United Kingdom: Brexit or not to Brexit? Global Economic Outlook, Q2 2016

High on the list of risks the United Kingdom faces is uncertainty over the outcome of the referendum on its EU membership. If voters choose to remain, it’s going to be status quo, but a vote to leave would be the start of a long, complex process of negotiation and a period of great uncertainty.

UK

Rising risk aversion, financial market stress, and weakness in emerging markets have continued to weigh on the United Kingdom’s growth prospects. The manufacturing sector, in common with the experience in most industrialized economies, has slowed appreciably. Business confidence has weakened, and the risk appetite among the chief financial officers of the United Kingdom’s largest businesses has dropped to the lowest level since the euro crisis (figure 1). Meanwhile, consumer activity remains fairly buoyant, with a tightening labor market, cheap finance, and rising real incomes supporting household spending.

Figure 1

The overall effect of these changes has been to reduce expectations for the United Kingdom’s growth in 2016 to around 2.0 percent, with activity more dependent on consumer activity and with a smaller impetus from manufacturing, exports, and investment.

The list of potential risks facing the United Kingdom remains long. But according to the latest Deloitte survey of chief financial officers, the principal uncertainty is the outcome of the referendum on the United Kingdom’s membership in the European Union, which will take place on June 23.1

The last referendum on the United Kingdom’s membership in what was then the European Economic Community (EEC) was held in 1975, just two years after the United Kingdom joined the EEC. The vote was an overwhelming victory for EEC membership, with the electorate voting 67.2 percent to 32.8 percent to stay in. Since then, the European Union has grown from 9 to 28 members, expanded into Central and Eastern Europe, and created the single currency. The euro crisis has accelerated the pace of integration within the euro area through initiatives such as the European Fiscal Compact and the European Stability Mechanism.

The current referendum debate encompasses the free trade and cost of living arguments of 1975 but ranges wider. In particular, questions of security, safety, borders, and the free movement of people are likely to loom large. The economic backdrop to the United Kingdom’s 1975 referendum was domestic economic and political weakness. British voters in 1975 looked enviously at the prosperity and stability of Germany. Today, the euro area is grappling with sluggish growth, the fallout from the euro crisis, and an influx of refugees and migrants. The European Union is on the back foot. Meanwhile, the burning platform of the United Kingdom’s economic failure and political instability, which helped win the 1975 referendum, is absent.

UK voters have consistently been among the most euro-sceptic in Europe. Nonetheless, in the last 40 or so years, the UK public has been more likely to support staying in the European Union than leaving. Since Ipsos MORI started polling the public in 1977, on average 47 percent of UK voters have supported membership, and 40 percent have opposed it, with an average of 12 percent remaining undecided.2

The opinion polls showed a strong lead for the “remain” camp in the first half of 2015 (figure 2). But this has been eroded by the migration crisis. By late March 2016, on average the polls showed a much reduced lead for the “remain” camp, with some individual polls showing a majority for those favoring a “leave” vote. Bookmakers betting odds in late March implied a roughly 40 percent probability of a UK exit from the European Union.3

Figure 2

The salience of migration in today’s debate marks a significant difference from 1975. The Maastricht Treaty of 1992 established the right of people to live and work anywhere in the European Union. The European Union’s enlargement into Central and Eastern Europe in 2004 led to a marked rise in immigration into the United Kingdom and pushed migration up on the list of UK voters’ concerns. More recent migration from North Africa and the Middle East and the breakdown of the European Union’s Schengen agreement have added new concerns. Since last year, YouGov’s polls show voters rating immigration as the most important issue facing Britain (figure 3).4

Figure 3

Yet, whatever the polls say about migration, the bedrock economic issues of “what will it mean for jobs” and “am I better off in the European Union” are likely to prove decisive. As in the Scottish referendum and last year’s UK general election, fear of the unknown will be a significant factor. The current, pervasive sense of geopolitical and economic uncertainty tends to heighten the appeal of the status quo, especially for the 10–20 percent of the population in the “don’t know” camp.

One of the major challenges for the anti-EU campaign groups is that there is no agreement on an alternative to EU membership. Any settlement would depend on what the United Kingdom seeks to achieve following a vote to leave the European Union, and what its former EU partners and other countries are prepared to concede. The most frequently talked-of options are the Norwegian and Swiss models or operating under the rules of the World Trade Organization (WTO).

Outside the European Union, Norway is a member of the European Economic Area, giving it full access to the Single Market and the ability to opt out of certain elements of the European Union, such as the Common Fisheries Policy. The downside is that Norway has to accept almost all EU legislation, including on the free movement of people, and it makes significant contributions to the EU budget while having no direct say in EU decision making or regulations.

Switzerland’s membership in the European Free Trade Agreement (EFTA) offers a more distant relationship with the European Union. As an EFTA member, Switzerland has been free to negotiate the terms of its relationship with the European Union and the rest of the world on a bilateral basis. Budget contributions to the EFTA secretariat are minimal. In practice, Switzerland has signed up for a high proportion of EU regulation, including the free movement of people, and has to make contributions to a number of large EU programs in return for access to the Single Market.

At the other end of the spectrum, the United Kingdom could opt for the most distant economic relationship with the European Union and forego preferential access to EU markets along Swiss or Norwegian lines. As a member of the WTO, the United Kingdom would acquire the “most favored nation” status and would be free to negotiate its own free-trade agreements with the European Union and other countries. This is the experience of countries such as Australia, which obviously is not subject to EU regulations and budget contributions, but does not have unfettered, tariff-free access to the Single Market.

These examples only illustrate the experience of other nations outside the European Union. The United Kingdom is a much larger, more populous nation than Norway and Switzerland, and there is no precedent for the departure of a nation from the European Union. Much would depend on whether the negotiations that follow a vote to leave would be harmonious or fractious. In such negotiations, the United Kingdom would face a trade-off between autonomy and accepting regulation to gain access to EU markets. A more distant relationship with Europe would give greater control over borders and regulations but could also mean more restricted access to EU markets.

In the referendum, voters will be choosing between a known, if evolving, relationship with the rest of Europe and leaving the European Union. A vote to leave would be the start of a long and complex process of negotiation as the United Kingdom seeks to create a new position in the world.

If the United Kingdom votes to leave the European Union, there is a formal period of two years during which all existing EU rules and regulations apply as the United Kingdom negotiates its exit. In practice, creating a new set of trading arrangements and an independent legal and regulatory framework would take much longer. A vote to exit would create a period of great uncertainty and risk aversion. Most attempts to model these effects suggest that UK asset prices, particularly sterling, would fall, possibly sharply, and growth would weaken appreciably. In time, as a new settlement comes into being, these effects would moderate.

In the referendum, voters will be choosing between a known, if evolving, relationship with the rest of Europe and leaving the European Union. A vote to leave would be the start of a long and complex process of negotiation as the United Kingdom seeks to create a new position in the world.

Aside from the short- to medium-term disruption, which is likely to be considerable, the debate is about whether the United Kingdom’s growth in the long term would be much altered by leaving the European Union. The answer depends on the imponderables of the United Kingdom’s post-EU trading arrangements and its ability to exploit the freedom available outside the European Union.

In the meantime, the EU referendum remains a central and growing preoccupation for the business community, which, by and large, favors continued membership within the European Union. The most likely outcome remains that the United Kingdom will stay in the European Union. But opinion polls are fallible and volatile. External events, such as economic news, migration, or terrorism, have the potential to shift public opinion.