By rolling the dice over its future trade relationships, British voters’ decision to endorse an exit from the European Union will cast doubt among market observers on the country’s export and long-term growth potential. Indeed, such ambiguity has already hit the U.K. economy, diverting foreign direct investment, causing a sharp depreciation of sterling and triggering a fall in U.K. gross domestic product growth and productivity — all of which have been evident since the June 23 Brexit vote.
Perhaps more surprising, therefore, was the hysterical reaction on global markets as investors wiped $2.1 trillion from the S&P Global Broad Market index (BMI) in the 24 hours following the vote, which some observers perceived as the first domino of the next global economic crisis.
Now that the dust has mostly settled, we can see that the global reaction was gratuitous. Brexit will remain exclusively a British crisis for two reasons: A fall in U.K. banks’ liquidity will not have global repercussions, and investment flows that are diverted away from the U.K. will benefit other economies, particularly the euro zone. Any Brexit-motivated hits to the global economy will be negligible, with maximum losses to euro zone GDP growth of 0.3 percentage points and to the U.S. a mere 0.05 points.
The U.K. economy, however, will continue to suffer following the vote as investors flee the domestic market to seek safe-haven investments. Because the U.K. is unlikely to negotiate better tariffs outside the single market, we anticipate weaker corporate and property investment flows, difficulty in financing both its external and fiscal deficits and, in turn, a continued weakening of sterling.
Indeed, the pound’s correction poses its own threat to the U.K. economy because, contrary to the assertion that a weaker currency is a universal remedy to stimulate exports, the U.K.’s sophisticated and service-based economy relies on a strong pound. The country’s core exports — such as financial, legal and information technology services — do not enjoy the kind of demand surges that manufactured goods get from a currency depreciation. In this respect, a 1 percent fall in sterling stimulates just a 0.14 percent increase in export volumes.
What’s more, these debilitating economic consequences will be magnified by the U.K.’s significant wealth effect. Its markets depend more than most on asset values increasing to attract further investment. For instance, as U.K. households typically limit spending during periods of sluggish growth, Brexit may increase the contraction in real estate and corporate investment as long as market confidence remains low — causing a self-fulfilling prophecy of downgraded growth.
In this context, U.K. mortgage holders face a danger similar to that in 2008, when household debt reached 160 percent of gross disposable income before returning to its current level of 140 percent. It is conceivable, therefore, that household debt levels and default rates will spike once again — a potential contributor to the expected 1.6 percent hit to U.K. GDP in 2017.
Although a U.K. mortgage crisis would be reminiscent of the U.S. subprime market crash, it doesn’t carry the same risks of global contagion. A British mortgage crisis will not expose global banks to losses to the same extent as the subprime crisis did, and the Bank of England is more capable than the Federal Reserve was — given the low interest rate and weak interbank credit environment — to prevent a liquidity crisis from spreading. In this respect, Brexit does not have the venom to paralyze the global economy.
What about trade? Investors are overplaying the impact of Brexit on global trade flows — the U.K. accounts for just 2.7 percent of global trade — and simultaneously ignoring the opportunities that diminished U.K. exports creates for other economies. Indeed, we can expect that corporates unsettled by the vote will relocate operations to the EU — particularly those in the finance sector eager to retain passporting capabilities into the single market — to a sufficient degree to offset the decline in U.K. trade volumes. As a result, we forecast a maximum net decline in euro zone GDP growth of 0.3 percentage points as a direct consequence of the U.K.’s departure; globally, this figure falls to 0.05 points off global GDP growth.
So, do these implications warrant the markets’ post-Brexit hyper-sensitivity? Only domestically. Indeed, investors should be more concerned about a populist contagion, rather than an economic malaise spreading, which could ultimately lead to further long-term risk within the union’s remaining members. However, this political threat fails to explain either the immediacy or severity of the markets’ reaction following the referendum.
While the U.K. braces for Brexit, the mind-set of investors elsewhere ought to be business as usual.
Patrick Artus is chief economist of Natixis, in Paris.
