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Brexit and Its Key Implications

Founder and CEO, Transfin.
Jul 18, 2016 4:30 AM 13 min read
Editorial

UK’s recent vote to leave the EU has astounded everyone. The upset was swiftly followed by the PM stepping down and a scramble for leadership within the Conservative party. Clear fissures are evident on the Labour’s front as well. Aside from greatly disrupting Britain’s political and economic landscape, the vote has challenged the very idea of a united Europe.  

 

34m UK residents voted on June 23rd, with a marginal majority opting to exit the EU, a politico-economic union of 28 nations and the world’s biggest single market. Britain is the EU’s 2nd largest member state by GDP, exporting 45% of its goods and services to the EU single market while sourcing 53% of its imports from the same. The inter-dependencies only begin here. There are c. 3m EU nationals living in the UK and over 1.2m British citizens living in various EU member states. The EU originates half of UK’s FDI inflows and holds 43% of its overseas assets. Moreover, UK’s foreign trade and investment treaties are all framed under the European umbrella it now abandons. For over 40 years, Britain’s laws have been influenced directly or indirectly by Brussels, regulating key areas such as its fishing activity, its environment policy, foreign affairs, trade & investment, financial services, immigration and so on.

 

Divorcing from this marriage while negotiating terms of exit and future engagement may take years. Britain would need to reassess its relations with the rest of the world, now as a stand-alone nation and not part of the world’s largest trading bloc. India has an incredible opportunity to leverage its position, identify potential areas of cooperation and enhance its relationship.

 

Short-term effects

 

The immediate aftermath has been chaotic across multiple fronts – upheaval in domestic political leadership, record weakening of the sterling, market volatility, downgrade of credit ratings and Scotland & Northern Ireland expressing their latent urge to separate. London’s position as one of the world’s principal financial centres is under threat. Major institutions are nervous about the status of their “Financial Passporting” rights, and already anticipate restructuring. HSBC announced movement of up to 1,000 people to Paris. JP Morgan is considering making a quarter of its UK staff redundant. Vodafone and easyJet may move their HQ to mainland Europe. Siemens announced possible restrictions on future investments in Britain (only softening its stance later) and so did Ryanair. Major cross-border M&A deals are on hold. In spite of no immediate change in fundamentals, UK’s GDP growth estimates have been significantly revised down. The market is bracing itself for a recession.

 

Degree of exit

 

Article 50 of the Lisbon Treaty triggers the 2-year legal window for withdrawal. Invoking it commences negotiations to determine the terms of exit and the framework for UK’s future engagement with the union. The “withdrawal agreement” requires a qualified majority of the European Council (excluding the UK) and the consent of the European Parliament. Regardless of whether the negotiations conclude within 2-years, UK’s membership will cease by the end of this period unless a jointly-agreed extension is granted.  

 

The legal consequence of an exit would be the end of application of EU treaties (and Protocols thereto). Though EU laws will cease to apply, any national acts adopted in implementation or transposition of EU law would remain valid until the British Parliament decide to amend or repeal them. Experts agree that in order to replace EU law, UK would need to enact substantial new legislation that would take a sizeable bandwidth of its Parliament. The withdrawal agreement could contain provisions for gradually phasing-out EU rules to ease this process.

 

Several potential structures can be considered depending on the degree of disentanglement intended. Britain could aim to join the European Economic Area (EEA), along with the 27 other member states of the EU, Norway, Liechtenstein and Iceland. The EEA is a club based on primary EU law and treaties. Britain would remain signed up to the so-called “four freedoms”, in which people, goods, services and capital move freely amongst members. This would be the least restrictive scenario possible, but it would imply that the UK would continue making large payments to the EU budget, observe all single-market regulations and have no say in drawing them up. Moreover, it goes against the anti-immigration stance of Brexiters, as UK would have to accept free movement of people as a member of the EEA.

 

Another option would be to adopt the “Swiss” model, where Britain joins the European Free Trade Association (EFTA). The EFTA is more limited in scope vis-à-vis the EU (no customs union, exclusion from EU law regarding agriculture and fisheries – which would be favoured by Brexiters). Britain could sign various bilateral agreements with the EEA (like Switzerland) for additional freedoms on the side. This option will again result in getting access to the EU single market but also the obligation to allow free movement of people. 

 

The most radical approach would be to start afresh and attempt a new relationship away from the frameworks of the EEA or EFTA. This option, although appearing flexible, is the riskiest. Britain would ideally like to maintain continued access to the EU single market but with restrictions on movements of EU migrants. Prominent EU leaders such as German chancellor Angela Merkel have already spoken against such “cherry picking”. The EU, in order to set an example, could play very hard during negotiations, stripping Britain of most of the benefits of membership if it is unable to commit to the obligations, thereby leading to sizeable economic uncertainty.

 

The new leadership will play a central role in carving out UK’s future within the EU. After 3 weeks of political drama, Theresa May, Home Secretary in David Cameron's cabinet, has been appointed the next PM. A hardliner, May is known in Brussels as a straight shooting deal-oriented leader. She has helped in carving out agreements at the EU-level on topics ranging from counter-terrorism to the refugee crisis. As a Eurosceptic supporting the Remain campaign, she is expected to be percipient to the EU's positive effects while pushing for British interests where possible. She does lack experience in the field of economic over-sight, having never held a relevant portfolio. David Davis, the newly appointed Secretary of State for Exiting the European Union who will aid May during the Brexit negotiations, worryingly lacks the same.

 

As per the new government, Article 50 may not be invoked till the end of this year, giving UK more time to set a plan in place before sitting across the negotiating table. On the other end, too much delay into next year would imply clash with election times in France, Germany, Netherlands and Italy, thereby distracting important member states from the Brexit agenda. Irrespective of the timing and outcome of these negotiations, we can look at the potential impact of Brexit through 3 themes: trade, investment and regulatory environment. It is worthwhile to assess the UK-India links within the context of the changed UK-EU equation.

 

Trade and investment

 

Although the EU’s share of total UK exports has steadily declined in recent years (from 55% in 1999 to 45% in 2014), it is still the largest overseas market for UK goods and services across all major sectors. EU-UK trade is dominated by goods rather than services (goods represent 2/3rd of UK exports and 3/4th of UK imports to and from the EU). The composition of this trade gives a good sense of potential concerns post Brexit. As per the OECD, UK is a net exporter to the EU within its areas of strength: financial services, insurance & pensions, telecom, IT, intellectual property and cultural/recreational spend. All of these services thrive on openness and connectivity and any restrictive regulatory framework going forward will generate headwinds.

 

In addition, emergence of any non-tariff barriers (NTBs) and tariff barriers would have a similar impact. UK’s membership of the EU single market helped reduce NTBs by harmonising product standards and enabling passporting regime for financial services. A singular set of standards reduces the overall cost of compliance. However, gradual regulatory divergence may increase NTBs on trade between the UK and the rest of the EU. Britain is also at the risk of paying external tariffs levied on many 3rd party countries to access the EU single market.

 

Moreover, the above points are also deterrents for the EU’s FDI inflows into UK. UK’s inward FDI position has increased significantly since its accession to the EU, amounting to £1tr stock in 2014. Half of these inflows can be attributed to EU member states. EU market access restrictions may lower the returns on investment as well as pose operational issues to foreign businesses, thereby reducing FDI in the medium term. Uncertainty over the share of future trade arrangements between the UK and EU could act as a further dampener.

 

Clearly, the possibility of reduced market access and economic uncertainty will negatively impact EU-UK trade and investment activity. UK would have to focus on its non-EU trading partners such as India to maintain competitiveness.

 

The current scale of India-UK trade is not commensurate with their close historic, political and cultural ties. We are each other’s 12th largest trading counterparties. The trade volume is sub-scale and of a composition not reflective of our economic strengths. Considering our service-oriented economies, it is surprising that the overall volumes are skewed towards goods. UK goods exports are dominated by commodities (non-ferrous metals, gems and jewellery, metalliferous ores and metal scrap) with machinery, equipment and instruments taking a smaller share. Indian goods exports comprise an increased proportion of motor vehicles, medicaments and aircrafts, and a reduced share of clothing and textiles. Marginal service exports for both include travel and transport and business services (financial services by the UK, IT services by India).

 

There may be multiple explanations for this skewness – mismatch of manufacturing strengths (disadvantage for India), competitive pressures of Germany and China (disadvantage for the UK) and lack of a comprehensive free trade agreement (FTA). India has been negotiating a FTA with the EU since 2007. After 16 rounds of negotiations, there is no end in sight. Dead-lock is on various areas such as market access to IT enabled services, business process outsourcing, knowledge process outsourcing, movement of skilled professionals, provisions for data security, cars and wine duty, agricultural commodities etc.

 

Things stand on the other extreme when it comes to foreign investment. UK is the 3rd largest investor in India after Mauritius and Singapore. It accounts for 9% of India’s total FDI inflow from April 2000 to September 2015 with investments worth US$22.5bn. According to the Bank of International Settlements, British banks’ account for more than 28% of their world exposure to India. India is also the 3rd largest FDI investor in the UK with 800+ companies. With over US$14.4bn inflows in 352 projects since 2003, we have a larger greenfield base in the UK as compared to China.

 

There is an obvious opportunity due to the potential disruption post June 23rd. The EU is currently UK’s largest trading counter-party. 7 of top 10 trading countries for Britain are EU member states. It is however unlikely that the UK would completely disconnect from the union post Brexit. An easy trading gap to be filled by India is only wishful thinking. From a geographic and appetite perspective, the EU single market would continue to be a natural and dominant partner. As Peter Lilley, Conservative MP and erstwhile Trade and Industry Secretary says “Countries succeed, with or without trade deals, if they produce goods and services other countries want”. Therefore, the trade dynamic between India and Britain should not change dramatically post Brexit unless some proactive measures are undertaken by both nations. 

 

Principally, the UK’s exit may accelerate a bilateral FTA in the medium term. One should note that trade agreements are both driven by tariffs as well as harmonisation policies. It would help on India’s part if a new accelerated FTA proposal could be drafted, focussed on specific harmonisation points contentious with the EU and where the UK, on a stand-alone basis, may be more flexible e.g. data security provisions, car manufacturing standards etc.

 

A fast-tracked negotiation process would be key as the new leadership at 10 Downing Street would be desperate to put non-EU agreements in place to calm citizens as well as the markets. One may comment that India has a position of strength when it sits across the table. But the competition is fierce. Already up to 11 countries, including India, have approached the British government to discuss future trade and investment. It will be in India’s interest to prioritise and focus on complementary issues, rather than think only in terms of an overall treaty, which may take a few more years to settle e.g. various aspects of the services sector (IT & outsourcing for India, financial & legal services and cyber-security for the UK) may be prioritised. With the Indian economy opening up FDI in defence, civil aviation, and pharmaceuticals, all areas of strength for the UK, we should take the lead in inviting British firms to invest and provide them with local assistance and support.

 

Changing regulatory environment

 

The largest casualty in the changing regulatory environment is free movement of services, which affects c. 80% of the British economy. Financial services, constituting 8-10% of GDP, has made London one of 3 global financial hubs along with New York and Tokyo. The bedrock of this status has been two-fold: light-touch domestic regulation and free access to the EU single market through “Financial Passporting”. The Financial Passport is an agreement amongst EU members that any firm in a member state can sell financial services to customers in another EU member states e.g. a London based investment banker can advise a Dutch client on a cross-border acquisition. Germany and France have long vied to make Frankfurt and Paris rival hubs but were unable to compete with UK’s light-touch regulation and first mover advantage. They can potentially push hard to disallow passporting privileges for London post Brexit to gain a competitive edge.

 

Other industries dependent on openness and connectivity are rightly nervous. The aviation sector is already predicting a slowdown, with UK passenger numbers expected to go down by 3-5% by 2020 as per IATA. The drop is driven by expected downturn in economic activity and the fall of the sterling. Air freight market is also expected to slow down due to the possibility of lower international trade. The bigger issue at hand is with regard to aviation regulation. Subject to negotiations with Brussels post Article 50, UK will face a trade-off between 2 key issues: access for UK airlines and customers to the European Single Aviation Market and policy freedom for the UK to set its own regulations.

 

Considering EU is the single biggest destination market from the UK, accounting for 49% of passengers and 54% of scheduled commercial flights, its access to the Single Aviation Market cannot be understated. Since the 1990s, EU-based airlines (including the UK) have been free to fly between any European airports without regulatory approval. UK’s routes to the rest of the world have also benefited from EU-based comprehensive agreements with 3rd countries, such as the EU-US open skies agreement entered since 2008. Depending on the terms of the exit, these agreements would potentially cease to apply to the UK, requiring it to negotiate separate bilateral agreements, but without the bargaining power of the EU. No wonder companies such as easyJet or IAG are tempted to move their HQ to inside the EU. 

 

Another sector possibly under threat would be technology, whose biggest resource (i.e. data) may come under restrictions post Brexit. Strict EU rules on privacy currently ensure online data can be transferred freely only within the EU single market or to countries which guarantee “adequate” level of protection. Under the EU approved “Privacy Shield", this protection is extended across the Atlantic. Unless Britain negotiates a privacy agreement of its own, the resulting uncertainty regarding application of the EU framework is bound to spook cloud computing firms such as Google or Microsoft to invest and grow in the UK.

 

Similar arguments of restricted market access and legal harmonisation also applies to energy (membership of EU internal energy market), telecom (application of Regulatory Framework for electronic communications in Europe; Digital Single Market initiative; Roaming regulation), pharmaceuticals (Unitary Patent System) and many other sectors. Any business which has a wide operational footprint in the UK but mainly exports to Europe will be under duress, both from reduced demand as well as diminished market access. That would include Japanese and Indian car manufacturers, Indian tech companies, German chemicals players and home-bred British exporters to name a few.

 

The last major regulatory theme having a huge effect on businesses and lives of people would be the changing immigration regime. Euro sceptics and Brexiters have long argued in favour of a UK-specific migration regime that treats EU and non-EU migrants equally. However, controlling or restricting the inflow of EU migrants goes against one of the fundamental principles of the union, which asks for free movement of EU nationals to live or work within member states. It is likely that those EU migrants already in the UK will be allowed to stay. Unfortunately, it is unlikely that the UK would allow free movement going forward due to the political sensitivity and divisiveness around this issue.

 

Most commentators align towards an “Australian-style points based system” which allows for admission based on certain characteristics such as language, qualifications, work experience and occupation, such as the one already in force for non-EU migrants. However, that system mainly covers highly skilled migrants and almost 3/4th of EU migrants would fail to qualify for a visa if put under the test. Fact of the matter is that some sectors of the UK economy are highly dependent on low-skilled workers – shops, hotels, and restaurants, where 8% of 5.7m workforce would fail the non-EU visa requirements. If EU immigration were to be restricted as a consequence of Brexit, EU migrants would have to be brought under a revised version of the non-EU points based system. Major skill shortages in industries such as construction, engineering, IT and healthcare need to be recognised. Decisions would have to be taken whether to expand current quotas and which skill groups to allow.

 

A revised points based system harmonised for both EU and non-EU migrants can be anticipated. By harmonisation, it is implied that rules for non-EU migrants will be relaxed vs. earlier to enable increased flow of migrants. EU migrants in contrast can expect more restrictions vs. earlier but targeting required skill sets.

 

Discussions regarding immigration would be key during the exit negotiations. The potential cost of such a system would be losing access to the EU single market and reciprocal treatment of British nationals. It is a huge cost to pay but considering the climate in the UK, it is unlikely that the political establishment can allow for the status quo to be maintained. To add a sardonic positive spin, at least the wide gap in terms of restrictions applied toward non-EU vs. EU nationals can be narrowed.

 

Concluding remarks

 

The Brexit vote, in addition to highlighting deep divides within Britain, has come as a rude wake-up call to the idea of Europe. It reflects the frustration of member states to the burgeoning bureaucracy and entrenchment of Brussels. There are already talks of re-invigorating and humanising Brussels by pouring investments into roads, power grids and data cables in Southern Europe and increasing transparency and accountability. On the other side of the debate are proposals of reducing centralisation and empowering national governments. Regardless, a hard inward look is required to sustain the long-term vision of a united Europe. Unless EU institutions quickly reinvent themselves and demonstrate sizeable course correction, it is only about time that the citizens of another member state decide to exit.

 

Nevertheless, Brexit does provide a unique chance for India and the UK to forge a deeper relationship across businesses and people. With the British government and civil service overwhelmed by post-Brexit activity, India should identify and prioritise key areas of trade, investment and cooperation with a stand-alone UK and initiate an accelerated dialogue. We should leverage upon each other’s strengths and level issues which acted as a road-block owing to the UK’s membership of the EU. India should also be wary of the changing leadership in Britain, and expect a more conservative and anti-immigration environment. The negotiations should attempt to balance these realities with the obvious opportunity at hand.