Our Opinion: 2017

Deal or no Deal?

With Brexit talks apparently at an impasse, talks of “no deal” are echoing again. The main sticking point seems to be money – the PM’s opening gambit of €20bn to plug the hole in the EU budget created by the UK leaving got short shrift. The Prime Minister is unlikely to offer any more until some sign of what the UK is being offered in return emerges. The EU is unlikely to show what is on offer (although leaks are likely), until it sees more money.

While a “no deal” scenario is unlikely, it is undoubtedly possible. The charged political atmosphere seems to have calmed, but it could easily arise again. This could cause talks to stutter temporarily in the next month or so. It is in both sides’ economic interest to seek an alternative that would see the UK enter a transition arrangement with the EU after March 2019. However, politics rather than economics could result in the UK leaving the EU without any deal.

Without confirmation of the likelihood of a transition deal in the next few months, companies based in the UK who operate in EU markets would be forced to exercise contingency plans for a no-deal scenario. This would likely mean relocating staff and redirecting investment away from the UK, which could be negative for economic growth.

Following round five of the Brexit negotiations, the impasse was clear. Theresa May’s valiant efforts behind the scenes to persuade EU leaders to allow the negotiations to progress from discussing the terms of the divorce, to the future relationship, did not succeed. It wasn’t all bad news though for the UK – the EU27 agreed to begin discussions among themselves about trade and transition. This gesture was no doubt given in recognition of the Prime Minister’s difficult political situation at home. Nevertheless, sufficient progress has not been made for now, and therefore talks between the UK and EU about the future will be delayed.

This outcome is not necessarily surprising – expectations of progress had
been low going into the October meeting – but it does up the pressure that
the two sides ensure sufficient progress can be achieved ahead of the next
EU Council meeting in December. For this, they will have to stick to their commitment to “accelerate” negotiations in the weeks ahead.

A commitment to speed up negotiations is one thing, but actions speak louder than words. A negotiation normally requires the sides to “negotiate,” of which we’ve seen little in the first five rounds of talks. The EU clearly has the stronger hand to play, not only in trade (given the size of the economy relative to the UK), but crucially in time. Thus far, the EU has, as expected, used this advantage by offering few compromises.

While wearing a brave face, the UK side has implicitly acknowledged its weaker hand. First in terms of sequencing of the talks, but also with the numerous concessions made by the PM in her Florence speech.

How things progress from here is the key question. Money seems to be the main sticking point – the EU wants more, the UK wants to see what is on offer before advancing it. In fairness, this seems a perfectly reasonable state of affairs, as both sides in this negotiation are playing their strongest hand.

However, the current state of affairs can’t last; the dynamics will change as the clock ticks down. Despite slipping down the G7 growth table, the UK economy has held up relatively well this year. However, as widely reported in the media, businesses are saying that unless there is an agreement on a transition deal within the next few months, they will have to assume the worst and exercise contingency plans. This will likely mean redirecting investment and moving staff to the EU. This could provide a hit to the UK economy at a time when growth is already sluggish.

The threat to jobs and investment in the UK is a key source of leverage for the EU in the negotiations; the longer the delay of a transition agreement, the greater the impact on UK growth. But this can only go so far.

There is a widely-held view that we shouldn’t expect any significant announcements on a transition agreement until the last possible moment.

Moving into next year, without any inkling of a transition deal, the UK government will have to begin preparations for a cliff-edge exit. This will likely involve redirecting spending to prepare for reverting to World Trade Organisation trade terms, and other areas where there is currently cross-border cooperation with the EU. The costs of this are likely to be large. If it is happening at a time when the negative impact of disinvestment is being felt in the economy, the willingness and ability of the UK government to agree to pay large sums of money to the EU could diminish. Hardened Brexiteers will likely blame the EU’s uncompromising stance for the failure of the talks and ensuing harm to the economy. Those in favour of keeping closer ties might also start to think this way, by which point there may be no going back.

However, given that it is in both sides’ economic interests to see a transition deal brokered, sufficient progress is likely to move the negotiations forward.

A no-deal though scenario cannot be ruled out. Neither side would prefer this option; but it could happen by accident rather than design.

Given the uncertainty about the outcome of the negotiations, there are different possible paths for sterling over the coming 12 months. The British pound has been one of the most volatile major currencies this year, and that is likely to also be the position in 2018.

If negotiations successfully move to the second stage by December, the Pound should stay close to current levels. Relatively high inflation and a relatively solid UK labour market should make the Bank of England hike rates twice, in November and May.

However, if talks between the EU and UK break down, sterling will likely suffer and fall to the lows seen in late 2016.

20th October 2017