BREXIT: Vote likely to trigger years of uncertainty for UK

• Longer term, whether the Treasury’s repayment capacity would decline is less clear. A vote to leave the EU would likely set in motion years of uncertainty over Britain’s trade arrangements with the EU, the legal status of foreign workers in the UK and British workers in the EU, the attractiveness of the UK as a financial center and destination for investment, and the UK’s own unity. If over time these factors resulted in higher interest rates, lower growth and a weaker currency, driving up Treasury yields, this could erode the government’s capacity to pay its debt, putting downward pressure on the ratings.

• A vote to remain in the EU, a scenario we view as better for the UK, could lead to a relief rally in the markets and an eventual economic recovery. Nevertheless, popular frustration among the ‘Leave’ voters over immigration, European regulations, and the cost of EU membership would likely remain. How the UK addresses these issues will be important to the future direction of the country.

Near term implications of a vote to leave

A vote to leave the EU would likely exacerbate two trends that are already apparent: asset price volatility and economic deceleration. Uncertainty over the outcome of the referendum has already resulted in greater risk aversion. This is apparent in volatility in the UK gilt market, equity indices and property markets, and bank stock prices. The exchange rate has been especially affected, with the dollar-sterling, euro-pound and trade-weighted exchange rates having depreciated sharply. (See Exhibit 2)
The Bank of England estimates that approximately one-half of the 9.0% trade-weighted depreciation over the six months to mid-May were attributed to the referendum. Options prices point to the risk of further sterling depreciation following the referendum, judging from the difference between implied volatilities from call and put options by currency and maturity. The cost of hedging against sharp swings in the value of sterling over the next month has jumped to its highest level in more than seven years, to nearly 20%. Unlike sterling, short-term market interest rates appear to have moved little in response to the referendum. Nevertheless, implied volatilities for shorter-term interest rates are high for maturities surrounding the date of the referendum, suggesting that an increase in risk premiums following a ‘Leave’ vote is a reasonable assumption.
Real economic indicators also point to a slowdown as greater uncertainty weighed on activity. Quarterly GDP growth softened in the first quarter of 2016. Growth of gross value-added slowed to 0.4% on a quarterly basis. Of this, services grew by 0.5%, while manufacturing, construction, and other production indicators were in negative territory. On the external front, exports declined over the second half of 2015, and the current account deficit widened to 7.0% of GDP. The deficit is largely due to lower income on UK-owned foreign assets, as well as slowing exports.
Some of this deceleration may be attributed to slower global growth. However, there are also indications that uncertainty related to the referendum may be weighing on activity. Consumer confidence indicators are showing a more pessimistic view on the state of the economy, and this is likely to lead to increased savings and lower consumption. Business surveys are also showing that corporate uncertainty has increased, and the number of firms that plan to limit future investment has risen.
However, even in the presence of greater asset price volatility or a higher risk premium, we would not likely downgrade our ratings on the UK. In spite of the credit weaknesses – high public sector debt and a weak external position – the UK’s credit strengths are formidable. As a large, high income economy with strong institutions, the UK has deep capital markets, a long average public sector debt maturity profile, and sterling is a global reserve currency. These strengths should offset short-term asset price weakness or slower growth in the immediate aftermath of a majority ‘Leave’ vote.

Longer term implications of a vote to leave

A protracted period of asset price volatility and economic deceleration would be detrimental to productivity growth and therefore output. Of even greater concern are the longer term implications of a vote to leave the EU. Such an outcome would set in motion years of uncertainty over Britain’s trade arrangements with the EU, the legal status of foreign workers in the UK and British workers in the EU, the attractiveness of the UK as a financial center and destination for investment, and the UK’s own unity. If over time these factors resulted in higher interest rates, lower growth and a weaker currency, driving up Treasury yields, this could erode the government’s capacity to pay its debt, putting downward pressure on the ratings.
Article 50(3) of the Lisbon Treaty states that a ‘Leave’ vote would trigger a two-year limit for the withdrawal agreement to enter into force. The European Council can extend this period, if it acts unanimously, and there is no limit to the length of the extension. In reality, it would likely take as long as 7-10 years for the UK to fully extract itself from the EU treaties and adopt alternative legislation.
As the Treasury argued in April of this year, the UK would be expected to be in a worse position under three of the most likely alternatives to EM membership. These are: (1) become a member of the European Economic Area, like Norway, (2) enter a bilateral agreement with the EU, like Canada, Switzerland or Turkey, or (3) become a member of the World Trade Organization, but with no specific agreement with the EU, like Japan, Brazil or Russia. The Treasury concludes that all three arrangements would make the UK worse off.
If it became a member of the EEA, the loss, relative to continued EU membership, would be between 3.4% and 4.3% of GDP by 2030 according to the Treasury’s estimates. If the UK entered a bilateral agreement with the EU, the loss by 2030 would be between 4.6% and 7.8% of GDP. If it became a member of the WTO with no specific agreement with the EU, the loss would be between 5.4% and 9.5% of GDP. Even if these were no more than estimates, a ‘Leave’ vote would render the UK economy less open to trade and FDI than if it remained an EU member. A more closed economy would necessarily result in lower productivity growth, and therefore lower GDP growth. After all, the EU is the UK’s biggest trade and investment partner. About 44% of British exports go to the EU, while 53% of British imports come from the EU. In terms of investment, 48% of FDI in the UK comes from the EU, while 40% of UK FDI overseas goes to the EU.
One of the notable impacts of a vote to leave would be the potential change in the visa status of EU citizens working in the UK. According to a recent study by Oxford University’s Migration Observatory, approximately three-quarters of the 2.2 million EU citizens working in the UK would not qualify for visa requirements, if the UK were to leave the EU and adopt current visa requirements for non-EU overseas workers. The British government would likely ease its immigration requirements in the event of separation from the EU. However, firms would likely struggle to find staff, if the visa requirements were to change, as many in the ‘Leave’ camp are pushing for.
Another issue is the impact of a leave vote on the attractiveness of London as the financial capital of Europe. In the event of a ‘Leave’ vote, the City of London would suffer losses from a lower share of euro-denominated finance transactions. One of the reasons that the City of London is a leading global financial center is that the UK enjoys direct access to Eurozone finance. An EU departure could cut off access to the Eurozone payments system, including the swap arrangement between the European Central Bank and the Bank of England. Resolution of cross-border banks could be more challenging, and the risk of capital flight would likely rise. Although the Bank of England’s May 2016 Inflation Report asserts that UK bank stress tests have demonstrated that the largest UK banks are resilient to shocks, Bank of England Governor Carney has said that the referendum poses a risk to domestic financial stability.
There would also be political repercussions of a UK departure. The referendum would be likely to determine the future of David Cameron: he has campaigned hard to remain in the EU. However, even in the event of a ‘Remain’ victory, he may fend off a leadership challenge and avoid a confidence vote by the backbenchers, perhaps by holding an early vote on the renewal of the Trident nuclear deterrent.
The prospects for Scottish independence is another area of uncertainty. Nicola Sturgeon, First Minister of Scotland and leader of the Scottish National Party, has claimed that a ‘Leave’ vote would “almost certainly” trigger a second referendum on Scottish independence, following the first referendum in September 2014. However, the SNP would likely wait before announcing a second referendum until a clear majority of voters favored separation from the UK. A UK departure from the EU would also create uncertainty for Northern Ireland. EU transfers are critical for its agricultural sector, the Republic of Ireland is Northern Ireland’s largest export destination, and Northern Ireland is a large net beneficiary of EU funds.

Implications of a vote to remain

In the event of a vote to remain in the EU, a crisis will likely be averted. The markets are expected to stabilize or rally and the economy should eventually resume a faster pace of growth. However, popular frustration in Britain is likely to continue over three main issues: immigration, EU regulations and concerns about UK sovereignty, and the cost of EU membership. The increasingly heated debate over the referendum suggests that for a significant portion of the British public, membership of the EU has failed to meet their expectations. Concessions to this group in the form of tougher rules for migrants, for example, could materialize. However, the reality is that the majority of migrants to the UK come from outside of the EU. In fact, new EU regulations have been delayed and existing ones have been dismantled. Moreover, the cost of EU membership for Britain is only a net GBP 10 billion per year, 0.5% of GDP. For Britain, communicating this to the public and handling its relations with the EU will be important to the future direction of the country.