Breaking down the Brexit

Referendum

The UK held a referendum on Thursday 23 June 2016, posing the question ‘Should the United Kingdom remain a member of the European Union or leave the European Union?’. The prospect of leaving the European Union became known as the ‘Brexit’. With a 52%-48% vote, the UK has made the unprecedented decision to leave.

Rationale for the Brexit

Prior to the Brexit, numerous reasons were raised as to why a Brexit may be beneficial for the UK’s economy.

  • The UK is currently suffering from a refugee crisis which is being enabled by the fact that there are no travelling barriers between member countries. In 2015, the UN said that it was expecting 700,000 migrants and refugees to reach Europe which has had negative economic and social impacts on the EU. European cities have said that since the influx of migrants began, they have experienced a large drop in living standards.
  • Membership in the EU comes at a cost since member countries are required to pay a fee. This fee came to a net fiscal cost of 0.5% of GDP. Exiting would eliminate this cost to the UK.
  • Application of EU law imposes significant costs to UK business. Since 2010, the EU has introduced over 3500 new laws which have increased red tape for British business, which was estimated by the British Chamber of Commerce to incur costs of around $US12 billion per year. The obligation to apply EU law has also deteriorated UK sovereignty as the UK has allegedly had less of a say in legal issues.
  • The lack of UK sovereignty following its less significant influence in the development of EU law inspired fear that the EU would increasingly dictate the operations of the UK.
  • The EU has experienced low levels of growth recently with the sovereign debt crises occurring in EU countries including Italy, Spain, Portugal and Greece. Given that the EU experiences a regional business cycle due to its strong trade ties with member countries, the UK’s growth was also limited from the slow and uncertain growth of the EU (HSC Topic 1 – The Global Economy). Moving away from the EU was argued to enable the UK to open to the world market to benefit from growth in regions such as Asia.

Immediate effects of the Brexit

The Brexit has sent economic, social and political shockwaves throughout the globe as the result became more and more clear. Major events that followed the decision include:

Economic

  • A depreciation of the British pound by more than 10%, an enormous decline in a developed country’s currency in one day.
  • Financial markets have experienced significant increases in volatility. The CBOE volatility index, which measures volatility of financial markets, surged by over 50% over the weeks leading up to the referendum. The decision to leave is likely to see uncertainty and therefore, volatility, to continue into the medium term.
  • Equity markets experienced heavy losses following the decision. The UK’s FTSE100 index opened about 7% lower, Germany’s DAX opened 8.1% lower, Japan’s Nikkei was down nearly 8% and Australia’s ASX200 was down more than 3%. The wealthiest individuals in the UK lost about $US7.3 billion following the decision.
  • The surge in volatility has caused a flight to safety to safe assets such as gold, causing its price to jump by 4.95%. Yields on US Treasuries plummeted as demand rose for US debt which is traditionally seen as a ‘safe haven’. Risky assets such as oil and the Australian dollar were sold, with the Australian dollar falling 1.4% relative to the US dollar.

Political

  • David Cameron, the British Prime Minister, has announced that he will resign in October, stating that new leadership is required to navigate through the uncertainties concerning the logistics of the UK’s break from the EU, renegotiation of trade relationships and economic implications.
  • A second Scottish independence referendum is likely to occur given the disparity in the margins to leave or stay in the EU. Scotland voted to stay in the EU by 62%-38%, directly contrasting with the vote to stay by the UK of 48%-52%. As such, the UK’s exit from the EU is likely to prove unpopular with Scotland, spurring another attempt at independence.
  • The Brexit has set a precedent for leaving the EU. Euro-scepticism has been observed amongst some other EU members such as the Netherlands which has sparked discussion about a ‘Nexit’. Other countries whose anti-immigrant parties have demanded a referendum include France, Denmark and Sweden.
  • The European Commission President Jean-Claude Juncker has stated his desire to negotiate the terms of the UK’s departure as soon as possible.

Social

  • The decision to leave has sparked social issues within the UK given the disparity in the votes to leave or stay amongst different demographics. Voters in the 18-24 age bracket overwhelmingly voted to stay whilst voters in the 65+ age bracket voted to leave. It is argued that given the aging population, the older age brackets, including the 65+ accounted for a disproportionate portion of the decision and did not truly reflect the UK’s true sentiments concerning a Brexit.

Implications of the Brexit

Given that no country has ever left or has sought to leave the EU (although there was discussion surrounding a ‘Grexit’ in the height of the Greek sovereign debt crisis), it is difficult to discern the implications of the Brexit in the long term. Noted, however, is that there has been considerable debate as to whether the standard of living in the UK will deteriorate over the long term as a result of the decision.

The implications given below are largely in the short to medium term.

Implications for the UK and the EU

  • As part of the EU trading bloc, the UK previous benefitted from the multilateral free-trade agreements between the EU members which lowered their trade barriers (HSC Topic 1 – The Global Economy). The UK’s exit removes it from the trading bloc, meaning it can no longer benefit from the established free trade agreements. Without a free trade agreement in place, the UK will face greater protection as a result of tariffs, quotas and other protectionist policies being re-erected. This is significant to the UK economy as 44% of its exports are purchased by the EU.
  • To reduce the trade barriers it now faces, the UK would need to renegotiate its free trade agreements with the EU. Given that trade agreements can take a long time to negotiate since parties want to come to a compromise that benefits their economy most, substantial uncertainty surrounds when and on what terms the UK will be able to re-establish its trade agreements with the EU. Most of the discussion around the renegotiations of the UK’s trade agreements however, have been in favour of the UK, implying that this may not be a significant issue.
  • Lowered trade barriers between the UK and other EU members is particularly important to the UK. The UK is a financial hub (41% of the world’s foreign exchange and 49% of the world’s derivative trading takes place in the UK) since any financial service company based in the UK is allowed to operate across the EU through passporting. Without membership in the EU, passporting may no longer be possible. There have been predictions that approximately a third of financial services companies would consider relocating their operations to the EU. Given that financial services is a major sector in the UK, this could damage their economic growth prospects (HSC Topic 3- Economic Issues). Since labour is a derived demand, there may be unemployment within this sector which may see skilled employees in financial services emigrate as the banks move to other countries (Preliminary Topic 4 – Labour Markets; HSC Topic 3 – Economic Issues).
  • Given that the UK is a net importer of goods, a Brexit may improve the goods and services deficit since it would be deterred from buying the more expensive goods, assuming that is demand for imports is relatively elastic (Preliminary Topic 3 – Markets; HSC Topic 2 – Australia in the Global Economy). Moreover, since the UK is a net exporter of services, it is expected that the services surplus would be deteriorated since they are more expensive to access by the EU.
  • The Brexit will most likely have a negative impact on the foreign direct investment (FDI) for the UK (HSC Topic 1 – The Global Economy. The EU was the source of 46% of the UK’s FDI in 2013. The uncertainty caused by the Brexit will cause investors to redirect their funds elsewhere, causing the FDI flow to deteriorate.
  • The uncertainty surrounding the UK’s economic growth prospects has already and is expected to continue affecting investment decisions by businesses within the UK. Since firms are uncertain about the capacity for demand in the economy and therefore the amount of output it needs to produce (Preliminary Topic 2 – Consumer and Business). As such, firms have been hesitant in investing into their business, causing a drop in investment. Since investment is a component of aggregate demand (AD = C + I + G + (X – M), this has caused aggregate demand to decrease and therefore economic growth to fall (HSC Topic 3 – Economic Issues). In the uncertain period in which the UK is renegotiating its trade agreements, it is likely that this trend will continue.
  • The Bank of England expects that the uncertainty created by the Brexit would also negatively impact consumption in the economy as consumers increase their precautionary saving (HSC Topic 3 – Economic Issues). As a component of aggregate demand, the reduction in consumption will also decrease aggregate demand, leading to a decrease in economic growth. The Bank of England believes the effect will be so severe that it will cause a recession in the UK. A recession is defined as two consecutive quarters of negative economic growth.
  • Christine Lagarde has stated that the IMF will standby to stablise the global economy in response to the effects of the Brexit if needed. This reflects the role of the IMF to ensure the stability of global financial markets and the global economy (HSC Topic 1 – The Global Economy).
  • The effect of the Brexit to the EU’s growth is also expected to be negative. The UK accounts for more than 15% of its GDP and 25% of its financial services. This will cause uncertainty surrounding the EU’s growth, which will cause a reduction in investment and consumption, similar to the effect in the UK.
  • The British pound (GBP) is expected to continue falling as investors form negative perceptions regarding the UK’s future growth prospects and sell the GBP. The sale of the GBP in the foreign exchange market increases the supply of GBP, causing it to depreciate (HSC Topic 2 – Australia in the Global Economy).

Implications for Australia

  • Given that the direction of Australia’s trade has shifted from its traditional ties to the UK to Asia, the effect of the Brexit on Australia’s trade will be minimal (HSC Topic 1 – The Global Economy). However, there is concern that the Brexit will affect Australia’s pharmaceutical and biotechnological trade flows to Europe as the UK previously served as an ‘English speaking gateway’ to the EU.
  • What is more significant to the Australian economy is the uncertainty that will be caused by the Brexit. If consumers increase their precautionary saving and businesses cut investment, aggregate demand will significantly decrease, causing a reduction in economic growth (HSC Topic 3 – Economic Issues). This may see the Reserve Bank cut the cash rate to record lows to help support the economy.

Theresa Dang THERESA DANG

Theresa Dang is an economics mentor at Keystone Education. She attended Sydney Girls High and achieved an ATAR of 99.70 in 2012. She is now studying Commerce and Law at the University of Sydney. She has experience in a global technology firm and a mutual fund.

Gary Liang GARY LIANG

Gary Liang is the founder and director of Keystone Education. He attended Sydney Boys High and achieved an ATAR of 99.95 in 2012. He achieved 5 state ranks in Mathematics, Mathematics Ext 1, Mathematics Ext 2, Chemistry and Economics. He is now studying Economics and Science (Advanced Mathematics) at the UNSW Australia, where he is the recipient of four scholarships.

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