United Kingdom: Uncertainty looms over the UK's economic outlook post Brexit
June 28, 2016
The United Kingdom’s vote to leave the European Union marked a turning point in British history and has cast a shadow over the country’s growth prospects and its position in the global economy. While Scotland and Northern Ireland, along with London, voted to ‘Remain’, the enthusiasm to stay within the EU was not echoed in Wales and most of England, where the majority of citizens voted to ‘Leave’. The potential economic consequences of this decision continue to evolve as this is the first time since the creation of the European Union that a country has decided to separate. However, regardless of how the UK moves forward form here, there is wide consensus that the country will experience a prolonged period of economic and political uncertainty until new agreements are approved.
The Brexit vote is only the first step toward a full exit, a process that could last years. Until then, the United Kingdom is still part of the European Union, bound by EU treaties and regulations. Last year, the Conservative government promised to hold an in-out referendum and later negotiated the UK’s membership terms in the EU. However, Prime Minister David Cameron, who had originally supported the UK leaving the EU but later changed his tune, failed to convince the British people to stay within the EU despite the major concessions given to the country. This led to his resignation shortly after the results of the referendum were announced. Cameron proclaimed that he will leave the right to decide when to invoke Article 50 of the Lisbon Treaty to his successor and the former mayor of London Boris Johnson seems to be one of the most prominent candidates to become the new prime minister. Article 50 formally triggers the departure of a country from the Union and gives it a two-year period in which to negotiate trade, business and political links with the EU; this period can be prolonged by mutual consent.
The new prime minister will likely be chosen by 2 September before the Conservative’s autumn conference, thus leaving Cameron in charge in the meantime and delaying the Brexit negotiations until after the beginning of September. However, the foreign ministers from the EU’s six founding members do not seem supportive of a delay in exit negotiations and have urged the British government to start the separation process as soon as possible in order to avoid a period of prolonged uncertainty within the already weakened bloc. The result of the referendum has created a split among the European leaders regarding how to handle Britain’s exit from the Union. Meanwhile, in the days following the vote, EU supporters have taken to the streets in protest and a petition to hold a second EU referendum has already been signed by nearly four million people. This paves the way for Parliament to discuss the validity of the vote, even though a rejection of the result is highly unlikely despite the small margin of victory.
The UK’s vote to leave the EU came as a major shock to investors and the immediate reaction in global financial markets was negative. On 24 June, the value of the pound plummeted to an over-thirty-year low. Moreover, Britain’s main stock exchange indices dropped sharply amid political and economic uncertainly. In addition, the banks’ indices plummeted to a seven-year low. Meanwhile, some government bond yields dropped following the country’s vote and gold recorded its biggest surge in years on 24 June as investors rushed to safe-haven assets. Market volatility is very likely to remain high going forward and a prolonged political vacuum will only add to the uncertainty, all of which will weigh on the currency and the investment outlook.
Credit rating agencies downgraded the UK’s AAA credit rating shortly after the vote and they also warned that there could be an abrupt slowdown in GDP growth. The credit downgrade has dealt yet another blow to the economy, especially considering the country’s wide fiscal and current account deficits. Moreover, the UK’s credit outlook was revised down by Moody’s and Fitch Ratings to negative amid fears that that the referendum result will have damaging implications for the country’s medium-term growth outlook. Scott Corfe, Director at Cebr, comments on Brexit:
“The economic situation in the UK is highly volatile and subject to considerable uncertainty. Our central view is that economic growth will be much weaker in the short term as a result of Brexit, with sharp declines in business investment. The Bank of England is expected to respond by cutting the base rate of interest to zero over the next couple of months. Beyond 2018, we expect stronger growth to appear, but this is contingent on the UK reaching an agreeable trading arrangement with the EU, and the UK political landscape stabilising.”
In the short term, the shock of the referendum result and the uncertainty regarding the negotiation period will prompt businesses to delay or cancel their investments. This also suggests slower hiring, which in turn will likely decrease employment growth. For the majority of businesses in the UK, Brexit is a major source of concern. Multinational companies that have chosen to locate their offices in the UK in order to have access to the EU’s single market may consider relocating. However, these decisions will likely take place once the relationship terms between the UK and the EU is clearer. Azad Zangana, Senior European Economist and Strategist at Schroders comments:
“The fall in investment and hiring is likely to be felt by households as employment growth slows and possibly falls. Meanwhile, sterling is expected to depreciate significantly, which could boost the competitiveness of UK exporters, but uncertainty over trade arrangements, especially with Europe, would dampen the otherwise positive impact on overseas demand.”
Mikael Olai Milhøj, Senior Analyst at Danske Bank, further analyzes the consequences of Brexit on the labor market:
“We expect the UK to fall into recession in the second half of the year which would likely cause unemployment to rise with a lag. UK is likely to be hit by falling investments due to higher uncertainty about the future economic environment for British firms. It is also likely that private consumption growth will slow. The longer-term consequences depend on the future UK/EU relationship and are more difficult to estimate. In the very short term, we expect GBP volatility to remain high. We expect EUR/GBP to stabilise in 0.85-0.90 range. Medium and long-term outlook is very uncertain. Flows, growth and relative monetary policy point towards a weaker GBP.”
The sharp depreciation of the sterling will drive inflation up through higher import prices, thus hurting disposable income and decreasing real wages. Moreover, a worsening outlook of the labor market could in turn lead to an increase in precautionary saving, therefore weighing on overall domestic demand. On the bright side, a weaker currency could bode well for trade as it will make the British exports cheaper to sell abroad, even though uncertainty regarding trade agreements, in particular with Europe, will likely offset the positive impact. William Devijlder, Economist at BNP Paribas, comments on the economic implications and also on some potential gains from Brexit:
“We expect the economy to be negatively affected through four main channels: uncertainty and confidence; financial markets; foreign direct investment and other capital flows; and trade and income flows. There are, however, some potential gains from an exit that could soften the impact: an end to the UK’s contribution to EU budget, or at least a reduction, should the UK end up as a European Economic Area (EEA) member; an ability to agree bilateral trade deals with non-EU economies (currently this is done by the EU on behalf of the UK); greater control over regulation, which could raise productivity and supply-side potential; and increased competitiveness, since sterling is expected to weaken.”
Once the separation process officially begins, the United Kingdom will need to negotiate new trade deals with the remaining 27 members of the European Union, with which it has a trade deficit. Today nearly half of its exports go to the EU, with Germany accounting for the biggest share, while imports from the EU account for 54% of the UK’s total imports. Analysts believe that the ideal solution for the UK would be a trade model that minimizes the economic damage while also assuring political independence. An immigration policy that is not independently determined by the UK could be a deal breaker for the British government, since this was one of the main promises of the Leave campaign. However, negotiating such a trade model that achieves the aforementioned objectives is like not an easy task and compromises from both sides would be imperative. In order for Britain to attain full access to the EU market, it might have to negotiate free movement of labor. In the long-term, the UK could also utilize its Commonwealth links to enhance trade with countries outside the EU. Miguel Jimenez, Europe Chief Economist at BBVA comments on the issue of trade agreements:
“The long-term economic impact of an exit for the UK is clearly negative but its magnitude is very uncertain as it depends on the trade agreements that the UK will have to negotiate with the EU and with a large number of third countries (now covered by EU trade agreements). Those models of relationship with the EU that allow a direct access to the EU single market and are less damaging economically (such as the “Norway model”) do not meet the Brexiteers’ demands of no contributions to the EU budget or an independent immigration policy. There are also doubts about a diminished role of the City as a financial center, given that outside the EU the UK would lose its passport to freely provide financial services in Europe, unless an alternative agreement is reached.”
Overall, the economic and political impact of Brexit will broadly depend on the new UK-EU relationship. As analysts at ING have stated that, “the key question is whether the divorce will be amicable or become acrimonious.” A toxic political environment would lead to prolonged negotiations, resulting in significant distress on both sides. James Knightley, Senior Economist at ING, holds the view that:
“In such a caustic environment, trade negotiations are likely to be long and tough and will almost certainly exceed the 2 year window that the UK can continue to operate in with free trade. Consequently UK-EU trade may have to operate under the World Trade Organisation rules for a time, leading to the introduction of some tariffs. This could become something of a barrier to trade although the actual economic cost is not particularly clear. Another consequence of this drawn out situation is that it will show to disaffected continental European voters that leaving the EU is not a panacea (note that opinion polls across Europe show rising demands for new deals and referendums along the UK lines) and may weaken support for anti-establishment political parties.
Given that the vote to leave was a narrow one, there is clearly the possibility that the UK negotiates in good faith and doesn’t seek to flout EU law before concluding formal negotiations. In turn, European politicians take the view that it is better not to penalise a key ally and trade partner meaning an amicable deal can be agreed that minimises the economic costs.”
There are other repercussions associated to Brexit that come in tandem with the economic impact. The exit of the country form the EU will likely result in the resurgence of the Scottish independence issue, thus increasing the possibility of Scotland pushing for a second vote on independence from the UK sooner rather than later. In light of the latest developments, Scotland’s First Minister Nicola Sturgeon has announced that she will seek immediate talks with Brussels and find a way to “protect Scotland’s place in the EU”. This has raised concerns that other pro-EU countries within the United Kingdom may follow in Scotland’s footsteps. Azad Zangana comments on some of the challenges that lie ahead should Scotland pursue independence from the UK:
“The question over Scotland’s membership of the UK is likely to return. The Scottish National Party has said that Brexit would be a sufficient condition to call for another referendum. This could indeed happen in time, but given the collapse in global oil prices, Scottish public finances would struggle without help from Westminster. Moreover, a requirement to join the euro for new entrants raises serious risks for a Scotland in transition. It would need to establish a new currency, and then peg it to the euro for at least two years successfully (along with meet fiscal conditions). We suspect that Scotland would vote to remain in the UK once again were a referendum held in the near-future.”
The results of the referendum have led to uncertainties on the political front as well. The ruling Conservative Party is undergoing an internal crisis as the party has divided into two camps. This has the potential to trigger early elections and delay the exit process further. Adding to that, pressure for Labour Leader Jeremy Corbyn to step down has mounted since the majority of his shadow cabinet has stepped down since the vote. Moreover, the decision to leave the Union, could create a domino effect in other EU countries, in particular those in which the popularity of Eurosceptic parties has recently increased considerably amid the migration crisis and criticism of the structural inefficiencies of the Union.
The risks of an unprecedented exit from the EU are being widely discussed and there is consensus among analysts that the separation process is associated with high economic uncertainty. Mark McNamee, Senior Analyst at Frontier Strategy Group comments on the economic prospective:
“We have revised our outlook for the pound, inflation, GDP, as well as all GDP components. Our revisions assume continued political volatility, particularly driven by a coming Scottish referendum, as well as interest rate cuts by the Bank of England and major drop in investment amid such continued uncertainty in the market.”
The United Kingdom’s economic outlook is gloomy. GDP growth is expected to decelerate markedly both this year and next amid a backdrop of low business sentiment, a significantly-weaker currency and a deteriorated outlook for the labor market. Economic ambiguity will remain high in the near future and it may be years before the full impact can be analyzed. FocusEconomics Consensus Forecast panelists have slashed their forecasts for 2016 and the Consensus Forecast now foresees 1.4% growth—a cut of down 0.5 percentage points from the pre-Brexit estimate last month. Our panel also revised their forecasts for next year as the fallout from the Brexit will continue to be felt. The Consensus Forecast shows GDP expanding 0.3% in 2017, which is down 1.8 percentage points from last month’s estimate.
Author: Dirina Mançellari, Senior Economist