Article 50: a trump card or joker?

We have today published the full report assessing the implications of our EU ‘wargame’ which simulated the negotiating dynamic under two scenarios: first, a UK-EU renegotiation from within and, second, under ‘Brexit’. As we’ve stressed before, the fact is that unless the UK wants to simply fall back on WTO trading rules and unilateral free trade, renegotiation and withdrawal will both require a negotiation with other EU states and the EU institutions.

The only formal way to the leave the EU is via the so-called “Article 50” exit clause of the EU Treaties, which stipulates a two-year timeframe within which to potentially conclude a continuity deal. In our simulation, after their initial hostility, all other member states recognised the need to strike a new trade deal with the UK with economic incentives trumping political rhetoric. Britain is unlikely to face the ‘worst case scenario’ of having to fall back on World Trade Organisation rules.

However, as our simulation showed, the initial new deal would likely fail to replicate the full access to the EU single market currently offered by full membership:

• A Norway-style deal – effectively single market membership but with no formal political influence – is likely to be rejected by EU partners and is in any case a bad deal for the UK as it amounts to “regulation without representation”.
• While a reciprocal trade agreement for goods, where the UK has a sizeable trade deficit of £56.2 billion (2012) with the EU, would be relatively easy to strike, access to the EU’s services market – where the UK has a trade surplus of £11.8 billion (2012) – will be far more difficult.
• Access for UK financial services would be a particular concern since a third of the UK’s trade surplus in financial and insurance services in 2012 came from trade with other EU member states – of the total £46.3 billion UK financial and insurance services trade surplus, £15.2 billion was with the EU and £14.5 billion with the US. Perhaps over time, further bilateral deals on market access could rectify this but the political resistance from France and some others could be high.

While Article 50 of the EU treaties has the benefit of definitely triggering negotiations – which isn’t guaranteed under Cameron’s renegotiation plan – it comes with several drawbacks:

• Article 50 is a one way street – once it is triggered, and even if the deal available at the end of the process proves unsatisfactory to the UK, there is no way back into the EU except with the unanimous consent of all other member states.
• It is likely to put the UK on the back foot in any negotiation. The remaining EU member states would be in charge of the timetable and the European Parliament would have a veto over any new agreement. Therefore, while having to fall back on WTO rules entirely is unlikely, it would remain a possibility.
• As the UK will not take part in the final qualified majority vote on whether to accept the new deal, protectionist-minded member states could have greater influence on the degree of market access the UK could secure post-exit – particularly on services (see graph below).

Compared to renegotiation from within, Article 50 therefore cedes more control than what is often thought.

Ultimately, though, while a high transaction cost is undeniable, the big question is if there is a point – and if so when – at which the high one-off cost of Brexit would be outweighed by the long-term benefits of more economic and political independence over areas such as financial regulation, agricultural policy or criminal justice, particularly if the eurozone comes to dominate the wider EU and the necessary reform proves unattainable.

Could Cyprus leave the Eurozone but stay in the EU?

Now, we're not necessarily saying that Cyprus should leave the eurozone.

But with eurozone finance ministers set for a pretty long and rough night of talks, trying to reach a compromise that will allow Cyprus to live another day inside the eurozone, the question is, if it came to it (i.e. if a deal can't be agreed and ECB turns off the taps), could the country leave the euro but stay in the EU? As we note here and here, due to Cyprus' geopolitical importance, if it did ditch the Single Currency it would be vital that it stayed in the EU.

Leaving aside the question of how Cyprus would be ring-fenced and given a reasonable chance of bouncing back with its own currency (a big one to leave aside admittedly), what would the legal and political mechanics look like?

There is currently no mechanism for a country to leave the eurozone. However, there is a provision (article 50 TEU) that allows for a negotiated exit from the EU. This has lead some analysts to conclude that a country has to leave the EU if it left the euro. We disagree.

As so often in the EU, this will come down to political negotiations. The below analysis is based on our paper from last year on a possible Greek euro exit (which, incidentally, we said was unlikely to happen in the short-term). The line of reasoning very much applies to Cyprus. 

Given the absence of a specific euro exit article, there are two ways in which a country can leave the Single Currency.

• Changing the EU treaties to allow for a euro exit mechanism, perhaps modelled around article 50 (possibly even simply extending the article to refer to a euro exit) or the idea – floated by German politicians – to automatically trigger an exit if a state is unwilling or unable to comply with the rules governing the single currency. This would require agreement amongst all 27 member states and would essentially be a treaty renegotiation (making it complex and long winded). 

• Using existing articles in the treaties which provide flexibility to address a number of issues, such as article 352, to legally facilitate withdrawal from the euro but not the EU. This would also require agreement amongst all 27 member states and the European Parliament. Per definition, a decision for Cyprus to leave the euro has to happen essentially overnight (some estimates have put the real time available at 46 hours). This is problematic as a treaty change could take months, even using the fastest track (the simplified revision procedure, which needs to go through at least some national parliaments). 

Historically, political expediency has trumped EU law. Although it would not be clear cut or easy – and involve a legal stretch – we believe that in order to take a swift decision and avoid a Treaty change EU leaders could (and most likely would) use existing provisions in the EU treaties to allow for a Cyprus euro exit. In particular Article 352 TFEU – sometimes referred to as “the flexibility clause” – allows member states to take measures to achieve EU “objectives” (subject to unanimity and consent of the European Parliament but not ratifications in parliaments), when those are not already provided for in the EU Treaties. Article 352 states,

“If action by the Union should prove necessary, within the framework of the policies defined in the Treaties, to attain one of the objectives set out in the Treaties, and the Treaties have not provided the necessary powers, the Council, acting unanimously on a proposal from the Commission and after obtaining the consent of the European Parliament, shall adopt the appropriate measures."

This article could be used to provide a legal temporary avenue for Cyprus to leave the euro within the framework of the EU treaties. This would be far from an easy process; there would likely be numerous legal challenges against the move, while the negotiations would be hazardous and subject to domestic political constraints.

Precisely for this reason, a full treaty change would almost certainly be necessary very soon after the actual Cyprus exit (and use of article 352), which would change Cyprus status under the EU treaties from a euro member to a non-euro one and recognise, at least in retrospect, that there is a way for a country to leave the euro (under an expanded article 50 for example). Such a Treaty change would, at least in theory, go some way to counter some of the political uncertainty and legal ambiguity around the status of Cyprus’s EU membership and therefore reduce the risk of legal challenges. However, a full treaty change would come with its own set of political and legal complications. As with Article 352, a treaty change could only happen if all member states agreed. In addition, the changes would most likely have to be ratified in national parliaments.

So far from straightforward, but still plausible.  

Cyprus crisis shows Europe cannot perpetually move in one direction only

In an op-ed yesterday's Times, Mats Persson argued that:

No matter how the nail-biting drama in Cyprus ends, the eurozone has never been this close to waving goodbye to a member. Yesterday afternoon the deputy leader of the ruling party claimed that his country was hours away from agreeing an emergency package of tax rises and spending cuts to secure the EU’s €10 billion rescue loan.

If no deal is struck by Monday, the European Central Bank, on whose cash Cypriot banks depend, will pull the plug. With a banking sector seven times the size of GDP, Cyprus would default and probably crash out of the euro. The big question is whether a country can exit the euro without taking all Europe down. In the case of Cyprus the answer is straightforward: it could leave without causing a crisis, but it wouldn’t be pretty.

For Cyprus it would be extremely messy. To avoid massive capital flight there would have to be strict controls on financial movements, with border guards ready to stop people taking cash out of the country. After that would come a decree establishing a new Cypriot currency and a series of defaults on foreign debt. This would probably all have to be done in a weekend to avoid panic and contagion. A new central bank in Nicosia would fire up the printing press, which could trigger inflation. Cyprus could limp on with the help of external cash, possibly from the EU and the IMF or Russia — but it would be painful.

 For the rest of Europe there is a fear that a Cypriot exit could bring down Greece, Portugal, Spain or Italy. There are three ways in which contagion can spread: direct losses for banks or governments elsewhere in the EU start a chain reaction; depositors in other countries panic and cause a bank run; or nervous international investors fearful of losing out to the “next Cyprus” push the cost of borrowing up for other indebted governments.

But this is unlikely. Cyprus accounts for only 0.2 per cent of eurozone GDP, and vulnerable countries have little exposure to its economy. Greece would take a hit, but is already ring-fenced via EU bailout funds. Depositors in other countries have so far been unfazed by Cyprus’s troubles and even markets have been relatively calm. This suggests that Cyprus is a special, and financially marginal, case. In addition, the ECB’s promise to “do what’s necessary” to save the wider eurozone will provide extra reassurance to markets.

Instead the risks of a Cyprus exit are mainly geopolitical. The fear is that Nicosia turns to Russia for aid in return for, say, a Russian naval base on the island. Given its location, this would be a strategic nightmare for Europe.

To avoid such a scenario, it would be vital for Cyprus to stay in the EU, even if it left the euro. While life outside the EU may sound appealing to many Brits, it is different for a small open economy such as Cyprus. To complicate matters, EU treaties currently provide only a way to leave the EU (Article 50 of the Lisbon treaty), not the eurozone.

However, the EU specialises in legal acrobatics and there are articles in EU treaties that can be used for all kinds of purposes. One such clause provides a general legal base to achieve the “objectives of the treaties”, which include protecting the EU itself. It will be wrapped in a cobweb of legal jargon, but will effectively come down to a political decision by EU leaders.

And this is where it gets interesting for Britain. A Cypriot euro exit would have wide political ramifications: one of the founding principles of the EU — “ever closer union” — would be history. A swift, “Band-Aid” solution would almost most certainly have to be followed by a reworking of the EU treaties to recognise that the direction of travel is no longer only towards greater integration. The EU will have become a two-way street in which powers can be passed back to member states and its laws and institutions will have to reflect that.

Even if Cyprus does not leave the euro — and a revised bailout deal remains the most likely outcome — this episode signals that Germany and the other northern European countries are no longer willing indefinitely to foot the bill alone. At the same time the eurozone continues to lack the tools to deal with an acute crisis. This makes change almost inevitable for the way the eurozone is governed. Some governments have already called for a formal mechanism to allow a country to exit the euro. Europe cannot, perpetually, move in only one direction. And, in one way or another, Cyprus may be about to prove that.