Who's playing first fiddle?

What’s the biggest economy on earth?

When the Group of 20 met in Hangzhou for an economic summit last weekend, the United States media was fastidious about putting China in its proper place. The Washington Post daily repeated, as relentlessly as a drumbeat, that China was “the second largest economy.” According to The New York Times, the People’s Republic “is determined to show the world that it is an equal partner in one of the most exclusive clubs of wealthy nations….Not for the first time, officials want to demonstrate to people at home and abroad that China, the world’s second-largest economy after the United States, deserves a bigger role in global governance.”

There is only one problem with these bromides. China is the largest economy and has been since 2014. No wonder the Chinese forgot to provide a gangway for the presidential entourage to clamber down from Air Force One.

The error occurs because the press ranks economies in a way that economists rejected decades ago. That is to adjust the value of a nation’s annual production (gross domestic product) by using the current exchange rate. Suppose that GDP in Kazakhstan is 10 trillion tenge and that the exchange rate is 200 tenge per US dollar. Then the dollar value of GDP is 1 trillion tenge divided by 200 tenge per dollar, or $50 billion.

The flaw in this method is that the exchange rate may vary for reasons that have little to do with the nation’s ability to produce. For example, in August 2015 the central bank of Kazakhstan decided to let the market determine the exchange rate of tenge per dollar; up to that point, the National Bank had held the exchange rate within a corridor. Overnight, the dollar value of the tenge plunged by more than a fourth. But Kazakhstan’s productive capacity certainly didn’t fall by this much.  

Numlock

Rather than use the current exchange rate, economists recommend an approach that mirrors productive capacity more closely. This is a metric that has the same value, in terms of output, in any country. For example, suppose that we are measuring national production in terms of newspapers. Also suppose that a newspaper costs $1 in the US and 100 tenge in Kazakhstan. Then our metric for comparing American and Kazakhstani production is 100 tenge per dollar, regardless of the actual exchange rate of the moment (340 tenge per dollar, as we speak). To calculate the dollar value of Kazakhstan’s economy, we will divide its tenge GDP by 100. For obvious reasons, the idea behind this metric is called purchasing power parity.

Here’s a simple example. Suppose that Rich Country has a GDP of $1,000; and Poor Country has a GDP of $100 at the current exchange rate. Also suppose that a newspaper costs $1 in Rich Country and $.50 in Poor Country. Then, adjusted for purchasing power parity, GDP is equivalent to 1,000 newspapers in Rich Country and 200 newspapers in Poor Country.

In reality, economists base PPP on a bundle of typical products -- not on just one good like a newspaper. But you get the idea.

The World Bank provides measures of parity for nations, online for free. Table 1 shows the lineup for 2015. Adjusted with PPP, gross domestic product in international dollars is higher for China than for the United States. (The international dollar is the price, in local currency, of a bundle of goods that would cost $1 in the US.) China’s GDP is 19.5 trillion international dollars; that of the US, 17.9 trillion.

Rank	Nation	ID
1	China	19.5
2	United States	17.9
3	India	8
4	Japan	4.7
5	Germany	3.8
6	Russia	3.6
7	Brazil	3.2
8	Indonesia	2.8
9	United Kingdom	2.7
10	France	2.65

Table 1: The 10 biggest economies in 2015, measured in trillions of international dollars of GDP.

Data source: World Bank, World Bank Indicators.

Well, surprises galore. Of the G7 nations, which journalists call the “rich man’s club,” only 5 are among the 10 biggest economies (the US, Japan, Germany, the United Kingdom and France). This is largely because the biggest economies are often big because of population rather than individual affluence. Moreover, of the 10 largest economies, 4 are in Asia (or 5, depending on whether you classify the Russian Federation as in Europe, Asia or Hades). There’s your pivot. Finally, 4 are among what used to be called "developing countries." So much for the American Century.

Why do journalists still refer to the US as the biggest economy? Because of the occupational hazard of journalism – intellectual inertia. Why bother to check the facts when you have the mantra down pat, especially when all the other journalists are chanting it, too? 

There may be a murkier reason. The White House surely knows of parity, and the puzzle is why it doesn’t correct reporters who still refer to China as second banana. Hmm…I seem to remember that this is an election year. China became the largest economy on President Barack Obama’s watch, although he didn’t have much to do with it. Pointing out the event might give the Republican Party candidate, Donald J. Trump, a card to play against the Democratic Party candidate, Hillary Clinton.  God knows he’s holding a weak hand. –Leon Taylor, tayloralmaty@gmail.com

Notes

Technically, the theory of purchasing power parity holds that changes in the exchange rate will ensure that a given bundle of goods will eventually have the same price in any country in a given currency.  Suppose, for example, that the bundle costs $1 in the United States and 100 tenge in Kazakhstan. Then the exchange rate will go to 100 tenge per dollar. At that rate, the bundle will sell for $1 in either country – or, if you prefer, for 100 tenge in either country.

This proposition is logical. Suppose, for example, that the current exchange rate is 200 tenge per dollar. Then the bundle’s price is $1 in the US but $.50 in Kazakhstan. Since the bundle is cheaper in Kazakhstan, people will demand tenge (and sell dollars) in order to buy it here. The tenge will gain value in terms of dollars until the exchange rate becomes 100 tenge per dollar. The bundle will now sell for $1 (or 100 tenge) in either the US or in Kazakhstan. That’s parity.

In the real world, the theory of purchasing power parity rarely holds, especially in the short run; for a good discussion, see the textbook by Kaufman, Obstfeld and Melitz. But because parity is logical, it provides a useful way to compare the output value of two countries.  For its GDP estimates, the World Bank calculates exchange rates as if parity held.

References   

Paul Krugman, Maurice Obstfeld, and Marc Melitz. International economics: Theory and policy. Ninth edition. Addison-Wesley. 2012.

Jane Perlez and Yufan Huang. China, eager to host elite club, primps for G-20 meeting.  New York Times. August 30, 2016.

World Bank. World Development Indicators. worldbank.org

The impact of Brexit on the Eurasian Union: Consequences and lessons

              

by Dmitry Belyanin

Can Brexit put the Eurasian union on ice?

Introduction

Late in June, when the British voted to leave the European Union, the news hit financial markets around the world like a ton of hot bricks. The pound sterling weakened 11% virtually overnight. How might Brexit affect the trade pact to which Kazakhstan belongs, the Eurasian Union? 

To answer this question, let’s consider the best-known of all trade agreements, the European Union. Formed in 1951 by Belgium, France, Italy, Luxembourg, the Netherlands and West Germany as the European Coal and Steel Community, its original purpose was largely to avoid another European war by strengthening ties between national economies It grew steadily in prestige, and it steadily attracted members, including the United Kingdom in 1973. By 2002, the Eurozone was running on all eight cylinders (sans the UK) -- and in a few more years, the European Union emerged in the form that we recognize today.  

The EU’s expanding powers create friction with its member nations. Trade and migration spur economic growth, but they also engender losers who are not compensated by the gains from trade, although they can be in theory. In new member states, including several post-Soviet nations, the rise in competition due to the EU has bankrupted firms and strengthened fears of losing jobs to immigrants. Many doubt that Brussels represents national interests fairly. Euroskeptic political parties, agitating for withdrawal of their countries from the Union, soared in popularity when the Syrian migrant crisis spread in 2015. The first vote for withdrawal was Britain’s.

Brexit (British exit) may affect a regional trade agreement for transition economies, the Eurasian Economic Union (EAEU), since it is intertwined with the EU. The EAEU began life as a free trade zone for Russia, Kazakhstan and Belarus, but it now includes Armenia and Kyrgyzstan. Though Eurasian integration was initiated by President Nazarbayev in the 1990s, the media often portray the EAEU as a Russian project. In any case, a British exit will affect Russia disproportionally…if it transpires. According to the Lisbon Treaty, a country pulling out of the European Union has two years to negotiate.

Results of the Referendum

 

The ambiguity surrounding Brexit is evident in the very results of the referendum: 51.9% voted to leave the EU and 48.1% voted to stay. Most residents of Scotland, Northern Ireland and London voted to remain, while most residents of Wales and England voted to depart (Table 1).

Region	Leave	Remain
South East	51.8%	48.2%
London	40.1%	59.9%
North West	53.7%	46.3%
East	56.5%	43.5%
South West	52.6%	47.4%
West Midlands	59.3%	40.7%
Yorkshire and the Humber	57.7%	42.3%
Scotland	38.0%	62.0%
East Midlands	58.8%	41.2%
Wales	52.5%	47.5%
North East	58.0%	42.0%
Northern Ireland	44.2%	55.8%

Source: BBC News

Table 1: Results of the 2016 European Union exit referendum in the United Kingdom by region

Age Group	Leave	Remain
18-24	27%	73%
25-34	38%	62%
35-44	48%	52%
45-54	56%	44%
55-64	57%	43%
65+	60%	40%

Source: Lord Ashcroft Polls

Table 2: Voting patterns in the European Union exit referendum in the United Kingdom by age group

Unexpected, the Brexit vote roiled financial markets and divided the Brits. Scottish rallies called for another referendum. Activists pressured the EU to reform, and Euroskeptics in other European countries may organize referenda of their own.

Older Brits voted to split; younger Brits, to stay (Table 2). Youths liked the freedom to travel throughout the EU to seek work. Older workers disliked the competition from youths with computer skills. Even so, older workers may lose from Brexit as homeowners. Real estate prices have increased in the UK over the last 50 years, but Brexit may cut them by almost a fifth, said George Osborne, former UK Chancellor of the Exchequer. This may benefit younger workers, who need affordable housing, at the expense of the old. 

Older workers do gain from the EU in this sense: Given the UK’s aging population, an influx of foreign workers boosts tax revenues for state services such as pensions and health care. But the effects take time to play out, so today’s retirees may not benefit fully from them, said the Quartz newsletter.

Conditions leading to the referendum

Though Great Britain joined the Eurasian Economic Community in 1973 and the EU in the 1990s, the British have always resisted integration. They joined neither the Eurozone nor the Schengen Area, which has no internal border controls. Poor performance of European economies after 2008 aggravated English euroskepticism. While the US central bank decreased interest rates, restoring American economic growth in 2010, the European Central Bank increased rates, driving the Eurozone further into recession. Since Britain has its own currency, it was not directly affected.

The UK balks at surrendering the monetary steering wheel to the European Central Bank because it suspects the ECB of mistakes. In July 2011, the Bank upped its benchmark rate from 1.5% to 1.75% in order to fight inflation. To the ECB, stimulating output was a job for fiscal policy – i.e., tax cuts and government spending. In contrast, the Bank of England put unemployment ahead of inflation, keeping its interest rate at a record low of 0.5% for 28 months, reports The Guardian.

In some ways, the single currency benefits countries of the Eurozone. It eliminates much uncertainty about exchange rates as well as conversion costs. Prices become easier to compare. Investment and competition increase. However, since each EU country is unique, external shocks and EU policies affect each in a different way. Devaluing the euro helps net exporters like Germany and hurts net importers like Britain. The effects of a “one size fits all” policy became more adverse when the debt crisis hit.  

This is especially true of immigration policy. The UK accepted about 1,000 Syrian refugees under the Vulnerable Persons Resettlement Programme (VPR) and planned to take in 20,000 by 2020. Another 5,000 Syrian refugees have found shelter in the UK since 2011. Britain has spent about £10 million on refugees. On the other hand, during January-October 2015, 315,000 people applied for asylum in Germany, the highest number in Europe. 

The impact of immigration also varies sharply across nations when we control for the size of the population. Per 100,000 residents, Hungary had the highest number of applications -- 1,450 refugees, compared with 323 for Germany and 30 for the UK. According to Eurostat, which calculated this statistic for 19 European countries (see the Notes), it was lowest for Britain. 

Each asylum seeker in Britain receives £36.95 a week for living but cannot supplement it with her own pay. In France, the figure is £56.62. For Germany and Sweden, which are among the countries most favored by refugees, the figures are £35.21 and £36.84, respectively, reports The Guardian. Hence, though English Euroskeptics use the refugee crisis to argue for more restrictions on immigration, British expenditures are actually modest.  

It’s not clear that EU membership has crimped the UK economy. Unemployment has been lower in the UK than in many other European countries (Table 3). This should have encouraged the Britons to stay in the EU. Only Switzerland, Germany and Norway had lower unemployment – and of those, only Germany is in the EU. Also, the UK did not perform poorly by EU standards in terms of inflation (Table 5). On the other hand, real GDP growth in the UK was only average by EU standards (Table 4). The United Kingdom was much better off than Greece, the country that suffered from the European debt crisis the most, as shown by the tables below, and considered withdrawing from the Eurozone.

In general, Brexit arose not from macroeconomic factors but instead from skillful campaigning. Nigel Farage, leader of the Eurosceptic UK Independence Party, and Boris Johnson, mayor of London from 2008 to 2016, emphasized the time-honored British themes of self-reliance and nationalism. 

Country	2008	2010	2012	2014	2016
Belgium	7.083	8.242	7.650	8.483	8.316
Denmark	3.458	7.475	7.542	6.533	6.000
Finland	6.367	8.383	7.742	8.700	9.292
France	7.433	9.250	9.758	10.292	10.141
Germany	7.408	6.942	5.367	5.008	4.583
Greece	7.750	12.725	24.425	26.500	25.028
Italy	6.733	8.342	10.675	12.642	11.392
Netherlands	3.663	4.995	5.832	7.434	6.421
Norway	2.595	3.584	3.221	3.530	4.600
Portugal	7.552	10.770	15.526	13.894	11.563
Spain	11.250	19.850	24.800	24.450	19.715
Sweden	6.167	8.575	7.967	7.933	6.842
Switzerland	2.577	3.516	2.905	3.164	3.461
United Kingdom	5.725	7.900	7.975	6.200	4.996

Source: April 2016 IMF World Economic Outlook Database   

Table 3: Unemployment rates in selected European countries (2008-2016)

Country	2008	2010	2012	2014	2016
Belgium	0.747	2.695	0.151	1.348	1.161
Denmark	-0.713	1.622	-0.077	1.263	1.598
Finland	0.721	2.992	-1.426	-0.699	0.912
France	0.195	1.966	0.183	0.180	1.143
Germany	0.805	3.945	0.613	1.580	1.456
Greece	-0.335	-5.479	-7.300	0.654	-0.576
Italy	-1.050	1.687	-2.819	-0.343	0.954
Netherlands	1.708	1.401	-1.057	1.013	1.841
Norway	0.384	0.602	2.749	2.215	0.998
Portugal	0.199	1.899	-4.028	0.906	1.397
Spain	1.117	0.017	-2.619	1.358	2.644
Sweden	-0.557	5.989	-0.286	2.267	3.668
Switzerland	2.185	2.860	1.123	1.891	1.242
United Kingdom	-0.467	1.540	1.179	2.853	1.891

Source: April 2016 IMF World Economic Outlook Database   

Table 4: Real GDP growth rates in selected European countries (2008-2016)

      

Country	2008	2010	2012	2014	2016
Belgium	2.699	3.382	2.082	-0.391	0.563
Denmark	2.500	2.819	1.967	0.307	0.800
Finland	3.381	2.766	3.449	0.552	0.833
France	1.175	1.977	1.530	0.110	1.086
Germany	1.101	1.728	2.075	0.000	1.206
Greece	2.193	5.158	0.318	-2.535	0.166
Italy	2.354	2.093	2.580	-0.083	0.522
Netherlands	1.651	1.844	3.374	-0.061	0.514
Norway	2.135	2.758	1.378	2.073	2.500
Portugal	0.842	2.444	2.090	-0.270	0.811
Spain	1.433	2.988	2.867	-1.042	0.666
Sweden	2.139	2.101	1.038	0.280	1.446
Switzerland	0.751	0.531	-0.416	-0.328	-0.300
United Kingdom	3.753	3.311	2.746	0.940	1.300

Source: April 2016 IMF World Economic Outlook Database

Table 5: End-of-period inflation rates in selected European countries (2008-2016)

Impact of Brexit on the UK economy

Even if they never plan to spend a foggy day in London, Central Asians may want to know how Brexit might affect the UK, for three reasons. First, they trade with the Brits. Perhaps more important, if the UK gains from Brexit, other nations may withdraw as well – with snowballing effects for the EU and its trading partners. Finally, Kazakhstanis and Kyrgyzstanis may deduce from Brexit the consequences of their own withdrawals from EAEU, as if this were politically possible.

 

Britain’s membership in the EU may affect about 63% of its exports, including those to the EU and those to countries that have trade pacts with the EU. Since manufacturing is declining and Europe’s importance in the global economy is decreasing, UK exports may not suffer much from Brexit. Countries may prefer to negotiate with the UK than with the EU. 

Although about a seventh of EU output is exported to the UK, EU regulations apply across the British economy, according to Woodford Investment Management. The 100 most costly EU regulations eliminate each year an estimated £33 billion from British gross domestic product (GDP, the value of production in Britain). Being a member of the European Economic Area, like Norway, would allow more flexibility. But even Norway had to adopt three quarters of the EU legislation.

British exports of financial services to the EU amounted to £19.4 billion in 2013, while imports amounted to £3.3 billion. The £16.1 billion surplus was about 0.9% of British GDP. But leaving the EU may deprive the UK of “passporting rights” -- the right of UK-based institutions to sell financial services to an EU country without establishing a branch office there. UK exports of financial services to the EU might halve, a loss of £10 billion.

Preserving access to the single market and passporting rights by staying in the European Economic Area may still injure the city: Britain may have to adopt financial regulations but will not have the power to block unfavorable ones. Ironically, the British government has been more zealous in installing regulations than many continental governments. For example, the Bank of England’s stress tests were stricter than the European Banking Authority’s. In 2019, retail banking in Britain will be separated from commercial banking. 

Britain may also boost exports to China and Hong Kong. But these are only 2% of the UK’s financial services exports, although China is the world’s largest economy (see the Notes), and its appetite for financial imports is rather mild. In 2014, Switzerland brokered a trade deal with China that tore down non-tariff barriers for Swiss financial firms. This deal has yet to pay off.

Despite the referendum, shareholders of the London Stock Exchange (LSE) still plan a $27 billion merger with Deutsche Bourse, which says it has enough support from shareholders to complete the deal, reported the New York Times. LSE shareholders would own 45.6% of the new company; Deutsche Bourse shareholders would own the rest. The LSE group already holds the Milan-based Borsa Italiana. The merger is to save Є450 million a year, a fifth of the combined group’s operating costs.    

Backers of Brexit point out that the UK would no longer have to contribute to the EU budget. For 2015, Britain spent 13 billion pounds, but gained 4.5 billion pounds, implying a net contribution of 8.5 billion pounds, which is equivalent to 7% of annual spending on the National Health Service.

On the other hand, trade with EU countries is crucial for Britain, since they account for most of its exports. And the EU is creating a free trade area with the US, which might have benefited Britain. Euroskeptics counter that most small and medium-size enterprises do not take part in this trade, being burdened by the EU’s administrative barriers. As for trade with the US, an independent Britain can arrange its own terms.

By providing Britain with a freer hand, Brexit might boost its GDP. Open Europe, a research institute arguing for flexible European integration, estimated that under the worst-case scenario, Brexit could knock off 2.2% of Britain’s GDP by 2030. Compare this to the 6% loss that occurred in the 2008-09 recession. On the other hand, if the UK negotiated a free trade deal with Brussels while deregulating on its own, its GDP could rise as much as 1.6%. But it’s unclear whether the EU would offer such generous terms for the exit. Supporters of Brexit contend that largesse would benefit EU members via gains of trade, while opponents claim that EU leaders above all would seek to discourage other exits by punishing this one, reports The Week magazine.

Prospects for small economies

Kazakhstan and Kyrgyzstan may take an interest in how an exit from an economic union affects small open economies like themselves. So let’s look at how Brexit may influence Scotland and Northern Ireland.   

Unlike England and Wales, Scotland voted overwhelmingly to stay, 62% to 38%. The Scots may push for a second referendum on their own independence, or they may negotiate agreements relative to the EU. Historical precedents exist. Denmark was in the European Economic Community but Greenland wasn’t, noted the newspaper Independent.

However, establishing separate trading and immigration regimes for regions of the UK opens another can of worms. If the new tariffs for trade between the EU and the UK are set too high, it will be much more difficult to stop smuggling of EU-made goods through Scotland to other regions of the UK, or vice versa. If the UK restricts immigration, illegal immigrants may come through Scotland. Both may worsen relations between London and Edinburgh.

If Scotland gains independence, it may share the British pound with the UK, join the Eurozone, or create its own currency. Nicola Sturgeon, first minister of Scotland and leader of the Scottish National Party, said the British pound “may not be as attractive a currency” after Brexit. But “it is not the SNP’s policy to seek entry to the euro now or at any time in the foreseeable future.” Joining the common currency zone would ensure robust trade with other EU members; but it could also lower interest rates in Scotland too much, inducing debt. And if Scotland had its own currency, it could devalue it to bolster net exports.

Since 1995, the EU has spent over $1.4 billion on peace-building programs for the UK and Ireland. EU membership of both countries enabled residents of poor Northern Ireland to cross the border and work in Ireland. Martin McGuiness, the deputy first minister of Northern Ireland, called for a referendum on Irish unification. 

Other possible exits

Shortly after the Brexit vote, Berlin warned that five more countries may head for the exit doors: France, the Netherlands, Austria, Finland and Hungary. Berlin has good cause for worry: Once the UK is out of the Union, Germany will have to pay an extra £2.44 billion a year to the EU budget. Marine Le Pen, Head of Front National, a radically right-wing Euroskeptic party in France, promised a referendum if she became President next year. After Dutch voters rejected a treaty between Ukraine and the Union, questions about EU unity became more pointed, reports Express. 

Though the Netherlands holds the EU Presidency, a June poll showed that 54% of the Dutch want a referendum on EU membership; 48% would vote to leave and 45% to remain. Geert Wilders, leader of the Dutch Party for Freedom, pushes for a referendum but is opposed by the ruling coalition and the two largest opposition parties. The referendum would require a constitutional amendment, which in turn requires a two-thirds majority of the Parliament. According to a 2015 law, groups that collect 300,000 signatures may initiate an advisory referendum, like the one on the EU-Ukraine treaty, which Euroskeptic parties can easily win. 

Austria’s radically rightist Freedom Party demands an exit referendum. Had Freedom’s leader Norbert Hofer gained just 31,000 more votes, he would have become President this year. The median voter favors restrictions on immigration. The Party wants to redistribute power to national parliaments, to repeal the Schengen Agreement on free travel, and to enable Austria to shape its own immigration policy. In a poll, 40% of Austrians wanted an Auxit referendum; only 53% said they would vote to remain.

A month before the British referendum, a survey in Italy showed that given the chance 48% would vote to leave the EU. The right-wing Northern League hails the British vote, while the left-wing Five Star Movement wants the lira back. Prime Minister Matteo Renzi fiercely opposes leaving the EU or the Eurozone.

In Germany, the extremely right-wing Alternative for Germany party supported the UK’s vote to leave. But a poll by Stern Magazine showed that only 17% would vote to leave while 79% would stay. Germany has the largest economy in the Union.

Hungary doesn’t plan to leave the EU, but it wants a referendum on Brussels’ plan to enforce migrant quotas for each Union member.

Poland opposes rapid removal of the UK from the EU, since this would empower Berlin and Paris to knit Europe together more tightly. And Warsaw worries about the status of Poles working in the UK.

In Finland, 17,000 people petitioned in less than a week for an exit referendum.  However, though the Euroskeptic Finns Party won 17.7% of the votes in the 2015 general election, it has been losing the support of the electorate, having joined the ruling coalition and reneged on many promises, reports an English newspaper, The Telegraph. For example, in mid-2015, the Party voted for a bailout for Greece, contrary to a favorite theme of their campaigns. More recently, the Party backed cuts in government spending to balance Finland’s budget, reports Stratfor, a research firm. The fiscal deficit in Finland is 3.2% of its GDP. 

Withdrawal of any of these countries from the Eurozone would revive its central bank and currency. It could devalue the latter, making its exports cheaper and its imports more expensive. If it is large, then other European countries would have to devalue the euro in order to compete. If the new currency proved to be more stable over time than the euro, the IMF might add it to the list of reserve currencies, enabling foreign-exchange investors to diversify. Also, the importance of the euro on global foreign exchange markets would diminish from instability. Though withdrawal from the EU technically does not compel withdrawal from the Eurozone (there are no precedents, and talks are possible), it is unlikely that the European Central Bank would accept responsibility for a country that does not play by Union rules.   

Impacts on commodity and currency markets

The Brexit vote quickly cut the value of British assets. Shortly after the referendum, the British pound declined to a 31-year low, down to $1.33, compared with $1.50 just before the referendum. The pound fell about 7% relative to the euro, becoming the worst performer of 31 major currencies in 2016. Meanwhile, gold prices rose 7%. Shares of HSBC, Britain’s largest bank, decreased 5%. By early July, the weakening of the pound had reduced the United Kingdom’s GDP, in terms of euros, below that of France, which had been the world’s sixth-largest economy. (The top four are the United States, China, Japan and Germany.) Several large property companies stopped trading in the UK, due to investors pulling out funds, reports the Independent. Moody’s downgraded its outlook on several UK banks and insurers.

European stock markets – especially those in volatile economies – dove after the vote.  The all-Europe STOXX 600 Index closed 7% lower than on the day before the referendum.  FTSE MIB of Italy and Spain’s IBEX closed over 12% lower. In Japan, another troubled economy, the Nikkei 225 closed 7.9% lower. In the US, the Dow Jones Industrial Average and the S&P 500 Indexes fell 2.5% when European markets closed, but they quickly rallied. 

Impact on the Eurasian Economic Union

The EU is a major trading partner for all EAEU countries except Kyrgyzstan, according to a presidential report from Bishkek. The EU accounts for 30% of exports from Belarus and 20% of its imports. Though trade with it is little more than a tenth as much as trade with Russia, the UK is the second most important trading partner of Belarus, after China. Germany is the second largest export partner of Armenia, accounting for 11.8%, and the fourth largest import partner, accounting for 6.8%, reported the National Statistics of Armenia. Germany, the Netherlands, Italy, Poland and the UK are Russia’s major trading partners, according to Russia’s Federal Customs Service. Germany is the third largest export and import partner of Kazakhstan, according to Kazdata. 

If the withdrawal of the UK leads to recession in the European Union, it will affect Russia and Belarus directly and Armenia and Kazakhstan indirectly. Diminishing demand in Europe, and depreciation of the euro against the ruble or Central Asian currencies, may reduce imports into Europe of EAEU products. Kyrgyzstan might suffer a bit if the Swiss franc depreciates against the som. Belarus may benefit from cheaper British exports, especially if these are inputs into products that it exports to Russia. The Kremlin might hope that European weakening will ease European sanctions, but this is conjecture. 

Expectations of recession in Europe may lead to the same expectations for the US, which the Fed might try to fend off. Indeed, it postponed a rise in interest rates in July due to Brexit, reported Reuters.

Now suppose that the UK negotiates a favorable deal with the EU but other countries do not follow its lead out of the Union; this may occur if the EU reforms its institutions to appease the mildly Euroskeptic median voter. Then the exchange rates of the pound and the euro may stabilize, and economic growth may resume. But UK-EU talks are obstructed by the appointment to Foreign Secretary of Boris Johnson, the former mayor of London and a Brexit leader, famous for undiplomatic comments about world leaders, reported NBC News. 

How has Brexit affected Kazakhstan?  Here, a tenth of fixed-income securities in international reserves are denominated in pounds. It gained by “fully exiting” a long position, initially opened at 1.435 dollars per pound, at the exchange rate of 1.492, a day prior to the announcement of the Brexit vote results, reported Bloomberg.

Withdrawal and accession issues for the Eurasian Economic Union

 Brexit might make Russian leaders more optimistic about the EAEU, since CIS countries that had considered joining the EU, such as Armenia, might find it less appealing now.  Nevertheless, because EAEU members trade little among themselves, some smaller economies may consider withdrawal someday. Kazakhstan is likely to remain in the EAEU because Nazarbayev’s Nur Otan party rules the Parliament. Armenia is also likely to remain, because it needs Russia’s support in its armed conflict with Azerbaijan over Nagorno-Karabakh, which heated up this year. On the other hand, Belarus is more likely to withdraw because its current regime is unpopular and may be replaced by one more hostile to Russia. But Belarus would risk becoming the second Ukraine if its future government decided to withdraw from the EAEU and join the EU.

In Kyrgyzstan, government is decentralized, by Central Asian standards; its tilt toward Russia counts for little. Having undergone two color revolutions, the latter of which created a parliamentary republic, Kyrgyzstan is the only EAEU member in which the Russians might intervene peacefully if it chose to withdraw. In other countries, civil war, territorial disputes, or separatist groups that may resort to terrorism are almost inevitable in the case of a pullout from the EAEU. However, given uneasy relations between Russia and Turkey, in spite of Erdogan’s apologies, Kyrgyzstan --- Turkey’s competitor in textiles, tourism and agriculture -- will still benefit from the EAEU. Growing export revenues will create jobs in other sectors.

The situation may change drastically if the EAEU admits non-CIS countries such as Iran. Russia faces a trade-off between increasing trade in the EAEU and sharing economic influence with other regional powers. It may accept them if it regards these countries as reliable allies.

Problems in the EU may induce EAEU countries to diversify trade. Being devoted to free trade and to the idea of keeping the Eurasian Union economic, rather than political, Astana will push to include more members outside the CIS while Moscow may be more cautious in admitting them. Non-CIS governments can’t appeal to Soviet nostalgia to convince their populations that the EAEU is beneficial, so Russia would need stronger economic arguments to persuade them to join. Hence, these countries may not be reliable political allies. As a close military ally of Moscow, Yerevan will probably take Moscow’s side. The positions of Minsk and Bishkek on admitting new members may grow in importance over time, and the leaders of these countries should play a more active role. To increase the popularity of the regimes of Atambayev and especially Lukashenka among the masses, necessary for sustaining the current geopolitical course in these countries, the Kremlin may encourage the above-mentioned leaders to become more active in foreign policy, including discussions on admittance of new members into the EAEU.                      

Conclusion

Though Britain’s economic performance has been no worse than that of the average European country, Euroskepticism has been particularly strong there. While the European Union increased trade and investment, its centralized institutions garnered criticism, particularly in the recession of 2008 and the migrant crisis of 2014-2015. Though most Brits voted to leave the EU, theirs was not an overwhelming majority. London and Northern Ireland voted to stay. So did Scotland; indeed, Brexit may strengthen the hand of Scots who want independence and who narrowly lost a referendum on that issue a few months ago.  

Brexit may well weaken the pound and the euro in terms of other currencies. Fearing recession, the Fed has already postponed an increase in interest rates. Asset prices in the UK are already on the decline. Expectations of recession can make it a self-fulfilling prophecy, as declining consumption would lead to declining incomes, due to the multiplier effect. Contrary to expectations, Kazakhstan was able to gain from the UK withdrawal by getting rid of pound-denominated assets held by the National Bank. EAEU members should diversify trade, by including new members or signing association agreements. 

Dmitriy Belyanin has a Master’s degree of Business Administration in Finance and a Bachelor of Arts degree in Economics from KIMEP University. Since 2007, he has been writing on issues ranging from stock markets to environmental economics. He is the associate editor of this blog.

Notes

The European Union is the best-known trade pact. Formed in 1951 by Belgium, France, Italy, Luxembourg, the Netherlands, and West Germany as the European Coal and Steel Community, it grew steadily in prestige, and steadily attracted members, including the United Kingdom in 1973. By 2002, the Eurozone was running on all eight cylinders (sans the UK) when the euro was established. In 2009, the pillars of the European Community were abolished, and the European Union in its current form took effect. Common government institutions were established. As stated on the EU website, the European Parliament, directly elected by EU voters every 5 years, the Council of the EU, consisting of heads of state and government of EU members, and the European Commission, consisting of Commissioners, one from each EU country, are the legislative bodies of the EU. The latter two bodies are headquartered in Brussels, while the European Parliament also has offices in Luxembourg, Luxembourg and Strasbourg, France. The European Central Bank, headquartered in Frankfurt, Germany, is responsible for monetary policy.

The Eurostat study of immigration targeted Hungary, Sweden, Austria, Finland, Germany, Switzerland, Norway, Malta, Bulgaria, Belgium, Luxembourg, Cyprus, Netherlands, Denmark, Italy, Greece, France, Ireland and the UK.

Although conventional wisdom says the US is the world’s largest economy, that conclusion flows from using current exchange rates. Since these rates are more volatile than are the sizes of the underlying economies, basing international comparisons on them is misleading. Economists have long pointed out that a better metric is “purchasing power parity,” since this adjusts exchange rates in such a way that a given good would have the same price in every country in terms of the local currency. If a newspaper costs $1 in the US, then it would cost 335 tenge in Kazakhstan, since these are worth a dollar. Under purchasing power parity, China has had the world’s largest economy since 2014, notes Mervyn King.

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