What is the difference between soft and hard Brexit?

As UK citizens head for the polling booths to vote on the European Union (EU) referendum, investors across the globe are keeping their fingers crossed. Markets across the globe have been volatile on Thursday morning. In India, the Sensex opened in red down by 12.45 points at 26,753.20.

The reason for investors to be on the edge are the implications if UK decides to exit the EU will have on the global economy. While the economies across the globe will feel the impact of Brexit, the magnitude of the impact is still a matter of speculation. This impact can be best explained in two ways, i.e. 'soft-Brexit' or 'hard-Brexit'.

What does a ‘soft-Brexit’ mean?

If UK decides to exit EU then it is likely to negotiate terms similar to members of the European Economic Area (EEA) such as Iceland, Liechtenstein and Norway or will enter into bilateral arrangements such as that between the Switzerland and the EU, said an HDFC Bank report. 

It may still contribute a little to the EU budget and may comply with some EU regulations, however it will have most of its own regulations on issues such as immigration and labour laws.

In this scenario the overall hit to the economy could be small and short-lived and there could be a recovery as early as 2017, said the report. This is termed as 'soft-Brexit'.

Hard-Brexit: Global markets worst nightmare

This scenario is the worst outcome from Brexit and will occur when the policymakers are unable to negotiate favourable terms for either side.

In such a scenario, the UK will likely lose complete access to the EU single market at the end of two years of negotiations. Trade tariffs between the EU and the UK would become compatible with WTO norms.

The UK financial sector could also take a substantial hit. The upshot is that growth would be much weaker for a prolonged period of time forcing the Bank of England (BoE) to possibly ease policy, said the report.

This all will mean a substantial adverse backlash to the global economy.

The HDFC Bank report predicts a 'soft-Brexit' scenario is more likely if UK votes for Brexit. This is given the strong trade and financial linkages it is in the interests of both the UK and EU policymakers to ensure that an eventual exit is neither complicated nor messy.

Another point to keep in mind is that there will be renewed questions raised about the viability of the EU project given that an important member has just chosen to exit the region. Hence, EU policymakers would want to protect the image of the EU to ensure that concerns about other regions (particularly in the periphery) leaving the region does not re-surface.