UK Referendum For professional clients only. Economic research note

For professional clients only Economic research note UK Referendum 16 May 16 The United Kingdom (UK) will hold a Remain/Leave referendum on their membership of the European Union (EU) on 23 June 16. Within the ranks of Government, Prime Minister Cameron, along with Labour and the Liberal Democrats support Remain, while former Mayor of London, Boris Johnson MP and Lord Chancellor and Justice Secretary Michael Gove MP, along with the UK Independence Party support Leave. The Conservative Party is split on the vote. Overall, the referendum is likely to be shaped by two factors; the uncertainty around economic growth and jobs for the Remain vote and attitudes towards sovereignty and immigration for the Leave vote. Current polling suggests a narrow victory for Remain, but polls have been tight and there remains a significant proportion of undecided voters. If the UK votes to Leave, they will enter into a two year negotiation process with the EU to determine their postexit arrangements on issues such as trade, regulation and immigration. The results of these negotiations will be key in determining the long-term outcome of a Brexit and represent a major source of uncertainty for markets. A vote to Leave is expected to be negative for UK growth in the short-term due to increased uncertainty and reduced trade, investment and immigration. HM Treasury estimates that the UK would be between 3.4% and 9.4% of GDP better off, over 15 years, remaining in the EU than leaving, depending on the final agreement. A UK exit from the EU would also likely be a negative for the EU, both directly from a loss of trade and economic ties and politically due to the weakening of the Union and a shift in the balance of power. Along with the November 16 US Presidential election, the UK referendum has the potential to add a political dimension to ongoing risks and volatility on global financial markets. In 13, prompted by Eurosceptic Conservative Party MPs and members, as well as the UK Independence Party (UKIP), Prime Minister and Conservative leader David Cameron pledged to hold a Remain/ Leave referendum on the United Kingdom s (UK s) membership of the European Union (EU) before 17. After much anticipation and political wrangling, the UK will head to the polls on 23 June 16 to decide their place in Europe. The referendum will have implications for both the UK and EU for years to come and represents one of the major political risks to markets this year. Pre-referendum negotiations: A new settlement for the United Kingdom in a reformed European Union As well as promising the referendum, David Cameron committed to renegotiating the relationship between the EU and UK to offer the British people a new settlement. PM Cameron set out the demands for renegotiating the deal between the UK and EU in a letter to European Council President Donald Tusk on th November 15. The letter outlined four key areas of reform to address the concerns of the British people. These include economic governance, competitiveness, sovereignty and immigration and also highlighted Our concerns really boil down to one word: flexibility. On the 18-19 February 16, a new deal was formally agreed to at the EU Heads of State Summit in Brussels. As table 1 demonstrates, the final deal is a more diluted set of reforms when compared to PM Cameron s original aims and is therefore unlikely to satisfy the Eurosceptics. Nevertheless PM Cameron achieved more than many expected he would. Carlos Cacho Analyst, Economic and Market Research Stephen Halmarick Head of Economic and Market Research This report is for Colonial First State Global Asset Management (CFSGAM)/First State Investments (FSI) clients only, not the broader voting public in the UK. CFSGAM/FSI does not intend to promote a particular outcome to the referendum on the UK s membership of the European Union. Readers who are eligible to vote in the UK referendum should vote as they personally see fit. 1

Economic research note Table 1: Summary of pre-referendum negotiations Area Target changes Result Economic Governance Protection of the single market for Britain and other non-euro countries. Non Eurozone (EZ) members will not need to take part in any future EZ bailouts and EZ decisions will have to respect the single market. Competitiveness Sovereignty Migration Boosting competitiveness by setting a target for the reduction of the "burden" of red tape. Exempting Britain from "ever-closer union" and bolstering national parliaments. Restricting EU migrants' access to in-work benefits such as tax credit and social housing and end the practice of sending child benefits overseas. A commitment to improve competitiveness, simplify legislation and remove red tape. Formal confirmation that the UK is not committed to further political integration. Introduction of a system whereby a majority of national parliaments (55% of votes in the EU council) could object to new EU legislation which would then be discontinued unless concerns were addressed. Exclusion of new migrant workers from in-work benefits for four years pending the activation of an emergency brake for a maximum of seven years requires a majority of support from EU members to implement. Child benefits would still be paid but would be indexed to the cost of living for children outside the UK. Initially this will only apply to new migrants. So when will the vote occur, what will the referendum question be and who can vote? The referendum will take place nationally on the 23 June 16, with a final result expected the following morning. The result will be decided by a simple majority vote with no minimum turnout required for an official result. The referendum will ask: Should the United Kingdom remain a member of the European Union or leave the European Union? with two choices, Remain a member of the European Union and Leave the European Union. All British, Irish and Commonwealth citizens who are over 18 and reside in the UK, as well as UK nationals living abroad will be eligible to vote. EU citizens who reside in the UK will not be eligible. Timing February 16 Deal agreed and referendum announced. 15 April 16 Campaign officially begins weeks before vote. 19 May, 15 June and 21 June 16 Three live debates on EU membership. 23 June 16 Referendum. H2 16 Article 5 activated by parliament, two year negotiation begins immediately. 18 Potential for extension or disorderly exit if negotiations not yet finalised. Who is on each side and what are their likely arguments? The campaign is in general split along party lines (as illustrated in table 2), with Leave supported by UKIP and the Democratic Unionist Party (DUP), while Remain is supported by Labour, Liberal Democrats (LibDems), Scottish Nationalist Party (SNP) and the other minor parties. The Conservative Party is however split, with five cabinet ministers and half the MPs supporting Leave. On 14 April 16 the Electoral Commission announced one lead campaign group for each side: Britain Stronger in Europe and Vote Leave. The designation as lead campaign group confers several benefits including a higher spending limit ( 7m compared to 7, for a non-lead campaign group), 6, in public funding, free broadcast advertising and one free mail drop to every voting household in the UK. A. Remain Remain will be represented by the Britain Stronger in Europe campaign group. This group has the support of several of the major parties including the Labour Party, LibDems, SNP, Plaid Cymru and a significant cohort of the Conservative Party. Conservative leader David Cameron and 16 of his cabinet members, including Chancellor George Osbourne and Home Secretary Theresa May, support the UK remaining in the EU and are likely to campaign alongside Britain Stronger in Europe. However the Conservative Party has pledged to be officially neutral in the campaign. As such, any Conservative Party staff wanting to work on either side will only be allowed to do so in their own time and the party will not supply funds or voter information to either side. B. Leave While the choice for the lead Remain group was clear, Leave has two major campaign groups competing, Vote Leave and GO Movement. Vote Leave is a cross party group supported by Conservative, Labour and UKIP Eurosceptics including former Lord Mayor of London, Boris Johnson MP and Lord Chancellor and Justice Secretary Michael Gove MP. They are campaigning on a platform of reducing regulation and returning sovereignty to the UK Government. The GO Movement is an alliance between the cross-party Grassroots Out group and Leave.EU. They are supported by several Conservative and Labour MPs and most of UKIP, including their leader Nigel Farage, who is likely to focus the campaigning on the issue of immigration. While Vote Leave won lead campaign designation due to their broader cross party support, Go Movement will still be an active and vocal part of the campaign. There is a risk that the staunch anti-immigration stance of UKIP and Nigel Farage could alienate some centrist voters who might otherwise consider voting Leave. This division will likely mean Leave has difficulty mounting a coherent campaign. 2

Colonial First State Global Asset Management C. Other Players In addition to these groups, political parties will also have spending limits allocated to their campaigns based on their performance in the last election. This may favour Remain, with total party funding expected to be 11m, while Leave will be 5m. Table 2: Campaign group details Vote share 15 Total spending limit, m % of total Remain Leave Conservatives* 36.9 7 Labour 3.4 5.5 UKIP 12.6 4 LibDems 7.9 3 SNP 4.7.7 Green party 3.8.7 Plaid Cymru.6.7 DUP.6.7 Sinn Fein.6.7 11.3m 4.7m * Conservative Party will remain neutral so will not offer funding to either side. Source: The Electoral Commission, BBC, party websites as at April 16. Business is also likely to play a key role in the campaign. Big business has been more supportive of remaining in the EU, due to the perceived benefits such as access to the free market and the ease of moving people, products and capital. However business in general seems more closely split, with the British Chamber of Commerce reporting 55% of members supporting continued membership of the EU. The Confederation of British Industry (CBI) has put their support behind Remain, warning voters that a Brexit could cost bn and nearly one million jobs (HM Treasury estimates that 3.3 million jobs are linked to exports with other EU nations). Additionally, many business leaders, including several chairmen and CEOs of FTSE companies, have thrown their support behind Business For New Europe, a Pro-EU pressure group formed in 6. On the other side of the aisle is Business for Britain : supported by 5 business leaders including Phones 4u co-founder John Caudwell and former Director of the British Chambers of Commerce, John Longworth. They argue that while EU membership offers the benefits of a wider domestic market, the regulatory burden is too high considering less than 5 per cent of UK companies directly export to the EU yet all are forced to bear the burden of its regulations. D. The Issues Overall the referendum is likely to be shaped by two factors, including uncertainty around economic growth and jobs on the Remain side and attitudes towards sovereignty and immigration on the Leave side. Remain is likely to run a fear campaign similar to that of the No campaign during the Scottish referendum, with a focus on uncertainty and risks over the eventual outcome. Chart 1: UK public views Brexit as risky % of people who view EU Membership/Exit as Risky/Safe 6 5 3 EU Exit "Very" or "Fairly" Risky Source: YouGov as at April 16. Remain in EU "Very" or "Fairly" Safe Leave on the other hand is likely to run a campaign focusing on the opportunities outside the EU and on taking back sovereignty. However, the influence of UKIP could push the focus onto the issues of security and immigration (now the number one issue facing the UK according to recent polling). Chart 2: Immigration is viewed as the top issue facing the UK % of population that cite each factor 8 7 6 5 3 1988 1992 1996 1999 4 8 12 16 Source: IPSOS MORI as at April 16. EU Economy NHS Unemployment Immigration How is the outcome shaping up? It is important to remember that voting is non-compulsory, so the campaign will be as much about encouraging turnout as persuading voters. If turnout is around 3%, which is normal for a non-national election, the vote is likely to favour Leave. This is because older voters are much more likely to vote in such elections and would generally be expected to support leaving the EU (see exhibit 1 for details). On the other hand, if turnout is closer to 6%, which is closer to what is expected from a general election, the vote is more likely to favour Remain as this indicates participation by younger voters, who would be expected to be pro-eu. 3

Economic research note Exhibit 1 In general, older voters are more likely to support Leave, with polls showing 56% of Britons over 6 want to leave while younger voters are more likely to support Remain. Londoners and Scots favour Remain, while the English support Leave. Also, in general, high socioeconomic groups favour Remain, while working class voters are more likely to favour Leave. On a political party basis, Conservative voters have a slight bias to Leave, while Labour, LibDems and most other parties favour Remain and UKIP voters almost unanimously favour Leave. This split generally favours Remain, baring a large swing in support from Labour or Conservative voters. While the Remain vote has periodically been ahead in the polls, the race has essentially been neck and neck for several months. However, this is likely to change as we approach the 23rd of June and late deciding voters make up their minds. Chart 3: Bloomberg Composite EU referendum poll tracker % 6 5 3 % Gender Income Level Age Party Region 8 6 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 Remain Leave Don't Know Source: Bloomberg as at 22 May 16. May-16 Male Female Rich Poor Young Old Conservative Labour Lib Dem UKIP N. England Remain Leave Don t Know Source: The Economist as at May 16. S. England Scotland Wales Latest poll as at 22 May 16 Favouring Remain 5% Favouring Leave 38% Don t Know 11% Recent polls suggest approximately % of the electorate is still undecided, so convincing these voters and getting them to the polling booth on the day will be key. Events between now and the referendum date are also likely to have an impact on the vote. For example, if there is a resurgence in the migrant crisis (and negative media coverage of it) or another terrorist event, this will potentially increase support for Leave in the polls. It is also important to mention the general lack of confidence in UK political polls as a predictor after their poor performance both during the Scottish referendum and the 15 general election. What happens after the vote? In the event of a Brexit vote, the UK Parliament would ratify the result and notify the EU of their intention to leave the Union (under article 5 of the Lisbon treaty) and enter into a two year negotiation process. In addition to negotiating their withdrawal, the UK would also need to negotiate post-exit arrangements with the EU, particularly on issues such as trade, regulation and immigration. When taking into account the complexity of this negotiation process and the involvement of all 27 remaining EU Member States, the two year period appears limited. While it is true that the period can be extended, this would require the agreement of all 27 remaining EU Member States and there is a high probability that this would not be forthcoming. At the end of the two year period, the UK will cease to be a member of the EU and all related treaties and agreements will halt whether or not replacement agreements or treaties are in place. This uncertainty is one of the key risks around the Brexit as it is not clear what the arrangements would look like post-exit, or if indeed any will be agreed before the UK formally leaves the Union. 4

Colonial First State Global Asset Management The status of trade between the UK and EU post-brexit is likely to be the most important outcome of these negotiations. While it is impossible to predict the outcome given the lack of precedents, there are widely considered to be five possible outcomes, each with their own advantages and disadvantages. Please refer to exhibit 2 for further details. I. European Free Trade Association (EFTA) and European Economic Area (EEA) Membership Upon leaving the EU the UK could emulate Norway and join the EFTA and EEA. II. Bilateral agreements plus EFTA membership The UK could negotiate sector by sector trade treaties with the EU and free trade agreements with the EFTA countries, like Switzerland. III. Customs union with EU The UK could enter into a customs union with the EU, developing a similar relationship to Turkey. IV. UK-EU Free Trade Agreement The UK could negotiate a comprehensive free trade agreement (FTA) with the EU, like that agreed with Canada in 14. V. World Trade Organisation (WTO) membership Failing to negotiate any replacement agreements, the UK could simply rely in its WTO membership to trade with the EU. The most likely outcome from these negotiations is partial access to the single market while committing to some EU regulations. Full access such as Norway s would likely require acceptance of the Four Freedoms which would be unpalatable for Leave supporters. Additionally while joining the EEA would offer the UK a similar level of market access, it would still increase transaction costs due to customs checks and the introduction of agricultural and fisheries tariffs. The post Leave negotiation phase is clearly a very complex process with many factors to take into account, a sentiment which is echoed by the government. In their policy paper, the British Government stated that it is probable that it would take up to a decade or more to negotiate firstly our exit from the EU, secondly our future arrangements with the EU, and thirdly our trade deals with countries outside the EU, on any terms that would be acceptable to the UK. This would be a long period of uncertainty, which would have consequences for UK business, trade and inward investment. What industries and sectors are most likely to be impacted? Exports represent 3% of UK GDP, with approximately 44% of all exports going to the EU. The possibility of a Brexit therefore poses a significant risk to the UK economy. As illustrated in chart 4, according to Open Europe, an independent think tank committed to EU reform, the sectors most at risk to be disrupted by a Brexit are: Goods: Cars, chemicals and pharmaceuticals, aerospace, capital goods and machinery, food and beverages and tobacco. Services: Financial services, insurance and professional services. Exhibit 2 While the Norway model would seem to be the most attractive for the UK, as it essentially maintains access to the single market, it would achieve few of the goals of leaving the EU. The Norwegian Government estimates they adopt 75% of EU directives, without having any influence over them. Additionally, Norway is still bound by the Four Freedoms (the freedom of movement of goods, services, labour and capital) a fundamental tenet of the EU, and is also required to contribute to the EU budget (approximately 6 per capita compared to the UK s own 128, according to estimates by the House of Commons library). The Swiss model may also appear suitable, but it would likely take longer than two years to implement sector by sector agreements and there would be no guarantee that the UK would be successful in achieving a comparable position. Again, similar to Norway, Switzerland is required to abide by many EU directives including the Four Freedoms and is also required to contribute to the EU budget, though at a reduced level. Further, Switzerland does not enjoy the same financial market access as the UK and is forced to passport through the EU to conduct cross border finance. While either a customs union or FTA would probably offer the UK a similar level of market access for goods, neither would likely offer access for services and judging by previous negotiations, it would presumably take longer than two years to reach such a deal. While it is not impossible that a deal covering services could be agreed, it is unlikely that the EU would offer this access without accepting some EU regulation and the Four Freedoms. Failing these, the fall-back option is for the UK to rely on World Trade Organisation (WTO) rules until new agreements can be reached. This would in itself also be a complicated process, with the UK having to agree on how they would inherit the rights and obligations, which it has as part of the EU, while being limited by the WTO s most favoured nation treatment from discriminating between member nations. While relying on WTO rules would protect most goods from punitive tariffs, there are some exceptions, such as car parts (one of the UK s leading manufactured exports) and agriculture which would be subject to higher rates. In addition to their trade relationship with the EU, trade deals with a further 52 non-eu countries would no longer apply upon exit. If the UK wanted to avoid a potentially significant impact on trade opportunities, these would also need to be re-negotiated within the two year period. The trade negotiation process is unlikely to be straight forward and will be influenced by EU politics. If there are signs that the UK could obtain a more favourable deal outside of the EU, there may be calls from Eurosceptic parties in other counties (such as the National Front in France and Podemos in Spain) to leave the Union as well. 5

Economic research note Chart 4: Sectors most exposed to Brexit risk % 7 6 5 3 Cars Chemicals Goods Aerospace Machinery Source: Open Europe and ONS as at 14. Food, Beverages and Tobacco Financial Services Services Insurance % of total UK exports % exported to EU Professional Services Together these sectors represent 53% of UK exports and 47% of exports to the EU. In the event of a disorderly exit (without new trade agreements in place) they would either likely be subject to steep tariffs (above 4%) or may be locked out entirely in the case of services. In the medium term, trade in goods would remain largely unchanged, as a preferential trade deal is likely to be reached. Service exports, on the other hand, may be more difficult to be maintained at their current level. Financial services could be the sector most at risk, as leaving the EU could potentially result in the loss of passporting privileges, which currently allow financial products to be sold into the EU from London. If this were to be the case, there could be a risk that some financial services firms may move at least some of their operations from London to mainland Europe, most likely Frankfurt, Brussels or perhaps Dublin. Bank of England (BoE) Governor Mark Carney has echoed these sentiments, saying that some financial-sector activity would without question move elsewhere in the EU if Britain lost access to the EU s single market. Additionally, the ability to clear Euro denominated assets and derivatives would potentially be removed from London, as has previously been attempted. No longer a member of the EU and without access to the European Court of Justice, the UK would be left with no recourse to appeal such a decision. It is important to consider not only the direct trade impact, but also the effect on inbound Foreign Direct Investment (FDI). Net FDI inflows were 44 billion (bn) in 14, representing one-third of EU inflows and making the UK the top FDI destination in Europe. With almost three quarters of foreign investors citing access to the European market as a reason for their investment in the UK, EU membership is clearly an important factor in attracting FDI. However, the UK would remain an attractive destination (as demonstrated in chart 5), even in the result of a Brexit for a range of reasons including its business friendly environment, flexibility of the labour market, use of English, low corporate tax rates and ease of doing business (the UK is ranked 2nd in Europe behind Denmark). Although in sectors where the UK is seen as a gateway to Europe, such as automobiles and financial services, the attractiveness of the UK may decline. Chart 5: Survey of foreign investors into the UK UK s domestic market 35 44 15 4 2 Local labour skills level 33 47 14 2 4 Transport and logistics infrastructure 41 15 2 2 Access to European market 47 36 4 3 Tech and telecoms infrastructure 47 38 9 4 3 Culture and language 54 36 8 11 Source: Ernst and Young 15 UK attractiveness survey. Per cent of respondents Very attractive Fairly attractive Not very attractive Not at all attractive Can t Say 6

Colonial First State Global Asset Management What is the potential overall impact? Without knowing the details of any final agreement, it is difficult to estimate the impact leaving the EU will have on the UK economy. Nevertheless, the main impacts on the UK in the event of a Brexit are reduced trade and immigration after leaving the EU and reduced investment during and potentially after the negotiation phase. With exports representing almost a third of UK GDP, trade is likely to be the most influential factor. Maintaining access to global markets, especially in services, which represent 8% of GDP, will be fundamental for the continued strength of the UK economy. Once FTAs currently under negotiation are finalised, 8% of UK trade will either be through the EU or FTAs with the EU. These agreements would all need to be negotiated in the event of a Brexit which would deal a blow to UK trade. Table 3: Summary of UK trade UK Trade Total exports Total imports flows, 14 billion % of total Cumulative % billion % of total Cumulative % EU 229 44% 44% 291 53% 53% EFTA and 35 7% 51% 33 6% 59% Customs Union Existing 26 5% 56% 23 4% 63% FTAs FTAs under 133 26% 82% 7 % 83% negotiation Rest of World 93 18% % 96 17% % Source: HM Treasury calculations based on ONS Pink Book and HMRC goods data for 14. In addition to trade, another disadvantage of leaving the EU that is often overlooked is the UK s potential loss of political clout in international affairs and trade negotiations. The EU as a bloc is the world s largest economy, while still significant on its own (#5 according to the International Monetary Fund (IMF)), the UK s importance on the international stage could diminish if it were to leave the EU. Suggestions that the UK could negotiate better deals with major partners, such as the US, outside the EU need to be taken in the context of President Obama s recent comments in the UK in which he suggested the relationship with the EU was a higher priority. As HM Treasury states in their paper No country has been able to negotiate a better deal and it would not be in the EU s interest to agree one with the UK. A sentiment echoed by the IMF which stated in April 16 that leaving the EU could do severe regional and global damage by disrupting established trading relationships and that negotiations on post-exit arrangement would likely be protracted, resulting in an extended period of heightened uncertainty that could weigh heavily on confidence and investment, all the while increasing financial market volatility. Another factor to consider is the funding of the UK s balance of payments. Currently the UK relies on foreign inflows to fund its large current account deficit, which was 7% of GDP in Q4 15 and averaged 5% of GDP over the last four quarters. In the event of a Brexit, capital may become more difficult to attract without a devaluation of the Sterling or a higher risk premium. We note that Standard and Poors stated on 21 May 16 the days for the UK s AAA sovereign rating would be numbered. Depending on the circumstances and consequences of a vote to leave, we could lower the rating by more than one notch if we reassessed our view of the UK s institutional strength and ability to formulate policy conducive to sustainable growth. Recent analysis by HM Treasury (table 4) also suggests that the cost of leaving the EU could be significant, representing a loss of between -3.8% to -7.5% of GDP over 15 years depending on the final agreement. Table 4: Annual impact of leaving the EU on the UK after 15 years (difference from being in the EU) EEA Negotiated bilateral agreement WTO GDP level (%) -3.8-6.2-7.5 central GDP level (%) -3.4 to -4.3-4.6 to -7.8-5.4 to -9.5 GDP per capita - 1, - 1,8-2, central GDP per capita - 1, to - 1, - 1,3 to - 2, - 1,5 to - 2,7 GDP per - 2,6-4,3-5, household central GDP per household - 2, to - 2,9-3, to - 5, - 3,7 to - 6,6 Net impact on receipts - billion - 36 billion - 45 billion Source: HM Treasury, April 16. The BoE has not, until recently, commented on the Brexit, short of the currency impact and potential risk to financial stability. In their April 16 Monetary Policy Committee meeting the BoE expressed the view that a vote to Leave would create uncertainty about the economic outlook after the vote itself, with that uncertainty possibly weighing on demand, as well as raising questions about the supply side and asset prices. Most private sector estimates of Brexit agree that the impact would likely be negative in the short-term. However as the final agreement is uncertain, the longer-term costs and benefits and resultant economic impact is far from clear. Table 5: The GDP impacts on a number of external studies Source Effect on level of GDP (%) PwC/CBI -3.1 to -5.5 (over 5 years) Citi -4. (over 3 years) Credit Suisse -1. to -2. (over 2 years) Deutsche Bank -3. (over 3 years) HSBC -1. to -1.5 (over 1 year) JP Morgan -1. (over 1 year) Morgan Stanley -1.5 to -2.5 (over 2 years) Nomura -4. (over 1 year) Société Générale -4. to -8. (over 5 years) Source: HM Treasury, April 16. 7

Economic research note Pros of leaving the EU If uncertainty and trade could be the main disadvantages of leaving what are the potential advantages? The overall argument for leaving centres on returning sovereignty to the UK, but there are also some more specific potential positives. Membership fee Last year the UK paid 13bn into the EU budget, but only received 4.5bn of spending, a net contribution of 8.5bn. While leaving would appear to offer an immediate cost saving, it is unclear how much would be realised in practice as most nations with access to the single market must contribute in some way to the EU budget. Additionally, analysis by HM Treasury states The negative impact on GDP would also result in substantially weaker tax receipts. This would significantly outweigh any potential gain from reduced financial contributions to the EU. Trade Outside the EU, the UK would be free to establish its own free trade agreements without being bound by EU law in areas such as agriculture, justice and home affairs. While this could be an opportunity, the UK may also lose trade deals with over 5 countries agreed through the EU and it would likely take years before equivalent deals would be reached. Regulation Free from compliance with EU legislation, the UK would be free to set its own regulation without outside influence. While the regulatory burden may be reduced in some areas, the UK is already ranked as one of the most deregulated economies in the developed world (OECD data shows it has the second least restrictive regulatory regime after the Netherlands). Finance Without EU membership the UK would be free to regulate financial services as it sees fit, protecting it from potentially burdensome EU regulations. However it may also be a less attractive financial hub as it could lose access to the EU markets. Immigration Leaving the EU would mean that the UK could resume control of immigration and limit the flow of EU migrants; as well as exclude them from in-work benefits. While the influx of immigrants to the UK has led to some difficulties, recent studies have generally shown the impact of immigration to be small relative to GDP with most suggesting, on balance, that immigration has been a net positive. Additionally it is likely that, to achieve a similar level of market access, the UK would have to accept the freedom of movement of labour. What will be the political impact? The Brexit vote also has the potential to change the political landscape in the UK, regardless of the outcome. While PM Cameron has stated that he will not resign in the event of a Leave vote, it is difficult to see him maintaining his position as leader of the Conservative Party and Prime Minister throughout the two year Leave negotiation phase. Even in the event of a successful Remain vote, there is the possibility that lingering political doubts within the party, especially if the outcome is close, could lead to a leadership challenge. In this event, Boris Johnson, having thrown his support behind the Leave vote, would be the front-runner to succeed PM Cameron as Conservative Party leader given the party is evenly split on the issue. There is also the possibility that in the event of a Leave vote, where Scotland votes to Remain (as the polls suggest they will), a second referendum on Scottish independence would be held, as the SNP has promised. What would be the impact on the EU? A UK exit from the EU could also be a negative for the EU, both directly from a loss of trade and economic ties and politically due to the weakening of the Union and a shift in the balance of power. As shown in chart 6, the direct trade impact would be felt most in Belgium, Netherlands, Cyprus, Luxembourg, Ireland and Malta, where exports to the UK represent greater than 5% of GDP. In the other markets, including the big four, UK trade is less important, which raises the risk of a tough trade deal. Chart 6: UK more exposed to trade than EU % GDP 3 Value of trade with UK as % of GDP 25 15 5 Belgium Slovakia Lithuania Czech Latvia Spain Hungary Poland Germany Portugal Austria Greece Italy France Netherlands Romania Slovenia Finland Cyprus Sweden Croatia Denmark Estonia Bulgaria Luxembourg Ireland Malta Source: Deutsche Bank, Haver analytics, Eurostat, as at April 16. UK exports to EU (12.6%) EU Average (3.1%) Exports to UK Imports from UK 8

Colonial First State Global Asset Management There have been some suggestions that, given the close ties between the UK and Ireland, an Irish exit from the EU would prove inevitable in the event of a Brexit. While the UK leaving the single market would prove a difficult transition given the open border between the two and the Common Travel Area, the same arguments were proved false when the UK opted out of the single currency. The EU would also lose the UK s contribution to the budget, which represented 12.6% of the total EU budget in 15 (only France and Germany contribute more). This shortfall would have to be made up for by either increased contributions by net contributors or decreased subsidies for net receivers. The politics of the Union would also be impacted, with the balance of power shifting from north to south; France and Italy would be able to outvote the more free-market leaning Germany and Netherlands. The impact of this may not be felt immediately, but it could lead to a more inward looking and less free-market based Union with an increased regulatory burden. Much like the UK, the EU s political clout would potentially suffer. The UK s special relationship with the United States and UK s permanent seat on the UN Security Council might represent a loss of influence in both trade and international diplomacy for the EU. A vote to Leave and the following negotiations may also have some impact on national elections in Germany, France, Netherlands and Spain over the next 18 months. If the public believe the UK is better off outside of the EU, there will likely be increased pressure from Eurosceptic parties, such as the National Front in France and Alternative Fur Deutschland in Germany. There have already been signs of rising support for these parties in recent regional elections in both France and Germany. What would be the global/market impact? The impact of the UK referendum will likely affect both European and global markets. We expect the uncertainty around the vote to weigh on the Sterling in the months ahead, indeed it has fallen 6.1% against the USD since November 15. Chart 7: Pound has weakened on Brexit risk TWI 1 GBPUSD 2.1 1.9 9 1.7 8 1.5 7 6 8 12 14 16 1.3 Source: Bloomberg as at 16 May 16. TWI (LHS) GBPUSD (RHS) In the event of a Brexit, the integrity of the EU may be called into question by the market as it did during the Greek and sovereign debt crisis. While a Leave vote is unlikely to be a catalyst to the breakup of the EU, there is a risk that the market takes it as a sign of further fracturing to come. Additionally, there is the risk that if the UK vote fuels further global financial market volatility, this could see the US Federal Reserve continue to pause when they consider raising interest rates at the 14-15 June 16 FOMC meeting. Along with the November 16 US Presidential election, the UK referendum has the potential to add a political dimension to ongoing risks and volatility on global financial markets. 9

Economic research note Colonial First State Global Asset Management EX2921_516_MR Disclaimer This document is directed at persons of a professional, sophisticated, institutional or wholesale nature and not the retail market. This document has been prepared for general information purposes only and is intended to provide a summary of the subject matter covered. It does not purport to be comprehensive or to give advice. The views expressed are the views of the writer at the time of issue and may change over time. This is not an offer document, and does not constitute an offer, invitation, investment recommendation or inducement to distribute or purchase securities, shares, units or other interests or to enter into an investment agreement. No person should rely on the content and/or act on the basis of any matter contained in this document. 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