Our Opinion: 2017

Article 50 to be triggered on 29th March

Nine months after the referendum where the UK electorate made the historic decision to the leave the EU, the government is on the verge of starting the process. Following parliamentary approval, Article 50 is set to be triggered on 29th March.

The prime minister, Theresa May, has signalled for some time her intention to trigger article 50 before the end of March, so this should come as no surprise to the markets. More interesting will be the response of the EU which will give its first unified public response.

Negotiations will be long and difficult, whilst it is in both sides economic interest to strike an amicable agreement, as the UK draws to a close its 40-year EU membership. However, the risk that no deal is agreed is high.

The ongoing uncertainty, together with additional uncertainty about whether Scotland holds a second independence referendum, are likely to keep markets volatile However, at current levels, the pound is already discounting a substantial amount of bad news around the outcome of the Brexit negotiations.

The UK is not the first country to leave a European union: that privilege goes to Greenland which quit the EU’s predecessor, the European Economic Community (EEC) back in 1985. However, on this occasion the stakes are much higher. The UK is the EU’s second largest economy, currently com- prising some 14% of the bloc’s GDP. It is also 12.5% of its population, and contributes 15% of the total EU budget. However, trade is where the UK’s relationship really matters. It is well known that 44% of the UK’s trade in goods and services goes to the EU, but the UK is also the EU’s largest trading partner receiving around 16% of the all goods exported.

The EU’s first response to the EU exit bill should be constructive, but firm when it comes to the EU’s red lines – including retaining the four freedoms for single market access (free movement of people, capital, services and goods).

The worst that could happen initially is very slow progress or a temporary stall before the German elections, with faster progress in 2018. In any event though, a full blown EU free trade agreement covering all areas within the two-year timeframe is unlikely. The sheer number of parties involved (27 EU states, the UK, EU parliament, EU Commission, European Council and the European Court of Justice), the importance of UK-EU trade as well as complex processes within the EU make such a scenario highly ambitious – especially when ratification of national parliaments is involved and referendum are called. To achieve such a feat would not be impossible, but it would be unprecedented.

Negotiation dynamics can certainly change depending on the electoral out-comes in France, Germany and Italy. One area where article 50 gives no guidance is on how the negotiations should proceed. As has been reported on many occasions, Michel Barnier, the EU’s lead negotiator is keen to work on the terms of the UK’s “divorce” which will include agreement on the UK’s liabilities before talks start on the future trade relationship. From the UK’s perspective, it is preferable that both talks are held in parallel, not only because of the time constraints, but also because the UK would prefer to use any future payments to the EU as leverage in the discussion on trade.

EU sources have suggested that the UK’s liabilities from leaving the EU could be as high as €60bn – a figure that is likely to be unacceptable to the UK government. If the EU’s opening gambit in these talks is to insist that this bill is settled before trade talks can begin, negotiations are likely to break down very quickly. The House of Lords has recently suggested that the UK would not have any legal obligations to make payments to the EU when it has left the bloc.

However, what is legally acceptable is unlikely to be politically feasible. Walking away from the talks could save the UK money, but it would come at the cost of no trade deal – the hardest of hard Brexits. It is a little too early to conclude that this is the most likely outcome. Economic self-interest should ensure that a deal is brokered that is acceptable to both parties. This will likely look something like a free-trade deal covering goods sectors, and less favourable terms for services. There are likely to be ongoing contributions to some EU projects, and crucially, there is likely to be a transition period from when the UK leaves the EU to implementation of the final deal in order to smooth the process. To be sure, there will have to be compromises – on both sides – for this scenario to become reality – but our sense is that there is scope for such concessions. The Prime Minister has set out her twelve broad negotiating principles in a white paper, but even here it is apparent that there is scope for compromise.

What does it mean for the UK economy?

Over the next couple of years as the UK negotiates its exit from the EU, trade with the single market will be on the same basis. However, although the existing trade agreements will not change, the behaviour of firms and households might, especially when it comes to investment. Business investment in the UK has already slowed, falling in both the third and fourth quarter of last

The reasons for this are likely to be many, but survey data has on occasion pointed to uncertainty over the outcome of the Brexit negotiations as a factor that has compelled firms to hold back on investment. There have also been a number of high profile investments into the UK since the referendum which confirms the reality that the UK is, and will continue to be, an attractive place to invest in, no matter what the outcome of the negotiations. Nevertheless, if the negotiations look to be proceeding in the direction where a trade deal looks unlikely, this could encourage firms who use the UK as a base to export to the EU to begin to look elsewhere.

As for the long-term outlook, it is difficult to put a precise number on the impact as the end relationship with the EU, and the rest of the world are as yet unknown. Undoubtedly, Brexit presents opportunities as well as threats to the UK’s growth rate. If the UK fails to strike a trade deal with the EU, the government will use all of its new found freedoms to make the UK a competitive place to invest (e.g. tax, regulation, investment incentives), which could offset some of the negative impact.

Triggering article 50 this month is unlikely to create much volatility in the markets in the short-term as it is widely expected by markets. However, how the negotiations unfold will be crucial.

Uncertainty is likely to remain elevated in currency markets as clarity on crucial decisions together with a relatively firm timeline against which to measure any progress are unlikely to be forthcoming. Markets have to be braced for the very real possibility that any deal is only agreed at the last possible moment given the potential wealth of diverging opinions around the negotiating table.

20th March 2017