When British voters voted on the "Brexit" option in a June 2016 referendum, it was understood that it meant the nation was leaving its membership in the European Union. But ever since the measure was approved by a 53% to 47% margin during that vote, debate has arisen over exactly what the idea of "exiting" the European Union actually will entail.
Voices from all sides are engaged in negotiating the terms of an eventual exit. Will it be a "soft Brexit," which would imply a continuation of some trade, immigration and close cultural linkages with continental Europe? Or will it be a "hard Brexit," which would mean complete separation from the EU and a return to an arrangement that existed before Britain's entrance into the organisation?
Brexit may represent the will of a majority of British voters, but the road to actually achieving it from the EU is rife with complications.
Britain joined the European Economic Community (EEC) in 1975 after earlier decisions to stay out of the organisation, which had formed in the 1950s during the reconstruction of Europe after World War II.
In 1993, with the Maastricht Treaty, the EEC became known as the EU. Despite calls to opt out of the organisation, the U.K. initially decided not to do so. However, the country did resist some features of the membership, including adoption of the euro currency and participating in the Schengen area, which allows free flow of individuals without strict passport controls.
In 2009, the EU formalised Article 50 that would allow members to opt out of EU membership if they chose to do so. Although the British government didn't initially make use of the rule, former Prime Minister David Cameron following his re-election in 2012 made good on a campaign promise saying he would put the matter up for vote in a referendum. That set the stage for the referendum vote of June 2016.
Triggering Article 50
One complicating factor for both Britain and the EU is that the provision that would allow country to exit the union has never before been used. Further, the language of the provision is not entirely specific about how such a breakup should be carried out. That means both parties will largely be determining what can and won't be permitted in the Brexit as they carry out the process.
The procedure is that the British government would invoke Article 50 of the EU treaty. Upon this action, the 27 member countries would meet to discuss the terms of Britain's withdrawal. The EU member nations would need to approve the terms with a majority vote during a two-year period. British Prime Minister Theresa May has said she plans to invoke Article 50 by March 2017, meaning the negotiation of Brexit would be completed by 2019.
Under Article 50, the EU must "negotiate and conclude an agreement with that State, setting out the arrangements for its withdrawal." The terms of the withdrawal must be approved by 20 of the 27 remaining EU countries, provided they also represent 65% of the EU population. Currently, EU laws and regulations are automatically internalised in Britain. Upon Britain's official withdrawal, British institutions would resume full authority over regulations that were previously delegated to EU authority.
After a challenge to the government's ability to trigger Article 50, a British High Court ruled that the government must submit the decision to the British Parliament. The court decision must still be reviewed by the U.K.'s Supreme Court and a decision on that is expected by January 2017.
Although considered unlikely, the British parliament could ignore the result of the Brexit vote and block Brexit. That's because technically the Brexit vote was considered an "advisory" referendum rather than a "binary" referendum with a predetermined outcome.
What Brexit Negotiations May Cover
Just as there are a number of procedural hurdles to negotiating the terms of Brexit, there are also a number of practical implications. They include:
- The U.K. will no longer participate in political decisions at the EU and only the U.K. House of Commons will decide how Britain will be governed.
- The U.K. will lose direct access to the EU's consumer market.
- All British goods would have to undergo customs procedures for entry into the EU.
- The U.K. will resume full management of immigration and travel of non-citizens within its borders.
- Diplomatically, the U.K. will no longer negotiate in a unified manner with the EU on subjects of global importance. Additionally, it will have to make its own security arrangements.
- U.K. citizens living and working in the EU will also lose their rights to residency there.
Theoretically, negotiations with the EU will cover a transition in all these topics, whether an immediate "hard Brexit" solution, or a "soft Brexit" solution is chosen.
When asked about Brexit following the referendum, British Prime Minister Theresa May said "Brexit means Brexit." But given some confusion over the details, May later clarified her position in a talk with a group of Conservative Party members, defining what has come to be interpreted as the "hard Brexit."
"Let me be clear," she said. "We are not leaving the European Union only to give up control of immigration again. And we are not leaving only to return to the jurisdiction of the European Court of Justice."
In view of that position, the harder Brexit option is understood to be a withdrawal in which Britain would give up participation in the EU single market and its legal rules. It would also resume full control over its own immigration system, introducing stricter controls on immigration from the EU and elsewhere. The harder option would require Britain to carry out trade with Europe and other nations under World Trade Organisation (WTO) rules.
By contrast, the "soft Brexit" is interpreted as any number of possible arrangements that might be negotiated with the EU representing anything less than a full withdrawal. Soft Brexit options are seen to be promoted mostly by British officials who were against the Brexit and would like to try to partially honor the outcome of the referendum without fully severing ties with Europe.
There are varying possible scenarios for a soft Brexit. However, many proponents of a softer solution imagine a "strategic partnership agreement." In this case, the U.K. would resume control of its national immigration rules, and both the EU and the U.K. would maintain mutual market access and avoid application of nontariff barriers to trade in goods and services. This would imply that the UK would need to maintain full compliance with EU legislation for all goods and services imported and exported with the EU single market.
The softer option would require authorisation from the 27 EU governments to allow the U.K. to remain inside the EU for a period while the nation transitions to something of an observer status in the organisation. A part of the negotiation could also allow for agreements on reciprocal rights covering immigration for the purpose of tourism, employment, education and retirement.
During this time, the U.K. would likely be required to continue its financial contributions to the EU. Depending on how the agreement was negotiated, the country would either remain under its privileged current trading status with the EU, or re-establish a trading relationship with the EU single market under the framework of the WTO. The advantage of this option, according to its supporters, is that it would allow for greater certainty and a smooth transition of trade and investment rules.
The British Government Position
Despite what initially sounded like tough rhetoric from Prime Minister Theresa May on a Brexit plan, the British government has been guarded about how it actually intends to approach the negotiations with the EU. However, there have been hints that it hopes to preserve some of its key economic ties with the continent.
This could include, for example, keeping Britain within the Europe-wide patent system, which is under the jurisdiction of the European Court of Justice in Luxembourg. As part of an effort to protect intellectual property, Britain was an early proponent of the patent system from the 1970s.
May's government has also shown sympathy toward selective EU integration for UK certain industries as well as participation in EU-wide security arrangements, such as sharing crime databases. This type of selective cooperation with the EU would suggest that where possible, Britain hopes to opt in to certain mechanisms where they prove economically beneficial, in a manner used by countries such as Norway and Switzerland.
May has also said that she doesn't want the U.K. to face a "cliff's edge." By that she means some form of substitute arrangement should be in place before the two-year negotiating process comes to an end. To obtain any kind of softer deal from the EU, the British government is seen having to offer some special, favourable concessions for its EU trading partners in negotiations.
EU Position: No "Cherry Picking"
The decision on whether Britain will be able to adopt a soft Brexit or be forced to undergo a hard Brexit, will ultimately be up to the EU and its evaluation of allowing the country to maintain certain. So far, the positioning of the EU leadership has been unreceptive to suggestions that Britain should be able to close its doors to Europe while "cherry picking" what advantages it can obtain.
EU leaders—such as high-profile figures Commission President Jean-Claude Juncker, German Chancellor Angela Merkel and French President François Hollande—have been vocal in insisting that maintenance of the so-called "four freedoms" is a prerequisite for obtaining the advantages of full access to the single market. The four freedoms, which serve as the underpinning principles for the union, include the free movement of goods, services, capital and labor.
European officials have expressed concerns that if one nation is allowed pick and choose which rules it wants to follow "á la carte," then all other EU members will make a similar demand and make the organisation unviable.
Possible Economic Impacts Of A Hard Brexit
According to initial estimates by the British government, leaving the advantages of EU membership behind and switching to use of WTO trade rules would cost the U.K.'s businesses about £65.5 billion per year (or around US$82 billion). Over a 15-year period, this would lower the country's GDP by between 5.4% and 9.5%. In addition to lost trade, the U.K. may also be on the hook for paying about £20 billion in unpaid bills to the EU.
Analysts believe that the U.K. would find it difficult to replace the lost trade revenues from the EU, which has a consumer market of around 500 million people and a GDP around €12 trillion (US$13 trillion or £10 trillion). About 44% (or £220 billion of £510 billion) of the U.K.'s exports currently go to EU countries. Export trade with the EU is linked to about 12.5% of U.K.'s GDP, while the EU's trade with the nation is linked to only about 3% of its GDP.
While the country might be able to expand trade unfettered around the world once out of the EU, it might also find it difficult to match the negotiating power of the EU. With more than 50 partners around the globe, the union has more free trade agreements than any other single nation or trading bloc. And in addition to its existing trade agreements, the EU is negotiating agreements with the U.S., Canada, Japan, India, Australia, New Zealand and others.
Weakening Britain's Financial Might?
In addition to hurting trade prospects, the harder option is seen as a possible threat to the UK's financial services industry. According to some estimates, the limitation of access to Europe's financial markets could cost Britain as much as the following:
- £38 billion in business,
- £10 billion in tax revenues,
- and more than 70,000 jobs.
Further, international companies may hesitate to invest and locate in the nation going forward, seeking instead countries that do have access to the EU single market.
Possible Economic Impacts Of A Soft Brexit
While the potential impact of a hard Brexit has been calculated, the impacts of a soft Brexit seem less clear. Much of the potential impact of the softer option has already been felt. In the wake of the Brexit vote, the GBP fell to a six-year low against the euro and a 31-year low against the dollar.
The U.K. also suffered downward credit ratings revisions from ratings agencies Standard & Poor's, Moody's and Fitch, losing its top-rated credit status.
Pro-exit campaigners have argued that the country participation in the EU is not as advantageous as it seems, and so the cost of continued participation through a soft Brexit would need to be measured in terms of a loss of competitiveness in the rest of the world. They argue that the U.K. is the second-largest economy in the EU, contributing €14.1 billion to the region's GDP, while receiving back only €7.1 billion in EU subsidies. At the same time, the U.K. sends more of its exports (56%) to regions outside the EU and might stand to gain more if it was unhindered by tariff and nontariff barriers mandated by EU membership.
Pro-exit campaigners have estimated that with a clean break from the EU, the U.K. could negotiate free trade agreements with other countries in a sufficient number to make up for lost EU trade within 12 to 24 months. It is also possible that with a weakened currency U.K. companies could begin to see an uptick in export sales and business abroad, reinforcing the country's current account balance and economic growth.
So far, the Brexit approval has led to a weakening of the British pound against other major currencies along with the introduction of uncertainties about the potential future strength of the U.K. economy. Those trends may continue ahead, but the weaker currency may also bring some advantages in the form of greater global competitiveness for the country's economy.
Economically, Britain stands to lose more in the short term by pushing for a hard Brexit. In the long-term, though, its citizens may find that the autonomy and right to self-determination afforded by that decision to be worth it. Ultimately, the decision about whether Britain will face a soft or a hard option will depend on the EU member states and how much advantage they see in allowing Britain to maintain direct ties with the single market.
In either case, the long-term outlook for Britain will now depend on the skill of its negotiators and the will of its government and businesses to forge new arrangements that can substitute its existing trade arrangements with the EU.
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Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…