19 April 2017

Brexit: Recent Developments and Potential Repercussions

Following its formal notification to the EU of its intention to withdraw from the union, the
UK will soon enter into negotiations with the bloc over an exit agreement. Early
indications are that the exit negotiations will be a difficult and uncharted process. While
Brexit has not caused noticeable damage to the British economy so far, the opening of
divorce talks will inevitably lead to a prolonged period of uncertainty, thereby creating a
significant drag on the UK's economic performance.

One of the most immediately apparent consequences of the Brexit vote has been the
decision of Theresa May, the British Prime Minister, to call for a surprise general election
on 8 June 2017, ostensibly a measure designed to smooth the passage of the required
Brexit legislation through Parliament by expanding the majority of the ruling Conservative
Party. Given the widely assumed positive outcome of the election, however, it is unlikely
that the UK economy will be adversely affected by uncertainty in the brief period leading
up to the ballot.

The ultimate British departure, in all likelihood, will pose something of a threat to the
global economy, including Hong Kong. Although the negative impacts may take time to
unfold, as Britain will remain in the EU for the time being, a weakened UK economy,
aggravated by an anaemic sterling, is likely to result over time in a weaker appetite
among British consumers and businesses for imports into the UK. In addition, Brexit may
erode the UK’s dominant position as an investment destination as the country becomes
less attractive as a gateway to the EU. On the other hand, Hong Kong does have an
opportunity to play a bigger role in helping UK companies get established in Asia to tap
business opportunities beyond the EU.

The Brexit Process

The UK voted to sever its 44-year EU membership in a historic referendum held on 23

June 2016. Overall, 51.9% of voters opted to leave the EU, against 48.1% who voted to
stay. While many of the English regions and Wales strongly supported Brexit, the
majority of voters in London, Scotland and Northern Ireland backed maintaining the
status quo.

After securing permission from the UK Parliament, Theresa May finally triggered Article
50 of the Lisbon Treaty on 29 March 2017, formally notifying the EU of the UK’s decision
to quit the EU. The EU then released its draft negotiating guidelines on 31 March 2017.
These guidelines, which are expected to be approved by the remaining 27 member states
on 29 April 2017, lay out the broad directions in which the EU expects talks with the UK
to proceed.

The withdrawal talks between the EU and the UK are likely to commence as early as June
2017. Under Article 50, two years are allowed to complete the talks, starting from the
date it was triggered. If negotiations remain unfinished by then, the two-year period can

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Brexit: Recent Developments and Potential Repercussions

be extended by unanimous agreement of the other member states. But if no extension is

agreed, the UK will automatically cease to be part of the EU by 29 March 2019.

All EU laws will remain applicable in the UK until the exit agreement comes into force or
the negotiation period expires. The UK remains an EU member during this period, and is
obliged to continue to carry out all EU duties and obligations; but it will be barred from
participating in the discussion and decision of new EU policies.

The UK’s Plan for a Post-Brexit Partnership with the EU

The UK has made it clear that in the upcoming negotiations it will not pursue a partial or
associate membership of the EU, or any other model that leaves it “half-in, half-out”.
Pursuing a clean break from the EU, the plan is for the UK to leave the European Single
Market and the EU’s customs union, removing the UK from the jurisdiction of the
European Court of Justice (ECJ), ending the country’s contributions to the EU’s budget,
and taking back control of immigration by halting the free movement of EU citizens into
the UK.

This plan shows it is the UK’s intention to avoid replicating other models of partial EU
membership which had previously been floated as potential prototypes for a post-Brexit
relationship with the EU. Most notable among these are the Norwegian model,
encompassing membership of the European Economic Area (EEA) and the European Free
Trade Association (EFTA), and the Swiss model, with EFTA membership and a myriad of
bilateral agreements with the EU enabling free access to the single market across a
number of different sectors. As far as trade is concerned, the UK will not seek to adopt a
model already enjoyed by other countries.

Comprehensive Free Trade Agreement

As an alternative to such models, the UK will seek the greatest possible access to the EU
market through a new, comprehensive and fully reciprocal free trade agreement (FTA).
Such an agreement would afford businesses on both sides the maximum freedom to
trade with – and operate within – each other’s markets. The agreement may try to tie in
elements of the Single Market in certain specified economic sectors such as financial
services. However, such cherry-picking will be difficult, if not impossible, as the EU has
already ruled out a sector-by-sector approach to the participation in the Single Market.

The UK hopes to reach an agreement on its future relationship with the EU by the time
that the two-year Article 50 process has ended. Yet the EU has opted for a phased
approach, with the priority given to talks on the terms of divorce rather than negotiations
on the future trade relationship. To further complicate this issue, trade deals with the EU
often take many years to conclude. Finding compromise among all member states, all
with their own diverse interests in the agreement, may prove challenging.

A New Type of Customs Relationship

The UK has stated its intention to remain outside the customs union after its withdrawal
from the EU, given its desire to begin preparing trade agreements with other partners
immediately, while still complying with its EU obligations. The UK government is
considering a number of options for a new customs arrangement with the EU, such as
drawing up a completely new agreement, or remaining a signatory to some of the
elements of the existing customs union.

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Brexit: Recent Developments and Potential Repercussions

In essence, the EU customs union is a trade agreement that allows goods that have
entered any country in the union to move freely to any other member country without
tariffs, border checks, rules of origin and customs formalities. All members of the
customs union are bound by the EU’s Common Commercial Policy and the Common
External Tariff, restraints which prevent members from freely negotiating their own trade
deals with other countries.

As an alternative to membership of the customs union, the UK is envisioning some sort of

customs agreement with the EU which would make cross-border trade tariff-free and as
frictionless as possible. Such an agreement would likely require the UK and the EU to
agree to adhere to the same product regulations on traded goods, and potentially require
the UK to harmonise its legislation with that of the EU in certain areas, including
consumer protection, competition law and intellectual property.

A Role for WTO Rules

The UK is currently a member of the World Trade Organisation (WTO), though like the 27
other EU member states, its relationship with the organisation is for the most part
governed by the EU. After the UK has withdrawn from the EU, it will have to renegotiate
its WTO terms of membership, including the maximum tariff levels that the UK can
impose on imports from other WTO members. It is expected that the UK will try to adopt
the EU’s schedules for tariffs in the short term, while in the longer term availing itself of
its newfound liberty to fix its own schedules.

If the UK and the EU cannot reach a trade agreement, their trading relationship will be
governed by WTO laws. Under this option, the UK would be free to impose import tariffs
on goods entering the country, both from the EU and elsewhere. On the other hand, the
EU would be obliged to impose its Common External Tariff on UK imports. Tariffs could be
imposed every time goods crossed the EU-UK border, suggesting that the UK would not
have any preferential treatment when accessing the single market.

In all likelihood, it will be an uphill battle for the UK to strike a favourable trade deal with
the EU. Reaction to the UK’s plan for the talks with the EU suggests that the UK might
have overestimated its negotiating leverage. It has been pointed out that the UK needs
trade with the EU more than vice versa – while about 47% of UK exports go to the EU,
only 7% of EU exports head to the UK.

Likely Consequences for the UK

The referendum result sent immediate shockwaves across the UK financial market, of
which the main features were a plunge in stock prices and sharp depreciation of sterling.
Yet such volatility proved to be short-lived. While sterling has remained weak, the stock
market has since resumed its upward trajectory, although the financial market has
fluctuated widely again following Theresa May’s decision to call for a snap election.

So far at least, Brexit has not brought about noticeable damage to the British economy.
Indeed, the sharp decline in the value of sterling since the vote has not only bolstered UK
exports, but also attracted a significant number of overseas visitors, resulting in a mini-
boom in the trading and tourism sectors. Unemployment, which had been falling for
several years, has continued to decline and interest rates, which some commentators had
initially expected to rise this year, have been kept at historically low levels in the wake of
the Brexit vote.

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Brexit: Recent Developments and Potential Repercussions

However, there are growing signs that consumers are becoming more cautious as the
anaemic pound pushes up inflation, while the looming exit negotiations are tending to
make businesses wary about long-term investment. Britain raised its official growth
forecast for 2017 from 1.4% in November 2016 to 2% in March 2017, but lowered the
figures for 2018 and 2019 from 1.7% and 2.1% to 1.6% and 1.7% respectively.

The commencement of divorce talks will certainly lead to a prolonged period of

uncertainty, one that will weigh heavily on the country's economic performance. Nearly
half of all British exports go to the EU, and exporting businesses may hold back
investment until they can see the terms on which the UK will be trading with Europe. The
heightened uncertainty over the new arrangements between Britain and the EU is further
expected to discourage investment inflows as foreign companies may prefer investing in
other EU countries, as an alternative to the UK, in order to guarantee free access to the
single market.

With this in mind, the British government has called for an immediate start of talks on
the future free trade relationship with the EU, while also making preparations to forge
new deals with third countries as soon as it is allowed. At a time when trade is
increasingly negotiated on a regional or bloc-to-bloc basis, the British government would
have to begin negotiations from scratch with a host of countries and trading blocs.
Compared to the EU, which has a huge market and substantial political clout, the UK on
its own will have a greatly reduced bargaining power when conducting these negotiations.

To complicate matters further, there is a possibility that the UK will lose so-called
“passporting” rights for its financial services industry. These currently allow the UK’s
banks and financial institutions to operate anywhere in the EU. If this right was given up,
it would threaten the dominant position of the City of London, and encourage financial
services firms to transfer to other parts of the EU – particularly locations within the
Eurozone, such as Frankfurt and Paris. HSBC, for example, is likely to transfer about
1,000 jobs from London to Paris; Goldman Sachs has announced plans to move the bulk
of its EU-based jobs to Frankfurt; while Morgan Stanley is expected to shift some
employees from the UK to a number of other EU member states.

Even more seriously, failure to conclude an exit agreement will have devastating social,
political, financial and economic consequences. As noted, the absence of an exit
agreement would lead to a reversion to WTO rules. As well as facing higher import tariffs
when exporting to the EU, UK firms may also face more complex technical barriers and
customs formalities. Moreover, the need to re-create a customs border between Northern
Ireland (which remains part of the UK) and the Irish Republic (an EU member state) is
likely to lead to intense political problems for the UK. The possibility of such a customs
border returning has already encouraged calls for a referendum in Northern Ireland on
Irish reunification. Coupled with the growing pressure for a new independence
referendum in Scotland in response to Brexit, the British government is already having to
deal with the possibility (albeit still a remote one) of an eventual break-up of the UK.

Likely Implications for the EU

The British departure from the EU will pose serious threats, not only to the UK, but also
the world economy at large. At present, the UK is the world’s 5th largest economy (with a
4% share of global GDP) and the EU’s second largest (it comprises 16% of EU GDP). It is
also the world’s 5th largest trader (with 3% of global trade) and the EU’s 2nd largest
(with 10% of EU trade). Brexit is likely to hurt the EU by disrupting its well-established
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Brexit: Recent Developments and Potential Repercussions

economic and trade relations with the UK. Although less than 10% of EU exports are
destined for the UK, Britain imports more from most EU member states than it exports to
them. The UK is therefore a valuable market for export-oriented states like Germany that
enjoy trade surpluses with the UK.

In the course of exit negotiations, sustained pressure on the pound is expected to remain
a drag on the euro, thereby aggravating Europe’s ongoing global currency instability.
Early indications are that the negotiations will be an arduous and uncharted process, with
the EU likely to delay talks on any trade deal until sufficient progress is made on the
terms of an orderly withdrawal. That will include a settlement of the UK’s “exit bill” (that
is, how much Britain must pay to meet its current and future obligations to the EU – a
sum currently estimated to be as much as 60 billion euros) as well as a resolution of the
border issue in Northern Ireland, and the status of Gibraltar. Growing uncertainty over
the negotiations will only lead to increased financial market volatility, which may cause
further harm to the global economic and trade environment.

For the EU as a whole, the loss of the UK, a leading financial centre and one of the few
comparatively fast-expanding economies in Europe, will definitely have negative
repercussions on EU growth. The bloc would further suffer from the absence of an
influential supporter of trade and service liberalisation. At member state level, those with
stronger trade, investment and financial links to the UK, such as the Irish Republic and
the Netherlands, are likely to be most affected.

However, a number of EU member states may benefit somewhat from the British
departure. Germany and France, the two largest economies in the EU, are poised to
absorb any diversion of trade and investment from the UK. Frankfurt and Paris are
emerging as the favourites to win banking and finance business lost by the City of
London. Even the Irish Republic and the Netherlands may be able to take advantage of
the UK’s withdrawal. Ireland will be attractive to companies that have previously invested
in the UK, given its similar legal system, while the Netherlands can boast of its excellent
transport links.

On the political front, the UK’s departure has provided a boost to populist and Eurosceptic
political parties across the EU. Although it is still proving difficult for such anti-
establishment parties to gain power in the short term, the rise in their popularity is likely
to encouraging governing parties in some EU states to take a more nationalistic stance,
and perhaps even spur some of them to push for their own referendums on EU
membership. Even if no member states ultimately choose to leave, any intensified anti-
EU sentiment will hinder the further integration and development of the bloc, which may
translate into a less lucrative market for the rest of the world.

Expected Impacts on Hong Kong

Although the impact of Brexit will be less significant in Asia, the uncertainty associated
with establishing a new relationship between the UK and the EU could still be detrimental
to Hong Kong businesses trading with and investing in the UK. The UK was Hong Kong’s
3rd largest market in the EU in 2016, with imports from Hong Kong worth HK$50bn
(some 15% of total exports from Hong Kong to the EU), and the 12th largest in the world
(accounting for 1.4% of Hong Kong’s total global exports). About 56% of Hong Kong
exports to the UK were consumer goods, such as electronics, clothing, jewellery, toys and
timepieces, with capital goods making up a 37% share.

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Brexit: Recent Developments and Potential Repercussions

However, as the UK is likely to remain in the EU at least until 29 March 2019, Hong
Kong’s relation with Britain should largely be business as usual for the time being. But
while the UK will continue to adopt the EU’s trade policy until the exact exit terms are in
place, increasing regulatory divergence over the longer term may add to the cost of
exporting to the country. More importantly, a fragile UK economy, along with a soft
pound, will weaken the demand for imports.

In terms of investment, the UK is now the largest recipient of foreign direct investment
(FDI) in the EU, but Brexit may erode the UK’s dominant position as an investment
destination. The UK is likely to become less attractive as a gateway to the EU, as a base
for business regional headquarters, and as a location for investment from the EU.

Against this backdrop, it is expected that, in the wake of Brexit, some Hong Kong
companies may consider shifting part of their investment in the UK to other EU countries.
The UK receives far more of Hong Kong’s outward direct investment than any other EU
member country (HK$249bn in 2015, 65% of the total amount invested in the EU), and
with 2.1% of the total invested globally, more than all but three other countries in the
world.

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Brexit: Recent Developments and Potential Repercussions

On the other hand, Brexit is expected to galvanise more UK companies into looking
beyond the EU to capture new business opportunities and new markets in Asia. Being the
business hub in the region, Hong Kong, with its close historical, cultural and trade links
with the UK, can play an important role in helping UK companies get established in Asia
in general, and in China in particular.

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