Economic growth expectations have been revised sharply downwards since the UK voted to exit the European Union. The asset manager Fulcrum has revised its 2017 British growth forecast down by 1.7% and for the eurozone down by 0.6% of GDP. Note that these are just 2017 forecasts. We are likely to see downward revisions in growth expectations for following years, too.
If the UK serves formal article 50 notice on the EU that it intends to exit by the end of this calendar year, we are unlikely to see the final contours of its future arrangements until late 2018 at the very earliest. And the EU trade commissioner Cecilia Malmstrom says Britain cannot begin negotiating trade terms with the bloc until after it has left. “First you exit, then you negotiate,” she told the BBC’s Newsnight.
If the UK must wait for its divorce arrangements to be finalised before it can negotiate its new trade arrangements, it may be the middle of the next decade before the fog of uncertainty finally clears.
At this stage, we are only in the foothills of danger, but we have perilous political mountains to traverse at a time when global economic storms are gathering. A fortnight ago, as he reclined in foothills pose, finance minister Michael Noonan sought to reassure voters that Brexit would not affect Ireland’s 2017 budget.
Last week, in mountainous pose, he was forced to admit that the situation was “evolving” and was “hard to get a fix on”.
The investment bank Morgan Stanley sees two possible scenarios for the UK’s conscious uncoupling from the EU. In the civilised divorce outcome, the relationship with the EU is progressively resolved, capping the negative hit to demand and keeping the British economy out of recession. In an acrimonious divorce scenario, “the sources of uncertainty interact with, and amplify, each other”.
Unfortunately, there is no shortage of acute uncertainties and dangers afflicting the EU right now. Will the pragmatic Angela Merkel or the doctrinaire Jean-Claude Juncker control the EU negotiators? Will Merkel remain German chancellor after next autumn’s federal elections? Will the Italian banking system — and Italy’s membership of the euro — remain intact? Will a gigantic economic crash in China plunge the global economy into recession?
The reality is that nobody knows for sure how Brexit will pan out. There are too many known unknowns never mind unknown unknowns. This uncertainty is already taking its economic toll.
European private equity transactions — the purchase and sale of private companies — slowed dramatically between the second half of 2015 and the first half of this year. The total deal value almost halved from €48.5bn to €25.6bn according to the Centre for Management Buyout Research. “The market is cooling off, with the EU referendum one of a number of challenges currently facing deal-doers,” it noted.
“There is evidence that some risks have begun to crystallise,” the Bank of England said in its latest financial stability report, published in London last Tuesday before concluding that the “current outlook for financial stability is challenging.”
The bank then facilitated increased lending by cutting its capital requirements for UK banks and pledged to implement any other measures needed to shore up their financial stability following the Brexit decision.
The Bank of England will do what it can to prevent the UK entering into recession. So will the British government, starting with chancellor George Osborne’s commitment to reduce corporation tax rate to 15% or lower. “What’s done is done,” Osborne stated. “The British public have spoken. We should accept their verdict instead of moping around or trying to unpick it. We must focus on the horizon and the journey ahead and make the most of the hand we’ve been dealt.”
The challenge for Osborne and his successor is that, while a reduction in the corporation tax rate is likely to have a positive long-term effect, it may have only a limited effect in the short term when Britain most badly needs a policy boost. The problem for policy-makers is that the cupboard is pretty bare when it comes to the most conventional form of short-term economic boost: fiscal stimulus.
The UK is only just getting its public finances back in order following the convulsion of the global financial crisis. But Osborne has now abandoned his target to get government finances back into balance by 2020. So if it has little or no room for manoeuvre on fiscal policy, how can Britain avoid a recession?
It has two remaining policy levers. It can run a stimulative monetary policy. That would mean relaxing some bank regulations, keeping interest rates lower for longer and more aggressive quantitative easing, aka money printing. The Bank of England governor has already signalled his readiness to consider all this.
The second policy lever that the UK has is its exchange rate. This will be heavily influenced by its monetary policy. Suppose, theoretically, that the Bank of England proposed to use quantitative easing to double the quantity of sterling issue. And suppose that markets expected the quantity of other currencies to remain fixed. Then, all other things being equal, we would expect sterling to halve in value against other currencies.
This simple theoretical example shows why the suggestions that UK monetary policy might be eased further has coincided with a significant drop in sterling. Since the evening of the Brexit vote, it has dropped 10% against the euro and 12% against the dollar. I expect sterling to fall still further over the coming months.
Allowing the pound to drop sharply against other currencies is a relatively low-cost way for Britain to adjust to weaker economic output and to its extremely large balance of payments of deficit, or excess of imports over exports. As the IMF recently commented: “The current account deficit has risen substantially in recent years, reaching 5.2% of GDP in 2015 . . . the widest deficit among advanced economies.”
Letting sterling take the strain of economic adjustment is something that the British have done before. Between 1972 and 1976, the pound fell by 40% against the dollar. Between 1980 and 1985, it dropped 55%. And between 2007 and 2009, it fell 35%. Since it peaked in 2014, sterling has already dropped by over 20%. So don’t be surprised over the next few years to see sterling fall by another 20%-30% from current levels.
But there is a problem in letting sterling slide in order to export recession and import economic stimulus. Other countries and currency blocs simultaneously want to do the same thing. Like the UK, the eurozone and China have an excess of debt and limited room for fiscal manoeuvre. They too want to see their currencies drop.
And it is a simple impossibility for everybody to drop their currencies against everybody else.
Cormac Lucey is the Programme Director of the IMI Diploma in Business Finance.
Cormac is also a Financial Services Consultant and Contractor who has previously worked with PricewaterhouseCoopers, Rabobank Frankfurt and the Department of Justice.