The Algebris Bullet

The Silver Bullet | Brexit: it’s not EU, it’s me

On 23 June, British voters will need to state their preference on “Should the United Kingdom remain a member of the European Union or leave the European Union?”

The UK and the EU have always had a complex relationship. Next week the UK will decide whether to continue with a marriage or to break up. The odds on either side are very close: our base-case scenario is for remain to win narrowly with around 51.2% of votes vs 48.8% for leave.

In this analysis we provide a brief history of the UK’s relationship with the EU, compare the scenarios that could develop following the referendum and explain the economic and political consequences of Brexit.

We also discuss the many challenges faced by the UK economy: a persistently high budget deficit, weak household finances, low productivity growth, and rising inequality. These problems will not go away even with a remain vote.

1.The UK & the EU: a troubled love story

1.1 The current UK-EU relationship: friends with benefits? The UK joined the European Economic Community (EEC) in 1972, which later developed into the European Union under the Maastricht Treaty, in 1993. The UK is one of 28 EU member states, meaning it has to adopt EU laws domestically. However, the UK has been able to negotiate four opt-outs from EU legislation or treaties – the most across EU members. These are 1) opt-out from the Schengen agreement, which allows visa-free travel between participating countries; 2) opt-out from the monetary union; 3) the right to opt out from legislation in the area of freedom, security and justice on a case-by-case basis and 4) a “clarifying protocol” which limits the ability of the European Court of Justice to interfere with UK courts’ rulings related to the Charter of Fundamental Rights of the EU.

1.2 How much do British voters really know about the EU? Not as much as they should. According to a recent poll study by Ipsos MORI, there are huge misconceptions among British voters about the EU. For example, four out of ten voters do not know that members of the European Parliament (MEPs) are elected by the citizens of each Member State, and just 5% can correctly name at least one of the MEPs representing their region. The British public also tends to overestimate the burden related to EU membership (e.g. immigration, UK’s contribution to Child Benefit) and underestimate the benefits received from the EU (e.g. investment into the UK by the EU), as shown below.

1.3 What are opinion polls suggesting about the odds of a leave vote? Average readings from the latest ten polls (5 June – 14 June) suggest that the leave camp is now leading with 48% votes vs 44% for remain.

However, the gap between polls and actual results in last year’s General Election and the Scottish referendum cast doubt on the reliability of these readings.

The betting market also still shows a higher implied probability for remain vs leave, though the lead has been narrowing since April. Betting spreads at Ladbrokes now suggest a 62% probability of remain vs 38% for leave.

1.4 What are our estimates about the probability of a remain vote vs a leave vote?

We run a Monte Carlo simulation model to test the likely outcome of the referendum based on polls and poll volatility since January. In our base-case, remain is likely to win by a narrow margin at 51.2% vs 48.8% for leave (see Appendix for methodology).

There are four possible post-referendum scenarios:

Base-case scenario – narrow remain win (<55% vote): 34% probability. A remain vote, even if narrow, will come as a temporary relief to David Cameron’s allies and financial markets. While this may not draw a definitive end to the long debates over the UK’s relationship with the EU, another major risk event like a second referendum is unlikely to happen in the short to medium term. There is likely to be a “reconciliation” reshuffle of the current Tory government, as suggested by PM Cameron’s allies previously. “Uniting” Tories again may not be an easy task for Cameron in this scenario, as some backbenchers like Nadine Dorries are already arguing that the PM might only survive if remain wins by a wide margin.

Scenario 2 – narrow leave win (<55% vote): 32% probability. This scenario only has a slightly lower estimated probability than a narrow win for remain. It would still come as a negative surprise to financial markets, with Sterling dropping to 1.15-1.2 vs the Dollar and a rapid decline in stock markets. While PM Cameron previously ruled out resigning if the UK votes to leave the EU, he could be forced to step down. Andrew Bridgen, a Tory backbencher, said in May that more than 50 MPs were ready to move against Cameron. This means a government reshuffle is also inevitable under this scenario, given the implicit shift in power within the Conservative Party. In addition, momentum could start to build for another independence referendum in Scotland, as suggested by Nicola Sturgeon and Alex Salmond, the current and former First Minister of Scotland.

Scenario 3 – large remain win (>55% vote): 24% probability. This would be the optimal scenario for financial markets. A strong vote for remain will also provide a more solid backing for PM Cameron in his planned government reshuffle and bring a short-term blow to the Eurosceptic party members. However, this scenario looks less likely based on recent polls.

Scenario 4 – large leave win (>55% vote): 10% probability. This is a tail risk scenario that could cause the most contagion – both across the global financial markets and in fuelling Eurosceptic sentiment across the rest of Europe, as we discuss below.

2.Brexit: a painful and dramatic break-up

2.1 What is the process for the UK to exit the EU in the case of a leave result? A leave vote does not mean Brexit immediately. In theory the referendum result is not legally binding, though the UK government would “have a democratic duty to give effect to the electorate’s decision“. The Parliament still has to enact laws to initiate the exit process, first starting with the repeal of the 1972 European Communities Act.

The UK then is likely to follow the guidelines set out by Article 50 of the EU Treaty. Under the article, the UK would have a two-year period to re-negotiate its relationship with the EU to reach a withdrawal agreement. The process would start with the UK informing the European Council of its decision to exit the union. The European Council members, except for the UK, would have to unanimously vote on the guidelines under which the European Commission would negotiate the terms of the withdrawal agreement. A final agreement would need to be approved both by the UK and an enhanced qualified majority among the remaining Member States (20 out of 27 Member States, representing 65% of the population). The final agreement would also need to be approved by a simple majority of the European Parliament.

During this period the UK would still be required to abide by EU treaties, and the two-year period may only be extended if approved by all remaining 27 Member States. In addition, the UK would need to negotiate a separate agreement regarding the future relationship with the EU. Whether the two negotiations should happen simultaneously or consecutively would also be a matter of negotiation after the referendum.

There is no precedent of a Member State exiting the EU, though Greenland, one of Denmark’s overseas territories, voted in a referendum in 1982 to leave the EEC. It took Greenland three years to negotiate with the European institutions to agree to an exit deal, despite its much smaller economy compared to the UK.

2.2 How strong a relationship can the UK have with the EU in the case of Brexit? The UK could potentially negotiate a deal to be a member of the European Economic Area (EEA), similar to Norway, Iceland and Liechtenstein, or to follow Switzerland’s model by joining the European Free Trade Area (EFTA). However, membership of the EEA also entails the need to allow free movement of persons, which goes against what some leave supporters are campaigning for. Even Switzerland has signed an agreement with the EU guaranteeing free movement of persons. The German finance minister, Wolfgang Schäuble, recently suggested that the UK would not be allowed to retain access to the European single market if it exits the EU. If this is the case, the UK might need to negotiate for a Customs Union deal like that with Turkey, which covers all industrial goods but not agriculture, services or public procurement.

2.3 Who are the winners and losers from Brexit? Some argue that UK exporters would be winners from Brexit, benefiting from currency depreciation. Some manufacturers also hope to benefit from relaxed regulatory standards, such as the release from the EU’s upcoming ban on high-powered appliances like toasters or hair-dryers. However, a currency boost to exports is likely to be short-lived. Around 46% of the UK’s exports go to the rest of the EU. The net long-term impact on exports is likely to be negative, and will depend on what post-exit deal the UK gets with the EU, as discussed in Qn 2.2. In any case, if the UK manufacturers want to continue to sell in the EU markets, they will inevitably be required to abide by the same product standards. In other words, Brexit does not equal freedom from EU rules.

The most obvious losers will be the financial services industry. Currently financial firms in the UK have “passport” rights to conduct their business in all EU countries, and UK mutual funds – who manage £5.5tn altogether – are operating under the EU’s UCITS Directive. These rights would need to be re-negotiated, unless the UK manages to join the EEA. In addition, the legality of Euro-clearing in the UK could also be questioned. The UK in 2015 won the case to stop the ECB from directing Euro-clearing houses to relocate to the Eurozone, but may lose its basis to do so if it is no longer an EU member. Financial services alone contribute 8% to the UK’s total gross value added (Parliament), and the decline of the sector could cause ripple-effects across related industries in the service sector like accounting and law firms. In total the service industry accounts for around 78% of the UK GDP.

2.4 How would the Bank of England and the European Central Bank react to a Brexit vote? In the Bank of England’s May 2016 Inflation Report, Governor Carney’s message was clear: a decision to leave the EU, would have a net negative impact on the UK economy by lowering growth and increasing inflation. Carney recently reiterated his views. In case of Brexit, the BoE will likely cut rates to support asset prices, in our view. And in any case, the prospect of a rate hike is becoming unlikely even with a remain vote, given increasing household leverage. Capital inflows, which have traditionally funded the UK’s current account deficit, may be less attracted by the combination of low interest rates and an uncertain economic environment. A leave vote – and higher Gilt yields – will make it harder for the UK Treasury to fund its deficit. The Bank of England could respond to this by re-activating QE through its Asset Purchase Facility. The ECB could also extend or expand its asset purchase programme to limit contagion to Eurozone risk premia and contain a tightening in lending standards.

2.5 What are the implications of Brexit for the rest of the world? The UK is one of the most important trading partners to the rest of the EU, and is economically linked with other Member States through labour movement, investment and bank links. According to Global Counsel data, the countries with the highest economic exposure to the UK are Ireland, Luxembourg, Cyprus and the Netherlands (based on the parameters shown in the chart below).

The biggest risk from Brexit, however, is political contagion. First, it would set the precedent and clear the myth around an EU-withdrawal – a risk that surfaced but never materialised at the height of the Greek crisis in 2015. In the future should Greece or another Member State run into a similar crisis, people’s psychological resistance to a withdrawal from the Eurozone or the EU could be significantly diminished.

Secondly, the exit of the UK, a key and established member of the EU, could pose a challenge to the rationale behind the European integration project and further dampen its momentum. In particular, it could lend a hand to Eurosceptic or anti-establishment parties that are rising across Europe, including National Front in France, AfD in Germany and the Five Star Movement in Italy. Regional separatism could also receive a morale boost, including pro-independence parties in Catalonia. Scotland could also come back to its independence plan, as discussed above.

Thirdly, a leave vote could act as a sign of the victory of populism and give a strong boost to radical politics outside Europe, including in the US. Despite their hugely different political agendas, Brexiteers and Trump’s supporters do share some similarities – dissatisfaction with the state of politics and the desire for a change to the status quo (see The Silver Bullet | Trumponomics). If the UK elects to leave the EU, it may not seem so absurd if Trump is to become the next US president. Trump recently has backed Brexit openly too.

Lastly, the UK is among the most economically liberal states within the EU, along with the Netherlands and the Nordics. With the support from Germany, the liberal block previously could secure enough votes to achieve a 35% blocking minority in the European Council on economic policy debates. If the UK exits the EU, this balance of power will be tilted towards the traditionally less liberal states, which arguably could lead to less market-friendly economic policies. 

3.The Divided Kingdom: challenges beyond the referendum

3.1 What are the challenges the UK economy faces beyond the referendum? The UK economy will face severe headwinds, regardless of the referendum. Productivity in the UK has plummeted since the start of the financial crisis, declining almost 15% between 2007 and 2014. While both cyclical and structural factors have contributed to lowering productivity, the BoE’s Ian McCafferty estimates that 50-60% of the decline since the crisis is structural and will not recover. Adding to the UK’s challenges is the country’s budget deficit – which is amongst the highest in the developed world. Further tax hikes are difficult to implement, as currently the top 1% of earners pay around a quarter of the taxes given the UK’s high and rising income inequality – higher tax rates may push this mobile elite to leave the country. The government plans to reduce the deficit through spending cuts, which will come at a time when UK household finances remain weak, as consumers have started to re-leverage.

The increase in household leverage has been supported by government programmes, like the Help to Buy programme, which helps first time buyers to buy a home with as little as 5% down payment. Household leverage (household debt to income) is projected to rise and reach around 164% of GDP by 2021. The rise in leverage has come at a time when household earnings have stagnated (FT). Hence, the net effect of higher debt but stagnant wages is that UK consumers may actually enjoy lower living standards than they did before the crisis.

UK borrowers have benefited from rock-bottom interest rates. UK mortgages remain predominantly variable rate (2/3rds) and the remaining mortgages are typically fixed rate for only a short number of years. Despite the prevalence of variable rate mortgages, only around half are aware that their payments could rise if the BoE hikes, according to a CEBR survey. The result is a catch-22 situation, where even after introducing macro-prudential policies on mortgage lending, the Bank of England has little wiggle room to increase rates – and would have to cut rates in case of a leave vote.


The UK economy thrived over the past few years in spite of a worsening European crisis, standing as a safe haven destination for capital and investment. This has supported a recovery in asset prices and job creation. But this safe haven status has been gradually dented: first by worsening public finances and the loss of triple-A ratings, then by political risks around the Scottish referendum and finally by uncertainty around the upcoming EU referendum.

Despite the Brexiteers’ optimism, the UK economy’s structural problems – persistent high deficits, rising household leverage, asset bubbles and rising inequality won’t disappear with an exit from the EU. Instead, a Brexit is likely to seriously hurt the UK economy, potentially pushing it into a recession.

To regain its safe haven status, the UK needs long-term structural solutions to plug its fiscal deficit, help households to de-lever and reduce inequality, diversify its financial system from bank lending into alternative channels, and broaden access to education.


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