Brexit & beyond

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On 23 June the United Kingdom voted to leave the European Union. The full consequences of that decision will not be known for years, and arguably decades. Indeed, at this early stage it is not even certain that Brexit will happen – it is at least theoretically possible that the UK may ultimately remain within the EU. Markets cannot wait for all the uncertainty to be resolved. Prices have already started to adjust to the new economic and political reality.

This article will discuss the likely domestic ramifications of Brexit. There are almost certainly economic and political consequences for the rest of Europe too – both good and bad – but these are beyond the scope of this article. To be clear from the outset, I will not express a view on the merits of Brexit: the people have already spoken on that issue, for the moment at least.

End games

One of the curses of modern life is the spoiler: those who record their favourite HBO series and plan to watch it at their convenience are forever at risk of having their 60 minutes of TV heaven being ruined by some well-meaning friend blurting out the twist in the tale. With Brexit it’s the exact opposite. If you want to figure out what the vote means for the economy or asset prices in the long run then the one thing you really need to know above all else is what the final settlement between the UK and the EU will look like. There are an almost countless number of possibilities, but we shall focus on three distinct scenarios.

Option one

Remain, despite the outcome of the referendum. The most plausible route to this scenario is via a second referendum. In order to get a second referendum there likely has to be a lot of economic, political and democratic pressure on the Government – that is, if the outcome of the first vote is clearly having a negative impact on the standard of living of the electorate, if opposition parties are able apply pressure on the Government and if there is clear public support for a second vote. This scenario starts to look less likely once the UK triggers Article 50, and formal exit negotiations begin, although in theory it is still possible for the UK to change its mind after this point.

Option two

Norway – that is, the UK chooses to leave the European Union but stay within the European Economic Area (EEA). This option would allow the UK to retain near complete access (n.b. not full access) to the single market and to negotiate its own trade deals with countries in the rest of the world and to regain sovereignty in a couple of key areas (agriculture, fisheries). However, the quid pro quo of the Norwegian option is the UK would have to accept near complete freedom of movement of labour across its borders, would continue to make (smaller) financial contributions to the EU budget and would have to accept EU regulations without any significant say on how those regulations are calibrated.

Option three 

Out, out – that is, the UK does not remain within the EU or the EEA. In this scenario, the UK regains control over migrant flows from the EU but loses preferential access to the single market and would therefore have to negotiate a new free trade agreement with the EU. It is impossible to be sure what that new deal would look like or the conditions that would be attached to it, but there appears to be a double lock on the UK being able to have its cake and eat it too. First, if the EU allows the UK to continue enjoying the perceived benefits of EU membership (the free movement of goods and services) without having to continue paying what is perceived to be by some the major cost (free movement of labour) then that could prove problematic: other members might start to question their membership of the club. Second, even if the UK is able to strike such a good deal with the key political figures in Europe it would still have to be ratified by every national parliament of the EU.

A recession is not inevitable but it is certainly a distinct possibility

The final settlement will not become clear for some time. The UK has a new Prime Minister in Theresa May and although she supported Remain during the referendum campaign she has been unequivocal in saying that she accepts the outcome – or ‘Brexit means Brexit’ as she put it. However, the new Prime Minister appears to be in no great hurry to extricate the UK from the EU. She has signalled that she does not intend to formally trigger exit negotiations with the EU (as per Article 50 of the Treaty) until the end of the year, and would prefer to begin a process of informal negotiations with the UK’s European partners. However, European politicians appear unenthusiastic about the prospect of delay: the Commission President, Jean-Claude Juncker, insists that there can be no informal negotiations without formal notification of exit.

Once Article 50 has been triggered there is a two year window in which the UK and EU can negotiate the terms of the divorce. This discussion is about important technical issues – for example, winding down spending and funding commitments, the UK’s political involvement in European institutions and the rights of UK and EU citizens. It should not be confused with the discussion that will follow over the UK’s future trading arrangements with the EU – whether the UK is in the Norway option or the ‘out, out’ option – that could take a much longer period to agree and ratify. One key distinction between these two processes is that the former is governed by Qualified Majority Voting, whilst the latter will probably require the unanimous support of all EU member states. [divider] [/divider]

This article was written by Richard Barwell, senior economist, on 1 July 2016 in London

Richard Barwell

Head of Macro Research

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