UK Economy

Assessing the negative impact of Brexit on the UK economy

Davy View

In this report, we examine the impact of Brexit on the UK economy. In the short term, uncertainty related to a potential EU exit is already hurting GDP growth with consensus forecasts for 2.2% in 2016 now looking too optimistic. In the event of a Brexit, a sharp depreciation in sterling would be likely, with GDP growth likely to suffer further as consumer and business confidence are hurt. Long-run effects are also negative at a minimum of 1-3% of GDP.

GDP growth slowing as uncertainty from Brexit weighs

The main impact so far of uncertainty on Brexit has been the weakness of sterling. However, there are growing signs that consumer and business confidence is being hurt, most apparent in February’s services PMI, the weakest reading since March 2013. In this context, consensus forecasts for 2.2% GDP growth in 2016 now look too optimistic.

An additional fear is that uncertainty on Brexit could serve as a trigger to current imbalances in the UK recovery. UK household debt is still high at 140% of disposable income, with the savings ratio at a historic low of 4.8%. Housing market valuations look stretched ahead of the imposition on April 1st of an additional 3% stamp duty charge for buy-to-let investors. The government and current account deficits are also concerning.

Worst-case scenarios on trade and migration unlikely to emerge

Most studies indicate that Brexit will have a negative impact on the UK economy. The estimates suggest that tariffs and trade barriers could reduce UK GDP by 1-3% over the next decade. Should foreign direct investment, competition or productivity be hurt, the estimated negative impact doubles or triples to 6-9% of GDP.

However, Article 50 of the Lisbon Treaty provides for a two-year ‘cooling off’ period. During this time the UK would still be subject to EU treaties, including the single market. Tariffs, trade barriers and restrictions on the movement of labour would only come into force if the UK failed to secure a trade agreement with the EU – an unlikely scenario.

Our view is that the UK would maintain its membership of the single market. A fudge would be required on the free movement of people, allowing the UK some limited autonomy on migration, but essentially the status quo should be maintained.

Financial services exposed to Brexit; fiscal savings not significant

The UK runs a significant surplus in financial services. In the event of Brexit, the loss of passporting rights and other measures between EU countries and the City of London would hurt the sector. Meanwhile, the UK could save £10bn at best by reducing its EU budget contributions, but this only accounts for 0.5% of GDP. The savings would be far smaller should the UK aim to maintain single market access.

The political timetable

The Brexit referendum will take place on June 23rd. This means that uncertainty on the UK’s continued EU membership will persist for a full four months. Sterling fell sharply on February 22nd following the news that London mayor, Boris Johnson, will oppose the government and campaign for an EU exit. So the Brexit issue could throw up broader concerns on the stability of the UK government and David Cameron’s continued leadership of the Conservative Party.

In the event of Brexit, the UK will invoke Article 50 of the Lisbon Treaty. This provides for a two-year exit period during which the UK will still be subject to all EU treaties including the single market. The challenge will be to negotiate new trade agreements, not only with the EU but also with other countries. A key point is that the UK would be constrained from agreeing new trade agreements with other countries while still a member of the EU during the two-year exit phase.

Prime Minister, David Cameron, has said that the process of invoking article 50 would begin straight after a Brexit vote. However, the Foreign and Commonwealth Office (FCO) has said that it would be difficult to conclude a successful withdrawal and re-negotiation of single market access within the two-year period to July 2018.

During this time, both the French presidential election, due in April-May 2017, and the German federal election, due in August-October 2017, could serve to delay the negotiations. Moreover, trade agreements tend to take a long time to conclude. Negotiations on the Canada-EU Trade Agreement (CETA) were started seven years ago and have still to be ratified by the EU. Any new agreement on trade between the UK and the EU would require the approval by all of the remaining 27 EU members. In short, the UK might have to negotiate not only with the EU institutions but also with each individual member state.

Any extension of the two-year period would require the agreement of all remaining 27 EU member states, strengthening their hand in the preceding trade negotiations. If the UK reached the end of the two-year period and left the EU, not only would single market access be lost but the rights of UK citizens to live and work in the EU would automatically be affected. The FCO has warned that a request for an extension to the two-year period would provide an opportunity for EU member states to extract concessions from the UK.

Opinion polls paint mixed picture

Most opinion polls still indicate a majority in favour of remaining in the EU. Table 1 shows that in six of nine recent surveys there was a majority in favour of remaining in the EU. In two, there was a majority in favour of leaving while in one survey the two sides were even. However, many surveys still indicate undecided voters in the range 15-20%. Looking at 64 surveys on Brexit since September last, 70% indicated a majority in favour of remaining in the EU.


Figure 1: Percentage in favour of remaining in EU, excluding don’t knows


Source: What UK Thinks

How Brexit could hurt the UK economy

There are several channels in which a Brexit could hurt the UK economy over the long term. The three main channels that have been discussed are:

  • Trade effects – primarily the impact of tariffs should the UK fail to negotiate free trade agreements to replace its membership of the EU single market;
  • Productivity – should the UK become less attractive to inward investment, or less open to competition, productivity growth could fall over the long term; and
  • Migration – should the UK restrict migration it could have a substantial impact on wage costs by reducing the supply of both skilled and unskilled labour.

In addition, some commentators have focused on the modest fiscal savings to the government’s budget by eliminating EU contributions. The impact of EU exit on the UK’s financial services industry has also attracted attention, given the potential for measures to divert business activity away from the City of London.

We discuss these measures below. However, the impact of many of them will only be felt over the longer term. In the short term, the key effects will be on confidence, potentially holding back UK companies’ and households’ spending decisions and investors from holding UK assets. We discuss these sensitivities in the next section, before discussing the long-term effects.


Growing signs that Brexit is weighing on economy

Key impact so far has been negative impact on sterling

So far, the depreciation of sterling in 2016 to date has attracted the most attention as evidence of Brexit weighing on the UK economy. Against the euro, sterling has depreciated to 79.2p and against the dollar to $1.39, its weakest level since 2009. However, Figure 2 illustrates that a substantial part of the depreciation had taken place in 2015, before the prospect of Brexit attracted much attention. During this period, UK macroeconomic data were weaker than expected, culminating in downward revisions to GDP growth in late December. Moreover, some of the depreciation has reflected investors pushing out the expected timing of Bank of England interest rate increases. Figure 3 shows that the Overnight Index Swap (OIS) curve implies that interest rates will rise to 0.9% by end-2020. At the beginning of the year, the overnight rate was expected to equal 1.75%. So, should the eventual Brexit referendum yield a vote to stay in the EU, sterling may not fully re-coup its losses against the dollar and euro.

Figure 2: UK exchange rates


Source: Thomson Reuters Datastream

Figure 3: Overnight Index Swap (OIS) rates


Source: Bloomberg

A recent survey by Bloomberg indicated that the vast majority of economists expected that sterling would fall below $1.35 against the dollar in the event of a referendum vote in favour of Brexit. This would push sterling to its lowest level against the dollar since the mid-1980s.

However, a key factor here would be the response of the Bank of England. Faced with a sharp depreciation in sterling (and associated upward pressure on import prices), the MPC’s forecasts for CPI inflation in the August Inflation Report would probably rise, even faced with deteriorating macroeconomic prospects. Moreover, the MPC would probably be reluctant to add to financial uncertainties by considering cuts in the bank or deposit rate.

That said, a vote in favour of Brexit would certainly push sterling lower against both the dollar and euro. Figure 4 shows how sterling lost over 25% against the dollar on three occasions, in 1981, 1993 and 2008. Compared with these episodes, the recent reaction of sterling is modest.

Figure 4: Sterling dollar exchange rates


Source: Thomson Reuters Datastream

Growing signs that uncertainty is weighing on economic activity

A key risk to the UK outlook is that uncertainty leading up to the referendum persuades companies and households to postpone spending decisions. Figure 5 illustrates that the GfK consumer confidence survey fell back in February to its lowest level since December 2014. Within the survey, households’ optimism on economic prospects fell to a three-year low.

So far though there is little sign of household spending falling back. Consumer spending rose by 0.8% in Q4 2015, up 3.2% on the year. Although retail spending was relatively weak through the Christmas trading season, sales volumes bounced back in January, up 2.3% on the month and 5.0% year-on-year (yoy). The labour market also remains supportive. Nominal wages continue to grow by close to 2% with CPI inflation close to zero, implying strong real wage gains. That said, household finances appear stretched. In Q3 2015, the household savings rate was 4.8%, its lowest level on record. In addition, the fall in UK household debt has flattened off and is now close to 140% of disposable incomes. The risk remains that at some point UK households will have to increase their savings.

Figure 5: GfK consumer confidence


Source: Thomson Reuters Datastream

Figure 6: UK household debt and savings ratio


Source: Thomson Reuters Datastream

Business confidence has fallen back slightly over past 12 months

Although UK GDP expanded by 0.5% in Q4 2015, one disappointment was the 2.1% contraction of business investment, albeit still up 2.4% yoy. Surveys of companies’ investment intentions have provided mixed signals on companies’ investment intentions. For example, the Bank of England agents’ scores for January show investment intentions falling back amongst manufacturing companies but not in the services sector. However, the impact of uncertainty on Brexit is only likely to become apparent in sentiment indicators through February and March.

The Deloitte CFO survey for Q4 2015 indicated for the first time that the majority of CFOs thought that the UK’s economic prospects had deteriorated. On balance, only 20% of CFOs expected to increase capital expenditure over the next 12 months, down from the 80% peak recorded at the beginning of 2014. This suggests that companies had already become more pessimistic on the outlook for the UK economy before Brexit came into focus.

Figure 7: Bank of England agents survey


Source: Thomson Reuters Datastream

Figure 8: Deloitte CFO survey


Source: Thomson Reuters Datastream

The most worrying sign that Brexit is starting to hold back UK GDP growth came from the February PMI surveys. The UK services PMI fell to 52.7, its weakest reading since March 2013. Worryingly, service sector companies indicated that jobs growth slowed to a two-and-a-half year low, unsettled by the risk of Brexit, financial market volatility and weak economic growth at home and abroad. The weak services PMI followed poor manufacturing (50.8) and construction (54.2) surveys.

Figure 9: UK composite PMI and GDP growth


Source: Thomson Reuters Datastream

Figure 9 illustrates that the composite PMI is now consistent with sub-2% GDP growth. In this context, the current consensus for a 2.2% calendar year growth in 2016 may be too optimistic.

Trade arrangements after a Brexit vote

Significance of two-year cooling off period after Brexit not fully appreciated

Article 50 of the Lisbon Treaty specifies a minimum exit period of two years. This provides a breathing space during which new trade agreements would have to be found. A key point is that the UK will not only have to reach new arrangements with the EU, but also with other countries such as the US. There are several scenarios should the UK leave the UK:

  • The UK fails to negotiate a trade agreement: This is clearly the worst case and least likely scenario. Tariffs would be imposed on 90% of UK goods exports to the EU. The average EU tariff on manufactured goods from non-EU countries is currently 4%. Retaliatory measures would raise import prices for EU exporters to the UK.
  • The UK stays within the European Free Trade Area (EFTA): This arrangement would replicate the position of Norway, Iceland and Lichtenstein – essentially retaining the status quo in terms of both single market access and free movement of people. Given the focus on migration in the UK, however, the latter condition would be problematic. Norway still has to make EU contributions to maintain its single market access, and such a requirement could halve the UK’s fiscal savings from EU exit.
  • The UK negotiates a bilateral trade agreement: The UK could attempt to negotiate a new trade agreement with the EU, possibly similar to Switzerland’s arrangements with the union. Following a referendum on migration in 2014, Switzerland has been unable to unilaterally impose restrictions with the EU using single market access as an effective block on measures to restrict the free movement of people.

Our view is that in the event of a Brexit vote the third scenario is the most likely one. A bilateral trade agreement could safeguard single market access, with a fudge on migration providing some limited autonomy for the UK while largely maintaining the status quo of free movement of people.

Bargaining power would be with the EU, not the UK

Pro-Brexit campaigners have recently suggested that because the UK runs a trade deficit with the EU it will have the upper hand in trade negotiations. However, the EU still accounts for 44% of the UK’s exports of goods and services. The share of the UK in extra-EU exports is considerably smaller. This means that 3.1% of the GDP of the other 27 EU member states is accounted for by exports to the UK, smaller than the 12.6% UK figure.

Simply put, the UK would have more to lose by not successfully concluding a new trade agreement with the EU. The country would also have to secure trade agreements with other states, not least the US. So close to 65% of export trade could but be at risk in the event of Brexit.

Figure 10: EU average tariff on goods imports, most favoured nation (MFN)


Source World Bank:

In a worst case scenario, the UK would face an average tariff on exports of around 4.6%. Figure 10 shows that the average WTO most favoured nation (MFN) tariff imposed by the EU has fallen from 8% in 1990. However, the impact would vary by sector. For example, the UK car-making industry would be hard hit, suffering a 10% tariff and a 5% tariff on imported components. In contrast, there are very few tariffs for exported services, such as financial and business services in which the UK specialises. However, the Brexit referendum means that the completion of the EU single market in services looks all the more remote.

Figure 11: UK export shares


Source Office for National Statistics:

UK companies would also face the additional administrative costs of clearing border controls and customs, complying with the EU’s rules of origin (i.e. measuring the proportion of inputs from outside EU) and technical standards. Some estimates have put these additional costs as high as 2-4%.

Brexit could hurt investment and productivity growth

Estimates that the UK economy could lose 1-3% of GDP in the event of Brexit double or triple if productivity growth is assumed to fall over the longer term. Moreover, there is strong evidence that the adoption of the single market in the 1990s had far greater benefits to EU countries through competition and efficiency, well beyond trade channels alone. Hence, Brexit could entail negative effects for the UK beyond the negative impact on competitiveness from trade barriers.

For example, the level of fixed capital investment by US multinational affiliates rose significantly in the UK, Ireland, Spain and Sweden after their EU entry. NIESR has estimated that EU exit could reduce foreign direct investment (FDI) into the UK manufacturing sector by 33% and into distribution and financial services by 10%. EU countries hold 46% of stock of FDI in the UK, albeit with flow slowing in recent years. That said, plans to cut the UK corporation tax rate to 17% might help to offset some of the negative impact from a Brexit.

There is strong evidence that EU members tend to trade more heavily with each other than with members of EFTA. Academic evidence has suggested that non-tariff barriers have fallen within the EU compared with the rest of the world – a benefit on which the UK could potentially miss out, implying that UK trade with EU countries would fall by 25% over time, relative to it remaining within the EU.

Figure 12: UK GDP per person employed



One key point is that UK labour productivity has performed poorly since 2008. The country’s recovery has been focused on consumer spending, the services sector and construction but with high-productivity sectors such as exports, financial services and manufacturing lagging behind. The threat of a further negative impact on UK productivity growth from reduced FDI and trade barriers is especially unwelcome at a time when UK productivity growth has been weak.

Migration and the labour market

Net migration into the UK in the year to September 2015 was 323,000, of which the EU accounted for 172,000. Immigration from non-EU countries equalled 191,000. Clearly Brexit is not a panacea for limiting high levels of inward migration from non-EU countries. In any case, most migrants from the EU come to work, pushing up UK annual labour force growth by close to 0.6%.

European Economic Area (EEA) members, Norway, Iceland and Lichtenstein, are required to permit free movement of people on a similar basis to EU countries. Switzerland and the EU are still negotiating after the Swiss referendum to restrict migration in 2014, with single market access an effective bargaining chip holding back Switzerland from unilateral action.

There has been some speculation that the UK could impose a points-based system, similar to Australia and Canada, to cherry-pick migrants with desired skills. However, both these countries adopted points-based systems to raise immigration levels. In any case, immigration of relatively unskilled migrants is highly unlikely to be curtailed significantly.

Figure 13: Net migration into the UK


Source: Office for National Statistics

Figure 14: Net migration into the UK by country


Source: Office for National Statistics

In the event of a Brexit vote, restrictions on migration would not be a one-way street. The latest estimate is that two million British citizens currently live in the EU and would no longer enjoy the advantages of EU citizenship. Those with permanent residency would be able to stay in the EU, but those without might have to leave. Should the UK impose restrictions on the rights of EU citizens living in the UK, reciprocal actions would be likely, especially in Eastern Europe.

The overarching point is that whether skilled or unskilled, the economic evidence suggests that inward migration has helped depress wage costs, address labour shortages and has been a benefit to the UK. Should the UK restrict inward migration, it will reduce the capacity of the labour market to meet demands from companies, hurting the potential for growth.

Our view is that in the event of a Brexit, the UK would essentially maintain its membership of the single market, in a similar fashion to Norway or Switzerland. A fudge would be required on the free movement of people, allowing the UK some autonomy on migration, but essentially the status quo will would be maintained.

Fiscal savings from reduced EU contributions insignificant

Those advocating a Brexit have often pointed to the potential £10bn saving from eliminating contributions to the EU budget. However, this represents just 0.5% of nominal GDP, a relatively small amount relative to the overall 4% government deficit.

In addition, the £10bn figure does not net out the €4.4bn of EU funds disbursed to the UK, for example through the Common Agricultural Policy (CAP). This would reduce the saving to €6bn or just 0.3% of GDP. Moreover, should the UK want to participate in the single market it would have to pay fees for doing so, in a similar fashion to Norway. So the potential savings are insignificant compared to the potential long-term cost to the UK economy.


Could Brexit hurt the City and financial services?

The UK ran a large £39bn surplus, worth 2.2% of GDP, in trade in financial services in 2014, the latest period for which data are available, of which close to half was with EU countries.

In the event of Brexit, one threat to the UK financial services sector would be the loss of passporting rights. Some estimates suggest that this could lead to a loss of £10bn of financial services exports. These rights allow UK-based institutions to sell financial services across the EU without having local branches. Some commentators have argued UK banks might only have to set up ‘brass plate’ companies in EU countries should passporting rights be lost.

However, EU countries could deliberately target new regulations to win business from the UK. For example, the UK recently prevented an ECB decision to force clearing houses settling euro-denominated contracts to relocate to the euro-area. This restriction could be imposed outside the EU, along with other measures designed to hurt UK financial services. HSBC’s Stuart Gulliver has already indicated that his bank could shift 1,000 staff to Paris in the event of a vote for Brexit.


Download full report with analyst certification and important disclosures

Mar 9 2016