Brexit, a Disruptive and harmful Divorce
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Negative repercussions are already starting to be felt on both sides of the English Channel, and will be even worse if the United Kingdom does not manage to negotiate an acceptable exit deal with Europe

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Divorce is never a pleasant business. It is divisive, distressing and disruptive for both parties involved. It is the source of multiple conflicts: emotional, financial, social, bureaucratic, legal and regulatory. Brexit―the United Kingdom’s decision to leave the European Union in barely a year’s time after the slim victory of the Leave vote in the 2016 referendum―is no exception. In a recent paper on the threats facing Europe, the veteran Hungarian financier George Soros warns that Brexit is an immensely damaging process, harmful to both sides. But he also argues that “a lose-lose proposition could be converted into a win-win situation.” That is if both sides finally come to their senses by giving some ground in their so far contentious negotiations. Mr. Soros, who has actively and financially supported an initiative called Best for Britain, designed to avoid a messy divorce and calling for a second referendum, says Britain would render Europe a great service by rescinding Brexit and not creating a hard-to-fill hole in the European budget. He adds that the economic case for the U.K. to remain an E.U. member is strong, but it has become clear only in the last few months and will take time to sink in. “During that time,” he says, “the E.U. needs to transform itself into an organization that countries like Britain would want to join, in order to strengthen the political case.” To achieve this Europe would have to revisit its outdated treaties and allow member states to reassert their sovereignty rather than surrender more of it. A multi-track Europe would allow member states a wider variety of choices that could at the same time reinforce cooperation between these states. In the meantime, the pressure has become all the greater to find a solution to the Brexit problem. For if Brexit is already proving highly disruptive both for the U.K. and for the E.U. to a lesser degree―for the time being at least―there are a number of other even bigger disruptive forces at work in the world these days.

Disruption from across the Pond

By far the largest source of disruption from both a global and European perspective over the past year has arguably come from the White House, where Donald Trump continues to amaze, enrage, and confound his allies and foes alike. His decision to impose tariffs on both his allies and his economic adversaries threatens to spark a major international trade war. This has profoundly upset his western allies at the same time as risking to undermine the U.S. economy itself. It has caused consternation in Europe which now fears the transatlantic alliance is being destroyed, especially following the U.S. decision to reinstate sanctions against Iran thus threatening the collapse of the Iran nuclear deal that took so long to negotiate. All this is already having a negative impact on European trade and business as European manufacturers and energy groups are reviewing their investments and projects in Iran while steel producers are bracing themselves for difficult times as a result of the Trump tariffs. This is also affecting the U.K. which has long boasted of a special relationship with the U.S. In the current circumstances it looks highly unlikely London will secure any new favorable trade terms from Washington as long as President Trump occupies the White House. In the meantime it is the U.K. steel industry, which has been slowly recovering during the last few years, which is baring the brunt of the tariff war.

The other pressures that have been building up and are among the root causes of both Brexit and the subsequent election of Donald Trump are two-fold. The first is the refugee crisis that has swept Europe and has strained relations between E.U. member states as well as having significant repercussions on individual countries. The U.S. has faced similar if less acute problems from the flow of migrants from Mexico, the Caribbean and other central and south American countries. The second is the still ongoing impact of the 2008 financial crisis that has led to many countries―including the U.K. and other European countries―to adopt economic and fiscal austerity policies.

These coupled with the refugee and mass immigration problem have inevitably provoked a popular backlash which has led to a sharp rise in populism and its growing influence on European politics.

A long transition period

Although Britain is due to leave officially the E.U. at the end of March next year, all signs suggest that the divorce is going to be a long process that will probably take more than five years. Such a long drawn out process risks being disruptive, especially if the most ardent Brexiteers in the Conservative Party force a showdown that could in turn bring down the government of Theresa May. That could lead to early elections where the opposition Labour Party, which has so far maintained an ambivalent position on Brexit, sees its chance of returning to power. Yet this long transition period could also have a positive effect in allowing politicians and voters alike to weigh up the pros and cons of leaving the E.U. and its long term impact on the U.K.’s future prosperity as well as its national security. In short, the question is whether the U.K. would be better off in an arrangement that enables it to retain the benefits of the single market and the customs union but obliges it to abide by E.U. rules and the European Court of Justice, or whether it will ultimately benefit more by leaving the E.U. altogether and forging a series of new relationships and trade deals with other countries including with the E.U. as well. It is basically an argument between sovereignty, or as the Leave campaign put it “taking back control,” and economic rationale and pragmatism.

Whatever the most virulent Brexiteers may claim, the economic argument for leaving the E.U. is already lost. A leaked assessment by the U.K. government suggests that full control of its trade risks cutting off 8 percent of Britain’s economic growth over 15 years. In the first part of this year, falling investment, weak household spending and a general loss of economic activity have proved a drag on the U.K. economy, which has almost stagnated according to official figures. Separate figures from the banking industry showed slow growth in consumer lending and another recent survey showed a decline in household confidence ahead of Brexit. Mark Carney, the governor of the Bank of England, has said business investment would normally grow much more strongly as the world economy prospers but is being held back by uncertainty over Brexit. The Bank of England has now chopped its forecast for annual average growth in 2018 to 1.4 percent from 1.8 percent.

Mr. Carney also told economists in London that interest rate-setters would be forced back into some of the same exceptional measures they pursued in the aftermath of the E.U. referendum if the Brexit transition was disruptive.

Economically, a terrible idea

At the end of May, a delegation of top European businessmen grouped in the influential European Round Table of Industrialists warned the Prime Minister that they needed clarity over Brexit on a frictionless border and customs union for their investments. Without such clarity, investments would suffer, as companies would be reluctant to embark on heavy funding commitments. The single market and customs union have long secured frictionless trade with the E.U., by far Britain’s largest export market, representing over 40 percent of total annual flows or around £240 billion a year. They have also attracted foreign direct investment into the U.K., creating, according to government figures, 1600 jobs a week in 2016. It was after all Margaret Thatcher, whose relationship with the E.U. was challenging to say the least, who led an inward investment thrust into the U.K. with the Japanese Nissan and other car companies in the 1980s. As David Warren, a former U.K. ambassador to Japan, points out in a recent article: “the crucial selling point was that these investors would become British companies selling into Europe through the customs union.” He argues that an ability to trade without friction is as important today as it was then. This is particularly the case in the car industry.

The litany of why Brexit is simply a bad idea from an economic standpoint keeps growing. The well respected Institute of Fiscal Studies reckons that both growth and public finance will suffer. There would be no chance of the much vaunted £350 million a week of extra funds for the U.K.’s financially strapped National Health Service – a dubious claim at the centre of the Leave referendum campaign. The Central Board of Industry and the Institute of Directors have also voiced their concerns on several occasions. The House of Lords E.U. environment committee has said it was “inconceivable” that there would be no impact on E.U. produce, which makes up 30 percent of the U.K.’s food imports. Ryanair has for its part warned of the risk of serious disruptions to U.K.-E.U. flights from April next year unless unless new arrangements are agreed in advance of September 2018. Even the U.K. tax authority has warned that in the absence of a customs union, the cost of implementing a new customs regime to companies trading with the E.U. could be as high as nearly £20billion a year. And this does not take into account the damaging political repercussions should any new customs arrangements lead to the reinstatement of a “hard” border between Northern Ireland and the Republic of Ireland. An Ernst & Young annual survey of 502 multinationals based in Europe has found that 33 percent of these companies believe Brexit will impact their current activities and indeed is already doing so.

Most active international investors are busy reviewing their supply chains, trade and customs, the costs of imports and other new costs that could imperil their business. In short, they are profoundly rethinking their long term European and global investment strategies concludes E&Y.

The Economist Intelligence Unit has also recently compiled a report on how a number of key sectors of the U.K. economy will be impacted by Brexit. The impact would be all the greater in the case the U.K. fails to secure an acceptable exit deal with the E.U. on the basis of a Canada-style trade agreement that includes some special terms that are important to the U.K. economy. The report suggests three sectors will face a direct impact as a result of Brexit. These include financial services, automotive and heath care and life sciences.

In the case of financial services, it expects London to retain its status as one of the world’s leading financial centers and Europe’s biggest financial hub even after Brexit. Given the significant interdependence between the E.U. and U.K. financial services sector, it is likely that there will be a mutual interest in achieving a deal that satisfies both parties. But the deal will inevitably be partial and some institutions will relocate some parts of their businesses elsewhere as is already happening.

Health care is expected to see its exports fall, while the automotive sector risks facing even bigger challenges if there is no trade agreement. This would make large scale car production in the U.K. difficult and the result would be a significant decline in vehicle sales by 2022 in the event of a “hard” Brexit.

The impact of Brexit on the consumer goods and retailing sectors, telecommunications and energy is likely to be more diffuse but still disruptive. Consumer goods and the food sector will be affected by the loss of E.U. workers and disputes over regulation. A no-deal outcome risks pushing down exports and pushing up prices of imports even further. Exit from the digital single market will have an impact on the U.K. telecommunications sector that risk undermining investment in innovation and the price U.K. consumers pay for mobile roaming.

Impact on the energy sector and the climate

As for the energy sector, the irony is that the U.K. has in the past been one of the strongest advocates for deeper integration of the European internal energy market designed to enhance energy security, reduce energy costs and promote the decarbonisation of supply. All these issues, as well as direct energy trade, are now subject to greater uncertainty. According to the Economist Intelligence Unit trade is perhaps the least of the issues but nonetheless important. The U.K. is a net importer of oil and gas, with Norway a key supplier. This oil and gas trade is unlikely to be affected by Brexit. But any disruption to supply chains could have an indirect impact on the natural gas sector in terms of operational and investment costs. A bigger issue will be trade in electricity at a time when the U.K.’s dependence on imported electricity from Europe is on the rise. The irony here is that the U.K. will be leaving the E.U. but its connectivity with the European electricity market is set to deepen.

Energy companies have practically all recommended that the U.K. maintain its full participation of the European internal energy market as well as of the integrated single energy market. But staying in these may no longer be possible if the U.K. pulls out of the single market and the jurisdiction of the European Court of Justice. The U.K.’s departure also risks undermining Europe’s climate and energy targets, as the U.K. has played an active role in the setting of the E.U.-wide 2020 and 2030 climate targets, the establishment of Europe’s emissions trading scheme and the development of other policies such as air quality directives. The U.K., which has also relied on its own climate policies, is expected to continue moving forward on climate goals. But doing this may become more difficult if the U.K. cannot stay in the European emissions trading scheme, which once again involves accepting European Court of Justice jurisdiction.

The U.K.’s departure from the E.U. will also impact the efforts of the remaining 27 member states on climate and energy targets. In the case of reducing emissions by 40 percent from 1990 levels, the U.K. has been a big contributor to the overall E.U. targets. If and when it leaves, Germany can probably take up some of the slack but the pressure on coal-dependent countries such as Poland to clean up their act will increase. France may also come under pressure not to retire its nuclear plants too quickly. Thus the E.U. may find it misses the U.K. as much as the other way round when it comes to the energy sector as indeed in multiple other industrial, financial, social, medical, security and diplomatic areas.

Public sentiment has certainly changed in the U.K. since the referendum two years ago. “Taking back control” is no longer considered by a majority of people in Britain as a route to new prosperity with the promise of “amazing trade deals” with the rest of the world. Recent public opinion polls have all shown that protecting the economy after Brexit has become more important for the majority of voters, especially the younger generation, than sovereignty.

Diehard Brexiteers, such as the Conservative Member of Parliament Jacob Rees-Mogg, are continuing to insist that the U.K. must regain its full sovereignty and leave the single market and customs union. Mr Rees-Mogg has warned that any compromise outcome in the current negotiations that involved the U.K. remaining in some way or other in a customs union with the E.U. would be tantamount of turning the country into a “vassal state.” This argument has support from older voters, but for the great majority of younger ones it seems to be far better to remain a “vassal state” if this protects their future economic prosperity and that of their families. The next few months will be critical for the outcome of the Brexit negotiations and the future course of the U.K.’s relationship with the E.U. But with each passing day, it is becoming clear that the price of frictionless trade and avoiding undermining the U.K. economy at large will be a requirement for the country to apply the current customs union and single market rules, or at least something similar.

The question is whether the hard core Brexiteers on both the right and left sides of the political spectrum will finally accept the general mood change towards Brexit or will fight to the bitter end for what would risk becoming a particularly disruptive divorce.