Brexit Through The Gift Shop

On the 23rd June the United Kingdom held a non-binding referendum to gauge the support for the country’s continued membership of the European Union. The so called ‘Brexit’ vote was won by the leave campaign with a slender majority of 51.9%.

In the weeks that have followed we have seen sharp drops and subsequent recoveries in world markets. One month on a great deal of uncertainty remains about the long-term impact of the Brexit vote and how this will effect investors.

Prior to the Brexit vote Neil Woodford, of Woodford Investment Management, commissioned a report from Capital Economics to examine the impact of the ‘Brexit’ vote on the British economy. We believe this report, and the thoughts of Neil Woodford, to be an excellent summary of the economic consequences of this historic referendum. In this article we have summarised the 33-page report to help investors understand the long-term economic impact of Brexit.


The EU may demand that in order to retain its access to the single-market Britain must keep the free movement of labour with the EU. However, given how important immigration was to the leave campaign this is an unlikely outcome.

It is more likely that policy will focus on being more specifically designed to Britain’s immigration requirements.  This will probably create restrictions on low-skilled workers and place more emphasis on attracting high-skilled workers.

Full Analysis

Annual net migration from the European Union has more than doubled since 2012 and reached 183,000 in 2015. Most migrants come to the UK to work and this has helped the economy grow without pushing up wage growth and inflation.

Europe is likely to make accessing the single market very difficult if the UK dramatically changes its immigration policy. However, given that immigration was a cornerstone of the leave campaign it is unlikely to remain the same.

In the short-term there may be a ‘rush to the border’ ahead of any changes creating a large influx of new migrants. At the same time those that are already in the UK will probably stay longer knowing that it may be hard to return after the UK leaves the EU. The result of these two factors is that there may be little change in net migration in the short-term.

Looking at the medium to long-term, we will probably see a shift towards an immigration policy that better serves the UK’s needs. This will mean more restrictions on low-skilled workers and more emphasis on filling labour shortages in specific sectors.

Leaving the EU will also free the UK from many of the European’s restrictive regulations regarding employment. This could increase the flexibility in the labour market, which in turn would boost productivity. However, it will be met by staunch opposition if it changes too much.

Trade and Manufacturing

There are advantages on both sides to maintaining a favourable trade agreement between the EU and the UK. Around 63% of all Britain’s exports go to the EU and countries that have free trade agreements with the EU. It is therefore highly likely that a favourable trade deal will be reached.

The worst case scenario is that the UK will be subject to higher tariffs under the “most-favoured nation” rules. This will bring higher costs to exports as will the cost of complying with the EU’s rules of origin.

The flip side of this argument is that the EU’s importance in the global economy is diminishing and the absence of a trade deal may not have such a large impact. In fact, with the freedom to negotiate its own trade deals, the UK may find it can strike quicker and more favourable agreements with non-EU countries once it is free from the EU’s red tape.

Full Analysis

Britain’s current links with the EU

The European Union is the destination for around 45% of British goods and services. Given that total exports account for 30.5% of British output, this means the value of all goods and services exported to the EU is around 14% of the overall UK economy.

The manufacturing sector of the UK is heavily reliant on exports to the EU. However, as the services industry has grown, manufacturing has become a smaller part of the UK’s output.

Strong chance of trade agreement

The chances are high that a favourable trade deal will be reached with the EU post Brexit because both markets are important to both sides. Around 18% of the EU’s exports arrive in Britain and, with the exception of Germany, Britain is a more important market for the biggest EU economies than they are for the UK.

Given the interdependence of the UK and EU and the advantages of maintaining close ties, there would be little benefit to either party if favourable trade deals were not reached.

Cost of losing access to the single market

Exporters are likely to face additional costs of selling into the European Union. There will be explicit costs, such as the extra costs of clearing customs and complying with EU regulations, as well as potential barriers such as quotas. However, it is important to not lose sight of the fact that many countries successfully export to the EU despite facing the same hurdles (e.g. the USA) . We must also not forget that Britain already sends half of its exports to non-EU countries.

There is also an argument to say that the parts of the UK economy that do not export to the EU would benefit from the freedom (85% of Britain’s GDP). Good examples of this would be the National Health Service (NHS), which must comply with EU Working Time Directives, and retailers who are affected by the Agency Workers’ Directive. These benefit should not be overstated, however, as these industries may wish to keep many of the regulations despite leaving the EU.

The services industry faces some risks in the form of not being able to drive forward, and benefit from, efforts to complete the single market in services. These changes seek to harmonise product standards in services and reduce fragmentation. The UK is primarily a service based economy and leaving the EU removes their ability to influence and control the outcome of these reforms.

Worst case scenario – no free trade agreement

There is a real risk that the leaders of the EU will make it very difficult for the UK to negotiate a free trade deal in an effort to discourage other leavers. It is conceivable that Brussels will make high demands that the UK will not accept – such as the free movement of labour – resulting in a stalemate.

In this scenario the UK would still be able to trade with the EU under the World Trade Organisation’s (WTO) ‘most-favoured nation rules’. These terms provide that the UK would be subject to the same tariff as other non-member countries, without any further discrimination and for several reasons this would probably not be a very severe outcome.

First, the UK could impose its own tariffs on EU imports if the EU tried to do the same to British exports. Second, the average most-favoured nation tariff on manufactured goods in the EU is only 4%, which is well within normal currency movements between the GBP and EUR. Thirdly, tariffs would not apply to services, which make up a much larger part of the UK economy than manufacturing. Finally, the percentage of UK exports that go to the EU has been declining over the past decade. This indicates a diminishing importance of the EU market to UK manufacturers.

It is important to note that the average tariff that could be imposed varies across sectors. In reality there is a lot of variance between different industries. Based on this the food and drink sectors will be hit the hardest, as will the car manufacturing industry. In the short-term, the UK government could use some of the savings that it makes from not being part the EU to compensate these industries. In the long term, the UK economy is flexible enough to reallocate resources away from industries that are made less competitive as a result of Brexit.

The benefits of leaving

The primary advantage to UK trade as a result of Brexit will be its ability to broker its own trade deals with non-European countries. Membership of the EU requires that trade negotiations only be carried out for the Union as a whole. This has proved somewhat restrictive and there are large parts of the world that have not reached a free trade agreements with the EU. Importantly, in recent years UK export growth has come primarily from non-EU countries.

In theory the UK would be able to reduce tariffs on imported goods from non-EU countries and could even implement a unilateral free trade policy. This could boost consumers’ real incomes and create competition. It will also allow for cheaper imported components, which would make UK manufacturing more competitive.

Striking new trade deals could open up new markets and make Britain’s manufacturing sector more competitive. This may help to rebalance the UK economy, which is currently disproportionately reliant on services. Improving UK exports will help to strengthen its current accountant and create a well balanced economy.

It would be an overstatement to say that Brexit will have only a positive effect on UK trade. There are some major barriers to overcome, not least, the outcome of negotiations with the EU following Brexit. By the same token, statements over the negative effects of Brexit are largely outdone. In particular, the resultant loss of jobs from companies that trade with the EU, which is highly unlikely.

Financial Services and The City

The financial services industry is placed in the most precarious position as a result of the Brexit vote because the UK will lose its influence over the single market. This could hurt the City in the short-term, but over the long-term there could be opportunities for growth in financial services as the UK negotiates trade deals with emerging markets.

Full Analysis

The financial industry is a major part of the UK economy and its exports to the European Union far outweigh its imports.

At the moment Britain’s banks enjoy “passporting rights” into the European Union, which allow them to sell without needing to have a physical branch. This benefit also applies to foreign banks, such as those from the US, that locate themselves in the UK. The Brexit vote leaves these rights in serious jeopardy and could reduce the UK’s competitive advantage.

It is hard to quantify the true value of these passporting rights and their relative importance. The exports of financial services to Europe are an important part of the UK economy and bigger than those to the US and Japan. It is conceivable that without passporting rights exports of the UK’s financial services sector could fall by half, or about £10 billion.

The UK could seek to preserve its access to the single market if it remained part of the European Economic Area (EEA). But this would mean that it would have to adopt all the European Union rules and regulations without having any influence over them. This could lead to the EU purposely undermining the City in order to win business for Frankfurt and Paris.

Instead of joining the EEA the UK could seek to create bilateral trade agreements with the European Union. However, given the large disparity of trade it is not in a strong negotiating position and will be unlikely to achieve a very favourable deal.

The counterargument to the risks that the City faces is the fact that it’s importance as a global financial centre pre-dates the single market. It still has many intrinsic advantages such as geographical location between New York and Asia, English language, a large pool of skilled labour and world-class support services like accountancy and law.

As mentioned above there is also scope for the UK to become a more important hub for accessing non-EU countries. In particular, there seems to be a lot of scope for the City to increase its exports to China and Hong Kong, which currently only account for 2% of its exports.

Regulation, innovation and productivity

There is little evidence that the Brexit vote will have much impact on the productivity of the UK. Historically there appears to be little connection between increased business investment and political developments. On the regulatory side, the estimates that the UK will make huge savings by axing EU regulations are exaggerated. The more likely scenario is that it will keep a lot of these regulations in order to maintain access to the single market.

Full Analysis

Despite positive growth in the UK economy recently, it’s productivity performance remains weak and below its 2008 pre-crisis peak. It is substantially weaker than growth in the United States and other large European countries. This is mostly due to underperformance of the industrial sector as opposed to services. It is hard to argue that this underperformance is the result of EU membership, or for that matter believe that it will improve as a result of Brexit.

The debate around EU regulation was a major part of the Brexit campaign. Currently, EU regulations apply to the whole of the UK economy, despite only 14% of its output being sent to the single market. It is estimated that the 100 costliest EU regulations account for £33 billion annually. This would appear to present an opportunity to save money in the 85% of the economy that does not export to the EU post-Brexit. In particular, the National Health Service could make significant savings as none of its services are exported to the EU.

In reality, the UK is likely to keep a lot of the regulations that are currently in place as a result of EU membership. A good example is Norway, which has adopted three-quarters of EU legislation despite not being required to do so.

Foreign Investment

Much has been made of the risks to Britain’s foreign direct investment as a result of the leave vote. However, there are other reasons why foreign firms want a foothold in the UK other than its EU membership. In the short-term inflows of foreign direct investment may drop due to uncertainty over the terms of Brexit. Depending on how the UK renegotiates its relationships there may be new opportunities that increase foreign direct investment.

Full Analysis

The EU represents an important part of the UK’s foreign direct investment and in 2013 accounted for 46% of inward investment. Britain has been used as a gateway to Europe with firms benefiting from the zero-tariff environment and free movement of labour and capital. Foreign investment tends to bring with it productivity-enhancing technologies and management practices. If this dries up as a result of Brexit then it will harm the UK economy. The financial services sector has the most to lose as it accounts for one-third of inward foreign direct investment. Manufacturing will also suffer as foreign investment currently helps to finance physical plants and machinery.

On the other hand, there are many intrinsic features of the UK that should attract investors regardless of EU membership, such as the ability to attain credit, good transport connections, welcoming political environment and the English language. Despite arguments to the contrary, it is unlikely that Brexit will result in a wave of harsh tariffs. So, while there may be a drop of foreign direct investment as Britain negotiates it’s terms of leaving, long-term this is likely to recouped.

Public Sector

Weighing up all factors it looks like Brexit will have a positive impact on the UK’s public finances, but not to a huge degree. There will be an opportunity to save around £10 billion on the contributions that the UK makes to the European Union’s budget. But the negative impacts and disruption to the economy may offset the majority of these savings.

Full Analysis

Depending on how the figures are manipulated the cost of the UK’s membership to the EU ranges between £6.1bn and £13.4 bn.

Regardless of what the savings are to the UK economy from Brexit, these could be quickly offset by the negative impact that it could have on the UK economy. According to the Office for Budget Responsibility it would take only a 0.8% permanent reduction in output to offset savings of £10bn.

Another factor that needs to be considered is that the UK may still need to maintain some contributions in order to gain access to the European Economic Area. If Britain sought to create a similar relationship as Norway then the savings could range between 56% and only 17%. The UK government may also need to use some of the savings it makes to compensate UK businesses that are severely affected by leaving the EU.

Finally, if the UK dramatically changes its immigration policy as a result of Brexit then it could lose significant tax revenue. One study has shown that between 2001 and 2011 European immigrants made net contributions of £20bn to public finances.

Consumption and Property Markets

There is a clear argument that shows that the property market in London could have the most to lose as a result of Brexit. The financial services industry has a large part to do with holding up this property market and if effected it could have a negative knock-on impact.

Overall, the impact is likely to be somewhat limited and consumption could benefit as a result of independent policy making on immigration, trade and regulation.

Full Analysis

Brexit could mean that the UK loses its status as a commercial gateway to the rest of Europe. If demand from overseas buyers falls as a result of Brexit it could have a significant impact as they currently account for half of all transactions in the British commercial property market.

The effect could be less adverse if foreign direct investment into the UK manages to remain stable. It is also important to note that other factors such as the legal system, language, size, liquidity and transparency of the UK property market will remain regardless of Brexit.

London has the most to lose as it is plausiable that a number of large overseas institutions could close or scale back their operations in the City. This comes at a time when there is a lot of development in the pipeline and could create a large surplus. If investors feel that the City is irreparably harmed by Brexit then we could see drops of 8-15% in capital values.

There are forecasts which show that damage to the UK’s property market could result in lower consumption. However, Capital Economics believes the UK’s economic prospects are good whether inside or outside of the EU. It is plausible that Brexit could create a more tailored immigration policy, freedom to make trade deals, lower levels of regulation and savings to the public purse. Overall, the effects on consumption could be positive and are unlikely to be large in either direction.

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