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What you need to know about 'Brexit' economics
Fund manager Neil Woodford has commissioned a report looking at the pros and cons of the UK's membership of the European Union.
With politicians and business leaders staking their positions in the EU referendum set for 23 June and stock markets on tenterhooks over the result, there is a danger the forthcoming debate will generate plenty of heat but precious light for voters seeking to make the right decision for the country.
In an attempt to reduce some of the confusion fund manager Neil Woodford commissioned a report from consultants at Capital Economics to consider the economic impact of a British exit, or ‘Brexit', from the European Union.
The report takes some of the stress out of the vote by concluding that although a UK withdrawal from the EU would cause a lot of uncertainty for the economy, the long-term economic implications may not be as extreme as is sometimes suggested.
In a video posted on his firm’s website Woodford (pictured) said the significance of the vote lay in politics rather than economics. ‘I think it’s really hard to see any significant credibility in an argument to stay or to leave that’s constructed around economics. I think it’s a nil sum game frankly, whether we stay or whether we leave. If we stay or leave the fundamentals of the economy will be relatively unmoved.’
Woodford reassured investors in his Woodford Equity Income fund that the referendum result would only have a marginal affect on his investment strategy. ‘The UK economy is important but is not the dominant factor by any means in determining my strategy for the portfolio. The big companies I invest in really have very little interaction with the slings and arrows of the UK economy. Many of them have absolutely nothing to do with the UK economy,’ he said.
Nevertheless, the Capital Economics report, which was published last week before the prime minister finished his negotiations with Brussels, has plenty of interesting facts and analysis for anyone wanting to keep up with the arguments for ‘in’ and ‘out’.
Costs and savings
How much money would the UK save from leaving the EU? The Capital Economics report cuts through the many figures bandied around by the ‘yes’ and ‘no’ camps.
It explains that in 2014/15 the UK paid a £13.7 billion contribution to the EU based on the size of the economy plus a £2.3 billion share of VAT receipts. It received back £4.8 billion from the British rebate that former prime minister Margaret Thatcher negotiated and a £0.8 billion fee for collecting customs duties on behalf of the EU. This all adds up to a cost of £10.4 billion.
It says some people like to quote the gross contribution which is higher because it includes the £3 billion of duties Britain collects for the EU and which it could keep after Brexit. However, this is dubious as it is likely the UK would cut the duties as it sought free trade links with other countries.
Others prefer to take off the £4.4 billion of support funds disbursed by the EU to British firms and households, for example by the Common Agricultural Policy. This makes sense if you assume a post-Brexit government would offer to reimburse some of this money.
‘Accounting for these two items leaves a net contribution of £9.1 billion, though the “true” cost of membership to the public purse may range from £6.1 billion to £13.4 billion, depending on whether these two items are included.’
Another uncertainty is the future of the British rebate. This could be reduced in future as the UK is not the weak economy it was when it was introduced. A cut in the rebate would increase the cost of EU membership and therefore the potential savings from Brexit.
However, Capital Economics believes the economic disruption and lower migration after Brexit would offset this. ‘We expect that Brexit will benefit the public finances but not to a huge degree,’ it says.
Annual net migration from the EU to the UK has more than doubled since 2012, reaching 183,000 in March 2015, says Capital Economics. This has boosted the workforce by around 0.5% a year, enabling the economy to grow without pushing up wage growth and inflation, thus helping to keep interest rates lower for longer.
A British exit from the European single market would reverse this, says the report, leading to upward pressure on wages and inflation, which although it would benefit some workers would hurt some employers, such as big farmers.
The main benefits of Brexit is that the UK could tailor its own immigration policy to attract more skilled workers from outside the EU.
It would also free employers from regulations such as the Agency Workers’ Directive, which gives temporary workers the rights of full-time workers. Making the labour market more flexible would offset some of the cost to firms from lower migration, the authors argue.
The report dismisses the alarmist figures sometimes used in relation to the impact on exports and jobs from Brexit.
‘The most striking – and most inaccurate – is that three to four million jobs, ie, the number of people employed in exporting goods and services to the European Union, could be lost through Brexit. Given that this assumes that all exports to the Union would cease if the UK was to leave it is a wild overstatement.’
The report says almost half (45%) of the UK’s exports go to the EU. As total exports account for 30.5% of British output, that equates to 14% of the overall economy.
Although large, Europe has become a less significant export market for the UK, with its share of our exports falling from 55% in 1999 despite the expansion in EU membership since then.
However, if you include the 60 countries that the UK has free trade agreements with via the EU, then the proportion of EU-linked exports rises to nearly two thirds, or 63%.
Quitting the EU would obviously jeopardise this but the UK could still retain access to the single market by becoming a member of the European Economic Area, like Norway, although that would leave us subject to the EU’s rules and regulations without having any influence over its policies.
It might be preferable to follow the example of Switzerland, the authors suggest, which is a member of the European Free Trade Association and has established a series of bilateral free trade agreements with the EU.
However, replicating the Swiss model would be hard as negotiations would be tough as Brussels took revenge after a ‘no’ vote. Nevertheless, the authors believe it would not be in the interests of the big EU members to stop trading with the UK as we import more from France, Ireland, Italy, the Netherlands, Poland, Portugal and Spain (but not Germany) than we export to them.
Besides, the worst-case scenario of Brexit with no free trade agreement with the EU would not be as bad as it would have been in the past. This is because EU tariffs have broadly halved to 4% from 8% in the early 1990s as part of a global trend to reduce trade barriers.
‘These costs would be well within the normal range of exchange rate movements,’ say the authors, pointing out that the pound has risen 12% against other currencies in the past two years, making British exports more expensive.
The City and financial services
This is one area where a Brexit would hurt, hence the warning from Standard Life, the FTSE 100 savings and investment group, on Friday that the UK needed to stay in Europe.
In 2013 exports of financial services to the EU produced a £16.1 billion surplus that was equivalent to 0.9% of British GDP (gross domestic product).
The loss of ‘passporting rights’ – which allow financial firms like investment banks to use a London base to operate across the EU – could halve these exports by about £10 billion, says the report.
Mitigating this by staying in the EEA or following Switzerland’s example would have the same disadvantages as negotiating new trade links. Arguably, the Swiss model would be harder to replicate as Germany and France might leap at the chance to boost the role of Frankfurt and Paris in financial markets at the expense of London.
The argument that a post-Brexit City of London would face less red tape does not hold water, however, as, according to Capital Economics, the British government has shown more ‘zeal’ for regulation than the EU.
Nevertheless, the impact would be lessened by London’s natural advantages: a time zone that sits half-way between the US and Asia, use of English and a well-established legal system and financial support services like accountancy.
There would also be the opportunity to increase financial links with countries like China. ‘The City’s competitive advantage is founded on more than just unfettered access to the single market,’ says the report. ‘A European Union exit would enable the UK to broker trade deals with emerging markets that could pay dividends for the financial services in the long run.’
Property and consumption
The UK is a property-loving democracy and bricks and mortar – particularly in the City of London – are where the pain from Brexit could be felt most.
Already, shares in commercial property developers and real estate investment trusts have fallen in response to the uncertainty the referendum vote brings.
Overseas buyers have accounted for around half of all commercial property transactions in recent years, a trend that could be reversed if the UK is no longer seen as a gateway to Europe, says Capital Economics.
Moreover, if financial companies cut their presence in the City after a ‘no’ vote, their lower demand for office space could come at an awkward time as lots of new properties near completion after the recent boom in development. Rents and property values would fall, the report says.
‘If investors felt that the City had been permanently damaged by the UK’s departure from the EU, a jump of between 50 and 10 basis points in City office yields, knocking 8% to 15% off capital values, would not seem implausible,’ say the authors.
However, the impact on overall consumption would be limited, the authors believe, as the benefits of independent policies on immigration, trade and regulation offset some of the hit to the economy.
The ‘one blot’ on the UK’s recent economic success has been the ‘continuing dismal performance of productivity’, says Capital Economics. ‘Output per hour worked remains below its pre-crisis peak and productivity growth has been substantially weaker than in the United States and other large European countries over the same period.’
Would scrapping European red tape reverse this? It has been estimated that the hundred most costly EU regulations take £33 billion from British business every year. The authors doubt in practice whether much of this would go, pointing out that Norway adopts around three quarters of EU legislation even though it is not a member. The UK would probably have to do the same if it wanted to access the single market.
‘Brexit is only likely to have a limited impact on Britain’s productivity. The major potential for improvements comes from increased business investment, which shows little connection with these political developments,’ it says.
On the other hand, neither does the report forecast a drying up in foreign investment. Overseas companies would continue to base themselves in the UK after Brexit, assuming trade deals with Europe were reinstated.
'Although the impact of Brexit on the British economy is uncertain, we doubt that Britain's long-term economic outlook hinges on it,' the report concludes. 'Things have changed a lot since 1973, when joining the European Economic Community was a big deal for the United Kingdom.
'There are arguably more important issues now, such as whether productivity will recover. The shortfall in British productivity relative to its pre-crisis trend is still over 10%, so regaining that lost ground would offset even the most negative effects of Brexit on the economy.'
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