Brexit: Keep Talking
- The mandates of Barnier and Frost don’t ‘click’, no matter how long they keep talking. As the talks go down the wire, political intervention remains necessary to break the deadlock
- The video call between Johnson and Von der Leyen was a foretaste of things to come; it seems reasonable to expect that direct involvement from Merkel and Macron will be required
- Johnson claims that the UK would ‘prosper mightily’ without a trade deal, but his problems with coronavirus and a looming rise in unemployment need to be offset by some successes
- The gaps on fisheries, level playing field and governance are not unbridgeable, but the tight timetable may prompt a further increase in no-deal rhetoric and preparations. The October 15 deadline isn’t set in stone, and very likely to slip even, adding to fears of no-deal
- A limited trade agreement remains our base case, but there is a non-negligible chance that the talks collapse. This will mean that trade between the EU and the UK will fall back on WTO terms
Short and sweet…
The ninth round of negotiations concluded on October 2. As usual, the two negotiation teams subsequently produced a statement to provide their version of events. There were no major differences in tone or substance relative to their previous statements. The statement by the UK’s negotiator David Frost can be found here; the statement by the EU’s negotiator Barnier can be found here.
The UK says that there has been ‘some limited progress’ on state aid, but that the gap on fisheries was ‘very large’; the EU sees some familiar ‘points of convergence’ as well as ‘persistent serious divergences’ on the well-known issues that were already identified in February (i.e. fisheries, level playing field, and governance). Both parties warn that little time is available to resolve these issues – again this has already been a point of concern for quite a while. The clock is indeed ticking.
Even though there has been gradual progress over the past couple of months on a broad set of topics, it’s clear that the two parties have been going around in circles on the three key issues: state aid, governance and fish. The two negotiating mandates –which were already published in February– are incompatible, and the negotiators need explicit political backing to override these mandates. An intervention like this, with all the associated news reports of ‘concessions’, ‘forfeits’, ‘climb downs’ or ‘U-turns’, is never likely to happen earlier than one minute to midnight. Keep in mind that the narrative of the deal is just as important as the content of said deal. The electorate doesn’t really care about the nitty-gritty details of state aid. What matters instead is the public perception that the government has their interests at heart and is willing to put up a fight to defend these. This is even more true, logically, if eventually no deal is being reached at all.
In the weekend that followed the ninth round of negotiations, UK Prime Minister Johnson and European Commission President Von der Leyen finally moved the negotiations into the political orbit. Even though it was a far cry from the game changer that such a moment could potentially have been, their joint statement was short and sweet:
The President of the European Commission, Ursula von der Leyen, and the UK Prime Minister, Boris Johnson, spoke today about the state of play in the negotiations on the future relationship between the UK and the EU.
They agreed on the importance of finding an agreement, if at all possible, as a strong basis for a strategic EU-UK relationship in future.
They endorsed the assessment of both Chief Negotiators that progress had been made in recent weeks but that significant gaps remained, notably but not only in the areas of fisheries, the level playing field, and governance.
They instructed their Chief Negotiators to work intensively in order to try to bridge those gaps.
… or not?
This statement has injected some new life into the negotiations, which are held in London and Brussels this week and next, yet it remains unlikely that the teams of Frost and Barnier suddenly find ways to break the deadlock ahead of the 15-16 October European Council meeting. Even though the UK has set this date as their own (artificial) deadline for the trade deal, it appears increasingly unlikely that said deal will be fully agreed at this summit. Instead, it would be a very positive signal if the political leaders conclude that almost all necessary elements are in place for a deal at a later point in October or November. Such a statement would allow the negotiators to commence the intensive ‘tunnel talks’ shortly afterwards and, if all goes well, to wrap things up in the ensuing couple of weeks. That would be the most positive scenario.
Although time needs to be reserved for ratification, further delays are also possible. There have been reports suggesting that European leaders want to see Prime Minister Johnson to get more ‘personally involved’, to be more ‘into the details’, and to show that he really wants to find the big trade-off that cuts this Gordian Knot. So we might need to live through more political drama first, before such a scenario eventually unfolds. It has also been noted that there is another EU summit planned for November 16. While this summit is scheduled to discuss Europe's ties with China, there has already been speculation that the EU-UK trade deal could be added to the agenda. However, even when a deal will be concluded at such a late point in time, we could reasonably expect lots of anxiety, market volatility, and the activation of numerous no-deal contingency plans first.
Cutting the Gordian Knot
How could the EU and the UK cut the Gordian Knot? Allow me to speculate:
Firstly, we have to keep in mind that the UK has been one of the main architects of the existing set of EU state aid rules. So in spite of all the talk about ‘absolute sovereignty’ and ‘taking back control’, it is pretty reasonable to expect that most Tories would ultimately be fairly content with a commonly agreed set of rules. Simply put: Conservatives generally don’t like the idea of taxpayers’ money being used to bail out failing companies, or believe in the state’s ability to pick winners in the market for start-ups. See for instance Chancellor Sunak’s commentary here. But there are internal divisions: Johnson’s adviser Cummings pushes for a more light touch version of state aid rules. You would wonder why, as the policy response to the Covid-19 crisis has demonstrated that both the UK and EU countries have experienced enough flexibility in their state aid regimes. These temporary relaxations are now likely to be extended until 30 June 2021.
Having said that, we also have to keep in mind that the UK has already signed up to tougher-than-WTO restrictions on state aid through its FTA with Japan. This signals that there is room to deviate from the current negotiating position. The dispute instead appears to be focused one the governance of these rules: it is politically toxic for the Tories to accept direct oversight from the European Court of Justice, having railed so hard against it. Something more pragmatic and nuanced will have to be put into place that provides the legal certainties the EU needs to protect the integrity of its Single Market, and allows the UK government to claim that the ECJ has no influence on UK domestic laws and policies. This is not impossible if the UK’s Competition and Markets Authority becomes a state aid regulator.
Secondly, something needs to be done on fish. Pardon my French, but it would be very silly if an EU-UK trade deal collapses on an industry that makes up such a small part of the economy, no matter how sensitive the topic is to certain interest groups. It seems reasonable to expect the EU to eventually back down from its original position that it wants to uphold the same level of access for its fishing fleets. It has to accept the reality that the UK has left the Common Fisheries Policy and that it can enter into its own fisheries agreements. Of course, EU politicians from coastal states will be under pressure not to make any substantial concessions, so any new model would need to be massaged, managed and implemented gradually and carefully. The UK has already offered a three-year transition phase to allow EU fleets to adapt to these changes, and this could help to kick the fish can a bit further down the sea lane.
So a deal could be done if the EU is seen to have compromised on fisheries, and the UK is seen to have compromised on state aid. This would help to get a trade deal over the line, and the politicians can re-focus on getting their economies back on track in 2021. This will be difficult enough even if an FTA is concluded: it can’t be stressed enough that the ‘economic distance’ between the EU and the UK will increase and that this is expected to have significant ramifications for the UK’s economic outlook.
The above, of course, is just one possible narrative… it surely won’t be as simple as this.
What about the Internal Market Bill?
The UK’s Internal Market Bill gives ministers the powers to breach certain parts of the Northern Ireland protocol, such as on state aid and customs duties. As this protocol is part and parcel of the Withdrawal Agreement, an international treaty, the bill immediately ran into domestic and international controversies. Ministers admitted that the legislation breaches international law, but it still passed the House of Commons with a comfortable margin (340 vs. 256). The bill is not yet law. It will still face scrutiny in the House of Lords, where the government does not have a majority. The second reading of the bill is scheduled for October 19. There will be Committee stages in the ensuing weeks (see here) before the Lords will have a final vote in November. This delayed timetable fuels speculation that the contentious parts of the bill were primarily included as a way to increase leverage in the EU-UK negotiations.
The tensions over the bill remain, but so far these haven’t really derailed the trade talks. It is still being treated separately, even as there is a link between the eventual deal and the relevance of the most contentious parts of the bill. When the EU’s deadline to remove these parts lapsed, the Commission published a “letter of formal notice”. It has now given the UK government until the end of October to “submit its observations”. If this response is unsatisfying, the Commission will issue a “reasoned opinion”, to which the UK would have yet another two months to reply. By then, the transition period will also have ended, and we will know whether these contentious parts of the bill are really relevant or not and what/if the Lords have done to amend this bill.
The British economy faces a trifecta of risks this winter, stemming from new virus restrictions, the realities of Brexit, and an imminent rise in unemployment. These risks are the subject of news reports day after day, which hurts confidence. It is not surprising at all that Prime Minister Johnson’s popularity is also rapidly declining. In fact, after leading the Tories to a landslide victory in the 2019 election, a variety of surveys shows that Johnson is in a dire situation. The Conservatives have polled behind Labour for the first time since he became prime minister. One poll surely doesn’t make a trend, but it’s clear that the Tories have seen their lead vanish. Within the ranks, Johnson’s ‘satisfaction rating’ has also plummeted to new lows. And a national poll from YouGov shows a similar trend: the “rally round the flag”-effects have more than faded. Boris Johnson may have wanted to be remembered in history as the one who ‘levelled up’ the country and ‘got Brexit done’, but he will mostly be associated with the pandemic and all of its tragedies. Is Brexit still a hill worth dying on in these circumstances? You wouldn’t say so, judging by figure 2, even when going hard on Brexit yielded the ‘Red Wall’-voters that gave him the win in 2019.
And the markets?
A final look at the markets suggest that investors are retaining their composure. The currency generally oscillates between EUR/GBP 0.89-0.92, a bandwidth that has become familiar territory over the past couple of months (and, frankly, ever since the referendum). Given the uncertain economic and political backdrop, we see scope for only a half-hearted recovery in the pound even when the negotiators conclude a trade deal. We would therefore look for EUR/GBP to be positioned at 0.89 on a 6 month horizon.
If the UK faces a scenario of WTO rules on trade with Europe, this would exacerbate the political and economic uncertainties. In such circumstances, a negative Bank rate could also not be ruled out. Although such a scenario is certainly not our base case, the mixture of negative interest rates, current account deficits, and significant uncertainties could eventually propel EUR/GBP towards parity.
The front-end of the yield curve has steadied in recent weeks, although bets on negative policy rates do tend to pick up on no-deal related headlines. Figure 3 shows that inflation breakeven rates –relative to the USD– have fallen a bit, after climbing to the highest in a year when investors worried over the legal shenanigans of the Internal Market Bill. It is generally expected that the decline in the pound will show up as faster inflation, in similar fashion to what we’ve seen after the 2016 referendum. Especially in the current economic situation, a sudden depreciation of the currency would have stagflationary effects.
Going into the finale of the negotiations, GBP options therefore remain skewed to the downside, with out of the money puts being more expensive than comparable out of the money calls (see Figure 4). This reflects the skewed balance of risk between a large appreciation (limited) and a large depreciation (real) of sterling.