- Ongoing discussions about the details of the divorce agreement combined with a polarized political landscape in the UK have increased the likelihood of a ‘No deal’ and resulted in higher uncertainty. The cost of such uncertainty could be as much as -0.1pp of GDP growth per quarter between now and making a deal, due to financial stress on the sterling, contingency stocking by companies and depressed consumption.
- We continue to expect a ‘Blind Brexit’ (70% likelihood), that is, a last-minute deal with the EU where both sides agree on a Free Trade Agreement with very close ties. This should pave the way for a transition period – by the end of 2020 – during which there will be no changes to the trade in goods and services and no migration control. Temporary market relief is expected in the aftermath of the agreement, with the pound to euro exchange rate going back to 1.14 after reaching a low point of 1.06-1.09 at end of 2018.
- In a ‘No deal’ scenario (25% likelihood), the UK will exit the EU under the WTO conditions. This means around 4% to 5% of mutual import tariffs. Overall, we would expect the GBP/EUR to fall to 0.88 in late 2019. Total good export losses for the UK would reach GBP30bn in a year. Top EU losers on exports of goods include Germany (~EUR8bn in the first year following the EU exit), the Netherlands (~EUR4bn), France (~EUR3bn) and Belgium (~EUR3bn).
The ghost of a ‘No Deal’
On July 26th, the EU rejected the Brexit deal the UK proposed in July (the Chequers plan) as it did not align with the indivisibility of the four EU freedoms (people, goods, services and capital). The EU judged this proposal as creating additional red-tape and bureaucracy on the collection of duties (the UK proposed to take care of duty collection for goods having the EU as a final destination). The EU also judged the deal as potentially creating unfair competition for EU companies in the services sector and reemphasized its concerns at the EU Summit in Salzburg on September 20th. Indeed, goods and services are strongly interlinked: 20% to 40% of the total value of each good is linked to services. Should the UK deregulate the services market, for example, this could allow them produce cheaper goods compared to the EU.
In response, the EU proposed two solutions: (i) a Norway type of agreement or (ii) a Comprehensive Economic and Trade Agreement (CETA) type of agreement with EU membership for Northern Ireland. For the moment, the UK rejected both proposals. The first solution was considered to go against the referendum result, as it doesn’t allow the control of EU migration flows. The second solution was seen to increase division within the UK.
In addition, the risk for early elections before March 2019 cannot be excluded. First, Theresa May’s majority is dependent on the 10 seats from the Democratic Unionist Party from Northern Ireland. Second, the Labor Party (257 seats/650) is now advocating for a second referendum, or general elections, before March 2019. Third, Boris Johnson announced his proposal for a “Better Brexit” which can make “Hard Brexiters” even more vocal.
Given the lack of unity in British Brexit policies, we increased the likelihood of a 'no deal' to 25%.
We believe Theresa May will manage to avoid a political crisis as Conservatives would be afraid of Labor leading the elections; and elections would delay Article 50 beyond the current deadline (29 March 2019). Also “Hard Brexiters” are unlikely to launch a confidence vote against Theresa May or vote against a Brexit deal, as she may manage to secure a (very thin) majority thanks to 56 MPs from the opposition – excluding Labor.
The cost of uncertainty
Higher uncertainty is already having financial costs, notably on sterling. Based on the expected trend of the Economic Policy Uncertainty Index and simulated shocks, we calculate that the GBP/EUR would reach a low of 1.06–1.09 at the peak of tensions in November-December. This would mean on average a -3% depreciation per month until a deal is concluded.
Figure 3: Scenarios for the Sterling in the aftermath of Brexit