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.
Scotland
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.
Conclusions
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.
