Brexit image

Background to Brexit

On June 23rd 2016, the UK voted to leave the EU - commonly known as ‘Brexit’. By July 14th a new government was in place, led by Theresa May, with Phillip Hammond as the new Chancellor. In the lead up to the referendum vote there was a broad consensus that Brexit was likely to cause a sizeable short term economic shock. This shock would, forecasters argued, be followed by a period of low growth, with fall-out adversely affecting the value of sterling, inflation, productivity and jobs.

The initial impact of Brexit on the financial markets stemmed from the uncertainty which followed this momentous decision - uncertainty about the short term impact on prices, jobs and growth, and about the kind of trading relationships that would emerge. Financial markets responded to this uncertainty in dramatic fashion, with the pound falling to a 30-year low against the US dollar, and stock markets around the world suffering considerable falls. There was a bounce back as the markets calmed immediately following the formation of the new government.

Sterling (daily spot rate against euro and US dollar)

Despite the Bank of England indicating that monetary policy would be loosened, interest rates were kept on hold at 0.5%, giving some room for manoeuvre later in 2016. The Bank of England’s MPC decided not to reduce rates immediately, until some hard evidence had become available regarding the impact of Brexit on the real economy.

Looking beyond the immediate shock, what is less certain is the medium and longer term impact of Brexit on the UK economy, given that, at the time of writing, there was no clear government policy on which ‘version’ of Brexit would eventually be adopted.

The main reason for the negative forecasts prior to the vote was the assessment that, while the benefits of remaining in the EU seemed clear, the benefits of leaving were far less clear, especially given the uncertainty about how Brexit negotiations would unfold. A consensus view emerged that the UK might find it difficult to compensate for the loss of the benefits that being an EU member bring. These include:

  1. Tariff-free access to other member’s markets, which reduces the costs of trade, and creates trade between members
  2. No customs check or controls on the movement of goods between EU members
  3. A single market with common regulation creating a level playing field
  4. Further access to 55 other markets through numerous EU-Free Trade Agreements (FTAs)
  5. Common external tariffs on non-member imports

Add to these benefits, the fact that UK trade as a share of national income – trade openness - has risen to over 60% in the past decade, compared to under 30% in the years before the UK joined the EU, the economic case against Brexit, at least in the short run, appeared a strong one.

As the economic ‘dust’ settles, much will depend on the kind of trade agreements that will be reached, how resilient the UK economy is in the short term, and on how much time the negotiations will take to complete.

Trading scenarios for the UK after leaving the EU

The European Economic Area (EEA) scenario

The EEA (European Economic Area) scenario involves the UK leaving the EU, but continuing as a member of the wider EEA. The EEA includes the remaining 27 EU countries, together with the four European Free Trade Area (EFTA) states of Iceland, Liechtenstein, Norway and Switzerland.

EFTA was founded in 1960 as a counterbalance to the more politically focussed European Economic Community (EEC) as it then was, and included Austria, Denmark, Norway, Portugal, Sweden, Switzerland and the United Kingdom. In 1973, the United Kingdom and Denmark left EFTA to join the EC (as it had then become) and were followed by Portugal in 1986 and by Austria, Finland and Sweden in 1995. In recent years, EFTA has successfully concluded free trade agreements with North America and Asia. Supporters of this option have argued that the UK could, fairly quickly, become a fifth member of EFTA. However, in this scenario there would still be free and uncontrolled movement of labour into the UK, and a budget contribution to the EU, while at the same time EFTA-only members have no influence on EU trade rules in the future. There seems a consensus among analysts that this EU-lite option would put the UK at a significant disadvantage in terms of influencing the direction of the EU going forward.

An EU-UK Free Trade Agreement (FTA) scenario

This option would involve the UK negotiating a completely new free trade agreement with the EU, similar perhaps to that enjoyed by Canada. Clearly this would involve a lengthy negotiation period, perhaps with the EU reluctant to fast-track this kind of agreement.

The WTO scenario

The WTO scenario means that a country’s trade is subject only to the rules of the WTO club. If the UK adopted this approach - as some supporters of Brexit do - it would be subject to the Most Favoured Nation (MFN) rules of the WTO. The main principle of this WTO rule is that members should not be discriminated against and, in the absence of specific free trade agreements, all members should enjoy the same treatment as the most favoured country. Hence, if one member grants another member a special trade advantage, the same advantage should be conferred on all other members. Adopting this policy would, of course, mean that the UK would not have free access to the EU, and could not influence EU trade rules.

The Unilateral free trade scenario

The unilateral free trade scenario is a variant of the WTO scenario, where UK goods and services are faced with the tariff levels agreed through the WTO, but where the UK reduces its tariff levels on imports without any reciprocal reduction by trading partners. This is widely thought to be the least likely option following Brexit, although New Zealand and Singapore have successfully adopted this kind of approach. For example, Singapore has negotiated 20 free trade agreements with its 31 main trading partners.

The models used by key forecasters in the run-up to the referendum assumed the unilateral free trade approach to be the worst-case scenario. While unilateral elimination of tariffs gives away key ‘bargaining chips’ in future trade negotiations, some economists (especially those in the Economists for Brexit group) believe that the unilateral free trade route would lead to the greatest long term gains for the UK. This view is based on the belief that any form of protectionism distorts trade patterns to the detriment of all parties. However, Economists for Brexit and other 'free traders' recognise that the UK’s agricultural and industrial sectors are likely to be severely squeezed, as the lack of a comparative advantage in these areas will be exposed by unilateral free trade.

Other implications of Brexit

Impact on FDI

In terms of FDI, independent analysis by the Institute of Fiscal Studies (IFS) prior to the referendum vote, concluded that it is most probable that flows will fall after Brexit. This it likely to reduce productivity (given that productivity relies on the level of capital investment) which will have a negative impact on GDP. Lower FDI will have both demand and supply-side implications for all key macro-economic performance indicators, including growth, jobs and trade.

Less regulation

Given that the EU sets regulation in many areas, including the environment, health and safety, employment and financial services, exit from the EU is likely to lead to a reduction in the level of regulation. However, many analysts have concluded that the effects of this may be fairly modest given that the UK is a relatively unregulated economy compared with many others.

Impact on public finances

It is likely that there will be two different, and contradictory, effects of Brexit on public finances. Firstly, the positive mechanical effect, which means that leaving the EU will strengthen the public finances in the short term as a result of a fall in net contributions of the order of £8bn a year - the gross contribution of £18.8bn, less the rebate and the return back of funds from the EU budget. However, a second and stronger negative effect, the national income effect, suggests that the possible fall in GDP as a result of Brexit will weaken public finances, as tax receipts fall and spending increases. Whatever the impact, there is likely to be a significant delay in its effect given that the mechanical effect will only happen once the UK ceases to make payments to the EU, which may well not be until at least 2018/19.

The digital economy

Research suggests that, apart from the US, web users are highly inward looking, generating a strong home-bias in favour of local online suppliers and internet providers, suggesting that trading in the digital world is both less open than we might believe, but also dominated by US based companies. While the internet should reduce ‘economic distance’ between countries, the home-bias effect may well counteract this. With its many languages, different cultural preferences, and inward looking approach to the digital economy, many doubt that the EU is best placed to cope with the new realities of a digital world. Although the EU has made some progress in liberating the digital market-place, many feel that the UK should adopt a much more outward looking approach.

Brexit image - planets orbiting - gravity theory

One view is that once the UK has ‘cut loose from its orbit’ around the EU it can connect more closely to the US, which dominates the digital economy, and where the ‘economic distance’ between the UK, US, Canada, Australia and other English speaking nations is much smaller than between the UK and the EU. The same may be said of the emerging power-houses of China and India, and indeed many see Brexit as a considerable opportunity for the UK to have a much closer relationship with these two countries.

The financial sector

Perhaps the single biggest unknown is the impact of Brexit on the UK’s financial sector. In the early days after the Brexit vote many were claiming that the UK would suffer irreparable damage, and certainly shares in UK banks were some of the worst to suffer - along with those of house-builders.

The UK is a dominant player in global financial markets, and has the largest market share of EU business in financial services - double that of France and Germany. How Brexit negotiations unfold will be highly significant to the UK’s financial sector.

Perhaps the most important aspect of Brexit for the UK’s financial services is the potential loss of so called ‘passporting rights’. This relates to the ability of banks and other financial institutions in one EU state to conduct business in another one. As a member of the EU, national banks and financial institutions do not need to obtain licenses in each country. It is certainly too early to tell exactly how Brexit will affect financial services at the global level, and in terms of the UK and the EU.

Farming

The impact of Brexit on the UK’s farming sector is also likely to be considerable, given that over 50% of farm income in the UK comes from CAP support. However, until new trade deals have been negotiated, and the UK government has made its position clear on subsidies, the overall impact on farming remains unknown.

New policies

As well as introduce a new outward looking approach to trade policy designed for the post-Brexit era, many see Brexit as an opportunity to develop a whole new range of domestic policies. Many argue that the UK has neglected its industrial base, and its infrastructure, and it is time to develop a new industrial policy for the post-Brexit age. This could also be said for technology policy and innovation.

See also:

Gravity theory of trade