Evaluating the Brexit Threat
February 26, 2016
by Darren Williams
Britain’s debate on staying in the European Union has moved into overdrive, weighing heavily on the pound. If Britain does vote to exit (known as “Brexit”), the impact on the UK economy could be profound—and felt well beyond its borders.
This week, the British government confirmed that a referendum on its European Union (EU) membership will take place on June 23. The long-term impact of an EU exit is highly uncertain and depends on the answers to several questions that are unclear today—such as the precise nature of the settlement between the UK and (what would then be) its former partners. We can, however, offer some preliminary observations.
Too Close to Call
Before moving on, it’s worth noting that we think Britain will probably vote to remain in the EU. But the debate is intense and opinion polls are much tighter than at a comparable stage of the Scottish independence campaign in 2014. The bookies put the probability of an EU exit at roughly 30%.
Several studies have been conducted on the long-term impact of an EU exit on the British economy. The findings differ wildly in terms of magnitude and direction—from plus 10% to minus 10% of GDP, depending upon the assumptions made. Often, the variation reflects the underlying biases of the authors (or those who commissioned the report). The better analyses stress the huge uncertainties involved when trying to gauge the long-term impact of an EU exit on the British economy—not the least being uncertainty over the future direction of the EU itself.
Capital Inflows Would Be Vulnerable
Gauging the long-term impact of an EU exit is by definition speculative. But there’s little doubt that the near-term economic impact would be negative. Although there would be a transitional period (probably two years) before the UK actually left the EU, the resultant uncertainty would weigh on business investment and threaten the capital inflows that have helped finance a record peacetime current-account deficit (Display). A weaker pound would help cushion the impact, but it would be difficult to avoid a sharp slowdown, or even a recession, in our view.
Falling Pound Highlights Currency Risk
The pound has been the first casualty of the rising Brexit risk. Since the beginning of the year, the pound has fallen by 6% on a trade-weighted basis and has traded below 1.40 against the US dollar for the first time since a brief period in 2009. Despite this, sterling is not that weak on a trade-weighted basis (Display, below) and is likely to fall further if Brexit risks crystallize, in our view. Without this, though, the UK would face an even harsher economic adjustment.
The implications for the gilt market are less obvious. Ratings agencies have already warned of risks to the UK’s credit rating should the referendum lead to its departure from the EU. But this needs to be balanced against the impact that Brexit would have on monetary policy and interest-rate expectations. As an EU exit would probably push the economy close to, or even into, recession, the Bank of England would almost certainly be forced to ease monetary policy. We think this would more than compensate for any negative impact from a ratings downgrade.
Impact on Europe
Finally, it’s important to note that Brexit would have ramifications well beyond the UK’s borders. Although the UK is often a difficult bedfellow for its Continental partners, leaving the EU would represent a huge setback for the European “project.” It would embolden populist/anti-EU parties in other countries, and remind investors that EU (and euro-area) countries are still sovereign nations and that nothing is “irrevocable” (note that until 2007, there was no exit clause in the EU treaty).
In many respects, Brexit is a peculiarly British affair. But in the wake of the sovereign-debt crisis, and with the migrant/refugee crisis fanning popular discontent and exposing long-buried fault lines across Europe, it could kick off the most challenging period yet for the EU and its French and German leaders.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.