Now that Article 50 has been formally triggered, Brexit negotiations can finally get underway. From the outset it is clear they are not going to be easy or straight forward. Nonetheless, overcoming the political obstacles and achieving a positive deal is in both sides interests.
The state of the economy
As we start the negotiations the macroeconomic backdrop is looking reasonably encouraging. European growth is improving while the UK economy has proved to be surprisingly resilient since the June 23rd referendum. We suggest that this is down to pretty much everything that could go right since the vote having done so. There was a smooth political transition as Theresa May took over from David Cameron as Prime Minister, there was stimulus from the Bank of England, sterling fell, which boosted international competitiveness, Article 50 triggering was delayed a full nine months, allowing the country to come to terms with the decision while a strong performance at the Olympics and better weather helped lift the national mood.
Unfortunately, there are signs that growth will soon be weakening. Inflation is rising sharply and wages are not responding, meaning that household spending power is being squeezed. At the same time businesses are becoming more cautious due to the uncertainty of the Brexit negotiations with surveys pointing to a slowdown in hiring and investment. On the positive side, a more competitive exchange rate should help net trade, but on balance we don’t think this is going to be enough to offset the weakness in domestic demand. While recent Bank of England comments have hinted at a bias towards raising interest rates given the jump in inflation, we doubt that monetary policy will change before Brexit negotiations are concluded in early 2019 given the downside risks to growth.
The negotiation process
Under Article 50 there is a two year window to agree both the divorce and the “new partnership” as British Prime Minister May is describing it. However, the time frame is probably going to be much tighter than that. EU lead negotiator, Michel Barnier, has suggested that from his side, the EU may not be in a position to formally start until June and then he indicated that four to five months will be required to get ratification from all of the individual parliaments at the end of the process. This means that there could be as little as 15 months in the middle to negotiate the whole package, which will be challenging. Remember that the EU-Canada CETA trade deal took seven years to negotiate and then nearly collapsed after the Wallonia regional government in Belgium threatened to block it.
As for the divorce, EU lead negotiator Barnier has estimated that the UK’s liabilities amount to €50-60bn. There is limited clarity on the breakdown of this exit bill, but it would likely include pension liabilities, funding commitments already made and loan guarantees. However, the UK House of Lords Financial Affairs sub-committee have said that Britain would be in a “strong” legal position on arguing against exit costs and the EU’s estimates are ''hugely speculative''.
Given how far apart the two sides are on this issue it seems likely, as with typically most European decisions, nothing is agreed until everything is agreed. We therefore think it would be almost impossible to separate the divorce negotiations from the new agreement, implying parallel discussions are probably going to happen. We also suspect that a transitional period (after agreement has been reached) will be required to adjust to the new environment.
The current position
The UK’s ability to win trade deals with other (non-EU) countries is seen as one of the benefits from Brexit. Trade with non-EU countries has grown 60% over the past decade versus 5% for EU countries. Nonetheless, both the UK and the EU need a positive Brexit deal. In the case of Britain, 44% of UK exports go to the EU, which generates jobs, incomes and tax revenues. More than half of all the goods and services the UK imports come from EU nations so any barriers to trade, such as tariffs or quotas, run the risk of higher prices for UK consumers and businesses. For Europe, the UK is a hugely important market (with the majority of EU members running trade surpluses against the UK) and frictionless cross border trade is an imperative for modern supply chains. Like with the UK, millions of European jobs are dependent on this trade.
A trade deal is mutually beneficial, but upcoming European elections will make already tense discussions even more challenging. There is a perception among many in the UK that the rise of anti-establishment/anti-EU parties in several European countries means the EU want to make leaving look as painful as possible. The EU needs to deter others from following the UK’s path.
The positive case
In terms of the deal, the UK ideally wants a solid trade relationship for both goods and services, but not the free movement of people. Nor does it want to be subject to rulings from the European Courts of Justice. The UK accepts it will not get access to the single market, but wants something that is as close as possible. Should the other European elections following the Dutch example and see mainstream parties hold power it would likely point to renewed EU stability, meaning that the EU can look forward positively to the future and the risk of a punitive deal for the UK will recede.
Moreover, we believe it is in the EU’s interest to have strong relations with the UK. After all, demographic factors mean that the UK will be Europe’s most populous nation and its largest economy within 25-30 years. Having ongoing access to this market will become even more important than it is today. With the UK also indicating it is prepared to make ongoing financial contributions there are huge incentives to negotiate a deal that can benefit all.
If the EU loses the net €12bn annual financial contribution from the UK and doesn’t get a cent of the €60bn divorce settlement that the EU is demanding from the UK there is going to a be a big hole the EU’s finances. This either means substantially more tax contributions from the likes of Germany, the Netherlands, France and others or significantly less spending on poorer states. As with most deals, money makes a big difference.
But it won’t be plain sailing
Nonetheless, politics will dominate the economics, at least in the early part of negotiations. This means uncertainty for business. Already there is survey evidence suggesting UK businesses are cautious about putting money to work. Should negotiations be perceived to be going badly then worries about the UK’s future relationship with Europe could see business drift away from the UK. A recent survey by Ipsos Mori suggested 10% of British business are already moving some activities out of the UK and the risk is that this could gain more momentum. Likewise, foreign direct investment could start to slow given the uncertainty over whether the UK is a sensible base for European operations. This may result in rising unemployment with asset prices coming under pressure. Should sterling fall further due to Brexit worries, then inflation will stay higher for longer, squeezing spending power in the UK economy.
The worst case scenario
While the Dutch election has passed without a swing to extremism, there are risks elsewhere in Europe. If there is electoral success for anti-EU parties, the prospect of EU break-up could return. Marine Le Pen of the National Front party looks set to get through into the second round of the Presidential election in France, to be held in May. Opinion polls suggest that she is unlikely to become the next President, but there is a risk. Probably of more concern is Italian elections, which are schedule for within the next twelve months. Two of the three biggest parties are decidedly anti-EU and if a new Italian government does push for a referendum on EU (and Eurozone) membership then the EU would take an even tougher line on Brexit discussions in order to make leaving look as unattractive as possible in an act of self-preservation. Toxic politics, combined with economic dislocation and financial contagion would likely lead to recession across Europe.
Another Scottish independence referendum would complicate the Brexit process. We doubt that the British government will allow it to happen before Brexit negotiations are concluded on the simple basis that negotiating two divorces at the same time will be almost impossible. Nonetheless, this means political uncertainty will be prolonged – well beyond the conclusion of Brexit negotiations in 2019, which will weigh on UK asset prices and sterling.
The next two years will see intense and tough negotiations that will generate significant uncertainty for many citizens and businesses right across Europe. The current electoral backdrop is not helpful, but it can be overcome. Given the close ties to the European economy, the UK needs a deal. Millions of jobs are dependent on it. Nonetheless, Europe needs one too. The UK is a key partner on the EU’s doorstep that will soon be the largest economy in Western Europe and is prepaid to make financial contributions. This gives us some confidence that a mutually beneficial deal can be achieved.