Europe's phoney war

Gavin Hewitt

There is an air of unreality hanging over Europe. This week, Theresa May will attend her first EU summit. Headlines will be eked out of the leaders' sound bites as they enter the Justus Lipsius building in Brussels.

But everyone knows that it won't be until next year that the EU and the UK fully engage and negotiate Brexit.

For the moment, the two sides are circling each other, searching out which has the stronger hand.

The official line is that no negotiations can start until Article 50 has been triggered. So leaders and officials communicate via statements, speeches and sound bites.

In the past week Donald Tusk, the President of the European Council, declared that "the only real alternative to hard Brexit is no Brexit", so setting off another round of speculation about the scale of the UK's task.

It is a strange way to do business. Conversations are taking place and cracks are appearing in the walls of silence. And pressures are mounting, from business, from investors, from the currency markets, from Europe's sluggish economy, to start talking.

What the UK government wants is to gain control over immigration, reduce migrant numbers and retain as much access to the single market as possible. If there is a priority it is to deliver on immigration, even at the expense of the single market.

From the European perspective the aims are irreconcilable. In the past week, Angela Merkel has said again that "if Britain says 'no' to free movement, it can't get full access to the European single market".

Some of the Brexiteers believe the EU will blink first. Their calculation is that it is clearly in the EU's interest to strike a deal with the UK. Common sense will prevail. The EU sells some £70bn more to the UK than we do to them. (However, the EU exports about 3% of its GDP to Britain, while the UK exports 12.5% of its GDP to the EU).

And they also point to the fragility of the eurozone's recovery. It is holding steady but little more. Certainly the defences of the banks have been strengthened but the problem of non-performing loans has not been solved.

Debt (both public and private) is higher than when the crisis began. It matters less when interest rates are low but it could return to haunt the single currency in the future.

The essential flaws in the currency - no common treasury, no pooling of debts - have not been addressed. And, most importantly, the eurozone is still struggling to escape from its reputation as a low growth/high unemployment area.

And, so the argument goes, a trade deal with the UK is very much in its interest. Trade will trump politics. "No, it won't," say some of Europe's leaders.

Some clearly want the UK to suffer for voting to leave. They fear contagion, that other countries might be tempted to follow in the footsteps of the UK. It should be said that there is no indication of that happening in the short term.

And some in Europe are waiting to take advantage if the UK is left outside the single market. Battle has been joined to lure bankers and financiers to Paris and Frankfurt. Red carpets are being laid out.

And in Brussels, they spy an opportunity to deliver what they have long wanted: for London to lose the right to clear deals denominated in euros. And there are some reports of European banks slowing the transfer of staff to London.

That having been said, many politicians in Europe recognise the mutual benefit of a smooth exit by the UK.

Many believe that a divorce is possible within those two years but without a trade agreement. In those circumstances, the UK is likely to angle for a five-year transitional arrangement during which it will try to negotiate a free trade deal.

The aim would be to retain as much access to the single market as possible. That might involve having to pay for certain sectors (like the City or cars) having full access to the single market. With the EU struggling to fund its budget demands there might be a willingness to see the UK pay up.

The government has long said that it wants a bespoke deal with the EU but some European leaders see the trade deal with Canada as the best potential model. It excludes 95% of tariffs on goods but it doesn't, however, cover financial services.

Spanish foreign minister Jose Manuel Garcia-Margallo has said that "the deal with Canada is the precedent for the deal between the EU and Britain".

But, as both sides test ideas and probe for weaknesses and advantages, there are pressures.

The EU is entering a period of political uncertainty. Italian Prime Minister Matteo Renzi is facing a referendum on constitutional reforms in December. If he loses it - and the signs are that it will be close - he may well resign.

The French are due to hold presidential elections in the spring and are unlikely to offer concessions in the heat of a campaign. Angela Merkel is hemmed in by her own election later next year.

The issues of terrorism and migration have not gone away. And the EU's ability to strike a trade deal is under scrutiny.

The business community is losing patience with the unknowns. Investment decisions are pending. They demand a road map. The list of companies, of investors demanding that the UK retains "unfettered access" to the single market will only grow.

Sterling is the worst-performing currency this year driven to a three-decade low. Increased exports have certainly boosted sections in the economy but inflation is increasing.

Eventually increases in food prices will be impossible to ignore politically. A recent poll suggests that the British people now place the importance of trade deals above controlling migration.

In the past week, the President of the European Council Donald Tusk has said that "the brutal truth is that Brexit will be a loss for all of us". The Brexiteers will dispute that and will argue that new opportunities lie outside the European Union.

For the moment, it is still a phoney war but both the EU and the UK are facing enormous pressures that will influence negotiations when they begin in earnest next year./bbc