Breakups Always Hurt


The Brexit process has been marred in controversies right from the start and now, as its March 29, 2019 deadline is rapidly approaching, many competing options still remain on the table.


The weeks ahead will be a test of the viability of many plausible scenarios. The U.K. parliament is to vote Tuesday, March 12 on whether it approves proposed amendments to the Brexit deal (withdrawal agreement). The agreement represents the successor arrangements that the U.K. government has negotiated with the EU, which are expected to ensure a soft landing of the U.K. economy after the exit and preserve in some form its preferential access to the EU market. If the vote does not garner sufficient support, there will be a vote on exiting the EU without a deal on Wednesday, March 13 (the so-called “hard”, or “no-deal” Brexit); and if rejected, there will be a vote on requesting a short extension to the process of exiting the EU on March 14. There is also the possibility of a second Brexit referendum, to which the Labor party has recently agreed.

For many analysts, the Brexit process looks like a road to hell paved with ill-conceived intentions. They have pointed to a myriad of risks that could hurt both Britain’s and EU’s near-term and long-term growth prospects. The IMF has recently revised its forecasts of U.K. real GDP growth to 1½ percent this year and next, down from about 1¾ percent in 2016 and 2017, to reflect Brexit-related effects. As the risk of a hard, “no deal” Brexit is looming, could the Brexit process be delayed or derailed by the public’s increased risk aversion?

WTO’boy

What long-term risks does Brexit entail for the U.K.? EU members enjoy free access to the single EU market. Brexit would mean reduced access to the EU market, with negative repercussions for U.K.’s trade in goods and services, business investment and ultimately growth. First of all, Brexit would entail barriers to trade and investment with the EU. Brexit also implies barriers to labor mobility and reduced access to imported, less expensive talent. Last but not least, Brexit would entail barriers to U.K.-based financial institutions’ business with the EU, jeopardizing London’s status as a gateway to EU’s financial services.

Under most possible scenarios, Brexit would deal a blow to the competitiveness of U.K firms in the EU market. Exports to the EU constitute about half of U.K.’s total exports, making the EU its single largest trade partner. Even if the U.K. and the EU agree on a new comprehensive, bilateral free trade pact covering both trade and services, the loss of EU membership would imply higher non-tariff barriers to trade and investment with the EU and restrictions on labor mobility. This would entail permanent output losses over the long run. Under the hard, “no deal” Brexit scenario, the U.K. would lose preferential access to the EU market and revert to the WTO tariffs for goods and even stricter rules on labor mobility. In this scenario, the permanent loss of output would be even larger.

Pounded

In the short run, Brexit fears have fueled uncertainty and financial volatility. The variable that has been hit the hardest is the exchange rate. The U.K. pound has depreciated by about 11 percent shortly after the referendum on increased uncertainty and remains at low levels. There is a risk of a further sharp pound depreciation under a no-deal Brexit. Most analysts agree that the weak pound has had for most part a negative impact on short-term growth. Despite giving a slight boost to U.K. firms’ export competitiveness, the depreciation has been associated with some increase in inflation and a resulting decline in real disposable household incomes.

Some analysts find that Brexit-driven uncertainty has hurt business confidence and business investment in the U.K. Recent empirical analysis suggests that many trade-oriented firms have cut their business investment in the U.K. after the referendum on expectations of higher trading costs.[ The decline in investment could be also driven by expected higher funding costs. Many U.K. banking stocks have underperformed their EU peers on fears a Brexit-triggered domestic slowdown could worsen their performance. This implies higher costs for U.K. banks raising new capital. U.K. corporate spreads also spiked on the Brexit news. Future bad Brexit-related surprises could push up funding costs for U.K. corporates.

The Brexit decision has encouraged U.K.-based international financial services companies to consider relocating to other EU countries. Although it is difficult at this point to reliably estimate the potential damage to the U.K. financial services industry, some estimates in the press suggest that more than a third of the 222 large U.K.-based financial services companies monitored by Ernst and Young are either moving or are considering relocating from the U.K. to the EU. There are several competing destinations for relocating banks, with the top places being occupied by Frankfurt and Dublin. Five of the largest international banks were reported to move assets worth 750 billion euros from London to Frankfurt. Most trading firms, including electronic traders, however, are relocating to Amsterdam. Trading firms have to be physically in the EU after end-March, in order to ensure that EU firms can have access to them. To avert large-scale disruptions in derivative markets, Europe’s financial markets regulator has recently granted UK-based derivatives clearing houses permission to continue serving EU clients in the event of a no-deal Brexit.

Beyond its damage to the U.K., EU and global growth, there is another often ignored Brexit cost. The Brexit decision has set a precedent that could potentially open the Pandora box of further European disintegration. The benefits of the single EU market to its members go up and down with the size of the single market. The U.K. is one of the largest EU members and its exit from the EU could reduce the attractiveness of the EU market for other members. Contagious EU skepticism could take root and spread also to other large EU members, leading to further disruptive exits and complete EU disintegration down the road.


References

Gornicka, Lucyna. 2018. “Brexit Referendum And Business Investment In The UK”. IMF Working Papers 18 (247): 1. doi:10.5089/9781484382011.001.

Chen, Jiaqian, IMF Brexit Blog, December 4, 2018

Chen, Jiaqian, Christian Ebeke, Li Lin, Haonan Qu and Jesse Siminitz, “The Long-Term Impact of Brexit on the European Union,” IMF Brexit Blog, August 13, 2018.

Górnicka Lucyna, 2018, “Brexit Referendum and Business Investment in the UK,” IMF Working Paper WP/18/247.

IMF UK Article IV Report, 2018 and IMF Managing Director’s press conference, September 17, 2018.

“Banks Lay Out Plans To Move Jobs From UK As Prospect Of No-Deal Brexit Looms”. 2018. The Independent. https://www.independent.co.uk/news/business/analysis-and-features/uk-banks-brexit-jobs-no-deal-move-eu-city-london-a8416506.html.

“UK Clearing Houses Approved To Continue EU Business Under No Deal…”. 2019. U.S.. https://www.reuters.com/article/britain-eu-exchanges-idUSL5N20D11N.

“Money Is Flooding Out Of London While The U.K. Bickers Over Brexit”. 2019. Bloomberg.Com. https://www.bloomberg.com/news/articles/2019-01-23/while-u-k-dithers-over-brexit-finance-outflows-pick-up-speed.


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