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New Year predictions #3 – How might Brexit pan out ?


Patrick Kelliher

OK, we are well into the new year, but I have had to re-write this blog twice in this fortnight: the first time when Theresa May announced last week that the UK will be leaving the single market, and now after the Supreme Court ruled yesterday that Parliament must vote on Article 50. I will go out on a limb and venture that yesterday’s judgement doesn’t change anything – the House of Commons will back the government and, despite its anti-Brexit sentiments, the House of Lords will shy away from a constitutional crisis by blocking this. The one major “fly in the ointment” was if the Scottish parliament was given a veto but this hasn’t happened.

Last week’s rejection of the single market is significant however. It has removed one possible path for how Brexit may pan out, but unfortunately the path with the least disruption to trade. The UK government is still keen to have a free trade pact with Europe but whether they will get it is another thing…

Pressure at the edges

Brexiteers argue that the EU will be up for a free trade deal with the UK post-Brexit even if it doesn’t sign up for free movement of people as Britain has a trade deficit with the rest of the EU. They claim imposing tariffs would be a spectacular act of self-harm by EU countries. Meanwhile Bremainers and EU officials point out that the UK only accounts for 8% of exports from the rest of the EU [1]. The implication is that the UK is not that important that it can dictate terms on trade with the EU.

Personally I am with the Brexiteers on this one. While the UK may not account for a large part of EU exports on average, it will be critical for many sectors. Mass market car manufacturers like Peugeot are struggling in a ruthlessly competitive marketplace. They can ill afford to lose sales in the UK which will happen if a free trade deal on cars cannot be agreed, as a 10% tariff is likely to be applied to car exports to the UK in line with WTO rules [2].

WTO rules also allow swinging tariffs on agricultural produce which will affect EU farm exports to Britain, particularly as they would lose their competitive advantage against non-EU agricultural producers like New Zealand which are already subject to such tariffs. While one could imagine French famers protesting about the loss of a market, Brexit could impact Danish farmers in particular – the UK has long been a major market for their bacon and other agricultural produce [3]. Indeed, the UK’s entry in 1973 into the then EEC was one reason why the Danes also joined at that time.

Another joiner in 1973 was the Republic of Ireland. Brexit could be catastrophic for Ireland, not least as the UK is the largest market for Irish agricultural goods [4]. As well as the economic impact of trade barriers which a “hard” Brexit would bring, these barriers might also require border controls between the Republic and Northern Ireland to be reinstated. This would be traumatic for those on the border who currently travel freely across it, and could set back the peace process in Northern Ireland. There is likely to be widespread smuggling in an ill-defined, occasionally lawless, border zone. I wouldn’t even be surprised if Republican paramilitaries burned customs posts as they did during the Troubles.

So I would expect a diverse coalition of industries and countries to lobby hard for some sort of free trade deal with the UK. The resolve of EU bureaucrats and governments to “punish” Britain for leaving the EU may wilt in the face of their lobbying and agree to some form of trade deal.

Towards a Customs Union ?

While the UK wants free trade, it also wants to put a stop to the free movement of people. The latter is a “red line” for Brexiteers who are unwilling to cede control of borders and of immigration. No doubt this political consideration was in Theresa May’s mind when she announced that the UK would not be seeking membership of the single market and the freedom of movement this entails.

So any trade deal that does emerge will not involve freedom of movement. There is a precedent for such a deal: the customs unions between the EU and Turkey [5], and also the Channel Islands and other small countries [6]. This does not involve freedom of movement but is inferior to the single market as it only covers manufactured goods and processed agricultural produce. It would suit manufacturers like Nissan and Rolls Royce [7] but would not cover financial and other services, which the City won’t like.

It also doesn’t cover unprocessed agricultural produce so would not suit the Republic of Ireland, Denmark and other agricultural producers. There may be scope for a “Turkey plus” deal with the customs union being extended to cover all agricultural produce addressing these countries concerns. In return, the UK could gain some concessions on financial services e.g. around MiFID equivalence, or “passporting” of existing customers, though I think it would be fanciful to expect similar freedoms to what financial services firms currently enjoy – that would be too much like the UK “having its cake and eating it”.

While some sort of a customs union does seem like a pragmatic compromise, there are plenty of impediments to this. The UK would not be able to negotiate trade deals of its own and would have to comply with EU tariff structures. Liam Fox would be out of a job but I would imagine he and other starry eyed Brexiteers will argue for a complete break with the EU allowing the UK to do whatever it likes on trade. The influence these “hard” Brexiteers have on May is clear from her rejection of the single market. We can’t rule out a rejection of even a limited customs union, notwithstanding the impact this would have on manufacturers and other businesses.


Even if a customs union could be agreed like that with Turkey, this does not automatically lead to free trade. For example, the Scotch whisky industry has experienced significant barriers exporting to Turkey despite the customs union [8]. With over 1/3rd of Scotch whisky exports worth over £1bn going to the EU, the industry is understandably concerned about barriers emerging when the UK leaves the single market [9].

The industry – which directly employs 10,000 Scots and provides indirectly for 30,000 jobs – would be traumatised if no customs union could be agreed as this would lead to standard WTO tariffs of 20%+ being applied on alcoholic drinks. More generally, unlike England and the UK as a whole, Scotland has a trade surplus with the EU which would be at risk from a hard Brexit [10]. It is little wonder that Scots are concerned about leaving the single market.

While Nicola Sturgeon’s plan for Scotland to stay in the single market while the rest of the UK leaves is probably impractical [11], the impression that Theresa May is not even trying to cater for Scotland’s desire to remain in the single market will feed separatist tendencies. Just the rejection of the single market alone could push Sturgeon towards another referendum on independence – I believe it would be all but inevitable in a hard Brexit.

That said, I believe Sturgeon is loath to call a referendum just now as she believes unionism would triumph again and another loss would postpone Scottish independence for a generation. Important factors behind the previous Remain victory such as concerns over currency and pensions persist. Most importantly, even if Scotland voted to leave, there is no guarantee it could stay in the EU.

I am not convinced Scotland would have to go to the back of the queue as a completely new candidate country as it is already part of the EU. I suspect the issue would first have to be decided in the European Court of Justice which could allow Scotland to retain its existing membership but if not, and Scotland had to apply as a new country, then political considerations would come into play. Spain and/or Belgium may veto Scotland’s application to prevent an unwelcome precedent being created for their want-away regions of Catalonia and Flanders. On the other hand, other countries may view facilitating Scottish independence and the dismemberment of the UK as suitable “punishment” for the UK leaving the EU and a warning to others from following suit.

At the present time, we can say that it is by no means certain that Scotland could retain EU membership and this uncertainty is probably staying Sturgeon’s hand in calling for an independence vote. However, even if single market membership like Norway was available rather than full membership, then I believe activists will force her to call a referendum as the UK heads out of the single market.

If a referendum is called, I believe the odds would still be on Scotland staying in the union, but after Brexit and Trump, there is every chance of an upset. Two factors will boost the independence vote. Firstly, the last referendum was partly won on the impact leaving the UK could have on EU membership, which is no longer an issue. Secondly, with the Labour Party in disarray, the prospect of Conservative government for possible another decade or more may cause many Scots to reach for the eject button.

In short, if the UK heads for a hard Brexit and/or the EU offers single market, or even full EU, membership, I would not be surprised if a Scottish independence referendum is called. In that case, there would be a good chance that the UK would be rent asunder. Either way a referendum would add to UK political risk [12].

“Cutting ones nose off to spite to spite ones face”

UK financial services will bear the brunt of EU countries desire to leave the UK with inferior trading arrangements. As well as a desire to “punish” the UK for leaving, cities like Paris and Frankfurt are eying up firms relocating from London due to restrictions imposed on selling financial services into the EU.

One blow that will land on the City after leaving the EU will be ECB restrictions on clearing houses dealing in Euro-denominated securities and derivatives. When these were originally proposed, it was mooted that clearing houses dealing in Euro-denominated financial products should be located in the Eurozone but the UK successfully sued the ECB over this [13]. With the UK leaving, however, clearing houses such as LCH.Clearnet will probably have to move Euro-denominated clearing to an EU country to meet ECB requirements. To prevent clearing of sterling denominated financial products move with this, I wouldn’t be surprised if the UK government imposed similar restrictions. This splintering of clearing will make it harder to net trades, increasing margin requirements and trading costs which will adversely affect not just financial institutions but also businesses and individuals which use financial services.

This could be just one of a series of restrictions imposed by the EU on UK financial services firms which could prove counter-productive. The success of London as a financial services centre isn’t just down to the skills and expertise of the people working there – important as this is, many City workers come from the EU – but also because of the pool of investors who ultimately buy the bonds, derivatives and other instruments arranged and traded by investment banks.

At the heart of this pool of investors are UK institutions including pension funds. The UK pension system is based more on private provision than its continental counterparts and the result is that of $5trn of pension fund assets in the EU, over half are held by UK funds. Only the Netherlands, Switzerland and Ireland come close in terms of pension funds size as a proportion of GDP [14].

This pool of assets is one reason why European firms such as EDF are heavy issuers of bonds on UK markets. However, tit-for-tat restrictions on financial services could make it harder for EU companies to raise finance on UK markets. This could add to their borrowing costs and add to difficulties EU firms already face in raising finance due to the weak nature of EU banks in the aftermath of the financial crisis.

If the EU could cut its nose off by making it harder for EU firms to access UK finance, the UK government could make similar mistakes by retaliatory measure making it harder for pension funds to invest in EU assets. This could increase investment costs, limit investment choice and ultimately lead to poorer returns, adding to pension fund deficits and/or reducing benefits.

While not receiving the same attention as free trade and free movement of people, the free movement of capital boosts borrowers and savers, in the EU as well as the UK. EU restrictions on UK financial services firms, and retaliatory measures by the UK government, could damage free movement of capital to detriment of all.

“Demography is destiny”

Perhaps the greatest pity of Brexit is the government’s rejection of freedom of movement, and the associated failure to put forward the positives of immigration. Young EU migrants generally pay more in taxes than they take out in benefits. They boost the dependency ratio, helping to make state pensions more affordable. To these economic benefits, there is also the cultural diversity they bring which helps make London in particular one of the, if not the most cosmopolitan cities in the world.

The problem is that these benefits are less obvious than the strain on services caused by an increasing population: the population of the south east of England increased by 10% in the first decade of the millennium, and London’s population increased by 1m to 9m. I believe a large part of deterioration in services is down to austerity as opposed to immigration, but I am sure the Conservatives are quite happy for immigration to take the blame

Similarly, it is also easy to blame immigration for the erosion of real wages and living standards in the aftermath of the financial crisis. Again the issue may have more to do with the Bank of England’s inflation policy in the aftermath, and the impact of the UK’s flexible labour market doing what a flexible market would do in economic downturns. For the man on the street, however, it is easier to understand that more immigrants equals increased competition for jobs, lower wages and higher unemployment. This may be termed the “fixed work” fallacy that there is a fixed amount of work to go around, and that all other things being equal, more workers chasing the jobs will depress wages.

The problem with this fallacy is that all other things are not equal. Immigration will increase the workforce, but also increase the population of consumers and hence the overall size of the economy. If the UK had not accepted Polish and other workers in the early 2000s, the UK population would be lower and so would economic demand, meaning there would be less jobs.

This would be particularly true for Scotland. Before the influx from Eastern Europe, its population was shrinking. Immigration has just about kept the population static at 5m. Without this influx, Scotland’s population and its economy would have shrunk, which would have fed a negative feedback loop of falling employment feeding migration to England and elsewhere, in turn adding to economic decline. One analogy would be the Republic of Ireland in the first 70 years of its existence with emigration offsetting the natural growth in population, leading this to stagnate at around 3m with the economy similarly moribund.

Perhaps the most relevant example of what can happen to a country which does not accept immigrants is Japan. Its borders are closed to migrants and following a post-war baby boom, its population is in decline. By 2020, sales of adult diapers will exceed babies’ nappies [15]. Unsurprisingly the economy has never really recovered from the bursting of its financial bubble in 1990, despite the government deficit rising to nearly 240% of GDP and the Bank of Japan increasing the monetary base 10-fold with quantitative easing [16].

The British people, and the UK government, should be careful in wishing for low immigration – they might get their wish, and all the problems this will cause in terms of a lower, aging population and all the long-term problems this would bring…
[1] Though this includes EU countries exports to other EU countries. Exports to the UK would be 17% of EU exports to non-EU countries – see
[2] See which considers WTO rules applying if no trade deal can be agreed. UK car manufacturers would also be affected by these tariffs – for details of the impact on UK car makers, see and
[3] See .
[4] The UK accounted for 41% of Irish agri-food and drinks exports in 2015 – see   
[5] See and also
[6] See and
[7] Ironically these are based in constituencies which voted for Brexit notwithstanding the reliance these major employers have on access to EU markets.
[8] See for example:  
[9] See;; and
[11] The issue is not so much freedom of movement – after Brexit, I would expect EU citizens to be able to travel to the UK as freely as at present – but the right to work and the right to benefits. At the least, Scotland would need to preserve these rights for incoming EU citizens to retain single market membership. It would therefore need to have its own system of work permits and a scheme to pay equivalent benefits to EU citizens which would probably need to be on top of the existing benefits system. The former might be feasible with devolution of employment legislation but the latter seems unlikely.
[12] See my previous blog in the run-up to the Scottish independence referendum in 2015 at: -  while dated, a lot of the issues are likely to re-surface in a future referendum.
[13] See: “Britain to sue ECB over threat to City”, FT 14/9/2011 at:  
[14] $2.7bn of $5bn in 2015 – source “Pension Markets in Focus” (OECD, 2015), table A.2 (p29) at:  
[15] For more details on Japan’s aging problem – see for example:  
[16] Japan’s gross government debt : GDP ratio in 2015 was 238% while at the end of 2016 its monetary base was ¥417trn compared to ¥40trn in 1990.

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