The United Kingdom’s turbulent post-Brexit future

The United Kingdom’s turbulent post-Brexit future

In this debate series, GRI asked: can a Post-Brexit Britain survive in the global economy? Analyst Etienne Desjardins makes the case that, without Europe, London will endure a notable decline in status. Read the opposing side here.

By voting to leave the European Union, Britain has turned down the right to free and unfettered access to the largest trading bloc in the world. By surrendering EU passport rights, it has maimed London’s claim to financial capital of the world. Two decades of growth and dominance may come to an end with the post-Brexit era.

The referendum that took place on June 23rd shook the foundations of Britain and the European Union. Given the complexity of the disentanglement involved, post-Brexit consequences will be severe and far-reaching. Will the British economy survive? Undoubtedly — but Britain is about to find out that what does not kill it does not necessarily make it stronger.

Short-term uncertainty

A dark cloud of uncertainty hangs over the United Kingdom. The vote to leave the European Union has thrown Britain’s political class into chaos of historical proportions. The Tory leadership race was wrought with political drama, while Jeremy Corbyn is facing unprecedented mutiny and revolt within the parliamentary arm of the Labour party.

This political upheaval, compounded by the regulatory uncertainty implied by the impending undoing of 43 years of regulatory entanglement, has wreaked havoc in financial markets. This may be no more than a temporary adjustment: some of the main British indices, including the FTSE 250, have already recovered. The short-term economic upheaval, however, warns of worse things to come.

The plummeting value of the pound is driven partly by a decrease in the amount of foreign direct investment expected to make its way into the UK during the course of the upcoming negotiations with Brussels. As long as it is unclear how different sectors will be affected, many investment decisions will be put on hold.

The UK has two years to negotiate exit terms from the date Article 50 is invoked, but this will not mark the end of uncertainty. Negotiations for trade deals replacing the ones being flushed alongside the EU are expected to take place over the next ten years. Postponed investment and a shortage of capital will stifle the ability of British firms to innovate and absorb new technologies, endangering the competitiveness of Britain’s economy. These effects are likely to outlast the short-term volatility that caused them.

Post-Brexit, opportunities lost

Most direct and indirect economic dividends conferred by membership of the EU stem from having access to the European Single Market, a customs union with harmonized regulations that promote trade among the 28 current members. This grants British companies the ability to sell goods and services across Europe free of impediments such as tariffs, quotas, and border controls.

The bloc of 27 other countries that form the rest of the EU collectively represent Britain’s largest trading partner; just under half of Britain’s exports are shipped to the EU, accounting for 13% of the UK’s national income. This access to the Single Market will be lost following Britain’s exit from the European Union.

This is because the two most important demands of the pro-Brexit campaign, greater control over immigration and regulatory sovereignty, are deal-breakers for Brussels. Evidence from Norway, Iceland and Switzerland suggests access to the Single Market is a no-go if Britain insists on either of these.

Norway and Iceland, as members of the EEA but not the EU, enjoy complete access to the Single Market, but are subject to the free movement of labour and to EU economic regulation. In exchange for this, they are exempt from following certain non-economic rules and can negotiate trade deals bilaterally with other markets.

Switzerland, on the other hand, is not a member of the EEA. It has, however, over 120 bilateral deals pertaining to the access to specific markets. These are not free lunches: EU regulations in these sectors apply in Switzerland and labour moves freely through its border with the EU.

When the Swiss voted in favour of restraining EU migration in a 2014 referendum, Brussels instigated an immediate backlash, including the cessation of negotiations on ongoing deals and the withdrawal of EU funding, as well as threatening Switzerland it would lose access to the single market if plans to restrain the free flow of people are implemented.

Other suggestions include a bilateral free-trade agreement like the one currently being hashed out with Canada. An agreement like it, however, would be a poor solution for a number of reasons. Chief among these is the fact that these agreements often do not include trade in services, a sector that constitutes more than 80% of the British economy.

Furthermore, Britain is unlikely to end up with much more regulatory autonomy in the event of a trade deal with the EU. As the current negotiations between the US and the EU for the TTIP demonstrate, regulatory convergence is a large part of what modern FTAs are about.

A common claim is that by preventing the UK from negotiating bilateral trade deals with the rest of the world, it is excessively and inefficiently forced to focus its gaze on Europe. A closer look at the current state of the EU’s trade relationships, however, belies that claim.

The EU presently has trade agreements with 53 markets worldwide. When you add the 27 other members of the EU, this means the EU offers the UK preferential access to 80 markets for its goods and services. These are not puny and irrelevant markets: besides the EU’s heavy hitters like Germany and France, they include Japan, South Korea, the United States and Canada.

Post-Brexit Options Map

Source: HM Government, “Alternatives to Membership: Possible Models for the United Kingdom Outside the European Union” (2016)

Important markets with which the UK still has no trade agreements include much of Africa and Latin America, as well as India and China. These being mostly developing markets, it is unclear there is much demand there for Britain’s specialized services industry. On the other hand, British agriculture and industry would find themselves outmatched by the cheap labour available in these regions.

The economic consequences of this loss of access to the Single Market will be loss of jobs and income. For example, the UK car industry directly and indirectly employs some 750,000 people but is heavily dependent on long European supply chains.

Large automakers such as Toyota and Nissan might move the bulk of their operations to continental Europe to continue operating unimpeded by borders. Half of all non-EU firms’ European headquarters are located in the UK, an economy less than 20% of the whole. Loss of access to the single market will significantly hurt the UK’s appeal to foreign firms and will trigger corporate relocations. This will not be a temporary hiccup: moving headquarters is costly stuff. Short of a comparable shock in France or Germany, those firms will not be coming back.

An icy stake in the beating heart of London

Brexit is likely to deal a second blow to the UK by diminishing the importance of London as a global financial centre. This status is endangered by the prospective loss of passporting rights. These include the right for financial firms in the UK to offer products and services across the Channel without establishing subsidiaries on the continent or acquiring new licenses. This right is a driving force behind the presence of many American, Asian and Swiss banks in London.

Post-Brexit, the financial service exports directed at the EU, some 41% of the UK’s total, would be at risk. Some banks have already begun moving operations out of London. Particularly at risk is London’s status as a Euro clearinghouse.

Around 70% of euro-denominated derivatives are cleared in London, but some European governments, eager to move this business back on the continent, are already on the prowl. It is estimated that more than 69% of the City’s derivatives-related market could follow the retreating borders of the EU.

This is more than a benign threat: it was barely a year ago that London won a battle against the ECB protecting the right of non-Eurozone members to clear trades in Euros. The key to winning that battle? Britain’s membership of the EU.

The departure of a few foreign banks could potentially trigger a domino effect, wiping a sizable share of the City’s business. This could deal a significant blow to Britain’s economy as well as its public finances, of which London accounts for more than 30% of revenues.

A bleak outlook

One cannot go as far as to predict economic death for Britain. However, for all the unavoidable short-term pain Brexit will bring, the long-term outlook is equally bleak.

There remains, at least, a glimmer of hope. Short of the European Union imploding, it is not unforeseeable that the United Kingdom will join it once more. Until then, let the United Kingdom serve as a warning to the rest of Europe. The economically disenfranchised wield a mighty mace — and more attempts must be made to spread the benefits of globalization.

GRI Debates provide critical insight into the world’s most challenging political risk topics. Through well-balanced opinion based articles, GRI Debates offer a forum for deeper discussion into how major political decisions and security challenges affect markets, investment, and economic growth across the globe.

Categories: Debate Corner, Economics

About Author

Etienne Desjardins

Etienne Desjardins is a doctoral candidate in economics at the London School of Economics. His interests are at the crossroads of macroeconomics and political economy. He holds an MSc in Economics from the London School of Economics and a BSc in Economics from the University of Montreal. He has worked as a research assistant in the department of International Economic Analysis at the Bank of Canada and now teaches undergraduate and postgraduate classes in macroeconomics at the LSE.