How dangerous for the UK economy is the European Union’s latest advice to Continental firms?

In a notice this week the European Commission has advised continental European businesses to think twice before using parts and components made in Britain.

It’s reported that European firms might need to look elsewhere for parts if they wish to continue benefiting from EU free trade agreements with other countries such as South Korea and Mexico.

But why is the commission issuing this advice? How serious are the economic implications for UK companies? And is there any way around it?

It’s a direct consequence of Brexit.

Leaving the EU automatically means that the UK becomes a “third country” to the bloc.

When the EU did some 40 free trade deals with the likes of South Korea, Mexico and South Africa the agreements stipulated that any produce or manufactured good which passed between them tariff-free had to have genuinely originated in the two signatory countries or blocs.

This stipulation was necessary to prevent other countries essentially free-riding on the deal. For instance, a firm in a third country could export their goods to one of the two parties to the free trade agreement and then re-export goods to the other party without paying the applicable tariffs.

To prevent this happening the two countries in the deal impose “rules of origin” checks on imports. For the UK, while it’s in the EU, this is not a problem. Any UK goods pass through fine. Also, any UK components in EU goods are not a problem at all.

But with the UK out of the EU’s customs union the situation is potentially very different. Rules of origin specify that a certain proportion of a good has to have been made in the country or bloc to qualify. The proportion varies with the good in question, but it’s often around 50 per cent. For cars the requirement is 60 per cent.

If, after Brexit, an EU business has used components sourced in the UK, that could potentially push the proportion of the exported EU good under the threshold, meaning it would fail the rule of origin requirement and be forced to pay the standard tariff.

This is why the commission has issued its warning to EU firms to be wary about using UK manufactured goods if they don’t want to have a nasty surprise when they seek to export to third countries with which the EU has a trade deal.

Potentially very serious, because the UK is firmly embedded in pan-European corporate supply chains. The UK sends around 44 per cent of its exports to the EU. Among the biggest categories of goods exported are chemicals, pharmaceuticals, aerospace and vehicles.

And research by the Institute for Fiscal Studies found the share of the EU’s imports from the UK that were “intermediate” goods and services (ie components) was 69 per cent in 2014, up from 61 per cent in 2000.

Not all of those imports will be baked into products and re-exported from the EU, but a fair amount will.

Sam Lowe of the Centre for European Reform think tank says that sectors which traditionally find rules of origin burdensome include textiles, food, machinery and vehicles.

To give one high profile example of a UK component of an EU export, the wings of the Airbus are currently manufactured in Broughton, North Wales. They are exported and the plane is assembled in Toulouse and then sold all around the world.

The natural way to solve the rules of origin problem would seem to be for the UK to form a new customs union with the EU and to “grandfather”, or roll over, the EU’s existing free trade agreements so that they are applicable to the UK, as well as the EU, after Brexit.

However, both are far more easily said than done. The UK cabinet is split on what sort of long-term customs arrangement it wants to push for with the EU – and both schemes they are considering have already been rejected by the EU.

There is also no guarantee the third countries will simply agree to roll over their trade agreements with the EU for the UK – some may wish to take the opportunity to reopen them.

For instance Mr Lowe of the CER reports that Korea is asking, in return, for Chinese inputs to its own cars to be treated by the UK as though they were Korean.

And even if they did grandfather their trade deals, as Peter Holmes and Michael Gasiorek of the UK Trade Policy Observatory have pointed out, when it comes to solving the rules of origin problem the UK would, for various technical reasons, often require not just the agreement of the third country but also the EU as well.

Given all these hurdles, it would hardly be surprising if EU firms currently using UK components became nervous about these multiple deals not, ultimately, materialising.

The two-year transition deal due to kick in in March 2019 should, in theory, delay the day of reckoning because it is assumed the EU will ask countries with which it has a free trade deal to treat the UK as if it is effectively still an EU member. But it cannot be taken for granted that those countries will agree to do this, adding another layer of uncertainty for Continental firms.

“Faced with this uncertainty EU firms may well start to source inputs from elsewhere because they don’t want to risk not getting originating status,” says Dr Gasiorek.

“This matters most where the tariffs that the EU would face on its exports are high. For some industries where supply contracts may have a long duration, I would expect this to already be an issue.”

However, Alan Winters of Sussex University thinks more firms will delay drastic decisions. “My sense is that there will be some re-sourcing …but a lot of these supply chain are pretty complicated and it’s quite expensive to do so, so they may wait and see,” he says.

Mr Lowe points out that the incentive for the European Union side to solve the Brexit rules of origin problem might be blunted due to the fact that if EU companies do start sourcing more in the rest of the EU that’s a potential spur to growth and jobs within the bloc.

Of course, the same post-Brexit rules of origin problems work in the other direction and British firms are likely to feel pressure to replace some EU-sourced components with UK-sourced ones.

The Society of Motor Manufacturers, for instance, has pointed out that only around 40 per cent of the average UK-made car is currently local content, potentially complicating any future trade deals the post-Brexit UK might seek to strike.