The debate on whether to exit or remain in the EU has divided Britain into two camps. Both sides have rock-solid arguments to support their views. As for the economists, regardless of the Brexit position they may take, it seems that all of them can agree on one thing: withdrawal from the EU will result in an economic shock for the British economy. The outcome of this shock will be a function of many variables. Whether the outcome will have a positive or negative effect on the economy is heavily dependent on the assumptions being made.
Before considering all the possible variables that will affect the economy in the long-run, it is crucial to understand the positive impact of this Brexit shock in the short run.
Let's follow this chain of events:
To begin with, the Brexit-shock is going to be a temporary one. It will inevitably begin with a sharp depreciation of Sterling. The depreciation of the Pound depends on a few factors but in relation to Brexit, two factors will play the largest role.
- If speculative traders, who are currently holding the largest amount of net-short positions on Sterling, decide to close their positions. In other words, speculative traders have an option to short-sell more than GBP2.5bn. in the expectation that it will depreciate in value after Brexit. Obviously the decision to close out on these position are guided solely by a profit motive and the extent of the weakness they expect for the Pound after Brexit;
- The other principal source of downward pressure on the Pound may occur if investors decide to flee Sterling as a result of a lack of confidence in the British economy.
Both factors can fuel each other, but depreciation of a currency isn't always a bad thing.
Whatever the reason for depreciation may be, it will have, in the short run, a positive effect on British exports. The price of exported goods and services will become very competitive to foreign markets leading to a significant increase in the volume of exports, which currently account for 28.4% of UK economic output.
The increase in the volume of exports will particularly benefit many export product groups such as: Machineries, Precious metals, Mineral fuels, Pharmaceuticals, Aircraft and Spacecraft etc. Imports, on the other hand, are expected to shrink due to an increase in price.
The impact of an increased export volume of goods and services and decreased imports will not only improve the current account deficit and balance of payments but will also have a positive knock-on effect to the related 'service industries'. Furthermore, it will significantly contribute to economic growth by creating new jobs in the manufacturing industries and the support services around them.
Improved economic conditions are expected to get a massive boost from an increase in foreign investment which will be driven by dropping UK asset prices related to the depreciation of the Pound.
In extreme circumstances, if some investors do decide to flee Sterling, British banks could become short of foreign currency. In order to reassure the market and support the financial system, the Bank of England will have to provide the banks with foreign currency loans. Another measure the Bank of England is expected to take to shore up confidence is to refrain from raising interest rates. Although raising interest rates will tame the rate of depreciation and curb inflation it will at the same time leave UK households worse off, paying more for their loans and mortgages. Therefore, in the short-run, the Bank of England is very likely to loosen its monetary policy, leave the base rate as low as it is now or maybe even drop it slightly, at least until market confidence has been restored.
The Financial Sector
Financials are going to be the biggest beneficiaries of a Brexit. On the one hand, the sector will finally be unchained from heavy and complex EU regulations and from ongoing EU threats to impose a "Tobin Tax", a levy on financial transactions that will affect profitability and will increase costs to households. On the other, it will enjoy the Bank of England loosening the requirements for banks to hold capital, as an attempt to prevent credit contraction. And as a bonus, it will enjoy the unlimited protection of the Bank of England in case of a liquidity panic.
All of these benefits to the banking sector will result in an even greater appetite to lend.
The effect of a depreciating Pound and increased lending at low rates will benefit the entire economy immensely including the property and construction sectors; which now needlessly fear a strong hit related to reduction in demand and shortage of labour.
Property Market/Construction Sector
The fear of falling demand for property is ill founded. First of all, EU immigrants who live in the UK at the time of Brexit will enjoy the legal protection of international law. According to the Vienna Convention 1969, the termination of a treaty "does not affect any right, obligation or legal situation of the parties created through the execution of the treaty prior to its termination". So EU immigrants who live in the UK at the time of Brexit are here to stay. In the most likely scenario, they will be given an indefinite leave to remain. Furthermore, the depreciation of the Pound will slash the price of UK assets in terms of foreign currency. This will lead to a strong increase in foreign investors purchasing UK property.
Fears of shortage of construction labour due to expected restrictions on immigration do not stand up to scrutiny, not only due to the Vienna Convention protection but also because it is absolutely certain that no responsible UK government will allow a labour-shortage in the construction sector. A labour shortage would otherwise place a sector that affects indirectly about 20% of UK output into freefall.
I believe the UK stock market will be minimally affected by the departure from the European Union because the UK stock market is dominated by large international companies whose performance is hardly affected by domestic UK issues. If anything, a lower pound will positively affect their exports and will boost the sterling value of their overseas profits.
In summary, the temporary economic shock to the Pound and the economy will result in a stimulated economy driven by a depreciating Pound, increased volume of exports, increased foreign purchase of UK assets and domestic investment. This will continue until market confidence in the UK economy is restored and then the stimulated UK market will begin to overheat. When this point is reached, the Bank of England will raise interest rates to help the Pound appreciate and tame inflation.
In my opinion, the long-run effect of Brexit will be characterised by a wealthy, sovereign country with a liberalised economy open to other major export markets free of "socialist" EU chains of endless regulation.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.