There is currently a lot of talk in Britain about remaining in the Customs Union with the European Union post-Brexit or forming a new customs union with the EU. This view is reportedly favoured by the Treasury secretary in government, and is currently popular in the highest ranks of the Labour party. There is even some indication that the government is considering the idea.
Most proponents of this option for the UK’s post-Brexit trading relationship with the EU argue it is the best way to secure frictionless trade with the EU and salvage the Northern Ireland Good Friday agreement.
So what is there to be known about customs unions to help decide the best course for Britain?
Customs unions tend to be tied to political integration
Have you ever thought about why, among the world’s many preferential trade agreements, there are only a handful of customs unions around the world, whereas there are hundreds of bilateral or regional free trade agreements?
The best known customs unions include the European Union, the Central American Integration System, Mercosur, the Gulf Cooperation Council, the Southern African Development Community, the customs union between Switzerland and Liechtenstein, and the Eurasian Economic Community. In contrast, the list of Free Trade Agreements (FTAs) is very long: the World Trade Organization has counted almost 280 of them across the world.
Customs unions eliminate border tariffs and ‘non-tariff’ barriers at the border, such as import quotas among their members. Customs union members apply exactly the same tariffs towards third countries. Free trade agreements eliminate such barriers among members but members retain the freedom to apply the tariff rates they wish towards non-members.
The advantage of a customs union is simplicity. Companies trading within the union do not need to prove the origin of their product but can just sell next door with no further questions asked.
In FTAs, governments need to agree on ‘rules of origin’ to determine what percentage of a product must be local content (“originating” from a member state) in order for it to qualify for the trade pact’s tariff benefits. Companies wishing to sell to an FTA partner must make sure their production processes comply with these rules – and source inputs accordingly. What is more, they need to provide proof of origin, involving rather complicated and costly paperwork.
So why don’t governments keep it simple?
There is domestic politics: customs unions tend to involve rather comprehensive trade liberalisation among members. Liberalising trade comprehensively is an almost impossible task for most governments, who face resistance and lobbying from import competing industries.
In contrast, FTAs accommodate domestic constraints. They tend to be full of exceptions to free trade, and exclude specific products or arrange special time-frames for tariff reductions and eliminations. Rules of origin can also be used as an instrument of continued trade protection: a restrictive rule of origin can offset the effects of a tariff elimination.
There is also international politics: states tend to wish to maintain their right to set their own tariffs and negotiate its trade agreements with third countries and not have their trade policies constrained by the other members of the customs union. In other words: customs unions curtail national sovereignty in trade policy.
Historically, customs unions are part of a political integration projects. The first customs union was the one agreed among five Central American states in 1833. Political leaders aimed to foster a political union among Latin American states after their independence from Spain. Mercosur, the huge South American bloc that include Brazil, Argentina, Uruguay and Paraguay is also born out of the desire for political union in Latin America.
The unification of Germany in the 19th Century was preceded by the 1834 customs union known as the Zollverein. The Zollverein was explicitly conceived as an instrument of German political unification, which occurred a generation later.
Nobody doubts the political nature of Vladimir Putin’s customs union with members of the former Soviet Union known as the Eurasian Economic Union (now Eurasian Economic Community). The Ukraine crisis in 2014 stemmed from Kiev’s reluctance to join Putin’s project.
The EU itself is a political project pursuing the goal of ‘ever closer union’.
And there’s the customs union Turkey established with the EU in 1995. The Turkish customs arrangement with the EU is part of its EU membership accession process and seen as a major step in that direction.
Customs unions reduce trade costs but do not eliminate them
Customs unions are very effective at integrating economies. Turkey became a major producer and exporter of textiles and automotive products thanks to the customs union with the EU. In the early noughties Turkey was able to attract European investors to locate part of their production there, helping it become part of Europe-wide production networks. As a result EU, Turkey’s trade increased fourfold in twenty years following the coming into force of the customs union.
The EU Turkey example shows that not having to comply with rules of origin is a major boost to trade. But this does not mean trade is frictionless. For example, all imports from Turkey to the EU require a variety of certificates: transit certificates for instance. Road transport between the EU and Turkey is limited by quotas, thus putting a lid to how many trucks can ship goods to the EU.
Turkey’s industrial integration with the EU was also facilitated by the fact that it agreed to apply EU industrial standards wholesale. Turkey is part of the EU standardisation bodies CEN and CENELEC for instance. But this policy is not formally part of the customs union arrangement.
Services matter increasingly in international trade. The current absence of a services agreement with Turkey is seen increasingly as an impediment to further growth and trade. The EU-Turkey customs union also excludes agriculture.
Turkey is not part of the EU’s single market. This means any trade not in strictly industrial goods – be it a telecommunications investment, a business visa, a public procurement tender – is a very complicated affair for business persons.
Being in a customs union does not guarantee that no duties will be applied on goods. Turkey and the EU have their own independent trade defence policy and regularly impose antidumping duties on some of their products.
Customs unions face trouble when political integration fails
The Turkish case brings us back to our introductory paragraphs on the importance of political integration for the success of customs unions.
In Latin America political integration among customs union members never materialised. Be it in Central America or in Mercosur, the customs unions are a glass half full or glass empty, depending on the perspective taken. For example, Mercosur excludes the auto industry – a major industry in both Brazil and Argentina. This makes finding a common ground on tariffs in free trade negotiations – for example currently with the EU – more complicated and difficult.
Ever since Turkey’s accession process to the EU has ground to a halt, there have been increasing problems with the customs union. Turkey complains that it has no say in the EU’s free trade negotiations with third countries. As a result of these FTAs, Turkey is obliged to apply the liberalising commitments taken on by the EU but has no guarantee that it will receive the same treatment by these partners than the EU. Many EU FTA partners agreed to sign a separate trade agreement with Turkey to accommodate Ankara – but not all have done so, for example Mexico. While Turkey was negotiating accession this issue was not seen as a problem. With EU membership out of the picture, this curtailment of sovereignty is problematic for Ankara.
Recently Turkey has started applying duties and taxes on imports of products from the EU and has been criticised for flouting the terms of the customs union. There have been attempts to launch negotiations to modernise the customs union, but these have not materialised. Among the many obstacles to the launch of these talks, the reluctance of EU member states to let Turkey have a greater say in EU trade policy and greater freedom for its truckers in the EU is among the most important.
Turkey has started to sign its own separate trade agreements with third countries and given the incomplete nature of the customs union with the EU and Turkey’s non participation in the EU single market, there is some scope to do so. For example, it has basically free rein in areas such as agriculture or services.
The question today is what will be the future of the EU-Turkey customs union now that Turkey’s integration into the EU is not an option in the foreseeable future.
Some implications for Brexit Britain
On customs union matters, Brexiters such as the trade secretary Liam Fox, who advocate leaving the customs union and the single market, are coherent.
Being in a customs union with the EU without being a member – and without having a say in its trade policy – will be a major constraint on the UK’s ability to shape its own trade agreements and sign meaningful trade agreements with third countries. Being in a customs union as part of a project that involves political separation – Brexit is about rejecting ‘ever closer union’ with the EU – rather than integration, is an unprecedented proposition. Historical precedents suggest that it will be hard to ensure that a continued customs union with the EU post-Brexit remains a functioning and stable arrangement over time.
Remaining in a customs union with the EU would help preserve the existing industrial value chains – in autos, aerospace, to name but a few – in which Britain is so deeply enmeshed. But it would not provide a wholesale solution for those who want frictionless trade with the EU. A customs union is a limited affair restricted to tariffs. Many other factors play into making sure there is limited or no paperwork at the border, not least regulatory harmonisation and mundane issues like road transport licences, transit agreements, visa issues, among many others.
Also Britain’s export strengths increasingly lie in the services sector, where the EU single market plays a major role in shaping British exports. The customs union does not provide a solution to frictionless trade in services.
Clearly, the customs union discussion in Britain needs situating in the wider picture of Britain’s trading relationship with the EU after Brexit, and will involve tough political choices that have yet to be made.
“The best known customs unions include the European Union, the Central American Integration System, Mercosur, the Gulf Cooperation Council, the Southern African Development Community, the customs union between Switzerland and Liechtenstein, and the Eurasian Economic Community. In contrast, the list of Free Trade Agreements (FTAs) is very long: the World Trade Organization has counted almost 280 of them across the world.”
Custom unions replace huge amounts of bilateral agreements. The EU customs union alone replaces 378 bilateral custom agreements. Also, over half the WTO members are in a customs union.
A better comparison is with RTA. Until the UK leaves the EU, every single WTO member will be in an RTA.
Bilateral agreements are plentiful, but they aren’t nearly as important to world trade as the explosive growth (and deepening) of RTA. RTA is where modern economies can stretch out their supply chains and hone their competitive advantages.
“Companies trading within the union do not need to prove the origin of their product but can just sell next door with no further questions asked.”
I think that actually requires diagonal cumulation of RoO to be part of the agreement. I’m not sure that it’s possible to have a CU without that, but I know you don’t need a CU to have diagonal cumulation.