- On 23 June 2016, the UK will hold a nationwide referendum to answer the question “Should the UK remain a member of the EU or leave the EU?”
- A Remain vote would be positive for UK and European assets, and we feel this is the more likely scenario. Corporate bonds and equities should rally as the risk premium for the uncertainty of future trading relationships is diminished.
- In the event of a Leave vote, sterling would fall, as would UK and European equities and corporate bonds. The gilt yield curve would steepen, while core European bond yields would fall. However, we expect the BoE and ECB would supply plentiful liquidity to prevent instability from spreading to the banking system and to calm markets.
The fact that the UK on 23 June 2016 is embarking on a referendum on its membership of the EU for the second time in just over 40 years is symptomatic of its somewhat schizophrenic relationship with its neighbours. The British, in Churchill’s words, “are with Europe, but not of it,” wanting to be part of a large free trading bloc but not wishing to relinquish their political sovereignty. This in essence has been the defining difference in attitude between the UK and the rest of the EU. The British see the EU as an economic project with a political cost while the other members of the union see the EU as a political project with economic benefits.
This discrepancy in attitude has resulted in the various opt-outs of EU treaty agreements that the UK has secured; the most obvious is membership in the euro, such that the UK has the appearance of a “semi-detached” member. However, a modus operandi had been established and in many ways the UK could have continued in this manner for the foreseeable future. Why, then, risk destabilising the compact by having a referendum?
To counter the eurosceptic wing in his own party and the leaking of support from the Conservative Party to the UK Independence Party in the wider electorate, Prime Minister David Cameron offered the prospect of a referendum on the UK’s membership to the EU prior to the 2015 election. With the polls pointing to a hung parliament, it was probably a pledge he thought he would not have to make good on. The price for any coalition agreement would have been the dropping of the referendum. Unfortunately, the polls proved wrong and a Conservative majority forced him to make good on his promise.
The issues that will determine the outcome of the referendum campaign will be those issues that have dominated the UK’s debate over its role in Europe since the 1950s, namely, the economic impact of remaining/leaving and the question of sovereignty. The former has tended to be employed by the Remain camp and the latter by the Leave camp.
At its most basic level, the debate will be distilled to focus on trade, investment and immigration.
With the EU being the UK’s largest export market, much has and will be made of the impact a Leave vote would have on that sector of the economy. The fact that the UK runs a substantial trade deficit with the EU suggests that continental European countries have as much, if not more, to lose from a disruption in trade. Indeed as Exhibit 1 shows, the total share of UK merchandise exports going to what is now the EU28 is at levels commensurate with the time of the UK’s accession. More pertinently, for all the talk of the single market fostering trade, the UK now exports less to the EU than it did at the inception of the Single European Act.
Admittedly, the UK has grown its service sector industries more rapidly than the merchandise sector over the last 30 years (although the majority of exports are still merchandise at 55%), but even here, of the surplus generated by the services trade, 80% is generated through non-EU trade. In terms of the UK’s trading relationship with the rest of the EU, it is clear it breaks down into relative advantages over goods and services trading, with a surplus in the former for the EU and in the latter for the UK, with the caveat that the overall trading balance is in favour of the rest of the EU, while the UK’s overall deficit in 2015 was at £67.76 billion, or 3.6% GDP. The obvious solution is that the UK would bargain a free trade agreement in goods for free trade in services, especially in terms of financial services with a continuation of the current “passporting” arrangements. A straightforward trade-off, which would still be to the overall advantage of the EU.
Whether the politics of the EU would facilitate this may be open to question, but some new form of trading arrangement would have to be agreed upon.
Alternatives to the EU
If the UK was to vote to leave the EU, the UK and the EU would have a number of options open to them, each with advantages and disadvantages. The main three, outlined below, are based on current trading relationships with current non-EU members.
- European Economic Area (EEA) membership (The Norway Model)
For the UK, it is difficult to see the attraction of this arrangement; the current issues regarding sovereignty and immigration would not be resolved, while the UK would continue to contribute to EU financing and accept regulation without any influence over its formulation. This would be the worst of all worlds.
- A Negotiated Bilateral Agreement (The Switzerland/Turkey Model)
Switzerland has had to compromise such that it has many of the disadvantages of the Norway model and it would take an extended period of time to reach agreement not only with the EU but also with the rest of the world in terms of trading relationship.
- World Trade Organisation (WTO)/Common External Tariff
This would clearly be the most disruptive for the UK's trading relationship, especially for financial services. Coupled with the negative effect on domestic confidence, this could potentially see the UK economy slow.
On leaving the EU, it is clear that the UK’s future trading relationships would be uncertain, at least until negotiations were completed. The options open above have both strengths and weaknesses, and the UK is unlikely to adopt one in its entirety. In the medium term, as history suggests, the UK would adapt, with the impact on trend growth negligible.
Foreign investment is the main source of financing for the UK’s current account deficit, either through portfolio or direct investment. Direct investment is key not only to funding the current account deficit but also to providing the finance for productivity-enhancing long-term investment, with the EU providing nearly 50% of all Foreign Direct Investment (FDI). The capital account is the source of vulnerability to the UK post a Leave vote. The inability to finance the current account deficit could in extremis lead to a sterling crisis. Would overseas investors cease investing in the UK on a Leave vote? Non-EU transfers are in part attracted by the UK’s membership in the single market and the relative attractiveness of the country’s business environment. Withdrawal from the single market may be perceived as a negative, but, depending on negotiations, this could be overcome, especially if post a Leave vote regulation on UK-based business was substantially relaxed. It is the concentration of FDI in financial services (see Exhibit 2) that makes the UK particularly vulnerable, especially if the EU decides to remove the UK “passporting” rights.
Despite the focus on EU immigration and border control, the largest proportion of immigrants have come from non-EU countries, certainly up to 2011. Since that time, as the eurozone sovereign crisis began to take hold and austerity-induced economic policies drove unemployment higher, EU immigration has risen sharply as a proportion but may have peaked. Surprisingly, the majority of EU immigration has been from citizens of the original EU15 (Germany, France, Italy, Belgium, Netherlands, Luxembourg, UK, Denmark, Ireland, Greece, Spain, Portugal, Austria, Finland and Sweden) at over 50% of the total. Citizens of the 10 countries that joined the EU in 2004 (EU10: Czech Republic, Estonia, Latvia, Lithuania, Hungry, Poland, Slovakia, Slovenia, Malta and Cyprus) total 27%, with the remainder originating from those that joined in 2007 (EU2: Bulgaria and Romania).
The issue of overall immigration is still largely in the UK’s hands, encouraging non-EU immigration is a deliberate policy and not an EU-dictated one. As a referendum issue, it is interesting but should be part of a wider debate.
Economic Impact of Brexit
In sum, the economic impact of a vote to leave, in the short run, will largely be determined by the interplay of two factors. The trading relationship that the UK can negotiate with its former EU partners and the rest of the world and the degree to which the UK government deregulates by rescinding EU regulations and not replacing them with equally restrictive domestically generated regulations. Obviously, the two outcomes are unknown, but, using the foregoing analysis we can make some “best guesses.”
A number of research institutes have conducted analysis into the economic impact of the UK leaving the EU in the short run. Obviously, the models are very much determined by the elasticity of the underlying variables that are assumed. Most try to capture what would happen under various types of trade agreement and various degrees of deregulation. Each reflects to a degree the biases of its authors. Summarised in Exhibit 4 is the anticipated GDP impact under each model.
It becomes clear that depending on the assumptions that are made, it will either lead to a substantial decline in GDP over the medium term or a substantial increase. Given that most forecasters have trouble forecasting the UK’s GDP over the next 1 to 3 years, the estimates are well within the usual margins for error. We would say the net long-term effect would be broadly zero, based on nothing more than on the basis that GDP growth will be fundamentally driven by productivity, labour force, innovation and education. Given that trend GDP in the UK has been remarkably stable since 1945 at 2.25%–2.50% per annum (pa), we see no reason for that to change materially.
The short run is more problematic, largely because of the uncertainty that would arise immediately after a vote to leave. How long would the negotiations take, who would drive them, and when would they begin?
In the event of a Leave vote, the timetable to leaving will be crucial in determining the negotiating path and the degree of uncertainty that is likely to surround events and financial markets. The longer the timeframe, the greater the likelihood that all the relevant trade negotiations can be completed and the smoother the adjustment for the EU to a new financing model.
The Leave campaign likes to believe that Brexit would return the UK to a utopian idyll, a land of milk and honey where the British would prosper and all would be right with the world. The Remain campaign paints Brexit as a dystopian nightmare, where nobody would trade with the UK, living standards would fall, security would be forsaken and the British would be diminished on the world stage to near insignificance. Even allowing for the hyperbole of a referendum campaign, neither of these is close to the truth; neither camp can know what might happen after a vote to leave.
However, the foregoing analysis does provide some pointers regarding how things could develop and what the potential sticking points are. Clearly trade has been mutually beneficial, indeed in the last 20 years it has been more favourable to the rest of the EU rather than the UK. Both parties have a vested interest in coming to an agreement. With the greatest part of the EU’s surplus with the UK generated with Germany, the driving force for much of the EU’s policy over the last 10 years, this is especially so. A free trade agreement in goods seems sensible from an EU perspective. With the UK’s comparative advantage coming from the service sector, particularly financial services, this is the UK’s bargaining chip in terms of goods’ market access. It is also the UK’s Achilles heel. The reliance on the financial services surplus is evident. With the European Central Bank (ECB) and euro member countries concerned about the dominance of London in euro currency and derivative trading, agreement on “passporting” may be difficult. Without an agreement on this, the UK economy would clearly suffer a short-term setback (unless there is a prolonged exit/adjustment process), which could only be partially mitigated by deregulation in financial services.
The big risk to the UK in the short term is the funding of the capital account. With a current account deficit of 7% GDP in 4Q15, the need for capital inflow is acute. Foreign direct investment is paramount as a long-term funding source. Although nearly half originates in the EU, this is considerably less than the proportion of the UK’s current account deficit that originates in the EU. The majority comes from the rest of the world, although this may be influenced by the UK’s participation in the single market and the country’s more business-friendly environment. If after a Leave vote, FDI ceased or even reversed, the UK would be reliant on the portfolio account for capital inflow; this is more short term and, in extremis, could lead to a monetary response by the Bank of England (BoE) to attract capital to prevent a sterling crisis. If the uncertainty is such that fears of an unruly exit mount, it is not inconceivable that a sharp fall in sterling, precipitated by a withdrawal of capital, causes the BoE to raise interest rates to attract capital or to print money to cover the gap. Either is a clear negative for sterling assets. EU assets would not be immune in such an environment as periphery and risk assets would quickly attract a risk premium while core assets attracted a flight-to-quality bid.
Sovereignty is a sensitive subject, especially when it comes to immigration. In this globalised world, is any nation truly sovereign? In the UK’s case, a large swathe of regulation could be returned to the UK’s ambit on a Leave vote. This will come down to individual choice, but, on the issues that most affect the quality of life (health, education) the UK is still sovereign. Even on immigration, the current “crisis” has largely been at the UK’s behest, with policy induced from the late 1990s. This is not to downplay the role of EU immigration since 2010, but it is not the sole creator of the crisis. Ultimately, if the UK leaves, immigration will fall back, and the treatment of non-naturalised citizens (both EU and British) will become part of the agreement. Will a reduction in immigration be a negative for the UK labour market? It is not clear it will. Reduced supply may push up wages at the margin, but it may also increase productivity. International analysis does not suggest immigration is a clear economic positive for host societies.
Ultimately, we view the risk to the UK as being in the short term following a vote to leave the EU. Long term, the impact would be moot as the fundamental dynamics of economic growth—productivity and labour force—would ultimately determine the UK’s absolute and relative economic performance.
Referendum Result and Immediate Impact
The weight of history and experience suggest that despite the tight nature of the opinion polls, ultimately the British voting public would elect to remain a member of the EU. In the previous two nationwide referenda the UK has held, the result has been in line with what the elected government of the time was advocating. In 1975, despite being decisively behind in the early opinion polls, the UK voted by a decisive margin to remain a member of the European Economic Community. The main political leaders all advocating a retention of the UK’s membership (with dissension allowed within parties, as per now) had the more united and high profile campaign, swinging the public behind the Yes vote. Similarly in 2011, when the issue of a change in the electoral system was put to a referendum, the early lead for a change vote quickly dissipated in favour of the status quo when the prime minister led the campaign for a no-change vote. Although we now have an avowedly eurosceptic national party in the UK Independence Party, the 16% of voters who support them would most probably have voted Leave anyhow. The same situation exists as in 1975 with the leaders of the main historical political parties all in favour of remaining in the EU, and with higher profile supporters and a united campaign. With the bookmakers pricing the odds of a Leave vote at less than 40%, we agree that a vote to remain is the most probable outcome.
A Remain vote would be positive for UK and European assets. Corporate bonds and equities should rally as the risk premium for the uncertainty of future trading relationships is diminished. Sterling should strengthen, especially versus the euro, as safe-haven trades are unwound, while gilt yields should remain largely unchanged as the BoE keeps monetary policy in abeyance.
If we are wrong, what are the immediate implications? We would imagine that the immediate response would be for Prime Minister Cameron and the leaders of Germany, France and the EU to come out immediately to try and calm things, stating that they respect the wishes of the UK people, the UK is still a long term partner of the EU, negotiations will look to preserve trading relationships, etc. Sterling would fall, as would UK and European equities and corporate bonds (especially those with exposure to UK-EU trade). The gilt yield curve would steepen, with yields rising 25–50 basis points, while core European bond yields would fall. Periphery spreads would widen and volatility increase. However, we expect the BoE and ECB would supply plentiful liquidity into the markets to prevent instability spreading to the banking system and to calm markets. Once embarked upon, negotiations and a set timetable (as discussed previously) would allow some calm to return, and with central bank support, we might see some reversal of the moves described above.