The UK has voted to leave the EU by 17 410 742 votes (51.9% or 37.4% of the electorate) to 16 141 241 votes (48.1% or 34.7% of the electorate). But what will be the economic consequences of the vote?
To leave the EU, Article 50 must be invoked, which starts the process of negotiating the new relationship with the EU. This, according to David Cameron, will happen when a new Conservative Prime Minister is chosen. Once Article 50 has been invoked, negotiations must be completed within two years and then the remaining 27 countries will decide on the new terms on which the UK can trade with the EU. As explained in the blog, The UK’s EU referendum: the economic arguments, there are various forms the new arrangements could take. These include:
‘The Norwegian model’, where Britain leaves the EU, but joins the European Economic Area, giving access to the single market, but removing regulation in some key areas, such as fisheries and home affairs. Another possibility is ‘the Swiss model’, where the UK would negotiate trade deals on an individual basis. Another would be ‘the Turkish model’ where the UK forms a customs union with the EU. At the extreme, the UK could make a complete break from the EU and simply use its membership of the WTO to make trade agreements.
The long-term economic effects would thus depend on which model is adopted. In the Norwegian model, the UK would remain in the single market, which would involve free trade with the EU, the free movement of labour between the UK and member states and contributions to the EU budget. 
The UK would no longer have a vote in the EU on its future direction. Such an outcome is unlikely, however, given that a central argument of the Leave camp has been for the UK to be able to control migration and not to have to pay contributions to the EU budget.
It is quite likely, then, that the UK would trade with the EU on the basis of individual trade deals. This could involve tariffs on exports to the EU and would involve being subject to EU regulations. Such negotiations could be protracted and potentially extend beyond the two-year deadline under Article 50. But for this to happen, there would have to be agreement by the remaining 27 EU countries. At the end of the two-year process, when the UK exits the EU, any unresolved negotiations would default to the terms for other countries outside the EU. EU treaties would cease to apply to the UK.
It is quite likely, then, that the UK would face trade restrictions on its exports to the EU, which would adversely affect firms for whom the EU is a significant market. 
Where practical, some firms may thus choose to relocate from the UK to the EU or move business and staff from UK offices to offices within the EU. This is particularly relevant to the financial services sector. As the second Economist article explains:
In the longer run … Britain’s financial industry could face severe difficulties. It thrives on the EU’s ‘passport’ rules, under which banks, asset managers and other financial firms in one member state may serve customers in the other 27 without setting up local operations. …
Unless passports are renewed or replaced, they will lapse when Britain leaves. A deal is imaginable: the EU may deem Britain’s regulations as ‘equivalent’ to its own. But agreement may not come easily. French and German politicians, keen to bolster their own financial centres and facing elections next year, may drive a hard bargain. No other non-member has full passport rights.
But if long-term economic effects are hard to predict, short-term effects are happening already.
The pound fell sharply as soon as the results of the referendum became clear. By the end of the day it had depreciated by 7.7% against the dollar and 5.7% against the euro. A lower pound will make imports more expensive and hence will drive up prices and reduce the real value of sterling. On the other had, it will make exports cheaper and act as a boost to exports.
If inflation rises, then the Bank of England may raise interest rates. This could have a dampening effect on the economy, which in turn would reduce tax revenues. The government, if it sticks to its fiscal target of achieving a public-sector net surplus by 2020 (the Fiscal Mandate), may then feel the need to cut government expenditure and/or raise taxes. Indeed, the Chancellor argued before the vote that such an austerity budget may be necessary following a vote to leave.
Higher interest rates could also dampen house prices as mortgages became more expensive or harder to obtain. The exception could be the top end of the market where a large proportion are buyers from outside the UK whose demand would be boosted by the depreciation of sterling.
But given that the Bank of England’s remit is to target inflation in 24 month’s time, it is possible that any spike in inflation is temporary and this may give the Bank of England leeway to cut Bank Rate from 0.5% to 0.25% or even 0% and/or to engage in further quantitative easing.
One major worry is that uncertainty may discourage investment by domestic companies. It could also discourage inward investment, and international companies many divert investment to the EU. Already some multinationals have indicated that they will do just this. Shares in banks plummeted when the results of the vote were announced.
Uncertainty is also likely to discourage consumption of durables and other big-ticket items. The fall in aggregate demand could result in recession, again necessitating an austerity budget if the Fiscal Mandate is to be adhered to.
We live in ‘interesting’ times. Uncertainty is rarely good for an economy. But that uncertainty could persist for some time.
Articles
Why Brexit is grim news for the world economy The Economist (24/6/16)
International banking in a London outside the European Union The Economist (24/6/16)
What happens now that Britain has voted for Brexit The Economist (24/6/16)
Britain and the EU: A tragic split The Economist (24/6/16)
Brexit in seven charts — the economic impact Financial Times, Chris Giles (21/6/16)
How will Brexit result affect France, Germany and the rest of Europe? Financial Times, Anne-Sylvaine Chassany, Stefan Wagstyl, Duncan Robinson and Richard Milne (24/6/16)
How global markets are reacting to UK’s Brexit vote Financial Times, Michael Mackenzie and Eric Platt (24/6/16)
Brexit: What happens now? BBC News (24/6/16)
How will Brexit affect your finances? BBC News, Brian Milligan (24/6/16)
Brexit: what happens when Britain leaves the EU Vox, Timothy B. Lee (25/6/16)
An expert sums up the economic consensus about Brexit. It’s bad. Vox, John Van Reenen (24/6/16)
How will the world’s policymakers respond to Brexit? The Telegraph, Peter Spence (24/6/16)
City of London could be cut off from Europe, says ECB official The Guardian, Katie Allen (25/6/16)
Multinationals warn of job cuts and lower profits after Brexit vot The Guardian, Graham Ruddick (24/6/16)
How will Brexit affect Britain’s trade with Europe? The Guardian, Dan Milmo (26/6/16)
Britain’s financial sector reels after Brexit bombshell Reuters, Sinead Cruise, Andrew MacAskill and Lawrence White (24/6/16)
How ‘Brexit’ Will Affect the Global Economy, Now and Later New York Times, Neil Irwin (24/6/16)
Brexit results: Spurned Europe wants Britain gone Sydney Morning Herald, Nick Miller (25/6/16)
Economists React to ‘Brexit’: ‘A Wave of Economic and Political Uncertainty’ The Wall Street Journal, Jeffrey Sparshott (24/6/16)
Brexit wound: UK vote makes EU decline ‘practically irreversible’, Soros says CNBC, Javier E. David (25/6/16)
One month on, what has been the impact of the Brexit vote so far? The Guardian (23/7/16)
Questions
- What are the main elements of a balance of payments account? Changes in which elements caused the depreciation of the pound following the Brexit vote? What elements of the account, in turn, are likely to be affected by the depreciation?
- What determines the size of the effect on the current account of the balance of payments of a depreciation? How might long-term effects differ from short-term ones?
- Is it possible for firms to have access to the single market without allowing free movement of labour?
- What assumptions were made by the Leave side about the economic effects of Brexit?
- Would it be beneficial to go for a ‘free trade’ option of abolishing all import tariffs if the UK left the EU? Would it mean that UK exports would face no tariffs from other countries?
- What factors are likely to drive the level of investment in the UK (a) by domestic companies trading within the UK and (b) by multinational companies over the coming months?
- What will determine the course of monetary policy over the coming months?
On 20 February, the UK Prime Minister, David Cameron, announced the date for the referendum on whether the UK should remain in or leave the EU. It will be on 23 June. The announcement followed a deal with EU leaders over terms of UK membership of the EU. He will argue strongly in favour of staying in the EU, supported by many in his cabinet – but not all.
Two days later, Boris Johnson, the Mayor of London, said that he would be campaigning for the UK to leave the EU.
In the meantime, Mr Johnson’s announcement, the stance of various politicians and predictions of the outcome of the referendum are having effects on markets.
One such effect is on the foreign exchange market. As the Telegraph article below states:
The pound suffered its biggest drop against the dollar in seven years after London Mayor Boris Johnson said he will campaign for Britain to leave the European Union [‘Brexit’].
Sterling fell by as much as 2.12pc to $1.4101 against the dollar on Monday afternoon, putting it on course for the biggest one day drop since February 2009. Experts said the influential Mayor’s decision made a British exit from the bloc more likely.
The pound also fell by as much as 1.2pc to €1.2786 against the euro and hit a two-year low against Japan’s yen.
This follows depreciation that has already taken place this year as predictions of possible Brexit have grown. The chart shows that from the start of the year to 23 February the sterling trade weighted index fell by 5.3% (click here for a PowerPoint).
But why has sterling depreciated so rapidly? How does this reflect people’s concerns about the effect of Brexit on the balance of payments and business more generally? Read the articles and try answering the questions below.
Articles
Pound in Worst Day Since Banking Crisis as `Brexit’ Fears Bite Bloomberg, Eshe Nelson (21/2/16)
Pound hits 7-year low on Brexit fears Finiancial Times, Michael Hunter and Peter Wells (22/2/16)
Pound in freefall as Boris Johnson sparks Brexit fears The Telegraph, Szu Ping Chan (22/2/16)
Pound falls below $1.39 as economists warn Brexit could hammer households The Telegraph, Peter Spence (24/2/16)
Why is the pound falling and what does it mean for households and businesses? The Telegraph, Szu Ping Chan (23/2/16)
Pound heading for biggest one-day fall since 2009 on Brexit fears BBC News (22/2/16)
Cameron tries to sell EU deal after London mayor backs Brexit Euronews, Guy Faulconbridge and Michael Holden (22/2/16)
EU referendum: Sterling suffers biggest fall since 2010 after Boris Johnson backs Brexit International Business Times, Dan Cancian (22/2/16)
Exchange rate data
Spot exchange rates against £ sterling Bank of England
Questions
- What are the details of the deal negotiated by David Cameron over the UK’s membership of the EU?
- Why did sterling depreciate in (a) the run-up to the deal on UK EU membership and (b) after the announcement of the date of the referendum?
- Why did the FTSE100 rise on the first trading day after the Prime Minister’s announcement?
- What is the relationship between the balance of trade and the exchange rate?
- What are meant by the ‘six-month implied volatility in sterling/dollar’ and the ‘six-month risk reversals’?
- Why is it difficult to estimate the effect of leaving the EU on the UK’s balance of trade?
The UK’s balance on trade continues to be sharply in deficit. At the same time, both manufacturing and overall production are still well below their pre-crisis levels. What is more, with a sterling exchange rate that has appreciated substantially over recent months, UK exports are at an increasing price disadvantage. The hoped-for re-balancing of the economy from debt-financed consumption to investment and exports has not occurred. Investment in the UK remains low relative to that in other major economies (see).
But other developments in the global economy are working in the UK’s favour.
Manufacturing globally is becoming more capital intensive, which reduces the comparative advantage of developing countries with low labour costs.
At the same time, the dividing line between manufacturing and services is becoming more blurred. Manufacturers in developing countries may still produce parts, such as chips or engines, but the design, marketing and sales of the products may take place in developed countries, such as the UK. Indeed, as products become more sophisticated, an increasing amount of value added may occur in developed countries.
The UK may be particularly well-placed in this regard. It can provide many high-end services in IT, business support and financial services to international manufacturers. It may have a comparative advantage in idea-intensive production.
Finally with a higher exchange rate, the UK’s terms of trade have been improving. The downside is that it makes UK exports more expensive in foreign currency terms, but it also makes commodity prices cheaper, which have already fallen in dollar terms, and also the prices of imported component parts. This helps offset the effect of the appreciation of the exchange rate on exports.
The following article by Jeremy Warner considers whether, despite its poor performance in traditional manufacturing, the UK might have hit an economic ‘sweet spot’ in its trade position.
Article
Unbalanced but lucky, Britain hits an economic sweet spot The Telegraph, Jeremy Warner (8/9/15)
Data
UK Trade (Excel file) ONS (9/9/15)
(See, for example, Worksheet 1. You can search for longer series using Google advanced search, putting www.ons.gov.uk in the ‘site or domaine’ box and searching for a particular series, using the series identifier found at the top of each column in the Excel file, such as BOKI for balance on trade in goods.)
Exchange rate data Bank of England Statistical Interactive Database
Questions
- Explain the difference between the balance on trade, the balance on trade in goods and the balance of payments on current account.
- Why has the UK not experienced a re-balancing of the economy as hope for by the Chancellor of the Exchequer, amongst others?
- What is meant by the ‘terms of trade’?
- What would cause an ‘improvement’ in the terms of trade?
- Are the UK’s terms of trade likely to move in the UK’s favour in the coming months? Explain.
- What current factors are mitigating against a recovery of UK manufacturing exports?
- Is de-industrialisation necessarily a ‘bad thing’?
- Does the development of new capital-intensive technologies in manufacturing mean that the UK could become a net exporter of manufactures? Explain why or why not.
Newspaper headlines this week read that the UK’s balance of trade deficit has widened to £34.8bn, the largest since 2010. And when you exclude services, the trade in goods deficit, at £119.9bn is the largest ever in nominal terms and is also likely to be the largest as a percentage of GDP.
So far so bad. But when you look a little closer, the picture is more mixed. The balance of trade deficit (i.e. on both goods and services) narrowed each quarter of 2014, although the monthly figure did widen in December 2014. In fact the trade in goods deficit increased substantially in December from £9.3bn to £10.2bn.
At first sight the widening of the trade deficit in December might seem surprising, given the dramatic drop in oil prices. Surely, with demand for oil being relatively inelastic, a large cut in oil prices should significantly reduce the expenditure on oil? In fact the reverse happened. The oil deficit in December increased from £598m to £940m. The reason is that oil importing companies have been stockpiling oil while low prices persist. Clearly, this is in anticipation that oil prices will rise again before too long. What we have seen, therefore, is a demand that is elastic in the short run, even though it is relatively inelastic in the medium run.
But the trade deficit is still large. Even when you strip out oil, the deficit in December still rose – from £8.7bn to £9.2bn. There are two main reasons for this deterioration.
The first is a strong pound. The sterling exchange rate index rose by 1.8% in December and a further 0.4% in January. With quantitative easing pushing down the value of the euro and loose monetary policies in China and Australia pushing down the value of their currencies, sterling is set to appreciate further.
The second is continuing weakness in the eurozone and a slowing of growth in some major developing countries, including China. This will continue to dampen the growth in UK exports.
But what of the overall current account? Figures are at present available only up to 2014 Q3, but the picture is bleak (see the chart). As the ONS states:
The current account deficit widened in Q3 2014, to 6.0% of nominal Gross Domestic Product GDP, representing the joint largest deficit since Office for National Statistics (ONS) records began in 1955.
This deterioration in performance can be partly attributed to the recent weakness in the primary income balance [see]. This also reached a record deficit in Q3 2014 of 2.8% of nominal GDP; a figure that can be primarily attributed to a fall in UK residents’ earnings from investment abroad, and broadly stable foreign resident earnings on their investments in the UK
The primary income account captures income flows into and out of the UK economy, as opposed to current transfers (secondary income) from taxes, grants, etc. The large deficit reflects a decline in the holding by UK residents of foreign assets from 92% of GDP in 2008 to 67% by the end of 2014. This, in turn, reflects the poorer rate of return on many of these assets. By contrast, the holdings of UK assets by foreign residents has increased. They have been earning a higher rate of return on these assets than UK residents have on foreign assets. And so, despite UK interest rates having fallen, as the quote above says, foreign residents’ earnings on their holding of UK assets has remained broadly stable.
Articles
UK trade deficit last year widest since 2010 BBC News (6/2/15)
UK’s trade deficit widens to 2010 high as consumers take advantage of falling oil The Telegraph, Peter Spence (6/2/15)
UK trade deficit widens to four-year high The Guardian, Katie Allen (6/2/15)
UK trade deficit hits four-year high Financial Times, Ferdinando Giugliano (6/2/15)
Data
Balance of Payments ONS (topic link)
Summary: UK Trade, December 2014 ONS (6/2/15)
Current account, income balance and net international investment position ONS (23/1/15)
Pink Book – Tables ONS
Questions
- Distinguish between he current account, the capital account and the financial account of the balance of payments.
- If the overall balance of payments must, by definition, balance, why does it matter if the following are in deficit: (a) trade in goods; (b) the current account; (b) income flows?
- What would cause the balance of trade deficit to narrow?
- Discuss what policies the government could pursue to reduce the size of the current account deficit? Distinguish between demand-side and supply-side policies.
- Why has the sterling exchange rate index been appreciating in recent months?
- What do you think is likely to happen to the sterling exchange rate index in the coming months? Explain.
One effect of an expansionary monetary policy is a depreciation of the exchange rate. Take the case of countries using a combination of a reduction in central bank interest rates and quantitative easing (QE). A fall in interest rates will encourage an outflow of finance; and part of the money created through quantitative easing will be used to purchase foreign assets. Both create an increased demand for foreign currencies and drive down the exchange rate.
The latest case of expansionary monetary policy is that employed by the ECB. After months of promising to ‘do whatever it takes’ and taking various steps towards full QE, the ECB finally announced a large-scale QE programme on 22 January 2015.
With people increasingly predicting QE and with the ECB reducing interest rates, so the euro depreciated. Between March 2014 and 21 January 2015, the euro depreciated by 20.2% against the dollar and the euro exchange rate index depreciated by 9.7%. With the announced programme of QE being somewhat larger than markets expected, in the week following the announcement the euro fell a further 2.3% against the dollar, and the euro exchange rate index also fell by 2.3%. The euro is now at its lowest level against the US dollar since April 2003 (see chart).
The depreciation of the euro will be welcome news for eurozone exporters. It makes their exports cheaper in foreign currency terms and thus makes their exports more competitive. Similarly Japanese exporters were helped by the depreciation of the yen following the announcement on 31 October 2014 by the Bank of Japan of an increase in its own QE programme. The yen has depreciated by 7.7% against the dollar since then.
But every currency cannot depreciate against other currencies simultaneously. With any bilateral exchange rate, the depreciation of one currency represents an appreciation of the other. So just as the euro and yen have depreciated against the dollar, the dollar has appreciated against the euro and yen. This has made US goods less competitive relative to eurozone and Japanese goods.
The danger is that currency wars will result, with monetary policy being used in various countries to achieve competitive depreciations. Already, the Swiss have been forced, on 15 January, to remove the cap with the euro at SF1 – €0.833. Since then the Swiss franc has appreciated by some 15% to around SF1 – €0.96. Will the Swiss now be forced to relax their monetary policy?
The Danish and Canadian central banks have cut their interest rates, hoping to stem an appreciation of their currencies. On 28 January, the Monetary Authority of Singapore sold Singapore dollars to engineer a depreciation. The Singapore dollar duly fell by the most in over four years.
But are these policies simply beggar-my-neighbour policies? Is it a zero-sum game, where the gains to the countries with depreciating currencies are exactly offset by losses to the those with appreciating ones? Or is there a net gain from overall looser monetary policy at a time of sluggish growth? Or is there a net loss from greater currency volatility, which will create greater uncertainty and dampen cross-border investment? The following article explore the issues.
Articles
Massive Devaluation of the Euro Seeking Alpha, Sagar Joshi (26/1/15)
Devaluation and discord as the world’s currencies quietly go to war The Observer (25/1/15)
Why is dollar strong vs. 18 trillion of USA’s debt? Pravda, Lyuba Lulko (26/1/15)
Central Bankers Ramp Up Currency Wars Wall Street Journal, Anjani Trivedi, Josie Cox and Carolyn Cui (28/1/15)
The Raging Currency Wars Across Europe The Market Oracle, Gary_Dorsch (29/1/15)
Why ECB action is likely to stoke global currency wars Financial Times, Ralph Atkins (22/1/15)
Euro slides as ECB launches QE Financial Times (22/1/15)
Will Australia join the Currency Wars? The Daily Reckoning, Australia, Greg Canavan (23/1/15)
Australia’s central bank cuts rates to record low; currency plunges and stocks spike The Telegraph (3/2/15)
Singapore loosens monetary policy Financial Times, Jeremy Grant (28/1/15)
Currency Wars Have a Nuclear Option Bloomberg, Mark Gilbert (12/2/15)
Questions
- Explain how quantitative easing results in depreciation. What determines the size of the depreciation?
- How is the USA likely to react to an appreciation of the dollar?
- In the UK, who will benefit and who will lose from the depreciation of the euro?
- What are the global benefits and costs of a round of competitive depreciations?
- How does the size of the financial account of the balance of payments affect the size of a depreciation resulting from QE?
- What determines a country’s exchange-rate elasticity of demand for exports? How does this elasticity of demand affect the size of changes in the current account of the balance of payments following a depreciation?
- Might depreciation of their currencies reduce countries’ commitment to achieving structural reforms? Or might it ‘buy them time’ to allow them to introduce such reforms in a more carefully planned way and for such reforms to take effect? Discuss.
Where practical, some firms may thus choose to relocate from the UK to the EU or move business and staff from UK offices to offices within the EU. This is particularly relevant to the financial services sector. As the second Economist article explains:
If inflation rises, then the Bank of England may raise interest rates. This could have a dampening effect on the economy, which in turn would reduce tax revenues. The government, if it sticks to its fiscal target of achieving a public-sector net surplus by 2020 (the Fiscal Mandate), may then feel the need to cut government expenditure and/or raise taxes. Indeed, the Chancellor argued before the vote that such an austerity budget may be necessary following a vote to leave.
