The EU - and not just Britain - is also set to lose in the Brexit divorce

Article 50 of the Treaty on European Union sets out the process by which member states may withdraw from the EU. The UK formally triggered this process in March 2017, marking the start of a two-year negotiation period for the UK to transition itself out of the EU and successfully reach a trade deal. We chatted to Michael Power, strategist at Investec Asset Management, to discuss his views on the Brexit implications for the EU.

He outlined the likelihood of the three potential outcomes:

• A transitional agreement between the two parties: This is the most likely scenario with Michael pinning it at a 70% likelihood, where the two parties will fudge out an agreement until they reach a place of common agreement.
• A unanimous agreement to extend the negotiations: There is a 20% chance that this will occur. Power says this scenario is only likely if the first option does not play out…and in the end, they will revert back to the first option. "There is too much for all to lose. Remember the EU exports far more to the UK than vice versa so they have a lot to lose in this trade-heavy round too. The longer it takes, the better it will be for Britain as the next slowdown is going to show up the deep-seated structural weaknesses of the EU," he says. He notes that once the Eastern Europeans have settled the issue of the free movement of labour, then he expects this part to move more swiftly. "The really sticky issue will be the continuing place of the City of London and the British financial services sector in the EU. Again, I expect time will favour London. In the short term, yes, the City could lose ground. But in the longer term - especially after the next downturn - I predict London could win even more. This would be a best of both worlds scenario. The lack of further meddling from Brussels will be more of a gain versus the more qualified access that London might have to the continent.”
• A fall back to WTO trading arrangements: Also typically referred to as a "Hard Brexit", this scenario has negative implications for both parties and is most unlikely with only a 10% chance of occurring, according to Power. 

Key problem areas for the EU

Power noted several key areas where he expects the EU to fall behind, stating that the combination of the first two factors - demographics and declining productivity growth - will inevitably lead to low to no GDP growth in the EU countries.

• Demographics: Eastern Europe, including Germany and Italy, is now facing population decline before immigration. The same goes for Spain and Portugal. By 2050, the UK will be the most populous country in Europe, overtaking Germany. Going forward and strictly from an economic point of view, the mix of EU immigrants will be less likely to help improve long-term economic position than the mix of UK immigrants, far more of whom will be coming from the EU.
• Productivity growth declining towards zero: Britain's productivity growth is not that good either but it is better than the EU average. This is confirmed by the UK Office for National Statistics, which says that Britain's economic productivity perked up in the three months to the end of September, growing at its fastest rate in more than six years, in contrast to its historically weak performance over the previous decade.  Power says there is a sense that when the dead hand of Brussels is lifted in the UK, a pick-up will occur. The UK remains the favourite place for young entrepreneurial Europeans to migrate to.

• Splits: There are two great splits emerging in the EU region. First you have the debt-drenched South versus the more frugal North.  Then you have the more autocratic capitalist Eastern EU versus the more liberal democratic Western EU. Unless there are significant problems from Jeremy Corbyn, leader of the British Labour Party, Power is convinced the UK will re-emerge as a liberal democratic capitalist haven.

• Negative structural trends: Greece and Italy and possibly also Spain and Portugal will suffer enormously in the next downturn; they are currently being succoured by cyclical growth but structural trends are moving against them in particular. For example, Eurostats tells us that despite a growing population, the EU's low fertility rates and rising life expectancy are shrinking its labour force and increasing its old-age dependency ratio. Higher employment rates, especially for women, older workers and young people, are therefore needed to compensate for the expected decline of the working-age population (20 to 64) by 1.9 million people by 2020.
• Fatal compromise in the Eurozone set to be exposed: Until now, the European Union has largely worked on monetary union only, without fiscal union. Under fiscal union decisions about the collection and expenditure of taxes are taken by common institutions, shared by the participating governments. "In the current scenario, the northern EU countries are unlikely to fund the profligate southern EU countries forever," Power says.
• Too much regulation: "Brussels" – where the EU Commission is based – is widely considered to be the de facto capital of the EU, and is often referred to as a "bureaucracy" speaking for 28 member states. At the time of the Brexit referendum, UK business representatives argued that Brussel's red tape was stifling UK businesses. Power says that going forward, this bureaucracy is likely to smother much needed economic "opening up" in the EU region.
• Unfunded pension liabilities: According to the EU annual accounts for 2016, the EU's total employee benefit liability equates to €67.7 billion. This is almost entirely in respect of the Pension Scheme of European Officials (PSEO) and the vast majority of these liabilities are unfunded. No assets are held to back the PSEO liabilities and a total of just €0.4 billion is held to back the other liabilities. In effect, the funding level is 0.6%. Power cautions that these liabilities are likely to become huge deadweight around EU’s neck and there will be - because of the Eurozone - no way to ring-fence the pension assets of the “good” countries, such as Denmark and the Netherlands, from the bad.
• Debt to GDP levels: These continue growing even as structural capacity to service them declines.
• Potential riots: Disenchantment of youth as the highest unemployed group in the EU will stoke populism, as will growing inequality. The Club Med countries are very exposed here as their industry is melting in the face of Asian competition. Populism mixed with autocracy will be an especially toxic combination.
• The lack of a financial powerhouse: The EU now does not contain within it a global financial centre with any real clout.
• The fragility of the banking system: After the GFC, the weakness of the banking system in countries such as Italy was identified. However, this problem remains to be thoroughly addressed.

What are the long-term implications of Brexit for the EU?

Over the long-term, the structural weaknesses, especially of the south, will become very exposed, particularly so if there is a downturn in financial markets. As this happens, austerity - which in practice means the country’s obligations rising faster than the state’s capacity to pay for them - will cause populism to unavoidably rise. "I sense Eastern EU nations will feel the harsh winds of Asian competition blowing and become more populist and so protectionist as their industries are undercut by those in countries such as Vietnam. The patience of Scandinavia, the Netherlands and above all Germany towards the South will be sorely tested and may run out. France's deeper structural issues will eventually get the better of Macron's good (but for France, tough) ideas," says Power.

He concludes with the thought-provoking statement that by 2025, the EU's demographic profile may well have turned Japanese!

Discovery Life Investment Services (Pty) Ltd branded as Discovery Invest is an authorised financial services provider. Registration number 2007/00596/07. The views expressed in this article are those of the author and may not necessarily represent those of Discovery Invest. This does not constitute financial advice.