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UK reaction - Barnier's "non" threatens dead-end for negotiated Brexit

UK reaction - Barnier's "non" threatens dead-end for negotiated Brexit

Market commentary
27 July 2018

David Page, Senior Economist at AXA IM, comments on the EU’s reaction to the UK government’s customs proposal

  • Barnier/Raab press conference reveals EU’s fundamental rejection of UK’s carefully crafted proposal.
  • Barnier rejected the UK’s proposal of the facilitated customs arrangement, he also suggested more work was necessary for the ‘backstop’ position.
  • This pushback risks shattering the fragile political compromise currently held in the UK.
  • The chances of a more fundamental political crisis in the UK has increased, with the UK facing options of breaching “red lines” over leaving the customs union or risking “no deal”, for which there appears little political appetite.
  • Financial markets posted little reaction to yesterday’s rejection, but if this is the more fundamental obstacle to a Brexit deal that we suggest, UK asset volatility is likely to rise over the coming months.  

New Brexit Minister Dominic Raab and Chief EU negotiator Barnier met yesterday to discuss the UK’s proposal for a framework for a future trade agreement. In the ensuing press conference, Barnier rejected the key stone to the UK proposal – the facilitated customs arrangement (FCA), that would see the UK collect EU tariffs on its behalf. Barnier state “The EU cannot – and the EU will not – delegate the application of its customs policy and rules .. to a non-member”. To our minds, this torpedoes the UK’s carefully crafted Brexit compromise in a way that months of Brexiteer scheming had failed to do. We see this as raising the probability that the UK fails to achieve a negotiated Brexit, a de-railing of negotiations that we consider would lead to a political crisis.

Over the past months, the UK has crafted an intricate proposal that carefully weaves around the “red lines” defined by the EU, the UK and the strictures of a frictionless border in Ireland. PM May’s government narrowly squeezed this through Parliament, including accommodating last minutes amendments from Brexiteers, to keep them on board. The government finally presented a plausible proposal, accepted by a UK majority, albeit a proposal resembling a swaying Jenga tower. Barnier’s comments appear to give this tower a fatal nudge. The FCA was at the heart of a trade deal, that would act like a customs union, but would not restrict the UK’s ability to negotiate free trade agreements (FTA) with the rest of the world. Without this tariff-smoothing feature, the UK would either be committed to maintain EU tariffs, or enter a customs union, that would prevent FTAs with the rest of the world. The latter would likely undermine the fragile balance of UK, internal politics.    

It is genuinely unclear how negotiations can progress from here. Brexit Minister Raab is meeting Barnier again in mid-August and it is possible we will see further details at this time. Thereafter, he will meet him on a weekly basis. However, while we had argued that the UK political system was endeavouring to defer facing up to the irreconcilable nature of the deal struck around Ireland until after the UK had left the EU, the EU does not appear minded to grant that luxury. Given the difficulties in determining ‘Plan A’, it is no surprise that the EU also focused on ‘Plan B’, the ‘backstop’ position to maintain a frictionless border in Ireland. Barnier made clear that the UK’s proposal on this, including the time-limited nature of its proposal, were inadequate – but this issue is one that both parties agreed to return to later next month.   

The following suggests some paths that Brexit might take over the coming months.

  • Barnier could change his mind (or have it changed for him). The UK is desperately trying to convince EU leaders of the viability of its proposal. However, Barnier suggested that such efforts would be “a waste of time”, which has certainly been the case to date.
  • The UK could commit to maintaining EU tariffs at its border. With a commitment to no tariff differential, the UK might remove the need for border checks from a tariffs perspective. It would still need to proceed with regulatory alignment measures as proposed in the White Paper and track goods shipments to manage “rules of origin concerns”, both of which could prove future sticking points with the EU.
  • The UK could propose joining a customs union with the EU. Barnier stated that the EU was “open to a customs union”. While Parliament only narrowly avoided opting for a customs union weeks ago, this looks likely to be a step too far for the Brexiteer faction of the Tory party and would fundamentally breach PM May’s commitment to leave the customs union.
  • In exhaustion of other options, Brexit negotiations could flounder. Already the 18-19 October Summit looks ambitious for finalising a deal. With December’s Summit appearing too late to allow time for EU ratification of any deal, an emergency summit in November could be the realistic deadline for negotiations. However, the risk of no agreement even by then has risen. This threatens a “no deal” exit for the UK. Despite the UK belatedly beginning preparations for this outcome, it is not clear there is a political majority for such an outcome. This threatens the scenario of political crisis that has always hung over this process, which could result in leadership change, general election and/or a second referendum.

Financial market reaction to date has been minimal. 2-year and 10-year gilt yields dipped 1bp at the close of yesterday’s session, but yields have opened higher this morning. Sterling dipped marginally, down 0.3% against a modestly rising dollar and down 0.1% against the euro. However, if our concerns about the fundamental difficulties posed by Barnier’s rejection are correct, this looks like a point from which markets will have to increasingly price the probability of extreme outcomes in the Brexit negotiations. In turn, this would likely result in gilt market outperformance against major international counterparts. It is also likely to see additional downward pressure on an already subdued level of sterling (something that could provide a lift for UK equities, at least in own-currency terms). The coming months looks likely to see a rise in UK asset market volatility.

 

Notes to Editors

All data sourced by AXA IM as at 27 July 2018.

 

Press contact

Jayne Adair

+44 20 7003 2232

Jayne.Adair@axa-im.com

 

Jamie Wynn-Williams

+44 20 7003 2680

Jamie.Wynn-Williams@axa-im.com

                                           

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Authors
David Page