Life in UK after ”B-Day”
During the weekend of 16th and 17th April, the International Monetary Fund (IMF) hosted its annual spring meeting in Washington D.C. As usual finance ministers and their central bank governors from all leading economies around the world attended. Ahead of the meeting, IMF warned against many negative economic consequences if Britain’s voters decide to leave the EU. The German finance minister made it clear that a British exit (Brexit) from the EU would prompt years of negotiations and it would be very expensive. Even the Italian government is concerned and President Obama has a couple of times declared that a withdrawal would be fatal. For the first time some weeks ago and latest during his visit to London on 23rd April where he told the Britons that a United Kingdom outside the EU would be the last in the queue when it comes to negotiation of a trade agreement with the USA.
As soon as the British finance minister George Osborne was back in the office Monday, April 18th he released a comprehensive report about the economic consequences of a withdrawal from the EU. The report concludes that it will have major economic implications for Britain to withdraw from the EU, and the report is actually quite specific. The Ministry of Finance has calculated that the total value of the country’s GDP will decline by six pct. in total until 2030. The analysis highlights that it will cost every household GPB 4,300 a year (USD 6,200) until 2030.
Apparently, there are plenty of supposedly rational arguments about the consequences and it should be clear how the vote would result. Despite these strong arguments, the polls are showing equal support to stay in or leave the EU.
Clearly, the voters are having a more balanced view on the economic risks, or may simply have reached an income level where they don’t expect it can be worse. Alternatively, the protest movement is so strong that almost half of the voters have been mobilized for that outcome. It might all come into play but I expect the financial markets will need to spend time on at least one of the issues. It is the assessment about how negative a Brexit actually will impact the UK’s economy, which of course is a difficult call as it is unknown territory.
What I regard as the more straightforward prediction is the short-term reaction in the financial market in the case of “status quo” i.e. that United Kingdom remains a member of the EU. Graphic one shows that sterling has lost 11 pct. against a trade-weighted basket of currencies since last November. If UK stays within the EU it is easy to bet on a reversal with a rising pound after the vote. I am certain that equity investors will feel relief if they don’t have to deal with the consequences of a Brexit. Though I expect the above opinion to be a standard market view. With a “stay in” vote, I could imagine that the Bank of England (BoE) will find it easier to hike the rates in favor of the GBP. Whether this is a consensus position I cannot evaluate right now.
BANK OF ENGLAND WORKING OVERTIME
The British central bank has also shared its thoughts in case of a Brexit. The central bank points at one specific risk factor for the UK economy which is the country’s balance of payments deficit. As graphic two shows, the UK has a somewhat larger deficit than other leading economies in the world. BoE warns that the country’s borrowing costs could rise due to the large deficit.
In situations with an increased risk of turmoil in the financial markets a central bank typically provides extra liquidity in the banking system to avoid stress in the money market. However, the initiatives are significant and already now BoE has announced that it is offering British banks nothing less than three additional options to get liquidity during the weeks surrounding the election. As mentioned, it is not unusual that a central bank provides additional liquidity in such situations. Conversely, it is also clear that the BoE is very alert towards turmoil in the financial markets before and after the elections, it seems that the central bank already is working overtime.
In the case of a Brexit, most market participants point at the opposite market reaction as described if the UK stays in. This means a further drop for the British pound and a loss in the stock market with about 10 to 20 pct. The most concrete suggestion concerning the stock market is that shares in major international British companies will weather a Brexit better than medium-sized enterprises. The reason is that medium-sized companies are more domestic-oriented than large companies. Some argue that a Brexit could cause a slowdown in consumer confidence in the UK.
But very interestingly, I increasingly meet a belief that a Brexit over time will be more harmful to the EU than for the UK. This applies to both GDP growth and the investor trust in EU countries’ creditworthiness. This is also my own long-term assessment which I do not see any reason to change.
FEAR FOR THE UNKNOWN
The BoE is right in its concern about the current account deficit. In itself, the deficit is no problem as long as foreign investors have confidence in the British economy. Though exactly trust is essential if a Brexit becomes reality. A direct economic consequence in dealing with this possible challenge I expect to be a tighter public budget which affects the GDP growth negatively near term. I also agree that the uncertainty about UK’s future after a Brexit could weigh on private consumption. However, I expect a limited effect because many households have not experienced any strong income growth since the financial crisis. Further, a majority of households have not benefitted from rising equity and housing markets. At the end of the day, I would not expect most households to feel a significant change, making private consumption relatively robust also in case of a Brexit.
Concerning the GBP exchange rate, my anticipation is that the currency market will be volatile until the vote. But even in the case of a Brexit, I expect sterling to trade higher after the vote because Britain’s economy is, and remains, basically stronger than other European economies. Therefore I maintain my long-standing view that Britain is a more attractive investment destination compared to continental Europe.
Based on the debate in the UK during the past few months I estimate that a Scottish vote about being independent comes into play in case of a Brexit. I judge this will have some effect on the financial markets with a big uncertainty about the value of assets in Scotland.
If the Britons decide to leave the EU the remaining members necessarily must figure out some penalties to deter other countries from having the same exit thoughts. Though, it would surprise me greatly if the business communities on both sides of the English Channel would not push for maintaining trade as it is.
My take on the financial market is actually that many participants fear the unknown rather than fear specific and already defined developments. It’s one of the reasons why I am less concerned about whether it will be a yes or no because the unknown also contains new opportunities.
