Brexit Will Not Change UK’s Economic Fundamentals

Despite gloomy forecasts, Britain’s expected economic collapse has not materialized, and new research suggests the impact on trade will be mitigated.

A year after British voters overturned most experts’ predictions by choosing to leave the European Union, the UK economy has steamed ahead, registering one of the highest growth rates in the OECD. There has not been the collapse predicted by the UK treasury, Bank of England, IMF, OECD and most banks and commercial forecasters. Inward investment remains the highest in Europe. Moreover, this outperformance is widely spread across consumer spending, housing and business investment.

How to explain this? Michael Saunders, a member of the Bank of England’s rate-setting Monetary Policy Committee, says it is partly because Article 50—the treaty mandate for a two-year exit negotiation process—was not triggered immediately, as most had assumed it would be. Even now, months after prime minister Theresa May did so in March, the UK economy is still operating within an EU environment. The sharp drop in sterling following the referendum, and the Bank of England’s loosening of the money supply, have also spurred economic growth, which accelerated in the first quarter of 2017.

The prime minister has called a general election in order to reinforce her mandate in negotiating exit terms with the European Commission. But public opinion in Britain remains deeply divided—as does the opinion of economists. Jonathan Portes, senior fellow at the Economic and Social Research Council’s UK in a Changing Europe initiative, a think tank based at King’s College, London, reflects conventional wisdom when he says, “From a purely economic point of view, it’s difficult to see any upsides in choosing to leave the largest integrated trading area in the world.”

Still, Neil Gibson, director of Ulster University’s Economic Policy Centre, notes that there are successful European economies outside, as well as inside, the EU. Although he voted “Remain,” he poses the question: If you’d just arrived from space, would you invest in Greece, which is in the EU, over Switzerland, which is not?

Neil Gibson, Ulster University: Many of the UK’s attractions to international investors won’t change whether we’re in or out of the EU.

Bemused by how many experts called it wrong, Gibson combined forces with Graham Gudgin and Ken Coutts of Cambridge University’s Centre for Business Research to re-examine the impact of trade agreements on the actual volume of trade between hundreds of countries over a long time-frame. Even with the 60 largest and most developed countries that most resemble the UK, they found that trade agreements had only slight impact on long-term GDP trends. Canada’s economy, for instance, has benefited only marginally from Nafta membership. As for the UK, they suggest that a hard Brexit and falling back on WTO rules with 4% tariffs would not be disastrous, as sterling has already depreciated by 12% since the referendum.

“Many of the UK’s attractions to international investors—its human resources, the rule of law, geopolitical security—won’t change whether we’re in or out of the EU,” Gibson says.

Their research takes in over a million pieces of data and effectively debunks the UK treasury’s “Project Fear” forecast of a 45% drop in trade with the EU. This was based on the “gravity model,” which assumes trade volumes depend on the size of each trading partner’s economy and how close it is geographically. But as Gibson points out, “If that were true, you wouldn’t have weak economies in large regions near London.” Moreover, recent McKinsey research suggests other factors, including a shared language and similar cultural and legal traditions, also impact trading relationships.

And although it prides itself on being a free-trading nation, the UK’s record on this is hardly enviable. Greg Hands, minister of state for trade and investment, notes that UK exports as a percentage of GDP languish at 28%, the lowest of any EU member state. “Only 11% of UK businesses currently export,” he adds, “and [only] 6%–7% of goods exporters target high-growth economies such as India and China.” In an effort to boost this dismal export performance, the government has doubled its export credit agency’s risk appetite to £5 billion ($6.5 billion) and extended the number of local currencies in which it can offer support from 10 to 40.

A new Department for International Trade under Liam Fox has been created since Brexit to negotiate treaties and facilitate UK trade with countries outside the EU. Gibson argues that an independent UK can push through structural reforms or a deal with China or India far faster than it could as a member of the EU, which, he reminds us, is “still dealing with the fallout from the financial crisis, nearly a decade later.” Much hope is being pinned on striking deals with the US and fast-growing economies in Asia and Latin America. Portes agrees that “it may be easier for Britain to negotiate individual trade agreements alone than as one of 28 nations. We could be more nimble, but we will have less clout.”

Gibson and his co-authors conclude that a hard Brexit could reduce trade with the EU by 20%, or less than half the treasury’s forecast. The effect on the overall UK economy will be manageable, with GDP continuing to rise by 2.5% through 2019 and then slowing to just under 1% post-2021.

“The gains will probably be broadly based, rather than confined to specific sectors,” says Laza Kekic, an independent consultant on the UK and Europe. “Judging from the commitments to further investment in the UK post-Brexit that have been made by many foreign companies (in contrast to widespread fears of an exodus of companies from the UK), a whole range of sectors are set to do well, including automotive, technology, retail, pharmaceuticals and aerospace.”

In terms of possible negative consequences, perhaps the financial sector, which is so important to the UK economy, has received the most attention. Especially worrisome is whether a hard Brexit will result in the loss of so-called passporting rights for UK-based banks. However Kekic believes that “these fears are almost certainly exaggerated. Aside from the many advantages of London as a financial center over places like Paris or Frankfurt, the UK would also have a big reserve policy weapon of radical deregulation to attract financial-sector companies.”

Jonathan Portes, Economic and Social Research Council: After Brexit, we could be more nimble, but we will have less clout.

While multinationals or large UK businesses are either setting up their own Brexit contingency plans or bringing in advisers from the big accountancy-based consultants and London law firms (Freshfields recently hired Lord Jonathan Hill, former European commissioner for financial stability, financial services and capital markets, to boost its advisory team), most SMEs have yet to address the changes Brexit will bring. Amelia Bishop, managing director of the Swindon-based consultancy Weenie Business Solutions, sees Brexit opening multiple opportunities for smaller and more nimble private companies—provided they plan ahead and review their product offering and suppliers. To that end she is establishing a Brexit Opportunities Centre.

Assuming that both tariff and nontariff barriers with Europe will rise, Bishop highlights those sectors such as agriculture and building materials where import substitution could be achieved rapidly. Niche sectors such as horticultural products—where, as Sir Nicholas Bacon, president of the Royal Horticultural Society, points out, “Britain currently imports trees and plants worth £1.1 billion, while it exports just £50 million,”—could also benefit, particularly if independence from the EU “allows the government to apply a passport scheme whereby plants coming from Europe are properly quarantined so that pests, bugs and diseases can be identified in a controlled environment.”

“The UK’s agricultural industry,” says Bacon, “is one of the most efficient in the world and has overcome price swings and volatility in the past.” But already, farmers of labor-intensive crops are facing severe challenges. “The cutoff of cheap labor from Central and Eastern Europe will have a profound impact on agriculture by pushing up wages, thereby forcing some firms, or even entire sectors, out of business,” says Portes, “The end result will not be lots of better-paid British workers but more mechanization to achieve higher productivity.”

The UK economy is now expected to retain robust growth up until the two-year deadline for negotiating exit terms expires. The Bank of England’s Saunders expects that “the next year or two will see steady growth, above-target inflation, stronger exports and a pickup in business investment,” adding that “there are no signs so far that productivity trends are weakening.”

But what of Brexit’s impact over the longer term? Some experts believe that a shake-up effect from upending an unsatisfactory status quo will bring its own benefits. “Brexit,” says Kekic, “could open space for the application of new ideas and for dealing with the long-standing ills of the UK economy, such as insufficient innovation, inadequate infrastructure and weak skills in certain areas.”

The political scene will be certainly be affected, too. “Brexit could allow a reset of economic policy to address some of the issues, such as the serious regional imbalances between London—by far the richest city in Europe—and areas that contributed to the pro-Brexit vote, like the former coal-mining communities of northeast England and the valleys of Wales, which are below the European average,” Portes says. “Reforms of training and skills, improving the education system outside of London and vocational training could reduce some of the regional discrepancies of wealth and opportunity that fueled anti-elitist populism.”

Portes also argues that “an immigration system allowing Britain to bring in workers with the specific skills that are needed from wherever in the world—India, Australia or China—could be a more beneficial system than the EU’s freedom of movement.” Although much will depend on the precise terms of the divorce—especially for financial services—Britain has a track record of resilience. And as Gibson points out, “Forecasts about the UK economy and how competitive it will be in 30 years’ time are meaningless. By then, there will be entire sectors we don’t know about.”