Brexit's Potential to Fracture the U.K.

Analysis

Splitting from the European Union will inevitably strain the United Kingdom's territorial integrity.
Those pushing for Scotland and Northern Ireland to secede from the United Kingdom are using
Brexit to justify their agendas. Brexit will also open a debate between the central government in
London and the country's devolved governments about who will control the powers that will be
repatriated from Brussels. With authority over policy areas such as agriculture, fisheries, industry
and the environment returning to the United Kingdom after Brexit, the administrations of Wales,
Scotland and Northern Ireland will push London to transfer many of those attributions to them.

The United Kingdom has a devolution system, according to which different policy powers from the
United Kingdom's Parliament have been transferred to assemblies in Cardiff and Belfast, and to the
Scottish Parliament in Edinburgh. The system was created to acknowledge the United Kingdom's
distinctive cultures and identities. So in addition to the negotiations it faces to determine its status
after it departs the European Union, the central government must also prepare for the issues that
will arise among the United Kingdom's constituent countries.

An Independence Push in Scotland

When Scotland held an independence referendum in 2014, 55 percent of voters chose to remain in
the United Kingdom. One of the main arguments against secession was that an independent
Scotland would not automatically become an EU member and thus would lose access to free trade
with the bloc.

After the Brexit referendum passed in 2016, Scottish authorities lobbied for the United Kingdom to
remain a member of the EU's single market (an area where people, goods, services and capital
move freely) to minimize the effect of leaving the bloc. But Prime Minister Theresa May's
government says it will withdraw from the single market to negotiate a free trade agreement with
the European Union instead. In response, Scotland's governing Scottish National Party said that
such a change in the status quo justifies holding another independence referendum. Scottish First
Minister Nicola Sturgeon said the vote should take place in late 2018 or early 2019, before the
Brexit negotiations are over. She hopes that by gaining independence before the Brexit process is
resolved, negotiators would be forced to consider Scotland in the final agreement, ideally fast-
tracking its accession to the European Union.

However, Scotland's referendum cannot happen without authorization from the United Kingdom's
Parliament. May has said that now is not the time for another Scottish referendum, because she
does not want it to interfere with the Brexit process. The British government faces a dilemma: If it
continues to reject a referendum, nationalism in Scotland could grow; but if it authorizes a new
vote, the result would be impossible to predict. According to an opinion poll published on March 13,
support for independence among Scots is at 48 percent. There likely will not be another Scottish
referendum before the Brexit process is over. But Scotland will continue to use the threat of a
referendum as a negotiating tool with May's government, both to look for ways to remain in the
single market and to get concessions from London.

The Complications of Northern Ireland

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Northern Ireland receives millions of pounds in farming, fishing and structural subsidies from the
European Union, as well as money to preserve the Good Friday peace deal. In 2015, the European
Union sent Northern Ireland 320 million pounds ($402 million) in subsidies and around 50 million
pounds in peace funds. This money will no longer be available when the United Kingdom leaves
the bloc, meaning that the British government would probably need to seek ways to replace it. The
United Kingdom's membership in the European Union also allows Northern Ireland to keep its
border with the Republic of Ireland open, contributing to the pacification of the island. After Brexit,
there is a chance that some kind of border controls will have to be introduced. The letter delivered
by the British government formally triggering the Brexit included Northern Ireland as one of the
main topics for its upcoming negotiations. In the meantime, an internal EU document with draft
guidelines for the bloc's talks with the United Kingdom suggests that "flexible and imaginative
solutions" will have to be found to preserve the Good Friday Agreement.

Northern Ireland is going through a phase of political turbulence. The Good Friday deal, finalized in
1998, brought decades of sectarian violence to an end. But the political system it created, in which
unionist and nationalist forces share power, has also frequently led to inefficient governments.
Frictions between the two largest parties, the Democratic Unionist Party (DUP) and the nationalist
Sinn Fein, precipitated the fall of the government in early 2017. In the snap elections that followed,
Sinn Fein performed strongly, potentially indicating a surge in nationalist sentiments in Northern
Ireland.

When the period allotted to form a government expired March 27 without success, the British
government gave the parties until April 18 to reach agreement. On the surface, the DUP and Sinn
Fein are divided by issues such as a nationalist proposal to give Irish language official status in
Northern Ireland. But Sinn Fein believes that its strong electoral performance and Brexit have
improved Northern Ireland's chances of unification with the Republic of Ireland. According to the
Good Friday Agreement, a unification referendum can happen if a majority of voters in Northern
Ireland express their wish for it. A survey taken in late 2016, put support for a unification
referendum at around 40 percent.

If the parties cannot form a government, the British government is legally authorized to take direct
control of Northern Ireland, but this is something that May wants to avoid. Even if there is an
agreement to temporarily unblock the current stalemate, the Good Friday Agreement is showing
signs of exhaustion, and the Brexit process will create frictions between unionists and nationalists,
which means that political instability will probably continue.

In late February, the Republic of Ireland's prime minister, Enda Kenny, said that the final Brexit
agreement with the European Union should include a provision to let Northern Ireland automatically
become a member of the European Union if it unifies with the republic. Then in early March, Fianna
Fail, the Republic's main opposition party, announced that it is working on a plan to prepare the
north and the south for unification. While both parties have said that unification is still a distant
possibility, these moves show the extent to which Brexit will reopen discussions about the territorial
and political future of the British Isles.

Seeking Advantage in Wales

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Support for Welsh independence is low, with polls persistently showing less than 10 percent of the
population in favor. Like their English peers, a majority of Welsh voters supported leaving the
European Union in the 2016 referendum. But while independence is not an immediate threat,
Welsh leaders are looking for ways to benefit from the Brexit process. First Minister Carwyn Jones
recently warned that regulations on issues that affect Wales such as agriculture, which is currently
an EU prerogative, should be transferred to Cardiff instead of London after Brexit.

Wales also expects to gain from whatever concessions London makes to Scotland. In the months
leading to the Scottish independence referendum of 2015, for example, London promised to grant
Scotland additional powers over taxes, welfare benefits and energy. In the coming months, London
may offer new sweeteners to Scotland to appease secessionist sentiments. This will open the door
for Wales to make its own demands. While the Welsh issue will not be nearly as pressing as the
Scottish or Northern Irish questions, it will create yet another headache for May's Cabinet.

A Tussle Over Gibraltar

In Gibraltar, 96 percent of residents voted to remain in the European Union. It is a British Overseas
Territory that participates in the EU's free movement of people, services and capital; but not in the
free movement of goods or in programs such as the Common Agricultural Policy. The main
activities of Gibraltar's services-based economy include financial services, tourism and online
gaming. Roughly half of its workforce consists of EU citizens (mostly Spanish) who are daily
commuters, and most tourists arrive to the territory by land. To make things more complicated,
Gibraltar's territory is claimed by Spain.

Brexit poses two risks for Gibraltar. The government is worried that Gibraltar's exports will no
longer have tariff-free access to the EU single market, especially because a free trade agreement
will be easier to negotiate for goods than for services. It is also concerned about Spain unilaterally
closing the border and isolating the territory (since the United Kingdom is not a member of the
passport-free Schengen Agreement, identity checks already take place at the border). The
government of Gibraltar excluded the possibility of leaving the United Kingdom and joining Spain,
but it recently held talks with Scotland to jointly seek ways to remain in the single market.

According to a draft of EU guidelines for the Brexit talks, the Brexit deal would not apply to Gibraltar
without a separate agreement between the United Kingdom and Spain. But Madrid will probably
not pressure London too much over Gibraltar, at least during the early stages of the Brexit
negotiations. Madrid and London will be interested in reaching a deal to protect the rights of the
300,000 British citizens who live in Spain and the 200,000 Spaniards who live in the United
Kingdom, as well as to preserve their strong bilateral trade and investment ties. In the future,
however, Madrid will gain some leverage it could use to negotiate the status of Gibraltar. To win
approval for a free trade agreement would require the unanimous support from all EU members,
which would give Spain veto power over the final deal.

Legal and Political Issues

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The Scottish government has said it will seek to remain in the single market, either through
independence or by a special agreement with the European Union as a member of the United
Kingdom. Should Scotland become independent, it would not automatically become an EU
member. The Scottish government has suggested that if it does become independent, while it
applies for EU membership it could in the meantime become a member of the European Free
Trade Association, a club of non-EU countries (including Iceland, Liechtenstein, Norway and
Switzerland) that participate in the single market. Should Scotland remain in the United Kingdom,
Scottish authorities have suggested emulating Denmark, where parts of its territory are in the EU,
while others (such as Greenland and the Faroe Islands) are not.

In Northern Ireland's case, secession from the UK would almost certainly lead to EU membership.
Northern Ireland would join the Republic of Ireland, which already is a member of the EU. A similar
situation occurred in 1990 after German reunification.

Without leaving the United Kingdom, it would be difficult for Scotland or Northern Ireland to remain
in the single market, because any free trade deal between the European Union and United
Kingdom would probably generate contradictions. The free trade agreement likely would cover a
shorter list of goods and services than the single market agreement. To solve these contradictions,
border controls would have to be introduced to ensure that goods and services moving across the
borders comply with the existing trade agreements in each territory. If Northern Ireland leaves the
single market with the rest of the United Kingdom, a border control with the Republic of Ireland
would have to be introduced. And should Scotland manage to remain in the single market, border
controls with England would have to be instituted.

Migration issues should be easier to solve, as neither the United Kingdom nor the Republic of
Ireland are members of the passport-free Schengen area. This means that both countries could
agree on joint migration controls at airports and ports. There would still be some issues to solve
connected with working rights, because under this scenario EU citizens would be free to work in
Scotland and Northern Ireland, but not in England or Wales.

A Political Question

Even if there were technical solutions to these issues, the negotiations between the United
Kingdom and the European Union will be mostly political. EU officials have said that Britain cannot
selectively pick the aspects of EU integration it wants to keep. At a time when Euroskeptic
sentiments are on the rise in Europe, EU leaders want to send a message home that leaving the
EU is not a painless process. In addition, EU members like Spain in which domestic secessionist
movements are strong would also be against making concessions to Scotland or Northern Ireland,
out of fear that local independence groups could feel encouraged to demand the same. The British
government also is unlikely to accept a settlement that would involve the introduction of internal
border controls and differentiated visa systems among the devolved governments, out of fear that it
could be the prelude to secession.

The British government will seek to find a balance between appeasing political discontent in the
devolved administrations and remaining in control of the Brexit process. London will reassure
regional governments that their interests will be represented during negotiations with the EU, and
will keep them updated on the status of negotiations. London will also promise subsidies,

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investment, tax breaks and the assignment of EU prerogatives to the devolved governments.
Considering the extensive list of policy areas that are currently under EU control but will soon be
sent back to the United Kingdom, London will have a long list of topics to choose from when it
comes to devolving powers. But London is unlikely to give Scotland or Northern Ireland a decisive
role in the Brexit negotiations, or to make moves that would jeopardize the country's territorial
integrity. As a result, in the coming years secessionist pressures could become hard to contain in
the United Kingdom.

European Disintegration
This year will be the one in which political risk reaches the European Union's core members.
During the second quarter, this will become evident as France the bloc's second-largest
economy holds presidential and legislative elections, the results of which will resonate far
beyond the country's borders. French voters will have to choose whether they want their country to
reform the European Union or dismantle it to restore their state's full sovereignty.

Italy will also become a source of political risk as it moves closer to holding general elections. The
current Italian government will probably stay in place this quarter, but the specter of an election in
which Euroskeptic forces are expected to perform well will do little to ease concerns about the
country's fragile banks and high debt levels. Germany, meanwhile, will try to keep the European
Union together as it opens its own campaign season. The coming quarter will be eventful for
Greece as well as Athens implements the reforms it promised to its creditors.

The Fate of the Eurozone

French presidential and legislative elections will be the most important events to take place in
Europe during the second quarter. A significant portion of France's political apparatus will be
elected and appointed over the next three months. The presidential election will be held in two
rounds on April 23 and May 7, while legislative elections (also split into two rounds) will follow on
June 11 and June 18. French voters will have to decide whether they want to further liberalize and
deregulate their economy or increase protectionism. They will also have to choose whether they
want France to stay a member of a reformed European Union or leave the Continental bloc entirely.

The biggest contenders in the elections are the nationalist National Front, the centrist En Marche!,
the center-right Republicans, the left-wing Unsubmissive France, and the center-left Socialists.
Should any of the moderate parties win the presidency, they will focus primarily on economic and
security issues. A moderate government (especially under En Marche! or the Republicans) would
seek to make the economy more competitive through various combinations of spending cuts, public
investment, labor reform and initiatives to reduce bureaucracy, cut down on regulation and attract
foreign investment. A moderate government would probably also direct more resources toward
security forces and defense spending, while at the international level it would work to reform the
European Union and defend France's leading role in it. The possibility of different parties controlling
the presidency and the National Assembly cannot be excluded. This would complicate
policymaking.

France's two-round electoral system has historically made it difficult for extremist parties to win
presidential and legislative races. Candidates have to receive more than 50 percent of the vote to

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gain the presidency or a seat in the National Assembly, a threshold that the National Front, for
instance, has found tough to reach. If the National Front overcomes this hurdle and wins the
presidency, it will set in motion a chain of events that could lead to severe crisis in the EU.

For one, the National Front wants to introduce tariffs on French imports and tax companies that
hire foreign workers, including EU nationals. Both ideas go against the basic principles of the EU
single market, which emphasizes the free movement of people, goods, services and capital. Even
more important, however, the party also intends to hold a referendum on France's membership in
the eurozone. Many of the National Front's campaign promises would require a majority in
Parliament, and in some cases the legal procedures to implement them would be arduous. National
Front leader Marine Le Pen has also said the referendum on eurozone membership would be
called only after six months of negotiations on reforming the European Union. But even the mere
victory of the National Front in the presidential election could trigger a crisis in the eurozone.
Savers in the eurozone's periphery states (such as Spain, Portugal and Greece) could, for
example, withdraw their money from local banks or transfer it to safer havens abroad, forcing
authorities to introduce capital controls at the national or Continental level to stop a run on
eurozone banks.

If France's moderates win, Germany will immediately invite the new president to shore up bilateral
ties between Paris and Berlin and co-lead Europe. In global markets, the euro, along with riskier
assets such as bonds from Europe's periphery, will strengthen rapidly. Should the National Front
win, on the other hand, the German government will seek accommodation with the nationalist
government in Paris, trying to dissuade it from fulfilling its most radical campaign promises. But
many of the National Front's policies are simply incompatible with EU structures, limiting its room
for compromise. And if serious trouble arises in the eurozone, Berlin will start making preparations
for the most orderly dissolution of the currency area possible while planning its next steps with its
closest partners in Central and Northern Europe. The market fallout of a potential eurozone
collapse would be immediately felt in global markets as European investors flee riskier bonds and
move their money to safer assets, such as German bonds.

Italy, meanwhile, is moving toward its own general elections, though it is unclear just how quickly
they will arrive. The country does not have to hold elections until early 2018, but disputes within the
ruling center-left Democratic Party could precipitate an early vote. The government in Rome, led by
Prime Minister Paolo Gentiloni, will remain weak as Italy's main political parties prepare for the
elections. Ahead of the vote, the Democratic Party will hold its primary to appoint a new leader in
late April a necessary step before the government resigns and parliamentary elections can be
held.

Still, the elections will not take place during the second quarter. This means that Italy's vote will not
coincide with France's, giving markets and EU governments time to digest the latter's results. But
the lingering risk of elections in Italy, where Euroskeptic parties would probably make a strong
showing, will add to the uncertainty clouding Italy's political and financial future. This will do little to
ease market fears about the health of Italian banks and the country's high levels of public debt. But
Italy could introduce some modest spending cuts to allay the European Commission's concerns
about its deficit, and whatever frictions may arise, Rome and Brussels will find a compromise,
allowing Italy to avoid EU sanctions.

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Greece, another troubled eurozone country, will also be politically and financially fragile this
quarter. Because Greece does not have any significant debt repayments to make until mid-July,
negotiations between Athens and its creditors on the disbursement of the next tranche of bailout
money could drag on for weeks, perhaps even extending beyond the end of the quarter.
Nevertheless, the Greek bailout program will stay on track since Athens and its creditors are eager
to avoid a default at all costs, though Athens will try to tone down some of the policies it has
promised to implement, or announce spending increases in some areas, in hopes of avoiding a
rebellion within the government.

In the meantime, Germany will continue to delay granting debt relief to Greece during its own
election cycle. It could, however, make vague promises to discuss the issue in the future. Even if
the International Monetary Fund does not announce a decision on its participation in the bailout
program during the quarter, Greece and its creditors will work to keep it in place.

For an export-dependent economy such as Germany's, the prospect of a trade war brewing with
the United States and Washington's threats to undermine the World Trade Organization are also
major sources of concern. Consequently, Berlin will keep communication channels open with the
new administration in the White House to defend Germany's stance on these issues, as well as on
many other points of controversy between the two governments. Germany will also use its rotating
presidency at the G-20 to defend free trade and the role of multilateral trade organizations.

Germany's strategy will include preserving the European Union's single market and expanding the
bloc's trade relationships with other markets, primarily by supporting EU plans to resume stalled
free trade talks. During the second quarter, for example, the European Union will revive
negotiations with Mexico to update their free trade agreement. Brussels' efforts to sign free trade
agreements with countries such as Japan and India will likewise intensify. Germany will advocate
the development of closer trade ties between the European Union and China as well, though the
bloc will struggle to get European companies the same level of access to China that Chinese
companies have to Europe, creating room for friction during any negotiations that are held. Berlin's
aggressive stance against Chinese takeovers of German companies will lead to similar
complications during the talks.

To curry favor with the United States, the German government is willing to make gestures of good
faith in areas such as defense spending. But this will not go over well in Germany. After all, it is an
election year and the German government will be forced to keep lines of communication open with
Washington while also being critical of the new administration, especially since a large portion of
the German public disapproves of U.S. President Donald Trump. The relationship between the
ruling center-right Christian Democratic Union (CDU) and its coalition partners in the center-left
Social Democratic Party (SPD) will encounter additional tension as the two try to differentiate
themselves before the general elections.

Regional elections in the northwestern German states of Schleswig-Holstein (May 7) and North
Rhine-Westphalia (May 14) will test the appeal of the SPD and CDU ahead of the September vote.
They will also act as a gauge of the popularity of smaller parties, such as the environmentalist
Green Party, the left-wing Die Linke and the center-right Free Democratic Party all of which
could become coalition partners to the SPD and CDU after the elections end. Moreover, the
regional races will show whether the nationalist Alternative for Germany (AfD), whose popularity

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has declined in recent months, can make gains beyond its strongholds in the east and enter the
legislatures of western regions. Regardless of the AfD's performance, other parties will refuse to
cooperate with it. Yet the AfD's role in German politics is not necessarily to enter government, but
to force moderate parties to incorporate elements of its nationalist agenda into their own.

Brexit and Beyond

Brexit negotiations among the British government, EU institutions and EU members will begin in
earnest in the second quarter. But the process will last at least two years. All sides will spend most
of the next three months in exploratory discussions that aim to define the framework and terms of
the negotiations, and no dramatic decisions are expected this early on. Before the talks can even
begin, the European Union's remaining 27 members will have to agree to give the European
Commission directives for its talks with London.

Some of the topics at the top of the Brexit agenda will include the legal status of British citizens
living in the European Union and of EU citizens living in the United Kingdom. The parties are also
likely to debate the Brexit's financial aspects, including the United Kingdom's contributions and
payments to the European Union in the years ahead. This will create frictions, as the British
government would try to keep its exit bill as small as possible. At the same time, the British
government will be interested in starting conversations on the free trade agreement it hopes to sign
with the European Union. But EU negotiators will insist on a sequential approach, starting with the
country's exit and leaving the debate over the terms of its future relations for a later date.

British Prime Minister Theresa May's administration, meanwhile, will face the difficult task of
reassuring the devolved governments in Scotland, Northern Ireland and Wales that their voices will
be heard and their interests will be protected during the Brexit talks. London will also have to make
sure that the central government remains in control of the Brexit process. London may promise
subsidies, investment, tax breaks and even the transfer of powers currently in the hands of the
European Union to regional governments to try to appease secessionist claims. It is unlikely,
however, to give Scotland and Northern Ireland a decisive role in the negotiations. And as Northern
Irish nationalist and unionist parties struggle to find common ground, the Good Friday Agreement
that defines how the region's government operates will continue to show signs of fatigue.

Divided EU Foreign Policies

The next three months will bring a flurry of debates about Russia to the Continent. As the July 31
expiration date for EU sanctions against Russia approaches, the bloc's internal discussions about
its relations with Moscow will become more frequent. Since there have not been any notable
changes on the ground in eastern Ukraine or in U.S.-Russia ties since the Trump administration
took office, most EU members will support the continuation of existing sanctions. Though the bloc
does not have to make its decision until late July, the possibility of it coming before the end of the
quarter cannot be ruled out. Should the issue be put to a vote within the next three months, some
countries will voice their criticism of the sanctions but are unlikely to veto the decision of the
majority. (That said, an electoral victory by France's National Front, which has argued against new
punitive measures toward Russia, would significantly threaten the Continent's sanctions regime.)

Crossing Borders

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As the weather starts to improve in the Mediterranean Sea, migration to the European Union's
southern members will pick up. Along the migrant route traversing the eastern Mediterranean, the
EU-Turkey immigration agreement still holds, but Ankara has the power to refuse to honor the deal
and to stop policing migrant traffic. If it does, it would be in an effort to put pressure on the
European Union, whose half-hearted compliance with the terms of the deal has rankled Ankara.
The bloc, for example, has not lifted visa restrictions for Turkish citizens one of the main
promises it made to Ankara in exchange for its cooperation in preventing asylum seekers from
entering the European Union. Several EU states will also continue to criticize the Turkish
government's attempts to consolidate power following last year's failed coup attempt, giving Turkey
added reason to threaten to renege on the deal.

Many migrants may, in fact, become emboldened by the Turkish government's threats and attempt
the journey from Turkey to Greece. But Ankara will not give up on the migrant deal completely,
since it still hopes to use the agreement and Europe's fear of the political side effects that
renewed waves of immigration could have in an election year to negotiate and expand its
customs union with the bloc in the near future. Maintaining these deep economic ties with Europe
is especially important to Turkey as its economy continues to founder.

Regardless, EU members will try to protect themselves from a possible uptick in asylum seekers,
keeping their borders closed along the biggest migration routes. This will pose a serious threat to
Greece, as the country risks once again becoming a bottleneck for migrants who reach its shores
but cannot keep moving northward.

There is also only so much the European Union can do to tamp down on the Central Mediterranean
migrant route. In recent months the bloc has stepped up its political, economic and security
cooperation with countries in sub-Saharan Africa, from which many migrants originate, as well as
with Libya, the main transit state for migrants trying to reach Southern Europe. These policies will
continue during the second quarter, but their impact will be modest. Italy and other southern EU
members will see more migrants arrive on their doorsteps as weather conditions improve, creating
tensions between them and their peers in Northern Europe. Rome will demand greater assistance
to handle the influx of people, and if it allows some migrants to pass through its borders and into
the rest of the Continent, frictions between it and its neighbors could worsen.