On June 23rd, the United Kingdom will have its referendum on whether to remain in or leave the European Union (EU). Not long ago, the polls projected a tight win for the “remain” camp led by Prime Minister David Cameron’s conservative government. More recent polls, however, give the “leave” camp a slight lead. Regardless of the outcome, the UK’s EU referendum is too tight to call, and the views of the voters and the parliament members are too far apart. This virtually ensures protracted economic uncertainty, market volatility, and political risk.
The “leave” campaign’s persistent focus on the EU’s costly, excessive bureaucracies and over-inflated security concerns has less to do with facts than flawed perceptions. Nevertheless, the campaign has been effective. Yet, any disruption ahead of the referendum – whether a terrorist attack or political debacle – could quickly shift the vote either way, as evidenced by the murder of British Labor politician Jo Cox only a week before the referendum. Cox advocated for the rights of refugees – an issue that the “leave” camp has exploited – and supported the UK remaining in the EU. While her death calmed the excesses of the referendum and resulted in the campaigns being suspended for a few days, the referendum is scheduled to go ahead as originally planned.
In 2013, Cameron pledged that, should the Conservatives win the parliamentary majority in the 2015 election, the government would negotiate more favorable terms for the UK’s membership in the EU before holding any type of referendum – essentially forcing Brussels into a corner, while reaping political benefits at home from improved membership terms. The option for a Brexit also helped to cement Cameron’s re-election as Prime Minister and his parliamentary majority. But the gamble came with a price: the Brexit risk.
Cameron is one of the political beneficiaries of the 2008-2009 global crisis and of Europe’s spring 2010 debt crisis. Cameron’s predecessors, Labor government leaders Tony Blair and Gordon Brown, ultimately received the blame for the UK’s drastic economic plunge following the crises. Cameron, who assumed the Prime Minister position in 2010, successfully became the leader of a coalition uniting the Conservatives and the Liberal Democrats.
Since then, Cameron has eagerly worked to purge the political system of Thatcherism and to build "compassionate conservatism," as he terms it. In other words, Cameron championed fashionable social causes, such as same-sex marriage, while also imposing austerity measures to reduce government deficits, including the implementation of large-scale changes to welfare, immigration policy, education, and healthcare.
In practice, these measures have failed. The UK’s national debt exceeds $2.3 trillion (84% of the GDP) and is likely to continue to climb, despite the efforts of UK Chancellor George Osborne. Recently, the IMF warned that maintaining deficits and debts at the current levels "would constrain the space to respond proactively to future large negative growth shocks."
At the surface, the UK’s economy expanded steadily until the referendum uncertainty and benefited from the Eurozone’s fragile rebound. Despite the possibility of Brexit and its accompanying downside risks, unemployment in the UK fell to 5.1 percent in late 2015 in what the IMF termed a “broadly positive baseline forecast.” Now, however, growth is predictably below trend, thanks to fiscal consolidation and the uncertainty accompanying the Brexit threat.
Before the UK’s EU referendum, the UK’s medium-term real GDP growth was projected to hover around 2 percent until the early 2020s. Inflation is expected to rise to about the same level in the late 2010s, despite expected rate hikes to 2 percent by 2020. However, these projections presume continued economic certainty, market stability, and low political risk. In the coming months, the realities may prove to be the reverse.
Last April, the UK Treasury published a report about the probable annual impact on the UK after 15 years should it leave the union. The report estimated that Brexit could cause an almost ten percent loss of GDP, a substantial dip in household wealth, falling exports, rising prices, and a possible recession. Much of the aforementioned depends on which of the three possible scenarios the UK pursues. (1) Would the UK retain its membership in the European Economic Area (EEA), like Norway? (2) Or would it opt for a negotiated bilateral agreement, such as that between the EU and Switzerland? (3) Or would it simply settle for membership in the World Trade Organization without any specific agreements with the EU, like Russia?
Regionally, the spillovers are varied, as measured by trade, investment, and financial linkages. Ireland, Luxembourg, and the Netherlands – Europe’s most traditionally open, free trade economies – would be among those most at risk of UK spillovers should there be a Brexit. In contrast, Russia, Eastern Europe, and France would be least affected. Internationally, the UK’s largest trade, investment, and financial partners – particularly Hong Kong and Singapore, South Africa, the United States, Canada, and Australia – would see the biggest spillover effects.
Should the UK vote to cut ties with the EU, the United States would be significantly more vulnerable to financial-market volatility than a trade breakdown. From a U.S. perspective, this could result in credit tightening, impaired trade finance, and reduced lending by European banks. Recently, U.S. President Obama highlighted the backlash the UK would face should it quit the EU. The anti-EU former mayor of London, Boris Johnson, responded that the UK would not take lectures from a “part-Kenyan” president. The Brexiters exploited the incident skillfully in their “Don’t Be Bullied By Barack” campaign.
China, unlike the United States, is significantly less exposed to negative impacts due to a potential Brexit. As Beijing has only begun critical financial reforms, it is not as vulnerable to British portfolio flows or bank claims. However, Hong Kong, with which China shares vital financial linkages, is highly exposed to Brexit risks. The UK’s exit from the EU could reduce the benefits to China in deepening economic cooperation between London and Beijing. In currency markets, a Brexit shock could boost traditional safe havens, including the U.S. dollar and the Japanese yen; however, it would penalize the British pound and the euro.
The British vote to remain in the EU would ultimately translate into greater EU integration and would see UK exports thrive and relief fuel the markets. Should the Brits vote to leave the bloc, negative feedback effects would contribute to the EU’s further disintegration, while UK’s exports would plunge, and the nation could face stagnation and recession.
For all practical purposes, the post-referendum period may prove more uncertain than conventional wisdom presumes. Even if EU proponents triumph, the ensuing destabilization could push Europe into a series of economic, political, social, and security crises. The EU would eventually prevail, but it could morph into a customs union. Conversely, if the Brexiteers win, Europe could still prove resilient and further the case for integration, though far more slowly. Countries with powerful core economies, such as Germany, would see an increase in their policy making influence amid a bloc that could become more akin to a protectionist European fortress.
Finally, the proportionality of the referendum matters greatly. However, if there is a marginal victory and a low turnout, Cameron will not be able to push a “Leave” Act through parliament, and may not even try. Within this framework, the decision to remain or leave the EU could be greatly complicated by the MPs who oppose a divorce from the EU.
Ultimately, the UK’s various referendum scenarios, the tight EU race, and the democracy deficiencies between the voters and the MPs indicate that the likeliest post-referendum path will result in more economic uncertainty, market volatility, and geopolitical risk. Unfortunately, this would come at a time when the global economy is more fragile, exhausted, and vulnerable than it has been since 2008, when global growth rate was still 3.1 percent.
Last April, the IMF again lowered its estimate for global growth to 3.2 percent, which is likely to fall further as a result of series of anticipated economic, political, and security shocks in the summer and fall. That, in turn, increases the likelihood of broader stagnation in advanced economies and slowdowns in emerging economies. Of course, UK’s uncertainty is only one factor in the big picture, but as the fifth largest economy in the world, its future matters. In this sense, before the actual referendum has occurred, the worst may have already happened.
Dr. Dan Steinbock is the founder of Difference Group and has served as research director at the India, China and America Institute (USA) and visiting fellow at the Shanghai Institutes for International Studies (China) and the EU Center (Singapore). For more, see https://www.differencegroup.net/