Yesterday the UK government triggered Article 50 and fired the starting gun on a two-year negotiation towards the UK's exit from the EU. These negotiations will be complex and contentious, and as Goldman writes this morning, the open question is whether they will prove constructive or adversarial.
While Goldman provides an extensive analysis of next steps, including a framework of the three most imporant issues to watch, what we found most useful for readers is the following "Wall Chart" which lays out in clear detail not only what the next two years will look like for the Brexit process, but superimposes on it parallel key events from across Europe.
Brexit wall chart -- The Long March: A crowded schedule for the two-year negotiation
With that out of the way, here are excerpts from Goldman's take on Article 50 and the long march to Brexit, as well as the three main issues to watch:
By Goldman analysts Andrew Benito, Huw Pill and Dylan Smith
Article 50 and the long march to Brexit — Three issues to watch
Yesterday (March 29), the UK government triggered Article 50 and thus fired the starting gun on a two-year negotiation towards the UK's exit from the EU. These negotiations will be complex and contentious. The open question is whether they will prove constructive or adversarial.
In the context of political negotiations in general — and EU negotiations in particular — process is an important determinant of outcome. Keeping track of process is central to understanding whether we will end up with a mutually beneficial agreement or a Brexit that is unnecessarily costly for both sides.
Given each party has its own interests and domestic political constraints, EU negotiations inevitably require an element of compromise. By broadening the set of issues that the contracting parties can trade off against one another, two mechanisms underlying EU negotiations promote such compromise: (1) the principle that "nothing is agreed until everything is agreed"; and (2) the practice that agreement is only achieved at the last moment.
Applying these mechanisms to the Brexit negotiation may improve the chances of a constructive final outcome. But they imply that few concrete decisions will emerge in the coming months. In the meantime, businesses are left in limbo.
We identify three indications that would suggest Brexit negotiations are proceeding in a constructive rather than adversarial manner, increasing the likelihood of a benign outcome:
- Substantial discussions on a broader final agreement (including on post-Brexit trading arrangements) start before agreement is reached on the mechanics of the exit itself.
- The EU-27 show flexibility over the timing (and thus immediate magnitude) of payments to settle the UK's legacy liabilities to the EU, which would avoid them becoming an obstacle to constructive negotiation owing to domestic political resistance in the UK.
- Most importantly, the UK government shows a preparedness to accept ECJ jurisdiction over any transitional phase after Brexit, even if this entails a political climb-down from its established 'red lines'.
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What to watch #1. Whether difficulty in reaching an exit agreement (in particular, over its financial aspects) holds up progress on other dimensions of the negotiation will be an important early indicator or whether the Brexit discussions are amicable or adversarial.
Even if they improve the chances of eventually reaching a mutually agreeable compromise, these two procedural mechanisms come with costs. Businesses have to plan ahead. Lack of any concrete agreement until autumn 2018 at the earliest leaves their decision-making in limbo. Contingency plans have to be activated. From the UK perspective in particular, the risk exists that nothing being agreed until everything is agreed at the last moment leads to a closing of the political barn door after the economic horse has bolted.
A changing political context — in both the EU and the UK
For many continental European politicians, Brexit is an unfortunate and (in their eyes) unnecessary distraction. They have plenty on their plates already: fixing Euro area governance; dealing with immigration from the Middle East and North Africa; facing down the rise of Eurosceptic populism at home; addressing security threats from Russia and the Middle East; and managing the economic nationalism of the new US administration.
In the face of these challenges, progress in deepening European integration has stalled, as tacitly acknowledged at last week's summit to celebrate the 60th anniversary of the Treaty of Rome. The recent Commission white paper was realistic in sketching out scenarios for the future of the EU, where the prospect of further integration was limited. European leaders have publicly (although not uncontroversially) discussed the potential for a "multi-speed" Europe.
There are those on the UK side who believe a fractured and weakened EU will be forced to accommodate British demands within the Brexit negotiation, particularly on immigration issues. While there is validity in this view, we believe an important distinction needs to be drawn between public concern over immigration from outside the EU (which is rising in many EU countries, in sympathy with concerns in the UK) and heightened concern in the UK over immigration from within the EU.
More generally, the sustainability of the EU in its current form is open to debate over the medium term, since it is widely accepted that institutional and governance reforms are needed to make the Euro area more workable. Electoral risks in France and Italy over the coming year cannot be ignored. But even if a troubled EU may create some tactical advantages for the UK's Brexit negotiators, they need to be careful what they wish for: an EU in chaos is directly damaging to the UK's economy and financial system, and is unlikely to constitute a rational and attentive negotiating partner.
Our working assumption is that the EU-27 will continue to operate on broadly the current basis through the two-year Brexit process. We are sceptical that fundamental changes to the EU will take place over that horizon which create greater flexibility to accommodate the UK in a form of associate membership.
In parallel, the political situation within the UK may also be in flux: political uncertainties are not one-sided. PM May's overall parliamentary majority is small. Internal division within the ruling Conservative party over the character of Brexit and the compromises with the EU-27 that are possible persists. Calls for a general election to bolster Ms. May's political position are returning. The weakness of the Labour opposition has re-opened questions about a realignment of political parties.
Moreover, the territorial integrity of the UK is again being questioned. Less than three years after the Scottish referendum, Scotland's Parliament has again called for a vote on independence on the grounds that the nature of the UK union will fundamentally change upon Brexit. Albeit for longstanding historical reasons more than over Brexit, Northern Irish politics is in turmoil. Commitments to maintain a 'soft' border between the north and south of Ireland after Brexit raise questions about whether a similar soft border could be established between Scotland and England, allowing the former to remain within the single market as its government has proposed.
Brexit negotiations will take place in a context of political and institutional uncertainty.
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What to watch #2. Transitional arrangements between Brexit in March 2019 and agreement on a new UK/EU relationship are key. Flexibility on the UK side towards accepting ECJ jurisdiction during this interregnum despite the political climb-down from established 'red lines' this would involve would be a signal that a constructive outcome can emerge.
As Brexit becomes more immediate, parts of the UK government have started to show greater flexibility, at least with regard to the transitional arrangements. In part, this reflects practicalities. While accumulated European regulation and directives (the acquis in Eurospeak) can be transposed directly into UK law via the envisaged Great Repeal Bill, the regulatory authorities to implement those rules in the UK simply do not exist at present. Even if the expertise required is available domestically, creating, staffing and funding those institutions takes time.
Relying on the existing European institutions beyond March 2019 may therefore simply be a matter of necessity in some cases. Recognition of such necessity may open up scope for a constructive compromise for the transitional period despite the political obstacles, and thus for less adversarial negotiations about the final arrangements. But should a hard line be imposed by the Eurosceptic hard Brexiteers, this would damage prospects for successful conclusion of a mutually beneficial final deal.
Agreeing a new trade relationship
The UK government's negotiating position establishes that it does not seek to participate in the EU's single market or customs union. As regards trading relationships, the "deep and special partnership" sought by the UK with the EU after Brexit (to quote from yesterday's letter triggering Article 50) is therefore likely to take the form of an Free Trade Agreement (FTA). But — notwithstanding its name — an FTA represents a significant degradation in the nature of that trading relationship relative to the status quo.
An FTA is likely to neglect trade in services and focus on trade in goods. Unless agreements on services — which typically involve much deeper (and more politically sensitive) treatment of regulation and labour mobility — can be established in parallel, this implies a significant deterioration in the UK's access to EU markets in the services sector within which it has specialised.
By their nature FTAs require local content rules. Otherwise third countries could circumvent trade restrictions of some members of the FTA by exporting to the member with easiest access. (The distinction between an FTA and a customs union is that the former allows participants to run their own commercial policy with the rest of the world, whereas the latter requires adherence to a single common commercial policy.) But policing local content requirements is potentially bureaucratic and invasive.
One way of overcoming the shortcomings of an FTA would be to create sector-specific carve-outs, whereby certain industries or activities are treated on a different basis from the normal rule. Such an approach has been entertained for the UK post-Brexit (e.g., in financial services, where the City of London plays a special role as a financial centre; and/or for the auto sector, where pan-European supply chains are the norm). But defining sectors may prove controversial. As with local content requirements, the bureaucratic process of policing sector-specific deals (and their limits) threatens to be costly in time and efficiency, and thus may mark a significant degradation in trading arrangements to that currently available within the single market.
All in all, the more ambitious the scope and depth of any FTA, the more that it will rely on goodwill and trust among the contracting parties. This is one of the mechanisms whereby the process will determine the outcome of the Brexit negotiation. If trust is lost early in the discussions (e.g., over the financial cost of exit), the more difficult it will be to find a constructive way to address the practical difficulties of policing local content requirements and industry or sector borders, which are likely to be crucial elements of any future trade agreement.
Settling outstanding bills
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What to watch #3. Understandably, the EU-27 will expect the UK to cover the costs of any reliance on EU institutions or programmes after Brexit. Flexibility on the EU-27 side regarding the timing (and thus immediate magnitude) of payments to settle the UK's legacy liabilities — thereby avoiding these becoming a domestic political obstacle to constructive negotiations in the UK — would represent a positive signal for a mutually beneficial final outcome.
The long march to Brexit
Brexit negotiations are complex. Little concrete can or will be finally agreed until the end of the Brexit process. This leaves business decisions in limbo.
We identify three indicators of progress in the negotiations: (1) willingness to conduct exit negotiations in parallel with discussion about the new UK/EU relationship; (2) EU-27 flexibility over the timing of UK payments to meet legacy financial obligations; and (3) UK government flexibility over the jurisdiction of European courts and institutions during any transitional phase after Brexit. We believe these indicators will signal whether a constructive or adversarial approach is being adopted by the negotiating parties.
The immediate reaction to PM May's Article 50 letter has not been constructive. British Eurosceptics have been understandably rigid on the government's red lines, while Germany's Chancellor Merkel has emphasised the EU-27's insistence on sequencing exit negotiations ahead of talks on a new EU/UK relationship. But much of this reflects attempts to harden opening bargaining positions.
If such rigidity were to be maintained into the fall of this year, we would become more concerned that an adversarial negotiation could lead to 'cliff edge' outcome on Brexit, with the likely economic disruptions that would cause. But our base case remains that an agreement can be found for tariff-free trade in goods between the EU and UK, an outcome that would require some flexibility on both sides. Nonetheless, this outcome falls well short of the status quo.