UPDATE – Brexit issues for the aerospace industry

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5 September 2016 - 16:30, by , in Uncategorised, Comments off

In light of the UK’s decision to leave the European Union on June 23rd 2016, we have been asked what the repercussions might be for the UK aerospace industry. Customers often ask us what our view on Brexit is.

Here is our view.

Summary economic outlook for The UK

  • Surprisingly buoyant now but medium uncertainties remain. Disposable income may be affected by rising inflation and government spending is supposed to be under control.
  • Inflation shouldn’t get out of hand, however, despite the fall in the pound. Domestic inflation is low and a more important influence than import prices. Importers/retailers may have to absorb some of the fall in the pound. Inflation may rise further, but probably to not much more than 3%.
  • The crux maybe whether reduced access to EU markets is offset by the beneficial effects on other markets of pro-business policies. This applies particularly to ‘hard Brexit’.

Will UK exporters have to pay tariffs?

  • Depends on the terms of the deal with The EU; there is a trade-off between market access and freedom of movement.
  • But the 1980 WTO plurilateral information agreement on trade in civil aircraft eliminates import duties on civil aircraft. This agreement has 32 signatories (Albania; Austria; Belgium; Bulgaria; Canada; Chinese Taipei; Denmark; Egypt; Estonia; European Union; France; Georgia; Germany; Greece; Ireland; Italy; Japan; Latvia; Lithuania; Luxembourg; Macao, China; Malta; Montenegro; Netherlands; Norway; Portugal; Romania; Spain; Sweden; Switzerland; United Kingdom; United States). Most WTO agreements are multilateral since they are signed by all WTO members. The agreement on trade in civil aircraft is one of two plurilateral agreements (with the agreement on government procurement) signed by a smaller number of WTO members. It eliminates import duties on all aircraft, other than military aircraft, as well as on civil aircraft engines and their parts and components, all components and sub-assemblies of civil aircraft, and flight simulators and their parts.
  • Some aero parts (and materials) may not be caught by the WTO agreement. This is being investigated by the governments concerned.
  • Although the EU was a signatory to the above agreement, but so were individual countries including The UK. So, providing the UK is still abiding by the terms, then the agreement should still apply and there is no need for the agreement to be renegotiated.
  • The WTO agreement should be OK for tariffs. But may not help with non-tariff barriers – see below.

Will UK exporters into The EU be damaged by tariffs?

  • Probably not, because of depreciation of GBP. There could be a net gain for The UK, assuming a modest uptick in market share, even though the cost of imported raw material and subcontracted parts will rise.
  • Airbus, BAE Systems, Cobham and Ultra are due to report soon, so we may know more.

Will UK exporters benefit from a lower GBP?

  • Maybe yes, where there is an existing product and a commodity competition e.g. Rolls-Royce should gain in competitions against GE to supply engines for B787. Rolls-Royce shares rose strongly after Brexit (not so high now, though for other reasons). Not all engine choices are open, as airlines may have loyalties to GE or have fleet servicing commonalities. Rolls-Royce has recently been awarded a contract from Singapore Airlines for Trent 1000. Was the falling pound a help? The two companies have had a long relationship.
  • Hard to benefit where a company is selling a new product or trying to get business from a new customer e.g. a UK parts supplier won’t suddenly be able to sell to Embraer. Programme suppliers will already have been chosen and, even if there is a new programme opportunity, it takes years if not decades to build up credibility with new customers.
  • The UK exports about 90% of what it produces in aerospace, so, although import costs for many raw materials and intermediate components will rise, they should be well outweighed by the benefits to sales revenue from a weaker pound.
  • Data from The UK’s Office of National Statistics showed the UK’s trade deficit narrowed in December. The deficit in goods and services fell to £3.3bn from £3.6bn in November. The improvement was mainly due to a £1.1bn increase in exports of goods to non-EU countries. For the October-to-December quarter, the deficit narrowed by £5.6bn to £8.6bn. “While both exports and imports grew over 2016, there remains little evidence that the weaker pound has had an effect on the trade balance,” according to the ONS. (Luxury yachts may be an exception as they are seeing a 25-30% increase in orders)
  • The UK exports about 90% of what it produces in aerospace, so, although import costs for many raw materials and intermediate components will rise, they should be well outweighed by the benefits to sales revenue from a weaker pound.
  • The value of USD-based order books will also rise.

Will UK exporters into The EU be damaged by non-tariff obstacles?

  • Quite possibly yes but there has been no light shed on these issues yet. It seems unlikely that the French would want to disadvantage Airbus but there could be unforeseen capacity issues e.g. not enough customs officials to cope.

Foreign Direct Investment (FDI)

  • Much FDI is to address the UK home market, which will remain an important market.
  • FDI to use The UK as a convenient manufacturing base as a way into The EU could decline. The crux, as explained by Japan in September 2016, is the attractiveness of exporting to The EU from The UK. This is partly about tariffs (which may be offset by currency depreciation) and partly about the ability to attract desired workforce skills from EU countries.
  • Airbus has said that future investment into The UK may be diverted to E. Europe or the US if it doesn’t have freedom of labour movement.
  • UK industrial companies still seem to have attractions to overseas buyers e.g. the acquisition of ARM but UK productivity is poor and ABB reported a Brexit-induced decline in UK orders for capital equipment, including robots.

Why has the GBP declined?

  • If FDI is lower and current account deficit likely to be bigger than capital account inflows, GBP has to reduce to a point to bring about overall balance.
  • UK interest rates declining, thus reducing attractions of sterling.

Will UK interest rates stay low?

  • UK savers are being made to pay for political mistakes and economic mismanagement.
  • Pension funds are stressed because: the Government removed the dividend tax credit in 1997; low discount rates for future liabilities; poor returns on government bonds, which punishes cautious funds which try to match liabilities with bonds.
  • Low interest rates are a market distortion but will stay to stimulate growth.

Will UK firms be excluded from EU research programmes?

  • Participation is extremely important to UK aerospace. There could have been a risk that research consortia wouldn’t want to take the risk that British members might be excluded e.g. from Clean Sky 2, even though some UK firms have unique specialisms, e.g. Airbus wings, and hard to substitute.
  • The UK Treasury has now agreed to cover the UK’s contribution for any projects entered into up to Brexit date.
  • We think that this arrangement should continue afterwards as so much in the interests of all.
  • Firms are worried, however, about loss of access to EU research programmes. British participation should be OK till 2020 but continentals may be reluctant to participate after that. There has been some anecdotal evidence that continental academics are reluctant to move to British universities.

What’s the outlook for UK GDP?

  • Buoyant currently
  • Could well become lower but Purchasing Manager’s Index for services saw August recover most of the ground lost in July. PMI for manufacturing in August also saw recovery.
  • Long term outlook depends on deal with The EU and extent of pro-business policies with the rest of the world.
  • Obama says UK will be at the back of the queue for any new trade deal (but elections in November 2016 could change this and trade officials have a different stance).
  • Our sense is that Germany and France want to minimise the impact of Brexit on their economies and want Brexit to be as seamless as possible.

Will EU countries be damaged by Brexit?

  • Yes, if there is exit contagion
  • And/or British slowdown
  • But note that The EU imports much more from The UK than vice versa.

We think that EU countries found the vote just as surprising as the British Government. They don’t want to mess up their own economies and so are still working out what they want from Brexit. It’s not just the British Government that doesn’t want a quick exercising of Article 50.

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