UK-EU TALKS: APPROACHING THE MOMENT OF TRUTH

The final drama

Ahead of the European Union summit on 10-11 December, the UK and the EU are trying hard to finally strike a deal on their post-Brexit relations within days. Following a 45-minute phone call between UK Prime Minister Boris Johnson and European Commission president Ursula von der Leyen on Saturday and a further round of formal negotiations on Sunday and Monday, Johnson and von der Leyen intend to take stock in a new phone this evening. As often in the final phase of complex international negotiations, a deal hinges on whether the different sides can muster the political will to bridge the final gaps. That 95% of the potential treaty on future UK-EU relations has reportedly been agreed already does not mean much unless the two sides can settle their differences on level playing field rules, dispute settlement and fisheries. The current swings from optimism to pessimism and from negotiators to top leaders and back are par for the course, as they have been ever since the EU27 and the UK started serious negotiations in the wake of the UK’s June 2016 referendum to leave the EU.

In our view, the fact that a) the two sides are still at the table and b) are not resorting to a high-level blame game suggests that both sides want a deal and believe it can still happen. We continue to see a 75% chance of such an outcome. However, the late-stage back-and-forth highlights the risk of a hard exit on 31 December (25% risk). According to some reports, negotiators have come close to resolving the fisheries dispute but remain deadlocked on level playing field issues. A major snag seems to be that the UK has reportedly brought up an issue again that the EU had considered resolved already weeks ago (should payments out of EU programmes be subject to a control regime for subsidies although the EU subsidy regime is designed to exert a common control over payments on the national level only).

Finding a breakthrough

As in the case of the late 2019 Withdrawal Agreement, the final decisions on the most contentious issues will have to be taken by the top political leaders. Unsurprisingly, the phone call between von der Leyen and Johnson did not break the deadlock on Saturday. Unlike Johnson, who has to watch his backbenchers but can shift the UK position somewhat, von der Leyen is bound by the EU’s negotiating mandate which she – and EU chief negotiator Michel Barnier – can interpret a little but cannot shift. On the EU side, the final decisions rest with the relevant national leaders such as French President Emmanuel Macron and Germany’s Chancellor Angela Merkel.

Alongside the UK-EU negotiations, we expect serious background talks within the EU in the next few days to assess whether the UK has already moved enough for the EU to soften its position further as well. For example, if Barnier believes that Johnson is finally meeting the necessary conditions on level playing field and dispute settlement, Merkel may discuss with Macron how to compensate French (as well as Spanish, Belgian and other) fishermen who may lose out if the EU signs up to future fishing quotas in UK waters that the UK government deems acceptable. On the UK side, Johnson apparently has the backing of his cabinet if he decides to go for a hard exit. However, as the earlier Brexit talks in late 2019 showed, Johnson can be a pragmatist who may first talk tough before taking the sensible steps to strike a deal when it really matters. If the UK accepts the EU’s red lines on level playing field and dispute settlement in order to maintain privileged access to the vast EU market, the EU may accept a stepwise reduction in fishing quotas that Johnson could sell as a success to his audience at home. Like the EU, Johnson could easily find ways to compensate the tiny fishing industry following any disappointment with the details of a UK-EU fisheries deal.

Economic outlook in the various scenarios

An agreement on key issues along with some short-term measures to ease the transition as the UK leaves the EU Single Market on 31 December remains the best outcome for both sides. A deal would support near-term UK momentum and confidence while limiting the long-run damage to growth potential. The long-run economic consequences of Brexit for the EU are minimal as a diversion of trade, investment and qualified migrants from the UK to the EU should offset the hit from losing privileged access to the medium-sized UK market.

If the two sides cannot strike a deal, expect them to accelerate preparations for a hard exit on 1 January 2021. The more steps they can individually and jointly take to smooth the transition, the less near term damage the UK and EU economies will suffer. Such measures could include temporarily waving through many goods across the UK-EU border without thoroughly checking all their necessary documentation, giving traders time to file the paperwork retroactively and allowing UK-based firms in vital financial services to still operate in the EU market on EU single-market terms (and vice versa) for an extended period to give them time to prepare for the new regulatory standards. However, a hard exit without such measures to smooth the transition could delay the UK recovery from economic shock of the second wave of the pandemic until Spring 2021 on top of substantially lowering UK potential growth.

Before the Brexit vote, the UK had trend growth of c2.0%. Even with a deal that preserves privileged UK access to major parts of the big EU27 market, UK trend growth will fall to c1.7%. A hard exit from the EU market would lower UK trend growth to c1.5%.

Kallum Pickering

+44 7917 106575

Holger Schmieding
+44 7771 920377

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