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Outlook on UK-EU Brexit negotiations and possible economic risks

  • Raj BadianiEmail author
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Abstract

The UK parliament on 29 January endorsed by 317 to 301 votes a government-backed amendment proposing to renegotiate the Brexit deal with the European Union, specifically demanding major changes to the so-called backstop on future border management between the UK region of Northern Ireland and the Republic of Ireland. EU negotiators, as well as leaders from the remaining 27 EU member states, have repeatedly stated that they reject such a move. While still failing to approve viable alternative routes, the UK parliament also confirmed in a nonbinding vote with a majority of 318 to 310 that it is opposed to leaving the EU without a deal. The easiest route is for the UK to secure an orderly Brexit on 29 March would require major EU concessions to the backstop, such as agreeing to a time limit or providing a unilateral exit clause for the UK. But, the EU continues to rule out a renegotiation, suggesting May could struggle to win some concessions to win over support from hardline Brexiteers. Should the EC refuse to budge on the backstop agreement, parliament could demand a legally binding vote to remove a “no deal” option from the table, increasing the likelihood of the UK edging closer to a softer Brexit instead. This could entail the establishment of a permanent UK-EU customs union, which could attract sufficient number of votes from the opposition as well as an array of pro-EU MPs from the governing Conservative Party. However, May has so far refrained from offering such an option as it would significantly increase the risk of splitting her party. Without either EU concessions or a cross-party alliance supporting a softer Brexit, the risk of exiting without a deal on 29 March increases. At this point in time (4 February), IHS Markit's assessment that the risk of a “no-deal” Brexit is more elevated, and sits uncomfortably around a 25–30% probability range.

Even before we examine the impact of a “no deal” outcome on the UK economy, the continued Brexit uncertainty represents a significant hit on business sentiment, with many firms bemoaning the continued lack of clarity and expressing deep shock that the no-deal option remains on the table. Business groups continue to highlight the lack of contingency planning for a disorderly Brexit. Specifically, London Chamber of Commerce and Industry chief executive Colin Stanbridge reports, “75 per cent of London businesses that we surveyed still haven't made any provisions in preparation for Brexit. Furthermore, the survey also reveals that 86% of businesses in London employing under 10 people have made no preparations at all due to lack of resources and time.” More encouragingly, some have welcomed the fact that parliament has indicated that it is against leaving the EU without a deal, although it is not legally binding. Indeed, Huw Evans, the director-general of the Association of British Insurers, noted that it was “encouraging to see Parliament saying it won't support a no-deal outcome”. Overall, parliament's indecisive vote on the Brexit path signifies that there has been no progress towards how the UK will leave the EU, with many UK firms angry that the point of departure is getting ever close. They highlight that the continued uncertainty is damaging business sentiment and economic activity. Indeed, the latest survey data suggest that the UK economy was close to stagnation in the final month of 2018 and point to limited growth in the first half of 2019. At this stage, we continue to advocate a cautious near-term growth outlook, with the UK economy set to expand by 1.1% (the January consensus is 1.4%) in 2019 and 1.3% (consensus at 1.6%) in 2020 from an estimated 1.3% gain in 2018.

1 Economic assessment and forecast up to 2026

1.1 Baseline scenario

The UK economy has shown some resilience since the Brexit referendum in June 2016, with several key supporting factors:
  • Borrowing costs are at historical lows, stoking strong further household credit growth and helping to sustain broadly solid spending developments.

  • The unemployment rate was at a historical low of 4.0% in the three months to November.

  • Employment has risen steadily since the 2016 referendum to stand at a record high in the three months to November 2018.

  • Wage growth, nominal and real, has strengthened.

However, more recently, Brexit uncertainty is leaving a larger footprint on UK growth. The economy grew by 0.5% in the first half of 2018 versus the prior six months, the weakest six-month growth rate since the second half of 2011. Also, the latest hard and survey data suggest the economy was close to stagnating in the latter stages of 2018 after growth in the third quarter spiked to 0.6% q/q due to one-off factors.

Other factors also indicate softer underlying UK growth:
  • Business investment fell for a third straight quarter by the third quarter of 2018.

  • Higher prices and lagging earnings growth have damaged households’ discretionary spending. However, real earnings growth resumed in the latter half of 2018, albeit moderately.

  • The resilience of the labor market is less assured. Indeed, UK employment growth in the third quarter was 0.1% quarter on quarter (q/q)—23,000 jobs—compared with gains of 0.1% q/q in the second quarter and 0.6% q/q (197,000 jobs) in the first quarter. However, job creation picked up some momentun in the latter half of 2018, rather surprisngly.

  • The UK’s under-employment rate (rate of involuntary part-time workers) remains well above pre-financial-crisis levels, suggesting more slack in the market than the headline rate.

  • Consumers are increasingly stretched, given historically low savings rates and high debt levels, along with lower confidence in the state of the UK real-estate sector.

Slow progress toward an agreement on the future trade relationship between the United Kingdom and European Union remains a significant headwind. Indeed, the prospect of the United Kingdom leaving the European Union without a deal still represents a significant risk, and has affected some firms’ current investment decisions. However, there is little evidence to suggest firms are pushing ahead with precautionary stock-building. The main demand from firms is to better understand the Brexit political process; mainly the point where a “no deal” risk is over, allowing them to put aside their contingency planning.

Overall, the UK economy lacks sufficient strength to absorb the full impact of a no-deal departure; we assess that the resulting shocks to supply and demand would be particularly damaging at this stage of its business cycle.

IHS Markit now assigns a higher probability of nearly 30% that the United Kingdom could leave the European Union without an exit deal, which would imply no transition period. This report lays out the likely impact of a no-deal Brexit on the United Kingdom and the other major European economies from 2019 to 2026.

2 IHS Markit core assumptions for the economic impact of a no-deal scenario

  • In the IHS Markit no-deal scenario, the point of departure is end-March 2019, with both sides failing to reach a deal. IHS Markit assumes that a no-deal departure would involve the United Kingdom leaving the EU Customs Union and Single Market, and switching to WTO tariff rules. This would introduce customs checks and tariffs overnight on both sides of the English Channel.

  • UK service providers would not be able to rely on WTO rules and would face losing free EU market access overnight, which would be damaging as this would include the country’s most successful export sectors. These industries include financial services, airlines, broadcasting, and a range of professional and business services. The entire service sector accounts for 80% of UK GDP.

  • The IHS Markit scenario applies a worst-case trade outcome, which assumes that the United Kingdom would fail to negotiate a free-trade agreement with the European Union during the seven-year forecast horizon. Historically, it takes a minimum of three years to conclude EU trade deals, and it will be even more challenging for the United Kingdom, which is ambitiously looking for a custom-made deal that is likely to take longer to agree.

3 A no-deal scenario would tip the United Kingdom into a painful and prolonged recession

Past travel and extraordinary disruptions to the United Kingdom illustrate how quickly the costs to the economy can accumulate. The fuel shortages of 2000 resulting from protests over gasoline prices led to the closure of schools, supermarket shortages, and the cancellation of nonessential operations in hospitals because staff struggled getting to work. The Institute of Directors said that the cost to business was GBP1 billion (KPMG, August 2017). In 2010, an Icelandic volcano eruption led to flight cancellations, with the British Chambers of Commerce estimating that the disruption cost the UK economy GBP100 million a day in lost output (KPMG, August 2017).

According to the IHS Markit scenario, the impact of a no-deal Brexit on the economy would start in the first quarter of 2019, with households and businesses bringing forward some purchases to avoid the higher prices resulting from the introduction of tariffs and the weaker pound alongside delivery delays arising from the reintroduction of border controls. In addition, firms would likely raise their stock levels in anticipation of acute shortages after the United Kingdom departs.

The UK economy would be in recession from mid-2019 to early 2021 in a no-deal scenario. With regard to the quarterly profile, it is expected that real GDP would register the sharpest plunge in the third quarter of 2019, falling by 2.6% q/q. This quarter would likely endure the largest disruption to firms’ supply chains, while inventories would be at their most depleted.

Overall, the economy will contract by 0.9% in 2019, 2.4% in 2020, and 0.5% in 2021. By 2026, real GDP would be 9% lower in the no-deal scenario when compared with the September 2018 baseline, which assumes an orderly exit and transition period for the United Kingdom.

4 Major realignment of UK export prices and volumes in the immediate aftermath of a no-deal exit

All UK exports to the European Union in a no-deal exit would need to comply with applicable regulations, but the United Kingdom would have no influence over the development or application of these. The IHS Markit scenario assumes a rise in UK export prices, driven higher by the average tariff applied by the European Union on manufactured imports from the United Kingdom, which is likely to be 4.1%. Some respite would come through the anticipated retreat of sterling against the euro and US dollar.

The Confederation of British Industry (CBI) also estimated in October 2017 that the average tariff on UK goods exports to the European Union would be around 4%, with the increase in tariff costs being worth GBP4.5–6.0 billion per annum, significantly affecting the competitiveness of UK exporters.

The end of free EU market access for UK service providers would be a major blow to the UK economy. The value of UK service exports (excluding the travel, transport, and banking sectors) to Europe posted record growth of 17.8% in 2016, rising by GBP10.6 billion to a peak of GBP70.1 billion, or 3.5% of GDP. Similarly, Europe is also a major source of UK service imports, accounting for above half of the total value in 2016.

Clearly, a no-deal Brexit would trigger several years of squeezed UK exports. Given the backdrop of rising global trade protectionism, the United Kingdom would find it even more challenging to negotiate new trade agreements rapidly that might partly compensate for the immediate loss of free EU market access. Comprehensive new trade arrangements with the EU post-exit could take several years to negotiate at best, and it is assumed they would not occur during the forecast horizon of our no-deal scenario.

5 Inflation impacts

A major impact of a no-deal exit would be an anticipated spike in consumer price inflation, peaking at close to 5.0% in early 2020. The no-deal scenario predicts that sterling would depreciate notably, from USD1.297/GBP1.00 in the third quarter of 2018 to a low of USD1.12/GBP1.00 in the second quarter of 2019, triggering a sharp pickup in import price inflation. The foreign-exchange markets have concluded that a no-deal Brexit would damage the UK economy. Pre-Brexit-referendum sterling exhibited some safe-haven currency characteristics, with an inherently stable political system being a key support. This is no longer the case with the political risks associated with Brexit weighing down on the markets’ view of the appropriate price for sterling well beyond the EU exit point.

The United Kingdom would introduce tariffs on 90% of its EU goods imports by value, and IHS Markit assumes that UK tariffs on EU imports would be around 3–4% when leaving the EU Customs Union. The IHS Markit scenario assumes significant shortages of consumer goods due to disruption at ports will stoke accumulating price pressures. Indeed, a no-deal departure would cause considerable turmoil at UK ports, with around 95% of the UK’s international trade arriving by sea. Although the UK’s ports are considered efficient and frictionless, the British Retail Consortium warns that UK imports could face three-day delays at ports after Brexit. The CBI estimates that a delay of just two extra minutes to process a truck would cause queues of more than 17 miles.

A useful illustration of handling customs procedures at the UK border for goods outside the EU Customs Union is imports from Switzerland. Specifically, customs checks of Swiss imports at the UK border can take between 20 min and one hour. The greater magnitude of trade between the United Kingdom and European Union implies that even relatively frictionless procedures would result in congestion and delays that would damage growth.

Many businesses have streamlined their supply chains over the years, and could accelerate the process ahead of March 2019. However, IHS Markit believes that many supply chains remain complex and long, and rely on several firms working together in a coordinated manner. Many firms have switched to just-in-time systems, measuring inventory in hours rather than weeks. These systems are not designed to cope with a no-deal Brexit, and shortages of imported inputs and finished goods are likely to be acute.

6 Damage to consumers’ real incomes, wealth, and job security

Household purchasing power would be severely damaged in a no-deal Brexit, particularly with higher prices for essential goods. In addition, households would be vulnerable given the increasing pressure on their personal finances, led by falling real wages with inflation outpacing nominal wage growth in the scenario. IHS Markit anticipates falling real household incomes, hit by rising inflation and employment losses, which in tandem with a step-up in the unemployment rate prompt a drop in consumer spending.

The IHS Markit scenario also predicts significant household wealth losses owing to falling equity and house prices. Indeed, we expect that house prices will fall by around 10% between 2019 and early 2020 before leveling off. Also, share prices of UK firms in sectors with significant domestic exposure will take a sustained hit, namely major banks, property companies, and retailers.

7 UK firms would face significant costs from a no-deal exit

The no-deal scenario involves increased nontariff barriers; firms would need to recruit additional staff to process new compliance requirements, or pay twice for licenses for the United Kingdom and European Union. Many businesses would also incur additional costs by seeking professional advice from lawyers, customs experts, or others, further elevating their Brexit-related costs and further damaging their competitiveness. A key risk is that some UK firms assumed that the United Kingdom and European Union would transition smoothly to a new trading relationship, and have probably delayed their preparations for a no-deal Brexit.

For example, UK chemical producers would need to reregister their products in an EEA country to continue accessing the EEA market. Similarly, UK airlines would have to obtain agreement from each member state to continue flying between them and the United Kingdom, as well as reregistering as nonmember airlines with the European Aviation Safety Agency (according to the CBI).

Many UK firms would face more red tape as they integrate the new processes established by the UK government. A key change would be the need for custom declarations procedures to comply with the UK’s new status outside the EU Customs Union. The UK government’s customs and excise department estimates that there are between 145,000 and 250,000 small firms in the United Kingdom that currently only export to other EU countries, which will have to adopt these processes for the first time.

In a “no-deal” exit, IHS Markit expects a sharp downturn in business investment, with UK firms facing shrinking domestic and export markets, new trade tariffs, regulatory divergence, squeezed credit conditions, and the relocation of some major companies away from the United Kingdom. Meanwhile, a reduction in lending capacity would be likely because of major financial disruptions and rising UK nonperforming loans. Critically, UK corporations and small- and medium-sized enterprises could face increased costs of borrowing and external capital, which would make marginal investments unprofitable. Therefore, shrinking fixed investment, in tandem with some production facilities being relocated away from the United Kingdom, would undermine the country’s capital stock, pushing down its growth potential.

8 Fiscal and monetary policy responses

The scenario assumes additional government spending on some infrastructure and public-sector workers. Indeed, the UK’s exit from the EU Single Market and Customs Union would lead to increased pressure on customs authorities and related physical infrastructure. According to the UK government, a no-deal Brexit would require an additional 5000 customs officials, and the training of a customs official can take three years, although the preparations are being accelerated as the UK approaches its EU exit point. However, the profound hit on economic activity and the widening public-sector budget deficit would constrain the wider use of fiscal policy to stimulate demand, and other areas of public spending would be damaged.

The Bank of England would cut its key policy rate from 0.75% to 0.25% by the end of 2021 with the economy in recession, and it would likely suspend its inflation targets. Still, we acknowledge that the bank has limited firepower to deal with such a considerable shock to the economy. Nevertheless, at some point, we anticipate that the bank would refocus on inflation, and the scenario assumes a gradual rise in interest rates beginning in early 2022.

9 Impact on UK financial services and other implications

IHS Markit anticipates some reduction in lending capacity in the United Kingdom and European Union for several years. The loss of UK exports of financial services to the European Union would be damaging to the latter. In 2016, UK exports of financial services amounted to GBP61.4 billion, of which GBP27 billion was provided to the European Union. Starting in the first quarter of 2021, these financial services would no longer be provided by UK-based banks. This corresponds to a 10.7% cut in the UK’s service exports, occurring progressively from the second quarter of 2019 onward.

UK banks, insurers, and asset managers would be unable to operate in the EU27 under the current passporting regimes. They would be unable to sell their services freely across the EU27 unless they already had or created a legal entity within the EU27.

Half of the stock of inward investment into the UK has been linked to investment by EU companies in past decades. These inward investments would therefore slow in our no-deal scenario. In addition, we expect that outward foreign direct investment (FDI) flows from the United Kingdom would increase as some UK-based businesses relocated in Europe to have better market-access conditions. Part of these would therefore increase FDI inflows into the European Union. Fleeing capital from the United Kingdom would increase the deprecation pressures on sterling. However, we acknowledge that the UK government could consider tax holidays or lower corporate tax rates to attract new investment to the United Kingdom.

UK-based banks could no longer rely on European Central Bank funding facilities. Meanwhile, UK firms would lose access to funding from the European Investment bank and European Investment Fund. According to the Bank of England (Financial Times, 10 October 2018), GBP41 trillion of derivatives contracts maturing after Brexit are at risk because of regulatory uncertainty. There is pressure on UK clearing houses to tell European members to move business out of the United Kingdom to avoid running afoul of EU law. This could trigger considerable financial disruption, although we acknowledge that EU regulators are showing signs of flexibility in this area to avoid the obvious problems.

With a no-deal scenario sparking a long recession alongside deteriorating fiscal metrics, IHS Markit anticipates that the major rating agencies would downgrade the UK’s sovereign credit rating, with S&P having already warned that its AA rating would be under threat; the country already lost its top rating after the 2016 referendum.

10 Moderate impacts on the eurozone

In the no-deal scenario, the harm on eurozone growth would be limited: real economic activity would be reduced in 2019–20. Growth in the core euro area would be moderately lower, reflecting some disruption as the City of London would no longer be the financial hub of the region, affecting liquidity and credit availability to the private sector. Meanwhile, the likelihood of some cross-border disruption and an impact on EU exports to the United Kingdom would be a drag on activity.

However, there would be some benefits to EU economic activity if the United Kingdom departed without a deal, and these could lift eurozone GDP above the September baseline in 2020–21. The relocation of some production facilities from the United Kingdom to the eurozone would have positive employment and output implications in the region. The imposition of tariffs on UK merchandise exports to the European Union would imply an overnight loss of competitiveness for UK exports, and could damage the UK’s EU market share, which could be captured by the remaining member states.

The no-deal scenario assumes that UK service providers would lose access to their EU markets, with nontariff barriers being insurmountable at first. This would open markets for service providers based elsewhere in the European Union.

11 Conclusion

A “no-deal” scenario is likely to deliver a significant shock to UK firms and households, tipping the economy into recession. First, firms will face a challenging trading climate, with their exports hit by the imposition of tariffs, and their logistics hurt by disrupted supply chains. Firms would postpone or cancel investment projects because of increased uncertainty, and consider major job cuts. Meanwhile, consumers will face intensifying price, income, and wealth pressures, pointing to a significant retreat in spending intentions.

An orderly exit and a post-Brexit transition period would provide some temporary relief for businesses and allow policymakers more time to organize future relations. However, it remains largely unclear where further negotiations would lead. An array of complex challenges, such as border management and trade relations, would likely resurface promptly. A wide range of outcomes remains possible, all the way from a delayed cliff-edge Brexit after the end of the transition period to full Single Market access. This is primarily dependent on domestic political developments in the United Kingdom. For instance, an early election and a possible new government would be likely to change the direction of travel. This would also increase the probability of another referendum on the final deal with the European Union.

Risks that could complicate negotiations outside of the United Kingdom include a change in the set-up of the European Parliament and European Commission from mid-2019 as part of the EU’s new institutional cycle and diverging trade priorities between the remaining 27 EU member states.

Notes

Copyright information

© Springer-Verlag GmbH Germany, part of Springer Nature 2019

Authors and Affiliations

  1. 1.IHS MarkitLondonUK

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