Brexit risks have shot up

September 9, 2014

Brexit risks have shot up in the past few weeks. The chance of Britain exiting the European Union by the end of the decade is now probably around 50 percent.

The main factor driving Brexit is the knife-edge referendum on Scottish independence. If the Scots vote next week to quit the United Kingdom, it is highly likely that the rump UK will leave the EU. If the UK doesn’t break up, it is much less likely that it will then part from the EU, but this is still a risk.

Financial markets are finally waking up to the risk of a “Scoxit” for the pound, gilts and the UK economy. They are also worrying about the knock-on effect in Spain, where the Catalan regional government wants to hold its own referendum on independence.

But investors don’t yet seem concerned about two other knock-on effects. One is Brexit. This will be even worse for the British economy than Scoxit. The other is that Brexit would be bad for the rest of the EU, just like Scoxit would be bad for the rest of Britain. On top of the economic hit as trade was disrupted, the EU would risk becoming less market-orientated.

As if that was not enough, both Britain and the EU would lose influence in the event of a combined Scoxit and Brexit. It is hard to put a price on clout. But a diminution of it would be damaging given that Europe’s neighbourhood looks increasingly dangerous and the United States is tiring of its role as global policeman.

Following a Scottish vote for independence, David Cameron might resign as British prime minister. He says he won’t. But members of his own party might well force him out if he presides over the breakup of the UK. It’s often forgotten that his party’s official name was originally the Conservative and Unionist party.

Cameron would deserve to go. He is a careless prime minister who offered Scotland a referendum on independence without thinking things through properly. While it would have been wrong to deny the Scots a vote, he should have agreed upfront how the national debt, North Sea oil and the pound would be shared after the divorce.

The prime minister should also have set out at the start a schedule for devolving more power to Scotland if it chose to stay in the UK. The main political parties are now scrambling to come up with such a plan in the last days before the vote. But such a promise will have less impact coming so late in the day.

Even though Cameron would deserve to quit in the event of a “Yes” vote for independence, this is not a scenario to be welcomed because a more eurosceptic leader would almost certainly replace him. The Conservative party is in a tizzy over the rise of the UK Independence Party (UKIP), which wants to pull Britain out of the EU, especially after a backbench member of parliament quit to join UKIP last month.

Whoever replaced Cameron as leader would probably have to promise such a radical renegotiation of Britain’s relationship with the EU that it was undeliverable. He or she would also be likely to pledge to campaign to leave the EU if such a renegotiation was impossible.

At present, Cameron has not set out impossible demands. Nor has he said how he would vote in a referendum if it didn’t get what he wanted. A Conservative prime minister who campaigned to quit the EU would be a very different proposition. Much of the media would line up like a phalanx behind the Tories and UKIP, making it hard for those who wanted to keep Britain in the EU to make their case.

Of course, Cameron might manage to hang onto power if the Scots voted for independence. And the Conservatives might easily fail to win next year’s general election – with either Cameron or somebody else at their helm. In such a scenario, there wouldn’t be an immediate referendum on Britain’s membership of the EU because the opposition Labour party doesn’t want one.

However, the reprieve would be temporary. Labour would probably have a majority only because it had a strong group of Scottish-based MPs. The Scots would get to vote in next year’s election even if they had already decided to quit the UK. But once independence took effect in 2016, the Scottish MPs would have to leave the British parliament, meaning that Labour might well then lose its majority.

At that point, a new Conservative government would probably take over. And its leader at that stage would not be Cameron: his party would finally have turfed him out after losing the general election even if it didn’t axe him after losing Scotland.

There are three other reasons why Scoxit would probably lead to Brexit. One is that the Scots, who are generally pro-European, wouldn’t get to vote in the Brexit referendum because they would have left the UK by then. Another is that the divorce negotiations following a “Yes” vote in the Scottish referendum would be long and acrimonious. It is hard to see the British government having the ability to focus simultaneously on renegotiating its relationship with the EU. As a result, there’s a risk it will mess it up.

Finally, after Scotland got independence, the rump UK would have fewer members of the European parliament and fewer votes in the European Council. Britain’s eurosceptics already run the narrative that the UK has no influence in Brussels. This would play into their hands.

Investors must hope for the best – but prepare for the worst.

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