LONDON—The free-trade agreement that the U.K. struck with the European Union on Christmas Eve will heap new challenges onto a British economy that has performed worse than its peers through 2020.
While avoiding a trade disruption of the magnitude that would have followed if efforts to reach a deal had failed, the new agreement is the first in history that will throw more obstacles in the way of importers and exporters. That is happening as the U.K. copes with a fast-spreading variant of the coronavirus that has forced lockdowns over most of the country.
On Christmas Day, ambassadors from the 27 EU countries met in Brussels to begin scrutinizing the agreement, ahead of its expected approval by governments next week. The British Parliament is set to meet on Dec. 30 to ratify the accord.
It will take effect with the U.K. and economies across the world already straining under the pandemic and governments’ efforts to contain it. The U.K. has been among the worst-hit economies, with gross domestic product at the end of the third quarter almost 10% less than it was a year earlier.
Britain will have to adjust to the new relationship with the EU as it simultaneously deals with the economic pain caused by the virus. That risks hindering a recovery, economists and business executives say, with unpredictable consequences for jobs and livelihoods as businesses adapt to the upheavals of both challenges.
“This deal is welcome. But it’s not a substitute for what we had, which was unfettered access to our largest trading partner and the largest single market in the world,” said Richard Swart, global sales and quality director at Berger Global, a northern England-based unit of Germany’s Ringmetall AG that manufactures rings used to seal container drums.
The free-trade accord does mean that the outcome most feared in corporate boardrooms—an abrupt end to 40 years of economic integration and the immediate imposition of tariffs on $900 billion of cross-border trade—has been avoided. “This deal above all means certainty,” Prime Minister Boris Johnson said.
The government’s hope is that greater freedom from Brussels-led regulation will, over time, yield economic benefits. From next year, Britain will be able to sign its own trade deals and redirect EU budget contributions toward education and technological research at home. It also will be freer to set its own labor and environmental regulations.
“I do see the opportunities,” said Nik Kotecha, chief executive of Morningside Pharmaceuticals Ltd., a maker of branded and generic drugs based in Loughborough, England. He said that in the past four years, time and resources that could have been directed toward investment and research and development have instead been absorbed by Brexit contingency planning. Now he is hoping to redirect his energy toward expanding sales in developing markets.
“Business always wanted certainty and I feel that in the last four years-plus we haven’t had that certainty,” he said. “Hopefully this deal will give us that certainty.”
For decades, manufacturing and financial-services companies, livestock farmers, fishermen and others have focused on mainland Europe’s accessible markets, where they could sell their products almost as easily as they could at home. Supermarkets sourced much of their produce—and manufacturers their components—from the continent, hauling them to Britain without hindrance.
There was also a ready supply of labor from across the EU, whose citizens all had the right to live and work in the U.K.
In stepping outside the EU’s customs area and single market, the U.K. is making it costlier to trade with neighbors that consume almost half its exports. Though the new free-trade accord eliminates the need for new tariffs, it means extra costs and paperwork for exporters and potentially higher prices for consumers. Companies seeking to hire staff will need to go through new bureaucratic procedures to get work permits.
U.K.-based financial-services firms will be barred from some activities in European markets, such as lending and deposit taking, and other activities will hang on a unilateral decision from the European Commission that has yet to be announced.
The arguments in favor of Brexit were mostly political: that it would return decision-making to London from Brussels and curb immigration from the EU. But Brexit was also sold on the basis that greater political freedom would bring economic benefits.
Advocates of Brexit say stricter immigration controls will bring more opportunities and fatter paychecks for British workers. They say a smaller labor supply might help push up wages and encourage businesses to make investments in automating processes that many have so far been reluctant to make.
Mr. Johnson, inspired by his now-departed aide, Dominic Cummings, also wants wider latitude than is available under EU subsidy rules to pump public cash into promising industries, such as green energy and artificial intelligence. Rishi Sunak, Mr. Johnson’s Treasury chief, wants to build a network of low-tax “freeports” along the U.K. coastline to lure foreign investment in jobs and factories.
“It will not be a bad thing for the EU to have a prosperous and dynamic and contented U.K. on your doorstep. It will be a good thing—it will drive jobs and prosperity across the whole continent,” Mr. Johnson said Thursday after the agreement was announced. “This giant free-trade zone that we’re jointly creating the stimulus of regulatory competition will I think benefit us both.”
Nonetheless, most economists expect Britain will be poorer in the years ahead than it would have been had it remained an EU member state. Leaving the bloc will crimp trade and diminish Britain’s attraction as an investment destination for foreign companies seeking a bridgehead to European consumers, they say. Lower levels of trade, foreign investment and immigration will drag on the country’s already slow productivity growth.
Some of those economic costs have already been borne in lower national income than would have been expected had the U.K. stayed in the EU. A paper published this month by the University of Sussex’s Trade Policy Observatory estimated the economy would be around 4.4% smaller by the middle of the decade than it would have been had the U.K. in 2016 voted to remain a member state.
Brexit advocates say such modeling overplays the role EU membership has in British prosperity and that completing the project will remove the uncertainty that has been holding back investment.
Economists contend uncertainty about the U.K.’s future ties to the EU has acted as a drag on growth since Britons voted for Brexit. The effect is most visible in weak business investment, a trend exacerbated by the pandemic. Business investment was flat after adjusting for inflation between 2016 and 2019, and fell by more than a quarter in the first half of 2020 as the pandemic took hold.
In 2016, the U.K. was the fourth-biggest export market for German factories, according to Germany’s Mechanical Engineering Industry Association. Now it is in eighth place, behind Austria and just ahead of Russia, a decline the association says reflects falling investment in Britain because of Brexit.
Brexit might encourage some domestic investment to substitute for imports that will become more expensive because of the new border formalities, though economists say British consumers are likely to face higher prices than they do now.
Car maker Nissan Motor Co. said in March it would invest 400 million pounds, equivalent to around $535 million, in building new vehicles at its plant in Sunderland, northeastern England. The investment, in a strongly pro-Brexit region, was cited as proof by Brexit supporters that the U.K. remained an attractive destination for multinationals irrespective of whether or not it was in the EU.
However, some companies are likely to focus on the EU’s huge market of 440 million people, rather than on the U.K.’s 66 million.
Ineos Automotive, a car-making unit of U.K.-based Ineos Group AG, said in December that it would build a new all-terrain vehicle in France. Founder Jim Ratcliffe, a prominent backer of Brexit, had previously said he planned to build it in Wales.
The free-trade accord agreed between the U.K. and the EU ensures there are no tariffs or quotas on traded goods but introduces new rules and formalities that economists say risks getting in the way of free-flowing trade. British food and animal exports to the EU will face checks on arrival. Exporters will need customs declarations. Professional qualifications for lawyers and accountants are no longer automatically recognized as sufficient to practice in the other jurisdiction. Logistics companies and airlines will face new bureaucratic hurdles to moving freight.
The pandemic has offered a taste of the possible short-term disruption Brexit might entail. A new variant of coronavirus loose in Britain prompted France to close the border crossing at the Channel Tunnel. Tailbacks of trucks stretched for miles.
Mr. Swart, of Berger Global, said his company has six truckloads of products shipping to European customers in January. Though he believes his company is ready with the correct paperwork, he said he isn’t confident there won’t be more delays.
Some major issues are unresolved. The EU has yet to grant a so-called equivalence decision that underpins the extent of market access afforded to U.K.-based financial-services companies.
The Brexit Saga in 2020
Longer term, the agreement heralds a period of economic reorganization that will play out for years, as workers and companies that prospered from untrammeled trade with the EU find new markets or shift into new activities. Inking deals with the U.S. and major trading partners elsewhere will take time, and, according to a government analysis in 2018, would provide only minor economic benefits.
The pandemic has created similar upheavals, but at a much faster pace, with painful disruption to sectors such as hospitality and tourism, and windfalls for online grocery shopping and delivery services. It has, economists say, exposed weaknesses in the British economy that had been building for years. Business investment, already weak, fell more sharply in Britain in the first half of 2020 than in neighboring countries. The economy is heavily reliant on consumer spending, which also took a steeper dive in Britain during lockdowns than it did elsewhere.
Hande Küçük, deputy director of the National Institute for Economic and Social Research, a nonpartisan think tank, said one difficulty is that the disruption from Brexit and Covid-19 won’t fall evenly across the U.K. economy. For instance, supermarkets have been buoyed during the pandemic by consumer stockpiling and online orders, but are at risk from disruption to just-in-time, cross-border supply chains if crossings get jammed.
“We can’t rely on less Covid-sensitive sectors to take us out of this crisis because they will be dealing with the implications of Brexit,” Dr. Küçük said.
The twin reorientation “could leave deep and painful scars on the British economy,” NIESR said in November.
—Laurence Norman in Brussels contributed to this article.
Write to Jason Douglas at firstname.lastname@example.org
Copyright ©2020 Dow Jones & Company, Inc. All Rights Reserved. 87990cbe856818d5eddac44c7b1cdeb8