Britain's vote to leave the European Union (EU) on the 23rd of June has thrown a literal mountain of sand into the gears of the European project once defined by the irreversible momentum of political and economic integration on the continent over the past 60-odd years. Few worldwide were prepared for such an electoral outcome and even fewer have a grasp as to the future of the UK relationship with its former EU partners.
The European project has a dual mandate, one that could loosely be defined by politics and one equally loosely defined by economics. The political end of the equation includes, among other things, supranational institutions that exercise both executive and judicial authority over member states thus, by treaty law, placing limits on member states' national sovereignty. The European Parliament and the European Council are the two most recognizable political bodies while the European Court of Justice (ECJ) is the final arbitrator of legal disputes and rule interpretation on the continent. Similarly, the economic component outlines the harmonization of trade in goods, services, capital and the free movement of workers across national boundaries, the so-called Four Freedoms set up by the Treaty of Rome (1958). The Customs Union and the Single Market through the common external tariff delineate the rules around commerce and access to the Project's 510 million consumers that make up one of the largest commercial markets in the world.
The British vote has upended two of the founding principles of the European project to date. The vote openly challenges (rejects) the political premise that allows supranational institutions to infringe on UK sovereignty. On the economic side, the vote equally challenges (rejects) the free movement of workers across national borders of member countries. Not far below the surface of the campaign rhetoric was the ever-hot issue of annual contributions to the EU budget, surprisingly a sore topic in the British hinterlands that more times than not either directly or indirectly benefited from EU economic development largess. Given these fundamental challenges to EU founding principles from both the political and economic spheres, is there enough remaining common ground to forge an agreement in a timely fashion?
Good questions both.
There is no existing solution in the EU toolbox that would come close to the largely unencumbered access to the single market for goods and services the UK currently exercises as an EU member state. For the UK, the real issue is services which make up about 78% of the economy. From banking to financial to legal, the UK holds a £15 billion trade surplus with the EU in services. Many of these high-end financial services are based in London and its environs and depend heavily on the very single market principles of harmonization and access rejected so matter of factly by the Brexit vote. Many of these services gain access to the single market through a process of passporting, which allows mainly financial companies to sell both products and services across national borders throughout the EU without national regulation by individual member states. The number of access passports held by UK companies total 36,421 as many have multiple passports for both different product sectors and countries in the EU. EU companies hold a total of 23,532 for access to the UK economy.
A quick sketch of the current programs in place will highlight the headwinds UK negotiators face in forging a new relationship with the EU:
- The Canadian trade agreement, formally known as the Comprehensive Economic and Trade Agreement (CETA), was originally launched in 2007. Nine years later, the negotiation process is complete but still has yet to begin the cycle of ratification in the now 27 parliaments of the EU. The CETA is largely a free trade agreement (FTA) dealing mostly with goods with very limited emphasis on services. Major issues for Canada, such as food and farm exports - beef in particular - still face EU quotas. Canada remains outside both the Customs Union and the EU, which subjects the country to rules of origin on goods shipped to the EU as well as customs checks at entry points to the EU to ensure compliance. Canada will also have no say over rules adopted by the EU regarding the single market.
- The European Economic Area (EEA) option of which Norway, Iceland and Liechtenstein are members and all have access to the single market. Similar to the CETA, services are a small and superficial component of the agreement. None of the EEA countries are part of the EU Customs Union or the EU so as such are similarly subject to both rules of origin requirements on goods and customs checks at entry points. EEA countries also have no input to the rule-making bodies, the single market. Importantly, the option does not allow the EEA to limit the movement of workers and requires EEA countries to contribute to the EU budget.
- The Swiss option is a variant of the EEA format that allows goods access to the single market in exchange for adherence to the four freedoms of the single market. Switzerland is also neither a member of the Customs Union nor a member of the EU so is subject to the rules of origin and entry point customs regulation. The country also has no say over the rule-making of the single market. Interestingly, Switzerland passed a referendum to limit the flow of immigrants into the country in February of 2014, which stands as a test case on the issue of the free flow of workers in the EU. Switzerland has until February of 2017 to put the referendum results in place. Further, the EU is pushing the Swiss to accept a broader framework agreement that would tie Switzerland's free obligations to other aspects of its EU relationship, including accepting future changes in some EU laws, a dispute resolution mechanism and EU court decisions in some areas. In the past two weeks, the Swiss lower house passed legislation that would make it more difficult for non-Swiss nationals to apply for job postings across the country in yet another angle to undermine the free movement of labor clause. The bill is currently being submitted to Brussels for comment.
- The World Trade Organization (WTO) - the UK has been a member of the WTO for almost 40 years, but only as a member of the EU. As an independent member of the WTO, the UK would have to renegotiate every existing trade agreement it has with other countries as an independent state. Currently, there are about 164 countries that are members of the WTO. Those with trade relationships with the UK are arrangements predicated on the UK's membership in the EU and its single market of 510 million consumers. The UK's market outside of the EU is a bit smaller, roughly 64 million, with its current trade relationship with the EU undefined. Tariff regimes would most certainly be adjusted for the new market realities created by the Brexit vote. The UK is currently party to about 50 FTAs, including many Commonwealth countries and former colonies of EU member states, waving all or most of the duties on goods and services required under the common external tariff. All of these trade arrangements would have to be renegotiated. Further, the negotiation process with outside states would likely wait until the EU and UK hammer out the scope of their future relationship before committing themselves to sitting across the table from UK trade representatives. The process will likely take years.
In short, all of these options are largely variations on a theme of a straight-up trade agreement in goods with scant attention paid toward services, hardly agreements that accommodate the overwhelming service bias of the UK economy. Banking and the delivery of financial services by their very nature require supranational regulation, supervision and compliance that would not normally be part of a free trade-type agreement. Further, the notion of supranational regulation would most certainly infringe on UK sovereignty, another underlying component of the Brexit vote. Lest it not be overlooked, each of these options includes the four freedoms and supranational oversight and most require annual contributions to the EU budget.
The EU is highly unlikely to grant the UK preferential access to the single market as a non-EU member country under any one of these current options or some new variant. As we have seen, the EU is a single market of 510 million consumers, or roughly 450 million consumers with the exclusion of the UK. The UK simply does not offer the same level of market clout, which means trade, economic and political concessions will necessarily make up the difference in market size in any negotiation exercise. In the financial services arena, seamless access to EU markets is the only option; anything less is simply not viable. London-based financial firms operate in highly protective environments that effectively limit competition. Licensing and the iron-clad grip on information create barriers to entry that sends fees skyward and directs copious amounts of economic rent to company bottom lines and into the pay packages of the specialized and chosen few. The European Central Bank (ECB) in its supervisory capacity has since 2011 sought to move the trading of euro-denominated derivatives out of London and onto the Continent, most likely the home-base of the ECB in Frankfurt. The UK has an equally long record of resisting such a move, including winning a legal challenge that ended up in the ECJ. There is every reason to believe that the ECB, absent the dissent of the UK, will be more successful in its plans to consolidate euro-denominated derivative trading on the Continent in the near future.
There is simply no incentive in the EU to allow such a hold on the EU financial system - particularly by a non-EU member country - to continue. Even from a regulatory standpoint, while UK and EU law currently mesh, there is every reason to believe that the regulatory regimes of both the UK and the EU will diverge in the future. In the absence of some negotiated mechanism to insure regulatory symmetry over the long term, there is no chance that Brussels will allow London's hold on the delivery of financial products and services to the EU to continue in the post-Brexit relationship. The post-Brexit relationship between the EU and the UK will most likely resemble quite closely the options already forged with EEA countries, Switzerland and Canada, without exception.
In a harbinger of events to come, British foreign secretary Boris Johnson flippantly opined in a Sky News television in New York (22 September) that he fully expected the UK to trigger Article 50 of the Lisbon Treaty in the early months of next year. He further ventured out onto the thinning ice in stating that his government will likely not need the full two-year window to negotiate a new relationship with the EU. He then crashed through the ice by labeling the link between access to the single market and the free movement of labor as "complete baloney." German finance minister Wolfgang Schäuble was quick to respond to the contrary, offering to "…send Her Majesty's foreign minister a copy of the Lisbon Treaty for him to read for himself the relationship between the single market and the four freedoms." The comments leave precious little to the imagination.
And it's a hard rain going to fall.
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