The threat of a no-deal Brexit is “focusing minds” and encouraging compromise, the chancellor has said.
Philip Hammond said the government was “determined to get a deal” before leaving the EU on 29 March and no deal would be “a very bad outcome”.
But he told BBC Radio 4’s Today programme “the possibility [of no deal] is very clearly there”.
Theresa May has met the EU’s Jean-Claude Juncker to discuss changes to the existing deal to win MPs’ support.
The prime minister said progress had been made on securing legally binding guarantees over the Irish backstop – the insurance policy to stop a hard border returning to the island of Ireland – on Wednesday but “time is of the essence”.
However, Mr Juncker said he was “not very optimistic” about securing a deal.
Brexit Secretary Steve Barclay and Attorney General Geoffrey Cox are travelling to Brussels to meet the EU’s chief negotiator Michel Barnier for further talks on Thursday.
Labour leader Jeremy Corbyn is also heading to the Belgian capital later to discuss his party’s proposals with Mr Barnier – which include a permanent customs union and a close relationship with the single market.
The backstop has become the main sticking point of the prime minister’s proposals – with critics fearing the policy would leave the UK tied to a customs union indefinitely – and it played a large part in her plan being voted down by a historic margin in January.
Earlier this month, Parliament voted for Mrs May to seek “alternative arrangements” to replace the backstop but the EU has consistently said it will not re-open the withdrawal agreement – the “divorce bill” part of the deal where it features.
Mr Hammond said government policy on Brexit was “very clear”. He told Today: “We are determined to get a deal. We recognise that a no-deal Brexit would be a very bad outcome for the UK and we are doing everything we can to avoid that.
“There is always a possibility of no deal as an outcome and that is why the government is carrying out appropriate contingency planning.”
However, the chancellor said that the risk was helping push some people towards agreeing with the government’s plan.
“I am not denying the possibility [of no deal],” he said. “The possibility is very clearly there and it is that possibility that is focusing minds on the compromise that is needed to get the deal through Parliament.
“I fully recognise that it is very uncomfortable that we are as close to the wire as we are but I am afraid that is just a feature of this kind of negotiation. We are making progress.”
Former Tory MP and new member of The Independent Group Sarah Wollaston predicted a third of the cabinet would resign if there was a no-deal Brexit.
Mr Hammond would not reveal if he was among that number but said: “My job is to avoid [a no-deal Brexit] and to make sure the government is focused entirely on avoiding that outcome.”
Speaking from the European Commission on Thursday, Mr Juncker said he could not rule out a no-deal Brexit, which would have “terrible economic and social consequences both in Britain and the EU”.
He added: “The worst can be avoided but I’m not very optimistic when it comes to this issue.”
On Sunday, Mrs May will be attending a two-day EU-League of Arab States summit in the Egyptian Red Sea resort of Sharm el-Sheikh with about 20 EU leaders, including German Chancellor Angela Merkel and Irish premier Leo Varadkar.
She is expected to hold a series of one-on-one meetings as she continues to push for her deal.