Brexit: So Far, the Costs Are All to the UK

by Erik F. Nielsen, Group Chief Economist and Head of CIB Research, UniCredit

The British population defied the advice of the vast majority of domestic and international political leaders, economic and financial institutions, the business elite and most of the media when they voted to leave the EU. 

The vote, which divided England (excluding London) and Wales against Scotland, Northern Ireland and London; old against young; and people with relatively little education against the ‘educated elite’, has already had three clearly negative effects on the UK.

First, the outcome of the referendum has caused huge uncertainty in the UK with respect to politics and policies. While the leadership vacuum after Cameron’s resignation was resolved faster than expected, new prime minister Theresa May is struggling with potentially unresolvable conflicts. Her first task was to appoint a government that reaches across the pro-EU and anti-EU divide in the Conservative Party. To do so, she appointed three prominent Brexit advocates (now dubbed ‘Brexiteers’) to the Foreign Office, and the newly created departments for International Trade and Exiting the EU. So far, most reporting from these ministries has been about turf battles.

While some have suggested that these ministers have been set up to fail, ultimately, the question of Brexit cannot be delegated. Not surprisingly, Theresa May’s first trip as prime minister was to Edinburgh to meet with First Minister of Scotland, Nicola Sturgeon, who predictably had responded to the Brexit vote with a vow to hold another referendum on Scottish independence. To keep the UK together is no doubt paramount to Theresa May.

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The new prime minister’s second trip was to Berlin and Paris, where the message from the hosts was clear: we want good relations, but there will be no cherry-picking from the EU agenda. Access to the Single Market, which includes ‘passporting’ (which is critical for London’s financial industry to continue to roam in Europe), will be conditional upon continued free movement of people. And negotiations will not begin until the UK has invoked Article 50, which in turn will start a clock that runs for only two years. So far, May has asked her European partners to be at least willing to sketch the possible landing field before she invokes Article 50; a request Germany seems willing to entertain, while France remains reluctant – at least until after the French elections.

On the one hand, Theresa May has committed herself to Brexit and suggested that Article 50 will be invoked early next year. On the other hand, elections in the Netherlands, France and Germany during 2017 will strictly limit the degree of flexibility towards the UK during this period. The European Parliament, which will need to approve whatever terms the UK receives, will hold new elections in 2019, which puts a major premium on a deal before then. While getting a divorce agreement to split assets and liabilities, including pension obligations, seems feasible in this time frame, getting a bespoke and comprehensive trade deal seems almost impossible.

Second, the market did not like the outcome of the Brexit vote and the uncertainty that came with it. The pound has dropped by more than 10% as investors have become nervous about the UK’s ability to attract the necessary investments and loans from abroad to finance its near-record current account deficit. The real estate sector is particularly vulnerable, and several major investment funds have suspended withdrawals from their property-related funds. 

Third, the Brexit decision has also led to a clear slowing down of the UK economy. While retail sales grew nicely in July (helped by good weather), investments are being put on hold, and early indications suggest that export orders are not picking up measurably in spite of the weaker pound. In early August, the Bank of England cut interest rates to 0.25%, introduced a new scheme to ensure that the lower rates will be passed on to new lending, and increased quantitative easing (QE). Even with this large package of easing measures, the Bank of England revised down its 2017 GDP forecast to 0.8% from 2.3%.

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A likely recession?

These measures, along with a less austere fiscal programme, will help cushion the blow, but at UniCredit Research we still think the UK economy will come to a halt and most likely move into recession during the next 12-18 months. Stimulus of demand will help – indeed, the UK may soon see a dose of (unannounced) ‘helicopter money’ as larger than previously planned budget deficits are broadly matched by the new round of QE to vacuum the additional debt financing – but while that may help in the short term, the underlying problem in the UK is now structural. What type of trade and investment relationships with Europe and the rest of the world will the UK end up with? Nobody will know for several years.

While these effects on the UK were broadly expected, most commentators extended their concerns to Europe. However, these concerns have not been justified so far. The political implications in Europe have been the opposite of the often predicted domino effect in which others would follow the UK out of the EU. The Spanish elections immediately after the Brexit vote surprised with a clear swing back to pro-EU mainstream parties, while opinion polls in virtually all other European countries have shown steady or strengthened support for mainstream (pro-EU) parties, even as Europe has suffered several terror attacks, events that historically tend to support more nationalistic parties.

Meanwhile, the economic outlook for Europe has weakened only marginally. Businesses report that they expect a slowdown only in exports to, and investment in, the UK, with virtually no other negative effects being reported.

It is still early days after the UK’s shock decision to leave the EU, but the effects are already clear: the UK is today a politically and economically weaker country than it was before 23 June. One would hope there would be a way back from this ill-conceived decision, but it would take more change in the UK political fabric than one could reasonably expect in the present environment.