Tuesday, August 11, 2020

UK Referendum on the EU: near- and long-term implications

di Lorenzo Codogno

It is not obvious if the EU would lose or gain from Brexit, while the UK would almost certainly lose out. Judging from trade and investment flows, Brexit should have less of a negative impact on the rest of EU than the UK. Some service sector businesses could potentially relocate to the EU, and the area could divert foreign direct investment from the UK. However, the net impact would probably be mildly negative.

Many econometric estimates of the medium-to-long term impact of Brexit on the UK economy provide an excessively bleak outlook for at least two reasons. First, they assume negative developments on trade negotiations, i.e. going back to WTO arrangements, introducing bilateral treaties with all counterparts or some form of association agreement similar to that of Norway. They miss out the most sensible solution, although admittedly a very difficult one from a political point of view, i.e. a ‘suspension’ of the current arrangements until a revision of EU treaties and not just for the two-year renegotiation period allowed by Article 50 of the Treaty. This would be the most sensible option, although difficult politically as it would imply unanimity by all EU countries and an embarrassing request by the UK government. Second, model estimates opt for a technically correct but unrealistic assumption of no policy change (or just the working of automatic stabilisers). In case of severe impact on the UK economy, the government and the Bank of England would put forward policies to limit the economic damage.

Financial market volatility, uncertainty, and loss of confidence in the EU project could pose a more immediate and severe risk. Brexit may become a catalyst for more deep-rooted phenomena and expose the weakness of the UK twin deficits. In fact, public deficit stood at 4.4% in 2015 and the current account deficit reached 7.0% in 4Q15. In recent years the deterioration of the current account balance has been offset by substantial net capital inflows. There may be a sudden stop in these flows given the uncertainty that Brexit would trigger (and, to some extent, it has already triggered). The Pound Sterling would then become sharply weaker.

Therefore, the risk is much higher in currency markets, and central banks would be unwilling to intervene unless the new situation threatens financial stability. The reaction of financial markets may include a sharp weakening of the Pound Sterling against the Euro but also a weakening of the Euro against other currencies and of Euro-denominated assets. Most vulnerable areas of the EU are to be affected the most. Government bond yield spreads and equities of peripheral countries would be under pressure again. EU/Eurozone safety nets should help making sure that any potential negative market reaction remains contained, manageable and temporary.

Moreover, there is a threat of political ramifications and domino effects from Brexit, with potentially huge negative impacts on the rest of the EU. Brexit would bolster anti-Euro populist opposition parties, with potentially destabilising effects for the EU and the Euro Area. These are by far the most difficult problems to manage and may entail permanent damage to the EU project.

Even if the UK remains in the EU, the February deal opens the door for opportunistic behaviour and centrifugal forces from other Member States. The principal of the UK-EU deal can be re-affirmed and used as a negotiating tool for any other country in the EU opposing specific initiatives to strengthen the EU architecture and governance. It would be a precedent.

It is not clear whether a narrow win by the ‘remain’ supporters would be beneficial for the rest of the EU either. It would expose the fragility of the construction. Internal opposition in the UK would probably shift strategy but the objective would remain the same—to bring sovereignty back to Westminster. This may continue to cause problems in the relationship with the EU. Any EU attempt to strengthen integration would continue to face UK opposition. Moreover, it is not clear whether this referendum mess would make it any easier for EU institutions to move forward.

The bottom line is that we would likely all lose out no matter how the referendum ends.


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