Can Brexit Be Achieved With Minimal Damage?

American University’s Michelle Egan discusses Brexit.

The steep dive October 7 of the British pound in early Asian trading — losing more than 6% against the U.S. dollar — has been attributed to computerized trades amid low liquidity. It has, nevertheless, become the most visible barometer of how painful Britain’s imminent exit from the European Union could be.

Brexit Europe
Image source: Public Domain Pictures
Brexit

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British Prime Minister Theresa May last Sunday stressed immigration over economic issues as the driving factor behind Brexit at a Conservative Party meeting, where she said negotiations on leaving the EU must get underway by March 2017. Experts predict that Britain will have a tough time at the bargaining table, and advise the EU to play hardball, if only to deter others among its member-states from considering similar exits.

How Brexit can be achieved with minimum damage to either side depends on how exactly it is negotiated and how the transition is managed, says Mauro Guillen, Wharton professor of management and director of The Lauder Institute. “The U.K. is a large economy and to take it out of the EU of course disrupts years of assumptions that investors, companies and consumers have been making.”

For sure, the U.K. will attempt the least painful way out while trying to protect trade, capital and labor flows with the EU. Indeed, French Prime Minister Francois Hollande’s latest statement calling for tough exit negotiations increases the pressure on the pound. “The pound continues to lose value because markets are anticipating that this is going to be messy,” says Guillen. “Today’s fall is a reflection of the fears over how this is going to be negotiated.”

Uncertainty is the dominant sentiment. “The steep fall of the pound is very much softening the blow, but it is also showing that there is clear lack of confidence in the long-term impact of Brexit,” says Olivier Chatain, professor of strategy and business policy at the HEC Paris business school and a senior fellow at Wharton’s Mack Institute of Innovation Management.

Wharton finance professor Joao Gomes thinks May is making “a grave mistake by rushing to the negotiation table.” For one, he expects the EU to take a tough stance on Brexit ahead of the French and German elections next year. The French presidential elections will be held in April and May 2017, while the German federal elections are set for between August and October 2017. “Afterwards, it is very likely that realism and a fair dose of euro-skepticism will creep into the views of those two key governments,” he says. He advises against the haste he sees in May also because “time would allow every party to take a more objective stand on what is simply the negotiation of an international treaty by sovereign parties.”

“I’d recommend the EU, the EC and member states to play hardball,” says Michelle Egan, a professor at American University’s School of International Service and a fellow at the Wilson Center’s Global Europe Program. She notes that Article 50 of the Treaty on European Union, the legal mechanism for an EU member state to break away, has never been used before. “If they make it easy and give too many concessions to Britain, then the risk is other states will want an a la carte Europe as well,” adds Egan.

Egan spoke on the issues that will come up as Brexit nears on the [email protected] show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)

Guillen feels the EU should not take a tough stance on Brexit but find some middle path. “It is not in the best interests of the EU to be tough on the U.K.,” he says. “The problem of course is that they also need to signal that there is a cost to leaving the EU because otherwise other countries may also say they want to get out. They have to find a balance.” He expects “some form of a soft Brexit,” adding that a hard Brexit would be difficult to implement.

“It is going to be very difficult for them to negotiate a soft Brexit in financial services.”–Mauro Guillen

Impact on Businesses

In gauging the business impact of Brexit, Guillen makes a distinction between the financial services and the non-financial industries such as manufacturing and tourism in the U.K. He says the non-financial industries would prefer some type of deal that allows them to remain in some way in the European single market.

The situation is much different with the financial services sector because of the fallout from the 2008 crisis, notes Guillen. “The uncertainty of the financial sector in Europe is because there is a lot of concern about the state of its banks,” he says. Banks in Italy, France, Spain and even Germany — with Deutsche Bank’s latest troubles — are in difficult straits, he explains.

For British banks, it would be important to negotiate a deal where they and their dealers could continue to do Europe-wide business, says Guillen. “But it is contentious because the Europeans don’t want to give the British the best possible deal without paying a cost for all this,” he adds.

Guillen notes that the City of London is critical for the U.K. because it is a major source of jobs and income. “Remember, the people in London voted to remain in the EU,” he says. All things considered, his projection is: “I think it is going to be very difficult for them to negotiate a soft Brexit in financial services.”

Economic Impact Thus Far

According to Gomes, the projections on the economic impact of Brexit have been “too pessimistic.” He says that is partly because he believes that “the Brexit vote will not amount to a significant change to business as usual.”

Gomes’s views are supported by the data for the months after the Brexit vote in June. “The economic indicators are strong after the Brexit vote, surprisingly,” says Egan. She notes that in July, unemployment stayed at about 4.9%, and company output, sales and orders have also been buoyant.

However, longer term pressures loom over the economy. In August, the Bank of England cut the interest rate to 0.25% and introduced monetary stimulus measures, stating that “the outlook for growth in the short to medium term has weakened markedly.” Egan points also to announcements by Philip Hammond, the U.K.’s Chancellor of the Exchequer, on higher infrastructure spending, housing growth, a focus on regional economic development and dropping an earlier plan to eliminate the budget deficit by 2020. Hammond on October 3 warned of a period of “turbulence” following Brexit, as The Telegraph newspaper reports. “He is focusing jobs, economy and living standards,” says Egan.

“The steep fall of the pound is … showing that there is clear lack of confidence in the long-term impact of Brexit.”–Olivier Chatain

Businesses will face changes in customs procedures, tariffs, their relationship with the EU single market, dealings with global supply chains and integrated production, says Egan. Brexit also brings new complexities for free trade agreements, especially CETA (Comprehensive Economic and Trade Agreement) that has been agreed between Canada and the EU; and the Transatlantic Trade and Investment Partnership between the U.S. and the E.U. “The U.S. has to evaluate what it means for its negotiating position if Britain leaves the EU,” says Egan.

Chatain notes that businesses clearly were not for Brexit, and the recent controversy over British home secretary Amber Rudd’s proposals to require businesses to hire more locals sharpens the battle lines. “[Businesses] are making it clear that they want as much flexibility on immigration and visas as they can have, but this contradicts the mandate given by the Brexit vote [to limit immigration],” he says. Businesses also fear that Rudd’s proposals may force them to disclose how many foreigners they employ. “Business groups reacted warily to the proposals, warning they would limit their members’ ability to recruit people with the right skills for the job,” says an October 5 BBC report.

Brexit will also affect the daily lives of people. The pressures of Brexit will be felt everywhere, from travel to health care, according to Egan. She notes that 44 million trips were made last year from Britain to the rest of Europe for pleasure and business. She says the benefits of being part of the EU shouldn’t be forgotten: “We’ve benefitted from travel without visas and passports. Airline liberalization has led to cheap flights. People don’t realize that if you are an EU citizen, if you are in another country and you fall sick, you can use your Europe-wide health card. All of those things are up in the air.”

With respect to Brexit, there are clearly “two Britains,” says Gomes. “The internationally mobile, mostly urban population will clearly find the costs very high,” he adds. “But for a large fraction of the population, the only perceived contact with the EU is either by watching TV, interacting with immigrants or buying European goods at various shops. They voted for Brexit and are unlikely to feel many of the direct costs of an exit — at least in the near term.”

The Immigration Factor

The overriding theme in the Brexit mandate is immigration, and May has lost no opportunity to reiterate that. The Guardian newspaper reported May as saying at last Sunday’s party meet: “We have voted to leave the European Union and become a fully independent, sovereign country. We will do what independent, sovereign countries do. We will decide for ourselves how we control immigration. And we will be free to pass our own laws.”

“If they make it easy and give too many concessions to Britain, then the risk is other states will want an a la carte Europe as well.”–Michelle Egan

However, Egan notes that the immigration debate is different in England as opposed to the rest of Europe. “A lot of the concern in rest of Europe has been with refugees and migrants coming from outside the EU,” she says. “In Britain, the debate has focused on EU nationals coming into Britain.”

Egan notes that the U.K. will face hard questions on this front. “What will they do with the three million existing EU nationals already in the U.K.? When will they start putting up any borders and visa requirements? What will they do with the almost one million British citizens who are in other EU member states?”

Egan says Britain will have to find ways to keep its labor markets flexible, noting that many in its agricultural workforce are EU nationals. “There will be some knock-on effects if the U.K. starts clamping down on labor mobility,” she adds. “The basic issue will be of people from other countries working in the U.K. and British citizens working in the EU.”

Outlook for Negotiations

Navigating between those political and economic uncertainties would be among May’s toughest challenges in the months ahead. “[May] is looking at the political time-table as well as the economic uncertainty and its implications,” says Egan. She notes that May herself will have to have an election by 2020; the next general elections in the U.K. will be held in May 2020. Further, the European Parliament and the European Commission that will vote on the Brexit deal will change in 2019 when the former has its next elections, she adds.

Chatain points to two obstacles ahead, even as he believes that a common agreement could be found. “On the one end, the ‘leavers’ (those in favor of Britain leaving the EU) run the risk of overestimating the leverage they will have with the EU, and overestimating how good the trade deals [are that] they will get outside of the EU,” he says. “Moreover, the EU will clearly not accept a deal that offers better terms than what is given currently to Norway and Switzerland, because doing so would undermine the value of staying in the EU” (Norway and Switzerland are not part of the EU, but have access to the European single market.)

That scenario of a tough EU stance “creates the conditions for very hard negotiations as there might be no deal that will seem politically acceptable to each party vis-à-vis their own political base,” says Chatain. “The ‘leave’ advocates might prefer a hard Brexit to what the EU is ready to offer. Similarly, the remaining EU members might prefer to let the U.K. go without a deal than any deal that the U.K. government is ready to accept given the composition of its majority in the parliament.”

The Countdown

Once Article 50 is triggered, the U.K. will be under a tight timeframe to complete the legalities around Brexit, says Egan. “They cannot negotiate any other free trade agreement or see themselves in a new position within the WTO (World Trade Organization) until they divorce from the EU,” she adds. “Until they formally leave and repeal all the acts that join the EU, they are still subject to EU laws, regulations and judicial decisions.”

May’s government, meanwhile, seems to be getting ready for life after Brexit. “You are starting to see the British foreign service, the treasury and others getting their act together in terms of what they would like in terms of a trade deal and a negotiating strategy [with the EU],” Egan says.

“Many people in Brussels continue to find it difficult to get over a sense of betrayal and shock.”–Joao Gomes

All those negotiations have to work against a surge of negative sentiment against the Brexit vote, notes Gomes. “Many people in Brussels continue to find it difficult to get over a sense of betrayal and shock,” he says. (Brussels hosts the European Commission and is considered the de facto capital of the EU.) “Their seeming need to exact some sort of punishment on the U.K. is bound to make any negotiations very complicated.”

Another factor that isn’t helping the sentiment in favor of the U.K. lies within the U.K. government, says Guillen. “Apparently, the more radical Brexit people and their strength dominate, and that is a problem. That is also what is causing the uncertainty.”

In fact, Egan notes that Euro-skeptics like Denmark are now more supportive of the EU than they have been in the past. “[The Brexit vote] has had an effect on other states,” she says. “They are saying they don’t want this disarray, so it has had a blowback effect politically.”

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