Brexit : Resilience of British and EU Economic System

A resilience view as of September 2017; the purpose of this post is not to undermine democratic will of the GB citizens but rather a resilience view as of September 2017 prior to exit 1 April 2019 from a resilience perspective.

A referendum was held on Thursday 23 June, to decide whether the UK should leave or remain in the European Union. Leave won by 52% to 48% (72,2 % eligible voters voted) Furthermore critical areas such as Scotland and Northern Ireland and London areas voted in favor remaining. What were their reasons for wanting the UK to leave?

They said Britain was being held back by the EU, which they said imposed too many rules on business and charged billions of pounds a year in membership fees for little in return. They also wanted Britain to take back full control of its borders and reduce the number of people coming here to live and/or work.

Simply stated the EU is like enormous golf club with its facilities extending over the whole of the EU whereby membership allows access to the facilities. These facilities included common customs, certification and compliance agencies and full access to single 17 trillion market. EU contributions are used to invest in these facilities whereby bulk of investment towards new members or less advanced economies and 12-14% towards aid outside the EU. There are some constraints regarding how to play the game but success mainly dependent on individual players (or countries). Systemic issues within Greece or Italy are less related to EU rules and governance but rather internal inefficiencies. The EU budget is approximately 129 billion Euro where its expenditure mostly around specific projects and about 11 billion in expenditure outside the EU.

Some facts with respect to GB and EU economic relationship:

  • The main contributors 2017 ; Germany, France, Italy, GB then the rest.
  • About 44% of UK exports in goods and services went to other countries in the EU in 2016—£240 billion out of £550 billion total exports.
  • Trade in services will be particularly important, because about 80% of the UK economy comes from providing services.
  • UK trade with the EU is dominated by goods rather than services; in 2014, trade in goods represented close to two-thirds of all UK exports to the EU.
  • Financial relationship GB with the EU as of 2015:
    • EU expenditure within GB: 7,458 billion EUR
    • GB contribution to EU: 18,209 Billion EUR. A 10,7 EUR billion deficit
    • GB contribution to EU in relation gdp 0,72 %
  • Exports EU 27 members states towards GB account for 3% the GDP, while exports from GB towards EU 7,5% of gdp.
  • 814,000 people are employed in the UK auto industry, which in 2015 turned over £72bn and exported £34bn worth of products, with 56% of auto exports and 65% of components going to EU countries. While 44 % of parts used to make U.K. auto supplied from British suppliers while rest imported.
  • Some examples; Germany exports to GB 2,8% of its gdp, Italy 1,7 %, Belgium 6,8%, Ireland 6,9% Holland 6,3%. Remaining members all within l’1,5 to 3% range. Zero loss of trade implies worst case scenario for EU around 2-3% of gdp, while GB 7,5 % gdp.
  • GB public debt 100 % of gdp; 100% growth public debt from 2005; private debt 135% of gdp. GB total debt per capita 2nd highest second in the world. Its credit card debt is 3 x  Italy total private debt. GB external debt (debt to non Gb citizens) 290% gdp , nearly 3 x that of Italy
  • Exchange rate GB to Euro September 2017 close to parity.
    • 30/11/2015 rate 1 GBP = 1,38 Euro
    • 12/09/2017 rate 1 GBP = 1,09 Euro
  • As a member state GB key benefit include passporting system for banks allows GB banks to freely operate in Europe. Further benefit allows GB airlines such as Easyjet to operate between EU member states
  • First quarter 2017 EU growth 0,6% , US 0,3% , Gb 0,2%, Greece and Italy 0,4%, Germany 0,6%
  • A large percentage of investements in the GB from US is based on access to EU single market.

The above factors are critical to understand potential damage to both GB and EU and the impact on resilience once Brexit is actually executed or leading towards Brexit (individual economy state space with respect to resilience of what to what)

As of September 2017 18 months before D-day there is no direction in place with respect to future economic relationship between EU and GB.

The following options are possible:

  • Soft exit; this implies that EU bows to all demands and accepts GB to continue trading and part of customs without restrictions. This option is politically suicidal for EU in that  it encourage other EU members adopting the same route as GB and it further cause relationship issue with Norway and Switzerland. A possible flavor soft exit implies GB allow EU citizens unlimited entry and pay in a certain membership fee but have no political influence. This is least likely scenario in that May does not have political strength to accept this kind of approach and is contrary to stated objective article 50 notification and is contrary to referendum key criteria.
  • Hard exit; this implies leaving customs and single market as confirmed by May article 50  but continuing to trade under WTO with GB agreeing to meet financial obligation. This assumes that GB accepts paying its dues and treating EU nationals fairly. This scenario implies loss of trade between both parties specifically banking services which will be close to zero GB towards EU and volume for products will also reduce due to increased costs specifically auto industry impacted by tariffs and custom costs. Volumes from EU to GB will also reduce caused by unfavorable exchange rate.
  • No deal; worst case scenario. This implies trade between GB and EU close to zero; GB will loose all its access to certification agencies, travel between two parties will be limited due to flight issues. Political relationship between GB and EU will be very strained and trade if any would be under WTO rules.
  • Article 50 withdrawal ; GB request to withdraw article 50. Not a viable political option for both parties

As of September 2017 the most likely outcome is a no ‘deal outcome’ which also seems the preferred outcome for both EU and GB from a political perspective. The probability softexit are zero while hardexit (ideal economic perspective) least likely mainly due to political conditions in both GB and EU; specifically GB not wanting to accept financial liabilities dictated by EU.

Hardexit implies political difficulties within the EU specifically getting all 27 members to agree on a ‘type’ of relationship. For GB hardexit is also the most sensible outcome in that respects democratic wishes and lot simpler to apply and is also politically acceptable for EU and more important, it maintains political and economic relationship between GB and EU. Furthermore from GB perspectives it removes all possible constraints from EU. From EU perspective it has to agree on a fair and realistic exit bill that enables GB politically to accept. Furthermore it can provide some flexibility such compliance and certification GB products.

Summary as of October 2017 (probability):

  • Soft exit; 0 %
  • Hardexit; 10-20%
  • No deal; 90-80%
  • Article 50 withdrawal: 0%

One of the fundamental requirements with respect to Brexit is to minimize economic damage and govern resilience effectively; this can be minimized if both parties take action prior to actual ‘d-day’ specifically from a resilience perspective ‘of what to what’; therefore plan ahead for effective adaptation.

Resilience is defined as the capacity of a system to absorb changes and tolerate disturbances without collapsing into a qualitatively different state so as to still retain essentially the same function, structure, identity, and feedback” (Brian Walker)  .As systems lose resilience they also become more vulnerable to changes , hence, less disturbance is needed to push the system through its threshold (tipping point) into a new regime. The greater the resilience in a particular system the more it can resist large or prolonged disturbances.  If resilience is low or weakened, then smaller or briefer disturbances can push the system into a different regime , where its dynamics change.

As defined by Walker1 et al., “a ‘basin of attraction’ is a region in state space in which the system tends to remain (2004). In this basin of attraction system achieves its maximum possible performance based on combination of its state sets.

Both exogenous drivers (external drivers such rainfall, exchange rates, competitor value proposition, access to markets) and endogenous processes (plant succession, management practices and governance efficacy, relationship with trading partners) can impact resilience, its capacity to recover and restore its system performance potential.

resl020

Resilience is not just about managing disturbance but also understand resilience question ‘of what to what’.

The size and shape of the basin of attraction indicates the resilience of the corresponding state and its ability to withstand disturbances and adapt to maintain maximum performance within resilience threshold.

  • The state space is dynamic therefore its topography is continuously fluctuating (changes in parameters and variables) which may affect the coordinates of the basin threshold (location and height).
  • When perturbed a system may escape the attractor, cross the threshold and reach alternate state (new regime) which results in a functional change and a different set of controlling processes and performance capacity.

Resilience is not just about managing disturbance but also understand resilience question ‘of what to what’. Considerations understanding dynamics of resilience:

One of the fundamental aspects about resilience is that once resilience is overwhelmed (resiliency threshold will be crossed) system enters a new state, restoration to original sate will be complex, expensive, and sometimes even impossible. Research suggests that to restore some systems to their previous state requires a return to environmental conditions of the same function, structure (resources), identity, and feedback well before the tipping point.  If the tipping point is crossed into a new regime then the dependency of having more favorable resilience threshold and performance/potential is dependent system experiencing less constraints and that its potential for output (will be at least be the same or higher than previous basin). Continuous negative regime shift increases exponentially resource requirements to enable system to bounce back to positive regimes (Greece example downward spiral)

Simply stated consideration for:

  • Consideration for a positive Resilience Regime (higher potential) implies the following perception:
    • EU constraints have prevented GB and other member states increasing its potential; therefore Germany and Italy gdp and excessive trade balance should even be higher. Cost of EU ‘red tape’ is estimated at 120 billion pounds (source economist free trade group) . This obviously applies to all EU member states. The red tape will impact German, French Italy ect.. output , trade balance ect…
    • EU constraints have prevented GB manufacturing sector to thrive
    • Foreign resources (investments) based in GB (US owned) that operate in GB and EU are disadvantaged
    • World markets potential is limited with respect to GB trade due to EU constraints
    • GB trade deals with rest of the world will be more favorable that EU trade deals
    • Saving GB contribution towards EU ; +- 9 billion (net contribution) can be used for alternate initiatives
    • The cost of customs facilities and setting-up its own compliance agency will be negligible
    • EU nationals in GB are a drain to the economic system
  • Consideration for a negative Resilience Regime (lower potential) implies the following perception:
    • GB trade deals will be less favorable and will take time to put in place
    • So called EU ‘red tape’ populist fabrication (http://blogs.lse.ac.uk/brexit/2016/07/08/is-red-tape-a-reason-to-quit-the-eu-hardly/)
    • High cost setting up customs facilities and recreating compliance agencies (time, cost and resources). Further aspect related to compliance implies recognitions; GB not only has to set-up it’s own compliance agencies but it formally needs to be recognized.
    • Replacing not only lost trade with EU but also secondary economy related to loss trade will take time and will be difficult considering that world has become extremely competitive. A trade deal does not imply that it will restrict competition from others
    • Perceived EU constraints with respect to GB manufacturing potential are not real but rather due to populist fabrication.
    • Loss of financial service with respect to EU not only implies direct trade benefit, but includes secondary economy (taxis, restaurant hotel ect..) and tax earnings

GB View

What is certain apart from ability to manage resilience (both from GB perspective and EU) GB will move to a different resilience regime while EU will tend to remain in its current basin attraction. This due to the fact that Brexit will change its structures, functions, feedbacks, and therefore identity. The trajectory most probably push system to a less favorable regime (resilience basin) not just due to trade losses (primary and secondary economy)  but also due to robustness factors such as low economic growth , low investments and uncertainty will guide trajectory to unfavorable regime. The high level of private and public debt futher constraint that will limit ability to influence trajectory to a more favourable regime. Time will be GB biggest enemy with respect to containing system trajectory within favorable regimes rather than negative regimes.

The change in relationship will influence GB economic system configuration whereby its basin of attraction is shifted by external conditions such as access to EU single market which in turn will impact industrial output and internal conditions such low confidence, high public and private debt. The system trajectory to the relevant regime will depend on strength specific variable that prevail which will impact economic system performance (production output, deficit, debt, gdp).

The new regime will be a less favorable with lower performance / potential ; its resilience resistance and latitude  will depend on many factors while precariousness; the current trajectory of the system momentum con result in further less favorable regimes (downward spiral). Its ability to adapt to a more favorable regime’s in order to reach pre-exit state (bounce back) or better depends on the following factors:

  • Internal production and governance efficacy maximizing potential
  • Public and private to fund resources considering total external debt already at 283% gdp
  • Robustness of local and world economic situation
  • Ability to recover losses with new trade deals; new trade deals need to be more favorable than what it has with the EU in order to impact output. The derived benefit must not only cover trade losses with EU but also secondary economic losses (loss of pharma agency typical example secondary economy)
  • New markets should have at least same per capita income from an affordability perspective

The permanence in the new regime will depend on system sate, its trajectory, momentum, resilience depth and its ability to stabilize trajectory within time constraints. Time will be GB biggest enemy in that it has to re-determine trading markets and new relationship to be able to generate enough production output to replace lost production due to exit from single market without shift to an even more negative regime.

The dynamic conditions of the economic system within the new regime will also have fundamental impact on gdp growth, employment, public and private debt, and consumer confidence. Its severity will impact trajectory and tipping points leading to less favorable regimes within the stability landscape.

Even after signing trade deals, competition from EU and other players will still remain impacting the ability to generate trade volumes. The new basin of attraction of the associated regime may dynamically change due to other external factors (war, bank crisis, downturn world economy).

EU view

EU will suffer some form of trading loss considering that it trades with surplus, at the same time the loss will be overcome by gains generated by new opportunities such as services (banking ) and redistribution of EU owned companies operating in GB. EU does not need to reconstruct reltationships; it has trade deals in place, compliance agencies customs ect.. implying that from system perspective there will be no change other than disturbance to its performance within current basin of attraction. Its recovery depends on its ability to react timeously via adaptation initiatives and that there are no exogenous shock that could impact its resilience basin shifting system to a new regime.

EU has to decide increase internal funding towards EU buget (8-10 billion p.a) and/or postpone, reduce funding towards projects and external aid.  Shortfall can be resolved by reducing/eliminating external aid and keep existing EU based projects as is.

Brexit is important for EU; chaos normally triggers fundamental change. The EU has many faults but at the same time the EU has created in general for most member countries to have one the best standard of living in the world; considering its income, quality of health, services , education system and security . Past 10 years, EU economy grown by 3 trillion, longevity increased on average by 3 years. EU economy has not grown due to toxic finance but rather sound growth; investments and quality products without resorting to excessive government or private debt (while UK explosion of public and private debt) . EU bureaucracy may be excessive but at least citizens are guaranteed quality food in supermarkets. The EU bill might be excessive but if one analysis in detail there is in general overall system benefit for all concerned. Most EU initiatives go towards newly joined countries whereby internal economic leverage creates general system benefit, plus there are saving such as customs, central bank, compliance agencies.

Some member countries have not performed adequately such as Italy and Greece but if one analyses systemic deficiencies; 99% cases internal rather than imposed by EU.

EU needs a Brexit without a deal to prevent any further member countries adopting same strategy. So far this has worked in that ‘exit’ is completely off the table. Even populist parties have their changed attitude.

It needs Brexit as a test case to test its resilience. This test will determine sooner than later if the EU is a sustainably political and economic entity. Its ability to deal with the disturbance (economic damage ) caused by Brexit is fundamental for long term existence and strengthens its governance. It needs Brexit to strengthen EU political system considering so called ‘allies’ such as USA are not really ‘allies’ (Trump stated policy to work towards downfall of the EU) . It has to consider its own defense and not rely on USA or NATO.

EU needs to grow its ability in financial services; Brexit provides a perfect opportunity to grow this industry within the EU. This industry has high potential, high income and high leverage.

The relocation of pharma agency to Europe also provides influx of skills and economic growth.

Brexit is a given therefore fundamental for both parties to minimize damage and capitalize on the situation. Trade can either drop to zero (no deal) or unknown volumes. Industries such as banking will reduce its volume to zero in that British banks will lose passporting rights.

Within hard exit agreement the key impact will be on trade volumes and cost. Cost will play bigger role for GB in that not only tariffs and custom increase cost but devaluation of the sterling will further increase costs impacting volumes. From EU perspective costs will also increase but offset by devaluation of the sterling.

  • GB has to declare its approach to hard exit and keep some form of relationship with the EU accepting financial liability. This will then reduce economic uncertainty and provide specific direction and the way forward. It also removes constraints from the EU. GB will lose substantial output (mainly banking) and products such as automobiles; specifically low cost vehicles that have low margins and have a dependency on imported components (Ford Fiesta, Nisan , Toyota) while limited impact Rolls.
  • The EU in turn has to quantify loss of trade and how that trade can be recovered. Germany main impact will be auto sales, but on the upside Europeans can start favoring German rather than British luxury vehicles and moving banking services from GB to EU will also leverage the economy. EU also has to identify strategic products which are mainly in pharmaceutical and military environment. Each case, strategy needs to be put in place to either replace or continue trade relationship at higher cost.

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systemic2016

IT Transformation consultant specifically within SAP space with strong interest in System Thinking and Cybernetics Management.

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