Sunday 26 June 2016

What's Next for Brexit?

I seldom like to blog about the latest financial news, primarily because I am a slow but deep thinker. Nevertheless, after the financial mayhem that Brexit caused on Fri, Brexit was at the top of my mind. So, I might as well pen down my thoughts. Furthermore, blogging helps to sharpen the thoughts on it. The current thoughts that you see in this post are already the second iteration. The first iteration of thoughts are similar to the general consensus, which is that UK is likely to break up with Scotland seeking independence and UK faring worse than the European Union (EU) post-Brexit. The second iteration of thoughts, however, is a refutation of the first iteration. Let's begin.

The single most important question after Brexit is, what will happen to UK? Will Scotland and Northern Ireland seek to break away from UK so as to remain in the EU? The initial thinking was yes, because Scotland voted clearly in favour of staying within the EU. In fact, when Scotland rejected its own independence referendum in 2014, it was partly on the premise that UK would remain in the EU. Now that Scotland will be taken out of EU against her wish, it is likely that the Scottish Government would seek a second referendum and succeed in gaining independence. It is interesting to note that in the 2014 independence referendum, 55% voted to stay in the UK. In the Brexit referendum, 62% of Scottish voters chose to stay in the EU. A net 7% of Scottish voters do not mind leaving UK but staying in the EU. So, a new independence referendum would definitely result in Scotland's independence from UK.

The current thinking is, Scottish independence is unlikely. With all these referendums happening, it seems that people could choose to conduct a referendum and vote to leave a country or union as they wish. However, referendums actually need approval from higher authorities for the results to have any legal effects. In the case of the 2014 Scotland independence referendum, approval from the UK Parliament was needed (see Agreement between the United Kingdom Government and the Scottish Government on a referendum on independence for Scotland). To run another independence referendum, similar approval would be required. Given the shock results of the Brexit referendum and the likely outcome of the next Scottish independence referendum, nobody would be in the mood for another shock.

The more important reason why Scottish independence is unlikely is that none of the major powers wish to see a break-up of UK. UK is a major ally of US, often siding with it on major issues. A UK without Scotland would be weakened, which would be to the disadvantage of US. This is why President Obama said that the special relationship with UK would remain despite Brexit. Even the EU, despite the current squabbles with UK, would not wish for a weakened UK when it faces Russia to the east. Thus, the major powers would tell the Scottish Government that a Scottish independence would not be welcomed, at least in the near future. To understand the geo-political considerations of nations, a very good book to read is George Friedman's The Next 100 Years. Anyway, as will be explained later, staying within UK might not be a bad option.

So, UK is likely to remain intact with Scotland and Northern Ireland staying put. The next question is, will UK enter into a long-term decline post-Brexit? Together with the earlier question, this question has implications on the value of UK assets and British Pound. UK would lose privileged access to the EU single market that is reserved for EU members. It might also see companies relocating across the English Channel to EU. All these present serious challenges for UK. However, as a civilisation, UK/England has faced significant challenges in her history, recovered and prospered. Despite years of war, England failed to conquer the whole of the British island and had to share the island with Scotland, yet, both nations managed to put aside their historical rivalry to join in a political union to create the Kingdom of Great Britain that would later dominate the world. Also, despite failing to gain an edge over France in the 100 Years' War, UK/England went ahead in the 16th century to build an empire that would eventually span across the entire globe. In addition, despite losing its first empire (i.e. America) in the American War of Independence, it went ahead to build a second empire in Asia, Africa and the Pacific. During this period, UK also ushered in the first industrial revolution that changed the world forever. It was only in the last century that UK declined, no thanks to the 2 world wars fought in Europe. The most glorious days of UK were actually when she was looking outwards towards the rest of the world. It would be a mistake to write off the British people. Thus, UK would also recover from this event and prosper in the medium to long term.

In the short term, UK would suffer an economic decline due to investors' uncertainty over the eventual shape of UK, reduced cross-border trade with EU, relocation of companies to EU, etc. She would also have to re-establish trade pacts with other countries. There is a global backlash against globalisation and free trade currently, which is one of the reasons contributing to Brexit and the rise of nationalism in many countries. However, given UK's status as the 5th largest economy in the world and the fact that the existing EU trade pacts are going to be missing the UK portion, I believe that UK should not have much difficulties re-establishing such trade pacts, so as to make whole the EU trade pacts at least.

The third question from Brexit is whether other EU members would be emboldened by the move and follow UK out of EU. The implication for this question is whether EU and Euro will survive. In the short term when UK is suffering an economic decline from Brexit, the answer is no. EU members who aspire to do their own EUxit would want to see what happens to UK first before making the move. However, in the medium term, if UK prospers despite leaving the EU and if EU remains the current state, then yes, more countries will exit EU.

EU was born out of a desire to end the centuries of war waged among the various civilisations in Europe and to replicate the large single market of US. However, despite the grand and noble vision, EU remains very much a work-in-progress after almost 60 years of existence. The main issue is the unwillingness of individual countries to relinquish further power to a central EU government (i.e. European Commission) for complete integration. For as along as EU citizens see themselves as British, Germans, French, Greek, etc. and not as EU citizens, there can no integrated and united Europe like the US. Look at the economic side of the union. There is economic and monetary union, meaning EU members have a common set of trade rules and can share a common currency and a common central bank, but there is no fiscal union, meaning there is no fiscal transfer of money from one member to another via a central government budget. Thus, when the threat of Grexit erupted almost a year ago, individual EU member governments had to approve the bailout for Greece instead of the European Commission dispensing money to help its member state in need. As an analogy, when West Germany merged with East Germany, if West Germany had refused to help East Germany, very soon East Germany would not want to be part of a united Germany. Thus, EUxit, whether Grexit or Brexit, is only a matter of time. I just did not predict it to be Brexit. Unless EU integrates further, the likely outcome is some EU members will follow the footsteps of UK in leaving and the Euro will fall apart.

The figure below shows the performance of the UK and European stock markets on the first day after the Brexit news. 

European Stock Market Performance on Day 1 after Brexit News

The UK market dropped 3.15%, but the German, French and Spanish markets dropped even more, at 6.82%, 8.04% and 12.35% respectively. If the conventional wisdom is that UK will fare worse than EU post-Brexit, why is it that the German, French and Spanish stock markets dropped more than that of UK? Granted, this is only Day 1 after the Brexit referendum, but it is something for us to think about.

Finally, the most important question for investors is, will markets recover or continue to tank further after Fri? It is difficult to answer. In Fri's stock market rout, banks led the decline. Early this year, even without the threat of Brexit, European banks had shown signs of stress with doubts over the banks' ability to meet their liabilities in contingent convertible (CoCo) bonds. With Brexit, there is further economic slowdown, reduced cross-border business, forex losses at UK operations, etc. The current thinking is central banks will step in to prevent a repeat of the Lehman Brothers collapse, so perhaps it is not as bad as it seems. The stock market rout in Jan this year taught me that if I cannot figure out what the market will do, at least I must figure out what I should do.

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  1. Hi Chin Wai,

    I just wrote my own views about Brexit too and comments which resonate with urs!

    EU can never be like US due to the diverse cultural/historical differences in Europe.

    I also agree the British has a historical good track records of evolvement to be a dominant force of the world.

    One thing I am more skeptical is of the younger generation of Britain have "what it takes" like their ancestors to be successful.

    Singapore is perhaps facing a similar challenge if our current and next generation can prosper in the next few decades or more.

    1. Hi Rolf,

      Yes, I saw your post and I agree with you! When there is a will, there is a way!

      I guess how tough a generation is depends very much on the circumstances that the generation grows up in. Challenges will make a people grow stronger and I believe younger Britons will rise to the occasion.