Brexit: Britain's Call Option

8 MINS READJun 22, 2016 | 09:00 GMT
Brexit: Britain's Call Option

Editor's note: The following analysis was written by ETM Analytics, an economic and financial advisory firm with offices in the United States and South Africa. While not a Stratfor analysis, it complements our views on the geopolitical stakes of the June 23 Brexit referendum with an eye toward the vote's macroeconomic implications. We hope this joint effort amplifies our readers' understanding on the eve of this historic vote. 

Betting markets still think Britain will remain in the European Union, the increased popularity of the "leave" camp notwithstanding: They are now pricing only a 27 percent chance of a Brexit. But betting markets are not infallible. After all, they priced an 85 percent chance of a hung British Parliament after the 2015 general elections, which proved emphatically wrong. The recent momentum in the polls suggests that this one is too close to call.

The uncertainty surrounding the referendum has been reflected in financial markets. Over the past week, for example, sterling volatility rose higher than it was during the global financial crisis of 2008. Observers simply do not know how things will look if Britain leaves the European Union, but most studies have come to the same conclusion: A Brexit would be bad for the British economy.

A Failure to Cure All Ills

But would it? The prevailing wisdom says Britain would be worse off outside the common market, subject as it would be to the European Union's common import tariffs. Those concerns, however, are misplaced. Europe is not, strictly speaking, a "free trade zone." Zero internal tariffs alone do not a free trade area make. Europe imposes extensive import duties, which by definition is not free trade. Internal EU commerce, moreover, is subject to onerous regulations on standards, packaging, safety, labor, logistics and so on. The European Union also engages in wide-ranging industry protectionism, particularly for the agriculture sector, which raises prices, lowers efficiency and hampers structural competitiveness. Britain would have the option to dismantle much of this stifling protectionism in a Brexit scenario.

The economic threat posed by tighter immigration policies is also cited as a reason against a Brexit. If Britain were to curb immigration, the argument goes, it would be less economically dynamic. And that's probably true, if it actually came to pass. But the British are not isolationists. Britain's demographics and economic ties with Europe — and, indeed, the world — demand a liberal stance on immigration. London is an international city that holds the rest of the country on life support. Having greater national control of immigration policy while maintaining a healthy openness seems well within the realm of possibility in the event of a Brexit. Therefore, we don't see sweeping, radical anti-immigration policies in such a situation, and certainly not the kind of immigration stance that would damage the economy.

If Britain left the European Union, it could unilaterally liberalize internal and external trade arrangements with any country or economic grouping in the world, cut subsidies and deregulate markets. The transition that would necessitate would be painful for those who benefit from the current arrangement, but it would eventually create more opportunities for wealth creation. Under the right policies, the benefits may well outweigh the costs.

Unraveling some 40 years of EU regulatory and political integration would, of course, be difficult and politically taxing. Those who gain from the status quo would clearly favor its continuation. There would be political casualties on both sides of the English Channel, and European relations could get colder. There has been some mild saber-rattling by Europhiles that a Brexit would see Brussels take a hard line with the recalcitrant Britain.

As bad as things would appear to be, though, it could just as easily be argued that deeper integration is aggravating rather than alleviating political tension in Europe — and that a Brexit could, therefore, ease those tensions. After all, the Brexit referendum aside, the European Union faces crises on many fronts — fiscal, monetary, economic, political and social. If Brussels wants Britain to continue sharing its burdensome load (immigration, bailouts, military commitments and absorbing some of Europe's unemployed), it would have to play nice with London.

That's not to say a Brexit would guarantee success for Britain. The country has a gigantic current account deficit, the present extent of which has never ended well for economy or currency. Like the United States, Britain is also overleveraged and beset by a zero interest rate policy, if not yet Europe's negative interest rate policy. It has a creaking welfare state, and its leviathanic National Health Service is an immense systemic burden. If Britain leaves the European Union but continues to look like the European Union, then a Brexit won't help. If Britain keeps the same EU-level tariffs and protectionist subsidies in place while facing higher EU tariffs after a Brexit; if it pulls up the drawbridge and massively curtails access to immigrants; or if it pushes financial services away from London, it would actually regress. But these outcomes are far more dependent on political choices than on the esoteric "inevitability" asserted by pro-EU campaigners.

A Brexit would fail to cure all that ails Britain. Leaving the union would not inoculate it from all the diseases that afflict Europe and that precipitated the referendum in the first place: financial dysfunction, onerous regulations, nationalism, resentment of the political establishment and a migration crisis. Its links to the Continent are simply too deep, and the regional risks are shared. But, critically, a Brexit could give London greater flexibility in treating these diseases. It offers an additional layer of immunity to systemic EU risk to that already afforded by retaining the British pound.

Whether Britain would ride a wave of reform after its departure is unclear. The Conservative government is not particularly conservative and doesn't have a sweeping mandate to reform. Still, the point is that London, having liberated itself from some of the constrictive policies endemic to the European Union, could reform if it wanted to. The scenarios supporting a "remain" vote seem to assume a stasis on the part of the government after a Brexit, making political representatives unresponsive to new realities and challenges. But the evidence from British political history suggests this is a naive perspective.

A Brexit, moreover, gives Britain a chance to structure a sensible and more market-friendly financial regulatory architecture. This possibility may even constitute Brussels' (and Washington's) biggest fear of a Brexit: that London could create and exploit a regulatory arbitrage by re-liberalizing finance and enticing capital, technology and expertise away from European and U.S. financial centers. There have been warnings that after a Brexit foreign banks and financial institutions will have to "de-Londonize." With the right kind of regulation, the opposite is possible.

The Power of Perception  

After June 23, Britain will have a definitive answer to the question of whether it will stay in the union. But the outcome of the vote won't change the fact that the British economy is cyclically and structurally fragile. Nor will it solve, by itself, the problems created by a debt super-cycle, zero interest rate policy, regional stagnation and asset market bubble risk. Europe's banking system is frail, Brexit or not.

The vote does, however, affect perception. A Brexit could create sufficient uncertainty to spark panic in financial markets, even though it would be a mere catalyst rather than the ultimate cause. A victory for "remain," on the other hand, could calm the markets. The latter could offer opportunities to position for a bearish phase of the business cycle and for the negative structural consequences of EU entanglement, including having less flexibility to treat Europe's chronic illnesses.

A Brexit would be more difficult to exploit. Do markets panic, or do they wait patiently to watch how leaving the European Union will unfold? The initial reaction, most likely, will be some degree of panic. In one scenario, this panic persists only for a few days or weeks and then settles down as the slow, measured process of a Brexit begins. Politicians convince markets that it will be a gradual, amicable split. There may have to be a series of joint announcements with the European Union assuring that the transition will be slow, steady and tightly controlled. If panic persists for more than a few days or weeks, however, and if political assurances are unconvincing, then it could begin to expose British (and European) macro fragility rather quickly. The especially destabilizing factor to watch here is that as business cycle risk emerges, markets correct lower and growth slows, so a Brexit would be in line for receiving the bulk of the blame. That could spark further rounds of Brexit panic, causing something of a vicious cycle that precipitates a recession and credit crunch.

Such a recession would be the inevitable cyclical outcome hastened by a Brexit, rather than a fundamental consequence of it. The strategic opportunity here is a long-term one. There is a significant chance that Britain Inc. gets oversold. If the country can move toward sensible economic and financial sector reforms and retain an open, smart immigration policy, it could present attractive re-entry opportunities for investors, especially as a relative play to the medium- and long-term dysfunction expected to prevail in the European Union and eurozone.

Despite the narrative in the mainstream media, a Brexit may not fundamentally hurt the British economy. On the contrary, it offers a medium- to long-term call option on greater economic dynamism and a more efficient and autonomous crisis response mechanism. Also lost in the Brexit noise are the macroeconomic problems Britain faces regardless of the referendum.

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