When the British electorate voted on June 23 to leave the European Union, they voted against the status quo. But they did not vote in favor of an alternate reality outside the EU. While many different options were openly discussed in the run-up to the referendum, it is now clear that the government at the time had not prepared a contingency plan should the referendum be lost, as it eventually was. Today, almost six months on, it is not entirely clear, to say the least, whether the new government under Prime Minister Theresa May has a coherent negotiating stance or a clear view on what the eventual relationship of Britain and the EU should be. The only concrete announcement has been that the U.K. government will pull Article 50, the starting pistol for Brexit negotiations, no later than March 2017. According to the Treaty of Lisbon, the U.K. will leave the EU two years later, whether or not an agreement has been reached for a post-Brexit relationship. While it is true that the two-year timeframe could be extended by unanimous agreement, this may not be easily achieved in practice. Nor may it be desirable as it would extend the period of extreme uncertainty for businesses, adding to potential downward pressure on investment and jobs.
Following the Brexit vote, S&P Global Ratings lowered the sovereign rating of the U.K. by two notches to 'AA' from 'AAA'. The downgrade reflected our view that the "Leave" result in the U.K.'s referendum on the country's EU membership (Brexit) will weaken the predictability, stability, and effectiveness of policymaking in the U.K. and affect its economy, GDP growth, and fiscal and external balances. The two-notch sovereign downgrade from 'AAA' was an extraordinary rating action, underlining the unprecedented step that is Brexit, which comes with multiple risks that are only partly under the government's control.
With the downgrade, we kept the negative outlook, indicating that the rating could be lowered again. The negative outlook reflects the multiple risks emanating from the decision to leave the EU, exacerbated by what we consider to be reduced capacity to respond to those risks. This assertion is based on what we view as the U.K.'s weaker institutional capacity for effective, predictable, and stable policymaking (see "Ratings On The United Kingdom Lowered To 'AA' On Brexit Vote; Outlook Remains Negative On Continued Uncertainty," published on June 27, 2016, on RatingsDirect). We affirmed the ratings and negative outlook on Oct. 28, 2016 (see "Ratings On The United Kingdom Affirmed At 'AA/A-1+'; Outlook Remains Negative On Brexit Uncertainties," Oct. 28, 2016). Here, we illustrate some of the risks that led us to take a negative view about the U.K.'s sovereign creditworthiness.
Hard Brexit, Hard Bargain
We currently believe that a so-called hard Brexit is the most likely outcome: the U.K. would not be able to count on continued unfettered access to export goods and services to the remaining EU-27.
We note that the priority of the May government appears to control immigration, including to citizens from the EU, which currently face no restrictions to living or working in the U.K. Judging from public statements, free access to the EU market seems to be a second-order priority, desired, but not as much as independently controling the country's borders. We agree that the question of immigration was probably a key driver in generating the Brexit majority on June 23.
But insisting on control over freedom of residence of European citizens will probably cost the U.K. access to the single market for goods, services, and capital as well, or at least much of it. Unambiguous statements from senior European leaders, be they of the European Commission, European Council, or European Parliament, or be they national leaders, underlined repeatedly their dogged commitment to the indivisibility of the four fundamental freedoms of movement (people, capital, goods, and services). If both sides hold onto their stance, and we believe there is a good chance they will, there is actually not very much to be negotiated: the two positions are mutually exclusive and won't yield a meaningful compromise. A hard Brexit would follow.
British observers sometimes note that immigration is a big concern in many other EU countries, too. But this argument overlooks that the apprehension of parts of the population in Germany and elsewhere stems from the large number of refugees from outside the EU that had entered Europe since 2015. Intra-EU immigration, on the other hand, is a worry only in Britain. On the contrary, in other countries the free movement of EU citizens is widely considered a key achievement of EU integration. It therefore seems currently unlikely to us that Britain will succeed in restricting EU citizens' rights to reside in the U.K., while at the same time benefitting from free trade.
Should a compromise be found against the odds as they currently stand, the large number of veto players puts a post-Brexit agreement still at risk of rejection. All remaining 27 EU members will have to formally ratify unanimously any post-Brexit arrangement (add to that the European parliament as well as a handful of regional parliaments). For example, for some EU countries' citizens, especially in central and eastern Europe, the U.K. has been a powerful magnet. It is highly doubtful that parliaments in those countries would be keen to endorse a more restrictive approach to the freedom of movement of its people.
A Pandora's box
Other countries may worry that unbundling the four freedoms is akin to opening a Pandora's box. What may come next? Would a country ask for other exemptions to respond to citizens' concerns about a declining industry? Where will it end? The prevailing view on the continent is that the EU is an all-in or all-out affair. The U.K. already enjoys some exceptional opt-outs (e.g., to the monetary union or the EU budget rebate), which have to be viewed as past concessions to keep Britain an integral part of Europe. But these are marginal concessions compared to what London may be about to ask for after Article 50 has been activated. The EU is viewed by the other members as a set menu, not a buffet. There is no argument here whether this is the right or wrong way to look at things, but that's how it's looked upon outside Britain. We believe that the U.K. side still has to fully appreciate the rather unified opposition it will face once negotiations are set in motion. The choice of chief negotiators for the European Commission and the European Parliament (Michel Barnier and Guy Verhofstaedt, respectively) bodes for a hard bargain.
One important reason for the relative inflexibility that the European side is likely to display lies in domestic politics. Euroscepticism may be at its pinnacle in Britain. But it has been growing elsewhere in Europe, too. Even in Germany, previously seemingly impervious, has witnessed a rise in the fortunes of the anti-European Alternative for Germany (AFD) (see "The Surge Of The German Eurosceptic Party AfD Could Complicate Eurozone Policies," Sept. 22, 2014). Marine Le Pen, leader of the Front National, is widely tipped to enter the second round of the French presidential elections. Italy, Netherlands, and Austria are other political systems that have seen an anti-EU/anti-establishment backlash. The governments of these countries will be very reluctant to offer the U.K. a deal that could be considered attractive. Doing so would only strengthen their homegrown populist movements further and encourage copycat initiatives. The fear is that this could lead to a first gradual and then an accelerated unraveling of the EU as we know it. When we asked investors at an S&P Global Ratings sovereign webcast which countries could hold their own EU referenda in the next five years, 23% of the almost 2,000 respondents believed that it could happen in the Netherlands (partly informed by the relatively low thresholds needed to initiate a referendum), 17% believed France might face a referendum, and 8% mentioned Italy. These numbers are in our view almost certainly too high, maybe biased by the immediate aftershock of the Brexit surprise vote (the webcast happened a few days after). Even so, it underlines that there is little room for complacency for Continental European governments when trying to contain their homegrown populist and eurosceptic parties.
A weaker U.K. government hand
We believe that the decision of the U.K. High Court on Nov. 3 that the government needs to consult Parliament before triggering Article 50 could weaken the hand of the U.K. government further. The ruling was not entirely surprising. After all, one motivation for Brexit was to restore full sovereignty of the Westminster Parliament to legislate over matters affecting the U.K. And since the Brexit process is all but irreversible once Article 50 is triggered, it appears reasonable that Parliament should have a voice in the process. Although financial markets appear to have taken a positive view of the court's decision (which the government will appeal), it could make a hard Brexit even more likely. Parliament may choose to attach conditions to the negotiation process or results, which can weaken the ability of the British negotiators to compromise. Should the government view Parliament's involvement as restricting the executive's hand too much, the prime minister could be tempted to call early general elections. Polling suggests that it would lead to a larger majority for the ruling Conservative party and an unambiguous Brexit mandate. The broader autonomy brought about by a friendlier Parliament would come at the cost of time lost in the negotiations (should Article 50 have been triggered when elections are called) or a further extension of the period of uncertainty (should it lead to a delay in triggering Brexit talks).
All things considered, the U.K. negotiating team (which is yet to be announced) will need to confront fundamental disagreements and will face a formidable defense when negotiations begin. And time appears exceptionally short to bridge those disagreements. As always in such negotiations, nothing will be agreed until everything is agreed. Agreeing everything, if at all possible, will take time. Time the U.K. does not have, as the clock will stop two years after triggering Article 50. As a point of reference, it is useful to remember the case of Greenland, the only country that has so far left the EU in 1985 over a dispute over fishing policies. Even this relatively simple departure took three years to formalize. The comprehensive economic and trade agreement with Canada (CETA) took seven years to negotiate. It started when Gordon Brown was prime minister. And in the case of CETA, all negotiating parties were in broad agreement on the overall contours of the agreement, which is much less ambitious than what a post-Brexit deal would require. And even CETA had been on the brink of failing when a regional government in Belgium temporarily refused to approve it. How will a much more contentious and complex EU-U.K. agreement be negotiated in just two years? And it could effectively be less than two years, as elections in countries like France and Germany will distract decision makers and slow down the process. The clock will tick inexorably against the U.K.
The Legacy For U.K. Cohesion
Far from healing festering wounds, as was then-Prime Minister David Cameron's intention, the referendum has deepened and laid bare the schisms in British society. The observation that both Labour and Conservative parties are internally disunited on the matter is merely a reflection of the wider reality in the country. The result was sufficiently narrow (52% against 48%, with a turnout of 72%, much lower than the 84% at the Scottish independence referendum two years earlier) for the losers to feel aggrieved, especially following the revelation that some of the promises that have been made by leading Brexit proponents have since been dropped. This would not be such a big concern if the distribution of voters to Leave or Remain had been distributed relatively randomly. But they are not.
There is a conspicuous regional divide: London and other large cities voted to remain, whereas more rural constituencies supported Brexit. In Scotland, all electoral districts voted to remain in the EU (overall 62% of Scottish voters opted for Remain, see chart 1), raising the specter of another Scottish independence referendum should the leadership in Edinburgh consider that Scottish interest outside the EU would not be sufficiently protected. Scotland leaving the U.K., into which it is deeply integrated, would leave both Scotland as well as the rump-U.K. facing formidable economic and financial challenges that could weigh further on the U.K.'s creditworthiness. Our current expectation is that no new Scotland referendum will be attempted while the Brexit negotiations are underway. However, should the British (and especially Scottish) economy take a stronger hit then currently expected, the Scottish National Party (SNP), dominating the political scene north of the border, could conclude that a second referendum could be successful. Once the SNP holds that view, we would expect it to call a second independence referendum to exploit any secessionist momentum building up.
The Irish divide
There is another regional divide that has received less attention. The majority in Northern Ireland voted to remain (56%). But this majority masks a worrisome confessional split: majority Catholic constituencies voted Remain while majority Protestant districts voted Leave (see chart 2). While this is not to suggest that the peace in Northern Ireland may be in jeopardy because of the referendum, it poses additional complex challenges. Northern Ireland has the only U.K. land border with the EU and unobstructed inter-Irish trade is critical for economic development in Northern Ireland, already a relatively less prosperous U.K. region. The focus on immigration control could force the U.K. government to establish border controls with the Republic of Ireland. This would only add to the sense that the northern and southern parts of Ireland are again moving apart, reversing decades of intra-Irish integration.
The old versus the young
Finally, there is a pronounced divide by age groups. Almost three-quarters of young voters between 18 and 24 years voted for Britain to Remain, while 60% of voters older than 60 voted Brexit (see chart 1). The intergenerational controversy about the future vision of Britain has only just begun. If and when the negative economic consequences of Brexit become visible, the intergenerational cohesiveness of U.K. society may take a hit.
The Economic Consequences
Most of the economic impact will hit Britain itself. The second-round effect on the world economy is likely to be more limited, as the U.K. economy accounts for a small and shrinking share of global GDP. According to IMF data (World Economic Outlook), the U.K.'s share of the world economy has been shrinking from around 5% in 1980 to just over 3% in 2020.
Britain is to a high degree dependent on trade with the EU. As chart 3 shows, the U.K. exports almost 14% of its GDP to the EU. By contrast, other large EU economies such as Germany, France, and Italy export only some 2%-3% of their respective GDP to the U.K.. This makes it immediately evident that Britain has more to lose from being shut out of the single market. The often-heard remark that the EU would be the loser of trade disruption because it runs a trade surplus with the U.K. is beside the point. There are in fact mutual dependencies, and a hard Brexit could disrupt U.K.-EU supply chains. All EU member states are likely to lose out, but no country would lose more than the U.K.
Some hope has been expressed that the U.K. could strike free-trade deals with non-EU members, thus making up for diminished access to EU markets. Just this week Ms. May made exactly that point during her visit to India. Chart 4 suggests that these hopes are hardly realistic. Trade with the EU, the U.K.'s natural trading partner due to proximity, is simply too important. Half of all value added exported from the U.K. goes to other EU economies. In contrast, North America and Asia accounted for only around one-seventh each. It is not a plausible assumption that in an era of stagnant world trade, the loss of EU market access could be offset materially in the medium term, even if trade agreements with third nations could be struck quickly. This in itself is not likely given the fact that the U.K. does not have an experienced cadre of trade negotiators: negotiating trade deals has been an EU prerogative, which is where the expertise resides. But even if for the sake of argument we assume that the U.K. can agree on free-trade agreements with significant non-EU economies, they still will not compensate for all of what U.K. businesses will lose. The significance of the single market is not only that it has abolished tariffs for intra-EU trade. It also provides a wide array of arrangements whereby goods and services produced from any member can be sold in all the markets of the others, with no additional documentation or licensing. No free-trade agreement or customs union with any other part of the world is likely to offer that benefit, reducing transaction costs for U.K. businesses.
WTO rules aren't enough
Other proponents of Brexit have suggested that simply abiding by World Trade Organization (WTO) rules would provide a sufficiently robust framework to secure a satisfactory U.K. export performance. Exports would be supported by a weaker pound that should offset the higher trade tariffs for EU market access. The reality is more nuanced, though. As chart 5 illustrates, Britain's exports are concentrated in the services sector. U.K. service exports account for almost 1.3 times industrial exports from the U.K. Well over half of those are financial service exports (equivalent to 74% of industrial exports). The same numbers for Germany, for example, look entirely different: service exports are only 40% of industry exports and financial exports are only a small part of that. WTO oversees first and foremost liberalized trade in goods rather than services. Operating under the WTO framework would therefore not benefit Britain as much as its continental European partners (Spain may look comparable to the U.K. in service-export intensity. However, much of the "other service exports" consists of tourism, which not subject to a potential loss of market access the way most British service exports are).
Whether the weaker pound will lead to a strong and lasting support for exports also remains to be seen. Similar to the sterling depreciation episode in 2007 and 2008, the currency has weakened this year because of concerns about the economic prospects of the U.K. economy. Weaker sterling is probably the consequence of the perception of a fundamental deterioration in the U.K.'s economic prospects rather than reflecting the removal of an export-compressing straitjacket, as was the case after Britain was ejected from the exchange rate mechanism fixed-exchange rate regime in 1992. In 2007 and 2008, depreciation was not followed by an export boom, and in fact exports hardly budged. Today, demand for many manufactured goods appears to have become less price sensitive and more determined by design, service, and specific functionalities. If so, sterling depreciation might have further to go before a broader export boom could manifest itself. But of course, and as just discussed, service exports are more important for the U.K., especially financial and business services. And here the lack of any certainty over issues like future passporting rights (allowing U.K. domiciled financial firms to offer their services EU-wide) or foreign worker hiring restrictions are unlikely to lead to a lasting growth of investment, employment, and exports in those vital sectors. A hard Brexit would most likely hit those critical parts of the U.K. economy hardest. Companies and workers in those sectors have been paying a large share of overall U.K. taxes. Should the service industry wobble, public finances could be in a bind, too. This will further limit the remaining fiscal room for maneuver to counter the economic impact of Brexit.
Trade undoubtedly matters a lot for the long-term future of the open U.K. economy. But the principal vulnerability may be the risk to external funding. After the U.S., Britain has the largest current account deficit of the world, over 5% of its GDP, or some $160 billion this year alone. The weaker pound could enhance British exports, even if only modestly. But it will also lead to higher import prices and inflation and therefore dampen disposable income, reducing demand for foreign goods. But the external gap is so large that the U.K. will continue to depend on the kindness (or avarice?) of foreigners for years to come.
FDI has gushed into the U.K.
Over the last 20 years, the U.K. has benefitted more than any other large EU member from foreign direct investment (FDI) into its economy (see chart 6). This has facilitated the financing of the current account deficit and also contributed to elevate the still rather low national investment rate. It is fair to assume that a significant part of the FDI continuous inflow was motivated by a conducive business environment (likely to remain) and unfettered access to the world's largest market, the EU (bound to disappear after a hard Brexit). FDI may be gushing in less bountifully outside the EU, depriving the U.K. economy of an important engine of investment, employment and growth, but also of a weighty contribution to the financing of Britain's gaping current account deficit.
The current account deficit is but one part of the story of Britain's external vulnerability, though. At S&P Global Ratings, our preferred broader metric for external liquidity risk is the gross external funding requirement (including debt amortization coming due, including short-term debt) as a share of current account receipts and official foreign exchange reserves (the denominator is a measure of an economy's capacity to generate or own funds that can be applied to satisfy the external borrowing needs). A value over 100% means that a country has to pay more resources to foreigners in a given period than it is able to create though its current ongoing transactions. In other words, a sovereign with a value of over 100% needs to attract ongoing external funding to roll over its existing external obligations. That funding can occur through FDI, but much of it typically takes the form of borrowing. The gross external funding requirement of the U.K. is almost 800% of current account receipts and reserves in 2016. That is the highest of all rated sovereigns worldwide. Chart 7 shows how much more the U.K. depends on external funding sources than any other G-7 economy.
The dependence on external funding is, of course, the result of the large flows generated in and out of the City of London as a global financial center. Much of the debt generated by the City is short term and needs to be constantly rolled over. Much of the financial sector's external liabilities are offset by external assets, as is the nature of financial intermediation. This may provide an important buffer. Nonetheless, the extreme dependence of the U.K. on cross-border capital flows can become a concern should confidence falter. This could occur if it were to become more discernable that the U.K. will not be able to secure free access and financial sector passporting rights. Since the financial sector faces the largest uncertainty and may have most to lose from a hard Brexit, inward financial flows could become more volatile and less bountiful. In the worst case financial, monetary, and economic resilience could be tested in an unprecedented way. It could also lead to a gradual demise of sterling's role as a reserve currency, a feature that is currently an important support of the U.K.'s sovereign rating.
The EU Is Not In The Mood
The U.K. economy has performed well since the referendum was held. This is not too surprising. Brexit has not yet happened. As it has turned out, the short-term damage limitation exercise undertaken by the U.K. authorities--the Bank of England's rate cut, renewed quantitative easing, sterling depreciation, and the promise of increased government spending in the autumn budget--has been effective to support economic performance in the short term. Even if present economic conditions have remained benign, complacency about the longer-term impact would be misplaced. We expect investment activity to stagnate as uncertainties about the post-Brexit relationship with the EU persist. Looking ahead, consumer demand may face downward pressure as disposable incomes decline with inflation surpassing wage growth, and as unemployment rises. The government's intention to counter the slowdown through a more gradual fiscal adjustment path can help to mitigate the expected economic weakness. But only to a degree, as the government's fiscal space has already been compromised by the fiscal fallout from the financial crisis and ensuing recession. We expect the U.K. to avoid an outright recession, but see average growth close to 1% in 2017 and 2018.
The stakes are high. An operation like Brexit has never before been undertaken. The U.K. government has still not divulged its objectives once Article 50 is triggered. One cannot even be certain that an agreement exists at cabinet level about what these objectives should be. The negotiation process needs to satisfy not only Westminster, but also every single EU member legislature. The risk of accidents is high and time very short. We are concerned that once Article 50 is triggered and the negotiation process is underway, the fault lines between the EU and the U.K. become more easily observable (and maybe even the conflicts inside the U.K. government). In such an environment, investors and businesses, but also consumers may become more nervous and tighten their purses, leading to a weaker economic outcome. in turn this raises the risks to territorial integrity and another Scottish referendum. It appears that the U.K. side has still not accepted that the EU partners are likely to stick to the indivisibility of the four freedoms. But even if Westminster were to acknowledge the EU position, it is hard to fathom how a rather hard Brexit can be avoided unless both sides become much more flexible than they appear today. Nothing today suggests that a common quest for compromise will overcome the gulf that now looks as wide as the English Channel.
Good reason to keep a negative outlook on the 'AA' sovereign rating of the U.K.