Hard Brexit!

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Summary

It is increasingly clear the UK is opting for a hard Brexit.

A hard Brexit has multiple serious ramifications for the UK economy.

A flexible exchange rate is softening the blow considerably, but this is likely to continue and could create problems of its own.

Brexit could be able to achieve something that has escaped all the big central banks, despite throwing everything and the kitchen sink at the problem. That is, creating inflation.

Why is that? Well, it's fairly simple. Theresa May, the new British PM, has made a surprising turn in the direction of hard Brexit. That is, prioritizing domestic sovereignty and border control at the expense of having access to the single market on more or less the same terms as the UK has today (The Telegraph):

Mrs May said that after Brexit the UK will be "a fully-independent, sovereign country" that will no longer be in the "jurisdiction of the European Court of Justice", suggesting that Britain is preparing to leave the single market.

It has become increasingly clear that the EU powers that be feel little enthusiasm for forgiving the UK its cake and allowing it to eat it, too, that is, giving it preferential access rights to the single market without the obligations of the four freedoms (of goods, services, labor and capital).

If not that, there was also looming veto power by countries with little to lose (BBC):

A group of Central European EU members known as the Visegrad Four is ready to veto any Brexit deal that would limit people's right to work in the UK, Slovakian PM Robert Fico says. In an interview with the Reuters news agency, Mr Fico said Hungary, Poland, the Czech Republic and Slovakia would be uncompromising in negotiations.

We earlier expressed incredulity at this British course of action, to such an extent that we thought it would not happen. But hard Brexit now looks firmly on the cards. Perhaps the main caveat remaining takes the form of potential political surprises.

In the UK itself, the Conservatives seem to be well entrenched in power after the opposition Labour party self-imploded. But on the continent, things are distinctly less solid, and anti-EU parties could do well in a number of countries, most notably Italy, France, Netherlands and even Germany.

Of these, Italy seems to be the most immediate danger, especially if Renzi loses the constitutional referendum in early December. But instead of the politics, which are highly unpredictable, let's focus on the economics.

What does hard Brexit mean?

  • Single Market
  • Passporting rights
  • Trade

The UK will lose access to the internal market. It very much remains to be seen whether they can pry some concessions, or manage to accomplish a trade deal with the EU within the 2 year confine of the Article 50 agreement (the relevant legal part of the EU governing Brexit).

In principle, a UK-EU trade deal shouldn't really be terribly complicated as the UK already complies with basically all single market regulations (which are going to be transcribed into British law). However (Business Insider):

The most important thing to understand is that once Article 50 is triggered, the EU can filibuster the talks, running out the two-year clock, until Britain is ejected in a "hard Brexit" without any of its demands or requests being met. The EU is heavily incentivised to give the UK the worst deal possible. Its leadership wants to keep the rest of the EU together. Therefore the EU needs to teach all its other members a lesson in what would happen to any other country wanting to leave. That is why it will be happy to see Britain drop out without access to the single market.

Without a EU-UK trade deal, trade between them will fall back to the WTO regime. This puts tariffs on many products (both ways) and is likely to have a dampening effect on trade, and the process isn't all that simple in itself (The Economist):

Yet its tariff, quota and subsidy rules are fixed by its EU membership. Post-Brexit it needs terms of its own, and they have to be negotiated and approved by all 163 other WTO members, a process that the WTO's director-general has called "tortuous".

The ramifications for the UK's trade regime are more serious, as it basically has to renegotiate trade deals with the rest of the world. We refer to this excellent article for the details. The real pain lays here though (The Telegraph):

It also glosses over the fact that both EU and WTO rules treat services in a much more draconian fashion than goods. And the former are far more important to the UK economy. That's why the Institute for Fiscal Studies has concluded that British output will be 6pc lower if the UK doesn't secure access to the single market.

There will be significant damage to the position of London as a financial center. This is because without single market access, financial institutions will lose their right to passporting. Here an explanation of its importance (British Banking Association):

passporting is very valuable to the UK. It has underpinned the growth of London as Europe's financial centre, and helped financial services become our biggest export market by far. The UK exports over £20 billion of financial services a year to the EU27, much of it underpinned by passporting rights.

There are nine different passporting regimes in EU law that allow financial services companies in one country to establish a branch in another country without having to be separately authorised or regulated. It is also allows financial service companies to sell directly to customers - whether companies or individuals - in other EU countries. It is two-way, and means also that banks from other EU countries can freely establish major operations in the UK, both to serve customers here, but also to serve customers across Europe. Almost every argument used to belittle the importance of passporting is based on at best a misunderstanding

The results of a loss of passporting rights could be rather dire. It could cost up to 70,000 jobs, and (The Telegraph):

Financial services attracted 35pc of the UK's total foreign direct investment between 2008 and 2014, increasing even after the credit crunch, TheCityUK said earlier this month as it began to set out the stall for the industry in the forthcoming Brexit negotiations. Meanwhile, the industry is responsible for an international trade surplus of £22.8bn, more than 40pc of which comes from European Union trade.

The city does a lot of euro denominated clearing (Wharton):

It is a huge business, with the value of daily transaction turnover exceeding $1 trillion. Though the U.K. does not use the euro as a currency, the court upheld its privileges to clear the euro because it is part of the EU. Leaving the EU could therefore not only mean losing the business itself, but the ecosystem around the business, which often follows.

A U.K. exit might also limit the ability of London-based clearing banks to execute derivatives transactions with EU clients if the country fails to maintain the EU passport for financial services. And there is more. Especially since the crisis, financial services have become one of the most regulated industries.

The EU adopted considerable common regulation to ensure safe, supervised, and pan-European banking services. The City of London has been benefitting from this. Though a lot of the deals, for example, M&A, ECM (equity capital markets) and DCM (debt capital markets) are 'sourced' out of London, the real economy transactions take place in Europe's strong economies like Germany and the Netherlands. Losing EU passport rights, deviating from EU regulation, disengaging from the Capital Markets Union will shift market players to the bigger piece of the pie (the remaining 27 EU countries) and away from the smaller slice (the U.K.).

The City is probably the most important economic motor of the UK, so they're not going to give up without a fight. But apart from the sheer complexity (hence the long quote above), contrary to trade, here the EU actually has more to win by holding out.

The financial services industry is as good as a zero-sum game, what the EU wins comes at the expense of the UK. They have much to lose, and some don't mince their words, like Will Hutton:

Nor do hard Brexiters confront the fact that alongside China and the US, Britain has accumulated a stunning $1tn-plus stock of foreign direct investment. Nearly 500 multinationals have regional or global headquarters here, more than twice the rest of Europe combined. They are here to take advantage of our ultra pro-business environment - so much for the Eurosceptic babble about being stifled by Brussels - and trade freely with the EU. Britain was becoming a combination of New York and California, with a whole continental hinterland in which to trade. Hard Brexit kills all that stone dead and puts phantoms in its place.

And then there is this (Bloomberg):

The U.K.'s vote to leave the European Union has left more than three-quarters of chief executive officers saying they would consider moving their headquarters or operations outside Britain, according to a survey of 100 business leaders by the accountancy firm KPMG.

Just as we are writing this article, a new study leaks with rather frightening sums involved (from CNBC):

"The Treasury estimates that U.K. GDP would be between 5.4 percent and 9.5 percent of GDP lower after 15 years if we left the EU with no successor arrangement, with a central estimate of 7.5 per cent," the leaked document noted. What's more, a hard Brexit would have a massive impact on government revenue.

Silver lining

There is a silver lining of sorts though. Realization has sunk in that the UK is on its way to a hard Brexit, without being a member of the single market, having to negotiate a whole series of trade deals, and risking losing a considerable part of its financial district.

All this has produced sharp falls in the pound, and this is the good news. It isn't surprising, as with diminished rationale for UK location, inward investment will decrease.

Capital inflows will also likely be affected as the city becomes less important over time, and these flows have been propping up the pound as the UK already has a very large trade deficit (over 5% of GDP last year).

Reduced FDI and financial flows can only mean one thing; a lower pound. And as liquid asset markets have a habit of adjusting rapidly, this is what we've seen happening over the last week and a half.

This fall once again illustrates what a disaster the euro is. Currency movements are great shock absorbers, and the fall of the pound is no different. It considerably softens the blow even before Brexit can have any effect on trade.

And if it falls further it could very well induce companies to remain located in the UK (or even move there), including financial companies.

One can also say that hard Brexit could achieve what every big central bank in the rich countries has tried, create inflation, the falling pound will produce that.

While this is good for debt dynamics, it's less good for wages, which are already suffering in the UK (from Bloomberg):

U.K. job seekers are starting to see the impact of Brexit, with salaries under pressure and companies advertising more contract positions as they resist committing to permanent hiring. The average advertised salary was 32,688 pounds ($43,174) in July, down 2.4 percent from a year earlier, according to an index by job search engine Adzuna published Tuesday. When inflation is taken into account, real earnings have fallen 3 percent, it said.

Conclusion

The forces are aligned against the pound sterling. The UK already has a very substantial trade deficit. Add to that the realization that a hard Brexit is the most likely outcome, and there is no way for the pound but down.

Since the UK hasn't left the single market or the EU yet, and isn't going to for at least 2.5 years, most of the negative effects will not really be felt until then.

If the pound falls further and inflation takes off, this could put the Bank of England in a difficult position of having to raise interest rates when a substantial negative shock is arriving.

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.