A Trivially Overlooked Brexit Scenario and Its Potential Aftermath in Early 2016

A Trivially Overlooked Brexit Scenario and Its Potential Aftermath in Early 2016

Although in early 2016 very few economists and analysts would bet their farms on a likely Brexit scenario, its serious systemic consequences and insightful potential root causes were clearly detailed and explained in the following article which still remains highly relevant in the current global economic outlook.

Figuring out these days (early March 2016) what Britons will actually vote on June 23rd is a sort of “Catch-22” game, although the author of this article certainly hopes for and favors success of the “Remaining with EU, it’s an advantage for UK” campaign.

When Britain’s prime minister, David Cameron, promised in January 2013 to renegotiate Britain’s membership in the European Union (EU) and to hold a referendum by 2017 on the country’s membership in the union, in order to be re-elected, he probably couldn’t envision the current turbulent and highly uncertain global economic and geopolitical climate or the dangerous implications of a potential “Brexit” (a fancy term meaning Britain’s exit from the EU) scenario on the UK, Eurozone, and the global economy. In fact, prime minister Cameron, who is the leader of the Tories  (conservative party) and a strong advocate of the benefits of continued EU membership, back in 2013 proposed to renegotiate the deal with the European Union in order to defend the interests of Britain, reduce the perceived growing power of Brussels over member states, and to reduce the pressure of the growing Euroskeptic fringes in the conservative party reclaiming sovereignty, as well as, in other parties such as the UK Independence Party (UKIP). Britain has been for a long time in a state of angst with the European Union due to the perceived view by Euro-skeptics that the country has ultimately surrendered to the EU power, inefficiency, technocracy, and overregulation (i.e., agriculture, fisheries, trade, and subsidies). More recently the Euro-skeptics also criticized the EU for what they perceive to be a failure in the management of the immigration crisis (i.e., refugee crisis) which has led to political tensions among a number of EU countries over the suspension of  the Schengen agreement (which allows free movement of labor in the EU). Brexiters want to restore British control of the frontiers by stopping free movement of people.

With EU, it’s Advantage UK

In spite of the uneasy relationship between Britain and the European Union, British trade with other EU countries has risen rapidly over the past decades, and today it accounts for approximately 45% to 50% of its total international trade, whereas EU exports to Britain account only for a small portion of their international trade activities (approximately 6% to 7%), according to the IMF (IMF, 2014). Given the status of the EU as the world’s biggest trade zone, there are concerns among analysts, economists, and political leaders about the potential negative impact on Britain’s trade, the EU and the global markets of a “Brexit” scenario. Some analysts predict that in case Britain leaves the EU, British exports to the EU countries might become more expensive due to higher tariffs and trade barriers, red tape, or potential restrictions for exports. Furthermore, according to “Britain Stronger in Europe”, Britain currently pays the EU £340 a year per household while receiving an estimated £3000 yearly benefits of membership, that is approximately £10 billion a year of reduced contributions to EU budget (Economist, 2016).

Furthermore, with the exit from the EU, Britain will lose full access to a single market that serves 500 million people in 28 countries and it will probably face also some kind of trade retaliations. International firms, as well as, some large ones based in Britain might decide to locate their offices somewhere in the EU to benefit of the access to the single market in case Britain decides to leave the 28-member bloc. Based on the OECD research, Britain seems to be one of the least regulated countries of the EU, having received many concessions over the years from Brussels on labor and product-market regulations, and on the regulation of its dominant financial industry (OECD, 2013). Of course, since Britain is a leading world’s economy and London is a leading global financial district, even the UE might have a significant political and economic drawback if Britain decides to leave the union. Those who are in favor of a “Brexit” solution argue that it would be beneficial for Britain to negotiate a new relationship with the EU, without being bound by rigid EU laws on employment, health, immigration, welfare, and safety. They also do not want to be locked in, what they perceive to be, a trade block that is not growing and whose future scenario is highly uncertain (i.e., the Eurozone just dips again into a very low headline inflation environment due to a number of concurrent national and global factors such as China’s slowdown, oil oversupply and the subsequent fall in oil and commodity prices across the globe, speed of technological innovations, automation, robotics, increased productivity, changing demographics, stock markets sell-offs, reduced capital expenditures, tighter fiscal policies, incomplete structural reforms, etc.). British Euro-skeptics also hope that their country may gain additional competitive advantages as a global economic leader, securing new trade deals with other important leading, dynamic, and high-growth potential economies such as North American countries, India, China, and other Asian markets. After all, London is already a global financial district and a foreign exchange capital, and it is well-known that the city is trying to develop closer ties with China and to become a major hub for offshore renminbi trading, thus making Hong Kong and London the two big centers for offshore renminbi. Britain also seems to be a strong endorser of China’s Market Economy status recognition at the end of 2016 whereas a number of EU countries are concerned about the potential “dumping” effects (i.e., steel industry, etc.) that this recognition might cause to a number of their industries if this status is granted as soon as the end of 2016. Furthermore, Britain’s trade deals with the EU market and with other countries are currently facilitated by the EU trading and institutional relationships, thus it is still unclear what kind of bilateral trade agreements Britain will have with other countries in the event of “Brexit” scenario, or how long will it take to set up new agreements. Bigger companies which are more exposed to international trade seem to be more concerned about the impact of a “Brexit” scenario. All these factors, of course, add uncertainty in the financial markets and do not provide long-term visibility and security to firms and investors, thus causing reduction in capital expenditures, “flight-to-quality” in the markets towards safe assets, and increased volatility in the currency markets. The ideal solution, for the advocates of the “leave” campaign (i.e., “Brexit”), would be a sort of illusionary “best of both worlds” solution in which the EU negotiates a special deal for Britain that allows the country to retain free trade with the EU but avoids all the disadvantages of being a member state of the union. This means that ideally they expect to become a sort of Switzerland or Singapore, with a greater independence and flexibility, full regulatory sovereignty, strengthened comparative advantages versus the other EU countries, thus avoiding unfavorable alternative solutions such as joining the European Economic Area; establishing a customs union with the EU; or simply relying on the normal World Trade Organization (WTO) rules for international trade. Brexiters are probably also hoping to develop a stronger special relationship with the USA through the TTIP (the Transatlantic Trade and Investment Partnership) in order to play a leading role in Europe within the new international partnership but also to boost unique trade opportunities for Britain. The EU is the world largest economic zone (single market) and with the support of the British political clout and its powerful and influential financial district, it might remain a leading global player in the future if all member states are able to strengthen their integration and their synergic economic and social resources and capabilities. But it is probably the political, social, and economic goal of achieving increased integration among the EU member states that frightens Brexiters the most. In a fast-paced, globalized, and highly competitive business environment, a well-integrated Britain in the European Union would guarantee enhanced stability, prosperity, and security to itself and to the rest of the union. It does not make much sense, for example, to envision a highly integrated and world-class European banking union and European capital markets without the strategic membership of Britain. A “Brexit” scenario might probably lead to more fragmented financial markets in Europe rather than more integrated capital markets and banking union, thus negatively influencing the perception of financial stability in the single market banking and financial services industry. Brexiters are also probably envisioning the benefits of an even stronger leading role for Britain in Europe and in the global financial markets (such as derivatives clearing services, foreign exchange markets, derivatives markets, fixed income markets) through the new international alliances (like the Transatlantic Trade and Investment Partnership) and partnerships with European leading countries (such as Germany – Deutsche Börse), and with non-EU ones, but without the restrictions of the EU regulations. Thus, it is quite likely that a portion of Brexiters are probably also members of the middle class, small business community, and educated and qualified professionals working in the City, who do not tolerate the excessive interference of the EU regulation in the UK financial industry, and in particular, on sensitive topics for the City such as the one concerning the cap on banking bonuses (The EU set the rules in a bid to curb excessive risk-taking after the financial crisis).

Many consequences

For a number of analysts and observers, Britain’s decision to leave the EU might have internal and external negative consequences. The internal ones would be related to a higher level of uncertainty around the new international trade agreements or what someone calls “the leap in the unknown” (that is, the uncertainty over Britain’s new relationship with the EU which might discourage investments, and in particular foreign direct investments, or the issuance of bonds).There are also fears of a potential economic slowdown due to the exit of Britain from the EU which might spur bad loans, impact banks’ revenues, force financial firms to raise additional capital, cut dividends, penalize credit ratings, and lead to higher bond yields. But “Brexit” might also lead to potential loss of jobs in a number of industries, at least for a while; higher currency volatility and inflation; a potential shock in the stock market, and geopolitical risks (i.e., Scotland’s decision to stay in the EU as well as Northern Ireland and Wales). What is more difficult and probably more complex to assess at this point  is what would be the longer-term economic consequences of a potential “Brexit” scenario. For example, the potential serious consequences of Britain and the EU countries slipping back into recession or worse. Recent data already shows signs of deterioration in the confidence of firms in Britain. Markit’s Purchasing Managers Index showed that factories had their worst month in almost three years in February 2016, while the services PMI dropped to 52.7 from 55.6. A major external impact of a “Brexit” decision, in a worst case scenario, would be instead the political risk associated with a potential nationalist and Euro-skeptics “spillover effect” to other EU states which might lead to a spike of anti-EU movements and parties aiming to hold in their countries similar referendum on EU or on their Eurozone membership. Political turmoil is also on the rise in Europe and there are big pressures on governments to move away from fiscal reforms.

Two worlds, one nation!

In Britain, like in other nations, there seem to coexist two parallel worlds, the one of the wealthy, highly educated, cosmopolitan, technologically savvy, and internationally connected white-collar workforces of the City, who are pro-Europe and who appreciate the value of global  competitiveness and global value chains, and the other one represented by less educated and skilled people who are afraid that their jobs, security, welfare, and incomes might be wiped out by disruptive technology, low-cost immigrants, unfair welfare benefits to foreigner workers, global competition, unfriendly EU regulation (for the British), and global economic shocks (i.e., global slowdown and potential global recession or stagnation). Some may think of these people as populist, uneducated, no global, anti-EU and enemies of modernity and innovation. Yet, one should also remember that these people are the ones who probably paid the highest price of the 2008 global financial crisis and its aftermath in terms of social and economic costs due to the “Great Recession”, the credit crunch, the financial industry bail-out, and ‘de facto’ bank nationalization by the UK Treasury. From this perspective and being aware of their structural social weaknesses (i.e., poor education, low competitiveness, and intrinsic fragility), one might easily understand why this vulnerable segment of the British society might be more scared than others about the risk of other potential systemic crises, deep and long global recessions, credit crunch, secular stagnation, or unfit regulations. After all the memories of the 2008 financial crisis, the Eurozone debt crisis, and the threat of “Grexit” are still alive and well in their minds. If one also add to this analysis the fact that since the global financial crisis of 2008, UK and Germany, and a few other economies, have become a sort of goldmine for anyone in Europe seeking a good job or a career in a more dynamic and vibrant economy, due to the fact that most of the other countries have been in deep recession for a number of years or subject to draconian austerity therapies, then it is easier to have a better picture of what might be leading Britain to its current painful dilemma about staying or leaving the UE membership.

What is changing Britons’ views

British are typically characterized by their unique mix of pragmatic, insular, and cosmopolitan identity which makes them very interesting and open-minded. Thus, the impression of the author of this article about the root causes of the “Brexit” phenomenon is that British people have not suddenly and collectively turned into closed-minded and anti-EU radicals or populists. Rather, it is more likely that after a number of years of growing uncertainty in a turbulent and highly interconnected global business and regulatory environment and downward global pressures on economic growth and inflation, the more vulnerable segments of the British society have amplified their feeling of angst, distrust, and frustration towards anyone (In the UE and in UK) who do not primarily secure their national interests. The EU and British leaders should probably pay closer attention to these signs of discontent and frustration since they might escalate in social unrest in the long-term if unsatisfactory conditions continue to persist in the UK or other EU countries. The policy makers should also pursue radical and effective solutions to the immigration crisis in order to avert the fear of a potential flood of refugees. They should stabilize economic growth, the risk of new potential banking crises, and boost consumer confidence, capital investments and consumption in the Eurozone and EU economy in order to allay their populations’ uncertainties and fears. Furthermore, they should also cooperate with other global partners towards the resolution of the current oil and commodity markets’ oversupply and the geopolitical tensions (OPEC and non-OPEC countries, Syria, Russia, the “bumpy-landing” of China and some Emerging markets, etc) to reduce consumers and firms’ fears about deflationary spirals, liquidity traps, welfare sustainability, and income and job security issues. The critical factor for the success of the EU (win, win strategy), however, is not to accomplish these goals at the expenses of other EU countries, creating competitive disadvantages within the union but harmonizing as much as possible EU rules and regulations among members states for the benefit of all (no asymmetric policies and benefits). The deal that Prime minister David Cameron seems to have secured in the negotiation with the EU, in order to keep Britain in the Union, consists of a restriction to the payment of certain welfare benefits to EU migrants for a number of years (i.e. “The Council would authorize that Member State to limit the access of newly arriving EU workers to non-contributory in-work benefits for a total period of up to four years from the commencement of employment. The limitation should be graduated, from an initial complete exclusion but gradually increasing access to such benefits to take account of the growing connection of the worker with the labour market of the host Member State. The authorization would have a limited duration and apply to EU workers newly arriving during a period of sever years”). He also apparently received a commitment by the EU towards a reduction of the “burden” of excessive regulation and red tape and won guarantees that countries outside the Eurozone, such as Britain, will not be required to fund euro bailouts and will be reimbursed for central EU funds used to prop up the euro. Finally, Cameron obtained from the EU some restrictions on migrant workers’ child benefits.

A few final words

Well, to conclude, the author of the article hopes that on June 23rd, 2016, Britons will decide to remain in the EU and will help develop a competitive, integrated, and globally relevant economic, political, and fiscal union. On June 24th, 2016 we hope to see a big rebound of the Sterling after a period of high volatility instead of potential capital flight from Britain abroad. Currently the sterling is under pressure amid concerns over the forthcoming vote on membership of the EU, the UK’s current account deficit, and the high public debt as a percentage of GDP (in excess of 80%); which have led traders actively hedging their positions with options. The large current-account deficit, which must be financed by capital inflows, in case of “Brexit” might lead to capital flight and reduced capital inflows with tough potential consequences for the currency, the country’s credit rating, and potential shocks for the UK and the EU economies. It is also quite likely that in the coming months the Bank of England will not raise rates as also currently indicated by swaps-based indexes. Thus, for the sustainability, peace, and prosperity of Britain, the EU and the global economy we all hope that “Brexit” will not happen and that Britain will remain a key player of the European Union and in the world economy as well.

Original version published in the March 2016 issue of The Global Analyst magazine