Macroeconomics and Brexit in the boardroom

Brexit - The economic implications

The outcome of the referendum on June 23 on whether to leave the EU has the potential to alter the UK economy at a cost. The long-term effects of an exit will depend on the relationships the UK forges with the remaining EU countries, and those further afield.

Yael Selfin

Director

KPMG in the UK

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Yael Selfin

Brexit - Economic implications

The uncertainty around the result of the vote is already inflicting damage on the UK economy, as businesses postpone some of their investment decisions. A fall of 2% in business investment in the fourth quarter of 2015 and a marked downturn in investment intentions captured by business surveys attest to that.

This briefing sets out some of the potential ways in which an Out vote could affect the UK economy, and provides a range of assumptions that businesses planning for the event of an Out vote may consider.The table below summaries some of the potential impacts, which are further explained in this paper. These are meant as indicative values and are based on the existing available evidence, but should not be seen as firm predictions about the impact of a Brexit.

This table summaries some of the potential impacts, which are further explained in this paper. These are meant as indicative values and are based on the existing available evidence, but should not be seen as firm predictions about the impact of a Brexit. 

Summary of potential Brexit impacts on the UK economy

If the UK votes to leave the EU, uncertainty about the future shape of trading relationships will dominate in the short term while negotiations with the EU about exit are ongoing. Those could last up to two years and possibly longer. Both foreign and domestic business investment are expected to be impacted as a result. 

The cost of capital is likely to rise as short-term uncertainty and increasing concerns about the UK’s future economic performance lead to both higher risk premia for corporate debt and equity and higher government bond yields, although some of the risk of Brexit may have already been priced in. 

Concerns over Brexit have also already contributed to the slide in the exchange rate since late 2015. Market analysts expect further falls in the immediate aftermath of an Out vote in the referendum- perhaps by up to 25%. Uncertainty on the status of the UK-EU relations could continue to weigh on the exchange rate in the medium term in the event of a Brexit. In the longer term, the losses in the value of sterling could be partially reversed once uncertainty is resolved through negotiations. An In vote may see the exchange rate recover more quickly, although expectations for an interest rate hike have also been pushed back, suggesting the pound is unlikely to regain all of its recent losses.

The fall in sterling will lead to a temporary spurt in inflation through higher costs of imports, and this could extend into the medium term if tariffs and non-tariff barriers increase the costs of trade - lifting inflation perhaps 0.5% to 1.5% higher. 

Whether the Bank of England’s Monetary Policy Committee would move to counteract this by raising its interest rate is unclear. They have not reacted to temporary inflationary effects previously, but it would be expected to act if there were a perception that inflationary pressures had become embedded in the economy. This could see interest rates up to 1% higher in the medium term, which should help steer inflation back to its 2% target in the long run.

Only once the dust has settled and the negotiations are over will we know the extent to which trade is likely to be impacted. There are many possible scenarios for the UK’s future position, ranging from preserving its existing trade relationship with the EU, through to a failure to reach agreement and reversion to World Trade Organisation (WTO) Most-Favoured Nation tariffs, which average 4.4%.

Under WTO rules, the most significant impact on UK trade is likely to be felt through sectors such as transport equipment and food and beverages, where tariffs are above average and their share in total UK exports is also relatively large (see Chart 1 below).

Chart 1: WTO MFN tariff rate on UK exports

Source: CEP, 2016

Even under the most benign scenarios, non-tariff barriers may emerge, particularly on services where the Single Market is still under construction. This is an area of particular significance to the UK economy, yet outside the EU, the UK would have no influence over its shaping. 

Half of UK trade is with the EU, but the other half may also be affected, depending upon whether existing trade agreements needed to be renegotiated and whether new ones could be negotiated outside the umbrella of the EU. Overall, the impact of a Brexit may therefore be a 5% to 10% fall in trade. 

The impact of a Brexit on the size of the labour force is the second big economic question mark in the longer term. Inward migration has been a significant contributor to UK economic growth for much of the past decade. If, post Brexit, the Government achieved its target of bringing net inward migration down below 100,000, UK population could be up to 1.3% lower by 2021. Migrants have higher labour market participation than the wider population, meaning that the labour market could contract by up to 2.5% by 2021. That would push up wage costs for low skill jobs in some industries. 

UK residents born outside the UK tend to have higher levels of education, on average, than those born in the UK so productivity could also be dented, although the impact from a less open economy, due to lower levels of  trade and Foreign Direct Investment is expected to exert a bigger weight on productivity performance, as they would lead to fewer opportunities for companies in the UK to catch up on latest technology and best new working practices.

Falls in investment, and increased cost of capital and uncertainty could reduce demand for commercial property, making leases more affordable, especially if some businesses choose to relocate to the Continent. A weaker economy, higher interest rates, and a smaller flow of net migration may also bring house prices down. London would likely see the greatest effect since foreign nationals account for a significant share of house sales in some areas. 

A Brexit would harm public finances. As the economy cooled as a result of the UK’s departure, we estimate UK government revenue could deteriorate by 1.5% to 2.25%. The UK would make up some of that fall by retrieving its net contribution to the EU budget, which amounted to about 0.5% of GDP last year. However, factoring in other payments the EU made to UK non-governmental bodies – payments the government may need to pick up - the net savings may amount to only 0.25% of GDP. It is also worth noting that both Norway and Switzerland contribute to the EU budget while not part of the EU, so the savings are not certain. 

Chart 2: Product market regulation

Source: OECD

The scope for changes to regulations will depend on UK trading agreements with the EU and the need to comply with the rules of the European Single Market. Open Europe estimated the UK could save up to £12.8 billion from revoking specific labour and product market regulations – equivalent to around 0.7% of GDP. It is worth noting, however, that an OECD study ranked the UK second best in terms of product market regulations, behind the Netherlands – a fellow EU member, so whilst there is some scope for improvement, the causal chain in terms of a Brexit is unclear (see Chart 2 above). 

In the short run – uncertainty, falling investment and possible knocks to consumer confidence and spending could reduce GDP growth on average by 0.5% to 1.5% per year. Once new trade relations are established, the UK economy is expected to recover some ground, but Brexit could still leave a mark with a long term impact on GDP, as some 15 years after a Brexit occurs GDP could be between 4% and 6% lower than had the UK stayed in. 

 

 

 

The numbers above should be treated as indicative estimates only. The uncertainties involved point at potential risks weighted towards the downside. However, other scenarios such as a lower reduction in labour supply or a more resilient economy could see the impact of a Brexit on the UK economy reduced. Businesses may therefore wish to incorporate broader ranges when planning for the possible economic effects. 

 

Please note that KPMG aims to provide unbiased, non-political information on the EU referendum. KPMG is not a registered campaigner in relation to the referendum and we do not express a view or a preference either for or against leaving the EU. 

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