UK (2013): The Economic Issues Surrounding an EU Exit

Allan Monks and Malcolm Barr, London.

Prime Minister David Cameron’s commitment to hold a referendum on the UK’s EU membership by 2017 has thrust the issue into the limelight. Here we focus mainly on the likely economic impact of an EU exit. On trade, there is little theoretical work that concludes that the economy would clearly suffer from an exit, provided the UK was able to enter into an agreement that enables exporters to compete on broadly the same terms as those in the EU. A priority for the UK is to promote its exports of services within the region. It is not clear that EU membership has enabled the UK to pursue services liberalization successfully, so the cost of an exit may be relatively small. On migration, an EU exit would open up the possibility of a regime that would limit net inflows of workers to the UK. But the UK is well aware of the benefits of an open migration regime, particularly for skilled workers. We suspect change would occur predominantly in the terms upon which foreign workers could reside in the country (in terms of access to welfare benefits, housing, and the like).

It is very difficult to envisage exactly what EU/UK trade arrangements would look like should the UK leave. Existing arrangements for Switzerland and Norway are unlikely to be a template, and new bespoke arrangements would have to developed. These issues will be discussed extensively over the next four years, creating a lengthy period of uncertainty, which in itself could affect the economy. Experience around the 1975 EU referendum suggests there is likely to be some adverse effects on business confidence, capital inflows, and investment. However, these are difficult to discern amid broader cyclical forces, and likely to be dominated by the weightier issue of Europe’s path out of its sovereign crisis.

Source: YouGov

Source to the Three Charts Above: ONS

The Basic Anatomy of UK Trade

The UK’s tendency to run a deficit on overall trade is well established, but a few points are worth highlighting:

• The deficit on goods trade is widespread. Net imports of goods have recently shown a quarterly deficit running near £26 billion (1.6% of GDP). This deficit is close to equally split between deficits with EU versus non-EU trading partners. And within the EU, the goods deficit is spread across partners.

• A services surplus, but not with the EU. The goods trade deficit receives a substantial offset from a large surplus in services trade, worth close to £18 billion. Though goods still account for around 60% of exports, the UK has tended to gravitate toward specialized, niche industries in which price competition is weaker. This echoes strength in services exports, which tend to be less homogenous. But on the services side, exports to non-EU destinations account for nearly the entire surplus in international services trade. The UK has had more success in exploiting its comparative advantage in financial and business-related services to trading partners outside of the EU.

• UK services exports are not just finance. The popular perception is that financial intermediation dominates exports, but the data suggest they account for less than a quarter of the total. Business services, which encompasses accounting, consultancy, legal, and related sectors, account for almost 30% of the total.

Source: ONS

Gauging the EU Trade Impact

A key issue is what trade benefits EU membership has brought to the UK, and whether these are distinct from a scenario in which the UK were outside of the EU but part of a formal free trade agreement (as Norway, Iceland, and Switzerland currently are). It is difficult to use the export performance of these economies as a counterfactual for the UK’s EU membership; they have a unique trade composition that is difficult to compare to the UK’s. It is also a challenge to find impartial analysis on the issue that has a strong analytical framework. But the studies we have found indicate little evidence that the long-run trade performance of a member state would be clearly worse off outside of the union, provided a trade agreement remained in place.

For example, Helga Kristjansdottir at the University of Iceland (“Evaluation of Icelandic trade flows, the gravity model approach,” 2006) uses a gravity model to evaluate the impact of EU/EFTA membership on Icelandic trade flows. Over long-run estimations from 1971-97, EFTA (European Free Trade Area) membership is a statistically significant determinant of Iceland’s exports. EU membership becomes a more significant explanatory variable if the sample is restricted to 1988-98, but this likely reflects the large number of trading partners that left EFTA for the EU during this period (with the EFTA-only sample becoming increasingly smaller).

The UK’s relatively heavy reliance on services exports creates other issues. The UK’s trade deficit with the EU highlights that it is really only exploiting its comparative advantage in services with its non-EU trading partners. As many academic studies and policymakers at the European level have recognized, this reflects significant non-tariff barriers to trade and highlights the need to liberalize trade in services within the European region. Significant heterogeneity within the industry makes it harder to break down barriers, which involve issues such as national level taxes, quotas, standards, licensing, and discriminatory access to distribution networks. The UK has long campaigned for “completion of the single market,” but with very limited success. Indeed, the lack of progress on the issue has been cited as an argument for EU exit by some (see, for example, Minford et al. at Cardiff University “Should Britain Leave the EU,” 2005). Some argue that, even if EU membership may not enable further services liberalization, it may position the UK to resist regulatory change that would be unfavorable to London’s position as a financial center. As the decision to impose financial transaction taxes within the Euro area demonstrates, the UK’s ability to influence those decisions within the EU is constrained. In or out of the EU, the fact that the UK runs a deficit with the EU on trade as a whole should mean that it is able to resist changes that are damaging to key industries, by insisting that trade is considered as a whole.

Social Issues on Migration Might Be Larger

Membership of the EU means that residents of existing EU states have the right to live and work in the UK, and vice versa. Countries have the option to put transitional limits on migration flows from countries entering the EU, but these are time limited. Having chosen not to put limits in place as eight countries joined the EU in 2004, the UK subsequently saw a marked increase in migration inflows. Though these are widely thought to have eased localized labor shortages and moderated inflation pressure, there have also been concerns about the strains migration has placed on UK infrastructure, the welfare state, and social cohesion. The result has been a tightening in the migration regime as it applies to non-EU residents, while the UK’s ability to limit migration from EU sources remains constrained by EU rules.

Leaving the EU would give the UK more ability to set its own, and potentially tighter, migration regime. This does not, however, appear to be a key objective of those arguing for renegotiation of the UK’s relationship with the EU. The Fresh Start Group’s manifesto, for example, seeks to give the UK more freedom to decide on EU migrants’ eligibility for welfare benefits, and to ensure the UK is able to put in place transitional migration limits for new countries joining the EU. But it does not call for new repatriation of powers that would fundamentally constrain the ability of exiting EU residents to migrate to and from the UK. Moreover, there is widespread recognition across political parties that the UK has benefited from an open migration regime, particularly with regard to skilled labor. So while EU exit would open up the possibility of more limited net migration inflows, it is not clear that autonomy would be exploited.

Source: ONS

Source: ONS

No Clear Post-EU Prototype

A key difficulty in the current debate is that it not easy to define how the relationship of the UK with the EU would look after an EU exit. Norway and Switzerland are the most often quoted examples of non-EU nations that have negotiated free-trade agreements with the EU. But each case has its idiosyncrasies and issues that mean they are unlikely to form a template for the UK. For Norway, EFTA membership has meant trade access, but it has also forced the implementation of EU-consistent legislation in labor and product markets over which it has had very little influence. In the Swiss case, the EU has become concerned about its ability to police the bilateral deals that are made. And the EU is increasingly insistent that free trade must come alongside some standards of workplace welfare and regulatory harmonization. The result is that UK arrangements after an EU exit would likely need to be bespoke, and it is unclear the extent to which some of the previous legal and regulatory framework would be retained.

Gauging the Macro Impact of Uncertainty

In addition to the uncertainty about whether a referendum will be held, and what the vote will be, the lack of clarity on what a post-EU environment would mean introduces an extra layer of doubt. This highlights the possibility for this uncertainty to have some macro consequences over the four years leading up to the possible referendum. We use the 1975 referendum on the UK’s position within the Europe Economic Community (EEC) as a case study to help gauge the potential economic impact of uncertainty.

In short, the 1970s episode highlights the potential for the uncertainty to have an adverse impact on business confidence, capital flows into the UK, exports, and investment. However, the 1975 referendum unfortunately coincided with a very turbulent economic period that included volatile output, high inflation, trade union disputes, a degree of disunity with Northern Ireland, as well as a seven-month period of political uncertainty following a hung parliament outturn to the initial 1974 general election. This makes it hard to single out the economic impact of the 1975 referendum, though this issue by itself likely had a fairly small influence in comparison to the other factors noted above.

This point has a clear parallel with the present situation, given the larger uncertainties related to the European sovereign crisis and the path of a fragile global economy. As a result, we do not expect EU-related uncertainty to have a material impact on growth. But below we single out a measure of business confidence in the CBI’s quarterly business survey that may have the best chance of revealing a possible macro impact — namely the reading on political and economic uncertainty as a factor limiting export demand.

Given the referendum will be some years away, we should not expect to see much response in the CBI survey initially. And one difference from the 1970s is that opinion polls back then suggested an EEC exit was highly likely; the polls now are more mixed, which may help to contain the adverse economic effects of uncertainty. Our base case is that while the uncertainty around EU membership will eventually have some negative impact on business investment and FDI, the magnitude will be sufficiently small that it will be hard to distinguish amid the swings being driven by other forces.

Source: First Two Charts - ONS, Third Chart - CBI

What Can Be Said About Now?

The 1970s episode suggests that the clearest economic impact of EU uncertainty might be visible in the quarterly CBI business survey on exports. The Q1 2013 reading of this survey was released at the end of January. It showed a move down to 31, following a prior peak in uncertainty of 41 in Q2 2012. Though still high, there is little sign that the debate about the EU has so far affected the survey. We would set out a move above 40 as one marker which would indicate a material move in business uncertainty.

Given the European sovereign debt crisis is likely to be a bigger political issue in the coming years, and is a larger driver of growth in our forecast, a move in the CBI above 40 is not a sufficient condition for signaling an economic impact from EU uncertainty.