On June 23, the British vote for EU membership. The outcome of the election and the risk of withdrawal – a so-called Brexit – is crucial for all EU countries. Not just for the UK. The importance is not yet fully reflected in the media’s focus and public debate.
No one dares predict the outcome of the British EU election. The polls flip, while the financial markets are slowly calculating a no for the EU. The consequences are already visible. The British pound has fallen about 12 percent since November 2015. The British central bank is ready to flood the country’s banks with liquidity in the case of Brexit. Uncertainty spreads, and European equities have fallen about 12 percent since the turn of the year.
Economically, there is no doubt that the EU, Britain and the British are best at staying in the EU. In addition, in the negotiations with the other EU countries prior to the referendum, the British Government has met virtually all its requirements. But as we know from the domestic EU debate, people do not necessarily vote with the brain, but with the heart. Many Britons detest the EU – even though they are told that it will cost them money, jobs, and welfare.
The economic and political implications for the British leaving the EU are immediately unmanageable. Therefore, one may be tempted to consider the risk too small. But in my eyes, Brexit is a real possibility. The US election is an example of elections being unpredictable – nobody really believed that Donald Trump had a real chance of winning the nomination.
The people’s mood is not with the EU, for many Britons have forgotten that Britain was Europe’s ‘sick man’ when the country joined in 1973. Today, Britain is among the sovereign richest in Europe, and although the positive development picked up in the years following the EC -the membership, it is difficult to document that this is solely due to the EU. However, a few facts support the claim: 50 percent of UK exports go to the EU against 30 percent in 1973. 53 percent of the goods imported by the UK are from the EU.
My personal assessment here just over two months before the vote is that the British realize that the negative consequences far exceed the more emotional gains. Therefore, I do not expect Britain, after all, to vote out of the EU, but it will be close.
The consequences of a Brexit are of course difficult to predict. A Brexit does not take place with immediate effect from June 24, 2016. At a no-to-date EU membership, a long process of complicated negotiations begins. It follows from the Lisbon Treaty, where a withdrawal process is set to last up to two years. It will be difficult negotiations that are likely to take longer. The forthcoming parliamentary elections in 2017 in Germany, France, the Netherlands and perhaps Italy will not speed up the negotiations. This can mean a long period of uncertainty, which is poison to the financial markets and the UK economy.
The British pound is likely to collapse further with the shares – both in the UK, Europe, and the United States. The pressure on the pound may mean that the British central bank must defend the pound, which is traditionally done by raising interest rates. It will be economically restrictive. A weaker pound will also mean that the British have to pay more for foreign goods, but they will, however, be able to export at lower prices measured in foreign currency.
London is Europe’s financial center. What is the future of the banks when rules and laws are to be written out of the EU framework? It is uncertain how the European financial system will look after any Brexit. Frankfurt and Paris will be strengthened as financial centers in Europe, as Brexit will, after all, mean moving financial companies and jobs away from London. It will affect the London real estate market – not just for office buildings, but also for housing due to lower employment in the financial sector. British financial stocks will also be negatively affected.
However, the biggest and most devastating effect comes from the absence of investments. Abroad will hold back investments in UK companies and properties. As investments are gasoline on the growth engine, an expected sharp fall in investment will slow down the development of the entire UK community. This was seen in Sweden during the period before enrollment in the EU, where foreign investment in Sweden fell. Investing in a non-EU country that was at the same time financially dependent on the EU was simply not a long-term perspective. The same will be the perspective of Britain.
Large UK companies are likely to flake out and establish themselves in another EU country (eg Ireland, France or Germany). This is necessary in order to maintain the commercial and competitive advantages of EU membership and the single market.
British companies with domestic sales will be adversely affected by the economic crisis. Unemployment will rise, and the British government will greatly increase its budget deficit – partly due to the crisis and partly to try to mitigate the negative effects through expansionary fiscal policies.
The creditworthiness of the state and the companies will decrease, which will increase the borrowing costs and thus reduce the activity further. Add to that, the elongated and cumbersome negotiations on withdrawal can easily take more than two years. In addition to the obvious uncertainty, it will involve enormous legal paperwork with complicated consequences for citizens and businesses. Lawyers, lawyers, and compliance specialists will be the only winners.
Britain is the EU’s second-largest economy. The country also has the third largest population of 12.5 percent of all EU citizens. In other words, Britain is an important member state. Will the EU not have an interest in mitigating the effects of a Brexit, both for its own sake and for the British? Yes – but the EU cannot make an agreement that is so beneficial to the British that other EU countries want to go the same way. The EU has a political interest in warning other countries that are also staggering in their love for the EU.
Conversely, the other EU countries have an economic interest in not being hit too hard, but economic considerations are likely to come to the fore in favor of the political. Brexit can simply be the event that determines the survival of the European Union.
Can the British then change their minds? Yes – you can’t actually exclude that. The British population will probably also have to vote on any negotiated withdrawal agreement once it becomes available in a few years. If they disagree with the conditions for leaving the EU, new negotiations on the UK’s continued affiliation with the EU can come. It is complex, long-lasting and completely unpredictable.
The domestic policy is also complex, and it can potentially affect the outcome. Indeed, Scots who want independence from Britain are interested in the election result being a British exit from the EU, paving the way for a new Scottish referendum to leave the UK kingdom with the clear aim of negotiating to remain in the EU.
Therefore, it may be a sham that Scots who want to release Scotland from the kingdom opt for tactical voting for Brexit, thereby provoking a new referendum on Scotland’s affiliation with Britain. High game, but the Scots have always been a brave people.
In fact, it is very simple: if the British agree to stay in the European Union, everyone will have a sigh of relief. The pound and the shares will increase and everything is good again. If, on the other hand, the British are in favor of withdrawing from the EU, we are very likely to see a somewhat larger share price for especially British, but also for European equities.
The market reaction after the referendum will, of course, depend on how much the financial markets have already calculated. European equity markets have fallen by 12 percent since the beginning of the year, while the US shares have remained largely unchanged during the same period. One can, therefore, argue that the risk of a Brexit is already partly calculated in the financial markets. I agree with that, but my assessment is that a few of the players in the financial markets really believe that this is a realistic scenario. Therefore, I also fear a major negative market reaction in the case of Brexit.
In my view, we have a large but asymmetrical drop-out room for the shares. Namely, a minor increase if the British vote to remain in the EU and a larger fall if they vote to retire. My recommendation to the investors I am talking to is, therefore, to keep the risk in their portfolios at a moderate level until the referendum on June 23. I also believe that investors should look at the composition of equity investments. Generally, one should not have too much share of its equity investments in European equities, including Danish, and specifically one should not have investments in English companies that are domestic-oriented.