Brexit: consequences and solutions
Brexit is adding to a long list of challenges for Europe, from refugees, populist politics, German-inspired austerity, government bankruptcy in Greece and perhaps Portugal according to Anatole Kaletsky (Project Syndicate). After an agreement was reached, on June 23, the UK will hold a referendum on whether to remain or not in the EU. Polls show an uncertain outcome, with populism, Europhobia and the refugee crisis supporting Brexit (Noelle Lenoir in Project-syndicate). EuroIntelligence reviews the political debate. Pedro Nicolaci da Costa (Peterson Institute) quotes from Adam Posen (interview) five key reasons to fear a Brexit: (i) negative market impact, (ii) monetary policy implication (raising rates), (iii) economic drag, (iv) misunderstanding on migration, and (v) heightened UK political risk. The Infacts website is looking at arguments from both sides.
The negotiated agreement
The Settlement (see for example Macroman) allows the UK to avoid the EU commitment towards further integration, place some curbs on benefits paid to migrants, and affords the UK a modicum of autonomy in regulating the City. Michael Emerson (CEPS) reviews in a book the ‘Plan A,’ namely the status quo for the UK in the EU as amended by the new agreement, and three variants of a ‘Plan B’ for secession.
For Stefani Weiss and Steven Blockmans (CEPS and Bertelsmann Stiftung joint report) and Fabian Zuleeg (EPC), the agreement reflects a clear desire to agree a deal on the British government’s demands for a renegotiated settlement on the UK’s relationship within the European Union, providing David Cameron with the political capital to call a date for the in/out referendum and to lead a campaign for the UK to stay in the EU. They view the deal as an acknowledgement that EU integration is not a one-directional process of ‘ever closer union’. Andrew Duff is very critical about Britain's opt-out from ever-closer union, with member states no longer to enjoy equality under the treaties in their commitment to the European project.
Financial considerations were key in the Settlement, notable the quasi exemption of the City of London from the single rulebook—which Erik Jones thinks could back-fire if it removes the UK from the setting of rules that will ultimately impact British financial institutions. Howard Davies (hat-tip EuroIntelligence) explains why the UK government is keen on breaking with the EU's single rulebook for the banking sector, mostly the larger share of market financing in the economy.
The economic and financial consequences for the UK
The impact of Brexit is highly uncertain, and difficult to predict through macro-models (Global-counsel). Estimates vary widely, for example an income loss between 1.1 and 3.1 percent of GDP according to CEP, 2.2 percent in 2030 for Openeurope. What are the key channels:
Trade: If Brexit ends UK’s access to the EU single market, the impact could be larger than the UK net contribution to the EU budget represents 0.6% of its GDP (statista), as highlighted by Angus Armstrong. Nauro Campos and Corrado Macchiarelli (VoxEu) present new econometric estimates showing that, after the introduction of the euro, the UK and Eurozone business cycles became significantly more synchronized—suggesting that the costs of a potential UK exit from the EU have increased. Patrick Minford points out that a more liberal trade environment could also be a risk. Jean Pisani-Ferry argues that the UK, which is strong in services (see also Chris Giles), needs the institutional framework of the EU single market much more than, say, Poland, which is stronger in goods, and makes the additional point that the global trading framework is in trouble.
Finance: Brexit could pose risks to London’s financial hub. In the short term, capital outflows from exiting investors could pressure the pound and lead to higher inflation and recession, said Harold James. Michael McMahon et al. (VoxEu) report near unanimity in the monthly Centre for Macroeconomics survey that the Brexit question will increase financial volatility (a point also made by Jan Zilinski (Peterson Institute)) and will pose economic costs in the medium term. Financial volatility can be expected to be especially high if polls remain close.
Investment: FDI flower could be lower, as noted by Pia Huttl and Silvia Merler (Bruegel), as the EU is the bigger FDI investor in the UK.
Political: As Scotland wishes to remain in the EU, a referendum to leave the UK is a plausible outcome (FT).
The economic and financial consequences for the EU
The arguments in the Brexit debate have been shifting from what impact it will have on the UK to what impact it will have on the EU, as noted by EuroIntelligence. The EU is exposed through trade (the UK is currently one of the most important trading partners) and through the EU budget (19% of total net contributions to the EU budget in 2014) for Willem Buiter. However, Paul De Grauwe argues that the EU may ultimately benefit from Brexit—a weakened UK will want to negotiate a new partnership but with limited political influence. Wolfgang Munchau rejects this point (hat-tip EuroIntelligence) and expects to see pressure in some other member states to follow the UK. It will produce disintegration without any offsetting integration.
In political terms, the main risk might be for Brexit to trigger chain reactions by invoking Article 50, the EU’s divorce clause (Politico and Willem Buiter, Ebrahim Rahbari, and Christian Schulz (VoxEu)). A Brexit could also lower economic and geopolitical influence of the EU (Bruegel). Willem Buiter, Ebrahim Rahbari, and Christian Schulz (VoxEu) argue that Brexit could have serious economic and political consequences for the rest of the EU. The economic and financial frictions could be limited if both parties try to strike an amicable separation agreement. A loss in soft power for the rest of EU following Brexit would be near certain, in our view. Brexit would likely further boost (intra-national and inter-national) political fragmentation in the EU and raise the risk of further EU and Eurozone disintegration.
UK – EU relations after the Brexit
The UK Government published a paper setting out the mechanisms and timeline for the withdrawal from the EU in the event of Brexit. The 2Y timeframe for agreeing a UK-EU settlement – as stipulated under Article 50 of the Lisbon Treaty would be challenging—with a long process that could lead up to a decade or more of uncertainty, requiring, among other things, a new UK-EU trade deal—a key for John Springford based on a gravity model of trade. Huttl and Merler (Bruegel) note that the UK would need to re-negotiate more than 100 trade agreements. Willem Buiter, Ebrahim Rahbari, and Christian Schulz (VoxEu) argue that the negotiations on future economic (and political) relations between the UK and the rest of EU would, however, likely be very asymmetric with negligible bargaining power for the UK – much less even than in the negotiations on the EU changes required to keep the UK in the EU.
Neither the government nor the campaign to leave the EU has put forward concrete proposals for what comes after Brexit. Lack of clarity about the UK’s economic arrangements with the EU following Brexit are the main concern for the medium term, as suggested by survey results (Michael McMahon et al. (VoxEu). Dhingra and Sampson shed light on the possible options:
An European Economic Area – the Norwegian model: EEA members are part of the European Single Market but EEA membership does not require deeper political integration. However, non-UE members of EEA must accept and implement single market legislation without giving their recommendation to this legislation.
Bilateral treaties – the Swiss model: Switzerland has a series of bilateral treaties under which it adopts EU policies in specific areas–this approach allows Switzerland the flexibility to choose which EU initiatives it wishes to participate in.
If UK leaves the EU without putting in place any alternative arrangements then Britain’s trade will be governed by WTO.
The Short View… The ECB’s Bazooka
The ECB announced a package of easing measures (see here for details), comprising of an expansion of QE (by one-third to €80 billion per month and new issuer and issue limits for the purchase of supranational bonds from 33 to 50 percent, as explained in the press release), purchases of corporate bonds, four new targeted longer-term refinancing operations (TLTRO II) to support bank lending, and a further reduction in all policy rates (including the deposit facility interest rate to - 0.4 percent) but setting a floor on negative rates at current levels and refraining from introducing a tiered deposit rate system. These moves follow the ECB’s downward revision to both inflation (2016 and 2017 inflation forecasts to 0.1 and 1.3 percent) and growth projections.
After a euphoric reaction, markets corrected on disappointment about possible limits to further rate cuts. The ECB was largely seen as over-delivering by analysts (see for example Marco Valli at Unicredit), which noted notably the more front-loaded pace of purchases and the inclusion of corporate bonds. For Biet Siegentaler at UBS, banks get 40bp subsidized funding for 30% of a defined loan book—a clever way to support banks indirectly and boost lending. The measures imply a shift away from interest rate policy towards more direct credit easing measures, as highlighted by Goldman Sachs and Pictet.
