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Can of Brexit worms

21 Feb 2016 By Hugo Dixon

Now David Cameron has clinched his deal to renegotiate Britain’s relationship with the European Union, the British people will vote on whether to stay in the union in a referendum on June 23. While the chance of Brexit looks less than 50:50, the economic consequences could be severe if the electorate does decide to pull out of the bloc.

The opinion polls suggest a high Brexit risk. NatCen’s poll of polls puts “remain” on 52 percent, just a nose ahead of “leave” at 48 percent.

But the contest is probably not quite that close – not least because Cameron has barely started campaigning in favour of staying in the EU. Nor has his cabinet, which has split 17 for remain versus five for leave.

On the other hand, Boris Johnson, the popular mayor of London, confirmed on Feb. 21 he would be supporting the campaign to leave the EU. This is a huge shot in the arm for the leave campaign — which is divided into two warring groups with different visions about what “out” would look like and whose most prominent figure was previously Nigel Farage, the leader of the UK Independence Party, who turns off more people than he attracts.

What’s more, many things could go wrong for the “remain” camp. Most obviously, the British people may think it is best to quit if, as seems likely, there is another surge of migrants from the Middle East and northern Africa into Europe this spring. Even though few are entering Britain and Brexit might expose the UK more to the refugee crisis, the “leave” camp is arguing the opposite.

Voters might also easily ignore what the political elite tell them is in their interests. They have done that in referendums in other EU countries in the past – for example, when the French voted against a proposed European constitution in 2005.

A better gauge of the chance of Brexit than opinion polls are probably the odds offered by betting agencies. The implied probability was 28 percent on Feb. 20, according to Ladbrokes, though that hadn’t yet reflected Johnson’s decision.

What such betting doesn’t show is the damage that would occur in the event of Brexit. The currency markets, though, do offer a glimpse. In the past three months, as the perceived probability of Britain quitting the EU has risen, sterling has fallen 9 percent versus the euro. If the UK actually left, the pound would probably drop further.

In analysing the economic impact, it is useful to distinguish the new steady state post-Brexit from the process of getting there.

The new equilibrium would be less advantageous compared to the current situation because Britain would struggle to gain as good access to the EU’s single market. Without that, the UK’s long-term growth prospects would be lower.

While the UK could, in theory, copy Norway – which has access to the single market while not being in the EU – it seems unlikely to go for such a model. After all, it would have to apply the rules of the market without a vote on them, as well as allow free movement of people. It would be hard to sell such a deal to an electorate that had just voted to quit.

If the new steady state is less attractive than the status quo, the transitional process could be even more damaging. For a start, the divorce could be acrimonious, with each side under pressure from its own people not to give ground. Given that Britain does nearly half its trade with the EU while only 14 percent of the bloc’s trade is with it, the UK would have more to lose from a bustup.

What’s more, a vote to leave the EU could trigger political turmoil in Britain. Though Cameron says now that he would stay on as prime minister if the people voted to quit, the pressure on him to resign would be enormous. Johnson would be best placed to succeed him.

If the economy took a dive after the referendum and the Tories tore themselves apart in a bout of bloody infighting, there is even a chance that Jeremy Corbyn, leader of the opposition Labour Party, could emerge as prime minister in the 2020 general election – a scenario few now take seriously. Given Corbyn’s unreconstructed socialist economic policies, markets would take this badly.

Quitting the EU could therefore lead investors to attach a risk premium to UK assets, as Mark Carney warned last month. The governor of the Bank of England said that Brexit could test “the kindness of strangers” given that Britain relies on foreigners to fund its current-account deficit, which is forecast by the European Commission to reach 5 percent of GDP last year.

Despite sterling’s fall in recent months, it doesn’t seem that the markets are pricing in such tail risks.

(Hugo Dixon is chairman of InFacts, a journalistic enterprise arguing that Britain should stay in the EU. He is a guest columnist for Reuters Breakingviews.)



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