Britain’s Chancellor George Osborne tried to calm tumultuous seas on Monday, 23rd of June, as markets struggled to understand the implications of the vote for the UK to leave the European Union. It’s unlikely it will be the last time. The truth is that Britain is now in the preamble of a deep recession, and a political “perfect storm”.
Britain’s vote to leave the EU is not legally binding, and there are a few ways it could theoretically be blocked or overturned. However, as the BBC noted, “it would be seen as political suicide to go against the will of the people as expressed in a referendum.”
Article 50 of the Treaty on European Union establishes the procedures for a member state to withdraw from the EU. It requires the member state to notify the EU of its withdrawal and obliges the EU to then try to negotiate a withdrawal agreement with that state.
Once Britain invokes Article 50, it will have a two-year window in which to negotiate a new treaty to replace the terms of EU membership. Britain and EU leaders would have to hash out issues like trade tariffs, migration, and the regulation of everything from cars to agriculture.
Now the big question: What is the likely economic fallout from the Brexit vote on the rest of the world and Britain itself?
The impact on global growth and inflation on the cyclical horizon (six to 12-months) is likely to be relatively small — and almost certainly not large enough to push the global economy into recession. Even if the UK fell into a recession, the direct knock-on effect on global GDP through lower UK import demand would be minimal as the UK accounts for only 3.6% of global imports of merchandize goods and 4.1% of global imports of commercial services.
However, according to Barron’s Asia, there are three related swing factors that could lead to a larger negative impact on the global economy over the next six to 12 months: the dollar, China and Central Bank action. First, a significant further strengthening of the dollar in response to global risk aversion would be a problem not only for US growth prospects but also for all the dollar debtors in emerging markets, and could also push commodity prices lower. Second, China might react yet again to dollar strength by allowing a more rapid depreciation of its currency against the greenback, which could intensify global growth and deflation concerns. Third, an important reason why some experts expect the short-term hit to global confidence and growth from Brexit to be limited is that they anticipate further action by virtually all major central banks to limit the potential damage. It is expected that the Bank of England will cut its official interest rate from 0.5% to zero relatively soon and, if more is needed, to restart quantitative easing.
As for Britain, in the short run uncertainty about its future relationship with the EU, its largest trading partner, could push the UK into a recession. Friday, 24th of June, saw huge market volatility. The British pound has lost about 9 percent of its value since Thursday’s vote, and Britain’s FTSE 100 stock index lost 3 percent of its value. When you consider that the FTSE is priced in pounds, that means British stocks are down more than 10 percent in real terms.
Moreover, that volatility reflects market worries about more severe consequences in the months ahead. With Cameron out of power, Britain’s prospects of negotiating a favorable deal with the EU could be weakened. The EU may decide to strike a hard bargain to discourage other countries from leaving the EU. Or the UK’s new leader might not be willing to accept the kind of restrictions that come with a Norway-style deal.
And that could create serious problems for businesses based in the UK.
The long-term effects are less clear-cut. The UK is one of the largest recipients of foreign direct investment (FDI) in the EU. The UK is also by far the most popular location for large corporate European and global headquarters. ‘Brexit’ could call into question the UK’s allure as a business destination over other EU states. The potential disruption and costs of relocation are likely to have a negative short-term impact on some EU companies, but the longer-term impact is unclear, as it will depend heavily on the regulatory environment. This point is particularly relevant for financial services where the UK is the undisputed EU leader. Other financial centres could now benefit. Of particular importance will be the shape of the future UK-EU relationship and its potential impact on regulation and policy. If the UK’s departure leads to greater integration of the remaining EU countries, accompanied by liberal policies, for example, this could benefit the EU economy, enabling it to attract foreign direct investment (FDI) and, potentially, some relocation of financial services from the UK. As the UK is one of the bloc’s most non-interventionist economies, however, its withdrawal could leave the EU with a less liberal policy agenda, with negative repercussions for long-term growth.
In addition, UK may face immigration problems as a direct impact of Brexit.
Annual net migration from Europe has more than doubled since 2012, reaching 183,000 in March 2015. Immigration from the European Union is currently boosting the workforce by around 0.5% a year. This has helped support the economy’s ability to grow without pushing up wage growth and inflation, keeping interest rates lower for longer. Whether the United Kingdom gains any powers to restrict immigration from Europe will depend on its future relationship with the European Union. If Britain wanted to retain full access to the single market, it may have to keep the free movement of labour between the United Kingdom and the Union. But this is unlikely. Policy is far more likely to change to restrict the number of low skilled workers entering the country and shift towards attracting more highly skilled workers. This would be a potential headache for low-wage sectors heavily dependent on migrant labour, such as agriculture, but could benefit other sectors with a shortage of highly skilled labour. Overall, policy would shift to be more specifically designed for Britain’s migration requirements.
Endnotes:
- The Conversation: “Brexit impact will be worse than the 2008 crash”, 2016, <http://theconversation.com/brexit-impact-will-be-worse-than-the-2008-crash-61648>;
- MarketWatch: “Opinion: Brexit’s impact on these 3 issues is what really matters for the rest of the world”, 2016, <http://www.marketwatch.com/story/brexits-impact-on-these-3-issues-is-what-really-matters-for-the-rest-of-the-world-2016-06-27>;
- Vox World: “Brexit: what happens when Britain leaves the EU”, 2016, <http://www.vox.com/2016/6/23/12021222/brexit-what-happens-next>;
- Woodford: “The economic impact of Brexit”, 2016, <https://woodfordfunds.com/economic-impact-brexit-report/>.
