Brexit deal achievable but needs increased political commitment... and cunning

Economic opinion

We are at a critical point in Brexit talks with much work to be done to overcome remaining political obstacles to a deal. The pandemic has taught us not all future circumstances can be foreseen and policies need scope to evolve. We think some flexibility on both sides can avoid an outcome neither wants and create scope for a different but positive future relationship between the EU and UK. 

A renewed surge in Covid-19 cases in many countries in recent weeks has raised questions about the consistency of economic and health policies when both should point in the same direction. The trick is to find the right shape and scale of policy interventions to deliver desired outcomes in rapidly changing circumstances. Much the same argument can be made about Brexit negotiations.

A Brexit agreement can be reached but careful and creative measures are needed to manage a complicated balancing of political and economic goals. It is sometimes suggested that the British position on Brexit prioritises often short term domestic political considerations at the expense of economic costs. That threatens an outcome to Brexit talks that would have negative economic consequences for the EU but altogether more damaging effects on the British economy.

The economic rationale behind UK political rhetoric is questionable. British government politicians have repeatedly promised that removing EU ‘shackles’ will permit the UK economic freedom to build a wide range of world-leading businesses. Such comments seem to reflect an unrealistic sense of how much scope small to mid-size countries have to run truly independent policies in an world that is hugely interconnected across most policy realms. In any event, any such gains could take years or even decades to materialise. In contrast, Brexit-related economic disruption would be front-loaded and would hit a British economy where the pandemic led to a much sharper drop in activity than in most of its main trading partners in the first half of 2020.

That the outcome of Brexit negotiations is still unclear and potentially threatening with less than three months to go before the UK fully quits the EU at the end of this year is partly due to the Coronavirus that has absorbed an extraordinary amount of policymakers’ time and energy. Unfortunately, the reality is that the pandemic reinforced rather than removed pre-existing difficulties in the negotiations. Since the UK voted to leave the EU in mid-2016, progress to agree a new post-exit relationship has been slow and strained. 

With the UK keen to focus on issues most important to it and the EU anxious to address a broader framework centred on protecting the longer term integrity of the single market, little progress was made in eight rounds of negotiations held since the spring. Both sides repeatedly accused the other of being unwilling to compromise on a range of areas. These run from access in sectors as diverse as fisheries and financial services, to broader issues around ensuring a ‘level playing field’ that centre on the particularly vexed question of future State aid.

While there has always been significant elasticity around EU deadlines, mid-October was seen as likely end point if a deal was to be struck, scrutinised and signed by end year. Again, following a familiar pattern, it was generally expected that September would see a step-up both in talks and threats. However, the EU was not prepared for the UK’s announcement of its intention to enact its ‘Internal markets bill’ that would overrule some elements of the Northern Ireland protocol in the Withdrawal Agreement that Boris Johnson’s British government concluded with the EU late last year. Although that protocol contains clear safeguards against such outcomes, the UK government now claims that in the event of no deal, the EU could use the protocol to affect trade between Northern Ireland and the rest of the UK as well as limit the freedom of the UK to provide state aid. 

One UK minister acknowledged in parliament that the bill breached international law albeit in a ‘specific and limited’ way. The motivation for taking this aggressive and antagonistic action at this delicate stage in negotiations is unclear. Some suggest it is an attempt to force the EU’s hand either to make substantial concessions or to walk away from talks and be blamed accordingly. Others argue that it reflects UK failings to properly understand the nature of trade negotiations and the balance of power resulting from the EU’s much greater economic size. Whatever the intention, a strong international backlash suggests that trust issues could cause the UK problems establishing trading relationships beyond the EU if it doesn’t manage to complete a deal with the EU.

The likelihood that the passage of the UK’s proposed Internal Market bill will not be completed until the final weeks of the year lessens but doesn’t remove its threat to Brexit negotiations. Similarly, the EU decision to start a slow-moving legal process in response gives an added impetus to both sides to reach a deal that would make the bill redundant. In this context, some encouraging noises have emerged from recent informal talks hinting at potential scope for agreement in some areas. 

Our longstanding view has been that a formal deal covering trade in goods and looser arrangements in other areas would be reached between the UK and EU. This will require substantial progress in negotiations in coming weeks and a related marked increase in engagement at the highest level politically to avoid a no deal outcome. This engagement should be forthcoming and the experience of the pandemic should allow creative solutions to emerge to remaining obstacles to a deal. 

Significant concessions will be needed by both sides. Some of these will be symbolic such as politically sensitive but economically less important areas such as fisheries (which accounts for less than 0.1% of UK GDP). Others will be more fundamental. The view that access to the single market carries with it significant obligations is central to EU thinking. However, it may be impossible to completely future-proof guarantees in relation to the Level Playing Field. In this context, the pandemic has prompted questions about a possible need to re-think the issue of State Aid both in terms of responding to the crisis and rebuilding the EU economy. As a result, a Brexit deal may be better served by enshrining mechanisms to handle perceived breaches of a Free Trade Deal rather than attempting to define in advance all actions that might be permitted or precluded.

While UK negotiators have repeatedly suggested a preference for something approaching the deal the EU has struck with Canada, the strength and spread of existing ties between Britain and the bloc means that isn’t practicable. Trade deals normally see countries build stronger economic ties. This deal will see deep bonds dismantled and replaced by much looser links. In economic relationships, the reality is that a divorce is not simply the reverse of a wedding. However, the nature of current binds also suggests that there may be merit in retaining a significant measure of flexibility to assess how the future relationship between the EU and UK evolves. In this respect, even a ‘bare bones’ trade deal creates the capacity to build a stronger future relationship whereas ‘no deal’ implies a lasting fracture. 

We began by suggesting that economic goals usually prove compatible with other policy considerations. However, this also requires that policy stances and settings need to evolve continuously if they are to continue to contribute positively to desired outcomes. We are seeing this in a wide range of unprecedented economic policy responses to the pandemic. Brexit suggests a similar need for creativity and flexibility in relation to trade policy. While we think the path may be bumpy in coming weeks and the final outcome may be less than perfect, we remain of the view that a Brexit trade deal can be concluded that will provide a basis for a positive if changed future relationship between the EU and the UK. 

Disclaimer:

Any opinion expressed in this KBC Economic Opinions represents the personal opinion by the author(s). Neither the degree to which the hypotheses, risks and forecasts contained in this report reflect market expectations, nor their effective chances of realisation can be guaranteed. Any forecasts are indicative. The information contained in this publication is general in nature and for information purposes only. It may not be considered as investment advice. Sustainability is part of the overall business strategy of KBC Group NV (see https://www.kbc.com/en/corporate-sustainability.html). We take this strategy into account when choosing topics for our publications, but a thorough analysis of economic and financial developments requires discussing a wider variety of topics. This publication cannot be considered as ‘investment research’ as described in the law and regulations concerning the markets for financial instruments. Any transfer, distribution or reproduction in any form or means of information is prohibited without the express prior written consent of KBC Group NV. KBC cannot be held responsible for the accuracy or completeness of this information.

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