Brexit: What to expect

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The U.K. voted to leave the European Union (E.U.) on 23 June 2016, and the indications in the months since have pointed to a clear separation – what the British media have dubbed a ‘hard Brexit’.

The first step is to trigger the article in the Treaty of Lisbon, one of the E.U.’s foundational legislative texts, that allows for the withdrawal of a member state from the bloc. Britain’s Prime Minister Theresa May announced in October that her government would trigger Article 50 in March 2017. Once Article 50 has been triggered, the U.K. government will have two years to extricate itself from the E.U. treaties and negotiate its future relationship with the E.U. May’s parliamentary opposition successfully demanded that the government publish its plan for the Brexit negotiations beforehand, but will not block the process of withdrawing from the E.U.

The view from the E.U.

Michel Barnier, the head of negotiations on behalf of the European Commission, the E.U.’s executive body, predicted that the talks themselves would only last for around 18 months after Article 50 is triggered. The rest of Article 50’s two-year window would be taken up by the ratification process, since the Brexit negotiations on the E.U.’s side are being conducted not only by the remaining 27 member states, via the European Council, but also through the European Commission and the European Parliament. As a result, the talks will be time-consuming and complex, with many competing interests.

This complexity and room for discord, combined with the very short timescale envisaged by Barnier, limits the chances of some kind of transitional or compromise deal being reached with the U.K. before Brexit is finally activated in March 2019. Compounding the problem, elections in France, Germany, the Netherlands, Italy, the Czech Republic, Hungary and Slovenia ensure a shifting cast of Brexit opinions and decision-makers, although it’s possible that in some cases, the rise of more Eurosceptic leaders could boost the British position.

Models of Brexit

It is becoming increasingly clear that the U.K. will not be able to pursue a ‘soft Brexit’ by falling back to the European Free Trade Association (EFTA) alongside Norway, Liechtenstein and Iceland. Those countries enjoy tariff-free trade with the E.U., but in return they agree to free movement across the EFTA bloc, have to pay a subscription to E.U. coffers, and have little influence over E.U. policy-making and regulatory development. They also must accept the primacy of E.U. law in matters relating to the single market.

While this would be the least disruptive form of Brexit from a trade standpoint, it would also be the least palatable to many British Leave voters: it would mean implementing E.U. laws in almost every sector as well as paying into the E.U. budget and, crucially, agreeing to the four indivisible freedoms of the single market: the movement of goods, capital, services and people. The British government, which already has only a slim working majority of 13 seats, would risk a mass exodus of voter support if it attempted a Norway-style agreement with freedom of movement, energising the U.K. Independence Party (Ukip), a vocal anti-E.U. and anti-immigration party that currently has only one member of parliament. For their part, the remaining 27 E.U. member states have made it clear that the U.K. will not be allowed to retain the benefits of membership while stopping the free movement of people.

It is unlikely that the U.K. will remain inside the E.U. customs union

It is also unlikely that Britain will remain inside the E.U. customs union, where all signatories agree not to impose tariffs on goods within the union as well as imposing common tariffs on external goods. First, if the U.K. stays in the customs union, third-country FTAs are illegal and the country would therefore struggle to offset the costs of leaving. The U.K. would also be obliged to accept all future FTAs agreed by the E.U. without any negotiating power.

Finally, the words of senior E.U. officials and leaders have pointed towards a ‘hard Brexit’. Donald Tusk, the president of the European Council, warned that ‘it is useless to speculate about ‘soft Brexit’…the only real alternative to a ‘hard Brexit’ is no Brexit’. The outgoing French president, François Hollande, made the case for a firm E.U. stance against the U.K. In Tusk’s case, he seems to believe that British ministers can yet be persuaded to reverse the results of the June referendum, if the economics look sufficiently painful.

However, the economic hardship triggered by a ‘hard Brexit’ is likely to arrive in 2018 rather than beforehand, when Brexit is complete and U.K.-E.U. trade is suddenly subjected to tariffs. Evidence since June has suggested that the uncertainty surrounding Brexit has not of itself been enough to damage British prosperity to the point where overturning the referendum result becomes politically viable for May’s Conservative party.

Part of the reason for Britain’s durable post-referendum growth data was the devaluation of sterling against the euro and dollar as an immediate result of the referendum, reflecting not only the outcome of the vote but also what the IMF’s current account regression model had suggested before the vote was the currency’s 18 per cent over-valuation, given the parlous state of the U.K.’s balance of payments. Sterling’s flexibility has focused further attention on the rigidity of the Eurozone’s one-size-fits-all currency and interest rates, which are currently contributing to various continental banking crises.

The sides also seem to differ on the importance of one another as trading partners, which is again likely to vex the negotiations. The U.K. imports more from the E.U. than it exports, making it a valuable customer for the remaining E.U. states. Nevertheless, the E.U. purchases 44 per cent of Britain’s exported goods and services. Although this has fallen from 55 per cent in 1999, the imposition of trade tariffs and regulations is likely to disrupt the British economy more than that of the E.U. as a whole, forcing a reallocation of commercial activity into less value-added areas to reflect the new terms of trade, though potentially also diversifying Britain’s service-heavy economy in the process.

However, the British government is likely to count on the E.U. not functioning as a whole during the talks, with major E.U. countries instead looking to their national economic interests. The British Isles control 60 per cent of the E.U.’s fisheries, for instance, and Brexit is likely to have an adverse effect on national fishing industries, for instance that of France. The French fishermen’s body, the CNPMEM, warned in October that Brexit could cost them 4,000 jobs and EUR1 billion in lost revenue. In Germany, cars are a more pressing concern – the VDA association of vehicle manufacturers has pressed the German government to prioritise free trade with the U.K., a major buyer of German cars. E.U. negotiators are alive to the threat of British ‘divide and rule’, however, and have to date been highly vigilant in maintaining unity.

Scenarios

All this militates against a ‘soft Brexit’, either based on EFTA or bespoke for the United Kingdom. There are therefore two likely scenarios. The first is for the U.K. to fall back onto World Trade Organization (WTO) terms of trade. This means establishing itself as a WTO member independently of the E.U. but probably replicating the bloc’s ‘commitments’, or terms of trade. The prospects for the U.K. establishing itself as a new WTO member will be discussed in a future report.

The other most likely option is that the U.K. agrees a longer negotiating timeframe with the E.U., possibly going over the two-year period mandated by the Treaty of Lisbon, and achieves a comprehensive FTA to include goods and services, while probably contributing to the E.U. budget for preferential access to the single market.

However, extending the negotiation period over the two years mandated in Article 50 would require the unanimous consent of all 27 remaining E.U. member states, including their own regional legislatures. Bearing in mind that an agreement on closer relations between the E.U. and Ukraine was recently blocked by just over two million Dutch voters, and that the Francophone region of Belgium, an area of 3 million inhabitants, recently threw the ratification of the free trade agreement with Canada into question, this would be no easy task.

The U.K. could find that its post-Brexit future lies in luring large international corporations away from the E.U.

If the U.K. does fall straight back to WTO rules, there would be what May has termed a ‘cliff-edge situation’ whereby trade barriers would appear within a few months, presenting enormous costs to certain sectors of the British economy. However, the cliff edge would not arise at the same time or be the same depth for all sectors. For example, many British service sectors sell their products in other E.U. countries via in-country subsidiaries. However, manufacturers and retailers with long international supply chains would see immediate costs in the form of multiple tariff regimes.

The U.K. could avoid this by using the two-year negotiation period to establish a framework setting out the terms for the future relationship. This would include, for example, the U.K.’s future connection – if any – to the single market; a position on whether or not to maintain a customs union, and some form of agreement on topics like freedom of movement, including study and research schemes like Erasmus. After the two-year period, there would then need to be a ‘transition’.

During the transition, the U.K. could seek to begin informal talks with major trading partners so that when the period came to an end, the foundations would be in place to negotiate trade agreements. However, third countries could be dissuaded by the uncertainty of the U.K.’s relationship with the E.U., its principal trading partner.

Bargaining chips

A Brexit where the U.K. leaves the single market means that trade deals between the E.U. and third countries are less valuable. The Department for International Trade has been set up to lay the groundwork for third-country FTAs, and the minister of the department, Liam Fox, has already travelled to the U.S., India, Bahrain, Qatar, and the United Arab Emirates, demonstrating the U.K.’s willingness to strike out on its own. The surprise election of Donald J. Trump to the U.S. presidency has strengthened Britain’s hand in this regard; Trump has said that the U.K. would be ‘first in the queue’ for an FTA with the U.S. This will likely apply pressure on the E.U. to offer some concessions in order to continue to benefit from the U.K.’s global trade relationships.

The British financial sector is also a key income generator for the E.U.: for example, U.K.-based banks account for more than 75 per cent of foreign exchange and derivatives trading. The British negotiating team knows that the E.U. will want to avoid as much disruption as possible to the financial services industry given the fragility of some E.U. banks, and will use this to try and persuade their counterparts that a transition deal is necessary.

The U.K. will also probably emphasise that the free movement of services has never been fully completed. ‘Services’ in the E.U. cover a wide range of sectors, which are regulated differently, with varying levels of national-level legislation and exceptions according to the type of service. Further, intra-E.U. trade in services makes up only 55 per cent of E.U. services exports, while the U.K. is rapidly increasing its services exports to non-E.U. countries.

The future for the U.K.

If the U.K. leaves the single market, sterling will weaken further, making imports more expensive and probably pushing inflation up. Inflation is likely to cancel out recent wage increases, as well as lowering profit margins; the construction and retail industries have already experienced rising costs. Trade unions are therefore likely to call for higher wages in line with rapid inflation; if businesses agree to the demands of their workers, shareholders will earn lower returns on British-based companies.

As the E.U. continues its investigations into potential ‘sweetheart deals’ in Ireland, Luxembourg and the Netherlands, the U.K. could find that its post-Brexit future lies in luring large international corporations away from the E.U. The British government will certainly welcome the news in December that the multinational fast-food conglomerate McDonald’s is moving its headquarters to the U.K from Luxembourg, which has come under increasing E.U. scrutiny for its corporate tax practices. Should the U.K. attempt to become a giant tax haven, however, the E.U. is likely to further limit access to its financial services sector to British competitors.

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