United-Kingdom : Why the UK should not call it quits

Market analysis - 2/15/2016

As we navigate the shoals in 2016, we must not overlook the risk of Brexit and its many political ramifications.

Brexit (British exit) is a take on Grexit, a term coined in the summer of 2015 during the Greek crisis. It refers to the country's potential exit from the European Union (EU). The Conservative and Labour Parties are currently neck and neck in the polls on this issue (see chart below).

Part of the reason this topic is in the news is because Prime Minister David Cameron, in his re-election campaign, promised to hold a referendum by 2017 on whether or not the UK would remain in the EU. This promise was driven by the rising influence of eurosceptics both in his own Conservative Party and among the opposition, including the anti-EU United Kingdom Independence Party (UKIP). Cameron's political tactic has two objectives:

> To determine whether or not the British people wish to remain a part of the European experiment
> To reform certain aspects of the European Union


Cameron has begun negotiations with the EU in a bid to stave off Brexit. He hopes for a breakthrough at the summit set for 18-19 February, so that the referendum could be held as early as June. He feels the sooner the referendum takes place the better, in view of growing immigration-wary sentiment (see charts below).


Cameron also submitted four major demands to Donald Tusk, the President of the European Council. Tusk responded by laying out proposals that could serve as a starting point for the upcoming talks:

1.    Sovereignty
Cameron's objective: In order to steer away from a political union, member states could opt out of the 'ever closer union' clause. Also, national parliaments should have more influence over EU legislation.

Tusk's proposal: Given the UK's unique situation, it would not be required to take part in further political integration.

2.    Competitiveness
Cameron's objective: In order to complete the single market, the free movement of capital is required and the burden of EU regulations on businesses must be eased.

Tusk's proposal: No problem. One of the EU's priorities is to further develop the internal market and expand it to include services and digital.

3.    Currency

Cameron's objective: The euro should no longer be considered the EU's only currency. This means that any policy agreed by eurozone Member States would not be binding upon other states.

Tusk's proposal: Any measures implemented in response to an emergency or a crisis and intended to preserve the financial stability of the eurozone will not entail budgetary responsibility for Member States that do not use the euro.

4.    Migration from the EU
Cameron's objective: EU nationals who move to the UK would have to live there for four years before qualifying for certain work benefits.

Tusk's proposal: An 'emergency brake' could be applied to migrant benefits. In addition, measures limiting a high influx of workers could be applied in exceptional circumstances.

Key points:

> Technically, it is much easier for a country to leave the European Union than the eurozone, since the domestic currency still exists. And technically, Article 50 of the Treaty on European Union allows a Member State to leave the EU; the Member State must inform the European Council of its intention to withdraw.
> Politically, among the major countries, Germany is ready to give London some flexibility so that the European Union remains intact. Germany does not want to be reduced to a one-on-one partnership with France and prefers to maintain the rigorous structure currently in place (see chart).


What are the consequences?

> Researchers have been attempting to identify the consequences of the UK leaving the EU for the past 20 years. No one has come up with a reliable estimate of the economic cost of such a move for the UK or for the rest of the EU.
> While the studies differ in their conclusions, they all agree on the areas that would be affected. The first is trade, since 42% of the UK's exports and 52% of its imports are with the EU (see charts below). The consequences thus depend on what sort of trade deal the UK is able to negotiate with the EU. The UK could find itself in the same situation as Norway, which is not part of the EU but still contributes to the European budget and complies with its regulations in exchange for access to the single market. Alternatively, it could end up like Switzerland, where access to the single market is negotiated sector by sector.


> Europe would lose one of its three great powers, one of the largest financial centres in the world, the USA's main diplomatic partner in Europe and one of the only European countries that maintains a large standing army. The Member States that would be most affected by Brexit are the Netherlands and Ireland. They each have very close trade and financial links with the UK. Their economic policy is also quite close to London's. Belgium, Portugal, Luxembourg and Cyprus also stand to lose out significantly.
> Within the UK, England's relationship with separatist, europhile Scotland could deteriorate. A second referendum on Scottish independence could take place. The City, which is the largest European financial centre (see charts below), would lose a large volume of business as eurozone transactions shift to European financial institutions.


On 12 June 2015, Standard & Poor's, the only rating agency that still has a much-valued AAA rating on the UK, downgraded its outlook from 'stable' to 'negative', noting that the referendum on leaving the EU was "a risk to [the country's] growth prospects". Moody's, for its part, warned that Brexit could lead it to cut its credit rating on the country. Voters' rejection of the EU would lead to capital flight and undermine the pound.

The UK will have to get past the referendum for the pound to return to strength. Our core scenario is built around several strong assumptions: key interest rates in the USA will be raised, the message from the Bank of England will become less accommodative, money creation in the eurozone will expand and the UK will remain in the EU. If all these assumptions hold – an admittedly tall order – the GBP/USD exchange rate could reach around 1.57 by the end the year and the EUR/GBP pair could slip to 0.65.


The political risk premium associated with Brexit can be estimated by the growing gap between the exchange rate and the real yield spread, which is around 10-15% for the GBP/USD and EUR/GBP pairs (see charts above). We clearly underestimated the impact of this political event on sentiment among forex traders. It is probably better to steer clear of the pound until the political fog in London has lifted.



Comments :

> The
GDP growth rates shown above are actual for 2014 and projections for 2015 and

> Each country's weighting is based on its GDP in US dollars as calculated by the World Bank.
> Contributions to global expansion are calculated by multiplying the GDP growth of each country by its weight. The sum of the contributions works out to 3.4% for 2016, a good estimate of this year's global GDP growth.