The "Leave" campaign’s unexpected victory in the UK’s EU membership referendum held on 23 June has led to a sharp increase in political and economic risk.
All sectors of the economy are affected, with manufacturing (which is integrated into EU supply chains) and the financial industry (which is heavily dependent on the continental European market) being particularly vulnerable, especially over the medium term. In response to developments in the immediate aftermath of the referendum, Dun & Bradstreet has downgraded the UK’s risk rating from DB2a (on par with the US) to DB2c. We have also assigned a deteriorating outlook, indicating that further downward revisions are possible in the weeks and months ahead. Although the economic impact of the Brexit vote is impossible to assess comprehensively at this stage, Dun & Bradstreet has cut its real GDP growth forecasts for the 2016-20 period and has increased its inflation, unemployment and government deficit forecasts.
The two biggest questions are: Who will replace David Cameron as prime minister? And when will Article 50 of the EU Treaty (the legal basis for withdrawal from the EU) be invoked? Our current baseline scenario anticipates the invocation of Article 50 in September or October, once the new prime minister is in office. This would mean that the UK will leave the EU by late 2018. However, there is an outside chance of snap elections, as the new prime minister might not have the required parliamentary majority to invoke Article 50. At this stage, it is impossible to predict the outcome of snap elections, given the disarray of the Conservative Party and the even greater chaos in the opposition Labour Party. In any case, we recommend monitoring the situation closely and frequently, as things are changing quickly.
Over the medium term (i.e. after the invocation of Article 50), the biggest question will be about the nature of relations between the UK and the EU. Both sides (but especially the UK) have an interest in maintaining close trade and investment links. However, some topics, such as freedom of movement, will make it difficult to reach agreement. Positively, our core scenario is for the UK to maintain access to the EU’s common market once it has left the EU, thereby limiting supply chain risk when doing business with UK-based companies from the EU or the more than 50 countries with which the EU has free-trade arrangements.
The Brexit vote has led to a sharp depreciation of the pound sterling against the dollar (and, to a less extent, the euro), increasing the price competitiveness of British companies. In a worst case scenario, the UK will lose access to the EU’s common market over the medium term, and such a scenario would hit the financial sector especially hard (and thereby the financial hubs of London and Edinburgh) with very negative repercussions for the wider economy. Regardless of when (or if) Article 50 is invoked, the UK faces a period of lower growth, as investment activity will remain subdued against the backdrop of elevated uncertainty.
Payments performance in the UK was below the European average in 2015; expect a further deterioration in the coming years. Stay informed about political developments such as the invocation of Article 50 and the leadership contest in the Conservative Party, as these events will severely impact the economy. From a supply chain perspective, assume that the UK will continue to have access to the EU’s common market, regardless of whether it leaves the EU. Base business decisions on the assumption that the pound will remain weak against the dollar (and to a lesser extent, the euro) in the 2016-20 period. Expect the UK to enter a technical recession in H2 2016.
Scenario A: Our current baseline scenario anticipates the invocation of Article 50 in September or October 2016, once the new prime minister (PM) is in office. The refusal of the EU to start informal talks without the invocation of Article 50 will force the UK government to make this move, setting the EU exit date for exactly two years after Article 50 is invoked. At that point in the future, EU law would cease to apply in the UK, which would lose access to the common market (unless a new arrangement had been negotiated). Although two years is an ambitious timeframe to negotiate a new arrangement, we remain optimistic that some form of compromise can be found, thereby maintaining close trade and investment links between the UK and the continent. Once the UK government invokes Article 50, we will assess the potential scenarios in a separate Special Briefing Paper. We currently assign a 55% probability to the invocation of Article 50 in September or October 2016.
Scenario B: However, there is an outside chance that the new PM will not be able to invoke Article 50. As the majority of members of parliament opposed Brexit (and as parliament would need to approve the Article 50 invocation), there is a significant risk that the new PM will have to call snap elections in order to overcome the stalemate. Given the complete disarray of the Labour Party and the leadership contest in the Conservative Party, it is currently impossible to predict if there will be a majority for Brexit in parliament after the snap elections. We will analyse the situation in more detail in a separate Special Briefing Paper once snap elections are called. We currently assign a 35% probability to this scenario.
Scenario C: Although significantly less realistic than Scenarios A and B, it is possible that the UK government will try to ignore the outcome of the referendum on 23 June, potentially in combination with a second referendum about EU membership. We assign a 10% probability to this scenario.
Background and Context
European integration has largely been one of success from its start in the 1950s until the 1990s. However, recent years have seen a sharp drop in approval rates for further steps towards a more politically and economically integrated Europe. This is especially true for the UK, which only joined the European Communities (the EU’s predecessor) in 1973. Since the outbreak of the euro-zone crisis in 2010, and amid plans to transfer more powers to the EU level, public opinion in the UK became increasingly sceptical about the UK’s role in the EU. As a result, the anti-EU UK Independence Party gained support (eventually winning the elections to the European Parliament in 2014), while the anti-EU camp within the governing Conservative Party also gained strength. In order to retain the vital support of most of his backbenchers, PM David Cameron promised an In/Out referendum about EU membership in 2013, but his then pro-EU coalition partner opposed such a move. But, having secured an unexpected outright majority in the parliamentary elections in 2015, Cameron kept his promise and the government set the referendum date for 23 June 2016. Unexpectedly, the Leave camp won the referendum (51.9% versus 48.1%), prompting Cameron’s resignation. However (and despite earlier indications) Cameron did not invoke Article 50 immediately after the Brexit vote, creating great uncertainty about what will happen next.
From a trade perspective, both the EU and the UK will be interested in maintaining close relations, increasing the likelihood that both sides will agree on some form of economic co-operation after the UK has left the EU. In absolute terms, the EU has more to lose from cutting trade ties: In 2014, the EU exported goods and services worth USD386bn to the UK, while UK exports to the EU were USD237bn. However, in relative terms, it is apparent that Britain is far more dependent on the EU than vice versa, giving the EU the upper hand in potential negotiations in the aftermath of a Brexit. In 2014, 46.8% of all British exports went to the EU, while only 6.2% of all EU exports went in the opposite direction.
In legal terms, Article 50 of the Treaty of the EU sets out the roadmap for Brexit. Once invoked by the British government, the process of a British departure cannot be stopped (even if a change in public opinion or government occurs). Britain would leave the EU exactly two years after Article 50 is invoked and, unless the EU and the UK were be able to negotiate a new agreement in those two years, EU law and regulations would cease to apply in the UK, overnight. An extension to the two-year deadline is only possible if all 28 EU member states support such a request.
Politically, a Brexit would deliver a serious blow to the EU at a time when anti-EU sentiment is on the rise in most EU member states. If the UK were to be economically successful after its departure, this would increase the likelihood that other EU members might try to leave, thereby risking the whole European post-war project. However, Brexit will also have ramifications for the UK’s domestic politics. Separatist movements in generally pro-EU Scotland and Northern Ireland (which has close links to its neighbouring EU member, the Republic of Ireland) could see increasing support, eventually threatening the integrity of the UK. In Scotland, which already has a strong independence movement, a renewed breakaway attempt from the UK cannot be ruled out, while Northern Ireland could see a resurgence of violence between pro-UK Protestants and pro-Irish Catholics amid efforts to achieve Northern Ireland’s reunification with the Republic of Ireland.