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Mood on global trade has shifted in past year

Brexit and the election of US President Donald Trump are set to lead to upheaval in the areas of trade and tax going forward.

A year ago, leaders of the G20 countries issued a statement defending global trade after a meeting in China.

“The choices we make together will determine the effectiveness of our response to the challenges of today and help to shape the world economy of the future,” the G20 leaders said at the time. “We will work harder to build an open world economy, reject protectionism, promote global trade and investment, including through further strengthening the multilateral trading system, and ensure broad-based opportunities through and public support for expanded growth in a globalized economy.”

Just half a year later, the mood among G20 members had shifted perceptibly.

“The president has tremendous power to restrict trade – almost unlimited.“

Gary Hufbauer, Senior Fellow, Peterson Institute for International Economics

At a meeting in Germany in March, the group’s finance ministers reached an “impasse” when it came to the free trade issue, and were only willing to comment on efforts to “strengthen the contribution of trade to our economies” in their statement. In July, G20 leaders spoke about “mutually advantageous trade” and the need to fight protectionism, including unfair trade practices.

The landscape is changing fast for multinational businesses.

The UK vote to leave the European Union (EU) and the election of US President Donald Trump, who ran a campaign that criticized trade deals such as the North American Free Trade Agreement (NAFTA) and the Trans-Pacific Partnership (TPP), are symbolic of a new anti-globalization philosophy that is threatening to overturn international trade norms and dampen economic growth.

Tariffs, which came down across the world in recent decades, are suddenly once again near the top of the list of risks that companies must monitor today. The potential is clear — less openness. What’s uncertain is whether this change will lead to the disruptions many fear.

“The world of trade has been flipped on its head,” says Adrian Ball, EY Asia-Pacific Leader for Indirect Tax, who describes businesses in that region as cautious.

Multinationals can take a closer look at their risks through supply chain mapping and financial modeling, monitoring exposed elements in their supply chain, considering priority supply chain lanes, and evaluating alternative sourcing, according to Bill Methenitis, a Dallas-based EY Global Trade professional.

“Change may occur quite rapidly, and businesses will benefit from being nimble in this environment,” says Methenitis.

Cracks in the foundation

For now, the twin pillars underpinning global political, economic and investment uncertainty are Brexit — the UK’s pending departure from the EU — and a recast of US trade policy under President Trump.

UK Prime Minister Theresa May formally started the official Brexit process in March when she sent a letter to the EU that triggered Article 50 of the Lisbon Treaty. The prior year, a majority of UK voters who participated in the referendum — 52% — unexpectedly opted to leave the 28-member bloc, which has become the world’s largest economy via its single market.

The journey ahead for the UK and the EU is long, precarious and complex.

The UK position, presented in a white paper to Parliament in February 2017, confirmed that the UK then was aiming to reach long-term solutions within a two-year time frame rather than opting for interim solutions.

Since then, the UK has had a general election that has resulted in a minority Conservative government, and there has been more discussion about transition agreements. On August 15, May's government announced it could seek a temporary customs union with the EU. However, the aim of providing certainty remains.

While trade deals typically take multiple years to negotiate, the UK argues that it should be able to resolve any concerns more quickly since the UK’s rules are already aligned with those of the EU. The goal is to sign a free trade agreement (FTA) and a new customs agreement, rather than to join the European single market like Iceland, Norway and Liechtenstein.

“When you consider how important these multinationals are, you see that the US is still very much integrated with the rest of the global economy.“

Ayhan Kose, Director, World Bank Group’s Development Prospects Group

In the absence of a transitional agreement, new trade and customs agreements, either permanent or temporary, must be in place by March 2019 for UK trade with the EU to carry on without the sudden impact of tariffs.

The alternative is considered a “cliff’s edge”: the loss of FTAs would send the cost of imported intermediate goods soaring, and tariffs and customs processes would sever supply chains. Companies in both the UK and the remaining EU countries would suddenly face a loss of zero-tariff access to each other’s markets, driving up costs in both places. The UK, which up to now has applied the EU’s Common Customs Tariff to goods originating from outside the EU, would need to legislate a domestic tariff system.

“Brexit is really unknown,” said Douglas Peterson, Chief Executive Officer of S&P Global. “It’s going to be very difficult to renegotiate the treaties and manage this in two years.”

This difficulty is therefore leading to more calls for a transitional agreement, to enable trade to continue while the new regulatory framework is formulated and agreed.

Stay or go

Some multinational organizations with UK operations aren’t waiting around to see if the plan works.

Driven by concerns that businesses may have to forfeit their seamless access to the single market, they are looking at reshaping, transferring, downsizing or moving their UK or even European operations, according to the EY European Attractiveness survey, Plan B … for Brexit.

According to our survey of 254 business executives with foreign investments in Europe, 14% of global businesses operating in the UK said they will transfer some or all of their activities elsewhere, while the remaining 86% plan to stay put.

Financial services in particular is a sector in which companies are considering leaving because they already know that Brexit will end their ability to offer services in the EU without suffering an increased regulatory burden.

A study from the Brussels-based think tank Bruegel estimated the change could cause €1.8 trillion in banking assets to depart Britain, and lead to the transfer of up to 30,000 banking, consultancy, legal and accounting jobs to the EU.

Brexit could also have an effect on manufacturers’ supply chains.

The aerospace and automotive industries are increasingly vulnerable, for example, in terms of the various parts that are gathered for assembly from different places. Moving from zero tariffs to a 10% rate for entry into European markets could severely damage the UK auto industry’s competitiveness and increase the price of cars imported from the EU by an average of £1,500, according to the UK’s Society of Motor Manufacturers and Traders.

Tariffs wouldn’t be the only problem. Leaving the customs union means goods will be subject to proof-of-origin checks as they cross borders. Research suggests this process adds 8% extra cost on average to the underlying value of the goods, according to Nikhil Datta, a researcher at the London School of Economics’ Centre for Economic Performance.

How businesses view investments in Europe in light of Brexit: the results of an EY survey

Tax implications

If the UK fails to reach an FTA with the EU, UK exporters will look to address changes in custom duties and value-added tax (VAT) by adjusting their business structure to find the “least disruptive point of entry into the EU in terms of certainty on custom duties, custom procedures, import quotas and payment of VAT, and route most of their trade through this point (rather than selling directly to the individual countries),” according to Plan B … for Brexit.

The UK government may be open to using tax competition as a solution to these problems, our report suggests. If free trade deals prove hard to negotiate, it could reduce corporate income tax rates further in an attempt to retain companies in the UK, for example, according to one Sunday Times report. But that would make it harder to balance the budget, Datta says.

“The government says again and again that it’s going to balance the budget, and cutting corporate tax rates would obviously make that very difficult,” Datta says.

The US view

Across the Atlantic, there is perhaps even more uncertainty about trade between the US and the rest of the world. President Trump withdrew the US from the TPP trade deal just three days after he was sworn in.

The TPP move was a major blow to free trade proponents seeking access to the US market. The other countries in the deal have said they will implement it without the US.

Trump has also vowed to impose tariffs of 35% and 45%, respectively, on imports from Mexico and China.

And during his campaign, Trump called the existing NAFTA deal with Mexico and Canada, now in its 23rd year, “the worst trade deal” ever signed.

Trump has singled out countries with which the US runs a high trade deficit for specific attention. However the talk of late from Washington, DC is more subdued than what was said on the campaign trail. Executive orders in March commissioned a study of the causes of the US’s $502.3 billion trade deficit — far short of the robust campaign language.

Complaints about Mexico will likely be addressed through renegotiating NAFTA, a course that Trump pledged to pursue in April.

“It is my privilege to bring NAFTA up to date through renegotiation,” Trump said in a statement earlier this year. “I believe that the end result will make all three countries stronger and better.”

Back to the table

In May, the Trump administration formally notified the US Congress of its intent to renegotiate NAFTA, marking the start of a required 90-day period before formal renegotiations may begin. Negotiations with Canada and Mexico could start as early as August 16, 2017.

When it comes to China, there isn’t one agreement that defines that trade relationship. Disputes can be addressed through the World Trade Organization’s (WTO) adjudication process.

Trump’s two days of talks with Chinese President Xi Jinping in early April did not generate any developments in this area, with the two leaders agreeing to meet again this year. US Trade Representative Robert Lighthizer has said that the WTO was not set up to deal effectively with a country like China and its industrial policy, according to a Bloomberg report.

In terms of trade policy, Trump does have more room to maneuver than in other areas.

“Entire industries are now reliant on global supply chains, and countries want to be a part of them rather than on the sidelines.“

Douglas Peterson, Chief Executive Officer, S&P Global

Multiple laws give the US President the ability to impose tariffs or halt the negotiated access to the US market for goods from certain countries.

The 1974 Trade Act, for example, allows the president to retaliate for large balance-of-payment deficits or unfair trade practiced abroad, and Trump could use that law or others to impose tariffs, duties or import restrictions, according to a report from the Peterson Institute for International Economics.

“The president has tremendous power to restrict trade — almost unlimited,” says Gary Hufbauer, a Senior Fellow at the Peterson Institute for International Economics in Washington. “But he cannot liberalize trade without Congressional assent.”

Once-in-a-generation tax reform

Tax reform could be another way for Trump to address trade concerns. US House of Representatives Speaker Paul Ryan has vowed that tax reform will be completed by the end of this year. And in late July the Trump administration and key Republican senators issued a statement indicating their joint commitment to reform.

“Tax reform could be valuable to the US in remaining competitive against other countries,” said Peterson of S&P Global. “But it needs to be permanent. Knowing that something is permanent gives you the ability to plan.”

Overhauling the tax code however is considered extremely difficult in the US, so much so that it is often considered a once-in-a-generation event.

A proposal from the House of Representatives contained a border adjustment tax (BAT) that would have exempted exports from taxation while subjecting imports (including components) to tax but key tax writers and the administration in July indicated the BAT would not be pursued as part of tax reform.

Link in the chain

More protectionism would add to what already is a relatively protected economy: trade accounted for about 30% of US gross domestic product (GDP) as of 2015, less than the average of 70% in other advanced economies, according to the Global Economic Prospects report from the World Bank Group in January.

American multinationals are a core element of the American economy — they account for more than a quarter of sales of US companies, nearly 20% of exports and 10% of jobs, according to Ayhan Kose, Director of the World Bank Group’s Development Prospects Group.

“When you consider how important these multinationals are, you see that the US is still very much integrated with the rest of the global economy,” Kose says.

The impact from any changes will be profound for the global economy as well.

“Trade is a formidable force as a vehicle for promoting growth and helping reduce poverty,” Kose says. “A number of countries have escaped the low-income trap and become middle-income by embracing trade openness.”

Staying the course

Amid this great global questioning of global connectivity, some countries remain committed.

Canada and the EU recently signed a free trade agreement. In Latin America, Brexit and Trump could provide the impetus for the Latin American Mercosur block to finally complete an FTA with the EU, and push for a deal with the UK as well.

While the US may have abandoned TPP, the 11 remaining countries involved are still casting about for free trade-friendly alternatives and invited China and South Korea to their March meeting.

“Trade is not going away,” says Peterson. “Entire industries are now reliant on global supply chains, and countries want to be a part of them rather than on the sidelines.”

After Canada signed its Comprehensive Economic and Trade Agreement (CETA) with the EU in February, Prime Minister Justin Trudeau’s speech to the European Parliament was both a celebration as well as warning of what could happen if voters’ skepticism of trade and a globalized economy deepens.

“Now we need to make it work,” Trudeau said. “If we are successful, CETA will become the blueprint for all ambitious, future trade deals. If we are not, this could well be one of the last.”

Key action points

  • Tax and trade risks are converging. Managing these risks means gathering expertise in both areas in order to build accurate forecasting models and plan tactics and strategies.
  • Brexit presents short-term risks, such as the return of tariffs, potential supply chain disruptions, and the potential need to shift some operations out of the UK and into the EU. The unclear outcomes narrow corporate options for immediate responses, but where businesses have been able to take decisive actions, such as in the financial services sector, the trend is toward other European locations.
  • US trade policy presents similar risks, including a loss of tariff-free access, but also potential opportunities if a tax reform package lowers the corporate income tax rate.
  • While new trade barriers are likely in the US, most countries remain committed to free trade. There will be new agreements and rules coming that present fresh opportunities as well as compliance challenges.

All information in this article was current as of the print deadline of August 15, 2017.

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