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The political and economic incentives driving UK-EU trade negotiations

21 March 2017

Stephanie Kelly, political economist at Standard Life Investments, considers the key points for British and EU negotiators ahead of the triggering of Article 50 and the UK's two-year exit from the bloc.

By Stephanie Kelly,

Standard Life Investments

The long-awaited triggering of Article 50 is a key step in the process of the UK leaving the EU. It will allow both parties to negotiate the UK’s exit, while possibly establishing a skeleton for a new trading relationship in tandem.

Article 50 allows two years for the initial exit agreement process, but an extension to this period can be granted if the European Council (excluding the UK) unanimously agrees.

The UK is deeply entrenched in the EU economic and regulatory infrastructure, which makes the process of leaving extremely complicated. Therefore, we expect a transitional agreement to be required.

Setting up the new trade agreement is likely to be a long process. 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 that requires treaty change, or that qualifies as a ‘mixed agreement’, would necessitate unanimous approval by all 27 remaining members. Countries may opt to, or formally require (i.e. Ireland), a domestic referendum. Others may need regional legislative approval before being able to provide ratification (i.e. Belgium).

There is clearly a great deal of uncertainty over the eventual outcome of this complicated process. In this article, we consider what each party is looking to achieve in these negotiations and examine the different types of possible institutional arrangements between the UK and EU. We then use game theory to try and establish the relative likelihood of different outcomes at this admittedly early stage.

The rules of the game

To start, we make an assumption that the EU and UK are two single negotiating parties. Of course, the reality is that the EU is made up of 27 disparate members (excluding the UK), all of whom have their own individual priorities and red lines which could lead to a breakdown in negotiations. In Germany, this could be a certain tariff level on auto-manufacturing, while in Ireland the red line may literally be a border line between the Republic of Ireland and the UK.


However, sorting these interests into an overall negotiating position will be part and parcel of setting the overall EU negotiation objectives, such that national and transnational interests are represented satisfactorily by a single player.

The need for unanimous agreement among EU member states should ensure that the ultimate deal does not cross any individual red lines.

So, what are the key issues? We think there are four major points of contention.

Free movement of labour

Controlling immigration was the dominant issue for the ‘Leave’ campaign in the run-up to the UK’s EU referendum and has become a central tenet of the government’s rhetoric around the future of the UK’s relationship with the EU. Given that free movement of people is a key pillar of the EU, changes to this principle are likely to be met with stern resistance by EU negotiators.

UK political sovereignty

The perceived democratic deficit in EU membership was another key message of the Leave campaign. The supremacy of the European Court of Justice and the requirement for the UK to adopt EU rules and regulations were particular gripes. However, there is a natural trade-off between the degree of sovereignty in these areas and access to the single market. A European Economic Area (EEA) or Swiss-style solution would still require the UK to comply with EU laws and regulations in return for access to the single market. In addition, such countries have no say in writing these laws or regulations.

Services access and the single market

The UK is a large exporter of services, particularly financial services. At present, financial institutions based in the UK can operate easily in the EU without onerous additional regulation, partly through passporting. Single market exit would raise the risk of non-tariff barriers to these types of activity. The government is seeking ‘the freest possible trade’ in financial services with the EU, which could come in the form of mutual recognition or tailored equivalence in regulation. The economic importance of the sector and the role of London as a financial centre make this a key issue.


Future of the eurozone and EU

There has been significant political capital invested in the European project. Brexit constitutes a threat to the sustainability of this union, especially given signs of growing EU scepticism in other countries. A fear is that the UK will be the first domino to fall in the unravelling of the European project. So, EU negotiators are incentivised to maintain the integrity of the EU and deter future rebellions. This must be balanced against a desire to maintain trade and political relations with a strategically important economy.

Let’s make a deal

EU exit is not as binary as sometimes portrayed. The new UK trading relationship with the EU could come in a number of shapes, sizes or consistencies; not just ‘hard’ or ‘soft’. Indeed, there is a spectrum of options for the new trading relationship, ranging between full EEA membership and a World Trade Organisation (WTO) relationship.

Overall, the closer that UK relations with the EU resemble actual membership, the less disruptive it will be for trade and associated activity.

EEA membership would imply relatively modest changes in the UK’s relationship with the EU, with firms still able to access the single market and the free movement of labour enshrined.

The Swiss model of bilateral trade agreements would allow access to large parts of the single market, but again comes with strict rules around migration. A more distinct separation would see the UK negotiate a Free Trade Agreement (FTA) with the EU. This sounds attractive, but in practice it would imply a rise in trade frictions. Tariff levels would depend on complex sector-by-sector trade-offs across member states.

Moreover, we would see increased non-tariff barriers to trade with the single market. The most disruptive outcome would be a fall back on WTO rules, which would imply material rises in both tariff and non-tariff barriers.

Stephanie Kelly is a political economist at Standard Life Investments. The views expressed above are her own and should not be taken as investment advice.

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