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UK economy hit by double shock in wake of Brexit

21 Jul 2016

LBS economists explore economic impact of Brexit in live webcast by AQR Asset Management Institute.

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The UK economy has been hit by a double shock in the immediate wake of Brexit, two London Business School economists explain.

Richard Portes CBE and Hélène Rey, Professors of Economics and Academic Directors of the AQR Asset Management Institute at London Business School, explained the nature of these shocks in a live webcast chaired by the Wall Street Journal’s Chief European Commentator Simon Nixon, earlier this week.

Professor Rey says: “In the short term, what we have are two very significant shocks. One is a large uncertainty shock, one is a financial market shock.”

The first manifestation of uncertainty shock was a political risk shock, Rey says.

“After 23 June it became quite clear that the Brexiteers had no real plan, and now we are left with Prime Minister Theresa May who wants something that is a priori inconsistent with the EU bargaining position for the UK. She wants both access to the single market and no free movement of labour. This is not something the EU wants to unpack. It’s going to be a very tough bargaining position to maintain.”

“There is therefore a great deal of uncertainty about access to the single market, in particular regarding financial passporting,” says Professor Rey. 

Financial Services are a key part of the UK’s exports. And as Professors Rey and Portes point out, Britain has the highest ratio of services exports to GDP in the G7, and the biggest Financial Services export by some way, in the region of 30%.

But the uncertainty doesn’t end here. There is also uncertainty, Professor Rey explains, about the movement of labour in and out of the UK and even uncertainty about the integrity of the United Kingdom itself, with the possibility of further referenda, for example in Scotland. 

Investment and hiring decisions are being delayed as a result and Professor Rey warns that: “If investment falls from 17% in 2015, we will have a slowdown at a minimum, and possibly, a recession.”

In terms of the significant financial market shock, sterling fell to a 30-year low against the dollar. Yet despite this large volatility, “the markets functioned properly,” says Rey.

“We have also seen significant equity market volatility, mainly within the FTSE 250, where we saw a decline of 30% in consumption, household goods and home construction stocks in the first two weeks after the vote to leave. Since construction investment accounts for 9% of UK GDP, and construction sector activity is also a leading indicator of recession, this is probably not a good sign,” Rey adds.

“Divorces are very messy,” Professor Portes says. Speaking of the UK’s negotiations with the EU, he suggests: “There is strong political motivation for the other 27 countries to oppose generosity for fear that other member states try the same trick.”

So what possible deals could the UK negotiate? Professor Portes explains.

“One possibility is that we just function under WTO rules. That would mean a huge disruption to existing trade patterns, a loss of access to the European single market, and a loss even of the preferential trade agreements that the EU has negotiated on our behalf with a number of countries around the world.”

The second possibility, he says, is a free trade agreement with the EU and elsewhere. “But,” he warns, “these are lengthy, complex negotiations which involve rules of origin and a lot of technicalities. They would take quite some time to negotiate and we would not have single market access for Financial Services.”

The suggestion of an association agreement with the EU is a “non-starter”, Professor Portes believes. The remaining possibilities he believes, are rather more attractive.

“One is Switzerland which has made various bilateral deals with the European Union, but it has taken many years to do this. Even with the deals, they still have to have free movement of labour and it involves accepting financial regulation without representation, and paying into the EU budget.”

A Norway style agreement is the other alternative. “Norway has full access to the EU market, but has to accept all EU market regulations and free movement of labour – so what’s the point of leaving in that case?” Portes explains.

“There is very little opportunity”, he concludes, “for unpicking, that is to say for full access to the single market with no free movement, no budget contribution, and no European Court of Justice, which enforces the single market regulations. It is just not possible.”

Amid much uncertainty, this, the professors agree is perhaps the one certainty. And it’s not impossible to foresee, Professor Portes says, a scenario in which at the end of two years after triggering Article 50, the UK has negotiated no deal and is forced into a “hard Brexit”.