Brexit: On the future of the UK and the global economy (Summary)

NAKAJIMA Atsushi (Chairman, RIETI)

Following the UK's referendum held on June 23, 2016 where voters opted to leave the EU (Brexit), the UK's negotiation with the EU is set to proceed. The decision made by the UK, the second largest economy in the EU only behind Germany, caused the world's financial markets to respond sharply to it and uncertainty to increase not only in the UK and the EU but also in the global economy.

For the past 10 years, RIETI has had research exchange with CEPR including jointly hosting international workshops prior to this symposium. In today's symposium, researchers from CEPR will deliver their lectures followed by a panel discussion to deepen our thoughts on Japan's responses to Brexit and other topics. I am truly happy with the timeliness of this symposium held on the eve of the U.S. presidential election to consider issues relating to Brexit that also has a significant impact on the world economy. I trust that this symposium will provide insightful knowledge about Brexit.

Richard BALDWIN (President, CEPR / Professor, Graduate Institute, Geneva)

Brexit becomes messy only after leaving the EU. Those who campaigned to leave the EU knew what they were against (namely EU membership), but did not have a clear plan about how to proceed after leaving the EU. There is no clear mandate from the referendum to guide choices, and the current government is deeply divided as to how to proceed. In negotiating post-Brexit, the UK is in a weak position because it needs the EU more so than the other way around. Only 16% of exports from the 27 EU countries goes to the UK, whereas 47% of UK exports go to the EU. The "Factory Europe" system of manufacturing responsibilities split between multiple countries would also be affected, making the UK less attractive for manufacturing.

Carrying out Brexit

The Brexit process entails the initial divorce from the EU as a whole and then the re-marriage to each EU member states individually. Although the divorce from the EU is relatively easy, it is difficult to negotiate with the remaining EU states. The first option would be to remain in the single market, which would minimize economic damage, but would yield little extra control for the UK. The second option is a Trans-Pacific Partnership (TPP)-type agreement that yields some control to the UK, but provide worse access to the EU market and thus exacts more economic damage to the UK economy. The final option involves "crashing out" of the EU and depending solely on World Trade Organization (WTO) rules. This would provide the UK with the most control, but would also exact the most economic damage. Since the UK has been part of the EU for 40 years, it is also integrated into the WTO and other international agreements and would need to renegotiate its position, a process that could take upwards of 15 years.

Regarding politics

As for high politics, the UK is in a weak position since the EU does not want to offer an attractive deal that would entice other member countries to follow the UK's lead. On low politics, since all member countries and the European Parliament have veto power, it is likely impossible to form some type of deep agreement with the EU quickly. As for likely outcomes, if hardliners in the UK prevail, the UK will "crash" out of the EU. If pragmatists prevail, the UK will have a long period of negotiation with the EU without disruption. A further possibility is that the idealists disrupt these long negotiations years after they have started.

Barbara PETRONGOLO (Director of the Labour Economics Programme, CEPR / Professor of Economics, Queen Mary University of London)

Brexit has caused uncertainty, with a nearly 50% drop in the number of online job advertisements in the week after the vote. Medium-term impacts will depend on how the UK balances the tradeoff between free movement of labor and strict border control. If the UK remains in the European Economic Area (EEA), models predict a 1.3% decrease in gross domestic product (GDP) per head and a 2.6% reduction if the UK drops out entirely, excluding further GDP decreases caused by drops in foreign direct investment (FDI).

Is the cost of full control over immigration worth it?

Immigrants make up only 6.3% of the working population. EU immigrants are more educated, with 43% having completed schooling through age 21 compared to 23% of UK natives. There is no evidence that immigrants harm the labor market since they contribute to the economy. There is also no evidence of immigration having a negative effect on the average wages of natives, except possibly for the lowest 10% of earners. EU migrants have contributed positively to the UK fiscal budget since they are young and contribute more in taxes than they receive in benefits. On the aggregate, there is no correlation between immigration on the unemployment rate of UK natives, nor is there a correlation between migration and the real hourly wages of UK natives. Even looking at specific areas that have higher percentages of immigrants, no negative impact was observed on the unemployment rate or wages of UK natives.

Effects of halting immigration

Low-skill jobs are disproportionally occupied by immigrants. In these sectors, restrictive immigration could cause wage and end-product price increases. However, these jobs are shunned by UK natives, so the impact would be negligible. A halt in immigration would likely cause a 0.16% increase in real wages for administration jobs and 0.62% for skilled trades, but is small in comparison to the 2.0% fall in real wages predicted in the Bank of England's (BoE) 2018 forecast. There is no evidence that restrictive immigration policies will positively impact the UK native population.

Tarun RAMADORAI (Research Fellow, CEPR / Professor of Financial Economics, Imperial College London)

UK financial and related professional services account for 12% of UK GDP and employ 2.2 million people. The UK is dominant in foreign exchange, rates trading, cross-border lending, offshore wealth management, and marine insurance. These areas are extremely sensitive to regulation, arguably more so than other areas. Such businesses are also reliant on payment and clearing systems.

Regarding payments & settlements

The Eurozone TARGET2 payment system has the European Central Bank (ECB) as the hub and national central banks as the spokes. The BoE does not participate, but UK banks do participate in TARGET2 in Euro-denominated payments. Following Brexit, there is an incentive for Euro countries to pull payment business away from the UK. There is currently a damping effect on FDI by the financial sector in the UK since future access to TARGET2 is not guaranteed.

Regarding settlements, central counterparty (CCP) clearing mechanisms have sprung up in the UK. The greater the trade is done through them, the more they become systematically important financial institutions. The BoE and ECB have agreed on joint supervision and oversight of CCPs and reciprocal currency swaps if multi-currency liquidity support is needed by CCPs. Brexit puts this system at risk since the EU has slim incentive to continue.

Prospects of international expansion

Brexit proponents suggested expanding overseas to India or China, but UK banks have been focusing more on the EU, and it takes time to rebuild an outward-focused financial sector. Financial services have been steadily shifting toward Asia, so an Asian pivot needs to be made, but negotiating entry into the Asian capital markets is extremely difficult. Indeed, without loosening restrictions on Indian worker/student mobility, it will be difficult to convince India to open up its market to the UK.

Regarding uncertainty

Geopolitical risk has doubled following 9/11. The economic shock caused by the Lehman Brothers bankruptcy also increased UK economic uncertainty, but it has come down post-2013. UK economic policy uncertainty is the highest since the global financial crisis due to Brexit. Prolonged uncertainty causes economic agents to become risk-averse when markets return to normal, so uncertainty will drag on the UK economy long-term.

Moderator:

NAKAJIMA Atsushi (Chairman, RIETI)

TANABE Yasuo (Senior Vice President and Executive Officer, Hitachi, Ltd.)

Hitachi's strategy in Europe

Hitachi Group companies operate throughout Europe, conducting environment-friendly infrastructure businesses and social innovations mainly in the nuclear energy and railway areas. The Group is also implementing various demonstration projects with a focus on decarbonization including those for electric power distribution and transmission in cooperation with Japan's New Energy and Industrial Technology Development Organization (NEDO). It is also strengthening its new business relating to big data.

Hitachi has invested significant amounts in many large projects in the UK, maintaining a close relationship with the UK government. Given that Hitachi supported the then administration's campaign to remain in the EU (Bremain) in the referendum, the result opting for Brexit was disappointing to us.

Impact of Brexit and its prospect

Although Brexit will have no significant direct impact on Hitachi, we are concerned about the long-term trend of the UK economy. While our business deals with the UK market, we also have supply chains in the EU. We need high-quality labor force and are concerned about whether such labor force can be secured in the UK. There is also concern over the recent depreciation of the pound that could weaken the UK's purchasing power. Therefore, we are requesting the UK government to maintain the single market system and freedom of movement for people, avoid the adoption of standards that are different from those of the EU, support macroeconomic growth, and keep a stable forex rate.

In terms of future trade policy, I believe that the UK and Japan should work together given their common stance to promote free trade and that, in doing so, the two countries should disseminate the concept of inclusive trade that benefits the entire world and leads the development of trade rules that take the recent trend of digital trade into consideration, especially given the existence of a fatigue sentiment against globalization. The Japanese government recently has been collecting the related industries' opinions and communicating them to the UK government. We would like to work together with the government to respond to this Brexit crisis.

KOBAYASHI Kazuya (Managing Executive Officer, Mizuho Bank, Ltd.)

Mizuho Group in Europe

Mizuho Group has a total of 15 offices in 11 cities throughout Europe. Mizuho Bank, which has the largest network among the Group, presently has its controlling functions for sales, planning, and administration concentrated in London.

Impact of Brexit from the perspective of Japanese financial institutions

The biggest issue for Japanese financial institutions is the loss of EU passports. Although Mizuho Bank is not directly affected by the loss of EU passports since its business is conducted through local branches and the local subsidiary in the Netherlands, the Group's securities and asset management subsidiaries conduct their businesses with passports issued in the UK and, therefore, might be required to reapply for EU passports.

Furthermore, beside the loss of EU passports, we need to take into consideration three issues. The first issue relates to working visas. Both EU citizens working in the UK and UK nationals working in the EU countries might be required to obtain working visas. The second issue is our business with the companies headquartered in the UK. I believe we need to align our location strategy to their post-Brexit strategies and business models in Europe. Third, Brexit might strengthen the voices calling for centralized euro-clearing within the euro zone, which might bar the London Clearing House from engaging in such transactions.

Mizuho's present consideration

We have started considering an optimal location strategy for post-Brexit Europe, anticipating the "Hard Brexit" as the most conservative scenario. While our points of consideration include such general matters as the market potential, geopolitical impacts, availability of labor force and professional staff, labor regulations, tax rates, financial regulations, and relationships with the local authorities, we also take the Mizuho Group's particular needs into account. These include the issue of EU passports for the Group's companies, availability of office spaces, cooperation among the Group companies, division of roles between new and existing offices, and our customers' business.

AKAISHI Koichi (Director-General for Trade Policy, METI)

The government's response

Given the close relationships between Japan and the UK as well as that between Japan and the EU, Brexit could seriously damage these relationships, depending on its future direction. Especially, pessimism concerning free trade could emerge, in response to which Prime Minister Shinzo Abe has confirmed strong commitment to free trade among the world's national leaders.

The Japanese government set up a task force, collected various information, and submitted our requests to the UK and to the EU headquarters. However, the UK has provided very little explanation to us, and we are unsure whether or not the Brexit procedure will actually start in March 2017.

The UK's foreign relations scenarios

I think that four scenarios can be considered concerning the relations between the UK and the EU. The first scenario assumes the UK's access to the single market to be maintained as exemplified in the case of Norway. The second scenario anticipates a customs union as in the case of the customs union between Turkey and the EU. The third scenario assumes a free trade agreement (FTA) between the UK and the EU as in the case of the FTA between South Korea and the EU. The fourth scenario anticipates a relation similar to that between Japan and Europe today. Based on these scenarios, the Japanese government naturally will seek to have a scenario actualized where Japan secures its access to the single market.

With respect to the relations between the UK and third-party countries, four patterns can be considered. The first pattern is where an FTA is already in place, as in the case of South Korea. What responses should be taken after Brexit? The second pattern is where the negotiation as well as ratification have been completed. What response should be taken in such a case? The third pattern is where the negotiation is under way. Once the Brexit procedure begins, other negotiations could be put on hold due to the lack of resources. The fourth pattern is where a country has not commenced negotiations at all, in which case the country will have to consider its future response from scratch.

Given the present situation where it is unknown what will happen to the procedure, to the relationship between the UK and the EU and to the relationship between the UK and third-party countries, we need to wait to determine our stance for the UK government's decision on its direction and implementation of its negotiation with the EU. In the meantime, it is important for us to be prepared for whatever happens.

WAKASUGI Ryuhei (Senior Advisor and Faculty Fellow, RIETI / Professor Emeritus, Kyoto University and Yokohama National University / Professor, University of Niigata Prefecture)

Relations between the UK and continental Europe

A historical review finds Brexit to be not very surprising. Remaining with the EU would have been economically beneficial to the UK, but, in fact, this has often caused the country to feel politically uncomfortable. Even until today, the UK has not become as fully a member of the EU as the continental member countries as demonstrated by the situation of the euro and the Schengen Agreement. Additionally, the issue of immigrants since 2000 has had an impact. Although the difference was small, the referendum outcome opting for leaving the EU has its historical background.

UK as a bridgehead

An observation of the relations between the UK and the EU from the viewpoint of the Japanese economy is the unchanged high percentages in the UK of production and sales activities conducted by Japanese companies' local corporations in the EU. Furthermore, Japanese companies' local subsidiaries produce and distribute high percentages of their products in the EU. The UK can be considered as a bridgehead for Japanese companies conducting business activities in the EU.

If this bridgehead leaves the EU's single market, trading functions and direct investment inevitably will shift away from the UK, which would cause a loss for the UK. The EU might incur a loss due to decreases in trading with or investment from the UK but might also benefit from the transfer of production bases to the continent from the UK. The overall result for the whole world would be negative due to a decline in efficiency. Apart from the manufacturing industry, the economy of concentration developed in London's financial center would be lost, which would lead to a loss.

If the UK leaves the EU, based on having the WTO's most favored nation (MFN) status applied to itself, this will definitely cause a significant shift in trading and investment in the long term. Based on such anticipation, the UK naturally will seek to develop new trade agreements with other countries, which could take various formats—not only WTO-MFN status but, for example, setting a long interim period with the EU, or pursuing an agreement similar to the European Economic Areas (EEA). There might be other formats, too.

Involvement in the relations between the UK and the EU

If the UK increases its motivation to develop relations with countries other than in the EU through such instruments as the Transatlantic Trade and Investment Partnership (TTIP) and the TPP, the EU might incur a loss. Benefiting the world's economy requires wisdom about how to keep the UK and the EU connected.

Japan is faced with a question about how it should contribute to maintaining factory EU. It should consider not only its economic partnership agreement (EPA) with the EU or FTA with the UK but whether there is room for Japan's contribution to the maintenance of the EU-UK relationship.

NAKAJIMA (Chairman, RIETI):
Although companies need to make business judgement on a timely basis, I think it will take time before we are able to see the concrete direction of Brexit. What is your judgement of this situation?

TANABE Yasuo (Senior Vice President and Executive Officer, Hitachi, Ltd.):
It is necessary to formulate various portfolios with bases diversified so that responses can be taken in a resilient manner even when an unexpected event occurs—as exemplified by our case where our railway business has bases in the UK and Italy.

NAKAJIMA:
If the UK completely leaves the EU, it appears no continental city will be able to become a financial center equivalent to London. Is there a possibility of consequently leaving all of the transacting and headquarters functions in London, or having part of the functions taken over by Tokyo in the future?

KOBAYASHI Kazuya (Managing Executive Officer, Mizuho Bank, Ltd.):
I think London is presently the most attractive city for conducting financial business in Europe. Although there is a possibility of having to transfer part of the functions to continental Europe, we will consider division of roles among our offices in Europe from a broad perspective. There is a long way to go before Tokyo is able to take over part of the functions mainly due to the language problem and partly due to the Japanese market's price-discovery function that has not fully matured yet.

NAKAJIMA:
Do the UK and the EU have realistic response measures to take that would reduce the sense of uncertainty held by companies? Is there a possibility that, while Brexit negotiation proceeds, the UK will enter into a preferential trade agreement with an individual country in the EU?

Richard BALDWIN (President, CEPR):
That is up to the UK government. The cause of uncertainty lies within the UK government. The UK government could talk very clearly about the aims it hopes to achieve with the new post-Brexit relationship with the EU. But politics gets in the way. The government is not monolithic and therefore is not able to present a clear vision of what it wants to do. In my view, the UK government is being intentionally vague and denying there are hard choices simply to avoid conflicts within the ruling Tory party. Given the EU is a customs union, and thus all EU members must have the same tariffs, entering into a trade agreement with an individual EU member country is impossible.

NAKAJIMA:
If most of the competition in the UK's labor market occurs between the immigrants and the low-waged and low-skilled workforce segment, it doesn't seem to be an issue to leave the freedom of movement of people, goods, and capital untouched as long as restrictions are placed on these competing immigrants. What do you think?

Barbara PETRONGOLO (Programme Director, CEPR):
In actuality, the immigrants have had no significant negative impacts on the low-waged segment because unskilled labor is not highly substitutable and does not compete heavily with immigrants. Furthermore, an increase in immigrants also increases demand and the labor force that fulfills it. Although it is said that a hard Brexit that restricts movement would have a positive impact on the low-waged segment, such impact would be lower than expected.

NAKAJIMA:
Given that the possibility is considered undeniable that foreign financial institutions now based in the City of London might leave the City, what measures do you think the UK government will take? Are Singapore and Hong Kong more competitive as international financial centers for Asia-related transactions? Will Tokyo possibly become part of the financial centers?

Tarun RAMADORAI (Research Fellow, CEPR):
The UK government's priority should be maintaining passports. The negotiation will be tough, however, because the EU is prioritizing the revocation of passports. It is important for the UK to expand its transactions into Asia. Although Tokyo, too, has an advantage as an international financial center, Singapore and Hong Kong will be the UK's rivals for the time being. The UK might not be able to make competitive proposals but has a comparative advantage in that it has unique know-how that Singapore or Hong Kong does not have.

NAKAJIMA:
What actions is the United States taking vis-à-vis Brexit?

AKAISHI Koichi (Director-General for Trade Policy, METI):
The United States is believed to have three scenarios in relation to the UK. The first scenario anticipates the United States and the UK to enter into an agreement. The second scenario seeks the prompt completion of the TTIP and apply it to the UK. The third scenario assumes the UK to become part of the TPP and/or the North American Free Trade Agreement (NAFTA).

NAKAJIMA:
Under such circumstances, does Japan have any advantage in terms of having the UK prioritize a FTA with Japan?

AKAISHI:
There are two points to consider. The first point is the fact that the EPA negotiation is in its final stage. Completing the EPA would make it easy to develop relations with the UK. The other point is that if the UK joins the TPP, of which Japan is a member, it will become possible to concurrently build relations with the UK.

NAKAJIMA:
What kind of FTA would be desirable in order for Japan to help connect the UK and the EU as their "synapse"?

WAKASUGI Ryuhei (Senior Advisor and Faculty Fellow, RIETI):
The intensely significant presence of Japanese companies especially in the UK among European countries reflects the extremely positive initiatives taken and accumulated between Japan and the UK to develop their industrial cooperation in the 1980s when the trade friction between Japan and Europe became serious. It is, therefore, very important for Japan to maintain trade and investment relations with the UK. When the possibility of actualization of the worst case scenario where the UK and the EU might sever their relations is not excluded, the development of relationships between the UK and the EU is very meaningful for Japan, too.

I think the TPP can be a standard for a desirable FTA. Among various regional trade agreements, the TPP has a high degree of freedom, covers broad areas, and is designed well. It can serve as a realistic standard given that it, fortunately, excludes the issue of immigrants.

NAKAJIMA:
It would be appreciated if your views on and responses to the world's overall economic trend could be shared.

TANABE:
I would like to expect rebounding capability from the UK economy. The UK is an open economy-oriented and globalization-oriented country and, therefore, should drive away the concerns about anti-globalization trends and develop trade approaches and agreements that lead the world's economy. We would like to formulate corporate business strategy in line with such orientation.

NAKAJIMA:
Why is the market regaining stability despite Brexit?

KOBAYASHI:
The market is calm perhaps because liquidity is fully secured. The loose monetary policies currently being implemented by various countries are making it easy to source the necessary funds from the market.

NAKAJIMA:
What would be the impact of Brexit on Europe's economic and political order?

BALDWIN:
The concern that I felt immediately after the outcome opting for Brexit was about other countries possibly following its footsteps. If such trend had started to occur, that would have caused a major turmoil in Europe. However, the depreciation of the pound caused people on the continent to think that leaving the EU might not be such a good idea. As a result, the trend is toward staying inside the EU. I believe that no other country will follow the UK's footsteps.

PETRONGOLO:
What will happen to the EU after Brexit still remains uncertain. The UK has always played a role as brakes against the EU's political and economic integration. With the UK leaving, the EU's integration faces no obstacles. However, given that the populist parties in other parts of Europe will gain greater voices, they will perhaps strengthen their calls for referendums.

RAMADORAI:
Brexit is an expression of anti-globalization that would have emerged eventually. In other words, perhaps it just happened to emerge in the UK. A lesson learned from it is that the voices in favor of globalization were somewhat too weak. Those of us who support globalization should have highlighted the benefits of globalization more loudly. Besides, the UK economy with nothing happening till today represents a status of calm before the storm. Furthermore, Brexit is fueling political instability.

NAKAJIMA:
Can we anticipate the world's economy to become further globalized? What will happen to the world's trade system in the future?

WAKASUGI:
The progress of innovation has accelerated globalization. There will be no way to stop this trend. On the other hand, the WTO has seen little progress in liberalization, faced with anti-globalism. It might seem that globalization is developing in parallel with the expanded income gap and the increasing serious issue of immigrants. However, would the prevention of globalization solve these issues? It is much more important to manage each issue while assuming that globalization is inevitable.

NAKAJIMA:
Given some trend after Brexit that seeks to change the conventional trade order, how will the government promote trade liberalization?

AKAISHI:
The 20th century saw the establishment of a trade framework. The 21st century, however, is seeing the development of mega FTAs with consequent fragmentations. Given that the WTO is unable to reach an agreement among all 163 countries, plurilateral agreements are being entered into. I have no negative view on the establishment of mega-FTAs and plurilateral agreements because they will collectively promote trade liberalization.

NAKAJIMA:
I now would like to ask Professor Baldwin to give us the closing remarks representing CEPR.

BALDWIN:
I think that Europe and Japan share various common economic issues—perhaps more so than Japan and the United States. The cooperation between Japan and the United States has progressed in many ways. I have always thought that Japan-Europe cooperation should advance further. RIETI and CEPR will provide a valuable link. I would like to firmly sustain this good cooperative relationship.

NAKAJIMA:
I am happy to have been able to listen to detailed analyses and views from professors and experts participating in this symposium. As demonstrated by them, even the single event of Brexit has impacts not only on Europe but also on other parts of the world, which would certainly affect the world economy. The necessity of viewing the economy from multiple perspectives has been reconfirmed. It would be our pleasure if this kind of knowledge is utilized in the future.