«Market Update January 2016 AIB Treasury Economic Research Unit BREXIT: Poses Many Risks for the UK & Ireland The issue of Brexit is coming much more ...»
Market Update January 2016
AIB Treasury Economic Research Unit
Poses Many Risks for the UK & Ireland
The issue of Brexit is coming much more to the fore. It is now the main topic of political debate in the UK.
The EU Heads of State Summit in mid-February could see an agreement concluded on Britain’s demands
for reforms to the EU. This would pave the way for a UK referendum on Brexit to be held in the summer or early autumn. Recent opinion polls point to a close result so this is very much a live issue.
Brexit would pose many risks for the UK, and thus a key trading partner like Ireland. It would be a long drawn out process with considerable uncertainty. There is no suitable, ready-made template for the UK to use as the basis for a trade deal with the EU. Indeed, the UK would almost certainly have to continue to adhere to EU regulations to maintain access to EU markets. Brexit could impose significant costs on UK exporters and those trading with the UK, and have quite a negative impact on its economy. For Ireland, there could be increased trade costs and negative effects on economic growth. We are already seeing an impact via the recent marked weakening of sterling, which is partly due to concerns over Brexit.
Brexit: The Key Points.
Most studies show that leaving the EU would have a negative impact on the UK economy. It could take up to a decade for the full economic impact to be felt in terms of FDI, trade flows, migration etc. There would obviously be negative knock-on effects for Ireland given its close ties with the UK.
It is very difficult to quantify the full macro-economic effects of a Brexit on the UK and Irish economies. We don’t know what the post-Brexit trade arrangements would be between the UK and EU.
Brexit would also be a prolonged and complicated process, creating much uncertainty. The latter is very difficult to model, but is likely to have a considerable negative impact on economic activity. FDI into the UK would likely be negatively impacted, especially if there is uncertainty over free trade with the EU.
Ireland has very close trade and economic links with the UK and so would be greatly impacted by Brexit. The UK is a very important market for Irish indigenous exporting firms. Those trading with the UK, at a minimum, would face increased administrative and regulatory costs following a Brexit. A recent ESRI report suggests that there could also be a significant decline in bilateral trade. Sectors such as agriculture, retailing, energy and financial services are likely to be most impacted by Brexit.
We are already seeing an impact, though, with sterling losing considerable ground against the euro since the start of December on growing concerns about a possible Brexit. A vote in favour ofBrexit could see sterling fall very sharply. The referendum could be held as early as this summer and recent opinion polls show only a small majority in favour of remaining in the EU, which is worrying markets.
EU law provides for a two year period for discussions on the arrangements for exiting the EU after a country decides that it wants to leave. Thus, the earliest the UK would leave the EU is likely to be mid-2018. However, the effects would be felt well before then, as a vote to leave the EU would create great uncertainty, impacting economic activity, especially investment, and financial markets.
Referendum on Brexit likely to be held this year The British Government is holding a referendum to decide whether or not the UK should remain a member of the EU. The expectation is that the referendum will most likely be held later this year. The UK is currently in negotiations with the EU about reforms that it wants to see adopted to improve the functioning and governance of the EU. The British Government believes that such reforms will strengthen the case for the UK remaining in the EU. In this regard, opinion polls do show that reforms would increase the likelihood that the UK will vote in favour of remaining in the EU.
The key issues for the UK Government in these talks are restrictions on access to in-work benefit entitlements for EU migrants, an opt-out from ever closer EU union with greater powers for national parliaments, protections to ensure that decisions taken by the Eurozone do not discriminate against other EU countries, especially in the area of financial services, and making the EU more competitive with less unnecessary EU rules and regulations. The EU Heads of State Summit in mid-February could well see an agreement reached on these reforms, with the issue of restricting EU migrants access to benefits proving the most contentious and difficult one to resolve. An agreement would pave the way for both the UK Government and main opposition party to campaign in the referendum for the UK to remain within the EU, although there will be some dissenters in both camps.
Opinion polls over the past year have generally shown a majority in favour of remaining within the EU. However, the lead has narrowed in recent months and is no longer that large. Referenda are unpredictable and sentiment can change quickly, so Brexit cannot be ruled out, especially given the present debate in the EU over migration policy. The current talks on renegotiating the UK’s membership terms and EU reforms could be important. Opinion polls show a clear majority in favour of remaining in the EU if the UK’s membership terms can be renegotiated and reforms are agreed, especially on migration.
There is no doubt that a Brexit would pose serious risks and challenges for the UK economy.
Virtually all aspects of UK external trade and much of economic activity are currently conducted under EU rules and policies. EU States are part of a customs union, with no tariffs or customs on goods moving within the EU. A common tariff is applied to imports from outside the EU. The EU is also a single market, based on the principle of the freedom of movement of goods, services, capital and labour between all member states. Thus, leaving the EU would be a radical change for the UK.
The main impact of Brexit would be on external trade, investment and the labour market.
However, it is unclear what type of trade arrangements would be put in place between the UK and EU in a Brexit scenario. This will have a major bearing on the economic impact of Brexit. Leaving the EU would also be a prolonged and complicated process, with a lot of uncertainty, which would be damaging for economic growth, especially investment. Other effects need to be taken into consideration as well, including restrictions on migration, impact of productivity, reduced competition and increased trading costs. Overall, it is very difficult, if not impossible, to quantify the full macro-economic effects and costs of Brexit, but they are likely to be quite negative for the economy.
It is unclear what the new trade arrangements would be, or indeed, what the EU would agree to, in the event of Brexit. Membership of the EEA (European Economic Area) would allow the UK maintain full access to the single market, but EEA countries such as Norway, must accept and adopt EU rules and regulations and also make a contribution to the EU budget. There would seem little point in the UK leaving the EU only to join the EEA. The UK could also seek to get Swiss-style bilateral accords for specific sectors or a Turkish type of customs union, but these are quite limited forms of trade deals. The AIB Treasury Economic Research Unit UK could also opt to negotiate its own Free Trade Agreement with the EU but again, it is likely that it would have to adopt many EU regulations and possibly make a contribution to the EU budget, in order to gain access to EU markets.
Thus, a major dilemma that Brexit poses for the UK, is that the more it seeks to regain control over policy and regulations, the more difficult it will be to negotiate a Free Trade Agreement that negates many of the downside effects of leaving the EU. In order to secure such a deal, the UK is likely to have to adhere to EU rules and regulations over which it will have no input or influence.
Many Risks for UK Economy from Brexit
External trade is very important to the UK economy. Exports account for some 30% of GDP. Key export sectors include financial services, chemicals and food/drink. The EU takes nearly half of UK exports.
Meanwhile, over 50% of UK imports come from the EU, with about half of these classed as intermediates which are used as inputs in the production other goods and services, and so are of vital importance to the UK. About 10% of EU exports go to the UK, so quite obviously, EU trade matters more to the UK than UK trade does to the EU. Nonetheless, the UK is still one of the major European economies.
The UK is the biggest recipient of FDI in the EU, with around half of this coming from other EU member states and 30% from the US. The UK is the main centre of the financial services industry in the EU. In another important European link, there is a large inflow of migrants into the UK from other EU countries. This helps address skills shortages in the UK, boosts productivity and also increases competition in its labour market. It is also very positive in terms of addressing the problem of the ageing UK population, as migrant workers tend to be young, improving the dependency ratio.
Brexit would threaten all of these close links between the UK and the rest of the EU. External trade at best would be faced with higher costs from increased regulation and controls. At worst, exports to EU markets could be restricted or face customs barriers or tariffs. Brexit would be a big threat to FDI as the UK would no longer be a gateway with uninhibited access to EU markets.
This could do major damage to the UK economy. Meanwhile, skill shortages might become an issue for the economy in the event of restrictions on inward migration. Lower FDI and skills shortages would also be a negative for the UK in terms of its impact on productivity growth and innovation.
Furthermore, important sectors of the UK economy, notably financial services, could find themselves facing regulatory changes which would put them at a disadvantage vis-à-vis EU countries. While it is hard to see the City of London losing its status as the premier financial centre in Europe, Brexit could make it more difficult to service EU markets from the UK, especially if the EU is not satisfied with the UK regulatory regime or the UK’s compliance with EU rules and regulations. There would also be a risk that some of the trading activities currently done in euros in the UK could shift to Eurozone countries.
Not surprisingly then, most studies and economic models show that Brexit would have a significant negative impact on the UK economy, lowering the level of GDP. Virtually all models agree it could take up to a decade for the full impact to materialise. A number of studies have estimated that there could be a loss of 2-3% in GDP. However, most of these studies tend to take quite a restricted view of the impact of Brexit and, in our view, the fall in GDP could well be much greater.
Most studies assume that the UK will be able to negotiate some type of free trade deal with the EU that would nullify most of the negative effects of Brexit on external trade and FDI. However, this may prove difficult to achieve for a number of reasons, some of them political. Meanwhile, most models and studies make no allowance for the impact on the economy of a prolonged period of uncertainty that would surround a Brexit. This would hit investment in particular. One also needs to allow for the impact of lower migration, less competition and the hit to productivity from Brexit. More dynamic models that try and capture these effects, while also assuming a severe impact on trade and FDI, suggest that UK GDP could fall by 10% or more.
AIB Treasury Economic Research Unit
Serious Implications for Ireland
Ireland has long and well established political, trading and economic links with the UK.
Although EU membership and FDI have lessened Ireland’s dependence on the UK, it remains a key economic partner. Some 17% of Irish exports go to the UK. This may seem relatively small, but Ireland has a very large and well diversified export base. Exports are bigger than GDP. Thus, exports to the UK actually account for 18.5% of Irish GDP. Indeed, when one includes imports, total external trade with the UK equates to 35% of Irish GDP. Thus, the UK economy is vitally important for Ireland.
Ireland enjoys an overall trade surplus of around €2.5 billion with the UK, thanks to a large surplus on services as the goods balance is in deficit.
The main Irish exports to the UK are food, pharma, ICT and a broad range of services, while on the import side, energy, manufactured goods and services are all important. Indeed, Ireland is the UK’s fifth largest export market. Some 33% of Ireland’s imported goods come from the UK. It is worth noting that more goods are imported into Ireland from the UK than the rest of the EU combined.
It is not just trade links that are important between Ireland and the UK. There is also substantial cross-country investment between the two countries. UK companies have a big presence in Ireland in particular, most notably in retailing and financial services. The two countries also effectively share a common labour market, with continuing significant emigration from Ireland to the UK. As the ESRI noted recently, a UK exit from the EU opens up the possibility of restrictions on the free movement of people between Ireland and the UK for the purposes of work. Indeed, passport controls could have to be imposed following a Brexit, including at the border with Northern Ireland.
Britain is Ireland’s most important market for tourism, while the UK is the most visited destination for Irish people travelling abroad. Ireland is the only EU country to share a common land border with the UK and there have been much closer ties between the Republic and Northern Ireland in the past two decades. Thus, the economic links between Ireland are the UK run very deep and are well established.
Hence, Brexit would have major implications for Ireland at many levels. The negative impact of Brexit on the UK economy would have knock-on effects in Ireland given it is a key export market. It would certainly impact trade between the two countries, even with a trade deal. Any customs clearance requirements would increases trade costs. Small firms that trade with the UK could be badly impacted by this.