An alternative perspective

16 May 2016

Brexit or EUxit? A Referendum on Europe

Dr Bob Swarup, Founder of Camdor Global

Ever since David Cameron fired the starting gun on the referendum on Britain’s membership of the European Union on 20 February, there has been an unprecedented amount of analysis as to the implications for Britain should it choose to leave – a scenario pithily referred to as Brexit. The battle lines are drawn and emotions are high, particularly as the vote looks closer than anticipated.

A recent poll for The Telegraph found 51 per cent voting to remain while 46 per cent backed the Leave campaign, with three per cent undecided. In contrast, an ICM poll on 26 April found 46 per cent of voters were in favour of Brexit, versus 44 per cent who wished to remain.

Much of the recent debate and analysis has focused on Britain’s ability to negotiate free trade agreements from outside the EU and the impact of different scenarios on UK GDP. Most agree UK GDP would suffer in the immediate aftermath as the currency weakens, investment stalls as the fallout is assessed and households save more in the face of uncertainty. The CBI estimated growth would reduce by between 0.8 per cent and 1.4 per cent in the years immediately following as Britain negotiates its exit terms.

Past that, however, the long-term impact is uncertain. For example, a comprehensive report by Open Europe1 concluded that GDP could be 2.2 per cent lower in 2030 in a worst case scenario where Britain fails to strike a deal with the EU and retreats into protectionism. Alternatively, if the UK were to enter into multiple trade agreements whilst deregulating aggressively, British GDP could be 1.6 per cent higher.

In truth, all this analysis is speculative, especially past the first two years. In the event of Brexit, the final number and its signage will be determined largely by the charm and skill of the team put together to negotiate future trade agreements.

What is hardly discussed is the impact of Brexit not on Britain but on the EU. This is the real elephant in the room and where real risks to the global economy lie.

Heading for the Exit

The furore over Grexit in recent years demonstrated the dramatic impact and turmoil that the potential exit of a small country could have on the far larger EU. The exit of the UK in this context is a far larger and more damaging hit. The UK is the second largest economy in the Eurozone after Germany. It is Europe’s largest individual export market, making up 16 per cent of all goods exported. It is the fourth largest contributor to the EU budget and the second largest net contributor after Germany, contributing £8.5 billion in 2015. This is not a small part of the European economy that is contemplating an exit. This is 17.6 per cent – the second largest after Germany – compared with a mere 1.2 per cent for Greece.

Europe can ill afford such an exit. The hangover of 2008 has yet to fade. The persistent deflationary environment coupled with an uneven halting recovery has fuelled widespread discord. While Mario Draghi’s perma-quantitative easing has somewhat salved the wound, the EU is still fragile.

Beneath the surface, the complex web of debt that granted us the European sovereign debt crisis is very much alive and well. Despite bank deleveraging, the PIIGS2 still owe significant sums to one another and to the stronger quartet of Germany, France, the UK and the US. Today, non-performing loans in the Euro area amount to more than €800 billion.

The result is a fragile game of geopolitical Jenga where even the smallest piece dislodged could result in economic contagion. Furthermore, any weakening of Europe’s ability to manage these debt burdens and bail out where necessary has major implications for the ability of these sovereigns to borrow cheaply in the financial markets. Brexit weakens the sovereign guarantee and credit backing for many European nations, opening the door to another raid by bond vigilantes. Moreover, it leaves Germany isolated as the sole country capable of bailing out the other European nations if needed.

That is a tough ask.

Grexit and more recently the migrant crisis have exposed sharp divisions within Europe. There is a growing move towards self-interest, even at the expense of weakening key tenets of the European project such as free movement. Germany feels increasingly worried about the sanctity of its fiscal prudence as demands for bailouts and monetary stimulus continue. Other countries meanwhile grumble about German demands for austerity.

Most recently, relations between Germany and Draghi have hit a new low, as German politicians publicly blame the ECB’s quantitative easing for hitting German savers and weakening the German banking system. Wolfgang Schäuble, the Finance Minister, has thrown the most incendiary charge to date by blaming the ECB for the rise of the AfD (‘Alternative for Germany’), a right wing anti-immigration party. Draghi responded by arguing that the independence of the ECB was under threat. This is hardly a united front.

One is a Lovely Number

In this volatile mix, Brexit is a disaster. In a continent of weak nations, Germany is short of allies. It has started to move towards Britain, as France increasingly becomes obsessed with its own internal problems. But a Brexit may leave Germany feeling even more isolated, and would further strengthen anti-Europe sentiment at home.

Germany is now beginning to question the European project – a national bout of soul searching best exemplified by the rise of the AfD. The AfD is an anomaly in the most fervent supporter of European integration and ‘ever closer union’. Founded in April 2013, it is a far right populist party that is both Eurosceptic and anti-immigration. It won 4.7 per cent of the vote in the 2013 federal election, narrowly missing the five per cent electoral threshold to occupy seats. Since then, its popularity has grown rapidly. The AfD now holds seats in eight German state parliaments. Based on current polling, it would win between 75 to 85 seats if elections were held today. Its support has come largely from the erosion of mainstream parties, who are already moving right as they look to staunch the bleed.

The tail risk here is that a Brexit only accelerates either a German exit, as the price demanded for bailouts becomes politically unpalatable, or a renewed attempt by Germany to reassert control over the European project. The latter unfortunately would only accelerate the move towards autarky amongst other European nations. The National Front in France is already campaigning for ‘Frexit’ and a return to the franc. It won the largest share of the vote in recent regional elections – nearly 28 per cent – and current polls indicate that their leader, Marine Le Pen, is leading the first round of the 2017 Presidential elections. Across Europe, Eurosceptic parties are on the rise, such as the Five Star Movement in Italy, the People’s Party in Denmark and Syriza in Greece. All support a refocus on domestic priorities and a weakening or outright rejection of the European project. That none of them have done so yet is because they fear uncertainty and lack a template. Brexit would provide such a template. By Britain leaving, it forces the EU to put together a process for exit and create tangible terms for the first time. It also enhances the bargaining power for other countries when fighting for further concessions. Once opened, this ‘exit’ genie may be hard to put back in the lamp.

A parallel may be drawn with the renegotiation of World War I debts in the 1920s. Though the US was initially inflexible, the British again led the way, renegotiating a settlement of 80 cents on the dollar in 1923. Over the next few years 13 further settlements took place, each more audacious till finally the Italians agreed to repay just 26 cents on the dollar.

Much as quantitative easing became conventional, EUxit may well become a reasonable policy option for EU leaders as they seek to minimise domestic pain, global growth and solidarity be damned. In this context, Brexit is but another step on this worrying trend globally towards economic nationalism and deglobalisation. The risks are not to Britain, but rather to Europe and the rest of the world.

Bob Swarup is the Founder of Camdor Global, an advisory firm focused on macro trends, investment strategy, risk management and regulation. He is a Fellow at the Institute of Economic Affairs and author of the critically acclaimed book ‘Money Mania’, which examines 25 centuries of financial crises.

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