How a ‘hard’ Brexit would harm US banks, carmakers and drug companies

Nearly three years have passed since British voters chose to leave the European Union, a decision that created uncertainty and risks that have become a focal point of economic forecasters like me.

Yet the U.K. still doesn’t know what sort of Brexit it wants. Does the U.K. want a so-called soft Brexit that allows it to keep most of the benefits of EU membership without certain requirements like the open movement of people? Or a hard Brexit that essentially isolates the U.K. market from the EU’s? Or something in between?

As a result of this indecision, it has become increasingly possible that the U.K. will not be able to negotiate a favorable withdrawal agreement before the revised deadline of April 12 – though that might be extended by several months, a year or longer. If negotiators can’t agree, that could force a type of hard Brexit in which the U.K. crashes out of the EU. While politicians, economists and others expect such an outcome to be costly for the U.K. and Europe, it’s much less clear what the impact would be for U.S. companies.

I’ve been forecasting the outlook for U.S. businesses for more than a decade as part of the Indiana Business Research Center and also co-author of its annual global economic outlook.

I believe American companies most exposed to Brexit are those with operations in the U.K. and in three specific industries: financial, auto and pharmaceutical. To understand why, it’s important to first learn the U.K.‘s special place in the EU for American companies.

America’s top market in the EU

The EU is an integrated market that has essentially eliminated all internal trade barriers between its 28 member states. Capital, goods, services and labor move freely across members’ borders. Regulations have been harmonized. And members share a common set of market rules.

This means that every port of entry into the EU – whether in the U.K., Germany or Bulgaria – is virtually the same. Businesses based in non-member countries face the same hurdles no matter where they send their products.

In practice, however, this hasn’t been quite true. American businesses have preferred to use the U.K. as their main gateway to Europe. Since the EU was set up in 1993, U.S. companies have opened subsidiaries and gained strategic partners in the U.K. to do just that.

As a result, the U.K. is the number one destination for U.S. goods and services within the EU and the second-biggest recipient of American investment. The U.K. is also the biggest investor in the U.S.

The reasons why may be rooted in the fact that the U.S. and the U.K. share a common history and a common language and have cultural ties. For U.S. businesses, removing the language barrier makes the U.K. a relatively low-cost entry point into the EU market.

Few sectors have gained more from this close relationship than financial institutions, carmakers and drug manufacturers. That also means they have the most to lose if Brexit gets messy.

Banks may face significant costs from Brexit. Reueters/Kevin Coombs

1. Banks and the end of ‘passporting’

One of the reasons London became the EU’s largest financial center – and the primary conduit to Europe for U.S. banks – is because of something known as “passporting.”

Passporting allows a company granted regulatory permission to undertake certain activities in one member state to do the same business in every other EU country. In practice, this has meant a U.S. financial company could simply open up an office in London to have access to the entire market. U.K.-based employees were then free to work in any other country in the EU.

But a hard Brexit would change that. U.S. banks with U.K. subsidiaries may need to obtain a new license from regulators in every EU country they operate in, which would disrupt operations.