By Willem Buiter, Chief Economist of Citigroup, Ebrahim Rahbari, Director in the Global Economics Team, Citigroup Research, and Christian Schulz, Director, Citi Economics Team. Originally published at VoxEU
Britain will hold a referendum on whether to stay or leave the EU. Current polls point a very close vote. This column argues that Brexit could have serious economic and political consequences for the rest of the EU. The economic and financial frictions could be limited if both parties try to strike an amicable separation agreement. But political considerations, including the desire of the rest of the EU to prevent Brexit emulation, might result in a far more damaging outcome, not just for the UK.
Britain will hold a referendum over whether to stay in or leave the EU on 23 June. Current polls point to a very close vote. Brexit is not our base case, but the probability we assign to it – 30% to 40% – makes it a material risk.
Analysis of the potential economic and political consequences for the UK is growing. At Citi, we conclude that while the precise economic impact will depend on many factors, including the future trade arrangement between the UK and the rest of the EU (EUx), its direction will be highly negative. We are particularly concerned about political uncertainty in the UK, including a possible disintegration of the UK into its more pro-European (Scotland, Wales, and Northern Ireland) and less pro-European parts.
Unfortunately for the rest of the EU, Brexit would not be a zero-sum game – nor would the economic and political losses be confined to the UK. The rest of the EU would also take a hit, even if we expect the economic impact to be milder than in the UK. UK trade is a far smaller share of GDP for the EUx than EUx trade is for the UK. The assessment of the potential economic and political fall-out from a British vote to ‘leave’ is likely to determine the negotiation strategies of both the UK and the rest of EU over a follow-on deal. We note that technically, there would be no negotiations about the terms of access (in all economic dimensions) of the UK to the rest of EU; the EUx would determine (according to the Treaty unilaterally) the future terms of access of the UK to the EU. The UK would, of course, set the terms of access of the rest of EU to the UK (in all its economic dimensions). The negotiations on future economic (and political) relations between the UK and the rest of EU would, however, likely be very asymmetric with negligible bargaining power for the UK – much less even than in the negotiations on the EU changes required to keep the UK in the EU.
What Would Follow Brexit?
Most likely, the UK would trigger Article 50 of the EU Treaty shortly after a vote to leave. That would set the clock ticking for a withdrawal agreement to be reached within two years, or else the UK would revert to the default trade arrangement with the EU governed by WTO rules. In this worst-case scenario, the EU would apply its external customs duties on UK goods and services as well as erect significant non-tariff hurdles such as regulations and licenses. For example, passporting of banking and other financial activities would cease. The rest of the EU would be free to impose material restrictions on London’s ability to conduct euro transactions and euro-derivatives transactions. UK citizens could lose the automatic right to work in the rest of EU.
An anatomy of the UK/EU economic links
Along with the US and China, the UK is currently one of the most important trading partners for the other EU states. In 2010-2014, total exports to the UK were 2.9% of EUx GDP, and total imports from the UK were 2.4% of GDP. Trade in goods such as cars, machinery, and chemicals dominates the EUx’s trade volumes with the UK, constituting about 70% of total exports and imports of goods and services. In goods trade, most EUx member states are running a sizeable surplus with the UK, in total 0.6% of EUx GDP in the past five years (see Figure 1). This surplus almost disappears, however, when accounting for foreign value added in exports, which was 30% in 2011 for EUx goods exports to the UK and 23% for UK goods exports to the EUx, according to OECD data. In services trade, most EUx countries are running deficits with the UK, amounting to a total of 0.2% of GDP. This is almost entirely driven by financial services, while deficits of the EUx in other parts of services trade are offset by surpluses in tourism.
Leaving aside indirect effects and temporary bumps during the negotiation period, a symmetric 10% one-off decline in exports to and imports from the UK would lead to a one-off reduction of EUx GDP by 0.05% (based on current account data), with negative effects from goods trade outweighing net positive effects from services trade. Subsequently, trade growth would likely be lower than otherwise, increasing the potential losses over time. The damage would be a bit more severe in the manufacturing hubs in central and eastern Europe as well as in the tourism hotspots in the Mediterranean.
Figure 1. Widespread goods trade surpluses and services trade deficits with UK
Notes: EU countries’ goods (x-axis) and services (y-axis) trade balances with UK (% of GDP), 2010-14. Bubble size corresponds to total trade with UK in euro billions. Sources: Eurostat, ONS and Citi Research
To minimise potential economic losses, the EU might focus its post-Brexit negotiation strategy on free trade for all goods and some services like tourism, where it is running a surplus. By contrast, limiting UK-based financial firms’ access to the EU’s internal market for financial services might set in motion an import substitution process which may eventually benefit at least some EUx member states. However, financial services trade barriers would still be disruptive at least in the short run given the UK’s near-monopoly in some sectors. If the rest of EU states fail to replicate the UK’s financial services productivity, they would end up permanently worse off when ignoring the short-term Keynesian (demand-driven) benefits.
One lesson from the turbulence of the past eight years is that financial links transmit economic calamities from one country to another almost instantaneously and often amplify the original shock. Avoiding a financial crisis is also likely to feature high on the list of the EUx’s negotiation priorities. In the case of Brexit, the stakes look particularly high, with the UK exposures of EUx banks, companies, governments and households dwarfing those to Greece in 2012. And even those were sufficient to throw the Eurozone economy into extended turmoil. With UK assets held by EUx residents worth nearly half of the EUx GDP (based on ONS international investment position data), a complete breakdown in relations could easily reduce EUx wealth by a few percentage points of GDP and, in some cases, put additional strains on already-challenged financial systems.
A financial crisis remains unlikely in our view and the economic cost-benefit calculus of Brexit might not even be entirely negative for the EUx. For example, EUx member states may try and usurp the UK’s position as the EU’s most popular destination for foreign direct investment. Over the past 15 years, the UK has received more than 20% of inward EU FDI, but without full access to the EU’s internal markets, future FDI flows into car factories or financial services hubs that would have gone into the UK had it remained a member of the EU might be redirected and create jobs elsewhere in the EUx.
Figure 2. Top spot up for grabs? Share in EU inward FDI (%), 2000-2014
Sources: UNCTAD and Citi Research
The Brexit impact on the rest of the EU via trade and finance will depend on the follow-on agreement between it and the UK. A number of models exist: Norway’s, Iceland’s, and Liechtenstein’s membership of the European Economic Area (EEA) or Switzerland’s European Free Trade Area (EFTA) agreement come close to full membership of the EU’s internal market. Only EEA membership would guarantee free mobility of labour, while EFTA membership can include it (and in the case of Switzerland, does). A Turkish-style customs union would cover most goods trade sectors, but the Swiss and Turkish models crucially exclude financial services. Free trade agreements such as those with Mexico or South Korea would also establish free access to the EU’s internal market, at least for goods trade. The extension of such agreements to the UK may face political obstacles, but at least the economic damage could be minimised.
Political Consequences of Brexit
Without the ‘unruly’ UK, EU decision-making may become slightly simpler, particularly in areas where unanimity is required such as most taxes and social security. This would not necessarily be a net positive, however, if the decisions taken more swiftly and easily without the UK as an EU member were significantly worse than those taken with difficulty and significant delays with the UK as an EU member. Clearly, the weight of the ‘market-friendly/liberal’ block in the EU (whose current core members include the UK, the Netherlands, Sweden, Denmark, and Estonia) would decline, potentially making the EU less market-friendly. The EU budget would also have to do without the €5 billion or so of net UK contributions (19% of total net contributions to the EU budget in 2014).
But the real political risk, in our view, is that Brexit would set a new and awkward precedent. It could trigger chain reactions, such as a backlash against any notion of ‘ever closer union’, even where this makes obvious sense, as in the areas of defence, foreign policy, defending the external boundaries of the EU, and certain aspects of environmental policy. Brexit could also encourage national exit movements elsewhere. The anti-EU mood in many EU member states, as reflected in the growing strength of nationalist, nativist, and populist parties in the EU, should not be underestimated. There could also be a rise in regional separatism (e.g. in Flanders, Catalonia, the Basque country or Northern Italy). The rejection of any form of supra-nationalism exemplified by Brexit could also further increase cross-border bail-out fatigue in particular in the Eurozone.
As a result, there would be a material risk that the terms of access of the UK to the rest of the EU following Brexit (as regards the movement of goods, services, capital, enterprises, and labour) would be much worse than those of Norway, Iceland, and Switzerland. This would not just (or even mainly) be because a non-EU member wanting closer relations with the EU is likely to be treated better than a former EU member that has seceded from the EU. The need to prevent the UK’s exit from the EU from creating a precedent would likely produce tough and damaging terms of access of the UK to the rest of the EU. ‘Pour decourager les autres’, the rest of EU would want to make it abundantly clear that it is not possible for an existing EU member state to exit and continue to enjoy most of the benefits of EU membership but none of the costs.
It is not our base case that the UK exits the EU. If it did happen, it could have serious economic and political consequences for the rest of the EU. The economic and financial frictions could be limited if both parties would try to strike an amicable separation agreement, but political considerations, including the desire of the rest of the EU to prevent Brexit emulation, might result in a far more damaging outcome, not just for the UK.
A loss in soft power for the rest of EU following Brexit would be near certain, in our view. Brexit would likely further boost (intra-national and inter-national) political fragmentation in the EU and raise the risk of further EU and Eurozone disintegration. Brexit could therefore have very severe political ramifications for the rest of the EU, even if the immediate economic effects remain modest. The EU without the UK would be an even more impaired regional and geo-political player than the current EU, which already punches far below its economic weight as regards regional and global diplomatic, strategic, security, and military matters. The step from soft power to no power could well be a small one.
“ever closer Union makes obvious political sense.”
To a certain classes of people, cui bono…
Yep. Those being the champagne left and the finance right.
Both are classes that can set up camp anywhere with a net connection and a credit card terminal.
The rest are location locked for various reasons.
Isn’t the Western World all free trade anyway? This isn’t 1972 when these countries had national development policies involving tariffs. Britain’s industry is kaput since 1980; all that’s left are banks. There aren’t any capital controls anymore. I mean, E. Europe gets free tax money and Mc Jobs. Germany get’s to export to the periphery. What is Britain getting out of this? What is Citi up to?
For whom, specifically?
I don’t understand how German hegemony is good for the other countries in the EU.
Psychology is a major issue. In theory, the UK is pitched as a counter balance or arbiter. It doesn’t hold up under scrutiny, but it’s the same argument Hillary knows how to get things done because she has been around during forever. Without the UK as an outside power, the EU members will start to look for exits or form anti-German blocs which can’t govern.
The other side is people do that grasp how mass communication has altered the world. I still think people believe the UK is a necessity for the U.S. to be a constructive EU partner. The White House will ride to the rescue. Without the AEF, France will be exposed as a German puppet state. Berlin can be tolerated because Paris, London and Washington guarantee the arrangement.
We are left with Buiter being Dutch and forgetting a) Britain has the largest fishing grounds in Europe which are raided by French, Spanish and Portuguese boats at the cost of a UK fishing sector. That Denmark is so dependent on UK trade it would probably leave the EU too as might the Netherlands and Ireland. Scotland has no prospect of leaving the Uk unless the ECB is going to prop up a currency in Scotland as it does in Greece.
Scotland is no more viable than Greece inside the EU as a standalone country.
Germany would lose its biggest external car market. German banks are big in The City – Deutsche Bank for example. The loss of the third largest NETT contributor to the EU budget would impose yet further burdens on Germany and increase Franco-German rivalry.
It is tiresome to read such loaded and one-sided arguments against Brexit. It is clear Germans would love to leave the EU too. The whole system is akin to the USSR and Americans have no comprehension of the failure of the EU to function either as an economic zone or a confederation.
Scotland with only 9% of the UK population has:
90% of the fresh water
65% of the natural gas production
96.5% of the crude oil production
47% of the open cast coal production
81% of the untapped coal reserves
62% of the timber production
46% of the total forest area
92% of the hydro electric production
40% of the wind wave and solar energy production
60% of the fish landings
30% of the beef herd
20% of the sheep herd
90% of the whisky industry
Scotland with only 1% of EU’s population has :
25% of Europe’s tidal energy
25% of wind power
10% of wave energy
Over 60% of EU oil production (largest oil reserve in the EU)
33% of the EUs total hydrocarbon production
We need the Whisky industry!
i’m guessing not much of that is solar
Denmark? Nah! The only thing here that is 100% dependent on selling to the UK are the industrialized pork farming industry – the messy demise of which at least half the nation would celebrate in the streets! B & O is going bust anyways.
We may leave the EU over refugees or (perhaps) more aggressive bank-bailouts, never over the farmers.
The City is not exactly part of Britain, The City has a special flag, it’s own government “The City of London Corporation”, chaired by “The Right Honourable Lord Mayor of London” – which is *not* to be confused with the elected mayor of London.
A deal can surely be created from this framework, making The City into something like Lichtenstein.
as for EU finance needing london, they do very little of their business in the UK, they just use it as the getaway car. the EU banks move their operations to dublin and, presto, dependency on the UK broken.
Brexit, if that’s what the people want, seems to make sense both for the UK and for the continental Europeans. London hampers, rather than helps, cultural integration within the Franco-German core.
“Cultural integration,” a good thing? What’s the old joke? Italian police, English cooking, French government, German military? What will be the least common denominators? McDonalds? Disney? Arthur Treacher?
And of course the mechanisms of Cultural Integration are modulated by the likes of the CIA, https://www.cia.gov/library/center-for-the-study-of-intelligence/csi-publications/csi-studies/studies/vol46no1/article08.html . And “putting OUR SOBs into power,” https://en.wikipedia.org/wiki/History_of_the_Central_Intelligence_Agency
And what is so glibly called “globalization.” That gets humanity to a kind of “cultural integration,” all right.
And since when does “what the people want,” in this age of Bernays and manufactured consensus, see link above, count for anything? Hierarchy rules (I know, a patent tautology…)
Interesting to see how much reaction this triggered. Probably more smooth to put this as one comment rather than reply separately.
1) As a general principle, yes, I think integration is a noble goal. I don’t think nation states should disappear, but I think perhaps the early 20th century was defined by too much nationalism, not too little. Integration can certainly be abused (what can’t?). And for me is dependent upon people wanting it. In no way do I advocate forcing cooperation. (Which is why I support both Grexit and Brexit.). And part of the reason such cooperation is valuable is because we are so far past peak nation-state. Many more countries exist today than a century ago, carved out of bigger empires into multiple smaller states.
2) I don’t follow any of the intelligence or globalization stuff. Anglo-American imperialism is both something that makes continental cooperation more difficult and something such cooperation could help put in check over the longer term. In fact, one might argue the successful rollout of the euro over the past few decades was a factor in pushing the Atlanticists into a clear position of global overreach. And it’s easy to forget now, but it was France, not West Germany, that called our gold bluff and recommended that countries peg their currency to the West German mark rather than float national currencies against each other in Europe.
3) What makes integration desirable? Good question at the heart of ever closer union. There is no one starting point to the story, but central western Europe has basically spent the past 12 centuries feuding over the remains of the Carolingian empire (Charlemagne and the Treaty of Verdun and all that) that spread across what we know today as the nation-states of Germany, France, Italy, and a number of smaller countries. The wars fought since then have been quite disastrous, and growing more so in scale and scope with Napoleon and the Great War and Hitler and Mussolini. To be able to integrate the economic resources of war such that war itself is rendered commercially and logistically impractical would be a great boon in creating lasting, long-term peace. Additional conveniences, like less paperwork for travel and so forth, are also nice secondary benefits. As one of the more impactful reports framed it, the costs of not integrating are why integration is so desirable.
4) On there is no Franco-German core: I agree most of it is aspirational for the future, not existing in the present; Europeans will never identify as Europeans in the way that French and German and Irish immigrants in the new world identify as Americans. But there is a Frankish historical and cultural legacy that distinguishes central western Europe. Not that France will become Germany or Germany France, but rather that the two of them are distinct from, say, Portugal or Ireland or Greece. I’m not sure if it is the existence of this that is being disputed, or the importance of it, but there’s a reason that the institutions of European integration today are essentially all in Germany, France, and the Benelux nations. There’s a reason that plaques with quotes about cooperation are in the sidewalk in Strasbourg. There’s a reason that the original European Coal and Steel Community has lasted and expanded rather than being torn apart by nationalism or irrelevance.
The above points are opinions from an outsider and so should be taken as such, but I think it does lay out a pretty compelling case to see how the main European powers might want to develop. If the UK doesn’t want to be part of that, I see no reason for them to stay. But similarly, this notion that more cooperation between France and Germany is either undesirable or impossible strikes me as a rather limited view of both what has already been accomplished – 70 years of relative peace and prosperity – and what the future could potentially bring.
Oh do tell, what makes “cultural integration within the Franco-German core.” desirable or even practical? Don’t get me wrong – I’m an inner, but have you seen how many Europeans are “culturally integrated” in London? We’re even France’s 6th largest city in terms of French people here. And they are dwarfed, nationally, by Eastern Europeans. We need each other, but your statement is less than useful.
There is no Franco-German core. There is increasing hostility. The French takeover of Hoechst, Siemens ICE, and Airbus and attempt to take over KMW reveal an ugly truth
LMAO – In your dreams…that phrase is both a German and French nightmare.
I cannot conceive of the French equivalent of “Dat is Deutsche” as praise, or the German Equivalent of a Gallic shrug.
Quicker than lightning… now we see the value of securing our existence. Thank you E.O. Wilson and all like minded people. Bottom-up, but don’t tell anybody please. Let us all start from the base: Half Earth. It will be a good thing. As Martha said but failed entirely to grasp. And the EU can stop cooking by recipe. So can we.
Their soccer teams get to keep more of their top talent, instead of losing them to the English Premier League?
I think the risk Citigroup sees in a ‘chain reaction’ of countries leaving EU is not in prospect.
The EU core is Germany, France and the Benelux countries and they have the critical mass to continue the project alone if needs be.
The countries who might suppose they can break their agreements, the southern block particularly, are precisely those who have the most to lose from separation and as Citi says the EU command would not be very particular in preserving the wealth of departing countries.
There is one aspect that Citi does not seem to have been upfront about. The AngloAmerican form of capitalism is threatened by UK’s diminishment if she leaves. It only takes a one or two percent drop to disrupt the payments chain. Then the world be faced with the socially-responsible alternative that Germany under Bundesbank, Sweden and Japan have. No more predatory capitalism. That must be an appaling prospect in London and New York.
I have nothing to offer except this. I recall that the German Chancellor lost favor during the height of the Greek crisis – as did the then existing Greek government while attempting to resolve the crisis and that the next Greek government has had no success in restructuring its debts to “payable” levels without austerity and privatization – totally detestable to the Greeks. I am left to think that a 0.5% loss of GDP is a small price to pay to retrieve fiscal and monetary sovereignty. Hence, were I a Brit, I’d vote to leave the EU. Then again, I supported Kirchner’s defiance of Singer – and look where that got Argentina. Glad I only have to choose between …, oh never mind.
Problem – EU is just another state of USA. It has no policy of it´s own. EU is hurting its own people and interest. It is part of USA´s economic warfare against Russia and China. Many EU countries lost their export and great opportunities for trade because of that. Makes no sense.
Question – Will it be possible for countries that leave EU to trade more freely with other countries like Russia?. Or is that determined by US and Co anyway? ( OK – this may be a leading question).
I´m strongly opposed to the EU-elite project. Yet I just can`t figure out if it is reasonable to stay and try democratize the system from within – At the moment, looking at the bigger picture and how Greece was treated, with such inhumanity and contempt for the people – I think it is a little naive and there is very little hope for this project to survive anyway. it seems like the EU are disintegrating all by itself with or without a Brixit. It may not be that important at all.
Pia, you hit the nail on the head about EU being completely subservient to the US.
It’s an elite project that is unravelling tho, and it will last till the US deems the cost sustainable
Then the Americans will pull the plug.
Exactly – That is why the “European Project” is now totally alien to most Europeans. If the EU wanted to succeed in what they claim are the benefits of the EU then the EU would have to become “Europe” a “Nationalistic Project”, placing the EU *against* both Russia and the US to some degree and certainly placing Europe *against* the middle east. The US of A is clearly nationalistic – which is why it can contain and survive much wider cultural differences between people in the North and South that we actually have in Europe.
The EU cannot do the same “trick” because is is basically a business venture – the only thing that matters to the EU are markets and growing them. It is not possible to “unfriend” someone over principles or the protection of ones citizens if business is lost by doing it; it is also not possible to define a border for the EU because then potential markets are limited; the EU can’t put it’s foot down on any fraud, looting and abuse either – all of those are just dysfunctional market activities that are self-correcting in the “long run” – well after we are all dead and our organs auctioned off.
The present EU is dead, it is a flesh-eating Zombie and someone should just shoot it in the head already. Double-taps, of course, before the infection spreads.
PS: Didn’t use to be like that, once upon a time in the 1990’s, the EU was actually about creating “The United States of Europe” – and then it got derailed into the mess we have now.
the EU may indeed be a vassal state-union to the US, but the UK wants to leave the EU to get even closer to the US.
i fail to see how this makes sense. tourism to greece, italy, spain or portugal is not fungible with tourism elsewhere, so i don’t see how brits would substitute it. furthermore, leaving the EU would not make it more difficult for brits to travel inside it. the UK is already outside of the schengen zone and it would take a vengeful act of spite for the EU to require tourism visas of UK citizens.