The Brixit

GEOPOLITICS

GLOBAL MARKETS RESEARCH

A UK exit from the EU looks increasingly likely

August 8, 2012

Britain and the EU: An Issues which keep me awake at night special report
Key judgments The eurozone crisis has fuelled eurosceptic sentiment in the UK against a backdrop of a historically ambivalent relationship of which there are significant echoes today.
Research analysts Geopolitics Alastair Newton - NIplc alastair.newton@nomura.com +44 20 7102 3940

The British governments response to the crisis of encouraging eurozone

integration while looking for a looser UK relationship with the EU appears to be fanning the eurosceptic flames.

The governments consequent current aim appears to be to put off a

potentially decisive moment in EU/UK relations until after a 2015 election.

Nevertheless, events in the eurozone as early as this autumn could see

even more pressure from eurosceptic parliamentarians for a firm commitment to a referendum on EU membership.

Further concessions to the eurosceptics could split the ruling coalition,

already subject to significant internal strains, and precipitate an early election to be followed, irrespective of the outcome, by a referendum.

Irrespective of timing, the outcome of a possible plebiscite looks finely

balanced, with much potentially resting on the governments ability to negotiate repatriation of single market-related sovereignty from Brussels.

However, especially with the UK already appearing to have lost some

influence at the negotiating table, we doubt that EU partners would be prepared to make major concessions.

Furthermore, we see a real risk that the UK could even be unable to veto
further transfers from London to Brussels, including over financial market regulation and a pan-EU banking union.

Assessing the costs and benefits of EU membership is made more

complicated still by the unpredictability of the EUs evolution in response to the crisis.

However, the we believe, increasing possibility of either a looser UK

relationship with the EU or a UK exit is bound, in our view, to raise both economic and political concerns, including in financial markets.

See Appendix A-1 for analyst certification, important disclosures and the status of non-US analysts.

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Introduction
Outside the Westminster village the question of the United Kingdoms membership of the European Union currently remains something of a sideshow relative to the allconsuming eurozone crisis. However, as the crisis drags on, it is increasingly fuelling long-smouldering eurosceptic flames in the UK, which have, in turn, been fanned by the current British governments efforts to strike a pragmatic balance between encouraging greater integration to try to stabilise the eurozone while looking to opt the UK itself out of that process. If what many commentators, as well as ourselves, see as the current trend towards some sort of EU/UK rupture, if not an actual exit, persists, we think it important to keep this issue firmly in mind at this time for two reasons in particular, ie: As we argued in a report published earlier this month (and despite the recent efforts of the ECB to calm markets), we believe the next few weeks could be critical in the evolution of the eurozone crisis see EU in September, Nomura Global Markets Research, 1 August 2012. Consequent developments in Europe could, in our view, result in further pressure on the British government at least to commit firmly to a referendum on EU membership. The acceptance earlier this month by the junior coalition partner in the UK, the Liberal Democrats (LibDems), that reform of the upper house of the British parliament, the House of Lords, is off the agenda, at least for the duration of this parliament, has added to strains within the ruling coalition. These are likely to be exacerbated further if, as we expect, the LibDems now block reform of the lower house, the House of Commons, which would have reduced the number of sitting Members of Parliament (MPs) and which analysts believe would have involved boundary changes worth an extra 20 seats or so to the senior coalition partner, the Conservatives, come the next election. Although this issue is, in our view, very unlikely to bring the government down, additional internal tensions in the coalition stand to make further stresses over the EU an issue on which the two partners are deeply divided all the harder to manage. As a result (and assuming that the EU/eurozone does indeed survive the current crisis), two main questions now deserve serious consideration, in our view, ie: Can Britain successfully negotiate the looser relationship with core Europe which the current government seems to be seeking while remaining in the EU? If not, is a British exit a Brixit likely, if not now then after the next general election due in May 2015? 1 This report therefore looks in some depth at recent relevant developments, the current situation and likely near-term developments, as well as looking ahead to how things might look after the next election. However, what we do not consider here is the possible consequences politically, economically and from a markets perspective of a UK exit, judging those to be better assessed on the back of a clearer picture of the context and circumstances in which an exit could occur. Thus, as things stand, we expect this to be the first in a series of reports on EU/UK relations over the coming months.
raising the possibility of a UK exit from the EU within five years and possibly more quickly and could exacerbate further existing strains within Britains ruling coalition The eurozone crisis is fanning eurosceptic flames in the UK

A history of half-heartedness?
To say the Britain may leave the EU or at the very least retreat to a looser arrangement with its continental partners has moved from the realm of eurosceptic daydreaming to that of an entirely plausible side effect of the present euro drama. Philip Stephens, Financial Times, 11 June 2012

It is, in our view, worth reflecting briefly on the UKs history relative to European integration in that it is relevant to where the UK is today and could find itself in the nearto medium term.
1

The UK has previously looked to promote European integration from the sidelines

We have coined the term Brixit based on the current common parlance for a possible Greek exit, ie Grexit.

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Strangely enough, experts in the history of the EU often point to the eminent British statesman, Winston Churchill, as one of the early promoters of European integration. In a speech delivered at Zurich University in September 1946, the by then former British prime minister, reflecting on how to remedy the travails which had long afflicted Europe, opined as follows:
What is this sovereign remedy? It is to recreate the European Family, or as much of it as we can, and to provide it with a structure under which it can dwell in peace, in safety and in freedom. We must build a kind of United States of Europe. The first step in the recreation of the European Family must be a partnership between France and Germany.

However, as Philip Stephens pointed out in the article quoted at the start of this section of our report, Mr Churchill coupled this with the caveatthat the enterprise would begin at Calais. We shall return to this point when we examine the policy of the current British prime minister, David Cameron, later in this report. Nevertheless, by the early 1960s, another British Conservative prime minister, Harold MacMillan, had determined to take the UK into the EUs predecessor, the European Economic Community (EEC), only to find accession vetoed by the then French President Charles de Gaulle. 2 Furthermore, General de Gaulle vetoed UK accession again in 1967, this time following an application for membership by a Labour government led by Harold Wilson. Many historians believe that General de Gaulle was not motivated primarily by economic considerations; rather, he (rightly) saw the UKs membership bid as driven in significant part by London and Washingtons shared desire to undermine Frances bid to usurp US leadership in Europe via the EEC. Nevertheless, with President de Gaulle succeeded by Georges Pompidou, a third British application (under another Conservative prime minister, Edward Heath) was to prove successful and, together with Denmark and Ireland, the UK finally joined the EEC on 1 January 1973. 3 Faced with deep internal divisions on the issue, Mr Wilsons Labour Party fought two elections in 1974 committed to renegotiating the UKs accession terms and then holding a referendum on EEC membership. 4 EEC heads of government agreed a revised deal in Dublin in March 1975, of which Mr Wilson said: I believe that our renegotiation objectives have been substantially, though not completely, achieved. In any case, sufficient had been achieved to persuade 67% of voters on a 65% turn-out to vote in favour of continued membership despite persistent divisions in a government which had had to depend on opposition support to carry most of the parliamentary preparatory votes for the referendum. 5 Indeed, the Conservative Party, under the leadership by now of Margaret Thatcher, had supported UK membership of the EEC in the referendum more or less en masse. In 1984, Mrs Thatcher, by now in her in her sixth year as prime minister, successfully negotiated a rebate to the UKs EEC budget contributions the main reasons for which were: the relatively small benefits which the UK obtains from the Common Agricultural Policy (at that time 80% of the total EEC budget and still 41% of the EUs today); and the UKs then ranking as the third poorest among the 10 member countries. The rebate, which currently amounts to around EUR 5bn per year, has become totemic among Britains political classes, to be defended at almost any cost in the face of increasing resentment among other EU members an issue which, as we consider later in this report, could come to a head before the end of this year.
Even after a change of heart, joining Europe was not straightforward

2 3

The EEC was also commonly referred to at this time as the Common Market.

Denmark and Ireland, together with Norway, were motivated in part by their close economic ties with the UK (and had joined the UKs previous bids for membership). Norways application failed after EEC membership was rejected in a referendum.
4 The February 1974 general election yielded a minority Labour government, which the party was able to turn into a majority in the second election held in October.

So deep were the divisions in the Labour Party that Mr Wilson took the unusual step of suspending the constitutional convention of cabinet collective responsibility on the issue.

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However and having been a driving force behind the Single European Act (SEA) which was signed in early 1986 and came into effect on 1 July 1987 by the time of her third election victory in June 1987, Mrs Thatcher was becoming more antipathetic towards European integration. 6 In a speech delivered in Bruges in September 1988, she made clear her opposition to federalism and increased centralisation of decision-making, arguing that the EECs role should be limited to ensuring free trade and effective competition in Europe. It is from this speech that the Bruges Group, a think-tank which spearheads the intellectual battle against the notion of ever-closer Union in Europe and, above all, against British involvement in a single European state takes its name. 7 Although cross-party, the Bruges Group, whose honorary president is (the now) Baroness Thatcher, is generally associated with the Conservative Party. Faced with growing euroscepticism not only in his partys ranks but also in the British press and among UK voters, Mrs Thatchers successor as prime minister, John Major, negotiated a permanent opt-out from the euro for the UK under the terms of the 1992 Maastricht Treaty (which was also the treaty which saw the EEC make the step-change into the European Union). 8 By the 1990s, Britains two main parties had more or less reversed their respective positioning on Europe, with the Conservative Party becoming increasingly eurosceptic and Labour less so. However, the incoming Labour government of Tony Blair in May 1997 failed to make the case for Europe and the semi-promised referendum of euro membership never materialised.

The launch of the single market in 1987 was the high watermark of UK euro-enthusiasm

Not top of the electorates priorities

The latest Eurobarometer poll indicates that only 13% of the British electorate have a positive image of the EU. Another opinion poll for YouGov indicates that only 15% would vote to stay inside the EU as is; and 50% would vote to leave the EU if the terms of British membership cannot be recast. Economist Intelligence Unit, 13 July 2012

The latest Conservative Party leader (now, additionally, prime minister) David Cameron seemed to go to some lengths to soften his partys stance on Europe in the run-up to the May 2010 general election. However, we think that his primary motive was to dampen an impression among the electorate that Conservative parliamentarians are obsessed by an issue which, to date at least, has been of little concern to the majority of voters. Indeed, the europhile Liberal Democrat party, openly espousing euro membership as part of its campaign, actually increased its share of the vote in 2010 (albeit while losing seats in the process). However, the LibDems accepted that the UK would not join the euro during the lifespan of the current parliament as part of the agreement which saw it form the current coalition government with the Conservatives. The LibDem decision, while probably essential to reaching agreement to form a coalition, may have been made easier by the very clear trend of British public opinion about euro membership. Opinion polls suggest that, for most of the first half of the last decade, opposition to joining the euro was no more than a few percentage points above 50%. By the time of the 2010 general election, it appeared to have risen to around 70%; and more recent polls put it as high as 85%. Although other polls confirm that these numbers do not translate directly into opposition to continued membership of the EU, they are nevertheless indicative of growing euroscepticism among the electorate which would have to be reversed if a referendum on EU membership were not to result in a Brixit.

Europe remains a relatively low priority for British voters

but euroscepticism, especially over euro membership, has continued to rise

6 The SEA was the first major revision to the EECs 1957 founding Treaty of Rome and is the legal basis for the Single Market. 7 8

See the Bruges Group website at http://www.brugesgroup.com/.

There has since been a whole series of UK opt-outs, the latest of which is an option to opt out of cooperation on justice and home affairs in 2014 which, as things stand, we think will be taken up.

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Echoes
George Osborne, the chancellor, blames the euro crisis for Britains recession. He demands action now to stabilise the single currency and talks of the inexorable logic of a leap to much deeper integration. Yet Britain will have no truck with this new order. Philip Stephens, Financial Times, 11 June 2012

Mr Cameron may have hoped that the coalition with the LibDems would give him an adequate counterweight against the eurosceptic wing of his party which has been bolstered by what is widely seen as a predominantly eurosceptic intake of new Conservative MPs in the 2010 election. Indeed, in the early days of the coalition, it looked as if that could prove to be the case as the government was able to keep Europe on a backburner and steer something akin to a middle course especially after parliament passed legislation in early 2011 imposing a referendum lock on any future EU treaty changes involving transfers of power to Brussels. 9 However, those were also what, in retrospect, proved to be the early days of the eurozone crisis. It is the continuing deepening of that crisis which has pushed the Cameron government towards a policy stance in which we see two central elements which together have something of a Churchill-ian echo as follows: support for deeper eurozone integration to save the single currency; and insistence that the UK itself will not only not participate in further integration but also wants to renegotiate the terms of its own EU membership with a view to the possible repatriation of powers from Brussels. It is also the eurozone crisis which has driven the whole question of Europe very much to the fore again in Westminster, with the consequence that in the view of a number of commentators, including ourselves, the government has been scrabbling for some weeks now to find a way to defuse it again. So, the immediate question is: can the Cameron government rein in the eurosceptic rebels or are we now heading inexorably towards a defining moment in the UKs relationship with the EU? Our starting point for considering this question is Mr Camerons relationship with his own party, where we see echoes in some respects of Tony Blairs relationship with the Labour Party. Rather like Mr Blair, Mr Cameron was elected to his partys leadership after a succession of general election defeats. That this was despite the fact that neither is, in our view, rooted in his partys core membership suggests that, in both cases, successive election defeats had driven the party to select as leader someone who was seen as an election winner rather than an ideological soul-mate. However, thereafter, we see two important differences. First, as leader of his party in opposition, Mr Cameron never had his personal equivalent of Mr Blairs Clause IV victory over his own party (which, in our view, could have revolved around the Conservative Partys policy on Europe). 10 Second, unlike Mr Blair in 1997 (and twice thereafter in 2001 and 2005), Mr Cameron failed to secure an overall majority in his first general election as party leader (in 2010), forcing the party into coalition with the LibDems. The perhaps inevitable consequence of this is that Mr Cameron has to deal with a significant number of dissenters from government policy in the ranks of the Parliamentary Conservative Party (PCP), not least over Europe. Indeed (and in an echo of the mid-70s Labour Party), it was over Europe that he suffered his first open rebellion in October 2011 when 81 Conservative MPs defied the party leadership and tabled a motion calling for a referendum on the UKs membership of the EU only defeated thanks to the votes of the LibDems and the Labour Party.

The Cameron government has tried to keep Europe on a backburner

However, the crisis has seen it calling for greater eurozone integration

which has encouraged Conservative eurosceptics to call for an EU referendum

See the European Union Act 2011 available at http://www.legislation.gov.uk/ukpga/2011/12/contents.

The original Clause IV of the Labour Partys constitution dated back to 1918 and, in simple terms, committed the party to the wholesale nationalisation of the means of production, distribution and exchange. Mr Blair was able to secure adoption of significant amendments to the text at a special conference in early 1995, a moment which, for many commentators, marked the transition from Old Labour to New Labour.

10

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At the time, this was the biggest rebellion in the PCP since 1993; and it is widely thought to have been an important factor in Mr Camerons unsuccessful attempt to veto the proposed fiscal treaty at the 8/9 December 2011 European Council unless the UK was guaranteed concessions to protect the City of London from EU regulation. 11 The outcome of the Council meeting, in turn, appears to have made the PCPs eurosceptics even more determined to push their agenda. The governments initial response was to rule out a referendum on EU membership. For example, in an interview with the Sunday Telegraph published on 13 May 2012, the foreign secretary, William Hague, commended the 2011 referendum lock but insisted that a referendum on EU membership per se was the: wrong question at the wrong time partly because we dont know how Europe will develop over the next few years. Tellingly, in our view, Mr Hague added in an echo of Mrs Thatcher circa 1988 that: Europe is the single market, which is there, irrespective of the euro. However, just seven weeks later, Mr Hague said in a BBC interview that the Conservative Party leadership was prepared to debate this stance after Mr Cameron had conceded the possibility of a referendum, albeit not during the current parliament, apparently in response to a letter signed by nearly one hundred members of the PCP calling for a legally binding commitment to such after the next election. 12 On 12 July, the government went even further in its efforts to defuse pressure for a referendum during this parliament when Mr Hague announced a review of the balance of competences of the EU as it affects the United Kingdom to be concluded in 2014. In what appears to us to have been a carefully calibrated statement to the House of Commons, Mr Hague said:
Membership of the EU is in the UKs national interests. The Government are committed to playing a leading role in the EU and protecting the UKs national democracy, but the EU needs to reform to meet the challenges of competitiveness, a stable eurozone and greater democratic legitimacy. The crisis in the eurozone will almost certainly mean great changes for the European Union over the course of this decade. We understand the case for eurozone countries to take steps towards closer fiscal and economic integration as a logical consequence of monetary union. Given the UKs place outside the euro, it is right that we have said we will not be part of that closer integration. 13

with financial market regulation a potentially pivotal issue

Under pressure the government has conceded a possible postelection referendum

and has announced an audit of competences for completion in 2014

He also stressed that the review was purely analytical and, as such, would not make recommendations but was intended to provide a factual basis for a national debate and future policy formulation. For the time being at least, therefore, Conservative Party leaders probably, in our view, to the relief of LibDem leaders seem determined to put off any defining moment until after the next election, which is not due to take place until 7 May 2015. However, even assuming that they are successful (a question we shall return to later in this report), we are left wondering whether the price which they may have to pay will be a bankable commitment to an early post-election referendum on membership in another echo of the Labour Party 40 years earlier.

The Cameron plan

the most serious problem in the short-term is how Mr Cameron rebuilds his authority with a section of his own party which, on issues such as Europe and constitutional reform, is itching for a more robust form of Toryism George Parker and Helen Warrell, Financial Times, 11 July 2012

11 There have since been two further rebellions of close on 100 Conservative Party members in votes in the House of Commons (ie the lower house of the UK parliament), the most recent (in July) over parliamentary and electoral reform consistent with an established pattern for governments in the UK that, once the party whips loses control of backbenchers, rebellion becomes something of a habit. 12

Mr Camerons concession was also made public in the Sunday Telegraph on 1 July.

13

The full text of Mr Hagues statement is available at http://www.fco.gov.uk/en/news/latestnews/?view=PressS&id=787171682.

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The consensus among UK political commentators appears to be that the government has had a difficult time of it since the 2012 budget was announced in March to the point where the term omnishambles has been coined in the press to describe its predicament. The common assumption is that the prime minister will use the current parliamentary recess to regroup, leading to a cabinet reshuffle in the autumn and the announcement of a number of policies intended to placate the Conservative right wing at the 7-10 October party conference. 14 Mr Cameron may also glean some advantage from the likelihood that conceding too much to the eurosceptics could split the coalition, forcing an early general election which opinion polls currently suggest would result in a clear Labour majority. 15 Assuming that Mr Cameron can indeed rein in sufficient of his partys rebels for now at least, we believe his aim will remain to take his party into the next election committing to enter into negotiations to repatriate a list of powers based on Mr Hagues audit, while avoiding any firm commitment to a referendum. The advantages of this approach are that: it should be enough to keep the LibDems on board with the coalition; it enjoys support within the wider Conservative Party; and opinion polls suggest that it has the support of a majority of voters. 16 The second and third points have caused political commentator Peter Kellner to hark back to 1975 as follows:
This echoes what happened in the run-up to the last referendum on Europe in 1975. Then, as now, the Prime Minister, then Labours Harold Wilson, had a problem managing party divisions. Then, as now, most voters wanted to leave the Common Market (as it then was). Then, as now, polling (specifically, a Gallup Poll in November 1974) suggested that, if the Prime Minister renegotiated the terms of Britains membership and recommended acceptance of the new terms, opinion would swing in favour of British membership. Wilson did talk to his European partners, and did claim a great victory (though dispassionate observers could find very little change in Britains membership terms). And voters duly rewarded him with a 2-1 majority for staying in Europe. Plus a change? Pro-Europeans should hope that Cameron is not so much heir to Blair but, rather, wily as Wilson. 17

Conservative rebels are likely to keep up the pressure for a firm referendum commitment

although there is public support for negotiating repatriation of powers

However, the Economist Intelligence Unit (EIU) takes a cautious stance on Mr Camerons prospects of a successful renegotiation, as follows:
The problemis that the rest of the EU is unlikely to give the UK what it wants. Eurozone members have many other issues to focus on and there is little goodwill towards the UK. European politiciansview the UKs proposed agenda as an unwelcome distraction at best, and, at worst, as a positively hostile act. Other EU countries will be strongly opposed to UK demands on, for example, working rights or the EU budget. They will point out that the EUs single market, of which the UK wants to remain a member, rests on a web of bargains from which the UK cannot just disentangle itself. Mr Cameron, then, will struggle to craft a new relationship with the EU that satisfies Conservative eurosceptics and British voters. 18

A renegotiation of membership would face significant headwinds from partners

14

This months abandonment of House of Lords reform, discussed in the introduction to this report, should help Mr Cameron in this respect.

15

For example, a YouGov poll published on 2 August 2012 puts Labour on 44%, the Conservatives on 33%, and the LibDems on 8%. A YouGov poll published in July suggested that 63% of voters support a firm timetable for repatriating powers from Brussels; and that a plurality of 42% would support remaining in the EU on that basis versus 34% wanting to leave. Potentially more telling still, it also suggests that Conservative voters who would vote 58-29% to leave the EU as things stand would vote 55-34% to stay in if the prime minister were able to negotiate terms on which he felt able to recommend staying in. Europe: Cameron as wily as Wilson? by Peter Kellner, 11 July 2012 available at http://yougov.co.uk/news/2012/07/11/europe-cameron-wily-wilson/. Is Britain on its way out of the EU? EIU, 13 July 2012.

16

17

18

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We agree with the EIU that it would be hard to secure a significant shift in sovereignty, although we do think that, like Harold Wilson before him, the UK would manage to wring some relatively minor concessions from EU partners. In such circumstances, we wonder whether Mr Cameron or, indeed, any British prime minister would try to avoid a straight in-out referendum by arguing for a multi-choice one, eg, in on the current terms, in on the renegotiated terms or out. The possible advantage of the latter is that, unless public opinion were to shift significantly in the meantime, the government of the day assuming it supported the UK remaining in the EU could look to profit from voters uncertainty over what they want from Europe. A recent poll conducted by Populus and published on 3 May 2012 by the centre-left think tank, Policy Network, suggested as follows:
36% of people think Britain should stay in the EU but only as a member of a free trade area, 18% as we currently are but with no further integration, and 14% of people say the UK should stay in the EU and play a full role in any further integration. A third think Britain should leave. 19 suggesting that a post-election membership referendum is a real possibility

Policy Network extrapolates from these findings to claim that two-thirds (67%) of people support staying in the European Union. However, we find ourselves sympathising with the interpretation of The Economist magazine, ie that two-thirds either want the UK to leave the EU or to enjoy a relationship based purely on free trade, with a further 18% arguing for no further integration (which is, in our view, a very unlikely scenario barring the complete collapse of the eurozone). As The Economist concludes: That adds up to 87 percent or so being unhappy with the current arrangements. 20 Thus, if one accepts The Economists interpretation of the poll, a multi-choice referendum could still result in a vote where the government of the day would find it very hard to resist pressure to quit the EU especially given the broadly eurosceptic stance of much of the UK press corps which would likely press for an exit in such circumstances. We therefore think it relevant to note that, presenting the findings of the poll during a speech on Britain and the EU on 4 May, the president of Policy Network, Lord Peter Mandelson, went as far as to call for a fresh referendum on EU membership in terms which suggested that he would support a straight in-out vote presumably based on what the EIU refers to as the longstanding conventional wisdom that, faced with such a stark choice and a spate of recent opinion polls notwithstanding, Britains sceptical but pragmatic voters would opt to stay in the EU. One way or the other (ie multi-choice or straight in-out), Mr Cameron and possibly a future Labour prime minister would, in our view, find it at least as difficult as Harold Wilson did in 1975 to unite his party behind a vote to stay in the EU, further compounding the difficulty of securing a popular majority to remain in the Union. In short, we see a non-negligible probability that, however the question put to the electorate was worded, a referendum on EU membership without first securing significant concessions from EU partners would result in the UK leaving the European Union.
We see difficulty securing an in vote no matter how the question is framed

and what could go wrong

Three views of the UK are now common across Europe: that it is unreliable and unconstructive; that it is an active distraction from solving the regions worst crisis since World War Two; and that it appears to be heading for the EUs exit door. Britain, Europe and the City of London: Can the triangle be managed? by Philip Whyte (Centre for European Reform, 20 July 2012) 21

19

Britain and the survival of the European project, Policy Network, 3 May 2012 available at http://www.policynetwork.net/news/3942/Britain-and-the-survival-of-the-European-project.
20

Some ideas for improving Britains relations with Europe. Why they may not work, Bagehots Notebook, The Economist on-line, 1 June 2012.

21

Available at http://www.cer.org.uk/publications/archive/essay/2012/britain-europe-and-city-london-can-trianglebe-managed.

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As we suggested earlier in this report, much could happen to disrupt the Cameron plan before a May 2015 election. First, and perhaps most obviously, Mr Cameron may be facing defeat at the next election. This prospect alone could encourage the Conservative Party to make populist commitments, including a firm pledge of a referendum on EU membership. A variation on this theme lies in the idea that Mr Cameron may be effectively forced to commit to a post-election referendum on EU membership by Labours doing so. We think that, under Ed Milibands leadership, such a move by Labour is unlikely, all other things being equal. However, we also note that the shadow chancellor, Ed Balls, suggested at a seminar organised by the Centre for European Reform (CER) last May that he might favour such a referendum. Furthermore, if as we expect the Conservatives go into the next election campaigning on a strong protecting British sovereignty platform, it may force Labour to make at least matching commitments to the UK electorate as far as the EU is concerned. Additionally, the thinking of both Conservative and Labour could be affected by the performance of the eurosceptic UK Independence Party (UKIP) in the 2014 European Parliament elections. In 2009, UKIP matched Labour with 13 seats, to come joint-second to the Conservatives (with 26 seats); the LibDems were pushed into fourth with 11 seats. Although UKIP has, so far, failed to win a seat in Westminster, a similarly strong or possibly even stronger showing in 2014 could encourage a significant eurosceptic shift on the part of all three major parties. Second, there is, in our view, a non-negligible probability that eurozone crisis-related events will encourage Conservative Party eurosceptics to exert still more pressure on Mr Cameron and that, although we sense that eurozone leaders would prefer to avoid another row with the UK, such events could occur in the very near-term. Consider the following: A single bank supervisor: The 28/29 June European Council meeting agreed (with the support of the UK which is also supportive of a eurozone banking union) to establish a single eurozone bank supervisor, based in the ECB, by the year-end. However, some of the powers that the ECB is seeking (eg, to restructure and/or wind down stressed banks) could go beyond the eurozone and into the single market of all 27 EU members where qualified majority voting (QMV) generally applies, denying the UK a veto. Indeed, the European Commission is already actively promoting a banking union (towards which the bank supervisor is a significant first step) of all EU members rather than just the eurozone. We see an emerging trend here, ie, as Philip Stephens noted in a second article published in June: Decisions about the single market, in which Britain has a vital national interest, would inevitably be made within the single currency grouping. 22 Bank transaction tax: Although four countries (to date) have opted out ie, Ireland, Netherlands, Sweden, UK work is under way to agree and implement a panEuropean bank transaction tax of some sort. What form this may ultimately take is far from clear at this stage, but we understand that some options being considered by the European Commission could affect trades based in London, despite the UKs opting out. Measures which discriminate against non-eurozone countries: The British government was powerless to prevent the ECB from bringing in measures relating to clearing houses handling euro-denominated transactions which discriminate against non-eurozone countries. Further discriminatory steps cannot be ruled out on the road to banking/fiscal union. To be fair, we remain cautious about the speed with which the eurozone will be able to move forward, even with steps which have already been agreed in principle such as the single bank supervisor and the transaction tax. However, the current aim is for extensive plans for these and other measures to be tabled at the 13/14 December 2012 European Council (ie, just one year after Mr Camerons failed veto attempt in 2011).
22

Mr Cameron may yet be forced to give a firm referendum commitment before the election

Eurozone-related events this autumn could force the governments hand sooner

Cut adrift between America and Europe by Philip Stephens, Financial Times, 21 June 2012

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Furthermore, as we noted earlier, a deepening of the eurozone crisis in the immediate future remains a real possibility despite the recent efforts of the ECB in particular to calm markets. This, in turn, could spur acceleration in integration in order to try to prevent the collapse of the eurozone, thereby advancing projects which are likely to prove difficult for the British government. One thing which is clear is that (assuming the eurozone does not collapse completely) it is only a matter of time, in our view, before crisis-related steps are agreed which necessitate treaty changes. In those circumstances, the British government will almost certainly demand treaty change for treaty change in an effort to repatriate powers, ie be looking to win repatriation of powers to London for every concession on treaty reform sought by the eurozone on a one-for-one basis. However, in so doing the UK would likely be looking to repatriate powers which EU partners may be unwilling to concede within the context of the single market. Third, and finally, we do not rule out the possibility of a serious schism between the EU and the UK developing over non-crisis-related issues, with the 2014-20 EU budget an obvious potential bone of contention. For sure, the UK is not alone in calling for the budget to be frozen in real terms. However, we believe that some EU members may look to the UK to forego its longstanding budget rebate as part of agreeing such a deal, a move which eurosceptics would almost certainly look to exploit in pursuit of their agenda. In the event of either the second or the third of these scenarios occurring, Mr Cameron could find himself in a very difficult position indeed, ie, under even more intense pressure from within the ranks of his own party to call an immediate referendum but knowing that, if he were to agree, this could be a bridge too far for the pro-EU LibDems who would try to force an early election rather than support the legislation necessary to hold a referendum. Thus, if there is to be a referendum in the UK on EU membership, it does indeed look likely to be after the next election, rather than before; but this could be at the price of the election being brought forward. Overall, therefore, we agree with CERs Philip Whyte that, for both domestic and nondomestic reasons, Mr Camerons current roadmap to get from where he stands now on the EU to the other side of the next election looks to be a very tricky one to navigate successfully.
especially with the prospect of treaty changes looming

EU budget negotiations could prove to be another stumbling block

An early move to a referendum could split the government, leading to an early election

And if the Cameron plan works?

The strategic consequences of an integrated eurozone are something else. If (and, given the record of the past couple of years, it remains an important if) governments create an economic and political union, Britains voice will be weakened. Decisions on Europes economic policy have already gravitated towards the euro-plus group of present and prospective members of the single currency. This process will be greatly accelerated if financial is added to fiscal integration. Philip Stephens, Financial Times, 21 June 2012

As the previous section of this report suggests, events at and since the 8/9 December 2011 European Council, tell us that Mr Stephens could just as easily have suggested that Britains voice will be further weakened in the text quoted immediately above. That said, we also acknowledged Mr Stephens point that, with smart diplomacy and a modicum of compromise Britain could continue to enjoy substantial sway over policy decisions in the face of greater eurozone integration. However, something closer to the other end of the spectrum ie akin to the status of Iceland, Liechtenstein and Norway in the European Economic Area can certainly not be ruled out, in our view, even with Britain still in the EU. Similar to a Brixit, the impact which a looser relationship with the EU would have on the UK economy in general and on the financial services sector in the UK in particular is not clear at this time, even though British eurosceptics argue that being freed from EU regulation would be a booster. 23. However, the prospect is, in our view, bound to raise
See, eg, Continental shift: Safeguarding the UKs financial trade in a changing Europe by Stephen Booth et al (Open Europe, December 2011) available at http://www.openeurope.org.uk/Content/Documents/PDFs/continentalshift.pdf.
23

Even if the Cameron plan works, the UK will likely have less say over future regulation

with uncertain consequences for the economy and for the financial sector

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concerns indeed, is doing so already in the City to judge from, for example, an article published by the Financial Times in June. 24 What is not clear is the extent to which the costs and benefits of EU membership are being accurately assessed. In this context, The Economist recently commented as follows:
Eurosceptics routinely get their costs and benefits wrong, both underestimating the present value of the single market and overestimating the ease with which Britain would negotiate a more attractive free trade pact with Europe. 25

That said, the same article offers a warning that there are degrees of EU integration which could significantly shift the balance towards costs and away from benefits and perhaps even more so with a weakened pro-free trade and competition UK voice at the table. We, therefore, see economic as well as political sense in the UK governments current efforts to put off any decisive moment at least until after the next election. For, as Lord Mandelson put it in his 4 May speech:
[A referendum] would not be relevant until the new shape of Europe, and the success or otherwise of its eurozone Mk 2, finally emerges and considered judgement is possible, something which is likely to be a fair way off.

However, the question still remains as to whether the UKs domestic politics will wait that long.

24 25

Cameron warned on risks of EU exit by George Parker et al, Financial Times, 25 June 2012.

Some ideas for improving Britains relations with Europe. Why they may not work, Bagehots Notebook, The Economist on-line, 1 June 2012.

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Appendix A-1
Analyst Certification
I, Alastair Newton, hereby certify (1) that the views expressed in this Research report accurately reflect my personal views about any or all of the subject securities or issuers referred to in this Research report, (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this Research report and (3) no part of my compensation is tied to any specific investment banking transactions performed by Nomura Securities International, Inc., Nomura International plc or any other Nomura Group company.

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Important Disclosures
Online availability of research and conflict-of-interest disclosures
Nomura research is available on www.nomuranow.com/research, Bloomberg, Capital IQ, Factset, MarkitHub, Reuters and ThomsonOne. Important disclosures may be read at http://go.nomuranow.com/research/globalresearchportal/pages/disclosures/disclosures.aspx or requested from Nomura Securities International, Inc., on 1-877-865-5752. If you have any difficulties with the website, please email grpsupporteu@nomura.com for help. The analysts responsible for preparing this report have received compensation based upon various factors including the firm's total revenues, a portion of which is generated by Investment Banking activities. Unless otherwise noted, the non-US analysts listed at the front of this report are not registered/qualified as research analysts under FINRA/NYSE rules, may not be associated persons of NSI, and may not be subject to FINRA Rule 2711 and NYSE Rule 472 restrictions on communications with covered companies, public appearances, and trading securities held by a research analyst account. Any authors named in this report are research analysts unless otherwise indicated. Industry Specialists identified in some Nomura International plc research reports are employees within the Firm who are responsible for the sales and trading effort in the sector for which they have coverage. Industry Specialists do not contribute in any manner to the content of research reports in which their names appear. Marketing Analysts identified in some Nomura research reports are research analysts employed by Nomura International plc who are primarily responsible for marketing Nomuras Equity Research product in the sector for which they have coverage. Marketing Analysts may also contribute to research reports in which their names appear and publish research on their sector.

Distribution of ratings (US)

The distribution of all ratings published by Nomura US Equity Research is as follows: 43% have been assigned a Buy rating which, for purposes of mandatory disclosures, are classified as a Buy rating; 21% of companies with this rating are investment banking clients of the Nomura Group*. 51% have been assigned a Neutral rating which, for purposes of mandatory disclosures, is classified as a Hold rating; 9% of companies with this rating are investment banking clients of the Nomura Group*. 6% have been assigned a Reduce rating which, for purposes of mandatory disclosures, are classified as a Sell rating; 0% of companies with this rating are investment banking clients of the Nomura Group*. As at 30 June 2012. *The Nomura Group as defined in the Disclaimer section at the end of this report.

Distribution of ratings (Global)

The distribution of all ratings published by Nomura Global Equity Research is as follows: 46% have been assigned a Buy rating which, for purposes of mandatory disclosures, are classified as a Buy rating; 40% of companies with this rating are investment banking clients of the Nomura Group*. 43% have been assigned a Neutral rating which, for purposes of mandatory disclosures, is classified as a Hold rating; 46% of companies with this rating are investment banking clients of the Nomura Group*. 11% have been assigned a Reduce rating which, for purposes of mandatory disclosures, are classified as a Sell rating; 21% of companies with this rating are investment banking clients of the Nomura Group*. As at 30 June 2012. *The Nomura Group as defined in the Disclaimer section at the end of this report.

Explanation of Nomura's equity research rating system in Europe, Middle East and Africa, US and Latin America
The rating system is a relative system indicating expected performance against a specific benchmark identified for each individual stock. Analysts may also indicate absolute upside to target price defined as (fair value - current price)/current price, subject to limited management discretion. In most cases, the fair value will equal the analyst's assessment of the current intrinsic fair value of the stock using an appropriate valuation methodology such as discounted cash flow or multiple analysis, etc. STOCKS A rating of 'Buy', indicates that the analyst expects the stock to outperform the Benchmark over the next 12 months. A rating of 'Neutral', indicates that the analyst expects the stock to perform in line with the Benchmark over the next 12 months. A rating of 'Reduce', indicates that the analyst expects the stock to underperform the Benchmark over the next 12 months. A rating of 'Suspended', indicates that the rating, target price and estimates have been suspended temporarily to comply with applicable regulations and/or firm policies in certain circumstances including, but not limited to, when Nomura is acting in an advisory capacity in a merger or strategic transaction involving the company. Benchmarks are as follows: United States/Europe: please see valuation methodologies for explanations of relevant benchmarks for stocks, which can be accessed at: http://go.nomuranow.com/research/globalresearchportal/pages/disclosures/disclosures.aspx; Global Emerging Markets (ex-Asia): MSCI Emerging Markets ex-Asia, unless otherwise stated in the valuation methodology. SECTORS A 'Bullish' stance, indicates that the analyst expects the sector to outperform the Benchmark during the next 12 months. A 'Neutral' stance, indicates that the analyst expects the sector to perform in line with the Benchmark during the next 12 months. A 'Bearish' stance, indicates that the analyst expects the sector to underperform the Benchmark during the next 12 months. Benchmarks are as follows: United States: S&P 500; Europe: Dow Jones STOXX 600; Global Emerging Markets (ex-Asia): MSCI Emerging Markets ex-Asia.

Explanation of Nomura's equity research rating system in Japan and Asia ex-Japan
STOCKS Stock recommendations are based on absolute valuation upside (downside), which is defined as (Target Price - Current Price) / Current Price, subject to limited management discretion. In most cases, the Target Price will equal the analyst's 12-month intrinsic valuation of the stock, based on an appropriate valuation methodology such as discounted cash flow, multiple analysis, etc. A 'Buy' recommendation indicates that potential upside is 15% or more. A 'Neutral' recommendation indicates that potential upside is less than 15% or downside is less than 5%. A 'Reduce' recommendation indicates that potential downside is 5% or more. A rating of 'Suspended' indicates that the rating and target price have been suspended temporarily to comply with applicable regulations and/or firm policies in certain circumstances including when Nomura is acting in an advisory capacity in a merger or strategic transaction involving the subject company.

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Securities and/or companies that are labelled as 'Not rated' or shown as 'No rating' are not in regular research coverage of the Nomura entity identified in the top banner. Investors should not expect continuing or additional information from Nomura relating to such securities and/or companies. SECTORS A 'Bullish' rating means most stocks in the sector have (or the weighted average recommendation of the stocks under coverage is) a positive absolute recommendation. A 'Neutral' rating means most stocks in the sector have (or the weighted average recommendation of the stocks under coverage is) a neutral absolute recommendation. A 'Bearish' rating means most stocks in the sector have (or the weighted average recommendation of the stocks under coverage is) a negative absolute recommendation.

Target Price
A Target Price, if discussed, reflect in part the analyst's estimates for the company's earnings. The achievement of any target price may be impeded by general market and macroeconomic trends, and by other risks related to the company or the market, and may not occur if the company's earnings differ from estimates.

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