Assessing Brexit Consequences

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Summary

Brexit vote is a short-term risk.

However, Brexit itself can have long-term effect.

The main long-term risk is uncertainty.

There are generally two types of economic risks. The first is long-lasting systemic risks. Usually, the economic growth is attributed to them. They include significant institutional or global macro changes, such as supplies shocks, changing banking, or trade legislation with a significant impact on the long-term growth trend prospects. The second type is short-term risks. They involve fluctuations of the output around some trend. The Brexit vote is a nice example of the second risk, while actual Brexit may have long-term effects and, thus, become the risk of the first type.

Since the vote itself does not mean the automatically UK leaves, it is too early to make projections about quantitative economic growth consequences. However, the vote itself will bring volatility to the UK and EU markets. First, we will see foreign exchange shifts. "Leave" vote will have a short-term negative effect on pound exchange rate and, to some extent, euro, as some investors will reassess risks and sell UK and EU assets. Ahead of the referendum, the pound has already lost 6.5% on the euro, 1.9% to the USD, and 6.1% to the CHD during 2016, according to Bloomberg. The main gainers of the UK "Leave" vote might be the USD and Swiss franc. Second, we will see stock markets moves, especially among stocks of the companies, exposed to the UK market. Uncertainty about the Brexit will drag on consumption and investments, decreasing demand. Third, there will be general securities market portfolio rebalancing as some investors will sell riskier assets, such as stocks, and buy safer, such as gilts, while others will close their positions in the UK market. And fourth, they will be shifts in the money market and we will see widening interest rates spreads, as many banks and institutions after the "Leave" vote will be regarded as riskier.

Such developments will require Bank of England to shift its projections on inflation and economic growth further and to continue conducting accommodative monetary policy. If the "Leave" vote does not have serious systemic and institutional change effects, we will see normalization within one or two years as uncertainty fades. In such scenario, pound exchange rate and other assets price will depend on UK economy performance, which will return to solid 2% growth rates and Bank of England inflation target of 2% by 2018.

What are serious systemic and institutional changes effects? The first and the principal effect is a prolonged period of the uncertainty. With the "Leave" vote there will be many discussions about what exact from this leave will take, about the possibility of the second "reaffirming" referendum, etc. It may take a lot of time, so the uncertainty will drag on economic activity and may place pressure on economic growth and inflation for a prolonged period until these issues are resolved. The second is the total change in the way of the political and economic cooperation between UK and EU. It includes free labor, capital and goods and services movements. Though they are very unlikely, in the case of such scenario consequences for both UK and EU economy will be significant. We will see a decrease in trade volumes, international cooperation, and markets flexibility, which will have a long-lasting effect on economic growth. The last serious and long-lasting consequence of the UK leaving may be strengthening of the "leave" agenda in other EU nations. As it was with Grexit, even the possibility of the breakup of the Euro area have a very negative effect on economic activity, and now for a fragile Euro area recovery.

However, most likely that even with the "Leave" vote, we will not see rising barriers for free economic activities. It has no benefits for both UK and EU, as it reduces competition and economic flexibility that is very important for sustainable economic growth.

We see that the bulk of the Brexit risks are short-term and concern market fluctuations. Monetary authorities, both in UK and EU, should deal with them by stimulating economic activity, and if uncertainty fades rapidly, we will see returning risk appetite. The uncertainty is the main, long-lasting risk. Politicians must negotiate about the UK's future quickly in the case of the "Leave" vote, since otherwise, consumption and investment will remain sluggish, dragging on the general economic performance.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.