Foreign Developed

Markets are Underestimating "Brexit" Risk

June 9th, 2016 | By Nick Sargen

Highlights

  • The June 23 referendum in which British voters will decide the country’s fate in the European Union (EU) has potential to unsettle markets if the vote is to leave.
  • The British Treasury contends such an outcome could catapult the U.K. economy into recession, and the Bank of England has warned about the consequences for sterling and financial markets.  Proponents who favor leaving counter these are scare tactics. They claim Britain will benefit from diminished regulatory burdens imposed by the EU.
  • Financial markets are pricing in the likelihood that Britain will stay, but polls are very close and worries about terrorism and immigration could result in an upset. If so, sterling and U.K. markets are likely to sell off.
  • The spillover to the rest of Europe is harder to assess.  Because sterling is not part of the eurozone, some observers do not foresee Greek-style contagion.  However, the British economy is much more important, with close trading ties to Europe and London’s role as a financial center. Should Britain opt to leave, moreover, the inevitable question becomes “Who is next?”

Background on the EU Referendum: Why Now?

Since Britain’s entry into the EU at the beginning of 1973, the UK’s stance has been lukewarm on the part of most supporters and more passionate by those who are opposed. Two years after Britain’s entry the Labor Government held a referendum in which voters opted to stay by an overwhelming margin amid worries that Britain’s economy was flagging and it would become increasingly isolated.  Over time, however, this support waned, and during Margaret Thatcher’s tenure as PM in the 1980s, she affirmed another vote should be taken when “the time was ripe.”  It never materialized, however, and her successor, John Major, sought to strengthen ties with Europe by having sterling included in the euro. However, this effort was undermined in 1992 by a speculative attack on sterling, which forced it out of the Exchange Rate Mechanism. Thereafter, the British Government opted to keep sterling out of the euro.

More recently, the ruling Tory Party has been divided about whether Britain should remain in the EU, as some members prize British autonomy and contend the regulatory burdens imposed by the European Community (“EC”) pose undue costs. During his campaign for re-election Prime Minister Cameron called for a referendum to be held on the issue by 2017.  His strategy entailed bargaining with the European Commission to obtain concessions for Britain so he could make a strong the case with the electorate for staying.

Following discussions with the EC, Cameron declared that he was able to reach a satisfactory agreement and he announced a referendum would be held on June 23.

Soon after, Boris Johnson, the former Mayor of London and potential rival to Cameron as PM, surprised party leaders by becoming a vocal supporter of Brexit.  In addition, the movement has gained a following among those who are concerned about the growing threat of terrorism and an influx of political refugees into the EU.  Polls indicate that the vote is likely to be close, although the investors appear confident that the outcome will be to stay.


Economic Consequences of Brexit

With the referendum now just two weeks away, the campaign is heating up.  The U.K. Treasury has issued two reports that assess the consequences of a vote to leave in which the outcomes range from a decline in real GDP of between 3.4 and 9.5% over the long-term. The Chancellor of the Exchequer, George Osborne, has stated that the U.K. would suffer a “do-it-yourself” recession. According to the Bank of England the most significant risk is that uncertainty about U.K. trading relations could cause a steep decline in sterling and a tightening in financial conditions. The uncertainty could adversely impact investment spending and contribute to stagflation, in which inflation accelerates while growth slows.

Proponents who favor leaving downplay these arguments as scare tactics, and they note that previous warnings about the consequences of Britain not joining the euro proved to be unfounded.  They contend Britain would in fact derive benefits from no longer being beholden to extensive regulations issued by EC bureaucrats. A leading economic spokesman, Patrick Minford of Cardiff Business School, claims that:  “In the long term, Brexit will herald a major growth-boosting period, as the UK breaks free of the over-mighty EU with its protectionist mindset and establishes free trade and intelligent regulation aimed at UK economic interests.”  (See “What are the economic consequences of Brexit”, Financial Times, February 22.).

In its assessment, the Financial Times considers several possible outcomes, ranging from dire to positive. The FT article notes that whereas the Leave campaign in 1975 was headed by those who were fundamentally protectionists, the rallying cry today is that Britain can enjoy freer trade and diminished regulations outside the EU.  However, it questions whether this is a realistic outcome.


Potential Impact on Financial Markets

Amid this debate, the Financial Times conducted a poll of more than 100 economists earlier this year. It showed that more than three quarters of the participants thought a Brexit would adversely affect the UK’s medium term prospects.  The principal reason is that trade creation from being part of the EU is thought to exceed the effects of trade diversion.  Only 9% of the respondents believed such an outcome would be favorable for the economy.

Similarly, most market participants view Brexit as a negative outcome, mainly because of increased uncertainty about trading, financial, and security relationships with the rest of Europe.  Earlier this year, sterling sold off against both the dollar and the euro amid worries about Brexit; however, it has subsequently rebounded and is now trading close about where it began the year, as investors anticipate a vote to stay.  With opinion polls showing a close vote, an upset is possible if the turnout proves to be light, as advocates of Brexit are thought to be more committed than those favoring remaining.  Such an outcome most likely would likely trigger a selloff in sterling and in UK financial assets, with some commentators calling for the British currency to depreciate by as much as 15%-20%. 

It is less evident what the spillover would be for the rest of Europe. Some commentators have observed that there is less risk of contagion than during the period of the Greek crisis, because sterling is not a member of the euro.  Yet, Britain is a far more important economy with deeper trading, financial, and security ties with Europe.  Were it to opt out of the EU there would be major political ramifications throughout Europe, and market participants would likely begin to ask “Which country is next?”  Nor are EU officials taking the outcome lightly. According to Reuters (May 25), they recently launched a round of confidential discussions about contingency plans.

While the debate goes on inside Britain, there’s no denying the significance of the referendum, which has been called the most important vote in Europe in a half century, (George Will, Washington Post, May 25).  Indeed, some observers describe the referendum as a “known, unknown” – namely, it is an event whose date is certain, but for which the consequences of a surprise outcome are unknowable.