‘Hard’ Brexit now seems the likelier scenario no. 3

BPCC Brexit Brief No. 3: updated 3 October 2016.

100 days after the referendum, and there is now some initial clarity concerning the key question as to whether Brexit will be hard or soft. On the first day of the Conservative party conference, Theresa May has given a firm date for triggering Article 50 – “by the end of March 2017”. The prospects of the UK remaining within the single European market look less likely.

The markets opened the next day to further falls in the value of sterling, as investors – rather than being cheered by the ending of uncertainty as to Brexit’s timing – took fright at the implications of how Brexit would look in practice (see graph below). It seems that curtailing migration has taken precedence over the UK’s remaining part of the single European Market, and this approach is worrying investors.

While trade minister Liam Fox continues to promote the UK as a champion of global free and fair trade, solving the migration challenge has become the political imperative. Her Majesty’s Government will first set out what it would like to see in terms of taking back control of UK borders, and then – having presented its proposals – will see what kind of trade deal can be reached with the EU, given the migration limits postulated by the UK. A migration-led hard Brexit could mean the introduction of tourist visas and work-permits for EU citizens.

The favourite Brexit configuration that’s currently being discussed is ‘Canada-plus’, being something along the lines of the free-trade deal currently being finalised between Canada and the EU.

Leaving the single European market and the effect on UK-Polish trade and investment

While the UK ran up a trade deficit in goods of £125 billion trade deficit in goods last year, its trade surplus in services was £90 billion, which kept the overall trade deficit down to a relatively manageable £35 billion. Post-Brexit, it is likely to become harder for the UK to export services to the EU. And at the same time, the UK will be paying more for imported goods, given the depreciation of sterling. This will mean an increase in the UK’s balance of payments deficit.

Is this inevitable? What about import substitution? Foreign capital, which has been flocking to the UK for decades, seeing the country as a great platform for manufacturing within the EU, may not be sufficiently attracted by the UK simply to serve the UK market. So if there’s to be import substitution on the kind of scale that would have an impact on the UK’s balance of payments, it will be down to domestic capital to invest in it. But will any investor risk their capital in a manufacturing venture to service a market of just 65 million (as opposed to 440m consumers across the remaining EU member states) – with exports subject to 10% import duties in their destination markets?

The likelihood is that the UK will continue sucking in imported goods, even with tariff barriers in place. Weak pound + tariffs = more expensive imports and inflation kicking off.

What does this mean for Polish firms looking selling to the UK after Brexit? Their cost-base will remain competitive in relation to western European economies. The weak pound and the new tariffs will hit all exporters, but those with the highest cost base may find their products are no longer affordable by British consumers. Polish exporters may have an opportunity here.

Looking the other way, a weaker pound that will probably cancel out price rises caused by tariffs, a rapidly rising GDP and ever-wealthier consumers mean that Poland should be seen as a priority export market for UK manufacturers.

Both sides to any trade negotiations will want to avoid a ‘Mexican standoff’ in which high tariffs hamper sales. The UK is a rich and lucrative market for German car manufacturers, while the UK is a major exporter of cars to mainland Europe. However, the German auto industry is German owned, while the UK’s is owned by Japanese, German, US and Indian concerns. While there’s little prospect of Nissan or Jaguar, for example, closing down auto plants in the UK in the near future, they may be less likely to increase investment in the UK after Brexit, and the danger to the UK is that they may choose to build new models on new lines in factories still within the EU. The same goes for the supply chain.

The impact of the 23 June referendum on UK-Polish trade is not yet noticeable in statistics for the first seven months of 2016, however looking at the Polish stats it is now apparent that the UK has lost its status as Poland’s second-biggest export market – it’s now Czechia.

Financial services and Brexit

Over 5,500 UK financial services institutions currently benefit from the ‘passporting’ regime that gives them access to the EU market – but then more than 8,000 financial services institutions from mainland Europe use passporting to access consumers in the UK. Discussions about the future of financial services post-Brexit are low-key. Last week Theresa May met bosses from the US financial services sector to listen to their concerns, but in the background there are signs that many foreign-owned financial services institutions based in the City of London are actively or passively considering to move all or some of their EU/EMEA HQ operations to mainland Europe.

Poland is unlikely to attract headquarters, given the lack of the necessary ecosystem, the most highly skilled people, the institutions, the real estate and the scale etc. However, many back-office activities could be outsourced to Poland, amplifying a trend that’s been visible for the past few years.

Macroeconomic indicators

It is still too early to judge the full extent of the referendum decision and its political repercussions on the UK economy. It will only be in late February 2017 that we’ll have the trade stats for the second half of this year, giving enough data to form a meaningful picture.

In the meantime, UK unemployment has fallen to its lowest level (4.9%) in the three months to July, and retail sales increased by 6.2% in the year to August (though down 0.2% month on month).  Consumer price inflation has inched up to 0.6% in the year to August, coming months are expected to see it rise faster.

The Bank of England, having cut base rates to a historically low 0.25% to boost to economic demand, is expected to make a further 15 basis-point cut to 0.1% in November. Whether this tiny cut will have any further effect on consumer spending or business investment is a moot point.

Currency markets

The markets are twitchy, reacting to news and rumours concerning the shape of Brexit, the early-October low of 4.92 zlotys to the pound being a reaction to intimations that a hard Brexit is now the more likely outcome. But once that news had been digested, the pound bounced back against most currencies. Usual macroeconomic factors that affect the currency markets such as GDP forecasts or interest rate movements are now joined by Brexit-related tidings.

It is therefore highly probable that sterling will continue to fluctuate with a greater amplitude than has been observed over the past four or five years. This will not help trading and investment decisions.  However, few can accurately predict tomorrow’s market prices!