April 11, 2017    7 minute read

Brexit: An Isolated Kingdom Enters Negotiations

The UK Outlook    April 11, 2017    7 minute read

Brexit: An Isolated Kingdom Enters Negotiations

The double barrel is locked and loaded. Heartbeats race. The slowing of time is felt across the country. The index finger, placed upon the trigger, pulls back in a smooth and unwavering motion. One races to check the currency markets. Surprisingly for a symbolic event of this magnitude, the waters were relatively calm. The reasoning is that Theresa May’s pacifying speech, heralding the start of Brexit negotiations, gave away what was already known. This reduced the volatility of the pound and hence, GBP/USD was unmoved.

Intriguingly, the euro seemed to be more affected. EUR/USD dropped and GBP/EUR rose towards €1.16. At the time of writing, it is currently just over €1.17, enduring a steep climb. What is also interesting is that the pound is up just over 1% against the dollar for the entire quarter. This may be the first quarter since 2015 when the pound finishes stronger than it started.

Nevertheless, the pound has not yet reached its pre-referendum levels, where it once stood strong. From a positive macroeconomic standpoint, this allows British prices to be competitive – especially against the euro. If the pound stays low, this would help smooth the transition of the British economy after walking away from the EU as British exports would stand a chance. It is important to remember that the triggering of Article 50 only represents the start of Britain’s two-year stumble out of Europe. That point in time last Wednesday was a symbolic gesture at best. What will really affect the pound will be the road bumps forming from the negotiations along the way. The first bout of real volatility may come at the end of April, at the EU’s first Brexit summit.

EU: Stirring the Pot?

Britain has, for the short term, unequivocally isolated itself from previous friends and the outside world. The EU are stirring uncertainty within Britain’s markets, many in Scotland want to leave the UK and parts of Britain’s financial sector want to move to Dublin.

May wants to start the negotiations of the EU-Britain independence relationship parallel to the exit process, but Angela Merkel wants to see Britain fully gone before starting talks on a future partnership. This creates a huge uncertainty within the UK. Surreptitiously, the EU knows this: the more uncertainty there is in Britain, the more British companies will move to the EU, strengthening the European economy. The withdrawal process also outlines Britain paying its outstanding debts, which Brussels estimates to be about €60bn to the EU. An excruciatingly large amount and one that could upset the rollercoaster of talks before they’ve even begun.

If they were to arrive at a stalemate with no trade agreements agreed upon, this would be devastating for both economies. It’s symmetrically known that one has to be reached. The only issue is the EU has the upper hand for a better deal, and hence, an emblematic win. If no agreements were to be formed, Britain would be cut clean from the EU.

Britain has two leverage tools for stopping a clean break of relations: security and money. They would pull out of Europol, to which they were once the biggest contributor and take all of their intelligence with them. They could also offer a monetary agreement; although perhaps that’s too ironic, as one reason for Brexit was to stop large amounts of money being paid to Europe.

The EU, however, has the single market to leverage. Without access to this single market, Britain’s imports may become a lot more expensive, raising prices and inflation. As this would not be demand-pull inflation, wages may not rise enough thereby reducing the UK’s average standard of living. British exports become more expensive for the EU so their trade deficit worsens, all to be left for the future generations. Or a default. Neither of which seem ideal.

A Divisive Theme

Also removing their loyalty from the UK is Scotland. Nicola Sturgeon has been adamant that Scotland voted for an overall Remain vote and does not want to be dragged along the carpet with the rest of the UK to leave the EU. She has written a formal letter asking for permission for an independence referendum to be held. Adamantly, she has said the question is “not if, but how” a second referendum, after 2014’s ‘stay’ vote, would take place.

A spokesman for Westminster has said it would be unfair to the Scottish people to call the referendum now, without knowledge of the future UK-EU treaty that may be signed. The removal of Scotland would be yet another appalling feat for the pound. Scotland is the UK’s main oil and gas exporter. If oil and gas revenues are included, the nation generates £26,424 GDP per capita. Comparing that with the UK-wide average £22,336 goes to show what Britain stands to lose from cutting off that sector. Scotland’s divorce would put downward pressure on the UK’s income.

Currently, there are no talks between May and Sturgeon to set up this referendum. The British Government wants to focus on negotiating with the EU without having to fight on two fronts and Sturgeon doesn’t have any leverage to overturn this decision. If Britain wins with a good deal from the EU, concurrently they may also ‘win’ over Scotland.

Running Away From Home

Arguably, London’s financial district has long since been the most prosperous financial realm in the world. This may be set to change. JP Morgan and other large investment banks have expressed their interest in moving some of their operations elsewhere within the EU. JPM have previously stated that if the UK left the EU, as many as 4000 jobs would be at risk. Dublin seems like it’s growing in popularity, with JP Morgan thinking of buying a new office block there.

On Thursday, Citi said they were preparing for a ‘hard Brexit’, which would mean having to relocate some of their business and start a new broker-dealer division in the EU. Goldman Sachs have also expressed an interest in creating “hundreds” of jobs in the EU which will be a “combination of [hiring] people inside Europe itself and … some movement (from the UK)”.

With the finance sector a major contributor to the UK’s GDP, this could spell worries for the income of the country. With output growth decreasing, the Government may be called upon to stimulate fiscal policy.

The Domino Divorce

In order to solidify strong confidence in the UK at the end of these two years of negotiations, the UK has to wield a deal that will allow it to stay a part of the EU’s single market. This will also allow the UK to find other trading partners and hence become even more globalised than it already is, opening doors for more trade. Like a domino, the divorce issue with Scotland would then vanish, as Scotland would reignite its confidence back into the relationship and would also prosper from more trade.

The last domino would then fall into place, allowing the UK’s mammoth finance industry to remain intact. Banks and other institutions would get to keep their foreign business partners with the added bonus of making new friends with firms from the UK’s new trading partners.

The EU bloc would also prosper from a stronger pound, allowing for an increase in EU exports. For this utopia to turn into reality, the first domino must be pushed. The UK needs that single market agreement, and without it, isolation may turn to havoc. With all of these variables at play and only two years for a miracle EU treaty to be signed, Britain must prepare to be dragged through the bushes backwards.

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