BREXIT IN PERSPECTIVE

Edited from a paper “Britain, the EU and the Sovereignty Myth” written by Robin Niblett, Director of Chatham House

"The EU faces the most difficult period in its history. The eurozone crisis and the recent unprecedented inflow of refugees and migrants have carved new political fissures between Member States and weakened established political parties. At the same time, there are wide divergences between rates of annual GDP growth across the EU, youth unemployment is over 40 per cent in parts of the EU’s south, and welfare systems are under stress throughout. This situation is driven by a combination of factors, including the impacts of ageing populations, underdeveloped capital markets and technological change, as well as by the EU’s emphasis on imposing supply-side reforms and deficit reduction on the weakest economies without a compensatory increase in demand in the strongest. These are real and pressing problems.

The EU is the world’s second-largest single market after the United States measured in US dollar terms, with a combined GDP in 2015 of $16.2 trillion. Even modest average growth of 1.5 to 2 per cent in a market this size in an era of near zero inflation and static population growth offers significant economic opportunities for its members and external trading partners for decades to come. The EU also contains eight of the 20 most competitive economies in the world. EU companies have built some of the best global brands, and some of the most advanced industrial and service technologies. These are now attracting foreign investment not only from developed economies such as the United States  and Japan, but also from emerging economies such as China and India, whose companies are looking to trade with and invest in the large, wealthy and highly integrated EU market.

The consequence of the UK  leaving the EU will of course, be the uncertainty associated with negotiating new terms of access to the EU market and to the more than 50 countries to which the UK currently has access through EU trade deals. Most independent estimates of the costs to the British economy are in the range of 1 to 2 per cent of GDP in the near term, and some rise to over 6 per cent of GDP by 2030. Britain cannot be confident of striking a better deal for itself in the long term on the outside. Two important facts illustrate the power dynamics likely to inform any negotiations over a new relationship. On the one hand, Britain is the largest single export market for the rest of the EU. In 2015 it absorbed £291 billion in imports of goods and services from the EU . The scale of the relationship suggests that both sides will have strong incentives to avoid imposing barriers to a continuation of bilateral trades. There might also be flexibility over the types of demands that remaining EU members will make of the UK in return for access to their markets, including over the size of British financial contributions to the EU budget and the sorts of rights that EU citizens will have to work in the UK. On the other hand, the UK’s economic leverage is limited by the fact that its imports from major EU trading partners like France, Germany and Italy account for only 2 to 3 per cent of their GDP. In contrast, British exports to the EU are worth some 12.5 per cent of British GDP. Overall, the UK is far more dependent on EU demand for its own exports – the rest of the EU was the destination for 44 per cent of UK exports last year, while the UK accounted for only 8 per cent of total EU exports. EU members will not, therefore, have much incentive to grant the UK special consideration in terms of the central benefit of belonging to that market – namely, participation in the drafting of the regulations and standards that any goods and services must meet in order to be traded freely within the EU. Even if they decided not to punish the UK for leaving the EU, the remaining Member States will  not want to help the UK to benefit from doing so. For the UK to retain the same level of access to the single market, therefore, British exporters will still have to abide by EU rules when selling in the EU – yet without the British government having the say that it does today in their definition. The result will be the UK parliament regaining sovereign power to set standards for British products and services in these and other sectors de jure and then promptly abandoning this right de facto. In effect, the UK will be less sovereign than when it had pooled sovereign power as a member of the EU. Alternatively, the British government could force UK-based companies to switch between British and EU rules for the same products and services depending on which market they were being sold in. Affected sectors will include cars, energy-efficient home appliances, chemicals, agricultural produce and financial services. Either change will not just be cosmetic. The UK will undoubtedly continue to retain and attract foreign investors interested in its large domestic market. But, excluded from the process of EU rule-writing, it will risk losing many other foreign investments. An example is the car industry, which has benefited from using the UK as a competitive base from which to access the rest of the EU while knowing that the British government has a strong voice in defining EU standards. Similarly, investment banks and asset managers in the UK, which can currently take advantage of a ‘passport’ arrangement to provide financial services to any other EU country, will lose this privilege outside the EU unless the UK adopts relevant EU laws wholesale. London will also lose its voice in setting future EU financial regulations, which might then be tailored to favour continental European approaches to banking, at the UK’s expense. It is far-fetched to believe that a UK outside the EU can compensate in any meaningful way for this uncertainty by freeing its economy from all burdensome EU regulations, say over environmental standards or rights for temporary workers. Given the UK’s track record of ‘gold-plating’ EU regulations to exceed minimum requirements when incorporated into UK law, and majority British public and political support for existing environmental, health and safety protections, most EU regulations will likely be reimposed nationally rather than diluted. Britons could hold parliament in Westminster accountable for their regulations, but they might simply come to resent Whitehall mandarins in the future as much as they do Brussels ‘Eurocrats’ today.

What, then, of the promise of a sovereign trade policy? Could the UK make up for a decline in the level or growth of its trade with the EU by striking trade deals with other major economies? There is nothing to indicate that this is likely. Those arguing that a sovereign UK trade policy can instead more easily expand British access to third country markets for financial, legal and other services ignore the risk that opening up these service markets could prove even harder from outside the EU than from inside it. They also ignore the fact that emerging markets have entered a particularly turbulent economic phase as they struggle to break through the middle-income trap, and to move from export- and investment-focused growth to economic models driven more by consumption and innovation. China, Brazil, Turkey and India are all facing significant obstacles in attempting this transition and are often adopting protectionist stances towards domestic sectors in order to manage the politics of structural change. In part reflecting this shift, trade has reversed its role as an engine for growth in the global economy, and is now growing more slowly than global GDP. The British government will also find its economic sovereignty curtailed in a number of practical ways. For example, the UK will need to ensure that each future trade deal with a non-EU partner meet EU rules of origin if British-based companies want to incorporate products from that third country into UK exports to the EU. Similarly, regaining the right to impose anti-dumping duties on unfairly traded products, such as Chinese steel, will  be a hollow victory if Britain feels compelled to shy away from actually applying them in case it provokes policy retaliation on its own exports to the much larger Chinese market. The UK today has a far better chance of influencing Chinese trade policy as part of the EU, which, taken as a whole, is China’s biggest export market.

There will also be an important opportunity cost from re-establishing sovereignty over trade policy. The UK currently has a surplus on its trade in services with the rest of the EU. Many EU members are looking for new ways to kick-start growth, and the European Commission has put creation of a digital services market and a capital markets union at the top of its agenda. Completing the European Digital Single Market could add €415 billion per year to the EU’s economy.  Outside the EU, British companies will have to adopt new EU rules on services, potentially designed to favour domestic EU companies and over which the British government will have no say, in order to access their most important market. The international economic context points to an important additional danger from ‘Brexit’. The UK runs a current-account deficit that has widened from 1.7 per cent of GDP in 2011 to 5.2 per cent of GDP in 2015, reflecting a persistent trade deficit and declining returns on its overseas investments. Financing the current-account deficit requires the UK to borrow more money from the rest of the world. The UK also still has a high budget deficit, which despite the government’s efforts was £74 billion, equivalent to 4 per cent of GDP, in the financial year 2015/16. The budget deficit is also a source of exposure to foreign creditors, notwithstanding the fact that a large share of government debt is held domestically. With Brexit, and were the UK to continue running these deficits, foreign lenders might doubt the ability of the UK government to repay its debts in the future. This could force the Bank of England to raise interest rates in order to continue attracting foreign funding, potentially dampening growth in the real economy.

It is very difficult to assess how the EU will evolve with the Brexit. The EU will be subject to ‘centripetal’ and ‘centrifugal’ forces simultaneously, some pushing for greater integration and others driving members apart. Both outcomes will be unattractive from a UK perspective. On the one hand, ‘Brexit’ could drive EU members closer together, lest the British decision set off a chain reaction of popular referendums in other countries on specific EU policies, or on leaving the eurozone or the EU altogether. Efforts to deepen cooperation will likely centre on the eurozone, where pressure has been building since the financial crisis to sustain the pace of economic and financial integration. Whatever such integration might look like, the one thing the UK can be certain of will be an even more inward-looking EU. Establishing a true economic and monetary union will  need to bridge entrenched differences between euro area creditors and debtors, big and small EU states, more competitive northern and struggling southern economies, and France and Germany. Under this sort of pressure and in Britain’s absence, the balance in the Council of Ministers between those open to trade and sceptical of state intervention in the economy and those with more protectionist and nationalist instincts could easily tilt towards the latter . Any consequent delays in economic reforms and market-opening initiatives will reduce business opportunities for UK companies, whatever bilateral trade deal is signed.

Continuing slow growth in the EU will  leave the UK exposed to one of the very forces that ‘Brexit’ was intended to reduce. With Brexit,  the 2.7 million EU citizens legally residing and working in the UK will still have the right to remain. In addition, during the two or more years it will take to negotiate the UK’s new non-member relationship with the EU, EU citizens will continue to have the right to move to the UK to work, and an even greater number might try to do so ahead of the UK’s departure. Even afterwards, high levels of migration from the EU will likely continue, given the needs of the UK labour market. It is true that the British government will have the right to decide whether to treat prospective workers from the EU in the same way as those from the rest of the world – whether from Australia, Nigeria or India, for example. However, it is questionable how much of an impact this will have. The government’s struggle to reduce numbers of non-EU immigrants, who account for about half the total, given family ties, labour market demands and education visas, illustrates the challenge it will have were it to try to apply the same constraints to EU immigration. Alternatively, without the UK, the EU could become more divided than it is already. With the loss of one of the EU’s ‘big three’ members, many EU governments and citizens could fear a further increase in German dominance of the EU, given its forceful role in managing the eurozone and migration crises. A Britain outside the EU will need to spend more political and diplomatic time and effort monitoring and negotiating with the EU than it does today. A more divided EU would be bad for Britain on multiple levels. The EU is one of the few collections of states working to strengthen the rule of law at a time when many around the world are struggling to sustain what rules they have, or are battling with debilitating cronyism and corruption at the heart of government and business. But EU states and societies are also vulnerable to these forces, and would be even more susceptible if EU institutions and solidarity were weakened as a result of internal divisions. A more fractious EU would also continue to struggle to halt the waves of refugees and migrants fleeing to Europe from chaos in the Middle East and poverty and violence in much of Africa. And, unless the rest of the EU is able to stem the flow and integrate those arriving, an ever greater number will try to make the UK their ultimate destination. Finally, under either the ‘greater integration’ or ‘greater division’ scenario, the EU will remain Britain’s largest trading partner by far and also a principal potential transmitter of political and economic risk into the UK. A second irony, therefore, is that a Britain outside the EU will need to spend more political and diplomatic time and effort monitoring and negotiating with the EU than it does today. Rather than escaping the EU’s embrace, British decision-makers will be even more obsessed by developments in Brussels than at present, when the government can deploy a large share of its diplomatic resources and sovereign power to focus on opportunities and risks in the wider world.