How the Brexit Referendum Will Foster Uncertainty, Volatility and Risk
Europe’s Summer of Discontent
Dan Steinbock, London
The UK’s EU referendum is too tight to call, which will virtually ensure protracted economic uncertainty, market volatility and political risk. The worst has already happened.
On June 23, the UK will have its referendum on the European Union (EU) and the Brits will decide whether they should remain in or leave the EU. Not so long ago, polls projected a tight win to the “Remain” camp, which is led by Cameron’s Conservative government. More recently, the “Leave” camp has enjoyed a slight lead. The race is tight.
The “Leave” campaigners’ persistent focus on the costly and excessive EU bureaucracies, over-inflated security concerns and immigration’s negative tradeoffs may have less to do with facts than flawed perceptions. Nevertheless, the campaign has been effective. Yet, any disruption ahead of the referendum – whether a terrorist attack or political debacle – could quickly shift the vote either way, as evidenced by the murder of British Labor politician Jo Cox only a week before the referendum. Cox advocated for the rights of refugees – an issue that the “leave” camp has exploited – and supported of the UK remaining in the EU.
While her death calmed the excesses of the referendum and suspended the campaigning for a few days, the referendum is scheduled to go ahead as originally planned.
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Domestic gains via European gambles
Prime Minister David Cameron is one of the political beneficiaries of the 2008-9 global crisis and the European debt crisis in spring 2010. As Tony Blair’s (1997-2007) and Gordon Brown’s Labor governments (2007-2010) took the blame for the drastic economic plunge following the crises. Cameron became the Prime Minister and the leader of a coalition between the Conservatives and Liberal Democrats.
Despite his elite schooling and the Eton old boys’ networks, Cameron has been eager to purge Thatcherism to build compassionate conservatism, as he likes to call it. In other words, Cameron has championed fashionable social causes, including same-sex marriage and the UN target for aid spending. However he also been willing to reduce government’s large deficits through austerity measures, including large-scale changes to welfare, immigration policy, education and healthcare.
In practice, these measures have failed. The UK’s national debt exceeds $2.3 trillion (84% of the GDP) and is likely to continue to climb, despite the efforts of George Osborne, the UK Chancellor. Recently, the IMF warned that maintaining deficits and debts at their current, high levels “”would constrain the space to respond proactively to future large negative growth shocks“.
In 2011, Cameron became the first UK Prime Minister to ‘veto’ the EU treaty. Initially, his call for the Brexit referendum may have been a way to bargain better membership terms with Brussels and boost Conservative support at home. In 2013, Cameron pledged that, should his Conservatives win the parliamentary majority in the 2015 election, the government would negotiate more favorable terms for British membership of the EU, before holding the referendum. That forced Brussels into a corner, while garnering political benefits at home from improved membership terms.
The use of the Brexit option also supported Cameron’s re-election as Prime Minister and parliamentary majority.
But the gamble came with a price: the Brexit risk.
Downside risks depend on post-Brexit trading arrangements
At the surface, the UK economy has been expanding steadily until referendum uncertainty. According to the conventional view, the UK economy has benefited from the Eurozone’s fragile rebound, which has been fueled by robust expansion of private demand at home and rapid job growth. Unemployment rate fell to 5.1 percent in late 2015 – a “broadly positive baseline forecast,” despite the Brexit’s downside risks, as the IMF saw it.
In fact, growth is now predictably below trend, thanks to fiscal consolidation and uncertainty. That’s penalizing business, investor and consumer confidence. Before the EU referendum, the UK’s medium-term real GDP growth hovered around 2 percent until the early 2020s, with inflation expected to rise to about the same level in the late 2010s, despite expected rate hikes to 2 percent by 2020.
However, these projections presume continued economic certainty, market stability and low political risk. And yet, in the coming months, the realities may prove precisely the reverse.
Last April, UK Treasury published a report about the probable annual impact of leaving the EU on the UK after 15 years. It estimated that the Brexit could cause an almost 10 percent loss of GDP, substantial plunge of household wealth, falling exports, rising prices and possible recession.
However, much depends on (1) whether the UK would retain its membership of the European Economic Area (EEA), like Norway; (2) or opt for a negotiated bilateral agreement, such as that between the EU and Switzerland, Turkey or Canada; (3) or a simple World Trade Organization (WTO) membership without any specific agreement with the EU, like Russia or Brazil.
Brexit impact in Europe and worldwide
In light of the likely spillover channels (trade, investment and financial linkages), Ireland, Luxembourg, the Netherlands – Europe’s traditionally open, free-trade economies – would be most exposed to the UK spillovers. In contrast, Russia and Eastern Europe, along with France would be least affected by adverse spillovers.
Internationally, the UK’s greatest trade, investment and financial partners would be most exposed to adverse spillovers, particularly the city-states of Hong Kong and Singapore in Asia, South Africa, as well as the US, Canada and Australia. If the UK would vote to cut ties with the EU, the US would be significantly more vulnerable to financial-market volatility than a trade breakdown. An adverse scenario could mean credit tightening, impaired trade finance, and reduced lending by European banks.
Recently, President Obama sought to encourage the “Remain” vote by threatening the UK with a backlash if it quits the EU. The intervention backfired. The anti-EU former mayor of London, Boris Johnson, said that the UK would not take lectures from a “part-Kenyan” President, while the Brexiters exploited the incident skillfully in their “Don’t Be Bullied By Barack” campaign.
Unlike the US, China is significantly less exposed to the Brexit. As Beijing has only begun critical financial reforms, it is not as vulnerable to British portfolio flows or bank claims as the US. However, Hong Kong, with which China shares vital financial linkages, may be most exposed to the Brexit. Moreover, the UK’s exit from the EU could reduce China’s strategic benefits from deepening economic cooperation between London and Beijing.
Financially, a Brexit shock could boost traditional safe havens, including US dollar and Japanese yen, but it would penalize riskier equities, British pound and the euro. Between late May and mid-June, the pound already plunged from near $1.50 to close to $1.40. A Brexit expected to penalize the UK pound by 20 percent to 30 percent from its recent high.
Referendum scenarios, proportionality and UK democracy deficit
In the “Remain” scenario, the Brits will vote to remain in the EU, which translates to greater integration. In this scenario, UK exports continue to thrive. Champagne will flow in the City. As London shows green light to Brussels, the EU can move toward greater union. A jubilant relief rally will fuel the markets.
In the “Leave” scenario, the Brits’ vote against the EU leads to further disintegration within the union. UK exports plunge. The City dusts off its contingency plans. A negative chain reaction may lead to further fragmentation of the EU. The UK would face prolonged stagnation and the risk of recession would be elevated.
For all practical purposes, the post-referendum period may prove more uncertain than conventional wisdom presumes. Even if EU proponents triumph, the ensuing destabilization could push Europe into a series of economic, political, social, and security crises. The EU would eventually prevail, but it could morph into a customs union.
Conversely, if the Brexiteers win, Europe could still prove its own resilience and further the case for integration, though far more slowly. Countries with powerful core economies, such as Germany, would see an increase in their policymaking influence amid a bloc that could become more akin to a protectionist European fortress.
Finally, the proportionality of the referendum matters greatly. If the referendum outcome is a clear, indisputable victory, say 60%-40%, it might result in decisive actions for or against the EU. However, if there is a marginal victory and a low turnout, Cameron will not be able to push a “Leave” Act through parliament, and may not even try. Indeed, while opinion polls reflect a tight race, surveys of the members of the parliament indicate that most of them would side with the “remain” camp (70%), as opposed to the Brexiteers (20%). Within this framework, the decision to remain or leave the EU could be greatly complicated by the MPs who seem to oppose a divorce from the EU.
Why only uncertainty is certain
At the end of the day, the UK’s various referendum scenarios, the tight EU race, and the democracy deficiencies between the voters and the MPs indicate that the likeliest post-referendum path will result in more economic uncertainty, market volatility, and geopolitical risk.
Unfortunately, this would come at a time when the global economy is more fragile, exhausted, and vulnerable than it has been since 2008, when global growth rate was still 3.1 percent. Last April, the IMF again lowered its estimate for global growth to 3.2 percent, which is likely to fall further as a result of series of anticipated economic, political and security shocks in the summer and fall.
That, in turn, increases the likelihood of broader stagnation in advanced economies and slowdowns in emerging economies. Of course, UK’s uncertainty is only one factor in the big picture but as the fifth largest economy in the world, its future matters.
In this sense, before the actual referendum has occurred, the worst may have already happened.
A slightly shorter version of this commentary was published by Georgetown Journal of International Affairs on June 20, 2016.