The EU's Strong Hand In Early Brexit Negotiations: Playing For A Large Settlement

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Includes: EWU, EWUS, FXB, GDP, GLD
by: The Balance of Trade
Summary

The EU has more incentive to stall and dictate terms in the Brexit negotiations than does the UK; they have designed the process to be difficult.

We take a look at the EU budget and where the UK fits in.

Discussion on the complexity of the settlement bill and the wide-ranging nature of the figures.

By Adam Zingg, CFA

This marks the third article in our series on the game theory behind the early stages of the Brexit negotiations between the UK and the EU.

The first article speaks to the basic game theoretic set up for the early rounds of discussion. Our claim is that the UK is motivated to "Negotiate", that is, to behave cooperatively with their counter party as early as possible.

The EU, on the other hand, has no such motive in these early stages. As such, their best tactic is "Dictate". Essentially the EU has a vested interest in running down the clock for the time being, in order to get the best economic and political set of outcomes for themselves.

Our second piece discussed exactly why Negotiate was their ideal approach to talks.

This third installment speaks to the first major reason the EU would prefer to not see early discussions as to Brexit to go well: money. The second set of reasons, more political in nature, will be discussed in a forthcoming piece.

Structure of the Talks

Before offering economic motivations for explaining why the EU wants to dictate terms and essentially stall the talks, let me provide you with a couple evidences.

First and most important is the structure of the discussions that the EU insists upon. Their official position has been that future talks that relate to cooperation and trade cannot and must not be handled until the terms of the "divorce" are first agreed upon.

Reuters quotes EU chief-executive Jean-Claude Junker (emphasis added):

'I would like to be clear that I did read with the requisite attention all the papers produced by Her Majesty's government; I find none of them truly satisfactory," he told European Union envoys gathered in Brussels for an annual conference. "So there are huge numbers of questions that need to be settled.'

'We need to be crystal clear that we will begin no negotiations on the new economic and trade relationship between the UK and the EU before all these questions are resolved ... that is the divorce between the EU and the UK,'

Mr. Junker sounds downright sinister. These are early rounds of a two-year negotiations process- who in their right mind could accept that they're supposed to come out of the gate as 'truly satisfactory' to the other side. I wonder how much attention the 'requisite amount' is. The last line is stunning frankly for how naked it is in terms of its bitterness and concomitant desire to inflict pain.

But why insist on the sequential nature of the negotiations? Why deal solely with the most contentious aspects first before moving on to more potentially congenial aspects of the new relationship, rather than having all the talks in tandem to see what mutually agreeable compromises can be made?

According to UCLA's department of economics professor David K. Levine:

Mechanism design theory differs from game theory in that game theory takes the rules of the game as given, while mechanism design theory asks about the consequences of different types of rules. Naturally this relies heavily on game theory. Questions addressed by mechanism design theory include the design of compensation and wage agreements that effectively spread risk while maintaining incentives, and the design of auctions to maximize revenue, or achieve other goals.

Based on this description, the EU's insistence on sequencing the discussions clearly falls under the realm of mechanism design theory. Is their design to create a new, positive and lasting relationship with its partner? Nobody can credibly posit this to be so.

An September 4th opinion piece featured on Bloomberg by Clive Crook has this to say (emphasis added):

To be fair to May, the EU is wrong to insist on "sufficient progress" on the exit talks before moving to other matters. There's no reason why these talks shouldn't be on parallel tracks, or for that matter bundled together, so that concessions in one area could be balanced by concessions in another. Putting questions into a series of silos, with permission needed at each stage to move on, is a good way to make talks fail. But then the Brits had no reason to expect the EU to be obliging about this: Britain has spurned the EU, not the other way round, and now the EU has the upper hand.

Pounds and Pence

As a way of maximizing the divorce settlement, the EU's position demonstrates excellent game theory. Stone-walling is more likely to bring the number higher. This is because the degree of political unity of the EU is temporarily higher than that of the UK with respects to how the Brexit vote went and how discussions are likely to proceed.

Also, just because the UK voted to leave the Union, does not mean that an ongoing relationship is not essential to the well-being of both entities. This is to say that they may have a motivation to cave to unreasonable demands in order to push talks forward.

Let's have a look at the EU budget:

Source: European Commission

The EU lays out its per-country revenue and spending figures on the European Commission site in a very organized and readable format. For a detailed breakdown of revenue and expense by country for the year 2015, click here.

The EU has an outstanding "Myths & Facts" link on the commission's sheet that helps detail some of the commonly held mistaken views of the EU from a fiscal standpoint. Feed your inner wonk and check the links!

In 2015 the UK's net contribution to the EU budget was €11.5 billion euros, .46% of Britain's GNI for the year. Only Germany contributed more in euro terms (€14.3 billion).

An €11.5 billion surplus may not sound like a big deal when compared to a budget of €148 billion. But consider that this is a net figure. About €7.5 billion of spending for the year went to the UK, which means that the gross revenue would have been closer to €19B.

FullFact has a great graphic that depicts the UK's net contribution over the years, which includes bars for money sent to the EU less money received from the EU; note that the figures are listed in pounds rather than euros:

When it's all said and done, the UK pays about €2 into the EU budget for every €1 they take out. This means that the European budget will have a hole in it that EU negotiators will want to aid by charging a hefty "divorce settlement".

Given Britain's motivation to push talks forward, the EU sees a "Dictate" stance as in keeping with their best interests.

At least officially, the EU believes there to be a moral principle at stake. Here's EU Chief Brexit negotiator Michel Barnier (emphasis added):

"I've been very disappointed by the U.K. position as expressed last week, because it seems to be backtracking on the original commitment of the U.K. to honor its international commitments, including the commitments post-Brexit. There is a moral dilemma here; you can't have 27 paying for what was decided by 28.

Now there has been notions of the EU having made commitments to promoting democracy in Turkey and aiding the Ukraine as part of these international commitments that the UK should be held responsible for. But on the European Commission website, the following claim is made (emphasis added):

The EU budget stands at about 1% of the 28 EU countries' gross domestic product (GDP) - the total value of all goods and services produced in the EU. By contrast, the budgets of EU countries represent 49% of GDP on average.

The EU budget is always balanced, so there is no deficit or debt. And 94% of what is paid into the EU budget is spent in the EU countries on policies and programmes that benefit citizens directly.

It sounds as though these post-2019 commitments that the EU is demanding the UK to follow through on amount commitments to EU countries themselves!

We're not here to say that the EU does not have a point. But when "international commitments" amount to things such as pensions for EU workers and funding infrastructure projects that haven't yet happened, the logic does become more tenuous.

What is the Total Bill?

Bloomberg highlights how complex the discussions are, as well as the wide-ranging nature of the settlement figures discussed.

At the high end there are figures of €100 billion. At the other extreme, if one counts past UK contributions to projects there is a case to be made that the EU owes Britain money! Realistic settlement terms may fall in the range of €5-45 billion.

The other factor is the timing of cash flows: what combination of lump sum vs. periodic payments.

It is worthy of notice that the EU as yet has not circulated an official figure and have said that it depends upon the methodology for calculating the liabilities.

What is the alternative?

Really there are four ways the negotiations play out:

  • The UK balks and gives in to a large settlement: great for the EU
  • The UK refuses and exits the EU with no settlement at all, in which case trade terms revert to World Trade Organization standards. This would impose tarriffs on both EU exports to the UK and UK exports to the EU. The trade deal that is in both entities' best interests are hammered out after the fact, and this is a big loss for everyone, but most importantly the EU as there would be no settlement (on net, the EU exports to the UK)
  • The two groups determine that a softer stance actually makes sense. The UK gives a little, and the EU determines that "sufficient progress" has been made so that the two groups can cooperate with the remaining time.
  • The stalled negotiations, with their attendant political toxicity for British politicians, short circuits the entire process and Brexit is aborted: huge win for the EU.

Conclusion

The EU is playing its hand shrewdly in order to maximize the economic payout associated with Brexit. It is quite likely that there will indeed be a short term boost to the EU coffers due to the settlement bill. Naturally, the EU is going to have to make future budgetary adjustments based on having a smaller budgetary footprint to work off of.

From a market outlook standpoint, I do believe that flagging negotiations will put downward pressure on the British Pound (FXB). On a longer term basis, this process could also create stress points for British equities (EWU, EWUS) and perhaps along the way some good opportunities for buying British bonds as investors flock to a risk-off trade. Also gold (GLD) could get a boost off the inevitable negotiating heart burn.

Final note: I do tend to side more with the UK on most matters related to Brexit, both as it concerns the tenor and style of negotiations as well as philosophically. I believe - and many very intelligent people disagree - that Brexit was a good decision that could very well prove beneficial for all or at least most of the twenty-eight member nations in the long run, as it calls into direct question what the appropriate level of authority the EU should have over the member nations. Do members of these nations think of themselves first and foremost as British, Swedish, Bulgarian? Or do they think of themselves primarily as belonging to some sort of European Project?

Regardless of my own personal opinions, which I only share as a disclosure of sorts and perhaps as a conversation starter, let me be clear that the EU is playing its current hand very well from a game theoretic perspective. They adroitly framed the discussions in such a way as to maximize the probability of two outcomes that strongly work in the EU's interest: big settlement and/or fizzled Brexit. Stonewalling helps to achieve these aims.

The next segment of this ongoing discussion will lean into the second aspect of why the EU has taken the posture of "Dictate" as a negotiating strategy. This will cover the attempt to essentially terminate Brexit altogether. It is actually not an entirely unlikely outcome, and there are many in Britain itself that would love to see it so.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.