EU countries are not expected to make up for the lower trade volumes with the EU (compared with the UK remaining in the EU). For example, a WTO/no-deal scenario is estimated to lead to the UK trading less with other countries than in a scenario where the UK remains in the EEA after Brexit.

Lower trade volumes would be expected to negatively impact economic output. The degree to which this is the case depends on the specific sector in question and how much it relies on trade (in particular trade with the EU). While the results of studies in this area vary, services sectors that appear most vulnerable to negative effects are the wholesale trade sector and the financial services sector.

Key issues

Regardless of the form of the UK-EU future relationship, there are issues that are common to many services sectors:

• Trade in many sectors depends on the freedom to establish businesses
• Freedom of movement provides access to qualified workers and gives flexibility to service providers.
• A large proportion of services trade is supported by free flow of data.
• Specific sectors depend on mutual recognition of qualifications or regulatory bodies.

More generally, businesses and consumers would arguably wish to have access to effective enforcement of the new terms of trade, comparable to what is now available through the court system of the EU.

Finally, perhaps the most important overarching principle which the UK and EU would need to address is the level of regulatory alignment. Both parties will have to determine the extent to which the UK’s standards and regulations for services will be allowed to diverge from the EU’s. The closer aligned the UK and EU remain, the greater the access the UK will have to the single market, but the less freedom the UK will have to change regulations. This reflects the inherent trade-off in trade deals between control over your economy’s rules – such as regulating products and markets – and the degree of access to the other economy’s market.

These cross-cutting issues are central to the UK future services trade with the EU. But these issues would also need attention in seeking to enhance trade in services with other countries.