Brexit Update 2016Q3

BBC

BBC

The Institute of Chartered Accountants in England & Wales Quarter 3 report forecasts GDP growth of 1.1% in 2017, business investment -3.7%. A basket of 21 forecasts published less recently (between July 20th and August 10th) averages 0.7% GDP growth, but with a very large spread (-1.3% to +2.7%). Our sense is that forecasting is generally becoming a little less pessimistic at GDP level based on (a) the rapid stabilisation of the UK government, under a relatively uncontroversial PM; (b) policy choice by the Bank of England (an easing of monetary conditions within the limited flexibility available to them); (c) ostensible abandonment of budgetary surplus targets and the removal of the former Chancellor; (d) relative resilience in consumer confidence; and (e) some recovery in business confidence from the large dip immediately after the referendum. Inflation and weak investment remain key areas of 2017 risk.

On trade, all indications are that our base case is likely to be broadly correct. Although the PM is doing her best to keep all her options open, it seems deeply unlikely that a Norway style ’emergency brake’ will come close to satisfying the perceived need for ‘control’ over immigration, and that therefore continued membership of the EEA will not be on the table. A bespoke trade deal will not realistically be achievable within two years post invocation of article 50, even if this is deferred to late 2017, nor will replacement of the 56 existing EU free trade deals. We can expect to default to WTO rules for an extended period of time.

Although average WTO most-favoured-nation tariffs are low (less than 2.5%), there are under-appreciated complications with this outcome that create significant risk of economic disruption in the medium term. For example:

  • Some specific sectors face much higher tariffs, notably motor vehicles at 10%. This is sufficiently high as to make the viability of the major Nissan, Honda and Toyota operations in the UK deeply questionable, for example.
  • Non-tariff barriers can be far more of an obstacle to cost-effective trade than tariffs.
  • The absence of the financial services passport will migrate some financial services to the continent at a few institutions which don’t currently have European operations, but will have a much more disruptive impact on others (notably Lloyds insurance market). With euro derivative trading probably having to migrate into the Eurozone, there will be some weakening of City GDP, even if it remains a global financial leader.
  • Specific vertical markets that require an association agreement with the EU, such as aviation and energy, will be in an uncertain and potentially compromised position.
  • Although the UK is technically a member of the WTO, its terms of membership currently come through the EU. To function as an independent member, its legal status (rights and obligations) will have to be renegotiated. All 161 other members would have to agree, and any one of them could object or seek to negotiate improved terms. In the mean time the UK’s legal status would be ‘undetermined’, with unclear terms of trade. Our best guess is that we would be subject to ‘out-of-quota’ tariffs during this period (i.e. a significantly higher average than the current WTO average).

In summary, we are a little more optimistic on short-term prospects that we were in July, but somewhat more concerned about medium term disruption, based on a better appreciation of the WTO complexities.