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A view of Brexit, from London

London-based economist Andrew Hunt says the outcome of the Brexit vote may well be decided on "emotional lines" rather than economics. If the UK does vote to exit the European Union then it could usher in the Euro’s next and probably most severe existential crisis.

Tuesday, June 7th 2016, 6:00AM

by Andrew Hunt

Although this month’s vote by the UK population on whether they should choose to remain in the EU or depart is being billed as being of immense significance to the UK, we suspect that it is the world that should fear any consequences of a possible Brexit as much as the UK should fear the event. 

Of course, for most British citizens, the subject of Brexit has become charged with a fair degree of emotion and we suspect that many people will simply vote on the basis of their gut-feel rather than the (usually pro-EU) thoughts of ‘200 economists and the IMF’.

Indeed, we suspect that much of the population has known for some time that, if you find enough economists, eventually you will indeed find 200 to support any particular view....

When it comes to the actual vote, we suspect that many voters will vote according to emotion and that the people that will turn out to vote may not be entirely representative of the population at large, thereby making the likely outcome of the vote still quite difficult to call.

Moreover, we suspect that voters will be ultimately swayed by news events regarding security and even the outcome of the European Soccer Championships which occur around the vote...... 

In the interests of full disclosure, the author should note at this point that he believes in the free movement of trade, capital and labour providing that the participants in this process are responding efficiently to appropriate price signals, i.e. that the suppliers of traded goods are profit maximisers operating within free markets without subsidies; that the owners of capital are not being provided with inappropriate price and quantity signals by wayward central banks; and that there are no non-economic externalities driving labour movement.

When these conditions are not met, it is possible that there may be too many (or too few) imports, too large flows of capital in one direction or another, or levels of migration that overwhelm the recipient country’s ability to efficiently utilise these resources and the donor country’s ability to survive them. 

Unfortunately, in the real world and particularly within the EU system with its various and varied agenda, there are many non-economic externalities that have always made it difficult from a practical point of view for the system to act in an entirely efficient way. Hence the EU, and the UK’s membership of this institution, we believe, must not be thought of in simple terms but rather along the terms of a classical cost benefit analysis (CBA).

Clearly there are costs and benefits that need weighing but unfortunately neither camp in the debate has been able to produce a credible CBA in our view, thereby leaving the population to vote on ‘emotions’ rather than rational cold analysis. 

In many ways, we believe that considering the pros and cons of Brexit from a solely UK point of view is the relatively easy part of any analysis. At present, the UK has a current account deficit which is the equivalent of around 7% of GDP and exports account for 30% of the nation’s GDP.

Of these exports, 47% go to the EU directly but we find that 55% of the UK’s imports come from the EU. In fact, the UK accounts for 7.5% of German exports (more than to the PRC), 6.9% of French exports, and 5.6% of Italian exports.

Clearly, were Brexit to occur and to cause a disruption (in particularly) the volume of intra-EU trade, then there would likely be few winners on either side of the Channel and it is for this reason we would tend to assume that the rational thing for both parties in the event of Brexit would be to propel the UK into a free trade agreement as quickly as possible.

In terms of foreign direct investment (FDI) within the UK’s physical capital stock, we find that although the existing stock of FDI is quite large at around US$2 trillion, the annual inflow at present is only of the order of US$80 billion per annum and presumably some part of this would be immune to any Brexit effects.

Current UK GDP is currently running at around US$2.8 trillion and hence we can suggest that any disruption to current FDI flows might be relatively modest both relative to GDP and even relative to the UK’s annual US$500 billion of fixed capital formation (but of course still significant in some specific areas).

Where the UK would perhaps have a more pressing ‘problem’ with regard to Brexit is that foreign investors already own circa US$10 trillion of financial assets within the UK and any uncertainty before or after the vote will likely lead these investors to refrain from adding more to their positions, or potentially even reducing them.

Were this to occur, then the UK’s substantial current account deficit would likely become unfunded at current interest rates and exchange rates. Thereafter, the BoE would either be obliged to raise rates (unlikely) or to allow the GBP to fall, potentially quite precipitously. 

Unfortunately, any sharp fall in sterling would raise import prices and this would be to the presumed detriment of household sector real incomes, at least in the near term. However, given that the UK is currently experiencing implied retail price deflation of 2% per annum, it is perhaps difficult to think of a better time for sterling to fall – arguably the UK needs a lower exchange rate to fend off the deflation that it is importing from abroad currently.

Moreover, with world trade prices falling, and we suspect China’s economy teetering on the precipice of a potentially major economic event, we could assume that the UK manufacturing sector and exporters in particular might actually welcome a lower exchange rate. If there was ever a time for the UK to ‘enjoy’ a competitive devaluation, 2016 might well be the moment given current global trade trends.

Conversely, it is probable that the City of London would be a net loser from Brexit – it could well lose trading and deal volumes to those centres still within the EU area (and as some have quipped, this is one reason why much of the rest of the country might want to vote for Brexit....) but in theory Brexit could lead to some form of re-balancing of the economy away from financial services. 

Elsewhere, we suspect that domestic farmers might lose from an EU exit but fisheries would probably gain. Finally, with regard to the all-important housing market, we wonder whether the impact of potentially lower domestic real incomes (and potentially lower net migration flows) might be offset by UK property becoming something of a bargain in third party currency terms.

Of course, the primary route by which the UK might suffer more widespread damage as a result of Brexit would be if the EU erected trade barriers and even capital flow ‘controls’ vis-à-vis the UK despite the direct damage that this would do to the UK and more particularly their own economies.

The rationale for Europe adopting such a hard line stance would be to make an example of the UK so as to deter other countries from following suit – Brussels and we suspect more particularly Frankfurt and Berlin would perhaps not wish to see a successful exit in case it caused others within its ‘area of influence’ to depart. Were some of these other countries to be non-members of the Euro, the result of any departures might be awkward and ‘annoying’ but were Italy, Greece, or Portugal to follow any lead provided by BREXIT, then the Euro Project would itself unwind – quite possibly in acrimonious and highly damaging circumstances.

Indeed, it is the global economy that we fear that there is more to fear from Brexit. Financial markets have long abhorred uncertainty and in what is, an already fragile global economic situation, Brexit itself would clearly be unwelcome.

Moreover, although there might be some potential benefits from a weaker sterling (if only potentially in the shorter term) for UK traded goods producers, the world clearly does not ‘need’ another G7 economy ‘depreciating’ its exchange rate at this time. At present, the UK accounts for some 3% of world trade. 

However, we would argue that the true ‘danger’ of Brexit is that it could prove to be the catalyst for an unravelling of the Euro Project with all that this would entail for economic and potentially even political stability around the world. 

We suspect that President Obama’s recent warnings over Brexit had more to do with the US’s need to ‘burden share’ the costs of maintaining global security with the EU rather than its concerns over UK economic trends per se. Indeed, given the dire economic situations in many of Europe’s Peripheral Countries, any sign that Brexit might ‘work’ for the UK would unleash a wave of economic and financial instability on the Continent that would likely result in the most severe existential crisis for the Euro yet and this would of course depress growth around not only Europe but the World.

Unfortunately this dynamic might well detract from any net gains that even UK manufacturers might have expected from the weaker GBP.

By way of an example, there may be some benefit in remembering the impact of the UK’s departure in 1992 from the ERM. There was always a view within Whitehall that the UK’s initial joining of the ERM represented a way to ‘wreck it from the inside’ and it is certainly true that the UK’s subsequent departure in 1992 helped to destabilize what was clearly a flawed system (to such an extent that it effectively failed in 1993...).

What is interesting in that episode is that as the UK departed, it began to leave its recession almost immediately while what was then known as Eurosclerosis not only persisted, it became worse until the remainder of the system fractured. In fact, the UK economy fared remarkably well in the mid-1990s following its departure from the ERM and we have no doubt that the then Chancellor of the Exchequer was indeed “singing in the shower” in glee after sterling’s fall....

From the admittedly narrow perspective of the UK, the 1992 departure from the ERM apparently worked rather well despite some dire predictions at the time. Indeed, ‘Black Wednesday’ now seems to be viewed as being ‘White Wednesday’ in the UK but the instability that the event created elsewhere was to reverberate around the remainder of the ERM / EMS for several years with notably adverse consequences for France and the other core countries.

In summary, from the point of view of the UK economy, there has yet to be a comprehensive and unbiased cost-benefit-analysis of Brexit with the result that the outcome of the vote will most likely be decided on emotional lines with large divergences between the Regions, although on balance it does seem to us at the moment that the ‘Remain Camp’ may prevail.

Nevertheless, although the ‘Remain’ camp has talked up the threat to UK manufacturing in the event of Brexit, we suspect that it is the UK’s traded service sectors that would stand to lose the most following any UK exit, since UK manufacturers will likely be insulated from any adverse effects by a probable sharp fall in sterling. 

However, the real threat from Brexit, were it to occur, probably lies in what a UK departure might imply for the Euro System as a whole, despite the UK not being a member of the Euro Area.

If the UK was seen to exit the EU successfully, then we would assume that anti-EU / EUR parties around the Mediterranean would gain and in so doing usher in the Euro’s next and probably most severe existential crisis, with all that this might entail for global growth.

As to whether these global costs should be included in a UK-centred cost benefit analysis is a moot point but we can certainly see why the rest of the world wishes that Mr Cameron had not opened this particular Pandora’s Box.

Andrew Hunt International Economist London

Tags: Nikko AM

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