28 June 2016
Brexit and its Implications
The UK voted to leave the EU in a historic referendum held on 23 June 2016. This has not only spawned instant repercussions across the global financial market, but also unleashed ambiguities over the future arrangements for Brexit. In addition to the negative consequences for the UK, Brexit will likely hurt the EU by disrupting its relations with Britain, as well as undermining the cohesiveness of the EU itself.
While the impacts of Brexit should be less significant in Asia, it would still be inauspicious for Hong Kong exporters targeting the UK. As Britain will remain in the EU until the conclusion of an exit agreement, significant changes may take time to unfold. However, a weakened UK economy, aggravated by a choppy sterling, could result in a weaker appetite for imports into the UK over time. Furthermore, Brexit may erode the UK’s dominant position as an investment destination as the country would become less attractive as a gateway to the EU.
A Vote for British Departure from the EU
The UK voted to sever its 43-year membership of the EU in a historic referendum held on 23 June 2016. Overall, 51.9% of voters opted to leave the EU compared with 48.1% wanting to stay. While many of the English regions and Wales strongly supported Brexit, London, Scotland and Northern Ireland backed maintaining the status quo.
The victory of the ‘leave’ camp has sent immediate shockwaves across the financial world, accompanied by a plunge in the global equity markets, as well as sharp depreciations of the pound sterling and, to a lesser extent, the euro against the US dollar. Such volatility in the financial markets is unlikely to die down any time soon.
The UK political environment is also hazy as Prime Minister David Cameron, a proponent of the EU membership referendum and the leader of the ‘remain’ campaign, has decided to step down by before the ruling Conservative Party Conference in October. It would be for the new Prime Minister to negotiate with the EU on the exit arrangements after invoking Article 50 of the Lisbon Treaty, though the EU has urged Britain to start the procedures of departing from the union as soon as possible.
Five Alternatives to Exit Arrangements
The vote to leave does not mean the UK has already ceased to be a member of the EU. The victory for Brexit would be followed by a UK request to invoke Article 50 of the Lisbon Treaty. This allows two years to negotiate and conclude arrangements for withdrawal. The two-year period can be extended by unanimous agreement of the other member states. The UK would remain a member during this period, and is obliged to continue to implement EU laws, though it will be barred from participating in the discussion and decision of new EU policies.
The impact of Brexit will very much depend on the arrangements for withdrawal. There are broadly five possible approaches. The first alternative is a Norwegian-style arrangement, under which the UK seeks to join the European Economic Area (EEA) – currently consisting of the EU and Norway, Iceland and Liechtenstein - in order to retain full access to the Single European Market. However, the UK would have to adopt EU regulations, including the free movement of people, without any influence in setting those regulations.
The second option would be a Swiss-style arrangement, under which the UK strives to conclude a myriad of bilateral agreements with the EU in order to enjoy free access to the Single Market across a number of different sectors. It would, however, be an arduous and tedious undertaking for Britain to strike such a large number of favourable deals with the EU.
A third alternative would be a Turkish-style arrangement, under which the UK seeks to set up a customs union with the EU. As such, EU tariff barriers could be avoided. The coverage of the customs union, though, would likely be incomplete, while the UK is still required to adopt most of the EU regulations governing merchandise trade.
A fourth solution would be to simply rely on WTO rules for entering the EU, although this would suggest that the UK would not have any preferential treatment when accessing the Single Market. Finally, the fifth option – widely seen as extremely difficult, if not impossible for the UK - is to negotiate a special deal that preserves free trade with the EU, while sidestepping the disadvantages of the other arrangements.
In all likelihood, it will be an uphill battle for the UK to strike a favourable exit deal with the EU. It has been widely reported that senior EU politicians and officials have been holding confidential discussions for some weeks on a so-called ‘Plan B’ for Brexit. The main focus of such discussions is neither how to make Brexit a success, nor how to smooth out the process of the UK’s withdrawal. On the contrary, the aim is to make Brexit a painful experience for the UK so as to deter other member states from following suit.
Likely Impact on the UK
The UK's decision to leave will certainly lead to a prolonged period of uncertainty, one that will weigh heavily on the country's economic performance. The heightened uncertainty over the new arrangements between Britain and the EU is expected to discourage investment inflows as foreign companies may prefer investing in other EU countries, as an alternative to the UK, in order to guarantee free access to the Single Market.
The UK government’s first priority should be to negotiate continued access to the EU’s Single Market. Close to 50% of British exports go to the EU, and exporting businesses may hold back investment until they can see the terms on which the UK will be trading with Europe. Negotiating an equivalent access to the Single Market, though, appears impossible.
Brexit would exclude the UK’s legal participation in all of the EU’s foreign trade agreements. At a time when trade is increasingly negotiated on a regional or bloc-to-bloc basis, the government would have to begin negotiations from scratch with a host of countries and blocs, including the US, which is currently working with the EU on the Transatlantic Trade and Investment Partnership (TTIP). Unlike the EU, which has a huge market and substantial political clout, Britain will have less bargaining power on its own when negotiating trade deals with individual countries or trade blocs.
There is also possible loss of easy access to the Single Market for UK financial services, which currently allows them to operate anywhere in the EU. This would threaten the dominant position of the City of London, and encourage financial services firms to transfer to the continental Europe, particularly locations within the Eurozone, such as Frankfurt and Paris.
Given the expected deterioration in the UK’s business environment, business confidence will be badly hurt, with the inclination to hire expected to wane. Increasing joblessness, coupled with dwindling equity and property prices, will likely dent consumer sentiment. To complicate matters further, rising inflation amid a weak pound will also erode the real incomes of British consumers, weighing further on domestic demand and the UK’s growth prospects.
While estimates vary, there is a general consensus that Brexit will have negative impacts on the UK economy. According to the UK Treasury, Brexit would lead to a 6% contraction of the economy in two years, a 2.7 percentage-point increase in consumer prices, a loss of 820,000 jobs, a 4% fall in average real wages, a 15% decline in the value of the pound as well as an 18% drop in house prices, under a 'severe shock' scenario.
The referendum result has also underlined the political, social and cultural gap among different regions of the UK, including a divide between London and provincial England. Following the victory of the leave campaign, there are now calls for a second referendum on EU membership, though such requests will almost certainly be rejected. To compound these problems, the likelihood of another independence referendum in Scotland has increased, while there are also calls for a referendum on Irish reunification, both suggesting a possibility, albeit remote, of an eventual break-up of the UK itself.
Potential Impact on the Rest of the World
Evidently, the British departure will pose serious threats not only to the UK, but also the world economy at large. At present, the UK is the world’s 5th largest economy (with a 4% share of global GDP) and the EU’s second largest (18% of EU GDP). It is also the world’s 5th largest trader (3% of global trade) and the EU’s 2nd largest (10% of EU trade). In particular, Brexit will likely hurt the EU by disrupting its well-established economic and trade relations with the UK.
Growing uncertainty over the UK’s negotiations with the EU on the exit arrangements will continue to bring about financial market volatility. Sustained pressure on the pound is expected to remain a drag on the euro, thereby aggravating on-going global currency instability, particularly in Europe. That said, a Lehman-like collapse of the global financial market remains unlikely as policy makers are now better prepared, with the Bank of England (BoE), the European Central Bank (ECB) and other major central banks having contingency plans to counter the volatility of the financial markets.
For the EU as a whole, the loss of the UK, a leading financial centre and one of the few comparatively fast-expanding economies in Europe, will definitely have negative repercussions on EU growth. The union would further suffer from the absence of an influential supporter of trade and service liberalisation. At member state level, those with stronger trade, investment and financial links to the UK, such as Ireland and the Netherlands, would be most affected.
More seriously, the UK departure could lead to a domino effect that threatens the whole EU, spurring some other member states, notably Italy, France, the Netherlands, Sweden and Denmark, to push for their own membership referendums. Even if no other member states ultimately choose to leave, any intensified anti-EU sentiment will hinder the further integration and development of the union, which may translate into a less lucrative, yet more difficult, market for the rest of the world.
Expected Impact on Hong Kong
Although the impact of Brexit will be less significant in Asia, the uncertainty associated with establishing a new relationship between the UK and the EU could still be detrimental to Hong Kong businesses trading with and invested in the UK. At HK$55 billion, the UK was Hong Kong’s 2nd largest market in the EU in 2015 (16% of EU total), and the 9th largest in the world (1.5% of world total). About 60% of Hong Kong exports to the UK were consumer goods, such as electronics, clothing, jewellery, toys and timepieces, with capital goods taking up a 35% share.
However, as the UK will remain in the EU until the conclusion of an exit agreement, it will largely be business as usual for the time being. While Britain will continue to adopt the EU’s trade policy until the exact exit terms are in place, increasing regulatory divergence over the longer term might add to the cost of exporting to the country. More importantly, a fragile UK economy, along with a soft pound, would mean a weaker appetite for imports.
In terms of investment, the UK is now the largest recipient of FDI in the EU, but Brexit may erode the UK’s dominant position as an investment destination. If anything, the UK could become less attractive as a gateway to the EU, as a base for business regional headquarters and as a location for investment from the EU.
Against this backdrop, it is expected that, in the wake of Brexit, some Hong Kong companies may consider shifting part of their investment in the UK to other EU countries. At HK$242 billion, the UK was the largest destination of Hong Kong’s outward direct investment in the EU in 2014 (65% of EU total), and the 5th largest in the world (2.2% of world total).