How Brexit Might Play Out

Given that the Brexit vote took pundits and markets by surprise, what lies ahead for corporate finance as Britain sets about extricating itself from its 45-year civil union to the European Union?

Brexit Pointing

Given that the Brexit vote took pundits and markets by surprise, what lies ahead for corporate finance as Britain sets about extricating itself from its 45-year civil union to the European Union?

In the immediate aftermath, sterling lost 30% of its value and equities tumbled in a flight to safety. Prime Minister David Cameron (who supported Remain) resigned, and it seems likely that Jeremy Corbin, the leader of the Labour opposition, may also resign. Since Westminster MPs overwhelmingly supported Remain, the event seems likely to reshape the Commons significantly.

How will the nations unravel their relationships? The Treaty of Rome—which established the European Economic Community, a precursor to the modern European Union—also established some procedures for a separation. Under clause 50, a member wishing to leave must provide written notice and then has two years to negotiate an exit. The UK, lacking a PM and facing significant political disarray, seems in no hurry to invoke clause 50.

Brexit advocates have insisted that the UK will be able to negotiate trade terms similar to the ones enjoyed now, but given the rancour within the union about this abrupt change of course, that now seems utopian. And with both left and right-wing movements in Poland, France, Italy, Spain, the Netherlands and Denmark demanding exit referenda of their own, EU leadership may want to demonstrate that apostates can expect a rough ride and a punishing change in economic circumstances.

Europe is divided between those who argue for this tough approach (including Francois Hollande, who wants to discourage a right-wing that seeks a “Frexit”) and others, like Merkel, who argue for a slower process ensuring minimum damage to either party and avoiding rancour. Merkel may be remembering the opprobrium heaped upon Germany after “Grexit” was avoided by imposing draconian terms on further financial support. She may also worry that cavalier treatment of the UK could backfire, and encourage disaffection.

Either way, the UK is looking at a potential loss of all favourable trade and tariff terms within two years, including fresh constraints on the movement of labour, tariffs on goods moving in and out of Europe, and exclusion of UK professionals like lawyers and accountants from offering services in Europe (EU-enhanced London has been a magnet for international law firms). These changes have a huge impact on manufacturing, legal and banking services, and on the much-loved National Health Service, which relies on immigrant labour and supplies from Europe. Replacing immigrant with domestic labour will require significant wage increases, and the erosion of sterling will inflate procurement costs.

The UK will try and get a free-trade agreement (FTA) with the EU that brings advantages comparable with membership, but negotiations will be slow and the result unlikely to match the preferential access that the UK currently enjoys. The UK will similarly have to negotiate its own FTAs with third countries that the EU has trade agreements with, in all probability losing—as a result of a weaker negotiating power—some of the benefits it currently enjoys under EU-negotiated agreements.

Starting immediately, therefore, investors who are attracted to the UK because it offers access to Europe’s market of around 500 million people are likely to hold off pending exit negotiations. If they do not have the luxury of time, they will likely select another location in Europe. Even before a final exit takes place, foreign and domestic investment is expected to decrease as a result of significant uncertainty about the UK economy.The UK will suffer—and suffer immediately.

But what will Britain’s woes matter to other countries? Many non-British financial institutions, insurance companies, and even law firms operate from the UK solely because they can provide services across the EU from their base in the UK (so called “passporting”). Unless otherwise agreed between the UK and the rest of the EU, this will cease to be an option. And since other major cities will be happy fill London’s shoes as an EU gateway, such companies might consider establishing their bases in France, Germany, Ireland, the Netherlands, or elsewhere in Europe. This will likely result in a spill-over effect on the business of other UK-based service providers, including law firms.

Many US and other foreign companies have established outposts in the UK in part because they can access the EU’s large talent pool. This will no longer be the case. While EU citizens currently employed in the UK may be permitted to remain in the country, further migration of EU citizens will be subject to serious restrictions. Accordingly, foreign businesses—including law firms—may experience a shortage of talent from other EU countries.

But is there an out? Constitutionally, a plebiscite is not legally binding in the UK. There is already a strong movement to delay or mitigate the result. A majority in the House of Commons would need to ratify the invocation of clause 50 and it is not clear that this ratification will be forthcoming unless the make-up of the commons changes—which might require a general election. Currently, many international lawyers are reassuring clients that nothing will change immediately, while at the same time they encourage them to consider multiple forward-looking scenarios and possible responses. For now, the only sure thing about Brexit is more uncertainty.