Thursday, 28 December 2017

The Customs Union is of minimal importance

In a letter sent to Jeremy Corbyn, Vince Cable and Caroline Lucas yesterday, Ian Blackford, the SNP's leader at Westminster, says the following:

“As we move into the crucial second phase of the Brexit negotiations, it is now absolutely vital that we have an effective cross-party effort to safeguard our membership of the single market and customs union. It is time for MPs of all parties to put politics aside and work together, in the national interest, to protect our place in the single market and customs union. Short of retaining our EU membership, that is by far the least damaging option, the best compromise, and the only way to protect jobs, incomes, and workers’ rights."

He is partly right and partly overdoing things. I am happy to see support for a softer Brexit, which I consider to be in our interests, but I don't get too carried away with interventions of this kind. The thing about a soft Brexit is that it is more likely to be brought about by logistical reality than ever it is the views of parliamentarians. The UK must leave the EU, must do so on uniform regulatory terms and must not undermine the Good Friday Agreement. Unless we pull something remarkable out of the hat, to me this means we will stay in the EEA.

Blackford is correct to warn against leaving the Single Market. The Single Market gives us not only regulatory conformity, but (more importantly) the assumption of regulatory conformity. This assumption we retain thanks to a carefully constructed behind-the-border enforcement strategy, where checks take place at the point of production. European agencies coordinate with governmental departments in order to ensure that the necessary standards are being adhered to. This we call market surveillance and is the reason for the absence of bureaucracy between the borders of member states.

It is also protected by a myriad of different defensive mechanisms. In order to export a car into Europe, for instance, third countries must be granted with EU Whole Vehicle Type Approval (WVTA). The UK's Vehicle Certification Agency explains that this device is designed to ensure that vehicles "meet relevant environmental, safety and security standards." This is an example of a non-tariff barrier, and leaving the Single Market framework could quite easily mean abandoning these approvals, as explained by Patrick Keating of Honda at a recent Industrial Select Committee.

It is for reasons like this that job warnings are entirely appropriate. Barriers to exporting will hurt productivity and an enforcement strategy which returns to the point of the border will cause break downs - some temporary and some permanent - in our supply chains. Just in Time (JIT) supply chains, where importers import parts as and when they need them and not in bulk (so as to cut storage costs), would find themselves particularly at risk. These are issues which are not easily dealt with as a third country, even with Mutual Recognition and Customs Cooperation agreements.

Where the likes of Blackford are wrong in my opinion is in placing so much importance upon the Customs Union. Thinking back, the Customs Union was barely mentioned during the referendum campaign. Vote Leave had nothing interesting to say about it and neither did any of the other Leave campaigns. Occasionally, individual politicians would reference the benefits of leaving it but nothing of substance was discussed. For this and other reasons, therefore, the Customs Union has remained largely uncharted territory, with few understanding its functions and scope.

In principle a Customs Union is a trading arrangement which comprises of a Common External Tariff (CET) and tariff-free trade between the countries inside. There are 16 Customs Unions in the world if we count the three separate agreements the EU has with Turkey, Andorra and San Marino. Others include the Eurasian Customs Union and Mercosur (in South America). Customs Unions tend to be operated amongst countries in close geographical proximity to one another and are a device used for strengthening both political and economic integration.

In the case of the EU, the Customs Union is no longer the reason for tariff-free trade between member states. That burden is now the competence of the Single Market, specifically Article 10 of the EEA Agreement, which states: "Customs duties on imports and exports, and any charges having equivalent effect, shall be prohibited between the Contracting Parties." Herein lies the major difference between Customs Unions in general and the EU's Customs Union. Hence the emboldened distinction between 'the' and 'a'.

The EU Customs Union's only residual feature is the CET. It is not the centrepiece of the EU's customs checks and information-sharing systems and it is not the mechanism which prevents bilateral UK trade negotiations. These things relate to the Union Customs Code and the Common Commercial Policy respectively. The external wall of tariffs which surrounds the EU does have a restrictive influence on the independence of British trade policy, in that it renders certain tariffs unalterable, but not all trade deals are tariff-relevant. Some focus on services, customs or Mutual Recognition.

Another point about the significance of the Customs Union is that it is replicable on a sectoral basis. We can copy over the CET on agricultural or alcoholic imports, for the sake of argument, or we could do what Turkey does and implement the CET on industrial goods. The Single Market cannot be replicated from the outside. Monaco also has a unique arrangement whereby it is inside the Customs Union thanks to a bilateral agreement with France allowing the EU to consider it French territory. This is not a precedent for the UK but I mention it because the facts are always interesting.

I favour leaving the Customs Union. It's protectionist and does, I rather suspect, harm consumers. Both sides of the Brexit debate greatly overstate the benefits and drawbacks of the Customs Union. We don't need to be inside it, but the gains from leaving are modest at best. Tariffs have plummeted globally and will continue to do so. They are much less of a problem to deal with than regulatory protectionism, which as we have discussed is the most important trading issue facing the world. We are essentially playing a game of Whac-a-mole: as tariffs drop, non-tariff barriers grow.

This has been the knee-jerk reaction of producers around the world as they have been exposed to more and more international competition. This is the reason I consider tariffs to be relatively insignificant. In principle I favour reducing tariffs, but I don't support dropping our tariff walls to zero post-Brexit because it will leave us with less leverage when negotiating with trading partners as an independent country. The unilateral free trade types view leaving the Customs Union as a passport to a free trade utopia, but a hard look at things tells a completely different story.

Such people also ignore the primary benefit of being part of the EU's Customs Union. I don't support being in it but I believe in having at the very least an honest debate about these things. Selective ignorance won't help readers and it certainly won't help me. Where the Customs Union does help us is in overcoming a Rules of Origin hurdle when exporting to the European market. That is, we do not have to prove that our goods originate from the UK in order to qualify for the tariff-free trade I mentioned earlier. There is quite a lot in this so it is worth unpacking it bit by bit.

Firstly, by Rules of Origin we mean the criteria necessary to determine the national source of a good. In practice, if the UK wants to take advantage of preferential tariffs agreed in trade agreements (such as in the EU-Korea FTA), it must prove that its goods come from the UK or have had sufficient work done on them in the UK. Sufficient work means any amount of processing above a certain percentage threshold agreed within the relevant trade deal. The proof is provided in the form of a document, whose text is determined by international conventions and customs authorities.

EU members don't need to carry out origin checks between one another because they know that anything that has entered a member state from outside the EU has filtered through the external tariff wall. That level playing field, crucial to the integrity of the Single Market, is therefore maintained. The CET is wrapped around every member state to eliminate the possibility of circumvention by a third country exporter. A good originating from the UK on its way to France is on equal footing with a good originating from the United States and heading through the UK on its way to France.

EU member states do operate checks on origin on goods coming from third countries. There will be a swift check to establish the exporting country and a further check, again through provided documentation, to see if the exporter qualifies for preferential tariff treatment facilitated by whichever trade agreement applies to the countries involved in the exchange. Our ports are not bogged down by these procedures. Checks for origin represent very light border friction taking up but a few seconds of transporting time. Thankfully they are smooth and not cumbersome.

Beyond this we have cumulative Rules of Origin, or what is called cumulation. In essence this is about recognising the origin of processing inputs, like components. Not the good itself. I mentioned earlier that the UK has to prove that 'sufficient work' has been done on a product it is exporting in order to qualify for preferential treatment. This is what I refer to now. In some cases, our exports to the EU will not be made entirely in the UK. Our cars, for instance, comprise of on average 41% local content, meaning 59% of the processing inputs (parts) were sourced from abroad.

There are three types of cumulation: bilateral, diagonal and full. FTAs routinely include agreements on bilateral cumulation. This means that country A agrees that processing inputs sourced from itself can be counted as being from country B by the time that good is exported from B to A. Diagonal cumulation is the same, but with added countries, like country C. A, B and C must all have FTAs with each other and agree amongst themselves that processing inputs from A incorporated into a good in B can be exported to C as if they all came from B. And the same for the other two countries too.

Diagonal cumulation is covered by Protocol 4 of the EEA Agreement and by the PEM Convention, which I believe the UK should rejoin post-Brexit. These devices simplify our RoO hurdle after leaving the Customs Union by facilitating qualification for preferential tariffs amongst the contracting parties. The danger of not having a cumulation agreement, if you are still wondering, is the same issue I mentioned above: countries can circumvent higher tariff walls by exporting into the target country through other countries (with whom they enjoy preferential tariff rates).

Full cumulation, on the other hand, is a slightly distinct arrangement. It is about including defined third countries completely outside free trade areas to participate legally in the processing procedure. So work done in a country outside of a free trade area can effectively count towards the production of a good. There will again be a percentage threshold, so the input from outside the free trade area (or web of FTAs) must be limited or it will not count as originating from one of the countries within the free trade area.

Cumulation relates to the Customs Union in that once we have our own schedule of FTAs, with low or zero tariffs on certain goods, there is potential for the UK to be used as the go-between country for exploitative exports seeking to circumvent the CET. This is really the important point. Single Market or not, we can sign our own FTAs and once we get off the ground and have our own distinct trading network in place it will become more of an issue. Rules of Origin is already an obstacle for our exporters as regards our trade with the rest of the world. We are simply extending that obstacle.

As for tariffs, if we stay in the EEA in some existing or bespoke form, we will have tariff-free trade, but not on all products. Article 8.3 of the EEA agreement states the agreement applies to “products falling within Chapters 25 to 97 of the Harmonized Commodity Description and Coding System”, i.e. manufactured goods only. Chapters 1-24 of the Harmonised Commodity Description and Coding System covers agriculture & fisheries products. The reason for these sectoral tariff differentials is that the CFP and CAP are not part of the EEA acquis. They are solely EU mechanisms.

The short of all this is that in principle the Customs Union doesn't matter very much. It doesn't benefit the economy in any noticeable way and doesn't have material benefits for citizens. It no longer facilitates tariff-free trade inside the EU and doesn't prevent bilateral trade negotiations (as other nations in Customs Unions demonstrate). But there is a caveat. It just so happens to be the case that the UK needs the Customs Union a little more than does the average EU member state. Because where it does have importance is in relation to the preservation of a frictionless Irish border.

If Northern Ireland pulls out of the Customs Union (and therefore the CET), it can be used as a back door for goods getting into Ireland at cheaper tariff rates. Thus, the EU would require physical infrastructure on the border in order to deal with origin checks. One way for the UK to avoid this scenario is to commit to aligning its tariff walls - also known as staying in the Customs Union. Initially I was under the impression this wouldn't be possible, but there now appears to be scope for it. This would mean sacrificing some of the independence of our future trade policy.

We could also have an Ireland-specific solution and move the customs border to the Irish Sea, but I don't think the DUP will accept divergence of this kind between Northern Ireland and Britain. They have been clear about the importance of Northern Ireland leaving the EU on the same terms as the rest of the UK and I consider this perfectly reasonable. The third option is to undermine the GFA completely and press ahead with customs posts. This is politically very risky even if the peace process has matured in a stable and promising way. In doing this we would be playing with fire.

This triad of options will form much of the battleground in the second phase of the Article 50 process. Christmas provided us with a welcome break from proceedings but when things resume they will be more hotly contested than before. Phase two is where the detail comes in. Haziness and broad outlines no longer suffice and I think the central theme of the coming months will be our place in the Customs Union. Things are about to get very interesting indeed.


  1. Thanks for giving such an honest and balanced appraisal. However, even if the "Rules of Origin" checks are as quick and painless as you claim, how would having these checks be consistent with having an invisible border between ROI and Northern Ireland?

    1. I know you say in the last paragraph about a reverse Turkey, replicating CET for agriculture, but that obviously doesn't cover all Ireland trade. I don't see how you can make the border soft without both staying in the EEA and entirely replicating the current customs arrangements

  2. Hi James. You might well be right and we may have to replicate the CET in its entirety. Or put up with customs posts. I don't have a magic solution to the Irish border problem, much as I'd like one.

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  4. Interesting blog, thanks.
    In a couple of recent posts, you've described tariff elimination as being 'competence' of Article 10 EEA, and the Common Customs Tariff (or Common External Tariff) as being the only 'residual feature' of the EU Customs Union.
    It seems to me that EEA Article 10 only complemented the then provisions in EU treaties for tariff-free trade within EU and extended it to rest of non-EU Contracting Parties. EU Customs Union (including internal tariff elimination) is defined now by Lisbon Treaty Articles 30-32.
    I've never understood the relationship between EEA and EU treaties when they make same provisions for the EU Contracting Parties. I guess EEA reinforces, repeats or complements the EU treaties, but I presume it never supersedes them? But it's clear, at least, that EEA is not the Single/Internal Market-defining legal document because, as you note, it doesn't cover fisheries and agriculture.

    1. The EEA ensures tariff free trade in that in theory a member state can leave the EU and still have that tariff free trade. To my mind this means the EEA is the mechanism providing assurance of it. Allie Renison at the IoD also thinks this.

    2. Ah OK. I can certainly agree EEA is the most obvious backstop for maintaining most tariff-free trade. Although of course as you're well aware that does not cover agriculture

  5. I think that the Irish government and by extension, the EU would be made satisfied with EEA regulatory alignment and would endeavour to create satisfactory arrangements via electronic declarations to overcome ROO. No third country FTA is likely to be ratified and implemented for a number of years, so providing enough preparatory time for future customs arrangements.

  6. Sounds like cherry picking to me.