Economic consequences of Brexit

Web Posted on : Mon, 29 Feb 2016

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The British Prime Minister called for a referendum on leaving the European Union (EU) to be held on 23 June. The accession to the EU in 1973 has benefited the UK through freer trade, inflow of workers and investment by companies looking to access European markets. A British exit from the EU, “Brexit”, will lead to a renegotiation of the agreements on trade and free movement of labour, which could be damaging for the UK economy for a number of reasons.

First, it could hurt exports as the UK is likely to lose its free access to the EU single market, its largest export destination, accounting for 45% of total exports. Brexit could also result in losing access to other markets beyond the EU. The UK will need to negotiate new agreements with the 60 trading partners that currently have agreements with the EU.

Second, Brexit could undermine the UK’s financial services sector, which accounts for around 10% of total exports. UK-authorised banks are likely to lose their EU “passport”, which allows them to do business in any EU state once they have set up shop in the UK. As a result, banks might move out of London to Frankfurt or Paris. The UK might therefore lose its position as a global leader for financial services.

Third, exiting the EU would result in lower immigration into the UK. Almost half of total immigrants into the UK come from EU countries. Brexit would reduce this flow of migrants, limiting the expansion of the UK labour force, which would weaken the growth of the economy.

Fourth, Brexit is likely to result in a prolonged period of uncertainty, which would be damaging for the economy. One source of uncertainty is the lack of clarity about the UK’s relationship with the EU during the separation negotiation period, which would take two years. A second source of uncertainty is the political ramifications of Brexit. The Prime Minister will likely resign in the aftermath, having campaigned for the UK to remain in the EU. Scotland could hold another referendum to leave the UK and stay within the EU.

This uncertainty could prove devastating for the UK economy. It could result in a downgrade of the UK’s rating, leading to higher borrowing costs for the government. Businesses are likely to delay investment spending and hiring decisions until there is more clarity on the outlook. UK house prices will be negatively impacted by lower investments. Lower house prices and the uncertain outlook could drive consumers to save more and spend less. Furthermore, foreign investors would divest out of the UK, leading to capital outflows and a depreciation of the pound. Indeed, sterling fell 3.2% in the 5 days after the referendum was announced. Currency depreciation could then lead to high inflation.

British pound vs US dollar

Sources: Bloomberg and QNB Economics

The combination of slower growth and higher inflation created by Brexit would cause a dilemma for UK policymakers. If they decide to tighten policy, they risk sending the economy into a recession. But if they decide to ease policy, this could result in even higher inflation. Even if they decide to pursue easier policy, the options might be limited. With interest rates near zero, the potential for monetary policy to be eased further is constrained, even in the new world of negative interest rates (see our commentary Can interest rates go even further into negative territory?). In addition, with public debt at near 90% of GDP and a government intent on fiscal consolidation, the capacity to ease fiscal policy is limited.

In summary, the economic arguments against Brexit are substantial. The long-term economic impact of leaving the EU would most likely be negative for the UK. Instead, the stronger arguments for Brexit are more political in nature, revolving around the principle of maintaining the UK’s sovereignty. Brexit or not, in the short-term, the referendum is likely to cause considerable uncertainty. Consequently, UK growth is likely to slow during the first half of this year.

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