What is the potential economic impact of Brexit?

With the UK due to leave the EU at 11pm on 29 March 2019, countries on both sides of the channel are figuring out what Brexit will mean for their economies. We take a look at the possible effects on the UK over the coming years.

Britain
Source: Bloomberg

Current state of affairs

After making enough progress in the first phase of negotiations, centred around the UK’s ‘divorce bill’, citizen rights and the delicate issue over the future of the Irish border, the majority of 2018 will see talks focus on the future relationship between the UK and EU. The current hope is that a deal, including an agreement on a transitional period beyond March 2019, will be ratified at the October 2018 European Council summit – but the Brexit timetable is extremely tentative and subject to change dependent on the level of progress being made.

The knock-on effect

Although governments, universities, think tanks and a swathe of other institutions have laid out their predictions on how Brexit will impact the UK economy, the amount of ‘known unknowns’ and ‘unknown unknowns’ means no one can paint an accurate picture.

An economy represents the state of a country in terms of production and consumption of goods and services, and the supply of the money. However, everything is heavily intertwined. For example, immigration feeds through to the labour market, which affects the country’s output and productivity, which dictates the likes of gross domestic product (GDP), which shapes public finances and debt. The amount of variables in play is staggering.

The UK government’s trade policy in a post-Brexit world is centred around three core strategic aims; for trade with the EU to be as frictionless as possible, establishing an independent international trade policy, and avoiding a ‘hard border’ between Northern Ireland and the Republic of Ireland.

The EU is built on two fundamental frameworks that distinguishes the bloc from the rest of the world – the single market and the customs union. The EU represents the most substantial customs union in the world economy. This extends into the single market to further harmonise standards to promote four freedoms at the core of the EU: freedom of movement of goods, capital, services and people.

While it is possible both could feature in any future agreement between the pair, the UK government has ruled out remaining in the single market or the customs union, or adopting existing arrangements such as membership of the European Economic Area (EEA) – as it sticks to its guns in the hope of securing a bespoke deal.

A tailor-made deal

There are several reasons the UK isn’t interested in striking a similar deal to those struck by non-EU nations. Norway may have access to the EU, but it has to pay in to the bloc’s budget. And while Canada may avoid having to make budget contributions, its access to EU markets is more limited, particularly in services. That is a significant point for the UK, which is driven by its services industry, particularly financial services. 

The UK also believes it should be given its own custom-made deal, because its standards and regulations are already aligned with the EU, which it believes opens up more options for a future trade deal compared to other countries, and allows for quicker negotiations than normal.

The EU is integral for UK imports and exports

Industries with high levels of trade with the EU indicate that sector is highly integrated with the single market, and therefore face the highest risks from Brexit if it results in trade becoming more difficult.

Exports are a source of revenue for companies while imports represent costs, with many choosing to look overseas for materials and components that are cheaper or of better quality than offered domestically.

On the export side, the three sectors most reliant on the EU market for their revenues are mining and quarrying (which is predominantly made up of oil and gas) at 43% of the sector’s total revenue, manufacturing at 21%, and financial services at 10%, according to data from the UK Parliament. On the import side, the three sectors most reliant on the EU market for their inputs are manufacturing at 20% of total non-staff production costs, health services (mostly the NHS) and social care at 18%, and accommodation and food services at 15%.

According to the Office of National Statistics (ONS), 59% of imports into the UK come from the EU, with the other 41% coming from the rest of the world, while 48% of UK exports go to the EU and 52% to other nations. Although the EU remains an important partner, the share of UK exports to the EU has fallen since the turn of the century. However, the decline is mainly in goods, not services.

Motor vehicles and parts are the most exported goods from the UK to the EU by value, followed by chemicals. Meanwhile, 37% of the UK’s exported services went to the EU in 2016 (notably down from 40% in 2015) – with financial services accounting for over a quarter of that.

The movement in sterling has turned the tables

Sterling started to depreciate in the weeks preluding the referendum in June 2016, sinking after the result, and although the pound has trended upward since, it is nowhere near the level markets had been accustomed to beforehand. In simple terms, this is good for some and bad for others. Demand for UK-built goods abroad increases as exports become cheaper, and tourism improves, as visiting the UK becomes more affordable, for example. Meanwhile, prices in the UK for goods, such as food made up of imported ingredients, get more expensive as firms pass on price rises to consumers, raising the cost of living. 

For public listed companies in the UK, those that predominantly earn their money from other countries (like many in the FTSE 100) have benefited from translating their overseas earnings into sterling. While more domestic-focused firms (like many in the FTSE 250) have had to deal with a weaker selling currency, at a time when input prices have risen.

Migration and the workforce

While immigration from the EU can’t be controlled when in the single market, the UK has always been able to dictate the inflow of migrants from every other country. Figures from the ONS show 11% of the UK labour market consisted of non-UK nationals in 2016: 7% EU nationals and 4% from other countries. 

The London School of Economics (LSE) estimates 3.3 million jobs in the UK are tied to exports to the EU, but Brexit does not necessarily mean these jobs are at risk. Still, job losses are likely in some sectors, and others could see an increase in jobs. Both are dependent on what replaces the current arrangements.

Regionally, the City of London is almost certain to encounter job losses after Brexit, while major exporters like those in the automotive industry may have to scale down operations if more hurdles are put up between the UK and the EU. Equally, domestic industries that compete with imported goods could see job increases if the cost of rival imported goods in the UK rises as a result of trade barriers or because relaxed regulations make UK firms more competitive.

Tighter immigration into the UK could limit the amount of money sent home by migrant workers, and could ease pressure on local authorities that have seen public services come under strain as a result of a high influx of people.

While gaining control over immigration from the EU is at the forefront of the argument for Brexit, the UK has failed to impose restrictions on immigration from the rest of the world.

People will still be coming to the UK after Brexit – the questions are how many and from where? Will the UK still give preference to EU citizens? And will policy tilt in a liberal or restrictive direction?

Public finances

Without knowing the impact of Brexit on the economy it is impossible to predict how public finances will fare. As the leave campaign’s infamous bus boasted before the referendum, the UK pays about £350 million a week to the EU budget, or £14.4 billion annually. In principle, the UK’s public finances could be strengthened by that full £14.4 billion a year if we were to leave the EU. However, once the rebate paid by the EU is taken into account, the UK pays a net contribution of about £275 million, or £8 billion annually, according to the Institute for Fiscal Studies (IFS).

That is £8 billion a year that could fund other spending, cut taxes or reduce the deficit. But spending that sum on new areas would deprive industries that currently benefit from those funds, such as agriculture, rural development, regional support and university research. However, even a minor drop in GDP could erase any savings from direct contributions to the EU budget.

Any tightening to the public coffers raises the threat of additional austerity in the form of spending cuts or tax rises and lifts to government debt, which would also come with higher interest payments. Demonstrating the sensitivity of the public purse to the most minor movements in national income, the IFS states 1% growth or contraction in the UK economy would see borrowing rise or fall by as much as £14 billion.

Importantly, any loss in GDP means lower GDP than would otherwise be the case, not an actual fall in prosperity. The LSE, for example, points out that if the UK maintained its trend growth rate up to 2030, the economy would be some 30% larger, and the ‘losses’ envisaged are relative to that projection. A loss of 6% would, therefore, mean 24% growth instead of 30%, but would also mean that the UK economy would be smaller indefinitely.

Productivity

Productivity is already an issue in the UK, having failed to return to levels seen before the financial crash when it fell sharply. Whether there is a permanent reduction in the rate of growth or level of output as a result of Brexit is unclear. The Bank of England (BoE) says the UK’s current ‘productivity puzzle’ is almost solely down to the finance and manufacturing sectors. Although growth has slowed in other advanced economies, it is already more accentuated in the UK.

The BoE expects a notable slowdown in activity as a result of Brexit, and has downgraded its outlook on GDP growth. But it does expect the UK to avoid a recession, after it responded to the Brexit vote by making a further cut in interest rates, increasing quantitative easing (QE) and by launching a new Term Funding Scheme to ensure that interest rate cuts are passed on to businesses.

Foreign direct investment

Only the US and China receive more foreign direct investment (FDI) than the UK. FDI is an important factor in productivity, and hence plays a major role in shaping the country’s output and wages. The LSE’s Centre for Economic Performance estimates about half of the UK’s FDI comes from other EU members, and flags the UK’s access to the single market as one of the main reasons it is able to attract it from non-EU members.

The UK’s financial services industry is the largest recipient of FDI (about 45% of the total), but activity could be dramatically affected by any restrictions imposed on ‘single passport’ privileges.

The UK has a deficit in goods but a surplus in services, particularly financial services. Exports of financial services amount to slightly more than 2.5% of GDP for the UK compared to 0.5% for EU peers, according to the Organization for Economic Cooperation and Development (OECD). Notably, the EU absorbs around 45% of Swiss exports of financial services, despite the absence of passporting rights for its banks, but Switzerland negotiated a favourable agreement when it was planning to join the EU in the early 1990s.

Property and construction

The outlook for this sector post-Brexit differs. The existing skills shortage in the construction industry is likely to be exacerbated without the free movement of people, placing additional pressure on an industry already struggling to build enough new houses. Amid weaker sterling and the high volumes of building materials imported from the EU, any slowdown in housebuilding could push property prices higher.

This contrasts with the view that any fall in property prices would be welcome news to anyone still trying to climb onto the housing ladder, following claims from the former Chancellor of the Exchequer, George Osborne, that prices could plunge as much as 20%. In addition, the high levels of investment in property from outside of the EU from regions like the Middle East and Asia have continued to provide confidence in the market.

Education and research

According to a BBC report in July last year, there are over 120,000 EU students across the UK – more than 6% of all full-time students in British universities – generating over £3 billion for the UK economy and creating 20,000 jobs. The EU has provided the UK with nearly £8 billion in research funding over the last decade, an important sum for universities at the heart of the UK’s research industry.

How immigration works on both sides of the Channel will impact the ease at which EU students can study in the UK, and vice-versa. Still, the already significant pull of the UK’s universities to the wider international student community could be enhanced, depending on how future immigration is tackled. And there has been talk about excluding foreign students from immigration figures, including those from the EU, to recognise the importance of attracting students from overseas.

In addition, research is one of the more likely areas that the UK and the EU will continue to collaborate on after Brexit, alongside the likes of defence and intelligence. University leaders from 24 countries across Europe have signed a joint statement following the UK’s vote to leave, citing the importance of continued European collaboration.

Energy and utilities

Utilities have been another sector keen on keeping close to the EU after Brexit, particularly in fear of dropping out of the EU’s internal energy market, which facilitates effortless trade in energy between its members. Any disturbance to the industry’s ability to trade energy could have profound effects on energy prices for UK households.

Since 1998, the UK has gone from being a net exporter to net importer of energy. And although all 28 EU countries have to import energy, the UK’s interconnectors are only tied to EU members France, the Netherlands, and Ireland – meaning the EU is integral to the UK energy market regardless of Brexit. Norway will also be key as it is the UK’s largest supplier of natural gas and oil.

The future possibilities of trade

How the UK responds through policy and the final outcome of trade negotiations will be decisive in determining the long-term impact on the economy as a result of Brexit. One of the reasons membership of an existing arrangement like the EEA is not seen as attractive to the UK government, is that it would likely see significant contributions continue to be made to the EU budget. If the UK was to make contributions proportionate to what Norway makes, it would amount to around £4 billion – or half of the current net contribution per year. But the precise numbers depend on whether the UK looks to participate in any EU programmes after Brexit.

A deal like that struck by Canada would see the UK avoid budget contributions, but tighter access to EU markets – particularly in services. No country outside the EEA has full access to the EU’s financial services markets.

Possible post-Brexit arrangements with the EU

Arrangement Example Characteristics

European Economic Area (EEA)

Iceland,
Norway,
Liechtenstein

  • - contributions to the EU budget
  • - free movement of goods, capital, services, people
  • - outside the EU customs union
  • - very limited influence on regulation
European Free Trade Association (EFTA) Switzerland
  • - contributions to the EU budget
  • - requires individual trade deals with EU members
  • - no passporting rights for banks
  • - outside the EU customs union
  • - very limited influence on regulation
Customers Union Turkey
  • - tariff-free access to single market, except financial services
  • - adoption of EU external tariffs for non-EU trade
  • - very limited influence on regulation
Free Trade Agreement  
  • - mostly tariff-free single market access, but compliance needed with EU standards
  • - no full access for services and no automatic passporting rights for banks
World Trade Organisation - Most-favoured nation  
  • - trade with the EU is subject to the EU's common external tariff

 

Whether the UK is eyeing trade deals with the EU or other nations, the fact the UK has not single-handedly negotiated a trade deal in the last 40 years is poignant. The UK will have to prepare itself to renegotiate deals to replace the EU’s 53 existing bilateral trade deals (with another 72 more in the pipeline, according to PricewaterhouseCoopers).

The importance of a transition period is highlighted by how long it has taken other trade deals to be negotiated by other nations and blocs.

Length of Free Trade Agreement negotiations:

  1. EU-Switzerland: 10 years
  2. EU-Canada: 7 years
  3. EU-South Korea: 4 years
  4. EU-Mexico: 4 years
  5. Switzerland-China: 4 years
  6. US-Australia: 3 years

 

Outside of the EU, the UK will free itself from the shackles of the EU and wouldn’t have to compromise with other members when negotiating deals with non-EU countries. However, bargaining power will be severely diminished, as the UK’s economy is under a fifth of the size of the EU’s single market, and it would miss out on new deals the EU strikes, with the US and Japan both currently negotiating deals with the bloc.

According to KPMG, the most significant impact on UK trade under World Trade Organization (WTO) rules is likely to be felt through sectors such as transport equipment and food and beverages, where tariffs are above average and their share in total UK exports is also relatively large.

Only when relations with the EU and WTO are clear will it be feasible to negotiate trade deals of various sorts with other countries, ranging from those the UK already has deals with via the EU, to those that currently trade with the UK on WTO rules.

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