Brexit so far

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Chapter highlights

The economy has performed reasonably well since the referendum. We were more sanguine about the economic prospects following a ‘leave’ win, but the economy has, if anything, performed slightly better than we were expecting.

Looking at the prospects for the Brexit deal, while the negotiations have been tetchy so far, there do seem to be grounds for a compromise. The UK’s ultimate destination currently looks likely to be that of a third country with which the EU has an enhanced free trade agreement.

However, Britain is likely to wish to maintain many of its existing single-market and customs-union privileges for a period and it has indicated that it is willing to pay for this. Given that the British bill is one of the primary issues for the EU side, it does seem that the scope exists for a compromise.

If, for whatever reason, that doesn’t happen, then the most likely outcome is Brexit without a deal, though the UK opting to remain in the European Economic Area and the EU’s customs union would also be possible in that circumstance.

In this section, we assess how the economy has performed since the referendum on EU membership and assess what we know of the likely eventual form of Brexit – considering the key issues of the negotiations and setting out, with evidence, our expectations regarding the final settlement.

The economy since the referendum

Since the ‘leave’ vote, the economy has continued to expand at the same pace seen before the referendum – a rate of around 1.7% per annum, which is the same as in the four quarters prior to mid-2016. (See Figure 1.) As a result, the economy has been more resilient than many forecasters expected it to be in the case of a ‘leave’ vote. (See Figure 2).

Figure 1: UK real GDP

Source: Capital Economics, Thomson Reuters

Note: Dashed data represents post-EU referendum quarter-on-quarter change in UK real GDP

There are various explanations for the economy’s overall resilience.

First, some forecasters genuinely saw a vote for Brexit as an adverse external shock akin to the Lehman crisis, with similar potential effects on consumer and business sentiment and financial markets. But that was never likely, given that it was something that was favoured by over half of voters, that the scale of the potential impacts was not very large and that those impacts would, in any case, be delayed for two years whilst an exit deal is negotiated.

Figure 2: Real GDP growth and forecasts for real GDP growth in the case of a leave vote

Source: Capital Economics, Thomson Reuters, International Monetary Fund, HM Treasury

Note: Dashed data represents projected real UK GDP growth for 2017, assuming that growth rates in Q3 and Q4 match that of Q2 (0.3%).

Second, the potential changes in Britain’s trading relationship with Europe are simply not of sufficient magnitude to cause such a shift in output and, what is more, the effects were always likely to be significantly delayed by the two-year withdrawal process, which was well known at the time.

Third, policymakers responded to the outcome. Monetary policy was loosened via interest rates being lowered from 0.50% to 0.25% in August 2016 and an increase in asset purchases.1 Furthermore, the Chancellor announced a slowdown in the planned pace of fiscal tightening in November 2016 such that the government would not need to balance its books by the end of the decade as previously set out.2

Fourth, the drop in the pound has acted as an effective shock absorber, helping to boost the stock market and increase the competitiveness of exporters. (See Figure 3.)

Nevertheless, sterling’s depreciation following the ‘leave’ vote has contributed to inflation outpacing nominal pay growth again. This is causing a squeeze on consumers’ real income, though the experience has been worse in many recent years. (See Figure 4.)

Figure 3: UK export surveys and sterling Trade Weighted Index (TWI)

Source: Capital Economics, Thomson Reuters

Figure 4: UK average earnings and consumer price index (CPI)

Source: Capital Economics, Thomson Reuters

The rate of jobs growth did appear to lose steam after the referendum, slowing to around 1% per annum over the second half of 2016. This may reflect the tightness of the labour market by historical standards, rather than being a result of the ‘leave’ vote. Employment as a proportion of the population over 16 is at its highest level since the 1970s. The unemployment rate has now fallen below the Monetary Policy Committee’s ‘equilibrium rate’ of 4.5%.3 Business investment weakened in advance of the referendum, but there have been no large falls subsequently. Investment appears to have proved resilient to uncertainty, perhaps due to credit conditions remaining supportive. Surveys of firms’ investment intentions have also held up well and point to an acceleration in annual growth of real business investment. (See Figure 5.)

Figure 5: Real business investment growth rate and investment intentions

Source: Capital Economics, Thomson Reuters, IHS Markit

In summary, over the last year, the economy has performed at near the levels it has performed at since the financial crisis. There may have been a modest post-referendum slowdown driven by higher inflation in the first half of 2017, but there are encouraging signs that even that will prove temporary. Certainly, forecasts of a post-referendum recession proved unfounded. (See Figure 1.)

The potential Brexit deal

The EU negotiating position is that there are three key issues that must be cleared up initially:

  1. The rights of EU citizens living in the UK, and UK citizens living in the EU
  2. Agreeing a methodology for calculating the so-called ‘exit bill’
  3. Solutions to try to avoid the imposition of a hard border between Northern Ireland and the Republic of Ireland

The British view is that these three issues – and particularly that of the Northern Ireland border – are intimately linked with the future trading relationship between the UK and the EU.

Brussels expects the UK to make a contribution towards the union’s outstanding financial commitments, which would limit any disruption to its programmes from Brexit. Britain will likely have to agree to this ‘divorce bill’ to secure a new trading agreement with the EU, even though the legal obligation on the UK to do so is debatable. The EU’s case for an exit bill is primarily dependent on the union having entered into various financial commitments on the basis of continued British contributions in the current EU budget framework – multiannual financial framework – for 2014-2020.

The UK is seeking to preserve certain aspects of membership at least for a temporary period. Britain has indicated that it is open to contributions to the EU to pay for these privileges. The ground does therefore seem to exist for a potential compromise involving British payments in exchange for certain single-market or customs-union benefits for a limited period, paving the way for an eventual free trade arrangement (though this may not be concluded before March 2019). Continued British contributions for transitionary privileges would therefore be:

  1. A way for the UK to pay for its temporary privileges
  2. A way for the EU to plug the hole in its current budget
  3. A way to remove many of the notional liabilities – from the 2014-2020 multiannual financial framework – in the exit bill

The third party in the configuration of the final deal is the British Parliament, which now has much more influence after the 2017 general election result. If the opposition parties were able to unite on a particular issue then, together with Conservative rebels, they might be able to force the government to change tack.

At present, however, that looks unlikely, especially for any of the key ‘red line’ issues. After all, Labour still appears quite uncertain of its own position. What’s more, few Conservative MPs actually rebelled on the legislation enabling Article 50 in spite of much speculation beforehand, while there are a small number of committed pro-Brexit Labour MPs who have and could end up voting with the government – as they did at the Second Reading of the Withdrawal Bill. Overall, while amendments to forthcoming Brexit bills are likely, it still looks difficult for Parliament to force the government to make a major change in stance.

As a result, the timetable and key developments at this stage seem likely to be as follows:

  • Negotiations continue for the next year and reach a conclusion in autumn 2018
  • Parliamentary ratifications of the deal (EU and UK) take place over the following few months
  • Britain leaves the EU, including the single market and customs union, on 29 March 2019
  • Britain retains many of features of membership during a transitionary period, which runs to end of current EU budget framework, which is the end of 2020
  • During transition, Britain continues to make normal contributions to the union. Retained features are likely to include customs privileges and significant single-market rights
  • From the beginning of 2021, the UK enters new relationship with EU based on an extensive free trade agreement

Figure 6: Possible Brexit timetable
Source: Capital Economics

Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 2018 2019 2020 2021 Ratification Ratification UK Exits EU Implementation phase UK enters new relationship with EU Comprehensive free trade agreement negotiationsWithdrawal agreement Q4 2018 Q1 Q2 Q3 Q4 2019 Q1 Q2 Q3 Q4 2020 Q1 Q2 Q3 Q4 2021 Q1 Q2Ratification UK Exits EU Implementation phase UK enters new relationship with EU Withdrawal agreement Comprehensive free trade agreement negotiations Ratification
Specific events
2017 Q4 Talks progress to future trade arrangements?
2018 Q1 Italian election
Q2 Terms of withdrawal finalised
Q3 UK Parliament votes on draft final agreement
Q4 Ratification by European, UK & European National Parliaments
2019 Q2 UK starts to formally negotiate non-EU trade agreements

The other options

If this Brexit ‘compromise deal’ scenario does not transpire, what are the other likely scenarios? Table 1 provides an overview of EU relationships with non-member countries.

Table 1: Options for Britain’s relationship with the EU
Source: Capital Economics, Thomson Reuters, Bloomberg, various others

UK’s current position EEA (Norway) EFTA & Bilateral deal (Swiss) Customs Union (Turkey) Free Trade Deal (Canada) WTO Rules Only
Restrictions on exports to EU None On some agricultural and fish products On some agricultural products On services, public goods and agricultural products On some agricultural products, manufactured goods Average tariff of 4.4%
Acceptance of EU laws Accepts EU laws Significant acceptance of EU regulations Opt-in to EU regulations Exports to EU have to conform with EU standards Exports to EU have to conform with EU standards Exports to EU have to conform with EU standards
Financial passporting Yes Yes No No No No
EU budget contributions Yes Yes Yes No No No
Free movement of labour Yes Yes Yes, with exceptions No No No
Reach-own free trade agreements No Yes Yes No Yes Yes

Broadly, the alternative options fall under two overarching categories:

  • Leaving without a deal or a minimalist deal that includes little on trade. This is probably the second most likely outcome. The parties could fail to reach an agreement or an agreement may be thrown out by either side at the parliamentary ratification stage. With this option, it’s also likely that the British side will not make an exit payment. We explore what this means for the economy later in this report.
  • Britain becomes more worried about the consequences of Brexit and consents to a more diluted form. This could involve remaining within the single market or customs union, or agreeing to terms that are close to membership of these arrangements, for the long term. This would likely not involve major economic changes from the status quo. Such a change in stance would likely be welcomed by the EU as it would probably involve the use of an off-the-shelf model (Norwegian, Swiss or Turkish) which may make the negotiations easier.

It is, of course, also possible that Britain will, in spite of everything, somehow remain a member of the EU. However, given the political hurdles to this, the probability of it occurring is very low. Still, nothing is inevitable until it has happened.

UK economy – defiant growth

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  1. Bank of England monetary policy summary, ‘Bank of England cuts bank rate to 0.25% and introduces a package of measures designed to provide additional monetary stimulus’, Bank of England, August 2016.
  2. HM Treasury, Autumn Statement 2016, 2016.
  3. Office for National Statistics, Labour Market Statistics time series dataset, September 2017.

The views and opinions expressed in this report are solely those of Capital Economics and do not necessarily reflect the views of Woodford Investment Management.

Woodford Investment Management Ltd is authorised and regulated by the Financial Conduct Authority (firm reference number 745433). Incorporated in England and Wales, company number 10118169. Registered address: 27 Old Gloucester Street, London, WC1N 3AX.

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