Wednesday, March 29, 2017, will be remembered as a momentous day in European and UK history. British Prime Minister Theresa May sent a letter to European Council President Donald Tusk that officially started the process of the UK’s withdrawal from the European Union (EU), ending a 40-year relationship and beginning the UK’s search for a new place in the global economic and trade system.

“Brexit means Brexit,” said Prime Minister May in July 2016, just weeks after the June 23 referendum that saw UK voters decide in favor of Britain exiting the EU. As she has explained many times since then, that means the people have spoken, there is no turning back, and the UK will leave the EU. There will be no watering down of the process, no second referendum, and no backdoor re-entry into the EU of any kind.

The UK and EU are now in uncharted territory, as no country has ever left – or attempted to leave – the EU. The only thing that is certain is the high level of uncertainty about the process.

Article 50 Triggers Brexit Timeline

The process for exiting the EU is spelled out in Article 50 of the Lisbon Treaty1 of December 2007, signed by the 27 EU member nations. According to Article 50, any country that wishes to leave the EU must notify the European Council of its intention and negotiate its departure. The process can take up to two years and, in the case of the UK, negotiations are likely to be lengthy.

With Article 50 now triggered, the UK will likely leave the EU officially no later than April 2019. It is possible for the timeline to be extended by unanimous consent of all EU member states, but that appears unlikely at this stage.

However, a more realistic timeline appears to be 18 months. Several EU parliaments must ratify the deal, and the EU Commission has suggested that six months will be required to complete this part of the process, so it is possible the Brexit deal would be completed by October 2018. That is not a lot of time for shaping a new relationship that will have many legal and political complexities.

European Council President Tusk has said the EU could provide an initial draft of guidelines for the negotiations within 48 hours of receiving Prime Minister May’s notification letter. However, the more formalized and detailed response is expected to come following a summit of EU leaders on April 29. They would provide guidelines to the EU negotiating team led by Michel Barnier. This first response will signal how tough a negotiating stance the EU will try to adopt.

Adding to the uncertainty are elections in France and Germany, scheduled for the spring and fall, respectively. The outcome of those elections may change the tone of the EU’s political response. In fact, although it is a low probability, there is a small chance that France may elect a new president who would also attempt to lead an exit from the EU. Against this backdrop, it is likely that the more technical aspects of the Brexit negotiations will take place first.

UK and EU Positions

The UK’s official Article 50 letter was friendly in its tone and contained no surprises, noting that Britain seeks a “deep and special partnership that takes in both economic and security cooperation.”2

However, based on Prime Minister May’s January 17 speech outlining the UK’s broad objectives for the exit, negotiations are likely to be more contentious. The British government’s red lines include restrictions on immigration from the EU and withdrawal from the European Court of Justice’s jurisdiction.

EU leaders have been remarkably quiet so far about their views. At the same time, the EU has made it very clear that the “four freedoms” it seeks to guarantee – freedom of movement of goods, services, capital, and people – are non-negotiable, and there will be no cherry-picking by the UK of one or two of these freedoms.

The UK’s red lines suggest that its access to the EU single market, which requires all four freedoms be honored, will not be possible, even as the Article 50 letter states the UK seeks a “bold and ambitious free-trade agreement.”2

Negotiating Challenges: Hard or Soft Brexit?

The negotiations between the UK and EU may be divided into three parts:

  • The modalities of the exit – or divorce as it is often called,
  • The UK’s future relationship with the EU, and
  • The transitional arrangements.

All involve contentious issues.

Barnier, the EU’s chief Brexit negotiator, wants to first agree on the principles of exit, including the so-called divorce bill, and the rights of EU migrants in the UK and vice versa. The EU’s initial demand for the divorce bill amounts to 60 billion euros ($65 billion), which includes future pension obligations and budgetary commitments the UK previously agreed to. Not surprisingly, the UK disputes that amount.

Residency Issues: Who Gets to Stay?

Another complicated issue is the rights of 4.5 million people in the UK and EU, who now face uncertainty in the place they call home.3 How will residency be defined? Who will be eligible to stay?

Under current EU law, EU citizens have the right to move freely among and live in any EU country. Residing in an EU member country for more than five years makes EU citizens eligible for “permanent residence.” However, no tracking mechanism exists for documenting when immigrants arrived. That makes proving eligibility for permanent residency problematic. Can EU expats claim social benefits, take jobs outside the UK and then come back? What about their partners and children, including unborn ones?

Reasonable solutions may be found to such issues eventually, but there are too many such difficult questions to be dealt with in too short a timeframe. A case in point is the complexity of the 85-page UK residency form, which by all accounts is a nightmare to complete.

UK Seeks Free Trade Deal with EU

Beyond the principles of the exit, the UK’s stated desire is to negotiate a free-trade deal with the EU. Given a mere 18-24 months for negotiations, there is probably not enough time to define the UK’s new trade relationship with the EU. Knowing this, the UK may seek transitional arrangements with the EU, rules to govern trade, and other arrangements until there is a permanent deal in place.

The world will have a sense of how the negotiations will proceed in the coming weeks. So far, it looks like the EU will adopt a principled and tough stance. As noted above, Barnier wants a sequential approach, first agreeing on the principles of the exit, which he says he believes will take six months, and then defining the future relationship.

The UK wants all elements of the exit to be negotiated on parallel tracks simultaneously. Recent news reports suggest that Germany will support Barnier’s sequential approach and take a patient, rather tough stance on negotiations.

Brexit Economic Fallout for UK

In our view, more limited access to the world’s largest trade bloc and immense uncertainty about the UK’s relationship with the EU will be costly to the UK economy in the long term. While the UK’s economy performed well in the first six months after the Brexit referendum, we believe that performance is not sustainable and the road ahead will be difficult.

Even without Brexit, the UK economy has faced its share of challenges in recent years – large current account deficits, high fiscal deficits and public debt stock, a leveraged private sector, and poor productivity performance. The sharp depreciation of the British pound may help with the adjustment, part of which would come from higher import prices and inflation and contraction in demand, which is already taking place.

Higher inflation, current account and fiscal deficits, and a potentially higher risk premium due to uncertainties around the Brexit negotiations, on top of higher global interest rates, all suggest UK interest rates will face upward pressures.

What the End Result Might Look Like

There is no doubt that both sides intend to seek a mutually beneficial, cooperative relationship. However, the EU’s priority will be to maintain its core principles and strengthen unity. It is not in the EU’s interest to make an exit attractive: life within the EU must be seen as better than life outside. While not part of our baseline, there is a non-negligible risk that negotiations will not make progress and the UK will fall back into the World Trade Organization’s terms for its trade arrangements with the EU. That would be significantly more restrictive than what the UK hopes for.

We believe the UK ultimately will get a free trade deal with the EU and cooperation in other areas such as defense, but access to the single market would be limited. Given the short time frame and the complexity of issues, a transitional arrangement could be reached that would be a positive and market-friendly outcome.

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1 Source: The Lisbon Treaty. The specific provisions of Article 50 may be found at: http://www.lisbon-treaty.org/wcm/the-lisbon-treaty/treaty-on-European-union-and-comments/title-6-final-provisions/137-article-50.html

2 Source: “Prime Minister’s letter to Donald Tusk triggering Article 50,” 29 March 2017, https://www.planforbritain.gov.uk/news/prime-ministers-letter-donald-tusk-triggering-article-50/?_ga=1.50061606.1487304826.1490729803.

3 Source: FT.com, “Millions of expats caught in Brexit no-man’s land,” Feb. 20, 2017. https://www.ft.com/content/0dc4306c-f504-11e6-8758-6876151821a6