The Intractable Irish Question

There are three issues that the EU insists are addressed before formal discussions about the post-Brexit UK-EU
relationship. 
These are EU citizens’ rights in the UK, the British
financial commitment, and the North Ireland border with the Republic of
Ireland.  

Progress has been reported on the
EU citizens’ rights, and speculation suggests
that UK Prime Minister May is prepared to shortly (within the next two weeks)
raise her to offer closer to the figure
that some EU officials have mentioned (60 bln euros). 
Many had
expected the financial negotiations to be the most difficult, but it now seems
that the Irish border issue may be the most intractable.  In fact, it may
turn out to be the deal breaker in the sense that a solution may not be
achievable in the next two weeks.  This, in
turn,
may prevent the EU Summit next month to allow the new phase in the
negotiations to begin.  

Why is it intractable? Don’t all three parties (Ireland, UK, and EU)
agree that a hard border is not acceptable?  The problem is that Ireland
and the EU want Northern Ireland to remain in the EU’s common market and remain
subject to the EU customs and internal market rules even after Brexit.  
Ireland is also concerned that a hard
border would undermine the Belfast Agreement (aka Good Friday Agreement), which
was vital in the peace process.  Peace between the Catholic and Protestant
parts of Ireland was forged within the EU
framework.

 There was one major political group in Northern Ireland that
opposed the agreement.
  The Democratic Unionists.  UK Prime
Minister May changed the fiscal priorities of the Tory government that she
inherited from Cameron.  She also maneuvered to hold snap elections, which
went against the spirit of the election schedule that Cameron’s government
implemented. The main thing she kept was Cameron’s willingness to make binding
the non-binding referendum.  In any event, upon losing the Tory
parliamentary majority, May sought out a coalition with Northern Ireland’s
Democratic Unionists. 

To be sure, the UK is not just balking at the Irish demands because of
the Democratic Unionists.
  Conceding the regulatory authority to the
EU over Northern Ireland would be tantamount to an abdication of UK sovereignty.   The UK’s Davis (Secretary
of State for Exiting the European Union) rejected the idea that Northern
Ireland will remain in the single market.  A hard border within the UK is
unacceptable to the British government and a hard border between Northern Ireland, and Ireland is not acceptable to
Ireland and the EU.  

Nevertheless, given the economic ties (e.g., bilateral annual trade ~65
bln euros) a disorderly UK exit from the EU would hit Ireland harder than most
of the EU.
  Ireland’s Prime Minister Varadkar argues that it is
incumbent on the UK to propose a solution.  He called for “specific
assurances and written guarantees.”  The Financial Times reports that
despite Varadkar’s claim that top European officials support his position,
“it is quietly acknowledged in Dublin that other member states are
unlikely to tolerate a breakdown over Ireland is money and citizens rights are settled.” 

Even if the Financial Times assessment is correct, it still does not make
an acceptable solution any clearer.
There are alternatives, but they may
require imagination and strong leadership, both of which are not in large
supply at the moment.  For example,  the Isle of Man may offer a model, though may not be a perfect example of what is possible. 

The Isle of Man is a self-governing Crown Dependency between the island
of Ireland and the island of Britain. 
The Queen of England is the
head of state, and the UK is responsible
for defense and foreign policy.  The local parliament is responsible for
all domestic policies. 

The Isle of Man it’s not part of
the British Commonwealth, but participates in some of its institutions. 

It is not a member (or associate member) of the EU.  However, under the
Treaty of Rome, it is part of the EU
customers area.  There are, though, some limitations on the movement of
capital and services.   The Isle of Man is also a tax haven insofar
as there are not capital gains, wealth or inheritance taxes, or corporate
taxes, and the top income tax rate is 20%.  

In any event, the EU chief negotiator has given the UK two weeks to
clarify its position on the three outstanding issues.
  UK Prime
Minister is in a weakened position has illustrated by the reports suggesting
that 40 Tory MPs are ready to sign a letter of no-confidence.  Another
eight would be needed to trigger a leadership challenge.  It is not clear
who could succeed May if it comes down to
that.  The bookmakers are divided.  Three bookies have three
different candidates favored Jacob Rees-Moog, David Davis, and Boris Johnson. 

What worries many investors is not simply that there is not a single
candidate that has emerged, but that some of the suggested candidates may actually be worse for investors than May.

And this is not to even discuss the economic straits of a slowing economy and
compression in household purchasing power, which will likely be brought to the
fore this week with inflation, employment/earnings, and retail sales reports
slated for release in the coming days. 

Sterling remains within a five-week trading range of roughly $1.30 and
$1.3320.
  Speculative positioning in the futures market is roughly
balanced between the bulls and bears, leaving a net position of long 1.2k
contracts.  The US two-year premium over the UK has to rinse from the year’s low
of 90 bp in mid-September to nearly 120 bp here in November.  The high for
the year was set in March a little above
130 bp.  The three-month (25 delta)
risk-reversals (skew between calls and puts) show a premium for sterling puts,
but that premium had been falling since early October, until today.

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