“The reverse, i.e. scaling down monetary union to a mere single market or even a free-trade zone, is viewed as even more of a risk, because dissolving monetary union with so many members could trigger capital flight, which would overload every banking system in the world, with unpredictable consequences for the real economy. Fear of moving in either direction makes the EU look increasingly like a bad marriage in the 1960s, when the partnership only survived because neither was prepared to risk leaving.”
Fra Commerzbank:
The UK has voted by a surprisingly wide margin to leave the EU.
We discuss possible implications. Markets already reacted strongly today, but not panicky. They could recover again in the medium term, as in our view an amicable divorce with a continued British membership in the single market is the more likely scenario.
We also show that the negative impact on the UK real economy will be smaller than in past crises. Nor will the EU emerge unscathed, because Brexit will encourage parties across the continent which are critical of the EU. Surprisingly clear victory for EU opponents
After a highly emotional campaign, the British electorate voted to leave the EU. According to the official outcome, 51.9% were for Brexit, 48.1% for Remain. Opinion polls did not give a clear picture, but the pound’s rally in recent days indicated that the expected the UK to stay in. Strong but not panicky market response today Because the market has been taken by surprise, sterling has already lost considerable ground.
The euro and Scandinavian currencies likewise came under pressure. The typical “safe haven” currencies – Yen and Swiss Franc – strengthened. However, the FX market has not yet shifted into panic mode. EUR-GBP is not markedly higher than it had been in April, EUR-USD is trading above the March levels.
The percentage change of sterling does not yet match the scale of the Swiss Franc’s move after the SNB shock on 15 January 2015. Therefore, markets are by non means “disorderly”. Thus, they are not in a state which might bring central banks around to agree on FX interventions. Several G7 central banks are against interventions in any case, be it as a matter of principle or out of self-interest.
And those which might contemplate interventions will not pull enough of a punch on their own. Equity markets reacted strongly, but – like the FX markets – not panicky. The Nikkei lost roughly 8%, US futures are currently down around 4%. Nature of split decisive in medium term What happens in the medium term after the inevitable market slump today will largely depend on how the UK and the EU part company. According to Article 50 of the EU Treaty, there is a period of two years for the split to be negotiated, and this period can be extended by mutual agreement.
The main concern for the UK economy during these negotiations will be to retain access to the EU single market after it has left the EU. The UK could argue that non-EU countries such as Norway, Iceland and Liechtenstein are also given this access, although the UK would then have to accept the rules of the single market (including free movement of labour) and would also have to pay contributions to the EU budget.
Before the referendum, the EU view was that if the UK left the EU, it could not stay in the single market, as a deterrent to possible copy-cats. However, in our view the EU still has a strong interest in a clean break: • Exports to UK important: 47% of British exports go to the rest of the EU, whereas only 7% of Continental EU exports go to the UK. The UK is thus still the EU’s number two trade partner, after the US and ahead of China (see chart 1).
The EU therefore has a strong interest in avoiding duties on goods traded with the UK and keeping it in the single market. Such duties would after all seriously disrupt cross-border production chains established over a period of decades.
In addition, EU companies would have to prove that their products complied with UK standards. • Avoiding market turbulence: If the divorce proves acrimonious, we could see upsets on the financial markets. The EU could limit the fall-out if it signalled willingness to reach an amicable agreement.
• Its own image: The EU has a major image problem. More and more voters regard it as undemocratic. If it plays the jilted bride after Brexit and refuses the UK access to the single market, it wouldn’t only be EU critics who would object to that the UK’s democratic decision has been respected. And this is something the EU really can’t afford. If signs of a clean break gradually emerge, sterling and the equity markets should recover again in the medium term.
Brexit: comparison with earlier crises Yet even as uncertainty fades gradually, it will remain high for some time. This could damage the real economy not just in the UK but also in mainland Europe. In order to obtain an idea of the impact on the real economy, we have considered various earlier crises:
• EMS crisis: In September 1992, sterling came under mounting pressure within the Exchange rate mechanism, prompting the government to leave the EMS on 16 September. The pound then lost almost 30% versus the dollar, a scale that is entirely realistic for the days and weeks ahead.
The large UK current-account deficit (as is the case today) declined rapidly. The effect of this shock on the economy was limited, though. The UK recovery continued at the same pace as that during the recovery which followed weak years, partly because the sharp rise in import prices had little impact on private consumption (see chart 2). Rapid sterling depreciation and subsequent speedy reduction of the current large UK current-account deficit need not necessarily trigger a UK recession.
Compared with the ERM crisis, there is admittedly uncertainty today about the future relationship between the UK and the EU, which will undoubtedly hold back investment in the UK. However, this should be a medium-term rather than a short-term factor, and need not result in an immediate recession. And this is even more true of the euro zone, which is affected less than the UK by Brexit.
• Lehman crisis: When Lehman Brothers collapsed in September 2008, the stability of the global financial system was threatened, and the foundations of economic activity in the entire world were shaken. The result of the shock and uncertainty was a slump in all the big industrial countries. This cannot be compared with Brexit. Banks may opt to relocate, but Brexit poses no threat to the stability of the financial system.
• Government debt crisis: The government debt crisis that broke in 2010 threatened the very existence of the European Monetary Union and seriously unsettled the business world. This is probably a major reason why investment in euro zone businesses never really recovered from the Lehman crisis (see chart 3). In 2012 and 2013, there was a slight recession. Brexit would be only mildly comparable, because the resulting risks are at least less severe for the euro zone than after the debt crisis, which threatened the future of monetary union.
Brexit, similar to the previous crises, means uncertainty, and in this respect is bad for the economy. However, Brexit does not pose as severe a risk as the sovereign debt crisis or the Lehman bust. We do not envisage the euro zone sliding into a recession. The same is probably true of the UK, especially if a clean separation gradually emerges.
Brexit a boost to anti-EU parties on the Continent Brexit is not just an economic risk, it is also a political factor. The British verdict supports the antiEU parties in a number of EU countries, and this at a very difficult time. The EU is after all torn between greater and lesser degrees of co-operation. The euro zone countries need to observe more stringent budget rules, or cede greater financial and economic power to Brussels, if monetary union were to be made fully functional. Yet governments are reluctant to move to a more powerful EU, on account of the growing number of critics and the lack of consensus on economic policy.
The reverse, i.e. scaling down monetary union to a mere single market or even a free-trade zone, is viewed as even more of a risk, because dissolving monetary union with so many members could trigger capital flight, which would overload every banking system in the world, with unpredictable consequences for the real economy. Fear of moving in either direction makes the EU look increasingly like a bad marriage in the 1960s, when the partnership only survived because neither was prepared to risk leaving.
Nevertheless, there is still some risk that monetary union will fall apart. The EU’s paralysis is fuelling further opposition among voters. Opponents in many European countries are gaining ground (chart 4), and might be in power in Vienna or Amsterdam before too long. And if one country dared to leave monetary union, it would be a core country rather than one on the periphery, since they would not face the problem of capital flight which might deter some peripheral members.
