Bank of England governor Mark Carney is the latest high profile figure to wade into the EU debate, saying the UK was in some respects “the leading beneficiary” of the single market, and that EU membership was an important factor in the UK’s strong economic performance over the past four decades. He came under immediate fire, however, from former chancellor Nigel Lawson, who said his remarks were “regrettable”.
This episode illustrates what an emotive subject this is - you rarely hear it analysed in a dispassionate way. Below I aim to do just that, looking at the facts about our EU membership and some potential scenarios if the referendum does result in ‘Brexit’.
Given the Conservatives have promised a referendum by the end of 2017, you might wonder why we are covering this topic now. The answer is that I believe it could happen sooner. The UK’s six-month presidency of the EU is scheduled for the second half of 2017. If this coincided with the referendum, it would prove at best embarrassing, and at worst unworkable. It is therefore quite possible the referendum could take place as early as next summer.
What do the polls say?
Polls suggest Brexit is a real possibility. At the time of writing, the most recent poll by YouGov puts the ‘In’ camp at 38%, down 6 percentage points since June, and ‘Out’ at 40%, up 6 percentage points. One suspects the vote to stay in would increase if David Cameron was seen to have made significant progress with his renegotiations, but the government is yet to set out clearly what it wants to achieve.
Another way to assess the probabilities is to look at the betting markets. At the time of writing the best odds available are 8/15 that the UK stays in the EU and 2/1 that we leave. This implies a roughly 33% chance of Brexit.
What are the main areas of debate?
The issues at hand can be summarised as follows:
- Costs of membership – is the cost accurately stated and is it too high?
- Regulation – is red-tape emanating from Brussels putting UK businesses in a straitjacket?
- Immigration – what are the facts regarding immigration from EU countries and what is the impact?
- Trade and investment – how important a trading partner is the EU and what would be the impact if we left?
Let’s deal with each of these in turn:
Costs of membership
Members’ direct contribution to the EU budget depends on the size of their economies, their VAT receipts, customs duties and levies. The chart shows the UK’s net contribution, after taking into account money received by the UK public sector from EU institutions (for example under the Common Agricultural Policy) and the rebate negotiated by Margaret Thatcher in 1984. The net cost of £9bn or so this year represents around 0.5% of GDP. Given that the Confederation of British Industry suggests the direct net economic benefits of membership to the UK are between £62bn and £78bn annually, this seems like a good deal. However…
Some claim there are substantial indirect costs of membership. For example, lost jobs (as a result of immigration), waste, regulation, resource misallocation, fraud and corruption. Economist Tim Congdon, a member of the Treasury Panel that advised the government on economic policy between 1993 and 1997, and today a prominent eurosceptic, estimates the total cost is actually as much as 11% of GDP. The truth is that there are no verifiable figures as to the total costs or benefits of membership.
The subject of EU red tape – an oftcited reason for leaving – is a murky one. Think-tank Open Europe estimate that the most costly 100 EU regulations cost the UK £33bn a year. Setting aside the accuracy of this figure for now, the problem is that these regulations couldn’t just be removed in the event of Brexit. If we wanted to retain a trade agreement along the lines of the ‘Norway model’ of being outside the EU but part of the European Economic Area – the same report estimates the UK would incur 94% of these costs.
Immigration from the EU has increased significantly in recent years, mostly down to the expansion of the EU from 15 to 27 countries. Given that free movement of labour is a founding principle of the EU, and income levels in the UK are much higher than in new EU members like Slovakia, Romania etc., this isn’t surprising. Free movement of labour works both ways, however. An estimated 2.2 million Brits live in other EU countries, which more or less balances the 2.4 million EU citizens living in the UK.
There are concerns that immigration suppresses wages in low-skilled sectors and increases unemployment among the UK-born population. But this isn’t necessarily an argument for restricting the labour market. Free movement of labour makes it easier for firms to find appropriately skilled workers and boosts the production potential (or ‘supply side’) of the economy.
A further concern is that immigration increases welfare costs. Yet, the unemployment rate amongst EU immigrants is lower than the UK average, and the number claiming benefits was 114,000 in 2014 (2.2% of the total). A study by UCL found that over the ten years to 2011, EU immigrants paid £20bn more in taxes than they received in benefits.
Trade and investment
The EU is still the UK’s largest trading partner, with 45% of UK exports going to the continent. The London-centric financial services industry has a large trade surplus with the EU, and is probably at the greatest risk from an EU exit. Some see a threat to the industry from EU regulations, such as the proposed tax on financial transactions – a threat that would be removed by Brexit.
However, one of the primary benefits to global financial firms of locating in London is that a company regulated in the UK is ‘passported’ into Europe. If this passporting is lost, these firms could decide to relocate. Deutsche Bank recently said it would consider relocating some of its UK operations to Germany if Britain leaves the EU. On the other hand Bill McNabb, CEO of US firm Vanguard, has said his firm would continue investing in the UK in the event of Brexit, and added that the EU would suffer most if the UK decided to leave.
This isn’t just about London. Exports to the EU account for 13.4% of the gross value added of the North East of England, for example; and EU trade generally makes up a greater proportion of the least prosperous regions’ trade. Furthermore if an EU exit resulted in the imposition of trade tariffs, it could lead to a reversal of foreign direct investment, for example in the automotive industry (Nissan in Sunderland, Honda in Swindon etc).
What could Brexit mean for the economy and my investments?The impact on economic output would depend on which, if any, of the models outlined was followed (about which the electorate will be given no choice), plus a host of other factors. Various think-tanks have attempted to quantify the effect, but as you can see from the chart above, the estimates vary wildly. In short, the outcome is highly uncertain.
If there is one thing financial markets abhor, it is uncertainty. We saw significantly higher volatility in currency and stock markets as last year’s Scottish referendum approached, followed by a relief rally when the ‘no’ vote became clear.
For now markets seem to be ignoring the risks. If the polls indicate an uncertain outcome in the EU referendum, we can expect more volatility.
Longer-term, the impact on investments is less clear. Share prices are eventually dependent on corporate earnings, and in the event of a significant hit to GDP, this could have a knock on effect to stock markets. On the other hand, if Brexit proves positive for the economy, markets could rally.
In summary, given voters’ tendency to vote for the status quo in referendums, I believe the chances of an ‘out’ vote are relatively small. The most likely scenario is that David Cameron manages to convince the electorate that he has successfully renegotiated the UK’s terms of engagement, and with cross-party support, wins a resounding vote to remain in the EU.
However, it’s important for investors to keep a close eye on such a potentially important event, and we will continue to monitor further developments. We will keep investors informed of our latest views on our website and in the Investment Times.
It is often assumed that in the event of Brexit, the UK could choose to be like Norway, Switzerland or Turkey; in Europe but not in the EU. However, these countries have never been in the EU - there is no historical precedent for a country leaving.
European Economic Area
The Norway option. The EEA is a free trade area comprising the EU, Norway, Lichtenstein and Iceland.
Pros: Direct contribution to the EU would fall by around 17%.
Cons: UK would still be subject to EU regulations but would lose its seat at the negotiating table.
European Free Trade Association
The Switzerland option. As above but EFTA also includes Switzerland.
Pros: not subject to EU regulations, budget contribution falls by c.60%.
Cons: would need to negotiate bilateral agreements to access the single market in specific sectors.
The Turkey option.
Pros: retain some benefits of membership, mostly with respect to trade in goods.
Cons: outside the single market, with a very severe impact on services sector.
There are many other options – the UK could set up its own free trade agreements with the EU and other nations, or simply rely on the World Trade Organisation’s ‘most favoured nation’ status, under which it would be free to set its own terms of trade.
The value of investments can go down in value as well as up, so you could get back less than you invest. It is therefore important that you understand the risks and commitments. This website is not personal advice based on your circumstances. So you can make informed decisions for yourself we aim to provide you with the best information, best service and best prices. If you are unsure about the suitability of an investment please contact us for advice.