Brexit - You go your way and I'll go mine
Written and accurate as at: Jun 27, 2016 Current Stats & Facts
“You go your way and I’ll go mine”. As everyone knows by now, Great Britain voted by referendum on 23 June to leave the European Union. The result was clearly a surprise, at least to financial markets. The arguments for leaving seem to come down to dissatisfaction with the laws “imposed” on the UK by the EU, particularly those relating to the free flow of people between EU nations. Anti-globalisation and anti-elite feelings also drove the Leave case.
What is quite clear is that to Leave is, at best, a very poor economic decision. International trade and investment in Britain will be severely disrupted. My personal view is that both sides overstated their case, so what has happened is only a major economic calamity rather than a complete disaster. But it is concern about the economic effects that caused such widespread market carnage on Friday 24 June. The pound sterling fell by an extraordinary 10%, share markets were down all over the world and commodity prices plummeted. Some markets did, of course, go up, including the US dollar, the Japanese yen (the Japanese won’t be grateful for that), long-term bond markets, gold and Bitcoin. This is why economics matters; because you ignore it at your peril.
So what happens next? Believe it or not, the British government has the power simply to ignore the result of the referendum but, given the 52-48 margin, it’s very unlikely that it would do so. The first step is to invoke Article 50 of the Lisbon Treaty, the means by which Britain informs the EU that it wishes to leave. This begins a two-year clock, during which time Great Britain and the EU negotiate the terms under which the exit is made. Paramount among these terms will be the conditions under which trade takes place. A little thought would suggest that, in this context, the EU will wish to impose on Britain many of the regulations relating to products and the free flow of labour that the Leavers were hoping to escape. Ironically, the main difference may be that the UK still has to abide by the rules but it no longer has the power to influence them! If full agreement is not achieved in two years, Britain exits anyway, although it is possible for the deadline to be extended.
Then, of course, Britain must also negotiate with “third party” countries, including the US and China, that currently have trade agreements with the EU but not with Britain per se. This entire process could well take a decade.
Meanwhile, trade will be severely disrupted, the UK financial sector will probably lose its position as the most important in Europe, and much international investment in the UK will go elsewhere since the UK will no longer serve as an easy gateway to Continental Europe. In addition, there will be negative effects on confidence, and uncertainty will curtail domestic investment.
All of this is long-term. While no-one knows, the UK Treasury and the OECD have estimated that the UK economy will be about 5% smaller 15 years from now than it would otherwise have been.
There has also been talk of a short-term recession as a result of the Leave vote. There is little reason to fear this provided that policymakers are prepared to do “whatever it takes” to ensure that markets continue to function. But the short-term effects on growth will clearly be negative. Given that the global economy is in its sixth successive year of sub-par growth, this was hardly the perfect time to inflict a negative shock.
There are other considerations, of course, that can be loosely labelled “contagion”. First, both Northern Ireland and Scotland voted to Remain (this may come as as surprise to Donald Trump!). There is already strong support in Scotland for another referendum to separate itself from the rest of the UK. The vote to Leave may well lead to the fragmentation of Great Britain!
Of more concern, of course, is what happens to the EU. The sentiments that drove the Leave case are hardly confined to the UK. The success of the vote will give succor to anti-globalisation, anti-elite movements elsewhere. These movements can range from the relatively minor (an independent Catalonia, anyone?) to the very serious (a movement in a large country (Spain or France?) to leave the Eurozone, which would spell the end of the latter).
It is this possibility of contagion that could open up Pandora’s box. While the Eurozone has its faults, its ending would be a momentous event.
It is the fear of contagion that has led many to the belief that the EU should make life as difficult as possible for the UK, “pour encourager les autres”. But punishing Britain would also have severe negative economic effects on the European Union, possibly increasing discontent. Better for the EU to examine itself and fix what ails it (there is no shortage here).
“Large country” contagion is not so simple in any case. The critical difference between the UK and, say, Spain, is that, while they are both members of the EU, Spain is also a member of the common-currency Eurozone. So if Spain were to leave, it would have to institute its own currency to replace the euro. This would immediately depreciate, thus increasing Spain’s debt burden. Much of the UK’s debt is denominated in sterling, so the 10% depreciation last Friday primarily affects the debt-holders (and the tennis players at Wimbledon) rather than the UK itself.
The Economic Effects on Australia
The direct economic effects on Australia should be relatively small, albeit clearly negative. Only about 1.5% of our goods exports go to the UK, and about 8% of our services exports, so tourism may see a larger impact than any other sector. The biggest avenue for economic effects may be via lower commodity prices, caused by lower growth in commodity demand both in the UK and elsewhere. In addition, the Australian banking sector has significant exposure to the UK and the Eurozone.
Depending on what happens in the coming week(s), it now seems far more likely that the RBA will go ahead with the “second shoe” and cut the cash rate again, most likely in August, but with some chance now of July.
This discussion has only scratched the surface, particularly of the political issues. It is clear that we are now in uncharted territory, and volatility in financial markets is likely to remain high as sentiment waxes and wanes.
Chris Caton
Chief Economist
The views expressed in this article are the author’s alone. They should not be otherwise attributed. The author is not licenced to give financial advice, and nothing written here should be construed as such advice.