Brexit: A Shakespearian Irony - My Economy Notebook

Includes: EWU, FXB, FXE, IEV
by: Dennis Viliardos


Britain was wise enough to stay out of the Eurozone. It is now thinking of leaving the sinking ship entirely.

Yet, it has to deal with an ever widening current account deficit, as a result of EU-related trade imbalances.

Outflows have also been quiet heavy, especially after the 2008 financial crisis.

Leaving the EU would endanger exports of services and would also most likely shatter Britain’s artificially growing GDP.

Currently, the devaluing pound can be seen as a very interesting opportunity.

Both the Eurozone and the European Union are experiencing existential challenges. Major current account imbalances within the common currency Union have encouraged multiple anti-EU movements.

The European North is running a current account surplus, while most countries of the South have to deal with a deficit. This development is closely linked to the fact that a common currency (and a common Central Bank) limits a nation's ability to choose its own monetary policy (example: devalue its currency to spur exports). As a result, members with a different economic model or of smaller size, have to deal with a stronger currency, while countries with a stronger/larger economy, can benefit from lower than normal exchange rates (rates being lower because the weaker countries are "pulling" them down).

As a reaction to this "mess" Germany and other surplus countries devised a new plan for the damaged nations of the South. A plan that was based on internal devaluation: "If you cannot reduce the cost of your products by devaluing your currency, you must make them cheaper using other means - like for example reducing the cost of production, i.e. wages".

While this notion makes sense, it also leaves us wondering why a country operating a deficit would want to enter a common currency union in the first place. After all, the only "benefit" it seems to derive, are lower living standards that in turn lead to an unstable political environment. Britain therefore, was wise enough to stay out of the Eurozone.

Many Economists have criticized austerity, the term used to characterize the cruel policy of internal devaluation. This very policy eventually devastated weaker economies and increased their debt, making them even less competitive. An overvalued currency (in terms of weaker economies), increased private debt as well. Eventually businesses and households started having difficulties paying their dues and as a consequence banks got hammered and governments had to rescue them - resulting in an ever increasing debt burden.

Now, if we add other problems to the equation as well, such as the immigration crisis and deteriorating relations with Russia (where again, the South has been exempted from becoming energy independent after the halting of the Bulgaria pipeline, while the North has Nord Stream up and running), the BREXIT incident is something more than just a coincidence. It looks more like as if Britain wishes to abandon a sinking boat just in time, before it drowns together with other European Union members.

But as much as it would like to satisfy its desire to quit the EU, certain economic factors will most probably put brakes on such a development. And while both pro-BREXIT and pro-EU supporters are currently at a tie (on average, because lately pro-EU supporters are gaining ground again), staying in the EU retains the "status quo" and people usually avoid changing what is known to them, always in fear of the worst.

Having said that and before we begin our own analysis based on facts and away from mainstream media factionalism, we will take a quick look at what two very prominent opinion leaders have to say about the BREXIT scenario - namely the Bank of England's governor Mark Carney and of course the market (aggregate opinion of investors):

In the event of a vote for Brexit, Mr. Carney said the Bank "will do everything in our power to discharge our responsibility to achieve monetary stability and financial stability".

But he added that he could not "provide a blanket assurance that there would not be issues in the short term with respect to financial stability and that potential reduction in financial stability could be associated - and normally would be associated - with poor economic outcomes, as we have seen in the past".

Asked whether uncertainties of this kind might lead companies to relocate business activities away from the City in the event of Brexit, Mr. Carney said: "One would expect some activity to move. Certainly, there is a logic to that.

So Mr. Carney seems to be skeptical and markets seem to agree with him:

*The development of the British pound against the Euro. The EUR/GBP exchange rate is more commonly used among investors, but I chose the reverse so that we can see the depreciation of the pound more clearly.

Britain's deficit and its dependence on EU trade

We will start our discussion, by going through one of the UK's greatest problems: its current account deficit. Many of the nation's media kept a different viewpoint concerning the country's dependence on EU trade. Magazines such as the Spectator, had many of its authors supporting the BREXIT, arguing that trade and political dependencies are keeping Britain from confronting its problems. Other media like the Economist, point out that the EU is the nation's greatest trading partner and that exiting the Union would cause fear and distress to investors.

So let's go through the data ourselves, in order to find out what the exact conditions are. For us to be able to understand the issue at hand, we should first of all examine the current account itself.

A major part of the current account, is the balance of trade. The balance of trade, has two components: Exports and imports. After 2006, Britain's exports kept rising and so did imports. During that period the nation's balance was many times close to 0 (the breakeven point if you wish). After 2013 and on, the country's economy started deteriorating, along with its trading partners. Exports and imports started declining, but exports went down faster.

Currently, Britain is at a trade "turning point", just before a major shift. Leaving the EU will most definitely hurt its balance further (at least temporarily).

Its current account also includes inflows and outflows of funds. Outflows have been quiet heavy, especially after the 2008 financial crisis, from which most European countries never really recovered. Further outflows would definitely be the case if the country was to leave the EU, at least as a temporary reaction (fear, uncertainty). It therefore seems as if the timing for a BREXIT discussion is pretty bad and without going further into it, it definitely looks more like "politics" than an economic resolution process.

Digging further into the UK-EU case, the extent to which the nation depends on members of the Union can be summed up with the following graph:

"Where do Britain's exports go?"

The graph reveals to us that the EU is more than just an important trading partner, especially now that Britain loses market in the US. Of course it is wise to point out that while the nation is running a trade deficit with EU members, it is at a surplus with non-EU trading partners (see graph below).

What pro-BREXIT factions won't of course tell you, is that the deficit concerning EU members, is only related to goods, while in services there is a surplus. Why is this information so important? Because a BREXIT will have limited effect on the trade of goods, but a major effect on trade in services (as far as the UK-EU trade regulations are concerned). Below I have added a table I found on Open Europe's website that will give us a clue, as to which trade sectors will suffer from a BREXIT:

The first column, presents the various sectors, separated in goods and services, to better exemplify the possible effects of a BREXIT. The second column, depicts the percentage of total exports (per sector) that are related/directed to EU member nations. We get a clear picture of Britain's dependence towards the European market. Now, a quick look at the 3rd column verifies what we stated earlier, that the UK is running a surplus with the EU in services. According to the table, there is a high risk for trade disruptions in all sectors, but only the service sector seems to have a limited chance for similar EU access after a BREXIT. In fact, financial services, the sector with the largest trade surplus, is also the sector that will be affected the most in such a case.

Let's take an even closer look. Margaret Thatcher, was among the first to realize the importance of the European market to Britain. She understood that England had accrued great expertise in the services sector, particularly in the financial industry, but also in other fields such as legal, accounting, research, media etc.

For Britain therefore, being a member of the EU is of vital importance. For other EU members though, it makes little difference if the country remains part of the Union or only of the WTO. If Britain now chooses to exit the EU, it would have to re-negotiate its terms with other members and follow the example of countries like Switzerland and Norway (their relation to the EU). It would make perfectly sense then that the European Commission would propose a similar agreement to that of those "semi-independent" nations - otherwise it would have to make concessions with other nations as well. This very same retreat, would then "open the doors" for other nations to leave the EU and the Eurozone.

Continuing, there are four conditions that Norway and Switzerland have accepted and that would never be negotiable. As a member of the EU, Britain is entitled to a much "better deal" compared to "semi-members". In particular, these two countries, have to adhere to all regulations and standards of the EU, without the right to take part in their formulation. The same countries have also agreed to incorporate all relating regulations of the Union into their national law, without conducting a referendum. At the same time, they have to contribute to the Union's budget and must also accept European migrants without questioning (the reason most of these "semi-members" have higher proportions of foreigners than regular EU members).

Now, if Britain was to refuse such interferences in its sovereignty, the EU would most likely disallow its services sector from operating inside the Union. Countries like Ireland hope for such a scenario to unravel, since many businesses would move there, to avoid losing access to the European market (banks, hedge funds, insurance corporations, etc.). Scotland then, would also try to remain a member of the EU, by raising the question of leaving Britain again (to also rip benefits from Britain's exit).

The short term disaster

Those who are in favor of the UK leaving the EU, believe that the trade deficit can be offset by pushing for internal production. Specifically, they think that exiting the Union will allow the government to impose tariffs on imported products and hence protect domestic businesses from global competition. While the idea behind this plan sounds promising for an economy (middle class businesses always contribute the most to GDP), in reality the WTO would most probably not allow it.

Even if Britain miraculously manages to "pull it off" and initiate its "national production" grand plan, it would take a very long time to construct this network. Currently, industrial figures have not been very promising (see graph below).

It is important for us investors, to understand what options the British government has. If we manage to clear them out, we will have a much greater chance of predicting its moves and benefit from the declining pound. That is the reason I am going to deepen this discussion even more by saying that a BREXIT would require public investments, even indirect ones (ex. lowering tax rates for businesses).

These investments, would put pressure on the nation's budget, again. In fact, a very same method was used after the 2008 crisis. Back then, the government had initiated a plan to boost growth, by incurring heavy deficits on its budget (see graph below).

The above graph, compares the budget development of the UK and Greece and we can see that there are only small differences (after 2015, Greece's budget got hammered because bank losses where added). Greece is in essence a bankrupt nation.

This comparison of course does not assume that Greece and the UK are experiencing the same economic conditions. What it was meant to show, is that these two nation might ultimately follow the same trajectory. That is of course if nothing is to change (in the longer term). With a rising debt (52,3% of GDP in 2008, 88,6% in 2015), the UK would most likely avoid investing in this "national production" grand plan, because it would risk generating further budget deficits. Lending to new businesses would also be limited, now that many of the nation's banks are greatly exposed to the Chinese market ( see my article on China). At the same time, the British government must be ready at all time to confront the housing bubble, when the bursting time comes.

"To be or not to be"

So for all these reasons a BREXIT would cause great discomfort. If we add to that the current account deficits (and the "would be" deficits in the case of a BREXIT), the case would become very risky. If we look at the graph below, we will see another great problem, namely the artificial growth on which the current government resides upon.

As we can see on the left graph, there is a huge divergence between the employment rate and the growth rate. This verifies our belief that growth in Britain today has been artificially sustained by generating budget deficits. The right graph will reveal to us yet another problem that might eventually be the result of this strategy: a form of hyperinflation. A lower than normal productivity rate, coupled with the immense supply of money that Britain's QE projects have generated, can fuel inflation as soon as energy prices rebound.

To fight off this danger, the BoE would be forced to increase interest rates, pushing the cost of borrowing for new domestic businesses up. And all that … under the constant fear of a decline in growth that, as can be seen from the graph, is non-sustainable.

So although from a political-social perspective, a BREXIT might be a good idea (due to Germany's and Holland's thirst for economic and political dominance), from an economic viewpoint, it looks like a bad idea - at least under current circumstances. Because political figures have to care about their re-election as well, short term results are most of the time given a priority. But then again, it is a referendum.

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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.