Brexit – Quo Vadis Europe?

The British vote for ‘Out’ is a reflection of larger trends that are currently visible in much of the developed world. In contrast to many of the emerging markets, the working class and a large part of the middle class have not benefited from globalisation.

Rather than increasing living standards, albeit on lower levels, these citizens have experienced stagnation or real reduction of living standards over the last several decades. Their trust in political and economic elites has been broken and active search for alternatives is on. Hardly surprising then, that polemic players who are good at voicing angst and discontent score points in Britain, the US, France, the Netherlands, Germany, etc. Unfortunately, the same players are typically unable to provide solutions to problems and to steer their countries into a better future.

In addition, polemic politics leads to polarisation rather than unification of the population in the face of massive external challenges. The US has suffered from the phenomenon for some time and its polarisation culminates currently in a presidential election campaign that has set new lows. In the UK, the Brexit votum has pitched young vs old, rural vs urban, and Scotland, Ireland, London and Gibraltar vs the rest of Britain. The Tories are split along party lines and Labour is in a state of open revolt against its leader. Clearly, internal tensions in the UK will take a long time to heal. Some, such as the potential independence of Scotland, a re-unification of Ireland and a loss of Gibraltar, may become permanent.

The current and future volatility that Britain is facing and will continue to face is hardly the environment that encourages investments. Investments in Britain already faced a slowdown in the run-up of the referendum. Even if Article 50 is invoked immediately, we can safely assume that the exit negotiations between the UK and EU will take the full two years (with a potential extension) that the EU treaties foresee. Leaving the EU after 43 years will be a messy and complicated affair rather than a quick and painless divorce.

A simple solution similar to a Norway or Switzerland approach seems impossible. While Germany's Chancellor Merkel is calling for calm analysis and discussion with Britain to protect both British and European business interests, others in the European camp are pushing towards a much faster disengagement with Britain to avoid contagion, i.e., the breakaway of other countries from the union. A calm, non-emotional discussion with Britain about the next steps is advisable. The vote has come to a clear decision, but with 48% voting ‘Remain’ and 75% of Britain's youth stating their commitment to the EU, support for ‘Leave’ is far from universal. As the British say, there is nothing permanent in this world and it is not in the EU's interest to burn bridges.

However, while Norway and Switzerland both have access to the common market, they in return abide by its rules (in particular, the free movement of people) and contribute to the EU budget. Both factors are against the promises that the ‘Leave’ campaign made to the voters and will be difficult to accept for the UK in any agreement. It is hardly surprising then, that the ‘Leave’ campaign does not seem to be very keen on starting and driving the secession process aggressively.

As a consequence, businesses will have to prepare for a solution potentially similar to the US where import processes and duties will apply. Production footprints in the UK will hence be less attractive unless production can be focused on local consumption rather than exports. Companies will not invest in a 60 million consumer market and forgo opportunities in the world's largest integrated market which will continue to have low-cost production opportunities in Eastern Europe that will be more attractive than UK production even with a weak British pound.

The UK also boasts of the highest number of European headquarters for non-European companies that have invested in the EU followed by Dublin. Here again, business will drive location decisions and headquarters of these companies will be moved to Berlin, Paris, Dublin, etc. While this will not happen immediately, it will be executed over the mid-term.

London to be hugely impacted

London will be affected massively. According to some estimates, about 20,000 jobs linked to businesses such as Euro denominated bonds, will have to move to the continent as London-based banks will lose the ‘pass’, i.e., the license to operate in the EU area. Deutsche Bank has already announced it is moving 9,000 jobs from London to Frankfurt, HSBC will move 1,000 jobs from London to Paris. Banks with a large London exposure are ruthlessly beaten down on global stock exchanges. The city of Frankfurt is already in London to talk to banks about alternative locations. Dublin and other cities have initiated similar activities over the last few weeks.

Clearly, business and related taxes in London will be impacted. As London is a major contributor to financing national schemes like the NHS, voters who voted leave will feel the impact of their decision themselves in the not too distant future.

The financial sector is also the UK's most important export sector with a contribution of 21% in 2015. It is vital to contain a current account deficit that is among the highest in the world. Diminishing the role of the financial sector and the city of London is akin to Germany actively impeding the performance of her automotive industry. To Germans, this is simply unfathomable.

With Britain's dependency on imports and exports from the EU at 44% and 53%, respectively, a Brexit with its resulting tariff and non-tariff barriers will lead to a recession in the UK. Predictions of long-term GDP reduction for the UK vary between zero and 10%.  This will be painful and hit both ‘Leave’ and ‘Remain’ supporters. Also, while slightly more than 2 million EU citizens work in the UK, nearly 2 million UK citizens work in various EU countries. Sorting out their challenges regarding right to work, house ownership, pension funds, other social services, etc will be far from easy and may cause significant discontent both within and outside the UK.

Brexit’s collateral damage

But the problem does not end with the UK. The European Union has yet another crisis to manage. Countries such as Germany will feel the pinch of reduced business with the UK as the country is Germany's third largest trade partner. The UK will also be missed as a German ally in the areas of free trade and liberalisation in discussions with more state-interventionist governments in Europe's south. With the UK departure, the EU but non-Euro camp has lost its most important member. This may polarise discussions in the EU and create additional tensions.

A break up of the union via contagion seems possible albeit not probable. Clearly, a splintering of the world's largest common market into national pieces would have a major impact on the global economy and poses a significant risk going forward.

Business as usual is not an option for the EU. The fundamental reason for the EU was and is centered on creating a security platform for Europe, a continent that not so long ago had a history of continuous wars and vicious bloodshed. It has achieved this objective not only for its founding members but also for many formerly Eastern European nations. Extending the reach of democracy to the East has stabilized the continent. Joining about 500 million consumers into a single market has created economies of scale that companies could leverage as their home advantage. Freedom of movement has created a European identity in many citizens including the under 30s in the UK that voted overwhelmingly for staying in the EU.

However, the stated objective of creating an ever closer union is currently reaching its end. EU expansion and alignment for their own sake will not be any longer accepted by the electorate. Voters want to clearly see what benefits the EU brings to them on the ground in terms of opportunities, growth and wealth. Governments both in Brussels and in the member states need to address the worries of the electorate such as a fear of losing their own culture, being driven out of jobs by lower cost immigrants, and of reducing living standards. They also need to emphasise and explain the benefits of the EU to the broader public. Assuming that the common man will follow the establishment and to continue the current way forward will be a costly mistake and the fastest way to ensure a disintegration of the union.

Populists are good at voicing the anger of the people, however, fall short on ideas how to fix the system. The current European leadership will need to listen to the people, understand and address their needs, leverage their potential and (re-) ignite their enthusiasm for project Europe. Only then will we be able to fight the polarisation and disruption that populists are currently sowing across the Western world.

Dr Wilfried G Aulbur
Managing Partner India, Chairman Middle-East & Africa &
Head - Automotive Asia, Roland Berger Pvt Ltd