The start of 2017 is peppered with political risks including the German presidential election and a general election in the Netherlands. But it is the UK which presents us with the biggest threat of all – Brexit.
The UK’s triggering of article 50 by the end of March will be riskiest political event of the first quarter because of the economic weight of the UK and the euro area, whose share of global GDP in USD is 3.9% and 15.7% respectively. Until now, the most visible effect of Brexit has been sterling’s depreciation (the other factor explaining the depreciation is the UK’s large current account deficit which is close to 7% of GDP). GBP has decreased by almost 17% versus the dollar and 9.3% against the euro since June 23. The downward trend occurred in two stages, first in the wake of the referendum, and then following prime minister Theresa May’s speech at the Conservative Party Congress on September 30 where she clearly favoured the option of a hard Brexit.
The UK’s three main economic challenges
Theresa May raises many hopes but it is way too early to judge her policies since she has not delivered anything yet. Opting for a hard Brexit means that the UK would need to completely change the structure of its economy by 2019 (the effective date of exit from the EU), which is obviously a very short timeframe. The British economy is heading for the most challenging period it has known since WWII. There are mostly three immediate economic issues that will appear in 2017:
Surge in inflation. The lower GBP exchange rate, which is certainly here to stay, leads to higher inflation through imports (forecast of 2.4% in 2017 and 2.5% in 2018) hurting households’ purchasing power. The rise in inflation is also accentuated by higher global commodity prices (+4.70% in November 2016 compared to November 2015). Until now, wage growth has been sufficiently high (+2.3% according to the latest data) to partly offset higher inflation but this should not be the case in 2017 if inflation forecasts are confirmed. In the medium term, however, lower GBP is likely to favour the substitution of imported goods by locally produced goods, whenever it is possible. Nonetheless, the gain in terms of purchasing power will not be that substantial.
Worries over wages. In a normal economic period, full employment is expected to lead to higher wages but this may not be the case as UK firms may be encouraged to postpone hiring due to the uncertain economic conditions. The triggering of Article 50 will probably have a significant psychological effect on British firms and will result in a hiring freeze. Some observers point to the resilience of the labour market as proof that Brexit has no real consequences. However, they forget that events usually take at least six months to impact the labour market, even when it is very flexible, like in the UK.
Competitiveness at stake. In theory, the depreciation of sterling should help the British economy in this period of uncertainty but the real gain remains limited because the price elasticity of exports is low. Indeed, a study conducted by the Office for Budget Responsibility concludes that a 1% decrease in relative price only results in a 0.41% increase in exports (excluding petroleum products) after nine quarters. By comparison, a similar decline leads to a 0.8% increase in exports for France. Therefore, it can be concluded that the expected gain in price competitiveness for British firms due to the fall of GBP will not be as decisive as has often been claimed. Lower corporate tax may constitute an incentive for UK firms to invest in the short term but, in the medium term, the UK will need to implement an ambitious reindustrialisation plan if it fails to reach a favourable association agreement with the EU. This plan would mean uncontrolled deficit spending which would increase the debt burden in a context of tensions in bond markets (the UK 10-year sovereign bond yield has been multiplied by 2.3 since its annual lowest point) and certainly a fresh credit rating downgrade for the country.
CEE is the UK’s best ally
During the negotiations with the EU, the UK will certainly face the intransigence of many countries, notably France, although the current government may have less influence at the European level because of the upcoming presidential election in April. At first glance, the balance of power is more favourable to the EU than to the UK, as European exports to the UK account for only 3% of EU GDP, while British exports to the EU represent around 13% of the UK GDP. However, Theresa May will be able to count on the support of central and east European (CEE) countries.
They face two crucial issues this quarter. The first one concerns a stronger USD which is not, from our point of view, a major financial risk for the region. Indeed, total US dollar-denominated debt as a share of GDP is quite low in CEE. The most exposed CEE countries are Poland and the Czech Republic where it reaches roughly 10% of GDP, which is manageable, compared with Chile (over 35% of GDP) and Turkey (around 25% of GDP).
The second issue relates to the potential economic impact of Brexit in CEE. The Czech Republic and Slovakia are among the most important recipients of UK investments in the region and could, therefore, be the most penalised in the event of a hard Brexit. In the short term the decision to leave the EU has not substantially affected investment flows. However, in the medium term, there is real uncertainty about the continued presence of British companies in the region (more than 300 UK firms are operating in the Czech Republic which serves as hub to penetrate neighbouring countries). This economic dependence represents a key advantage for the UK government, which could bargain the support of CEE countries during the negotiation process (regarding passporting rights for instance) in exchange for maintaining UK investments. On one hand, British diplomacy has not negotiated any major trade agreement since 1973 and no longer has the teams to do so. On the other hand, it knows how to divide and rule, which suggests that the UK could, at the end of the day, do better than expected by obtaining substantial concessions from allied European countries IF Brexit occurs, which is far from certain.
By Christopher Dembik, Head of Macro Analysis, Saxo Bank
Christopher Dembik has been the Head of Macro Analysis at Saxo Bank since 2016 and focuses on delivering analysis of monetary policies and macroeconomic developments globally as defined by fundamentals, market sentiment and technical analysis.