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Spotlight - Political and economic incentives driving

Issue date: 2019-11-29

With Article 50 set to be triggered, we consider the options for a new UK-EU relationship. We can use game theory to try and assess which outcome is most likely based on the signals that both parties are sending at present.

 

Stephanie Kelly
Political Economist

 

The long-awaited triggering of Article 50 is a key step in the process of the UK leaving the EU. It will allow both parties to negotiate the UK’s exit, while possibly establishing a skeleton for a new trading relationship in tandem. Article 50 allows two years for the initial exit agreement process, but an extension to this period can be granted if the European Council (excluding the UK) unanimously agrees. The UK is deeply entrenched in the EU economic and regulatory infrastructure, which makes the process of leaving extremely complicated. Therefore, we expect a transitional agreement to be required.

Setting up the new trade agreement is likely to be a long process. The final agreement on the terms for the UK leaving the EU can be agreed by a qualified majority of the European Council. However, any new trade deal that requires treaty change, or that qualifies as a ‘mixed agreement’, would necessitate unanimous approval by all 27 remaining members. Countries may opt to, or formally require (i.e. Ireland), a domestic referendum. Others may need regional legislative approval before being able to provide ratification (i.e. Belgium).

There is clearly a great deal of uncertainty over the eventual outcome of this complicated process. In this article, we consider what each party is looking to achieve in these negotiations and examine the different types of possible institutional arrangements between the UK and EU. We then use game theory to try and establish the relative likelihood of different outcomes at this admittedly early stage.

 

The rules of the game

To start, we make an assumption that the EU and UK are two single negotiating parties. Of course, the reality is that the EU is made up of 27 disparate members (excluding the UK), all of whom have their own individual priorities and red lines which could lead to a breakdown in negotiations. In Germany, this could be a certain tariff level on auto-manufacturing, while in Ireland the red line may literally be a border line between the Republic of Ireland and the UK. However, sorting these interests into an overall negotiating position will be part and parcel of setting the overall EU negotiation objectives, such that national and transnational interests are represented satisfactorily by a single player. The need for unanimous agreement among EU member states should ensure that the ultimate deal does not cross any individual red lines.

So, what are the key issues? We think there are four major points of contention.

 

Free movement of labour
Controlling immigration was the dominant issue for the ‘Leave’ campaign in the run-up to the UK’s EU referendum and has become a central tenet of the government’s rhetoric around the future of the UK’s relationship with the EU. Given that free movement of people is a key pillar of the EU, changes to this principle are likely to be met with stern resistance by EU negotiators.

 

UK political sovereignty
The perceived democratic deficit in EU membership was another key message of the Leave campaign. The supremacy of the European Court of Justice and the requirement for the UK to adopt EU rules and regulations were particular gripes. However, there is a natural trade-off between the degree of sovereignty in these areas and access to the single market. A European Economic Area (EEA) or Swiss-style solution would still require the UK to comply with EU laws and regulations in return for access to the single market. In addition, such countries have no say in writing these laws or regulations.

 

Services access and the single market
The UK is a large exporter of services, particularly financial services. At present, financial institutions based in the UK can operate easily in the EU without onerous additional regulation, partly through passporting. Single market exit would raise the risk of non-tariff barriers to these types of activity. The government is seeking ‘the freest possible trade’ in financial services with the EU, which could come in the form of mutual recognition or tailored equivalence in regulation. The economic importance of the sector and the role of London as a financial centre make this a key issue.

 

Future of the Eurozone and EU
There has been significant political capital invested in the European project. Brexit constitutes a threat to the sustainability of this union, especially given signs of growing EU scepticism in other countries. A fear is that the UK will be the first domino to fall in the unravelling of the European project. So, EU negotiators are incentivised to maintain the integrity of the EU and deter future rebellions. This must be balanced against a desire to maintain trade and political relations with a strategically important economy.

 

Let’s make a deal

EU exit is not as binary as sometimes portrayed. The new UK trading relationship with the EU could come in a number of shapes, sizes or consistencies; not just ‘hard’ or ‘soft’. Indeed, there is a spectrum of options for the new trading relationship, ranging between full EEA membership and a World Trade Organisation (WTO) relationship (see Table 1).

Overall, the closer that UK relations with the EU resemble actual membership, the less disruptive it will be for trade and associated activity. EEA membership would imply relatively modest changes in the UK’s relationship with the EU, with firms still able to access the single market and the free movement of labour enshrined. The Swiss model of bilateral trade agreements would allow access to large parts of the single market, but again comes with strict rules around migration. A more distinct separation would see the UK negotiate a Free Trade Agreement (FTA) with the EU. This sounds attractive, but in practice it would imply a rise in trade frictions. Tariff levels would depend on complex sector-bysector trade-offs across member states. Moreover, we would see increased non-tariff barriers to trade with the single market. The most disruptive outcome would be a fall back on WTO rules, which would imply material rises in both tariff and non-tariff barriers.

 

Deal or no deal

Using a variation on the famous ‘prisoner’s dilemma’ in game theory, we can try to establish how likely these outcomes might be depending on the degree of compromise required on each side around key issues (see Table 2). A high level of implies that domestic politics takes a back seat to what is necessary to secure the least economic disruption. At the other end of the spectrum, low levels of compromise imply that short-term domestic political considerations take precedence over economic considerations. Moderate levels of compromise are a hybrid of the two.

Although EEA membership would produce less disruption for both sides, it is only politically desirable for the EU. The lack of control over migration and sovereignty makes this the worst political outcome for the UK. According to current signals, it looks highly unlikely at present.

The ‘Brexit Ideal’ creates little economic disruption, particularly for the UK, but it is politically untenable for the EU. It would compromise the four freedoms and increase the likelihood of future member departures. Therefore, we also deem this as highly unlikely.

If neither party is prepared to compromise, a fall back to WTO trade rules could emerge. Although this would produce the worst outcome economically, we see it as modestly more likely than either the EEA or Brexit Ideal because each side’s approach would mirror the other.

On balance, we believe that both sides will be prepared to compromise to some extent. This makes an FTA the most likely post-Brexit arrangement. The differences between types of FTAs depend on how much each party is willing to sacrifice political capital for economic benefits. Overall, we think the most likely outcome is the middle-ground ‘Regular FTA’. This allows both parties to retain political reputations along their key-issue red lines, while also building an effective, if not comprehensive, free trade relationship. We place ‘FTA Max’ in a similar probability range to a WTO relationship because it requires a higher degree of compromise on both sides than has been displayed thus far. The remaining and more plausible solutions are less inclusive versions of an FTA, where tariffs, regulations, immigration and taxes are used as the primary bargaining chips.

Of course this could all change. The red lines that are emerging from both the EU and UK are not set in stone. Similarly, the negotiations could proceed in a more or less constructive manner than we have assumed. We will need to watch carefully for triggers over coming months and quarters that tell us in which direction we might be heading. However, this game theory approach provides a solid framework in which to analyse the forthcoming discussions.

 

Disclaimer

This material is for informational purposes only and does not constitute an offer to sell, or solicitation of an offer to purchase any security, nor does it constitute investment advice or an endorsement with respect to any investment vehicle.

All information, opinions and estimates in this document are those of Standard Life Investments, and constitute our best judgement as of the date indicated and may be superseded by subsequent market events or other reasons.

Standard Life Investments (Hong Kong) Limited is licensed with and regulated by the Securities and Futures Commission in Hong Kong and is a wholly-owned subsidiary of Standard Life Investments Limited.

Standard Life Investments Limited is registered in Scotland (SC123321) at 1 George Street, Edinburgh EH2 2LL. Standard Life Investments are authorised and regulated by the Financial Conduct Authority.

www.standardlifeinvestments.com



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