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UPDATE: 'Most difficult phase' of Brexit talks ahead as EU moves to next stage

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UPDATE: 'Most difficult phase' of Brexit talks ahead as EU moves to next stage

European Union leaders have agreed to begin negotiations with the U.K. over their post-Brexit trading relationship after agreeing to terms of a "divorce deal," but Germany's leader warned that tough talks lie ahead once London clarifies what it is seeking.

The decision came after Prime Minister Theresa May clinched a deal with European Commission President Jean-Claude Juncker following a last-minute scramble to find a formula to avoid the creation of a hard border between the Republic of Ireland and Northern Ireland. The U.K. has also agreed to pay the EU at least €40 billion to €45 billion to meet its commitments to the bloc and agreed to guarantee the rights of EU citizens living in the U.K.

"EU leaders agree to move on to the second phase of #Brexit talks," European Council President Donald Tusk said on his official Twitter account, adding: "Congratulations PM @theresa_may."

European leaders will now set out negotiating guidelines before talks begin in March, with a tight schedule to meet before the U.K. is set to leave the bloc in March 2019. The U.K. government must also make clear what sort of trade relationship it is aiming for.

"The most difficult phase is ahead of us," German Chancellor Angela Merkel said after the meeting of European leaders in Brussels.

One possibility for the U.K. would be membership of the European Economic Area. But, while this would permit British businesses continued access to the EU, it would also require the U.K. to continue to permit freedom of movement for EU citizens, something which would likely anger many of those who voted for Brexit. Another possibility would be for a free trade deal, like that between Brussels and Canada, but this arrangement would be unlikely to cover services — of vital importance to the U.K. economy.

The U.K. will probably have to opt for one or the other of these two options, ING analysts James Knightley and James Smith said in a note to clients.

"Clauses embedded in existing free-trade deals mean that whatever the EU offers the U.K. on services, it would also have to offer to other countries that it already has agreements with (Canada and South Korea for example). This means there is a reduced incentive for the EU to offer the U.K. a bespoke deal, which makes it more likely the UK will ultimately have to choose between the Canada-style free-trade agreement or the EEA," they said.

"Skies less menacing"

The first issue to be discussed between the EU and the U.K. will be a transitional period, which will phase in the impact of Brexit, reducing the economic disruption.

"While our working assumption for our economic forecasting remains a hard Brexit (defined as the U.K. leaving the single market), the delivery of this outcome may be smoother than we expect," noted Barclays analysts Fabrice Montagne and Sreekala Kochugovindan.

"While we maintain our view that the U.K. will eventually leave the single market, we also acknowledge that the skies now look less menacing, with a reduced risk of early negotiation failures and less disruption."

The issue of the Northern Irish border came close to scuppering the move to the second phase of Brexit talks, after the Democratic Unionist Party, whose support is vital for May's minority Conservative government, said it would oppose any measures which led to different rules in the province from the rest of the U.K. An eventual compromise will allow for the U.K. to apply the principle of "regulatory alignment," which it had initially intended only for Northern Ireland, to the rest of the country.

The government has insisted that this will not mean that the U.K. remains within the EU's single market — something the EU says will limit access to the bloc to a level similar to that granted by a trade deal.

The U.K. government's plans were further complicated Dec. 13 after Conservative rebels joined with opposition parliamentarians to back an amendment to limit ministers' power to make sweeping changes to the EU withdrawal bill before parliament has approved a final deal with the EU on Brexit.