The UK economic outlook has radically shifted after the victory of the Leave campaign in the June 24th referendum. At the beginning of July we revised our main UK macro forecasts. Our baseline scenario is for the UK to declare article 50 and negotiate a trade deal with the EU which is somewhere between Norway’s EEA style arrangement and the more restrictive bilateral agreements between the EU and Switzerland. Together with the uncertainty shock that has already been triggered, this leads an initial post-referendum GDP forecast of 1.5% in 2016 (revised down from 1.9% in the May forecast) and 1% in 2017 (revised down from 2.1% in the May forecast).
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Figure 1: Baseline Brexit Scenario
Source: Euromonitor International Macro Model
The pound’s depreciation is likely to push inflation up towards 2.7% by 2018. Nevertheless, the Bank of England will cut interest rates towards zero in 2016-2017 in response to the decline in growth. There is significant uncertainty even within the baseline scenario, depending on the intensity of the short-term financial and confidence shocks hitting the economy. As a result, 2017 GDP growth could easily range from 0.2% to 1.4%. We assign the baseline Brexit scenario in this range a roughly 50% probability over 2016-2017.
We have added two new Brexit scenarios to account for alternative outcomes to the negotiation process. The “disorderly Brexit” scenario assumes that the UK and the EU cannot reach an agreement by the two year deadline after article 50 is triggered, leading to a further 5.5% cumulative decline in GDP relative to our baseline forecast. We assign the disorderly Brexit scenario a 30-40% probability over 2016-2017. In the opposite direction, there is still some speculation that the new UK government will not trigger article 50 after all and no Brexit will occur. While the new Prime Minister (PM) Theresa May has repeatedly announced that “Brexit means Brexit” and has appointed “Leave” campaigners to the top foreign policy cabinet positions, we still assign this scenario a 1-10% probability. Finally, there are still other scenarios that may become more important as the situation evolves, such as a prolonged delay in the declaration of article 50 accompanied by informal negotiations between the UK and the EU.
Disorderly Brexit
In this scenario PM Theresa May triggers article 50 by early 2017, starting a 2 year negotiations process for exiting the EU. The EU negotiators refuse to make any concessions on the free movement of people in exchange for full access to EU markets. The British government insists on significant immigration restrictions that are incompatible with the EU position.
The strong disagreements increase the concerns of business that negotiations will fail, greatly amplifying the negative impact of uncertainty on investment and employment in 2017-2019. Investors engage in a massive sell-off of UK stocks and bonds. This leads to a depreciation of the pound by another 15-20% against the US dollar and the Euro and a tightening of private sector credit conditions. Banks and other financial institutions start major staff relocations to Frankfurt and other EU cities in anticipation of losing their EU passport rights from the UK. The combined confidence and financial shocks spill-over into declining consumer spending as well, due to lower wages, higher unemployment and reduced future income prospects. Exports benefit from the pound’s depreciation, but with the decline in domestic demand output is still likely to drop by more than 3% relative to the baseline forecast in 2017-2018.
Figure 2: Disorderly Brexit Scenario
Source: Euromonitor International Macro Model
The depreciation of the pound and further rise in import prices raises annual inflation towards 4% in 2018 before declining gradually back to the 2% target. The Bank of England (BoE) decides to ignore the temporary rise in inflation, and loosens monetary policy to counter the fall in aggregate demand. The BoE has very little room for cutting interest rates, but it keeps them close to zero until around the second half of 2019 and expands its quantitative easing operations.
Negotiations stall, and the UK leaves the EU in 2019 without reaching a new free trade agreement. As a result, trade relations with the EU default to WTO conditions with significantly higher barriers. The average increase in tariffs on UK products would be close to 5 percentage points, tariffs on cars would rise by 10 percentage points and those on some agricultural and food products could rise by more than 20 percentage points. Other non-tariff barriers would also rise significantly. The loss of the EU passport for financial institutions could reduce UK financial services exports by up to one third.
While the UK would still probably negotiate a more limited bilateral trade agreement with the EU in the next decade, total UK trade is likely to decline by around 20%. Foreign direct investment is also likely to fall by more than 20%. The decline in trade and FDI will reduce long-term labour productivity through several channels: lower innovation and technological spill-overs from abroad, a reduction in the size of markets available to UK firms and a reallocation of business activity from higher productivity export sectors to lower productivity domestically oriented sectors. Reduced migration would also restrict employment growth and raise labour costs for employers. The combined effect of lower labour productivity and lower labour supply would lead to another round of declining business investment and employment. UK output would decline by around 5.5% over a ten-year horizon relative to the post-referendum baseline forecast.
No Brexit
In this scenario the conservative party leadership starts having doubts on triggering article 50 after seeing the negative short-term impact of Brexit uncertainty. Fears of triggering a new Scottish independence referendum and reigniting tensions in Northern Ireland also cause politicians to reconsider exiting the EU. Since the Brexit referendum is non-binding, the new prime minister puts the declaration of exit from the EU to a parliamentary vote. The majority of MP’s reject Brexit. This leads to a political crisis and a second referendum, which the Remain campaign wins.
Figure 3: No Brexit Scenario
Source: Euromonitor International Macro Model
With the uncertainty surrounding Brexit eliminated, business and consumer confidence recover. The earlier “Leave” vote effects would still leave GDP growth in 2016 at 1.6% (compared to a pre-referendum forecast of 1.9%). However, the rise in investment and consumer spending would boost growth to 1.9% in 2017. The Pound would appreciate by around 10% against the Euro and the USD. As a result inflation would remain below the BoE’s target in 2016-2017, returning towards 2% in 2018-2020.
Brexit Impact still most likely to be moderate, but the risks are heavily tilted to the downside
Overall, our baseline forecast at this stage still assumes a relatively successful negotiations process, which would leave the UK economy smaller by 2-3% in 2026. However, a disorderly Brexit with much greater damage to the economy also has quite a high probability due to the fundamental disagreement on migration policies between the EU and the UK. In this case, the economy would contract by another 5.5%, reducing GDP by around 8% in 2026 relative to the pre-referendum outlook.