Senior Research Fellow
On June 23, a public referendum will decide whether Britain will leave the EU (a.k.a., the “Brexit” scenario) or not. If the country were to break away from the EU, years of difficult negotiations with heavy impacts on the futures of both sides would follow. After an initial shock, however, the negative short-term impact on companies due to regulatory uncertainty and increasing trading costs would remain quite manageable. Governments on both sides have strong incentives to move very gradually and avoid major disruptions. The biggest problem for the UK and the EU is how to manage the long-term outlook, since the loss of one its most liberal major member states would deliver a severe blow to the EU and its future. After a long and quite successful phase of European integration, which has turned the market into one of the world’s most attractive investment targets, the EU actually faces a vicious process of disintegration, which would have a severely negative impact on foreign investors. If, on the other hand, a Brexit can be avoided, reform dynamics in the EU might finally be revitalized.
The risk of a Brexit has increased to the point where some opinion polls see almost as many “exiters” as “remainers.” If that is truly the situation, then the decision would depend on the large group of undecided voters, who would likely vote in favor of the safer status quo, i.e., keeping Britain in the EU. As things currently stand, however, any additional shock could tip the balance the other way. Crucially, the Brexit option did not evolve as a well-thought-out government strategy to leave the EU for better opportunities, but rather as a “Braccident,” and either outcome seems equally likely.
In contrast to negative public sentiment, the government and most corporations remain largely in favor of EU membership. EU membership, after all, not only guarantees unconditional access to the world’s largest market but also closely integrates the rather small British economy with its closest partners while giving it a strong say on its future direction and providing a scapegoat for necessary but unpopular (i.e. globalization-related) reforms at the same time. Overall, as one of the most dynamic and liberal member states in the EU, Britain seems to have gained strongly from investment and innovation related to FDI inflows (which increased from 16% GDP in 1995 to 56% today; UNCTAD Data). The economy has grown tremendously by hosting the EU’s financial center in London, and it has developed market-leading business services, which drive exports, investment and technology. Additional regulatory burdens, on the other hand, seem to be limited, as the UK’s economy is ranked at the top of most indicators of liberal market regulation and ease of doing business. (The World Bank’s ease of doing business indicator ranks the UK above the US in 6th place, while Luxembourg, for example, ranks only 61st.)
Indeed, when comparing GDP per capita gains since 1991 in the UK, Germany, Switzerland and Japan with the EU average in Figure 1, it seems difficult to make a case for a Brexit. Before the global financial crisis in 2008, not even Switzerland’s increase in real income per capita was significantly stronger than the UK’s. Japan, on the other hand, which remained in “splendid isolation” in Asia during the period, suffered relative income losses while it restructured internally without expanding its external markets much. The underperformance of the UK economy occurred largely after the global financial crisis, when Switzerland and Germany were able to add about 4,000 (international) dollars per capita more to their GDP than the EU average while the UK and Japan stagnated at their pre-crisis levels. Clearly, economic structures and national crisis responses have played a greater role in differing fortunes after the financial crisis than EU or Eurozone membership.
Note: Based on purchasing power parities (PPP) calculated as IMF “international” dollars
Source: IMF-WEO Database (2015)
If the EU seems to have had an overall positive impact on the UK economy, how is it possible that public sentiment in England turned so strongly against the European community project? From a British perspective, after economic growth collapsed during the global financial crisis in 2008 and the EU struggled to rescue its banks while building a much more tightly regulated banking union around the European Central Bank, the EU project seemed to have become intertwined with the fate of the Euro and the Eurozone, which alienated much of the public. Over the last two years, an immigration and refugee crisis coupled with public sentiment turning against immigration has only deepened the rift, as immigration lies at the heart of the EU Single Market project (where it is actually not seen as immigration but as mobility of EU citizens). Ironically, it did not help that the UK was one of the most vocal supporter of immigration from Eastern Europe before the financial crisis, when foreign labor was seen as a necessary ingredient for strong growth.
Furthermore, the EU seems to be failing to deliver on promised non-economic benefits: United, the EU was supposed to be a stronger global player than its small and mid-size member-countries on their own. During the Middle East and Ukrainian crises, however, it failed to have a sizable impact, and the Syrian refugee crisis demonstrated the limits of internal coordination and burden-sharing. Finally, confusion about EU responses to terrorism and security threats seems to have made the EU less safe than an independent and determined nation state might be. Together, these different threats helped to create the perfect storm for the future of EU integration.
From a corporate perspective, on the other hand, the global asset manager BlackRock has pointed out in a report to investors that a “Brexit offers a lot of risk with little obvious reward.”(1) Not surprisingly, following the news of the upcoming Brexit referendum on June 23, the British pound depreciated by more than 2% to the euro and 3% to the dollar. Compared to highs in 2015, the pound has been down by more than 10% to the euro and almost as much to the dollar. Following a Brexit, a significant depreciation not just of the currency but of other asset classes as well, including government bonds and perhaps London real estate, would likely occur.
When estimating the post-Brexit costs to the UK economy, the focus has been on the trade-related costs that come from higher tariffs and trade disruptions, not just with the EU but also with the rest of the world. The UK, after all, would have to renegotiate most of its international trade agreements. The standard model for estimating such trade-related costs and benefits is the comprehensive GTAP trade model and database.(2) Open Europe, a think tank which follows reforms in the EU critically and conducts excellent analysis, has estimated Brexit costs for the UK based on a widely used GTAP trade model. According to the analysis, costs for the UK economy would add up to approximately -0.8% of GDP in the case of an unfavorable deal with the EU. In the most optimistic scenario, where the UK would turn the trade shock into an opportunity for far-reaching deregulation and further trade liberalization with the US and China, a Brexit could actually result in permanent gains of +0.6% of GDP until 2030.(3)
Such a positive result is extremely unlikely, however, because Brexit supporters are mostly in favor of less globalization, not more. Most economists’ analyses therefore result in significant losses after a Brexit when taking potential economic long-term dynamics into consideration. Indeed, a more inward-looking UK in a Europe struggling with its future governance would almost certainly create a more challenging business environment.
Because it is nearly impossible to estimate the impact of such economic and political dynamics, the Global Council provided an excellent qualitative analysis of potential changes in the business environment during the Brexit process.(4) Clearly, the biggest challenges for companies emerge during the initial period of uncertainty, which might last for many years while new trade and regulatory frameworks are being sorted out. An even more negative long-term impact might result, however, if foreign direct investment (FDI), which is among the most important drivers of growth, productivity, and innovation in the UK, were to suffer. If foreign investors lost trust in the UK market or the wider European market, long-term growth would almost certainly deteriorate significantly. The German Ifo Institute and the Bertelsmann Foundation have tried to assess the potential long-term impact of the Brexit process based on the hypothesis that the reduction of trade between the UK and the EU would reduce competition, and with it, investment and innovation, resulting in a long-term decline of productivity growth. They find that the UK could face a drop in per capita GDP of 2-14%, depending on the level of the UK’s isolation in a future trade regime.
Finally, the UK government, in the most comprehensive study on the Brexit impact so far, put together the results of different models in a multi-level study and arrived at an estimate of -6.2% GDP if it were outside the EU in 2030, when realistic non-favorable trade terms with the EU are taken into consideration. Without much change in the trade regime, i.e. if the UK leaves the EU but joins the general European Economic Area (EEA; joining Iceland, Liechtenstein and Norway), the UK’s GDP would still be -3.8% lower under this scenario.
For companies and investors the baseline result of all these economic analyses and model-based experiments is the expectation of significant macroeconomic costs resulting from increased trading costs, a potential deterioration in the market framework, and a further loss in the dynamics of the European market. From the perspective of individual companies, however, these general costs might very well be seen as marginal compared to the individual impacts on their business models, strategies, and European market access. A careful analysis of business-related dynamics of the Brexit process and the potential impact of the EU market becomes therefore necessary when the UK indeed breaks with the union.
While a Brexit would clearly have a negative impact on the business outlook in the UK, closer analysis shows that business risks and costs during a Brexit may be much lower than is often feared. Compared to the hard-to-predict long-term questions, however, it seems unlikely that companies would face an immediate and persistent general shift in business conditions after a Brexit. The separation of the UK from the EU would turn out to be a slow-rolling process, anchored in the status quo, and not a fast expulsion of the UK economy from the continent’s wider market and regulatory framework.
Most likely, the Brexit process, if it materializes after June 23, would unfold as follows. A shocked UK government (probably after the current government resigns) would have to work out a concrete exit strategy in coordination with its EU partners even before triggering the EU Article 50 exit process, which seems unlikely before 2017. During this period, markets would realize that in fact not much had changed. The UK would remain part of the EU until a comprehensive FTA had been worked out. Negotiating exit terms alone could take up to two years and would become intertwined with negotiations on the new terms of market access. Experience with (less complex but also less urgent) FTA negotiations tells us that this process would last about a decade. During this period, Britain would probably have to settle for an intermediate regime based on the general EEA, which would give full market access but provide neither independence nor influence. From a business perspective, this would change surprisingly little, except that political relations would be fraught with frustration on both sides.
During and after a Brexit, the UK side would have to review its global trade and regulatory strategy in a likely politically charged situation at home. Many analysts even expect the current government to collapse after a Brexit, which would add to the difficulties of starting an orderly negotiation process. The EU side, on the other hand, would be urged by businesses on both sides to not to turn political frustration into business retaliation and to maintain the status quo for businesses as much as possible. It is therefore quite likely that Britain would be pushed into the general EEA, as Iceland, Liechtenstein and Norway have been. Since almost all Single Market regulations apply in the EEA as well, such a result would be largely welcomed by companies but would certainly frustrate the UK government and Brexit proponents because the UK would have lost almost any say in shaping its trading relations with the EU and the rest of the world.
The post-Brexit government would therefore have to move towards reshaping new trade and investment relations with non-EU countries in America and Asia while liberalizing its domestic market enough to become (more) independent from the EU. Optimists would hope that a virtuous cycle of increasing strength in the UK economy might, over time, put the UK in a better negotiating position, or it might even force the EU towards more liberal regulation through increasing competition with the UK. Much more likely, however, is the possibility that the exit of the UK as a liberal EU member would result in further loss of dynamism in the EU. This, in turn, would weaken the UK economy at a time when globalization already has many detractors during the difficult Brexit process. A more inward-looking, protective turn of UK government policies in combination with disintegration of the EU market would indeed be the biggest risk for the UK economy and investors in Europe.
One of the most important decisions during the Brexit process would relate to the government’s stance on immigration. Britain has been one of the strongest and most open recipients of immigrants from Europe, which significantly contributed to its economic performance before the financial crisis. Unlike much of Western Europe, Britain even accepted Eastern European immigrants from the start of their EU accession. Ironically, increasing immigration control is now one of the most commonly raised issues by Brexit proponents. At a time when young people in Southern Europe are being hit by the restructuring of their economies and high unemployment, their mobility within the EU will be one of the most important factors for future growth. If the UK were to turn against immigration as a consequence of a Brexit, it would be highly doubtful that any of the hoped-for liberalization for driving Britain’s future growth could be realized. A less liberal and more isolated British market would indeed entail high costs for an economy that has thrived as a liberal member of a much larger union.
Post-Brexit, the most significant difficulties would emerge in finance, in particular in the banking sector and the City of London. Since financial regulation and market access to the EU are based on the principles of “equivalence” and “reciprocity,” London would in principle be able to operate as it is. For hedge funds, forex, and derivative trading, the strength of the established London market would certainly be reason enough to stay. Asset management and insurance would also face few additional constraints because they often remain locally regulated in the EU anyway. Most of these industries face the long-term risk, however, that they might become the targets of adverse or protective regulations in the EU, since they will no longer be able to shape the regulatory environment in the EU.
Banks in England, and particularly foreign banks with headquarters in London, would lose the “passport” right to operate in the EU without established subsidiaries, however, which would make it significantly more difficult to operate from London. A Zurich bank, for example, currently operates a London subsidiary in order to have full access to the EU market. After a Brexit, Frankfurt would be the much more cost effective alternative. At a time of continued financial distress, it also seems highly likely that the ongoing reregulation in the Eurozone would turn against London, either directly or as required by EU regulations on operations in its market. In particular wholesale banking, which targets the EU market, would have strong incentives to move their operations under the regulatory umbrella of the EU again.
Manufacturing investment would almost certainly not be as sensitive to a Brexit, but supply chains might have to be adjusted. The automobile sector in particular would be threatened, since EU tariffs are particularly high for cars and chemicals while the importance of the UK share in supply chains is too small for it to successfully request favorable exceptions. Supply risks and potentially declining competitiveness could push companies to the continent for all products with final demand in the EU. Risks should not be exaggerated, however. Similar concerns were raised for the significant exchange rate risks when the Eurozone was first established. Instead of exiting, however, companies have been focusing on higher value-added parts and expanding their market reach towards global markets in America and Asia, which would likely be sufficient again; if not, not only UK operations but overall EU strategies would have to be changed as a result of a Brexit.
Fortunately, business services and ICT would be much less affected by regulatory changes following a UK extraction from the EU. Regulatory trends related to ICT tend to be global, while local regulation has not been integrated significantly enough within the EU to make a difference for home country decisions. Frustratingly, the EU process towards creating a “Service Union” and developing a common “Digital Agenda” has been progressing at glacial speed, so not too much would be lost to headquarters outside of the EU. The MSCI stock market indices in Figure 2 below, for example, show how much the UK information and technology sector has been outperforming the larger EU market (which is, significantly, not the case for the UK’s stock market in general). The same is true for R&D investment, which has been booming in two of the UK’s burgeoning industries: IT technologies and automobile parts.
The advantage that business service and IT-related companies had when operating in the dynamic UK service market and talent pool would likely only deteriorate if foreign investment declined and the R&D environment were affected. In particular, the Southeast of the UK (including London) gained tremendously during the investment boom before the financial crisis (as did Ireland). Not only did financial investment boom, but technology and R&D investment in IT, automotive, and machinery grew strongly, as well. Investment in IT and mobility R&D continued to grow especially well after the financial crisis, although the overall economy remained weak, because capital costs were low and government incentives caused investors to look for efficient long-term opportunities (Figure 3). Universities, research centers and related startups have gained from these opportunities and created new technology centers around London, Cambridge and Oxford.
These technology centers would almost certainly not be lost or immediately challenged in the case of a Brexit. Only if the economy were to slide into a long restructuring mode, with companies cutting costs, the government becoming more inward looking while limiting immigration, and foreign investors leaving for more promising regions in Asia, would innovation dynamics likely deteriorate and affect these important service sectors significantly.
Source: UK Office for National Statistics; CEIC.
Japanese investors have been among the top international investors in the EU, in particular in the UK, which serves as a gateway to the larger EU market, and in Germany, the EU’s largest market and manufacturing technology center. Even after the global financial crisis and during the euro crisis (2011-2016), Japanese M&As targeting the EU almost doubled compared to the previous global boom (2003-2008). With relatively little production in the EU, these investments have focused on distribution and services, which both depend on successful EU integration of the otherwise small and dispersed markets of individual cultures, languages and regulations. Over the last two decades, English-speaking London has become the top location for headquarter functions, related services and R&D, which served as a basis for servicing the increasingly harmonized “EMEA” market (see Table 1). In Germany and many other locations on the continent, in contrast, most investment went into manufacturing, technology, and distribution services. For Japanese investors, a Brexit would therefore not only affect the outlook of current businesses in the UK, but threaten long-term investment plans and strategies in Europe in general.
||Auto Parts & Equip
Source: Bloomberg as of May 2016
While a Brexit would disrupt supply chains and affect the overall organizational structures of Japanese companies in the EU, rushing to escape from the UK market into another EU country to mitigate the impact would not be an immediate option because the locational advantages of London cannot easily be replaced. Only in the longer run, and depending on the political dynamics in the UK and the EU post-Brexit, would investors start to draft new business strategies for the overall EU market, which might include significant relocations.
Challenges for foreign investors in the UK after an initial phase of Brexit adjustment (to risks, costs and exchange rate swings) would come from government action to stabilize the economy through significant restructuring, which would be reflected in a stronger exchange rate and an even more challenging environment for exporters (the OECD estimates a PPP-based overvaluation of 20% to the euro already in 2015). As after the financial crisis, the UK would have to focus on restructuring its production base and boosting services through efficiency gains to keep the expensive London market competitive. Essentially, and if history is any guide, the UK would have to follow restrictive Swiss or German long-term strategies to generate trade and current account surpluses or risk being dominated by the larger EU economy even more than before. While necessary, such a restrictive business environment would be very difficult to accept for the UK public, which might result in more anti-business policies and could become potentially more costly and destabilizing than the initial Brexit challenges.
The policy environment in the Eurozone after a Brexit, on the other hand, would look even more challenging. The long-term consequences of the Eurozone’s banking and debt crises are still largely unsolved, and a Brexit would weaken the Euro further. During the initial years post-Brexit, the Eurozone would see the centrifugal forces in the EU growing, as more countries or regions tried to either leave or negotiate exceptions from the Eurozone’s increasingly strict obligations and regulatory framework. Such a scenario would be in many ways disastrous for the Eurozone because the functioning of a currency union indeed requires closer integration to function.
To stabilize expectations about the euro’s future, a clearer vision would be needed of the Eurozone’s future, including the roles of its institutions, its governance processes, structural reforms, and further labor and services market integration. Drafting such proposals after Brexit would add a new dimension of policy difficulties in the Eurozone because until now adjustment processes have worked on the premise that no country leaves and that solutions can be found through a process of “muddling through” and gradual adjustments. After a Brexit, when much tougher choices will need to be made, EU governments, and in particular the German government, would find it even more difficult to develop acceptable scenarios for mutual growth and stabilization without appearing increasingly hegemonic when pushing for further structural reforms or strengthened institutions. From a foreign investor perspective, leaving the UK for the EU market during such a period of difficult adjustment would indeed be a much more difficult choice than sticking to the (also negatively affected) UK market.
Ultimately, the exit of the UK as a liberal EU member might create one of the biggest risks to the future of EU integration and prosperity. Just as Brexit proponents fear, the EU might close ranks and venture into an “ever closer union” to protect the working of its core, the Eurozone, even more forcefully. Without the UK, EU voting rights would soon require adjustment, which would either give relatively more weight to less reform-minded countries or would increase friction with Germany when it tries to maintain a blocking minority for the economically liberal voting bloc. In either case, reform dynamism in the EU would deteriorate, which would undermine growth and integration. Such a negative result would be to the detriment of the UK, too, which would be unable to compensate with newly negotiated trade deals and investment relations with America and Asia.
Furthermore, the civil wars in the Middle East and the Ukraine, which both relate to conflicts with Russia, require a unified EU response. The EU needs the UK to deal with both conflicts, for its foreign policy expertise, its various diplomatic relations, and its military. Although the UK will certainly continue to play a role in European security (including as a member of NATO), a split from the EU would greatly undermine the EU’s position while not leveraging the UK’s position as a single entity in these conflicts. The fundamental idea of the EU was to play a pivotal role in a volatile world by aligning the interests of small and mid-size countries, to combine their powers into an entity more capable than their individual means. This principle would certainly be undermined at a time when it is most needed.
Overall, the outlook for the European market would be negatively affected by a Brexit, which is clearly not welcome at a time when the market already underperforms. Strategically, some of the strongest potentials for growth and profitability in the EU market would suffer, too. In the large, slowly growing, and still highly dispersed market, successful business strategies do not depend as much on individual markets as on trans-national investment strategies: for example, leveraging integration gains by combining highly efficient services in the UK, sales in Germany, and production in Eastern Europe. Such successful investment strategies require a continuation of the EU integration process, based on a solid banking union and driven by liberal forces in the EU including the UK. In the case of a Brexit, greatly diminished prospects for such integration would necessitate a significant review of most EU-wide business strategies.
If a Brexit can be avoided, on the other hand, the path to EU reform would have to become much clearer since the status quo would be unsatisfactory to the entire union, not only to the British. This was the original intent of Mr. Cameron, which turned out to go so terribly wrong because the time was not ripe before the current Brexit storm. The EU, and in particular the members of the Eurozone, would have to clarify what the future of EU governance should look like – well beyond the current “muddling through” approach to euro crisis management and (mostly) backward-looking structural reforms of government finances.
During the Brexit discussions, the important role of the EU in creating peace in Europe and lifting living standards through trade integration has been evoked many times, but such historical achievements have clearly not been inspiring enough to ensure broad public support for the EU’s future. Furthermore, during the pre-Brexit reform negotiations between the UK and the EU governments, reform proposals have focused only on tweaking the reform process, while leaving the EU’s biggest challenges and issues with its vision of the future largely unaddressed (not least because the UK was not interested in shaping the EU’s future at a time when it was threatening to exit). As a result of the current Brexit crisis, this might change, and a new positive case for EU integration could emerge which builds on new opportunities from EU-wide market reforms, encouraging youth mobility, education initiatives, technology innovation and digitization on a European scale.
The EU and its members have been working on all of these pressing issues for a long time and have proven their ability to develop innovative concepts in the past. After the wakeup call of the Brexit debate, one can hope that agreeing on and implementing new pathways for growth and sustainable integration moves to the top of the agenda again. Ultimately, a newfound purpose and strength of EU cooperation and integration would also help to solve some of the crises along the union’s borders to the south and east by spreading the benefits of a recovering EU market and creating a new positive case for international integration.