The UK referendum vote to leave the EU on 23 June 2016, and the subsequent paroxysms of British politics, have held us all captivated. And so it is understandable that, to date, there has been little focus on the question of the impact of the vote on the rest of the EU.
The atrocity in Nice last week has shifted that focus, and in any event, we ignore the rest of the EU at our peril. What is taking place within the wider European landscape will have a bearing on the nature of the UK's terms of exit and for the global economy in general.
This newsletter considers what that impact might be by reference to three time frames:
- short-term: instability issues
- medium-term: trade and finance issues
- long-term: 57 varieties of trade agreements
The referendum result itself shows that 'black swan' events can indeed occur, which does make predictions in this climate inherently uncertain. In considering the economic and regulatory enivornment, we should also not forget the response of the UK politician Harold Macmillan to a journalist as to what he feared most - "events dear boy, events".
Short-term: instability issues - due elections in Italy, France and Germany
Setting aside the most immediate impact of the Brexit vote on the financial exchanges (for which see later), the main short-term impact in EU Member States is likely to arise from the democratic process. The remaining 'big three' EU Member States; the Netherlands (and now also Austria) all have polls in the coming 12 months which could have a major impact on governance in the EU.
Euro-scepticism - not just the British disease
It is already clear, for example from the immediate reaction of Mrs Le Pen to the UK referendum result - "Victoire pour la liberté" - that the UK electorate's choice to leave has made Euro-scepticism even more immediately concerning for mainstream national EU politics. Many in established EU governments now appear determined to prevent the 'contagion' spreading in their countries. This may give them an electoral incentive to ensure that the UK's exit is a rough one.
Italy - in November of this year, the Italian people will vote on a referendum proposition to reform the Italian constitution - strongly supported by the current centre-left administration led by Matteo Renzi. Formally, the question to be put to the people is whether to abolish the Italian Senate and create a unicameral legislature, which is of extreme interest to constitutional lawyers, but few others. Renzi, however, has presented this change as a precursor to a package of legislative reforms designed to free up the Italian economy and create jobs.
If the vote is lost (and the status quo maintained) it is very possible that the Renzi government will lose what support it has in the continuing two-house parliament, so that an early election will be needed.
Currently, the Eurosceptic 'protest' party 'Five Stars' is rising in the polls (the recently elected mayor of Rome is from this party) and is very likely to have a significant representation in the new legislature. In the medium-term, this will make resolving the ongoing issues in the Italian financial services sector much more difficult (see below): the longer-term impact could be more profound but also more difficult to predict.
France: In May/June 2017, the people of France are due to elect a new President. At present, the future line up of candidates is unclear - particularly on the right of French politics - but the two-round system of French presidential voting requires there to be a 'head to head' contest between the two top candidates from the first round (where there is - essentially - no limit on the number of candidates).
On current polling, one of the two 'final round' candidates could well be the leader of the Eurosceptic, right wing 'Front National', Marine Le Pen. She has already promised a French referendum on EU membership if she is elected president next year: current polls suggest that around 60% of the French are dissatisfied with the EU.
Germany: Elections are due to the German Bundestag in the early autumn of 2017. Again, the polls suggest that the Eurosceptic party 'Alternative for Germany' (AfD) is likely to enter the Bundestag for the first time (polling more than the required 5% of votes cast). At the very least, commentators suggest that this will make forming a coalition government significantly more difficult.
Austria: history has taught us not to overlook Austria. Following the decision of the Constitutional Court in Austria, after a challenge of the presidential election result by the right wing 'Freedom Party', there will be a re-run of the presidential election. The popularity of the anti-EU Freedom Party in the May elections has been seen as a further indication of Euro-scepticism.
The Netherlands: a general election is due in March 2017. Earlier this year, the rejection by referendum of the proposed EU-Ukraine trade deal, was taken as an indication of increased antipathy by the Dutch voting public to the EU, and this may again translate over in the general election.
Fall in sterling - impact on the rest of the EU
As noted above, the most visible immediate impact of Brexit - the sharp fall in the sterling exchange rate - is also likely to have an effect on EU countries.
The UK is still part of the EU and its Single Market - and will probably remain so until at least the beginning of 2019 - such that the immediate effect (after any short-term hedging of exchange rates) will be to increase the cost of EU imports into the UK.
The highest profile of the goods we import are cars - mainly from Germany, but also France and Italy - where there may well be price increases. Correspondingly, the cost of UK manufactured cars in the EU will decrease.
At first blush, this appears to be good news for UK export manufacturers. However, we operate in an interconnected EU and many supply chains now stretch across the EU, whereby such a sudden shift in exchange parities may have a disruptive effect even here in the UK, as the goods we manufacture have a relatively high component of imports. For instance, when the £/€ exchange rate fell to similar levels following the financial crisis in 2008/9, this did not cause a surge in UK goods exports - suggesting that the price of products, in the markets where the UK manufacturing sector competes internationally, is not the most important driver of sales.
A final short-term effect arises from the sharp falls in equity prices in the banking sector, due to the likely bank profit reductions caused by central bank interest rate reductions to counter 'Brexit' instability. If this feeds through into the saleability of other securities in banks, recapitalisation of banks in the Eurozone is likely to become much more difficult.
This issue may most keenly be felt in Italy in the short-term, as a number of its largest banks need to boost their liquidity buffers to meet the European Central Bank's solvency criteria. For example, the world's oldest bank, Monte dei Paschi di Siena, has already been told by the European Central Bank (ECB) this summer to reduce its book of non-performing loans by around €16 billion in the next three years (to around €33 billion). The UK Financial Conduct Authority temporarily prohibited short selling of Monte dei Paschi's shares on London exchanges when this news was announced.
Expect more similar stories in the coming months - Italian banks are estimated to have around €360 million in non-performing loans and have not yet made provision for around €200 million of them1. Given that the Italian State's debts are already around 135% of national income (GDP) - and EU rules require this percentage to be reduced over time to a final benchmark of 60%2 - Italy's room for manoeuvre to bail out the banks through taxpayer-funded support is very limited.
Likewise, Spain and Portugal have recently been found by the Commission to be in breach of the prescribed deficit rules. An overzealous reaction of the other Eurozone members to this, which in principle includes the adoption of penalties, may also further de-stabilise matters.
The medium term: trade and finance issues
Impact on trade deals
In the medium-term, it may become more difficult for the EU to negotiate international free trade deals - both with the UK and with third countries. The UK has generally been in favour of opening the EU's Single Market to trade with non-European countries. The balance of 'open' to 'controlled' access to Member States in the EU will now tilt towards more control. There is a query as to whether this could affect trade deals in the pipeline between the EU and both Canada - signed but not yet fully ratified in the 27 EU Member States - and the USA (the TTIP agreement), which remains under negotiation.
Even in those international trade forums where the EU continues to engage, its own position will be impaired by losing around 15% (by GDP) of market size and one of its four national members of the G7. And, of course, the UK will now be competing with the EU for trade and investment treaty deals.
In particular, bilateral trade agreements remain to be negotiated by the EU with developing economies - India and China, for example, and it is here that the UK may press for an early bilateral agreement, if only to demonstrate to the world and to the British public (irrespective of the quality of such a deal) that is it back in the game.
Impact on Eurozone - ever closer union?
The medium-term impact on the Eurozone may also be transformative - and much depends on the political climate in the three main Eurozone countries by the end of 2017 (see above). Broadly, there appear to be two possible outcomes for the Eurozone in the medium-term.
Ever closer union?
Is this the next logical outcome for an EU under siege - to press for 'more Europe' - in particular by creating a common EU fiscal policy? This would set (possibly within parameters) the tax and spending plans for Eurozone Member States - effectively 'unionising' their finance ministries in a similar way to the 'Europeanisation' of the Eurozone central banks as a result of the introduction of the Euro from the mid-1990s.
It would give the Brussels and Frankfurt authorities more powers to ensure fiscal stability - but at the expense of national sovereignty. It will only be politically possible for governments with a pro-EU majority in their legislatures - and possibly beyond. For many Member States, a common fiscal policy would require constitutional change - and in some this means either a popular referendum (Demark, Ireland) or a favourable opinion from a constitutional court (Germany). The lessons of Brexit may militate against another EU government putting any EU questions to a plebiscite.
Or more Euro-scepticism?
If the political climate across the continent becomes more Euro-sceptic, a common fiscal policy will be a non-starter. The question of how far (or how long) the existing Eurozone mechanisms can cope with the apparent stresses on the Euro will then be very real.
The need for some (southern) EU Member States to increase public borrowing to support either or both of their struggling financial or public sector (e.g. sickness and retirement insurance) institutions will mean that they will face (probably unbearable) popular pressure to breach the Eurozone rules. But (northern) creditor States will not be willing to subsidise them through Eurozone or EU budget transfers indefinitely - and (particularly without the UK's net contribution to the EU budget ) this issue can only become more acute over time.
One solution to this kind of impasse is for some Member States to decide to withdraw from the Eurozone ('€xit' perhaps?). The Greek experience demonstrates vividly that this 'solution' is neither popular nor straightforward. In particular, changes to the EU Treaties will be required (there is at present no legal mechanism for leaving the Eurozone but staying in the EU), again triggering the need for referenda and/or constitutional court intervention in several Member States.
The further uncertainty for the banking and wider financial services sector around the outcomes of the Brexit negotiations will compound this '€' question - with potential dramatic effects on the risk ratings for (at least) many EU Member State government bonds.
The long-term: 57 varieties of trade agreements
Looking further ahead is difficult at present. For the UK, the outcome of the Brexit trade negotiations will be a key element in the future shape of our economy. We cover in a separate alert the open question as to how such negotiations are to be concluded - i.e. by way of qualified majority or unanimity.
In brief, while there is in place a veritable smorgasbord of varieties of Association Agreements and other bilateral and trading arrangements that the EU has concluded with other states, there is no precedent, other than for Greenland, of what an arrangement will look like for a State that is exiting the EU stage, rather than aspiring for entry.
Although speculation is rife as to the possible type of EU-UK relationship - with, to continue the culinary metaphor, maple syrup (Canada), fondue (Switzerland) and pickled herring (Norway) flavours all possibly on the menu - we suspect that in fact, given the UK's size and 'special' relationship with the EU, a bespoke solution will emerge.
In particular, the UK's central place in international fora - which will continue - as a member of NATO, the UN Security Council and (likely more prominently post-Brexit) the World Trade Organisation - place it apart from other countries with which the EU already has close trade relationships.
As we have shown here, the rest of the EU's own position is seriously affected by Brexit - and moreover "events, dear boy, events" (as we have seen to our horror last week in Nice) may give rise to the risk that the EU itself becomes more inward looking and less able to act in a joined up fashion when dealing with external issues - including those which may now arrive from the direction of the UK.
For example, if there is another referendum on Scottish independence which separates Scotland from England, Scotland's negotiations to re-enter the EU will be difficult (and not on the same terms as those currently enjoyed by the UK as a whole). So, in particular, Scotland would need to join the Eurozone - possibly by then complete with a common fiscal policy telling the Holyrood government just how much it can tax and spend.
In all this, let's not overlook the possibility that the Eurozone will be facing another full-blown banking crisis which will distract attention and resources away from this process on the (rest of the) EU side.
Although it is clear that the key to avoiding these pitfalls requires open and honest dialogue between the EU, its Member States and the UK, the reaction to the referendum result has not been encouraging in this regard to date- from either side. But economic and political circumstances should (hopefully) mean that the current posturing will subside and serious engagement can begin after the summer.
1 'The Economist', 9 July 2016 'The Italian Job'
2 Treaty on Stability, Coordination and Governance in the Economic and Monetary Union, 2 March 2012
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