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Politics

Now the Brexit gun has been fired, what happens next?

As divorce talks begin, contagion could spread in Europe and world

It is official. Britain's Prime Minister Theresa May will today give formal notice to the European Union of her country's intention to quit the group. There is no template for what happens next but there is a time limit. So-called Article 50 negotiations, named after the article in the Treaty on European Union that covers the financial, legal and organizational terms of the divorce, must be completed by March 2019 (unless there is an unlikely extension) or else the U.K. will leave the EU without agreement. While most of the focus is on the consequences for the U.K.'s economy and constitutional integrity, there are potentially global implications that could affect Asia.

Although there is a two year time limit for the completion of the divorce negotiations, the realistic time frame is much less. Forthcoming elections for the presidency and parliament in France mean there may not be a government in Paris with which to negotiate until at least September, when the country's summer recess is over, putting a significant squeeze on the two-year discussion time. Similarly, German parliamentary elections in September will probably yield another coalition government, but this may not be formed until November or later. Meanwhile, EU officials have said that the ratification process of any deal involving member governments of the EU and the European Parliament requires an agreement to be made by October 2018. Even allowing for slippages, negotiations may need to take appreciably less than two years.

In addition to the Article 50 talks, the U.K. and EU will also start to negotiate the outlines of a new trade arrangement. The U.K. has stipulated it wants control over immigration and rejects the bloc's principle of freedom of movement. It wants to be free of the jurisdiction of the European Court of Justice, which oversees European laws including those pertaining to the single market. And it wants to strike its own trade arrangements, which means it will leave the European customs union. Given the harmonization of laws and regulations between the U.K. and the EU over the last 40 years, Scotland's pro-EU position and desire to hold a second independence referendum, and the sensitivity of the contiguous border between Northern Ireland and the Irish Republic, it will be virtually impossible to strike up a new trade deal within two years.

More time

At the very least, then, the U.K. and the EU might have to agree in principle to extend aspects of the status quo for several years, during which a new trade agreement could be crafted, and at the end of which the U.K. would leave the EU. Remember that the EU accounts for about 46% of U.K. exports and that while this has fallen from a decade ago, the structure of the U.K. economy is inextricably bound up with that of the EU, as indeed its geography dictates.

There is not going to be a wholly satisfactory alternative to leaving the biggest free trade area in the world, and Westminster's pitch for privileges from the EU will have to be replaced by compromises acceptable to the government's own supporters. Both the U.K. government and its EU counterparts will need to dig deeply into the well of goodwill, without which a 'hard Brexit' will happen. If that occurrs, the U.K. will fall back on membership of the World Trade Organization to govern its trade relations with others. That would not be the end of the world, but the organization's status is under threat from the new U.S. administration, and relying on it would expose companies based in the U.K. to a commercial world that is more about tariffs, barriers and complex regulations than the status quo.

What does this all imply for Asia, the world's most dynamic growth region?

Last year, when the referendum vote was announced, angst spread through global financial markets, creating significant risk aversion even in Asian financial markets. Equity markets wobbled, as did currencies such as the Indonesian rupiah and Malaysian ringgit. Yet, the shock effect of the referendum result was fleeting, and there were no negative economic consequences on the U.K. economy. It is possible that Asian markets could be adversely affected in the event of a collapse in the Brexit negotiations, but the enduring effects of Brexit are unlikely to have sudden or shocking effects on Asia. China and U.S.-China relations are far more significant.

Limited exposure

Asian exports to the U.K. account for less than 1% of the region's gross domestic product, though Hong Kong's exposure to the U.K. is rather larger at just over double this rate. The "new" low-value manufacturing hubs of Cambodia and Vietnam have higher exposure at almost 6% and 3%, respectively. However, the "hit" that Asian countries may experience is more likely to come from weaker economic growth in the U.K. -- unless the effects of Brexit are successfully mitigated by domestic economic policies -- and from a possible deterioration in the foreign direct investment climate.

Inward FDI into the U.K. now amounts to almost 1.5 trillion pounds ($1.89 trillion), according to 2015 figures. While the bulk of this stock is EU and U.S.-owned, Asian countries account for just under 8% of it. Japan accounts for about half of this, while the other significant contributors are Hong Kong, Australia, Singapore, South Korea, India, and China. If we look at the more recent flows of FDI, rather than the stock, the more prominent countries are Japan, India and, coming up on the rails, China, whose recently announced energy and infrastructure-based as well as property investments will raise the country's profile significantly. India's focus has been more on pharmaceuticals, technology and manufacturing.

The opportunity for Asian companies in the U.K. is first and foremost the Brexit-induced cheaper pound sterling, but could be boosted if the U.K. government steers Brexit Britain away from financial services, where the bulk of FDI arrives, towards the information, communications and transportation and logistics sectors.

The downside for Asian companies is that Brexit, and the terms under which it might evolve, could be detrimental to the economic and investment climate generally, and undermine the U.K.'s comparative advantage to date of being an ideal place to invest as a hub from which to export to and trade with the EU. The government has allegedly sought to assuage the commercial fears of companies such as Toyota and Nissan but it cannot and will not do this for all investors.

Ultimately, though, Asia has less to fear from Brexit directly than from the catalytic effect it might have in encouraging populist movements -- in France and Italy, for example. If French voters elect Front National leader Marine Le Pen to the presidency in early May, the economic and political mood would darken quickly. She may not be able to get a parliament full of establishment political parties to approve the "Frexit" referendum that she seeks, but the EU would be further destabilized just as its economy is looking a bit better. Opinion polls say that the pro-EU challenger Emmanuel Macron is in pole position to win the presidency, but if he does not, then for Asia -- as everywhere -- the threat of European economic and political paralysis, if not disintegration, is the real danger.

George Magnus is an associate at Oxford University's China Centre and former chief economist at UBS.

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