In March 2019 the UK is slated to leave the European Union, thereby following through on the results of the 2016 referendum in which voters opted to leave the trading bloc. Current talk is about transition periods and deals to continue access to the single market, but the risk that we will leave the EU, including the free trade area and customs union, without any type of trade deal in place remains.
What would it actually mean for the UK from a financial and economic perspective if this were to happen?
If the UK leaves the EU without any form of trade deal then it can choose to automatically revert to rules for international trade set by the World Trade Organisation (WTO), of which it is a member. Currently, the UK’s membership is bundled with that of the EU, so re-joining as a single trading entity would require some negotiation with regard to terms of trade.
The other option at this stage would be to abandon tariffs completely and forge bi-lateral trade deals with countries around the world. WTO rules only exist as a ‘fall-back’ position for countries that have no trade agreements in place. At this stage, it appears likely that the UK will opt for the WTO rules approach, at least initially.
The UK economy is approximately £2 trillion in size – that is, two thousand billion pounds – and £143bn of this is made up of exports to the EU. This equates to just over 7% of the whole economy. Imports are somewhat larger, equalling £235bn, or 11.75% of GDP.
These may be large figures, but imports and exports will continue regardless of the status between the UK and its trading partners; after all, British people are not going to stop buying BMWs any more than businesses in France and Spain are going to stop buying British plane parts and pharmaceuticals.
Nevertheless, if the UK falls back into a WTO regime then we can expect to have to pay tariffs on anything we export to the EU. And given that the average trade-weighted WTO tariff levied by the EU is 2.3% this would equate to about £3.2bn.
Another thing to consider is that the UK imports a lot of food from the EU, and EU agricultural tariffs are high, so we could expect to see food price rises.
On the other side of the equation, typical EU import tariffs are much lower at around 1.5%, so this figure would have to be absorbed by the EU economy, which at around £12 trillion (assuming the UK has broken away) would barely notice the cost.
However, given that the UK is largely a services economy, it’s arguably more important to focus on services rather than physical goods; so what impact would there be? The UK handles a great deal of non-physical business for clients in the EU, including services such as legal utilities, architectural reports and capital market operations. Luckily for the UK, these services are classified as ‘wholesale’ and are exempt from tariffs.
The other type of services – retail – are those that are carried out in conjunction with individuals and private clients and, given their non-material nature, routinely sidestep any tariffs as corporations set up subsidiary companies to get around them.
So, the answer to the question of whether WTO tariffs would impact the services industry is that there would not likely be much economic impact.
Despite there being little impact to services in general, the UK is a special case in that the financial centre of the City of London is based here. The City is one of three major European trading hubs, with the others being Paris and Frankfurt.
News reports have focused on the possibility of financial service firms, such as big banks and insurers, moving their offices to continental Europe in the event of Brexit. With financial services and insurance contributing over 10% to the UK economy, protecting the sector has naturally become a political issue. UK ministers have been keen to reassure the City that any Brexit turmoil will be minimal. To that end they have been trying to appeal to the EU, saying that special measures are needed to protect the City of London. So far, however, their pleas have fallen on deaf ears.
One often-overlooked consequence of the UK leaving the EU would be that the EU would be able to impose a financial transaction tax (aka a ‘Tobin Tax’) – something it has been held back from doing for years – by the UK. If this were to happen we could expect to see businesses relocating from Frankfurt and Paris to London. This would be further down the line, however, and as it stands at the moment estimates of the number of jobs that will be relocated overseas number between 9,000 and 12,000.
Established businesses and other large organisations are generally risk-averse and have a natural bias towards the status quo as it makes it easier for them to plot future growth and calculate returns in a regulatory framework they are familiar with. It’s perhaps for this reason that trade bodies, such as the Confederation of British Industry (CBI), have warned that its members are growing impatient with the political uncertainty surrounding Brexit.
Whilst it’s a relatively straightforward job to calculate the financial costs of tariffs, the same cannot be said of estimating the effect leaving the EU would have on business confidence. A whole array of factors prompt industries to react in multitudinous ways to the prospect of leaving the EU, from agribusinesses concerned about losing access to the supply of cheap labour, to universities concerned about European students finding it more difficult to study in the UK. As such, business confidence is the wild card in the calculations and cannot be estimated with much accuracy.
Currently the UK pays around £17bn annually to the EU and receives around £4.5bn back in EU spending. The UK also gets a special ‘rebate’, fought for by Margaret Thatcher, to the value of around £4bn – meaning the net annual contribution to the EU is £8.6bn.
The £4.5bn that ‘comes back’ from the EU is generally paid in the form of subsidies to farmers, as well as various payments made to structurally disadvantaged regions. These payments are likely to be guaranteed by the government to continue for some time after Brexit, so even if they were matched like-for-like the UK would be ‘saving’ £8.6 billion per year.
Given that the UK retained Sterling as its currency and opted out of the Euro, Brexit would not have any direct impact on the demand for either of the two currencies. Where the danger lies is the possibility of a sharp devaluation in the Pound, such as was seen after the initial referendum when Sterling lost about 10% against the US dollar. The currency has since recovered some ground, however, with most markets having priced in some form of Brexit.
A weaker currency, of course, means that UK exports are cheaper to the rest of the world, benefitting major export industries such as manufacturing and tourism. The flip side of a weaker currency is that it makes buying from the rest of the world more expensive, having a knock-on inflationary impact across the economy.
This is of particular concern to the UK which runs a high trade deficit (i.e. we import more than we export), although in the longer term it would likely stimulate jobs growth in new export industries.
De-coupling the UK from the EU is likely to be a messy process with various complications. Some things on the balance sheet are straightforward, such as the £8.6bn the UK would no longer need to send to Brussels.
In the absence of a crystal ball, however, one can make some reasonable if broad assumptions about economic factors, such as the relatively minor impact tariffs would have, and the likely safe position of the City as one of the world’s pre-eminent financial hubs.
In terms of the more variable ‘unknowns’ it would seem that what is needed to limit any damage in terms of business confidence and market sentiment is a clear pathway being laid down by the government. In reality, turning around at such a juncture and abandoning Brexit is not consequence-free, as the UK would then lose nearly all of its bargaining power within the EU.
The approximate £4-5bn rebate would not likely be reintroduced, and any imposition of a Tobin Tax on the City of London would see financial services companies relocate to more ‘tax friendly’ places such as New York and Shanghai. Thus, when considering the cost of leaving the EU, we must also balance it against the cost of changing course at a late stage.
One thing seems certain, however, and that’s the fact that we can expect to see more swings in the value of Sterling as the date of leaving the EU approaches and passes. Bearing this in mind, it makes sense to hedge your bets if you need to transfer sums of money around that time and use a specialised currency broker to limit your exposure to exchange rate volatility. Because whatever else happens you’ll want to make sure that you’re not caught out by the currency markets as they react to the likelihood of a no-deal Brexit.
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