Spotlight on... Brexit

Background

In 1975, the UK held a referendum to gauge support for the country’s continued membership of the European Economic Community. The electorate expressed significant support, with 67% in favour. Fast forward 40 years, and support for the European Union as an institution appears to be waning, with the electorate becoming more Eurosceptic amidst a proposal for an exit referendum to be held on 23 June 2016. The main driver of British dissatisfaction is the loss of sovereignty due to the delegation of competencies to the European Commission, especially on immigration policy.

UK-EU negotiations and the results

David Cameron in late 2015 demanded a negotiation package labelled “The Four Baskets”, which include an end to in-work benefits for EU migrants, an opt-out for further political integration towards an ‘ever closer union’, safeguards for non-Eurozone countries and the protection of the City of London from discriminatory measures. Despite the fact that ending in-work benefits is a violation of the Single Market and freedom of movement within EU, a deal was struck in February 2016 by the 28 members of the union.

Cameron used the threat of ‘Brexit’ as leverage in obtaining concessions from the European Union, but this was seen as a failure by many even within own his party. The latest opinion polls show that the Remain camp is ahead, with 51% of respondents favouring staying in the EU against 38% preferring to leave. However, the Leave camp is gaining momentum with key supporters such as Boris Johnson, Mayor of London, and Michael Gove, Justice Secretary. According to Bloomberg, 13% of economists believe that the lead-up to Brexit will be the greatest political risk of 2016, whereas 45% believe that Brexit itself will be. The run-up to the 23 June referendum will cause severe uncertainty for the markets and investors.

Market and economic consequences

Brexit uncertainty has already hit the currency markets, with huge capital outflows leading to a sharp fall in sterling to its lowest level since 2009. UBS warned that Brexit could drive sterling down to parity with the euro. The FTSE100 has also sunk to a three-year low, with significantly higher volatility. According to the FT, there has been weak demand for 10-year UK gilts due to precautionary measures taken by foreign investors. The latest UK bond issuance covers roughly £78 billion of the budget. Uncertainty over Brexit will lead to investors demanding a higher interest rate to lend to the Treasury, which will lead to higher borrowing costs. More than a third of FTSE100 company bosses have signed a joint letter, declaring that an exit would threaten investment within the UK across all industries. In these circumstances, a strong ‘sell’ recommendation for portfolio managers and investors in UK equities, fixed income, and currency is in order until the referendum is held.

44.8% of British exports go to the EU, which is worth £230 billion. If British voters choose to leave the EU, a smooth transition will be heavily contingent on the government’s ability to renegotiate a new, favourable trade agreement with the EU. The loss of market access in the EU would harm the growth and competitiveness of British firms. Regardless of any replacement agreement, there will still be significant adjustment costs that will especially negatively impact small- to medium-sized enterprises. The UK as an independent nation would lose negotiating power in trade agreements. The best-case estimated permanent loss of GDP would be 2.3%, while a worst-case estimate falls between 6.3-9.5%. This latter scenario means that leaving the EU would be just as detrimental as the 2008 financial crash. Property developers and builders will also be impacted if Brexit leads to lower demand for UK property markets from overseas buyers. The full formal exit process could take up to ten years in which further negotiation with the EU to define the new EU-UK relationship would take place.

Political consequences

The risk of political contagion from Brexit is especially high, as it would set a precedent which could lead to a domino effect of other countries leaving the EU. Within the UK, former Scottish National Party leader Alex Salmond has stated that a second referendum for Scottish independence would be inevitable in the case of Brexit. This would compound the aforementioned negative effects on the UK economy.

About Sean Urquhart

I am a postgraduate student currently reading MSc Political Economy of Europe. My current main academic focuses are European integration and the political economy of international trade agreements. My career ambitions lie within asset management and I am interested in how political risk affects different asset classes and the financial markets as a whole.