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The fallout from Brexit: what’s next?

The fallout from Brexit: what’s next? article image

Coface, a world leader in credit insurance, has downgraded its 2016 GDP growth forecast for the UK from 1.8% to 1.2% in the wake of Brexit.

In the short-term, uncertainty and volatility is likely to prevail on financial markets, it says.

The impact on business and consumer confidence in both the UK and in the rest of the world will depend on the magnitude of the correction on financial markets and on political developments in the coming weeks.

In the UK, if business and consumer confidence is affected by financial market volatility and political uncertainties, private consumption related sectors will be affected.

And business investment will also take a hit.

Coface says the construction sector could be impacted by higher prices of imported inputs.

The good news for Australia is that exporting sectors are not the most at risk in the short-term, as they could benefit from the lower level of the GBP.

All in all, this could push the Bank of England to cut rates by the end of the year, Coface notes.

“And this leads us to revise down our GDP growth forecast (to 1.2% this year instead of 1.8%, and 1.1% next year).”

Late last week the UK voted to leave the European Union, with 52% voting to leave and 48% to remain.

Soon after the vote, Britain’s Prime Minister David Cameron announced he would step down.

Uncertainties are high

Shockwaves have spread across financial markets as both short-term and long-term uncertainties are high.

The GBP plunged to its lowest since 1985. Global equity markets have fallen too (Japan, Germany and France down by 7-8%), even more than the Footsie (-4.5%), as some stocks could not be traded when the market opened in London. Oil (-5%), gold (+5%) and the euro (-3% vs USD) also reflect this surge in volatility and global risk aversion.

Domestic political uncertainties add to this risk, say Coface, as a conservative leadership election could take several months.

And the UK's vote to leave may lead to calls for another Scottish referendum, as Scotland voted to remain in the EU. Northern Ireland’s case could be an issue too, all the more since the region has borders with an EU country, the Republic of Ireland.

In the rest of the world and more specifically in the EU, the magnitude of spill-over effects in the short-term will mostly depend on coming political developments and central bank actions.

Long-term challenges

And a general election in Spain could bring further uncertainty on to the future of the European project, says Coface.

Later this year, a referendum in Italy on the constitution reform is expected and the resignation of Prime Minister Matteo Renzi is at play. Then elections are scheduled in the Netherlands, France and in Germany in Q1, Q2 and Q3 2017 respectively.

Higher volatility and uncertainty in the short-term will be driven by long-term challenges and unknowns resulting from the outcome of the referendum.

In this regard, the key issue is of course the negotiation of a trade agreement between the UK and the EU. The trickiest point is the access to the single market that ensures free movements of goods, services, capital and people (and makes it possible for firms of the financial sector based in the UK to operate easily in the whole EU without having to comply with local regulations).

According to Article 50 of the Treaty on EU, the UK has to formally announce its intention to leave the EU during the European Council on June 28.

The UK will then have two years to negotiate a new agreement with the EU, which seems nonetheless unlikely due to the very long period usually required to negotiate trade agreements. It took seven years for Canada and the EU to settle one (and it is still not ratified).

Prolonged countdown

The two-year countdown could therefore be prolonged. 

Three types of agreements are conceivable:

  1. EEA membership, like Norway, which implies full access to the single market but loosing voting rights on regulatory framework and EU decisions
  2. A “customized” bilateral agreement, like Switzerland, which establishes access to the single market for specific sectors and
  3. WTO rules, with existing custom tariffs and no access to the single market.

The agreement will largely depend on political choices of the future PM, as there is a trade-off to be done between economic benefits resulting from the access to the single market and political/regulatory constraints.

As one of the leaders of the “Leave” camp is very likely to be the next PM, a Norway-style agreement is less likely and the negotiation process with the EU will be tricky.

And defaulting to WTO rules means higher custom tariffs and no access to the single market. In this worst case scenario, the long-term economic cost of the Brexit would be higher.

Higher custom tariffs

In the UK, usual competitive exporting sectors being linked to the EU through supply chains (pharmaceutical and automotive are notable examples) will suffer from higher custom tariffs on their exports to the EU in the long-term. But on the other hand, the government could also decide to impose higher import tariffs, especially to help sectors currently suffering from foreign competition (metal industry).

The long-term effect on the financial sector (8% of GDP, i.e. twice higher than the OECD average) is an unknown at this stage.

In the EU, countries having the strongest links (in terms of trade and investment) with the UK and comparatively small domestic markets are most exposed: Ireland is by far the most at risk in this regard, followed by the Netherlands, Belgium, Denmark and Sweden, where the impact will be smaller.

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