RaboResearch - Economic Research

Brexit update: "There is no free lunch", but we all want it

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  • Prime Minister (PM) May’s long-awaited key speech on the future relationship with the EU provided a bit more clarity on the government’s preferred Brexit end-state, but brought few new insights.
  • The British government reiterated its interest in maintaining current rights and obligations in some sectors while diverging to various extent in others; it also reiterated well known demands such as autonomous legislation and trade policy and no hard Irish border.
  • The speech failed to address key concerns of the EU, as illustrated by the EU Council‘s negotiation guidelines for the post-Brexit partnership with the UK; the guidelines were published only a few days after May’s speech and position the EU at far distance from the UK ahead of the 22-23 March EU Summit.
  • Labour’s move on 26 February to officially support a permanent customs union with the EU could affect parliamentary dynamics to PM May’s disadvantage if Labour and pro-EU Tories were to join forces.
  • Our base case for the post-Brexit partnership agreement remains a transition period followed by a Free Trade Agreement; though Labour’s official endorsement of a customs union tilts the probability of it being included in the agreement.

Co-author: Jessica Saat

PM May shows more realism, but few new insights

On 2 March Prime Minister Theresa May gave her long-awaited key speech on the future relationship with the EU at Mansion House. Her speech came across as more realistic than previous ones, as she recognized some of the consequences of leaving the EU. For example, she acknowledged that it would have consequences for market access, that the European Court of Justice (ECJ) will continue to affect the UK and that the UK would have to make some binding commitments in order to get a trade deal. But she also reinforced the red lines, such as the sovereignty of the UK parliament and UK’s autonomy in trade policy. Also clear from the speech is the fact that PM May wants to reach a deal with the EU, which is positive for reducing uncertainty around the future business environment. Although PM May provided a bit more clarity on the government’s preferred Brexit end-state, she did not bring many new insights. Theresa May has been under pressure to meld together competing visions of Brexit in her own party and by summoning her cabinet to the PM’s country resident in preparation for her speech, she has avoided another public row within her party for now.

The speech also failed to address key concerns of the EU, as illustrated by the EU Council‘s negotiation guidelines for the post-Brexit partnership with the UK published on 7 March 2018. The council reiterated that the British red lines constrain the possible future partnership to a Free Trade Agreement (FTA), one that could be negotiated once the UK is no longer a member state and which cannot offer the same benefits as membership or “amount to participation in the Single Market or parts thereof” as the four freedoms of the Single Market - the free movement of goods, services, capital and people - are indivisible The EU proposes zero tariffs, zero quotas, but also rules of origin and appropriate customs operations on goods. The envisaged trade agreement would thus reduce UK’s access to EU markets and increase trading costs.

There is some common language between May’s speech and the EU council’s guidelines, such as the right balance between rights and obligations and a level playing field. But, as the two negotiating parties jockey for position ahead of the 22-23 March EU summit where the EU27 is expected to sign off the negotiation guidelines, the distance to be bridged remains huge. The vote would pave way for trade talks in April, but there is a serious risk that they will start in a stalemate.

No off- the-shelf model is not the same as cherry-picking

PM May repeated that the off-the-shelf trade models are not suited for the UK and stuck to her demand for a creative, tailor made deal with the EU. On the one hand, the Norway model is rejected as it wouldn’t allow the UK to end the free movement of persons and the jurisdiction of the ECJ. On the other hand, the EU’s free trade agreement with Canada (CETA treaty) is also found an inappropriate model as it would provide insufficient access to each other’s markets, as customs and border checks would damage integrated supply chains and as it would lead to a hard border between Ireland and Northern Ireland. Consequently, PM May is arguing that a tailored approach is in the best interest of all parties involved. Moreover, in response to EU’s accusations of “cherry-picking” she argues that every free trade agreement could be labelled as such as it has various levels of market access defined by the interests of the countries involved. Instead, she reinforces that the UK does not want a deal where UK’s rights and obligations are not held in balance.

Recent remarks of German Chancellor Angela Merkel have opened the door for a tailor made Brexit deal. The EU’s negotiation guidelines also do not close the door for such an option, stating that the Union is prepared to reconsider its offer if the UK position was to evolve. Nevertheless, May has failed to alleviate key concerns of the EU, as the guidelines explicitly label a sector-by-sector participation (see details below) as “cherry picking” and reject it as being a threat to the integrity and functioning of the Single Market. In order to strike a more comprehensive trade deal with the EU, the UK will probably have to make a trade-off between regaining sovereignty and access to the single market, though the EU might also compromise to some extent. However, we believe that the UK will be the one that has to make the largest concessions as the disintegration of the Single Market is a much bigger threat to the EU than Brexit.

Managed divergence and mutual recognition

To maintain close links to the EU Single Market, PM May suggests a comprehensive system of mutual recognition which would preferably imply that legislation would not be identical to the one in the EU but would lead to the same outcomes. Moreover, PM May also preserves the UK parliament’s right to diverge from EU regulation if seen fit in the future, while acknowledging the consequences for the access to EU’s markets. We note that this option would translate to high uncertainty for long term business decisions. Also, the EU has rejected mutual recognition outside the Single Market in the past, though the recently published guidelines do not specifically refer to it.

For some sectors the UK envisages maintaining the current close ties. For example, the UK wants to participate or become an associate member of the European Medicines Agency, the European Chemicals Agency and the European Aviation Safety Agency, sectors in which the UK has a leading position. This would be positive for business, as it ensures continuity and access to EU markets. However, the EU Council negotiation guidelines rejected such an option, as the Union wants to maintain its autonomy in decision making and that “excludes the participation of any third party countries to EU institutions, agencies or bodies”. On the other hand, the EU guidelines do express the intention to ensure aviation connectivity with the UK. We note that current agreements that give third countries access to the Common European Aviation Area imply the adoption of the EU acquis communautaire for aviation and ECJ oversight and thus cross the British “red lines”. PM May also proposes closer ties for energy, transportation and science and innovation. In other sectors the UK wants to be able to deviate more substantially, like in agriculture and fisheries, a proposal that was directly rejected by the EU Council in their guidelines. The UK does not intend to pursue financial services passporting rights, but does want a deeper and more comprehensive partnership than existing ones. The EU on the other hand does not mention financial services, but says the trade agreement should allow market access under host state rules, in line with UK becoming a third country after Brexit. Leaving out financial services can be interpreted as either a tacit disapproval of the British proposal or maintaining all options open.

The sensitivity of the Irish border

The Irish border remains a major problem in the negotiations. In her speech, Theresa May acknowledged that it is the UK’s responsibility to help find a solution and avoid the return of a hard border in Ireland, but was not able to provide a concrete and realistic solution to prevent that. The sensitivity of the issue is illustrated by the fact that the Withdrawal Agreement draft that the EU published last week triggered fierce responses amongst UK politicians, while the document was a mere translation of the December 2017 agreements on the withdrawal to a legal text. Namely, the text indicated that Northern Ireland would remain aligned with EU regulation on free movement of goods if the UK and the EU failed to find a solution for avoiding a hard border in the island of Ireland through a free trade agreement or modern technology. In practice, this means that Northern Ireland would remain in the European Customs Union and that would create a hard border in the Irish Sea if the rest of the UK left the Customs Union. The suggestion of a border in the Irish Sea is unacceptable to the Democratic Unionist Party (DUP) - whose support provides Theresa May’s Conservatives a parliamentary majority – as they are opposed to Northern Ireland being treated differently from the rest of the UK.

Global Britain versus European Britain

Theresa May spoke about a “customs partnership” and a “customs arrangement” as viable options for avoiding border frictions, but rejected a customs union. In the EU customs union all members share the same external trade policy (apply the same tariffs to goods from the rest of the world). But the UK wants to be able to close free trade agreements with non-EU countries, which is not possible if the UK would remain in a customs union with the EU. Trade agreements with the rest of world are a key element of the Conservatives’ Brexit-backers’ policy of a “Global Britain”.

However, pro-EU Conservatives who do prefer the UK to remain in a/the customs union might join forces with the Labour party. Labour changed the dynamics in the UK’s domestic Brexit politics on 26 February when their leader Jeremy Corbyn announced that his party supports a permanent customs union after Brexit. Pro-EU Tories had already tabled an amendment to the Trade Bill calling for the UK to remain in a Customs Union and Labour’s new stance could lead to enough cross party backing in parliament, thereby pushing May towards a Brexit deal that keeps the UK in a customs union with the EU. The UK parliament votes on the Trade and Customs Bills have been postponed until April, and might even be delayed until after the local government elections on 3 May 2018.

This shift in support for a customs union with Europe would make sense in our view, given that the EU is by far the largest trade partner of the UK. Moreover, such an arrangement could help in preventing a hard border between Ireland and Northern Ireland. But if Theresa May makes a concession on this point, she could lose the support of hard-line Tory Brexiteers, who could challenge her leadership. A humiliating defeat on the Trade Bill or the Customs Bill could also result in Theresa May resigning. Perhaps Labour’s endorsement of the customs union is an attempt to capitalize on the rifts within the Conservatives party and trigger an early election. However, given the Conservatives’ poor performance in recent polls, it is questionable whether enough Tories would support a motion of no confidence or a motion for an early election needed to trigger them.

Our baseline view

Considering all the above we are maintaining our base case of a transition period until 31 December 2020 followed by a Free Trade Agreement somewhere between the EU’s deal with Canada and the agreements with Switzerland. We do note that Labour’s endorsement of a customs union increases the odds of a customs union after Brexit. But it also increases the odds of more tensions in British politics that could even trigger an early election. A customs union or even membership of the European Economic Area, like Norway, or a 'hard' Brexit also remain possible outcomes. The persistency of issues such as the Irish border also remain a threat to an orderly Brexit. With just a year to go before the UK leaves the EU, any further delays of the negotiations can become problematic.

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