brexit-from-across-the-channel

PERSPECTIVES JUNE 2016
This is for investment professionals only and should not be relied upon by private investors
Brexit from across the Channel
Markets have been increasingly nervous about a potential ‘Brexit’ vote in
the UK’s upcoming referendum on EU membership. In this Perspective,
Dierk Brandenburg and Andrea Iannelli look at the potential impact of a
Brexit on the EU.
They show that the economic impact of the UK leaving the union would be
negative but manageable, although the technical intricacies of
disengagement would be substantial and require years to solve. Most of
the markets’ concern centres on the potential political domino effect
across the rest of Europe and the future of the union.
Short term, a Brexit vote could still lead to further adjustment in bond
markets but less so than many are speculating, as the ECB would
intervene to dampen any negative impact.
Size matters in the world
The UK accounts for 17% of EU GDP (Chart 1), exceeded only by Germany,
and its population is the second largest in the union. Without the UK, the EU
would therefore lose some economic clout, falling behind NAFTA (the North
America Free Trade zone, including the US, Canada, and Mexico). The
European single market, however, would still comfortably rank second globally
(Chart 2).
Although part of a smaller free trade zone, the remaining members of the EU’s
single market would be in a better competitive position than a standalone UK,
as the large proportion of trade that takes place within the EU shields it
somewhat from the protectionist trends that are on the rise globally.
These positions could shift if the UK succeeded in striking more beneficial
trading agreements with its trading partners. If, for example, the Transatlantic
Trade and Investment Partnership (TTIP) were to fail, the UK might be able to
negotiate a better agreement with NAFTA and possibly with a future Trans-
Pacific Partnership (TPP). But such negotiations tend to take a long time, which
plays in favour of the EU’s single market, at least in the short term.
Politically, the EU’s global standing would suffer from losing political
representation, for example on the United Nations Security Council. (In defence,
however, the UK and the EU would still be bound together through the NATO
treaty.)
DIERK BRANDENBURG joined
Fidelity International as a senior
credit analyst in 2003. After
leading the financial team in the
fixed income division for six years,
Dierk took responsibility of
developed markets sovereigns &
strategy in 2014.
Prior to joining Fidelity, Dierk was
Deputy Head of Credit at the Bank
of International Settlements and
also worked at Deutsche Bank.
Dierk holds a PhD in Economics
and degrees from Freiburg
University and the London School
of Economics.
ANDREA IANNELLI is an
Investment Director at Fidelity.
Andrea joined Fidelity in 2015, and
represents the Fidelity fixed
income investment team to
institutional and wholesale clients
in Southern Europe and Latin
America.

PERSPECTIVES | Brexit from across the Channel 2
Chart 1:
UK represents less than 17% of EU single market
Chart 2:
EU single market is #2 among global free trade areas
without UK
0.80
0.90
1.00
1.10
1.20
1.30
1.40
1.50
1.60
1.70
1.80
10%
11%
12%
13%
14%
15%
16%
17%
18%
19%
1999 2002 2005 2008 2011 2014
UK GDP % EFTA GDP (LHS)
GBP/EUR Rate (RHS)
0
2
4
6
8
10
12
14
16
18
20
1995 2000 2005 2010 2015
Real 2010 $
EFTA ex UK UK NAFTA
Japan China
Source: Fidelity International, Haver, 20 June 2016 Source: Fidelity International, Haver, 20 June 2016
UK growing faster than EU average
The UK has been a growth engine for the EU and a destination for excess
savings from the eurozone. Its monetary and fiscal independence allowed it to
escape the eurozone’s ‘double dip’ recession in 2012 and led to higher UK GDP
growth (Chart 3) - but also to higher budget and external deficits (Chart 4).
Not only is it close to the continent, but the UK has also been an EU member for
more than 40 years, so its economy is deeply integrated with the rest of Europe.
This is unlikely to change in case of a Brexit vote, even over a long-time
horizon, as it is not in the interest of either side to disrupt the status quo.
However, the economic cycles of the EU and the UK are not always in sync and
the incentives for integration may change over time.
Chart 3:
UK has grown faster than eurozone since crisis
Chart 4:
UK budget deficit is similar to Spain’s
-5.0%
-2.5%
0.0%
2.5%
5.0%
1995 2000 2005 2010 2015
Eurozone Real Growth (EUR)
UK Real Growth (GBP)
-12
-10
-8
-6
-4
-2
0
2
4
1995 2000 2005 2010 2015
Eurozone UK France
Germany Italy Spain

Disruption of trade would weigh on EU growth
The EU’s trade surplus with the UK is about 1.2% of GDP, as EU countries
export more goods and services to the UK than vice versa (Chart 5).
Export exposure to the UK varies by EU country, with smaller eurozone
members such as Ireland and the Netherlands more exposed (Chart 6). Ireland
in particular stands out given the proximity and strong trade ties with the UK.
Irish trade and GDP could come under pressure due to the uncertainty over
future UK demand as well as potential for renewed political tensions after years
of relatively peaceful interaction between the UK government and the Northern
Irish separatist movements. Overall, however, European businesses are very
international, with a modest sales exposure to the UK and a much smaller share
of revenues derived from the domestic (EU) market than US or Asian
businesses.
The UK’s exports to the EU as a percentage of GDP are more significant. Yet
this has been changing: over the past few years of anaemic growth in the EU,
the UK’s exports to the EU have fallen from 10% of GDP to 6% of GDP. This is
sometimes used to argue that the UK may be better off outside the block,
although the disruption to trade from a Brexit could put its own growth at risk.
Chart 5:
UK is major export partner of EU
Chart 6:
Smaller EU countries goods exports most exposed to UK
demand
0.0%
0.2%
0.4%
0.6%
0.8%
1.0%
1.2%
-300
-200
-100
0
100
200
300
400
1999 2001 2003 2005 2007 2009 2011 2013 2015
EU Goods Exports to UK (EUR bn)
EU Goods Imports from UK (EUR bn)
Net Balance % EU GDP ex UK
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
IT ES FR DE NL IE
Goods Exports to UK,
% GDP (10yr average)
UK current account deficit puts EU savings at risk
Due to the widening gap in savings and demand, EU residents have built up a
sizeable positive net asset position in the UK. In other words, the total amount
of UK assets held by EU investors exceeds the sum of EU assets held by UK
investors (Chart 7). This is a reflection of the EU trade and current account
surplus, as well as the attractiveness of the faster growing UK economy.
The uncertainty about the economic outlook that would follow a Leave victory
would be likely to put pressure on sterling, which would act as a shock absorber
and help rebalance the external deficit. But a weaker sterling would reduce the
value of EU investments in the UK, which are sensitive to moves in the
exchange rate (Chart 8). Thus, the wealth effect of a Brexit could amplify the
negative repercussions on the EU of a disruption to trade and growth in the UK.

Uncertain times don’t help investments
The prolonged period of negotiations that would follow a Brexit vote would
prove a headwind for investments in the UK, with both domestic and, more
importantly, foreign investors likely to take a more cautious approach.
Foreign Direct Investment (FDI) has played a key role in financing the UK’s
large current account deficit, and it is likely to slow for as long as the trade and
legal ties between the UK and the EU remain uncertain. With less capital
flowing to the UK, the EU should benefit as investments are instead diverted
towards European destinations. This is particularly relevant for the financial
sector, with cities like Frankfurt or Milan keen to win market share from London.
Future UK governments, however, would not stand idle, and could support
domestic companies via subsidies and deregulation as they would no longer be
bound by EU regulatory constraints.
Chart 7:
Eurozone has excess savings, while UK imports capital
Chart 8:
EU net assets in UK vulnerable to GBP/EUR volatility
-300
-200
-100
0
100
200
300
400
1999 2001 2003 2005 2007 2009 2011 2013 2015
EU Current Account (EUR bn)
UK Current Account (EUR bn)
-6%
-4%
-2%
0%
2%
4%
6%
-1,200
-800
-400
0
400
800
1,200
1999 2002 2005 2008 2011 2014
EU Assets in UK (£bn)
EU Liabilities to UK (EUR bn)
Net balance (% EU GDP ex UK)
‘Conscious uncoupling’ unlikely
Technically, once the UK has formally activated Article 50 of the Treaty of the
European Union, the country has two years to formalise its exit from the EU.
This window can only be extended if agreed unanimously by all remaining EU
countries.
It is not yet clear whether the UK government would invoke the clause
immediately after the referendum, as there is little evidence that a plan is in
place to manage what would be challenging exit negotiations. It is also possible
that the result in favour of Brexit would be challenged if the outcome is close,
preventing the UK’s parliament from voting for an exit immediately.
Both sides would have a stake in a smooth transition to a new regime, with
minimal friction in trade and capital flows, but they would face significant
obstacles on their path.

Brexit campaigners in the UK have long advocated an end to UK contributions
to the EU’s budget. More recently, campaigners have suggested the UK should
end free movement of EU citizens to its territory as soon as possible, even
before the negotiations are completed. EU expats could then be subject to the
same immigration regime as citizens of non-EU countries such as India or the
US. With 3 million EU expats living in the UK and 1.2 million UK expats living in
the EU, this could become a contentious issue in the negotiations.
Both demands are fundamentally at odds with EU principles applied to the
single market, even for non-EU members of EFTA such as Norway,
Switzerland, Iceland and Liechtenstein, making it unlikely that the UK would
stay in the single market.
This means that it is unclear what the UK’s trading relationship with the EU
would be, and that it could take many years before a compromise is reached.
On their part, EU negotiators would fear a potential domino effect among other
countries, and would - at least initially - be reluctant to yield much ground.
Risk of domino effect
Beyond the economic risk, a Brexit would present a political blow to European
integration after many decades of continued expansion.
Markets are concerned that a successful exit referendum in the UK could trigger
further disintegration over time. Smaller EU countries such as Denmark, the
Czech Republic and the Netherlands are frequently cited as potential
candidates for exit referendums, with the Dutch being a particular risk in view of
their eurozone membership. Additional complications could arise within the UK
itself if a largely pro-EU Scotland were to hold another referendum.
Like in the UK, anti-establishment sentiment could resurface in Italy, affecting
the Italian constitutional referendum in the autumn and posing a challenge to
further reforms necessary to make the country competitive.
However, while we believe that political risk will remain elevated in coming
months, every event would have to be analysed on its own domestic merits and
we would caution against generalising across the EU.
EU budget likely to be a thorny issue
The economic impact of a Brexit on the EU budget would be manageable, but
disentangling financial interests could prove technically complicated and take
several years.
According to on the latest available statistics, the UK contributed £5.7bn (net) to
the EU in 2014. This takes into account the substantial rebate the country has
received from the EU since 1984 (€6 billion in 2014). The net contribution
amounts to 200 EUR for each UK citizen and is below the EU’s average
contribution (Chart 9).

Chart 9:
Thorny budgets
-€200
-€100
€0
€100
€200
€300
€400
€500
€600
Bulgaria
Romania
Croatia
Hungary
Poland
Latvia
Lithuania
Slovakia
CzechRepublic
Estonia
Greece
Portugal
Slovenia
Malta
Cyprus
Spain
Italy
EUaverage
France
UK
Ireland
Belgium
Germany
Finland
Austria
TheNetherlands
Sweden
Denmark
Luxemburg
Per capita contribution before UK rebate
UK rebate per capita
Per capita contribution after UK rebate
Gross contributions to the EU budget by member
state, before and after UK rebate, 2014
Member states are ranked by GNI per capita with the poorest on the left and the richest on the right.
Source: Fidelity International, Institute for Fiscal Studies, 20 June 2016
EU budgetary contributions are based on multi-year agreements among all EU
member states; the current arrangement is up for review in 2020. Any decision
by the UK to exit the EU and the single market, and to cease contributing to the
budget, would probably only take effect from 2020, although the UK is likely to
push for a speedier solution in view of the general elections that year.
Moreover, in terms of size, when compared to EU GDP, both the UK’s budget
contribution and the EU budget itself are relatively small (0.08% and 0.80% of
EU GDP respectively, based on 2014 numbers), and the UK share has been
shrinking gradually over time. The remaining EU members would see their
budget contributions increase, to make up for the shortfall following the UK exit
(in the region of €5-9 billion based on recent numbers), and there would be less
burden sharing among members in the future.
But there are some necessary technical steps that would make a full UK exit
more challenging than it would initially appear, and turn the disengagement
process into a multi-year exercise. Before exiting the EU, the UK would have to
settle liabilities which have arisen over decades of interacting with EU countries
and engaging in common agreements and initiatives.
Without trying to provide a comprehensive list, the EU and the UK would need
to reach agreement not only on the current budget but also on pension liabilities
as well as contingent liabilities such as the EFSM (European Financial
Stabilisation Mechanism), the EIB (European Investment Bank, EUR 450bn
debt), outstanding EU debt (EUR 54bn) and the UK’s symbolic equity stake in
the ECB.

Conclusion: Markets will focus on politics, not numbers
The economic and financial consequences of a Brexit on the European
economy appear manageable, but the political repercussions would be
profound.
A UK vote to leave the EU would be defined as the peak of EU integration, and
could fuel the already increasingly popular anti-European movements on the
continent.
Initially, the ensuing uncertainty might boost demand for high-quality
government bonds and for more liquid, defensive assets. It could lead investors
to review their exposures towards corporate and government debt in those
countries where the political fallout would be higher, given also the second-
round effects on investment and consumer confidence.
But if there were any short-term widening in credit spreads, the ECB, already
actively buying government and corporate bonds as part of its quantitative
easing programme, would be swift to respond to any tightening in financial
conditions, to cushion any blow to the already fragile European economy. This
would mean that the spike in yields would probably not be as dramatic as some
commentators fear. Firm forward guidance towards monetary easing would be
required from the ECB to steer markets through this critical phase.


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