Why the UK needs that BREXIT deal (Part 1)

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When the United Kingdom joined the European Union in the mid-70s when it was still called the European Communities, the United Kingdom was a rather weak economy. Burdened by outdated manufacturing capacity and still attempting to hold on to its already passed colonial world power on top of the tremendous costs of World War II, the United Kingdom was among the weakest in the bloc.

Without significant changes, the United Kingdom would have continued on a downward economical spiral, but a very smart strategy prevented that from happening. Step one was to renegotiate the conditions of the membership of the bloc, something which later became famous as the Thatcher Discount. The result of this renegotiated membership deal is that the United Kingdom has a 66% discount on the net contributions to the European Union. No other member state of the EU bloc enjoys such discount!

Another benefit of the renegotiated membership conditions lays in the opt-out clause, which allows the United Kingdom to opt-out from certain European Union regulations and still enjoy full and unrestricted access to the largest economical bloc and economy in the world. These two conditions combined formed the foundation of the successful relaunch of the United Kingdom economy. But it was and is in the long-term a risky relaunch as we will soon see.

The United Kingdom created a haven for service providers by combining its full access to the European Market, its enormous discount on EU contributions and relatively low corporate taxes, while at the other hand maintain tight relationships with its former colonies and the Common Wealth, which in many cases are former colonies. ‘The best of both worlds’ was a strategy that made the United Kingdom very attractive to the majority of consulting and accountancy firms, and financial institutions.

London was booming. New businesses moving in, existing businesses stepping up. Traditional and economical relationships with Hong Kong and Singapore opened up the doors to the financial markets in Asia. Full access to the European Union at lower rates and a love/hate relationship with the financial markets in New York. London was sexy!

The first risks of being sexy in the newly found European Global Identity was ignored because there was no alternative. What the United Kingdom, and especially London, lacked was capital. Available capital, not the kind of capital that only exists on paper like it was the case with most British companies and the establishment. And capital that could be invested freely within the United Kingdom.

That capital came with the new partners. Asian capital. New-Rich Russian capital. Even German capital. Investing and buying. It didn’t matter much where the capital came from and it didn’t matter much what was done with the capital, as long as there was capital. And there was plenty of capital to go around. If only there wouldn’t have been this tiny little problem. The British manufacturing capacity was in horrible state and hardly anyone was willing to invest in it, not even the British rich and famous who were making a fortune on services and selling off their real estate.

The British automotive industry was cut like a cheap sausage. Once majestic brands sold off to foreign investors and cut to pieces to only keep what was somehow profitable under new foreign ownership. The aviation industry underwent a similar fate. Other industries were either shut down completely or restructured to a fraction of what they used to be long ago. The British Government and the local investors didn’t care much because they discovered a new source of income which required much less investment and labor. Services!

Those wonderful services. No need to have expensive stockpiles and warehouses. No expensive shipments. No expensive infrastructure. No constantly changing requirements and market demands. Services were and are the sweet spot of the United Kingdom and the world noticed that quickly. Within a decade after entering the European Union and defining its unique role with the bloc, the entire Global Top 10 in both Accountancy and Consulting firms either moved their headquarters to London or had set up a major branch there. And soon the financial markets followed with even bigger presence and footprint.

The second risk of this strategy was also ignored by the Government and establishment in the United Kingdom. Those service providers have no long-term commitment other than the offices they lease. They don’t built factories. They don’t create jobs in the bottom and middle sector of the economy. They can depart just as fast as they arrived. But there was no alternative to this strategy in the eyes of the ruling parties and their sponsors in the establishment.

A third risk established itself in the mid-90s, about the same time that the financial services in and around London really started to bloom. Maybe the glory of the blooming financial industry placed what was happening in the rest of the economy in such dark shadows that nobody was able to see what was happening. On the other hand, maybe nobody wanted to see it and there was no reason to because nobody could expect what would happen 20 years later.

With most of the manufacturing capacity in the United Kingdom either downsized or completely dismantled, the United Kingdom started to depend more and more on imports from the European Union. A similar shift from producing to consuming happened in the food industry. The bloc became the main supplier of parts and food, and the United Kingdom supplied services and financial flows to the bloc. A perfect match as long as the relationship is at eye level and intact.

Fast forward to 2020. The United Kingdom still mainly exports services. 80% of the exports are services and more than half of that are financial services supplied to the European Union. A unique regulation called “passporting” makes that possible. It basically says that any registered financial institution within the European Union can provide services within all member states of the bloc. That saves significant costs by not needing registered branches in all 28 (soon 27) member states. And the low corporate taxes and ties to the Asian and American markets makes the United Kingdom and London the place to be. Made them the place to be…

With or without a BREXIT deal, the United Kingdom is no longer a member of the European Union which renders the previously existing passporting arrangements for United Kingdom based financial institutions invalid. Some have already left completely, others are shifting their branches to places within the bloc, like for example Frankfurt in Germany. Leaving behind a downsized version of the previously booming market dominators.

Other service providers in consulting and accountancy will not be stripped of their rights to operate freely throughout the bloc, but they do depend on a BREXIT deal to uphold their British footprint as profitable entry point to the European Union. Without a BREXIT deal they would become a fully foreign entity on the bloc’s huge market which will strip most benefits of operating from their British branches for themselves and for their clients.

BREXIT advocates have always argued that a NO-DEAL scenario would not create any issues because in that case the WTO rules apply, which to some relatively limited extend is even true. Some of those advocates even prefer a NO-DEAL scenario with WTO ruling over a DEAL scenario. There is however a “tiny little problem” which covers all ignored risks from the past.

  • WTO ruling hardly covers services and the United Kingdom depends almost completely on delivering services.
  • WTO ruling hardly covers capital and 92% of the available capital on the British market is foreign capital.
  • WTO ruling covers trade and goods at a governmental level, it does not have the power to force companies and organizations to supply or purchase.

Besides the fact that WTO ruling applies at governmental level and not in the board rooms of companies and organizations, the United Kingdom depends on the customers for its service industry and the suppliers of its foreign capital and products. To maintain at least a significant part of its current GDP and role on the markets, the United Kingdom needs that BREXIT deal much more than the European Union does, and the COVID19 pandemic only made that situation worse for the UK and its dangerously unbalanced economy.

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