The big unknowns behind Brexit, UK at a crossroads

UK citizens find themselves at a historical point, a vote to opt out of the union would affect Britain and the rest of the continent in an unseen way. The lack of understanding of what a Brexit could really mean is driving investors and businesses into uncertainty. Considering Europe’s critical state after suffering from a eurozone crisis where Greece almost slipped away, not much is taken for granted anymore. Moreover, the rise of anti-establishment movements worldwide is questioning the authority of governmental institutions significantly.

The upcoming UK referendum reminds us of the one in 1975 in which yet-to-be prime minister Margaret Thatcher campaigned in favour of staying in the European Common Market. Today we live in another world and after holding back a Grexit last summer, fears of a Brexit are lighting up for European leaders.

The two exits are representative of the EU’s massive struggle in maintaining its core foundations but are also inherently different. Greece’s risk of defaulting stands at opposite ends of the UK’s desire of sovereignty and personal prestige. As the executive director of War on Want (a British anti-poverty charity), John Hilary, put it: “In comparison with Greece, Britain is voting with an incredible privilege.” He refers to the fact that Britain’s economy is growing, ATMs are well provisioned and no unproportioned scale of refugees is coming in the country.

Much will depend on the turn-out of the day and whether the undecided will pick a side or abstain from voting. There is no electoral threshold needed, which makes predictions less reliable. Moreover, the sudden death of Jo Cox by a right-wing extremist could result in a positive impact on the stay camp and diminish the advantage points of the leave front in the polls.

However, the polarisation visible in UK households is nurturing uncertainty on the financial markets. Some people are calculating the risk and taking measurements to prevent major losses. An internal source at an American investment bank confirmed that a substantial amount of investors has reduced their allocations to the UK as they consider the risk to be big enough. The fundamental point is that if the British public decides to stay in, investors have a reasonable idea of what is going to happen. Namely, the reforms Cameron and Brussels agreed upon will be implemented, whether those are considered by the British to be satisfying or not. On the other hand, if the results reveal a demand to opt out, there is no arranged plan as there is no precedent for a country leaving the union. The UK would be entitled under EU law to a two-year negotiation period and that is likely to keep markets unstable for a while.

Brexit arguments and potential gainers

Former economics correspondent for Reuters, Alan Wheatley, stated that in Britain there is “a visceral deep mistrust of this notion of a United States of Europe.” Although scepticism has always been higher on the British isles, Wheatley also claimed that the UK acts as “a balancing force politically inside the EU” controlling the hegemony of Germany and France. Still, the UK was not a founding member and some accuse the country to hold a misplaced superiority. Professor in European Law and Governance, Laurens Jan Brinkhorst, wrote that “for many years Britain has been suffering from post-imperial depression.” Moreover, Wheatley warned that “many people will vote not on the facts but on their emotions.”

Brexit supporters stress that the deal between Prime Minister Cameron and the other EU nations did not live up to expectations and will keep the UK strangled to the continent’s wishes. The relatively small changes in terms of in-work and child benefits for European immigrants do not stretch far enough for many conservatives. On the other hand, some believe the deal is already harmful to European integration as it allows one country to have special concessions, which can be considered unfair towards other member states.

The free movement of people in the EU also implies that the UK has no control over the amount of European immigrants entering the country, a percentage that has been increasing significantly over the years. A Brexit scenario would allow Britain to install a selective migration from the EU, while looking for other talent outside the EU.

The Brexit campaign has focussed on migration, borders and security but considering the strategic importance of the city of London also economic arguments have been forwarded. The idea that Britain is wasting its resources by subsidising other European nations is a widespread but also superficial observation. Numbers and figures can contradict each other due to the fact that complex layers of investment, budget contribution, funding and trade percentages all need to be taken into account. How much money is given to the EU and how much is generated from it, is not a straightforward question as it seems. As argued by Robert Cole, business journalist at Reuters, “the economic debate is unprovable from both sides.”

Yet, the argument held up by Brexit supporters that trade relations with other nations (specifically the emerging markets) will be facilitated outside of the union is hugely debatable. As pointed out by an analyst at a large German bank: “Why would an emerging economy invest time and money in creating separate agreements with only one country if it can have common deals by trading with 500million people at the same time?”

Another keystone that captures Brexit votes is the call for less (or none) EU legislation and regulation. Following the example of the US, Britain has always had a more flexible regulatory regime with less state-control than for instance France. However, after the recent global financial crisis, governments and institutions have enforced a large proportion of regulation to prevent new bail-outs. Brexit campaigners want to do away with EU regulation and decide for themselves which rules to follow, leaving no strings attached. This scenario could definitely appeal to some investors that benefit from less state interference, such as hedge fund managers. As opposed to banks and insurance companies, hedge funds operate in a different way and prosper from market volatility and economic shocks. In fact, some big names in the hedge industry have admitted to actively support the campaign and made considerable donations to the Brexit front.

Immediate vs. long-term effects of a vote in favour to leave

There seems to be a large consensus on the short-term consequences of the referendum. If Britain votes to stay in, the sterling might open strongly the next day and markets would normalise whilst erasing political concerns. A strategist at a major American bank explained that since the announcement of the referendum last February the foreign exchange market has been focussing entirely on Brexit and that data regarding the British economy has not been influencing the strength of the sterling at all. Once this option is cleared out, the markets could adjust and trade again against weak commodities, issues in China and US growth. On the contrary, if the British public votes the leave, panic will invade the markets immediately. “We know we could leave but people are not fully prepared for it,” said Keith Pilbeam, foreign exchange expert at City University. Due to fears of disintegration the sterling would depreciate tremendously in a short time, likewise the euro.

The immediate effects of an exit vote would be quite harsh for both Britain and Europe but the matter at stake is how long markets would be subjected to instability, which they notoriously do not like. “Any unknown has to be feared,” said a trader based in a London firm. Negotiations on how the Brexit would be officially implemented could take a while, but in the meantime the UK would suffer from a drop in foreign direct investment flows that are core to the British economy. “Those investors will come back when UK assets are cheap enough but the problem is I do not know what point cheap enough is,” affirmed a strategist from an American bank. Waiting for a bargain does not sound like a welcoming alternative and although a weaker currency would initially stimulate exports, it would also go hand in hand with a higher inflation and ultimately result in job losses. The same strategist summarized Brexit as a “jumping off the cliff, hoping to build some wings on the way back.”

“Joining the euro or not joining the euro is relatively minor, but leaving the EU is a completely different thing,” stated Pilbeam. The long-term effects of a Brexit are mostly a guess, but as these sort of negotiations never occurred in the EU before, anything could potentially happen. Trade agreements between the UK and the EU will have to be redefined and the technical aspects could become a battle field. Marino Valensise, head of multi asset group Baring, wrote in Financial News: “The EU would not want to signal to other member countries that there is an easy way to ‘leave and renegotiate’.” For Pilbeam the uncertainty consists of exactly that: “If I would be France, I would boost our exports to Germany and play tough with the UK. We will not have much negotiation power, we would have left them.”

“Do we need them more than they need us? I suspect we do,” continued Pilbeam. He argued that free movement of capital is key to British exports and that London’s privileged position in the financial world could quickly shrink. According to a study led by Deloitte, 40% of the  top 250 global companies have their main or European headquarters in London. Even if those companies would move only partly to other capitals in Europe due to increased administration costs, it would be a harmful deal in which the city is set to lose significant business. Moreover, the UK would be restrained from receiving EU funding for regions and research. Pilbeam also suggested that a Brexit could indirectly devalue the London property market, which is at unsustainable high levels because of too low interest rates.

Even so, the power of the city of London should not be underestimated. A trader at a London firm underlined that the talent pool in London is not the same elsewhere and the amount of financial infrastructure does not exist in Frankfurt or Paris, but could be created in case. It is also important to keep in mind that a referendum is not legally binding and if negotiations would fail a second vote, yet very unlikely, could be arranged. However, the immediate damage to UK businesses would have happened already and as put forward by an analyst at a German investment bank: “You already opened the bottle, so the gin is out.” Whether the risks of a Brexit really outwear the benefits is a debate that can unfortunately only be assessed once it gets to that point.

The repercussions on British politics    

More than anything else, the conservative party is playing an in-house poker game that will by definition leave winners and losers at the closing of the referendum. In 1975 it was the Labour party that found itself divided, now the political spectrum has turned upside down. Mr. Cameron is dealing with opposition from inside his own party and recently had to defend himself from controversy of his involvement in the Panama Papers’ scandal. Still, Cameron has proven before that he is a strong and convincing politician during campaign season.

Boris Johnson’s support to Brexit has been viewed by many as a stab in the back of his own city. However, his decision does not originate from an economic argument but is triggered by political opportunity. In fact, UK internal politics could be severely shaken if Cameron’s deal gets rejected by the voting public. Not only is it likely that the Prime Minister would be asked to step down, but independent movements pro EU could experience an important revival. The Scottish National Party would see a new opportunity to raise its devolution demands and cause long-lasting trouble.

Either way the referendum goes, the conservatives are facing a serious clash that could lead to a break-up of the party. Scenarios differ sharply: some say the divisions are too big to heal and a split is the only way, whereas others believe Mr. Cameron might be shaking hands again with Brexit supporters in order to save the party. What is for sure is that the British public has a chance on June 23 to radically change course and although a vote in favour of Brexit would be a step into the unknown, it is perhaps for some a tempting challenge to pursue.