5 minute read

After Theresa May on March 29 formally notified the European Union (EU) of Britain’s intention to withdraw from the bloc, we consider the prospects for the country’s economy.

The resilience of the UK economy in the nine months since the EU referendum has come as a welcome surprise to many, including ourselves. That has led many official forecasters, including the Bank of England (BoE) and the Office for Budget Responsibility (OBR), to lift their growth projections for this year.

However, while the near-term prospects are far brighter than seemed likely nine months ago, the outlook for next year and beyond still hinges upon the shape of the deal Britain agrees with its former European partners.

At this time, there is no way of knowing how the talks will proceed. With such high stakes riding on them, Prime Minister Theresa May and her team of negotiators have every incentive to keep the discussions amicable. The Europeans do too, although arguably to a lesser extent and not necessarily for the same reasons.

If all goes well and the UK strikes a good deal in terms of its trading arrangements, it is conceivable the economy could fare slightly better than the BoE and OBR expect. Consumers, undeterred by higher inflation, might continue to borrow and spend, while the widely expected slowdown in business investment may fail to materialise.

However, it is also possible discussions could become fraught and end acrimoniously. Even before they have begun, the two sides appear to be at risk of falling out over the size of any final divorce settlement. Media reports suggest the EU wants the UK to pay up to €60 billion (£52 billion) to settle its share of long-term liabilities, such as pensions for EU staff and ongoing infrastructure projects.Such demands are unpalatable to Tory hardliners, who are demanding May refuses to cough up.

John Kerr, the British diplomat who helped draft Article 50, told US-based political news organisation Politico that the process outlined in the text is “about divorce … about paying the bills, settling one’s commitments, dealing with acquired rights, thinking about the pensions. It’s not an article about the future relationship.”2

Trade trouble?

In the event the UK is unable to reach a trade agreement of any sort, the economic outlook would be bleaker. After all, in the first nine months of 2016, the UK sold goods and services worth £184.3 billion – 46 per cent of its total exports – to the EU.3

Since the UK runs a large deficit with the EU – £44.3 billion in the same nine-month period – in one sense the bloc has more to lose. However, it unclear the EU’s negotiators will see things that way. While exports to the EU represent 13.2 per cent of the UK’s economic output, exports to the UK account for around just three per cent of the EU’s gross domestic product.4

Regardless of how the talks progress, it seems certain UK exports to Europe will fall; especially as May seems intent on pulling the UK out of the EU’s customs union in order to secure trade deals with other countries. If it is outside the customs union, the UK will face non-tariff barriers that do not apply to EU members, such as rules-of-origin requirements and anti-dumping duties.

According to a 2016 study by the London School of Economics (LSE), even in an optimistic scenario where the UK is able to secure access to the single market, and after allowing for reduced fiscal contributions to Brussels, average annual household incomes would fall over time by 1.3 per cent (£850).5

The LSE authors estimate that in a pessimistic scenario, where the UK fails to secure a trade deal; has to fall back onto World Trade Organisation (WTO) rules; and its exports are subjected to tariffs, Brexit will lower income by 2.6 per cent.

Potentially more damaging, higher trade costs threaten to reduce foreign direct investment (FDI). The UK’s stock of FDI was estimated to be worth £1.68 trillion at the end of 2016, making it the third most successful nation in attracting overseas capital, behind the United States and China.6 Over half of the UK’s FDI comes from other members of the EU.

It seems incontrovertible that part of the UK’s attractiveness for foreign investors is that it has brought easy access to the single market. On the basis the UK is set to lose that access some major global financial institutions, including Goldman Sachs and Morgan Stanley, have signalled their intention to relocate staff out of London.7 Meanwhile, companies in the autos and aerospace sectors have warned they may begin to shift production overseas in the event they are subjected to trade barriers.

In a separate study on the impact of Brexit on foreign investment, the same LSE economists reckon higher trade costs with the EU would likely cut FDI by 22 per cent over the next decade, leading to a 3.4 per cent decline in annual real incomes – equivalent to £2,200 per household.8

They say estimates of the impact of Brexit on the UK’s car industry imply that UK production would fall by 181,000 cars – 12 per cent – and prices would rise by 2.5 per cent in the event the UK faces trade barriers on cars and components. Even if the UK manages a comprehensive trade deal and keeps tariffs at zero, production could fall by 36,000 vehicles.

Always look on the bright side….

There are other economists, albeit a minority, who argue that the UK is likely to flourish after Brexit. For example, Economists for Free Trade (formerly the Economists for Brexit campaign group) argue that there would be a more-than-four per-cent gain to GDP and consumer welfare over the long term if the UK were to pull out of the single market and revert to trading under WTO rules.9

They argue this is because consumers lose substantially as EU protection of food and manufacturing raises their prices around 20 per cent and lowers productivity; regulation raises costs and lowers living standards; and free unskilled migration creates a net-cost welfare burden that consumers must shoulder through higher taxes.

According to Patrick Minford of Cardiff University, even if the UK were unable to secure tariff-free access to the EU after leaving, it should be prepared to scrap all tariffs on imports unilaterally. That would allow the UK to import cheaper goods, gain access to new markets, and deliver greater prosperity since the boost it gave to consumers would outweigh the damage inflicted on business.10

If we know one thing about Brexit, it is that nothing is certain. After all, warnings from the UK Treasury and BoE that the economy would suffer a sizeable downturn in the immediate aftermath of any vote in favour of Brexit proved unfounded.

However, the argument that the UK should simply rely on WTO rules at the very moment when that institution’s existence could be under threat from US president Donald Trump is based on dangerous assumptions.

While there may plausibly be an overall economic benefit in the very long run, there is no way of knowing as there are simply too many variables involved. What seems more certain is that in the event the UK leaves without any trade deal, there are likely to be significant negative effects in the medium term.

The UK would not be able to compensate for all the trade it lost with the EU with greater exports to the rest of the world overnight. And we know already that some companies are already looking to shift operations in readiness for Brexit. Only in the fullness of time will we know whether the doomsayers are wrong and the economy can comfortably survive – perhaps even thrive – outside of the EU, or that there are serious adverse consequences resulting from that choice. We lean towards the latter.

While the performance of the UK since June last year gives pause for thought, there are several reasons why this has happened. Account must be taken of the cut in interest rates, the re-start of quantitative easing, support from fiscal policy, the recovery in global demand and the competitive boost from the currency depreciation. Yes, the UK economy has been robust, but it has received quite a bit of help. Looking ahead there are legitimate causes for concern.

1 https://www.ft.com/content/480b4ae0-aa9e-11e6-9cb3-bb8207902122

2 http://www.politico.eu/article/brexit-article-50-lord-kerr-john-kerr/

3 UK Office for National Statistics (From Balance of Payments and GDP releases)

4 Aviva Investors’ estimate: based on data from ONS, Eurostat and using average GBP:EUR exchange rate.

5 http://cep.lse.ac.uk/pubs/download/brexit02.pdf

6 https://www.cia.gov/library/publications/the-world-factbook/rankorder/2198rank.html

7 https://www.bloomberg.com/news/articles/2017-03-21/goldman-morgan-stanley-signal-london-job-moves-as-brexit-looms

8 http://cep.lse.ac.uk/pubs/download/brexit03.pdf

9 http://economistsforfreetrade.com/about

10 http://www.politeia.co.uk/trading-places-consumers-v-producers-in-the-new-brexit-economy/

Important Information

Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 29 March 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.