2016 is the year the United Kingdom (UK) decided to strike out on its own. The decision to exit the European Union (EU) and untether itself from the great European experiment was a surprise result. Now the future of the UK is in flux as the consequences of the decision are subject to years of negotiation.
This article is from our latest edition of MarketWatch, an in-depth report focusing on the economic and political outlook for 2017.
Despite naysaying surrounding the economic impact of Brexit, the headlines out of the UK since the referendum have been surprisingly positive. The UK economy has been resilient on the back of strong retail sales and industrial production, while manufacturing and services data show positive readings. There has been no wholesale exit of companies to other parts of the EU and export manufacturing has been booming.
The true implications will be more evident during 2017 as the effect of the massive sterling depreciation hits home. Consumers will see inflation erode their buying power and corporate investment and employment will slow. The longer-term fallout, including companies compelled to move to maintain access to the European market, will not begin to manifest itself for some time.
Although the vote to leave the EU took place in June last year, the process of leaving has yet to begin. This is the first instance of a nation leaving the EU so it is not surprising that the process is not linear. Complicating things further is the fact that Britain, unlike most modern states, does not have a codified constitution. Its unwritten constitution is formed by Acts of Parliament, court judgements and conventions. That has required the courts to determine the extent of Parliamentary involvement as some rights of British citizens will be rescinded and replaced in the exit process.
The focus of talks will be the future of trade relations between the UK and the EU and there are a myriad of potential trading arrangements. The cost and impact of these various alternatives come down to one simple question: is it more important for Britons to limit immigration or have access to the EU Single Market? The prime minister has made it clear that limiting immigration is paramount. As a result, the UK will not meet the “four freedoms” of the Single Market: free movement of goods, capital, services and people. Any trade deal outside the Single Market will result in higher cost of trade for the UK and stiffer trade regulations. How much more it will cost depends on the eventual deal. While the legal aspects of Brexit will be sorted out within the two-year deadline, a trade deal is likely to take closer to five years to negotiate. If an interim deal is not reached within the two-year period, UK trade with the EU would default to World Trade Organisation tariffs, which are on average 5% but swell to over 12.5% for agricultural products and 42% for dairy products.
Many commentators predicted an immediate crash in the UK economy if it voted to leave the EU. However, the only real impact has been a c.20% devaluation of the currency.
A number of factors, including increased exports and more domestic tourism due to the weaker pound, have meant that many economic indicators have painted a rosy picture for the UK in the last few months. Nevertheless, the economic outlook is weaker than in the first half of 2016.
Most forecasts suggest that as we move closer to the EU exit, we will see increased economic friction. Gross Domestic Product (GDP) forecasts are beginning to reflect this with our economists projecting a significant slowdown to 0.2% in 2017. Aside from the obvious strains of a devalued currency on importers, we are likely to see a drag on business investment as companies delay investment plans due to uncertainty on the UK’s trading relationship with the EU. Households are also expected to feel further strain in the coming months from inflation.
UK household savings rate, in %
Source: Office of National Statistics
The weaker pound will cause increased inflation in the medium and longer term which will hinder growth. More importantly, any temporary boost to exports will be overwhelmed by the impact on consumers. Real wage growth, having only recently turned positive, will begin to erode as the employment market softens. With inflation set to rise towards 3% in late 2017 and employment slowing, consumers will start to feel the real impact on their wallets.
The UK has had budget and current account deficits for the last number of years. Running large deficits over an extended period of time comes at a cost – deficits have to be financed by overseas investors buying British assets or Britons selling overseas assets. To date, financial markets have been relaxed about Britain running a current account deficit of 7% of GDP, but uncertainty around Brexit means it is time to consider closing it. A large current account deficit is vulnerable to reduced foreign investor appetite in UK assets, a worry in the wake of Brexit.
A classic method to close deficits, and a technique deployed by Britain in the 1960s, is to devalue the currency. This is one of the reasons why many commentators called for the Bank of England not to intervene as the pound was plummeting after the Brexit vote and continue to call for further accommodative monetary policy going forward. In theory, sterling’s devaluation makes imports more expensive and exports less expensive, allowing manufacturers to increase market share, leading to an increase in investment and helping the balance of payments. However, due to lingering uncertainty for the next few years, the likelihood of this actually transpiring is low.
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