Question

Britain is in the process of leaving the EU. If this proves to be a bitter divorce that shakes domestic and international confidence in the EU and in Britain, explain how (using appropriate graphs) this would affect the EU and the British economies-including their currencies?

Answer 1

On June 23, 2016 by a referendum people of UK voted to leave the European Union, a decision that surprised many and one whose consequences still aren’t totally clear. There have been many twists and turns in British politics that have led to this particular moment.

The global ripples from the UK Brexit vote were small, but it has led to slower growth in the Euro zone by 0.2 percentage points in the year 2017-18, at 1.5 per cent per year. There are considerable risks to the UK outlook and the economy is projected to underperform the Group-of-Seven average through mid-2018.

In the euro zone, we can distinguish between near-term and medium-term Brexit impacts of macro and political nature. The near-term macro implications are likely to be contained, though they are not insignificant. Euro zone exports to the UK are around 13% of total exports. If we estimate that UK GDP drops by 1%–1.5% over the next 12 months due to the decision to leave the EU, this would translate to a GDP shock for the euro zone on the order of 0.1%. This would come on top of a hit from tighter financial conditions and lower confidence. This latter effect on GDP is harder to quantify, but we would estimate it to be around 0.2%. In total, the shock might be around 0.3%, modest but not irrelevant for an economy where underlying growth is close to 1.25%. This additional shock to an already fragile recovery means that the European Central Bank may need to add yet again to its already aggressive quantitative easing program.

Investments:

Since the referendum, the value of the Pound has fallen 10-15% reflecting markets more pessimistic view about the long-term economic prospects for the UK.

The devaluation in the Pound has led to a rise in cost-push inflation, which has reduced living standards – this is particularly problematic because of low nominal wage growth.

EU membership robustly increases FDI inflows for UK. It is estimated that that leaving the EU would reduce FDI inflows by around 22%. There is a risk some FDI would be diverted to other EU countries if Britain lost access to the EU single market. Meanwhile, costs in terms of financial services, foreign direct investment and impacts on London property markets are more likely to be short-term and there are longer-term opportunities from Brexit even in these areas.

Migration: 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 ination, keeping interest rates lower for longer. One of the main arguments for Brexit campaigners is to limit migration of workers from other EU countries, even though both Norway and Switzerland have had to accept free movement of people in return for access to EU internal markets. If Britain did cap immigration, it could have a negative impact on eastern European countries, from which some 1.2 million workers were in Britain in late 2015.The impact could be most acute in the countries with the most citizens in Britain - Poland (853,000 in 2014), Romania (175,000) and Lithuania (155,000).

Trade Effects: The rest of the European Union has a trade surplus of around 100 billion euros in goods with Britain, while Britain exports some 20 billion Euros more in services than it imports, the same gap as for financial services. Leaving the EU is likely to have a sizeable negative effect on UK welfare.

The true realities of Brexit will not come into play until the end of March 2019. More negative outcomes are a distinct possibility, the real effects of Brexit will play out gradually over time, adding elements of economic and political uncertainty and this overlay of extra uncertainty, in turn, may open the door to an amplified response of financial markets to negative shocks!