Irish border remains the ultimate stumbling block for Brexit
As things stand, the UK will exit the EU on March 29th 2019, as set out in the terms of its EU Treaty Article 50 declaration. Long drawn out negotiations between the UK government and the EU produced an agreement before Christmas on a withdrawal agreement and a broad outline of future trading relations. However, the UK government was unable to obtain support in the British Parliament for this agreement, leaving the process in limbo. A clarification of the deal aimed to ease concerns in the UK that the wording of the withdrawal agreement could mean that in certain circumstances the UK could be permanently trapped in the EU was agreed between UK and EU negotiators on March 11 and was presented to the British Parliament for ratification on March 12. However, this proposal has been rejected by a large margin of 391 no-votes against 242 yes-votes.
With just over two weeks to go before the scheduled exit date, the margin of the Government defeat might suggest that a ’crash out’ Brexit is all but inevitable. For this to be avoided a level of political realism not evident in the UK to this point will need to emerge. That said, as the debate is mainly concentrated on the Irish border rather than on a wide range of issues, we believe a deal is still possible with further ‘clarifications’ or re-structuring of commitments around the Irish border. Therefore a ‘softish but not smooth’ Brexit remains KBC’s base scenario.
If no deal can be agreed in the coming weeks, this would produce a ‘hard Brexit’ in which trade in goods between the UK and all other countries (including the EU) would occur under World Trade Organisation rules entailing significant tariffs and other barriers to trade. While we don’t have full details on new proposals emerging from the UK in this regard, a brief consideration gives some sense of the scale of technical difficulties that could arise in addition to the adverse macroeconomic impacts of such a major change in trading conditions.
On March 13th, the UK proposed a temporary twelve month postponement of WTO tariffs on a wide array of goods but, significantly, tariffs would be applied in many areas including food and cars imported from the EU. It is suggested that this could lead to a price increase of 10% in prices of cars imported from the EU and significant increases in the prices of many foodstuffs. However, uniquely, these tariffs would not apply to goods crossing into Northern Ireland from Ireland. While the UK has spoken of its intention to use an ‘honesty box’ approach to this cross border trade, this creates huge scope for trade arbitrage and related distortions such as smuggling. It is difficult to see how the EU could protect the integrity of the single market while mirroring this UK approach. More generally, the EU might have significant problems adopting temporary deviations from WTO tariff in line with the new UK proposals. So, the future UK-EU trading relationship under these proposals seems all but unworkable.
Reflecting the range and scale of difficulties the new UK proposals suggest could be attached to a ‘hard Brexit’ regime, most analysis suggests that the costs of Brexit to the UK and its trading partners would be sharply diminished if some formal agreement that avoids a movement to a WTO style trading framework can be reached. Such alternatives are described as the so-called ‘soft’ Brexit option.
Political difficulties have made getting UK parliamentary agreement and approval of a Brexit negotiating position extremely difficult. Following the crushing mid-January defeat in the UK parliament of the withdrawal agreement agreed between Prime Minister Theresa May and the EU after nearly two years of negotiations, the default option is that the UK is now scheduled to leave the EU on March 29th without any exit deal unless some agreement acceptable to a very divided UK parliament can be reached with the EU. Following tortuous negotiations between the UK and EU, a set of documents was agreed on March 11 that is intended to address UK difficulties in relation to a ‘backstop’ that would ensure that a hard border is avoided between Ireland and Northern Ireland (which is part of the UK). The significance of this issue is largely related to a determination to sustain a peace agreement following a period of violence in Northern Ireland, but the Irish border would also be the only land border between the EU and UK. As this new clarification hasn’t been passed by the House of Commons at the first attempt, several further ‘tweaks’ may be attempted in the next week or so.
Consistent EU may lose its patience
So far, the EU position has been consistent, but patience with the UK may be wearing thin. The UK Parliament is scheduled to vote on March 14th to request an extension to the March 29th exit date. The EU has indicated that the remaining EU27 would be willing to agree to a request from the UK for a temporary delay to Brexit, meaning the UK will not ‘crash out’ of the EU at end March. Moreover, the European Court of Justice ruled the UK can unilaterally revoke the Brexit process, but only through an ‘unequivocal and unconditional’ decision, implying any delay or postponement of the exit date must be agreed unanimously by the remaining 27 EU members. The upcoming EU parliamentary elections in May mean that a long extension would require that the UK took part in these elections and sent members to the new EU parliament. Consequently, any extension is likely to be only for a couple of months
Markets don't go for no-deal scenario
Markets take the view that some sort of ‘fudge’, likely entailing a delay in Brexit, will occur. Financial markets strongly hold the view that the UK will not crash out of the EU at the end of March, because there is a strong consensus that this would be hugely damaging to the UK economy as well as to many EU economies albeit to differing degrees. It is also clear from the history of relevant votes in recent months that there is a majority within the UK parliament opposed to a ‘no deal’ Brexit. The problem is that there also appears to be a majority against all other proposed alternative options and no immediately obvious mechanism to ensure that the UK avoids exit from the EU without a deal at the end of March.
Our KBC economic scenario continues to be that some ambiguous wording can be found that will be sufficient to deliver a withdrawal agreement. In this context, in spite of the heavy defeat in the UK parliament on March 12th, the March 11 documents provide at least a template for some form of wording that offers sufficient clarification and comfort to the UK on the backstop’s non-permanent nature and on some possible mechanisms and timescale for its removal. This would allow a withdrawal agreement to be reached entailing a short delay of a couple of months to allow enabling legislation to be passed in the UK. Such an agreement would likely also incorporate a ‘transition’ or ‘implementation’ period of up to two years. This would permit a short timeframe for negotiations on the UK’s future relationship with the EU to be progressed if not completed. These subsequent negotiations are likely to take place against a background of political difficulties in the UK because of deep divisions within the major political parties about the preferred future trading relationship with the EU. Such difficulties are likely to weigh on sentiment and investment decisions in the UK and its main trading partners. Hence, we characterise our central Brexit scenario as ‘softish but not smooth’, but we caution that circumstances are changing rapidly and markets are probably too optimistic in entirely ruling out the possibility of ‘no deal’.
While a range of indicators suggest the UK economy is seeing some negative impact from Brexit related uncertainty in areas such as consumer sentiment, home-buying and business investment, growth overall has remained modestly positive if slower of late. The initial estimate of monthly GDP growth did fall unexpectedly in December but rebounded in January. The outlook for the coming year is very unclear because of continuing uncertainty about the timing and manner of the UK’s proposed departure from the EU. However, if a withdrawal agreement is reached, GDP growth for 2019 should be close to 1.5%. If no deal is struck, GDP growth is likely to be negative. Market expectations could change quickly and repeatedly because of notable difficulties in arriving at a workable compromise mean that the next month could see Brexit concerns causing further volatility but this bumpy path is broadly consistent with our long held expectation of a ‘softish but not smooth’ Brexit process.