Executive summary

Capital Economics has been commissioned by Woodford Investment Management to examine the United Kingdom’s relationship with Europe and the impact of ‘Brexit’ on the British economy. A referendum is due to be held before the end of 2017 but it looks increasingly likely that it will occur before the end of 2016. The latest opinion polls suggest an extremely tight vote but this could easily change due to, for example, another escalation in the Greek crisis, further rises in net migration from Europe or an escalation of the refugee crisis. In addition, the nature and extent of any renegotiation of the terms of British membership could also be important in determining the referendum outcome.

Our report covers the economic impacts of the most important elements of the Brexit debate.

Immigration

Annual net migration from Europe has more than doubled since 2012, reaching 183,000 in March 2015. Immigration from the European Union is currently boosting the workforce by around 0.5% a year. This has helped support the economy’s ability to grow without pushing up wage growth and inflation, keeping interest rates lower for longer.

Whether the United Kingdom gains any powers to restrict immigration from Europe will depend on its future relationship with the European Union. If Britain wanted to retain full access to the single market, it may have to keep the free movement of labour between the United Kingdom and the Union. But this is unlikely. Policy is far more likely to change to restrict the number of low skilled workers entering the country and shift towards attracting more highly skilled workers. This would be a potential headache for low-wage sectors heavily dependent on migrant labour, such as agriculture, but could benefit other sectors with a shortage of highly skilled labour. Overall, policy would shift to be more specifically designed for Britain’s migration requirements.

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Trade and manufacturing

Official trade statistics show that the European Union is the destination for about half of all British goods exports. The trading links are bigger if we include the countries that the United Kingdom trades freely with because they have a free trade agreement with the European Union. These agreements mean that 63% of Britain’s goods exports are linked to European Union membership.

It is highly probable that a favourable trade agreement would be reached after Brexit as there are advantages for both sides in continuing a close commercial arrangement. But the worst-case scenario, in which Britain faces tariffs under ‘most-favoured nation’ rules, is certainly no disaster. Exporters would face some additional costs, such as complying with the European Union’s rules of origin, if they were outside the single market. However, these factors would be an inconvenience rather than a major barrier to trade. In addition, fears that exporters would be left high and dry the day after the Brexit vote are unfounded. Under the Lisbon Treaty, a country leaving the European Union has 2 years in which to negotiate a withdrawal agreement.

In addition, falling tariffs, the decline in manufacturing and Europe’s diminishing importance in the global economy mean we doubt that even the absence of a trade deal with the European Union would hurt the United Kingdom’s overall exports materially. The benefits of being in the European Union are smaller than they were a few decades ago, when a Brexit would have been a far bigger deal. However, the effects will vary across sectors. Brexit would give Britain a crucial opportunity by allowing it to broker its own trade deals with non-European Union countries; indeed Britain could even have a unilateral free trade policy. Non-European Union countries may find negotiating with Britain easier and quicker than dealing with the European Union’s bureaucratic machine, as Switzerland has shown.

The production sectors in the economy face a more uncertain outcome than services. The range of potential outcomes is more variable as production sectors are more dependent on whether or not the United Kingdom agrees a trading agreement with the European Union and the nature of any such agreement. The possibility of tariffs on goods exports to the European Union gives greater downside potential, while the opportunity to open up trade with other countries or to increase the sector’s competitiveness through greater competition or cheaper inputs gives it more upside potential.

Contrary to the claims of many authors and commentators, it is probable that the impacts of Brexit on trade would be relatively small. Moreover, it is certainly possible that leaving the European Union would leave the external sector better off in the long run, if Britain could use its new found freedom to negotiate its own trading arrangements to good effect.

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Financial services and the City

Financial services have more to lose immediately after a European Union exit than most other sectors of the economy. Even in the best case, in which passporting rights were preserved, the United Kingdom would still lose influence over the single market’s rules. The City would probably be hurt in the short term, but it would not spell disaster. The City’s competitive advantage is founded on more than just unfettered access to the single market. A European Union exit would enable the United Kingdom to broker trade deals with emerging markets that could pay dividends for the financial services sector in the long run.

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Regulation, innovation and productivity

Brexit is only likely to have a limited impact on Britain’s productivity. The major potential for improvement comes from increased business investment which shows little connection with political developments. Estimates that axing European Union regulations would save Britain a lot of money exaggerate the true picture as the United Kingdom would still choose to implement many of them. It would also need to implement the union’s regulations to continue to export easily to the single market. Reduced regulation might give a small boost to productivity but wouldn’t be a game-changer.

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Foreign investment

Concerns about a drying up of foreign direct investment if Britain votes to leave the European Union are somewhat overblown. Access to the single market is not the only reason that firms invest in Britain. Other advantages to investing here should ensure that foreign firms continue to want a foothold in the country. It is likely Britain would remain a haven for foreign direct investment flows even if it was outside of the European Union. Of course, we could see a period of weak foreign direct investment inflows as the United Kingdom’s new relationship is renegotiated. However, if Britain is able to obtain favourable terms, then foreign direct investment would probably recoup this lost ground.

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Public sector

The British government could save about £10bn per year on its contributions to the European Union’s budget if the country left the bloc. This figure could be higher if either the British rebate was to be threatened in the years ahead or Brexit was to result in overall faster economic growth.

On the other hand, a little economic disruption and lower migration as a result of Brexit could offset these savings. The government might also continue to make some contributions to the union if it wanted to preserve single market access, it might need to compensate sectors of the economy and specific regions that currently benefit from European Union handouts and it may have to sacrifice customs duties income to strike new trade deals with countries outside Europe.

We expect that Brexit would benefit the public finances, but not to a huge degree.

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Consumption and property market

It seems clear that the City is the part of the British property market that has most to lose if the United Kingdom opts to leave the European Union. It is certainly possible to tell a story in which the damage done could be considerable, but the role of the financial services sector in holding up the property market is probably overstated, leading us to believe that any negative impacts will be small, certainly at a macroeconomic level.

We anticipate that the impacts on the property market overall and on aggregate consumption in the economy will be limited. In the case of the latter, they may well be positive due to beneficial effects from independent policymaking on immigration, trade and regulation, as well as savings to the exchequer (which may then be disbursed in the form of lower taxes).

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Overall

Although the impact of Brexit on the British economy is uncertain, we doubt that Britain’s long-term economic outlook hinges on it. Things have changed a lot since 1973, when joining the European Economic Community was a big deal for the United Kingdom. There are arguably much more important issues now, such as whether productivity will recover. The shortfall in British productivity relative to its pre-crisis trend is still over 10%, so regaining that lost ground would offset even the most negative of estimates of Brexit on the economy. Based on assessing the evidence, we conclude that:

The more extreme claims made about the costs and benefits of Brexit for the British economy are wide of the mark and lacking in evidential bases

It is plausible that Brexit could have a modest negative impact on growth and job creation. But it is slightly more plausible that the net impacts will be modestly positive. This is a strong conclusion when compared with some studies

There are potential net benefits in the areas of a more tailored immigration policy, the freedom to make trade deals, moderately lower levels of regulation and savings to the public purse. In each of these areas, we do not believe that the benefits of Brexit would be huge, but they are likely to be positive

Meanwhile, costs in terms of financial services, foreign direct investment and impacts on London property markets are more likely to be short-term and there are longer-term opportunities from Brexit even in these areas

It is not likely that any particular region or regions of the country would be more adversely affected by Brexit than the country overall. Likewise, we do find support for the notion that Brexit would benefit some sectors more than others, but the range of outcomes for production / manufacturing industries is probably wider than for services

We continue to think that the United Kingdom’s economic prospects are good whether inside or outside the European Union. Britain has pulled ahead of the European Union in recent years, and we expect that gap to widen over the next few years regardless of whether Brexit occurs.