Brexit – where do we go from here?

03 July 2017

On 23 June 2016, the UK electorate voted to leave the European Union (EU), having been a member since 1973. Twelve months on from this historic moment, formal negotiations between the UK and EU on the terms of the UK's exit have begun. The outcome of these negotiations will shape the political and economic landscape in the UK for years to come, and will have major ramifications for Europe and beyond.

The already uncertain outlook for the negotiations has been clouded further by the UK's recent general election that left no single party with an overall majority. This has introduced a level of doubt as to who will lead the negotiations for the UK and what type of settlement the UK will pursue. For now, Theresa May is looking to govern with the support of Northern Ireland's Democratic Unionist Party (DUP), and has stated her intention to be at the helm for the duration of the negotiations. 

Brexit timeline

Brexit is a process, not an event. On 29 March 2017, the UK triggered Article 50, formally notifying the EU of its intention to leave. On 29 March 2019, an agreement on the terms of the UK's withdrawal must have been reached and ratified, or an extension to negotiations agreed. Within this two-year timeframe, there are several key stages.

June 2017 – Negotiations Begin

June to December 2017 – Withdrawal Agreement

  • Effectively, the 'terms of the divorce'. Both parties will need to agree on issues such as the rights of EU citizens living in the UK (and vice versa), transfer of regulatory responsibilities and cross-border security.

January to June 2018 – Future Trade Relationship

  • What trade arrangement will the UK and the EU have after Brexit has concluded? There are a number of potential options, ranging from full membership of the European Economic Area (EEA), through a variety of free trade agreements (FTA), to a relationship based on World Trade Organization (WTO) principles.

July to October 2018 – Transition Negotiation

  • The UK government has expressed its intention to seek what has been termed a 'transitional deal'. This would be a temporary arrangement that would kick in at the end of negotiations, and would allow the new UK-EU agreement to be phased in over a pre-agreed period.

October to March 2019 – Ratification

  • Any deal must be ratified by all 27 EU member states, the European Council and the European Parliament. The UK parliament will also vote on the deal before it takes effect.

29 March 2019 – UK exits EU (if no transition deal agreed)

It's complicated

The complexity of the Brexit negotiations should not be underestimated. The UK is deeply entrenched in the EU economic and regulatory infrastructure. Setting up the new trade agreement is likely to be long and arduous. The final agreement on the terms for the UK leaving the EU can be agreed by a qualified majority of the European Council. However, any new trade deal requiring treaty change, or that qualifies as a 'mixed agreement', would necessitate unanimous approval by all 27 remaining members.

Each EU member country will have its own individual issues on which it will not want to compromise excessively. The need for unanimous agreement among EU member states should assure that the ultimate deal does not cross any of these 'red lines' as it would, de facto, prevent unanimity being reached. We believe there are four key issues, the resolution of which will dominate negotiations:

  • free movement of labour
  • UK political sovereignty
  • services access and the Single Market
  • future of the Eurozone and EU.

Fifty shades of trade

Whatever deal is reached, the options are not as binary as sometimes portrayed by the language of 'hard' Brexit or 'soft' Brexit. Instead, there is a spectrum of potential outcomes.

Using a variation on the 'prisoner's dilemma' of game theory, we can build a picture of the likelihood of certain outcomes given the levels of compromise required from each side around the key issues (see Table). High compromise outcomes imply domestic politics taking a back seat to what is necessary to secure the best economic outcome. At the other end of the spectrum, low levels of compromise imply that short-term domestic political considerations take precedence over economic considerations.

Who blinks first?

Likely outcomes from negotiations

Overall, the closer UK relations with the EU resemble actual membership, the less disruptive it will be for trade and associated activity in the UK. This would be EEA membership, but we consider this highly unlikely. Although EEA membership would produce a better economic outcome for both sides, it is politically desirable only for the EU; for UK politicians, an EEA result with no modifications would be the worst political outcome.

On balance, we believe that some form of FTA is the most realistic arrangement. The differences between potential FTA solutions are driven by how much each party is willing to compromise some political reputation for economic advantages. We think the most likely outcome is therefore the middle-ground 'Regular FTA' because it allows both parties to retain their political reputations on the key issues while still building an effective, if not comprehensive, free trade relationship.

If neither party is prepared to compromise much, a relationship based on WTO principles might emerge. Although this would produce the worst outcome economically, we see it as modestly more likely than the EEA option.

The nuclear option

However, there is another possible outcome. Since the triggering of Article 50, authorities in the EU have used firm language regarding the need to agree conditions for the UK to leave the EU before negotiating a new trade deal, with a particular focus on the UK's financial responsibilities.

The EU's negotiating position will leave the current UK government facing a difficult trade-off. It can soften the stance on EU migration flows and regulatory oversight to gain a better FTA, but at the risk of upsetting those pushing for a larger increase in sovereignty and greater migration restrictions. Or, it can prioritise a significant increase in control over immigration and Single Market-relevant regulations over negotiating a high-quality FTA and risk a worse long-term economic outcome. What is certain is that the UK government cannot have the best of both worlds and that the tail risk of a complete breakdown in negotiations remains.

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