An economic cost to Brexit

A UK vote to leave the EU in June 2016 would trigger economic turmoil, albeit largely in the short term, writes Danielle Haralambous

THE Economist Intelligence Unit’s view is that the UK electorate will reject “Brexit” in the 23 June referendum on the UK’s membership of the EU. We expect voters’ fears about leaving the EU to rise as the referendum approaches and the economic arguments in favour of staying to prevail. We also believe that Mr Cameron’s support for staying in the EU will influence the voting intentions of a significant proportion of the electorate. However, the risks to this forecast are meaningful and were it to happen, a Brexit vote would have significant financial and economic implications.

The impact of a vote to leave the EU would first be felt on the financial markets, with the immediate reaction dominated by uncertainty about the impact of Brexit on the economic outlook. We expect the currency to depreciate in the run-up to the referendum, but a Brexit result would prompt a sharp sell-off, driven by an assessment of the potential costs involved in leaving the EU. Investors would be concerned that a likely flight of capital and labour would impair the economy, undermining the UK’s “safe haven” status. This would drive a similar reaction in the UK bond market, with investors reducing their holdings of gilts.

Following this, there would be a gradual return to market stability. Initial statements from the UK and the EU would be designed to reduce uncertainty and assuage concern over how a UK exit would play out, with reassurances of a swift resolution. This would support a partial recovery in the pound and return some stability to the bond and equity markets over a period of weeks. However, broader investor sentiment would be slow to recover and credit spreads would be wider than before, reflecting higher risks associated with UK borrowers. A higher than usual degree of uncertainty would also mean that financial market volatility would persist for some time.

The broader economic costs associated with Brexit would depend entirely on the precise details of the exit agreement, which the UK would have two years to negotiate once it notified the EU of its intent to withdraw. In the short term, in view of the difficulties surrounding the renegotiation process that Mr Cameron led in the months before the referendum, and the political capital he expended in securing revised terms of membership for the UK, there would be little confidence in the UK’s ability to dictate the terms of its new relationship with the EU. This would lead to an increase in precautionary savings and delayed investment decisions, hurting the pace of economic growth.

Exit negotiations would involve striking a balance between retaining access to EU markets but freedom from the rules that govern the EU (and the associated contributions to the EU budget). Following a vote to leave, the EU would have little incentive to offer the UK many concessions on the latter. The country would therefore be likely to end up accepting large chunks of EU legislation in exchange for continued free trade in goods as a part of the European Economic Area. This is similar to Norway’s current relationship with the EU. The obvious downside is that the UK would no longer have representation in the European institutions, and would therefore lose its ability to shape the legislation that it still had to abide by.

However, it would also allow the UK to reduce its contribution to the EU budget. Our view is that such an arrangement could be presented to the UK electorate as a fair deal, particularly if, as a non-EU member, the UK was able to secure some limits on freedom of movement.

The UK’s political capital is likely to be running low in a Brexit situation, and we would expect access to the services markets to be off-limits. This would damage the ability of the UK’s financial sector to provide services to EU markets, and companies that rely on this would probably relocate. We would also expect a sizeable drop off in foreign investment from companies that view the UK as a gateway to Europe. This would involve a loss of typical spillover effects from such investment flows, such as new working practices and new technologies. It will also make it more difficult for the UK to finance its current-account deficit, which remains substantial. As a result, we would expect a further deterioration in the UK’s international investment position, raising the risks to financial stability.

Nevertheless, in the longer term the UK remains an attractive business environment. The short-term economic costs of a Brexit vote are likely to be significant, but we would expect economic growth to recover over the medium to long term, albeit to a level below our current baseline forecast for real GDP. Cities such as Frankfurt and Paris are keen to displace London as the financial centre of Europe, but London should retain its status as a strong international financial centre by virtue of language, time zone and an existing concentration of interconnected businesses. It may even gain a competitive edge through its ability to repeal some EU regulation. Structural features such as a flexible labour market and a broadly pro-business policy orientation would also help the UK to remain an attractive destination for inward investment. However, these features would be set against a wider and more persistent current-account deficit, and a loss of skilled labour from the EU, which would undermine the recovery in productivity.

Danielle Haralambous, UK Economist, The Economist Intelligence Unit