Brexit – Is No Deal the Only Deal?

 

Currently it seems like no deal is a most probable outcome for the upcoming Brexit negotiations. No deal seems to work for everyone – EU Commission never has to show how far its willing to accommodate countries exiting the union; UK would not have to pay the “exit bill”.

Where are we today?

On March 29, Theresa May triggered Article 50 of the EU Treaty. Clock for Brexit started ticking. On March 31, Council of the EU released draft guidelines for Brexit negotiations. Both of those events are really more procedural and their content was fairly easy to script.

First opening shot in actual negotiations was fired by the EU parliament on April 5. EU Parliament adopted a resolution demanding that UK “abide by its budgetary obligations”, meaning exit bill needs to be settled before exit negotiations can begin. EU Commission is estimating the UK’s exit bill to be around 60 billion euros, roughly 3.5 years worth of UK’s contributions to the EU budget.

Is no deal better than a bad deal for the UK?

To analyze the scenarios for the UK, we need to first put a reference framework around possible outcomes and likelihood of each outcome.

Brexit outcomes diagram

Diagram above outlines outcomes and their probabilities. It also shows that there is a limit to how bad of a deal is UK willing to accept, that is what Teresa May was talking about in January. No deal means that trade relationship between the UK and the EU reverts to World Trade Organization rules; most favored nation WTO tariffs are imposed on imports on both sides of the border.Trade relationship under WTO rules would not be so bad for the UK; it is reasonable to expect that tariffs imposed would be offset by depreciation of GBP vs Euro. Great deal would be for the UK to cherry pick privileges while not assuming any of the obligations of EU membership. This is highly unlikely outcome, the EU would unravel and EU Commission would be powerless to stop it. So somewhere in between lies the possibility for a deal.

What will likely to happen and why?

EU commission wants the Brexit to be as painful as possible – this will hopefully act as a deterrent for others to follow the UK out of the union. However, the EU Commission will have to balance economic interests of EU members countries with its political goal of maximizing the pain of Brexit, not an easy task when there are 27 different constituencies.

UK’s negotiating position is much simpler since the UK does not have two competing interests – most favorable deal possible is the main and only objective, there are no competing objectives or the need to send a political message.

EU Parliament’s demand for the settlement of the exit bill before negotiations on the status begin was a wrong way to start the negotiations for the EU, as the EU Commission is the party with least leverage:

  • With no deal on future UK contributions EU Commission will need to make an adjustment of around 9% of its total spending, meaning it will either have to cut spending by 9% or increase member contributions by the same amount or find some solution in between. Whichever solution is pursued it will be unpopular with member countries.
  • It is reasonable to assume that future UK contributions would be contingent on the deal struck – the more favorable the deal to the UK the more UK will be willing to pay its exit bill and to continue to contribute to the EU’s budget.
  • Current UK contributions are equivalent to around 1% of UK government’s spending, relatively small amount giving plenty of room for the UK government to negotiate.

By trying to disconnect contributions and the overall negotiations EU’s approach is destined to fail. EU is in effect saying “pay for something, but we do not really know what”. Generally in any transactions there is a price; but there’s also a pretty good understanding of what is being bought. By agreeing to pay the exit bill UK is not sure what it is buying, this is a difficult way to proceed. However, this approach also shows the full difficulty of EU’s position. Asking UK for money is the only part of the exit negotiations that EU Commission can probably muster an agreement with EU member countries. Reaching consensus on the details of future relationship is going to be very difficult for the EU internally, maybe even impossible.

Easiest deal for the EU Commission is to stall negotiations and run the clock. Problem of Brexit would solve itself, difficult and potentially dangerous conversations with member states would be avoided. It is reasonable to expect that member states are paying attention to what concessions EU Commission is willing to offer and are weighing those against their own interests. Interests that might include possible exit negotiations in the future.

It is very early in the process to be confident of the outcome but at the moment no deal outcome is highly likely. “No deal is better than a bad deal” is true, Mrs May knows that no deal might be the only deal EU can offer.

UK vs EU, let’s look at the numbers

Brexit negotiations are about to begin. Certain voices inside the  EU Commission are advocating adoption of a hard line against the UK. Specifically re: future trading arrangement.

Couple of things need to be taken into account when negotiating positions are analyzed:

i) GBP vs Euro exchange rate
Screen Shot 2017-03-19 at 12.17.53 PM

GBP is down 17% vs Euro since January 2016.

ii) Big Mac Index – implied currency valuation

Big Mac

Euro is approximately 10% overvalued

iii) Inter EU largest trading partners

UK is either second or third largest export market for: Denmark, Germany, Ireland, Spain, Italy, Cyprus, Malta, the Netherlands, Poland, Sweden – that’s roughly a third of the EU.

iv) UK trade balance of goods with the EU

UK trade w EU

UK is a net importer of goods from the EU.

v) WTO tariffs for major UK exports to the EU

WTO tariffs.png

Assuming that should there be a “hard” Brexit, tariffs would revert to WTO levels.

What do these numbers tell us?

In January Theresa May said:”I am equally clear that no deal is better than a bad deal”. Is she right? If we look at the figures above then it would look like she is right. In case of “hard” Brexit, it is logical to assume that WTO rules would govern trading relationship between the UK and the EU. If we look at import duties across the major UK exports, we can see that general rates are much lower than the implied over-valuation of Euro vs GBP. All this means that UK’s competitive position at current exchange rates would not be eroded if there is no deal and WTO level tariffs are applied against UK exports to the EU.

EU’s leverage over the UK is limited, unless EU decides to go nuclear and unilaterally increases customs duties above WTO levels. How likely is that the EU will take a hard line? If the decision is left to EU Commission in Brussels, then it should be expected that hard line will be taken. EU Commission is currently demanding that UK should agree to pay some 60 billion euros as part of its exit bill, and that is before any negotiations even start! Seems like a huge arbitrary sum of money that has very little chance of getting paid, for starters it is very unclear which court would even have jurisdiction over such a demand. This demand in itself could stall the negotiations with WTO rules automatically becoming a de-facto new trading standard after 2 year negotiations period has expired. If WTO tariffs become the standard, UK would end up with a pretty good deal, while EU’s exporters to the UK would be hurt.

More likely scenario is for the EU Commission to feel pressured by the EU exporters to make an economic deal that will maintain EU’s access to the UK’s market at preferential rates, especially in a weak GBP environment. When we analyze where will the political pressure come from – Germany, Denmark, Italy, Spain, Sweden – it is reasonable to expect that EU Commission will give in to the pressure. Commission’s interest and national interests do not align if we assume that Commission will want to make a political statement while national governments will have to live with the economic consequences of such political statement, possibly a gamble too risky for national governments to take.

Overall, UK’s position going into the negotiations is pretty solid, that position only looks better if free trade deal with US is a possibility. This analysis begs the question:”Who is next?”