On 23 June 2016, in a historic decision, U.K. citizens voted in a referendum by a majority of 52% in favour of their country leaving the European Union (known as the "Brexit"). The outcome caused much concern, confusion and even panic among some investors in financial markets because of uncertainties about its implications and how it would be implemented. Despite the concern, there are questions about whether the result of the vote was binding and whether it will be implemented at all.
Analysts note that the June referendum was an "advisory" referendum, and not a mandatory referendum. As a result, there is a question of how the decision will be implemented. The matter is also controversial, because the U.K.'s referendum to join the EU in 1975 was considered an "advisory" referendum.
The U.K. in the EU
The U.K.'s participation in the European Union dates to the 1960s. What later became the EU originally took shape with the formation of the European Coal and Steel Community in July 1952, involving Germany, Belgium, France, Holland, Italy and Luxembourg. This particular group ended, however, in July 2002.
The European Economic Community (EEC) was founded in 1958, and Britain first applied to join in 1961. The application was vetoed by France in 1963 and in 1967. In 1967, European countries signed a treaty from the merger of ECSC, EEC and Euratom, and in 1968, they formed a customs union which removed customs duties between member countries.
The U.K.'s application to become a member of the EEC was finally accepted in 1969, and the nation joined on January 1, 1973, along with Denmark and Ireland. The Labour Party sought renegotiation of EEC membership. The U.K. held a referendum in 1975 to ratify its participation. Membership in the EU was approved with 67% of the vote.
In the 1970s and '80s, Europe moved toward greater integration, with implementation of direct elections, the launch of a European monetary system and the formation of a unified regional market. This all made it more difficult for individual member countries to veto legislation by the bloc. And in the '90s, the EU adopted the Schengen Agreement, allowing for travel between several countries on the European continent. It also launched a European central bank and single currency (the euro).
In the decade of 2000, the EU adopted the Amsterdam Treaty, which allowed several Eastern European countries to enter the bloc. In 2007, it ratified the Lisbon Treaty, which gave the EU a unified democratic and diplomatic character. The treaty included Article 50, which outlined provisions for member states to withdraw from the EU. In 2014, the European Parliament elected the first president of the European Commission.
In Or Out?: The Decision To Leave
The U.K.'s vote to leave the EU was the culmination of a lengthy process in which many U.K. voters, businesses and officials came to question the economic and social benefits of remaining part of the union. The chief complaints of those backing the "Brexit" were:
- The U.K. forfeited control over its economic, social and trade policies to the EU,
- was subject to uncontrolled immigration,
- and spent local money against its will on EU programs rather than on its own programs.
There had been questioning of the U.K.'s participation in the EU in the past, particularly from the Labour Party in 1983. However, the big push for leaving the EU came in 2014 European Parliament elections in Britain, when the anti-EU U.K. Independence Party won the largest number of seats. It became the first party other than Labour or Conservative to win a majority in British elections since 1906.
In January 2013, Prime Minister David Cameron promised that if the Tories were re-elected in May 2015, he would renegotiate Britain's membership and hold a referendum on the question of the EU by the end of 2017. This was seen as an effort by Cameron to stave off encroachment of the Independence Party on the Conservative Party's voting constituency.
Under the terms of the Lisbon Treaty and following the June 23 referendum, the U.K. and EU have two years to negotiate and implement the U.K.'s decision to leave. The vote makes the U.K. the first member country to implement Article 50 and request withdrawal from the EU.
The Implications Of Withdrawal: How Dependent Is The U.K. On The EU?
In the days and weeks following the referendum, U.K., European and global financial markets saw a heavy selling of assets amid fears of possible losses of U.K. trade, investment, production and employment. Quantifying exactly what the Brexit might mean for the U.K., however, is an exercise in uncertainty, because it may depend on the terms of how the country leaves its relationship with Europe.
One sector analysts believe may be most affected by the Brexit is the financial services sector, which is closely linked with Europe. Total UK lending to EU-based entities totals almost US$900 billion, including credit to households, companies and governments. At the same time, EU credit in the UK totals around $1.7 trillion.
According to a study by PricewaterhouseCoopers (PwC), the Brexit could cause a reduction in the financial services sector of between 5.7% and 9.5% by 2020. This would represent a reduction of activity worth between £7 billion and £12 billion. That loss would diminish to between 1.8% and 4% by 2030, representing between £2 billion and £5 billion.
Another area that could impact the UK negatively is foreign trade. This is significant for the U.K. given that 28% of what it produces is sold abroad and 45% of U.K. exports go to the EU. Future U.K. trade with the EU as a non-member would be subject to the EU's "Common External Tariff." However, the U.K. has recently run a trade deficit with EU countries of some £60 billion, so a reduction in trade between the two regions may stand to hurt the EU more than the U.K.
According to a report by consulting firm Global Counsel, the U.K.'s foreign trade increased by as much as 55% due to its membership in the EU, or an amount equivalent to around £130 billion. It's not clear, however, whether that amount would be lost with an exit from the EU. It may be offset by future U.K. trade agreements with the EU or with other countries outside the EU, as well as lower costs brought with an elimination of EU regulations. EU regulations alone are estimated to cost the U.K. economy about £33 billion annually.
Investment is another area where the U.K. may be affected with the implementation of a Brexit. Britain receives the third-largest amount of foreign investment in the world, following the U.S. and China, and the EU has been its largest source of investment funding, accounting for more than 40% of foreign direct investment in recent years.
Some analysts have expressed concerns that the U.K. could lose investment from foreign partners who fear the country's loss of preferential access to the single EU market. They note that many non-EU businesses are headquartered in the U.K. and could end up moving their investments to locations on the continent to maintain EU market access.
Regarding potential job losses related to a Brexit, the U.K. government has estimated that as many as three million jobs in the U.K. are linked to trade with the EU. However, a PwC study estimated that only about 950,000 jobs might be put at risk with approval of the Brexit vote.
Participation In The EU: Path Of No Return?
While a great deal of concern has arisen about the potential impact of a Brexit, a considerable amount of doubt has been raised about whether it will be implemented at all. Following the result of the referendum, Cameron was forced to relinquish his position to fellow party member Theresa May. Analysts note that Cameron and May—in addition to a majority of members of the British Parliament, both from the Conservative and Labour parties—were positioned against leaving the EU. Neither Cameron nor May signaled they were preparing to invoke Article 50 of the Lisbon Treaty.
Given those positions, it's been reported that the U.K. could attempt to negotiate a deal whereby it can maintain access to the single EU market while opting out of EU's freedom of movement provision, which facilitates entrance of migrants into the country. It is unclear, however, whether the EU would allow for that, because it could encourage other member states to pursue similar strategies.
The Conservative government will face general elections in 2020, shortly after the deadline for withdrawal from the EU expires. If the economic consequences of the Brexit vote worsen significantly, the government would be hard-pressed to continue efforts to distance itself from the EU government in Brussels. Further, the Article 50 clause of the EU's Lisbon treaty is reversible. This means that while the U.K. is free to negotiate its exit, it is under no obligation to formalise it at the end of the process.
An "Independent U.K." And Mitigation Of Brexit Damage
Despite forecasts of doom-and-gloom scenarios, proponents for the U.K.'s departure argue that in the long run, the outcome of the referendum may actually bring positive returns for the country. They argue that the U.K.'s historically lower taxation and reduced regulation—and the agility made possible by remaining outside the EU—will provide it with economic advantages to make up for any losses in trade and investment from association with the European economic bloc. The British pound sold off about 10% in the weeks immediately following the referendum, but this may have a silver lining over the long term, helping attract investment and reverse the country's long-running trade and current account deficits.
Another important element for this scenario would be the U.K.'s eventual negotiation of a free trade agreement with the EU. It's unclear whether the EU would give priority to such an agreement in the immediate aftermath of the referendum. However, the negotiation of a trade pact could represent a win-win situation for both the U.K. and the EU in the longer term.
Backers of this scenario argue that other non-EU countries in the region, such as Norway, Iceland and Switzerland, have all managed to negotiate Free Trade Agreements with the EU, and there's no reason the U.K. couldn't do the same. They argue that the U.K. will represent a profitable export market for the Europeans that will be too attractive to be ignored. Some observers even argue that such an agreement might be negotiated before the U.K. and EU finalise their separation negotiations regarding.
High Court Ruling
On 3 November 2016, the High Court sided with a lawsuit arguing that even after the referendum, the government could not trigger Article 50 without first securing the approval of Parliament. In contrast, the government asserted that the executive powers it has under the royal prerogative grant it the ability to contact the EU on behalf of the cabinet.
Following the High Court's decision, the government announced it would appeal the ruling, and the Supreme Court plans to start reviewing the matter starting December 7. The hearing could last up to four days.
The long-term consequences of the U.K.'s vote to leave the European Union remain uncertain. The move initially triggered a steep selloff in U.K. and European assets that raised warnings about possible negative economic repercussions of the move. However, flexibility in negotiating rules surrounding the exit may allow the delayed imp.lementation of the referendum mandate, or even its indefinite postponement.
Whether an exit occurs or there's a reversal, officials from the U.K. and the EU can be expected to manoeuvre pragmatically to minimise the fallout of the Brexit along with its political and economic effects on both regions.
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Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…