Brexit and Britain's economic might

Dr Chandra Thapa looks at the effect Brexit is having on the British economy in this latest in a series of posts following the UK's referendum decision to leave the EU.

Britain’s lead in the world stage is predominantly backed by its economic strength. Further, the living standards of Britain’s residents is one of the highest in the world and it also offers admirable public services and a liberal social security scheme.

The economic supremacy and provision of valued public services is arguably attributed to the creation of wealth by businesses, entrepreneurship and innovation. Could this very foundation of Britain’s economic prosperity be held back or even go backwards as a result of the referendum decision to exit the valuable single European market? Early signs of post-Brexit economic activities may offer some insights.

George Soros, perhaps the world’s most famous currency speculator, predicted a fall of approximately 15% in the value of pound against the US dollar before Brexit. As of 21 July 2016 - almost four weeks after the decision to leave the EU - the pound was USD 1.32, almost 12% lower than its pre-Brexit value of US$1.50 (Bloomberg, 21 July 2016, 12.46 hrs BST). Moreover, a completely unclear picture of Britain’s future trade relationship with the EU has also created a seemingly lengthy period of economic uncertainty. What could be the economic incentives and/or ramifications of such fallout?

First, the fall in the value of the pound makes Britain’s exports competitive around the world. British businesses exporting their products should potentially benefit from the depreciation of the pound. However, while the plunge in the value of pound may boost exports, the growing concern of global economic slowdown, particularly in Europe, in part triggered by Brexit shock, may dampen the demand for British products.

Second, Britain imports way more than it exports to the world market. The difference between its exports plus investment incomes and export value is called current account deficit. This deficit for the year ending 2015 was approximately £96 billion or 5% of GDP (BBC, 31 March 2016) and almost £33 billion for the first three months of 2016 (BBC, 30 June 2016). The deficit signifies that any weakening in the value of the pound relative to foreign currencies should raise the prices of imports leading to a higher inflation rate. Consumers may feel the pinch when filling their car, shopping for groceries and making purchase of other consumable products, including foreign holidays.

For example, the BBC reported on July 6 that the US computer-maker Dell and the Chinese smartphone company OnePlus were both increasing their prices in the UK as a result of the pound’s drop following the Brexit referendum. Since these companies receive the revenue in the depreciating pound, the functional currency they obtain should be lower ensuring significant foreign exchange costs. The majority of these costs, depending on their competitive advantage, are then passed to consumers in the form of higher prices. This simple example suggests that with the fall in the value of the pound, British consumers’ purchasing power may significantly degrade, which further implies that British residents may become poorer in real terms assuming no significant growth in their wages. Further, the Bank of England has little leeway to manage such imported inflation with interest rates being already at a record low.

Third, the deficit in the current account is usually financed by surplus in the capital account that records the purchase and sales of real and financial assets denominated in pounds by foreigners. This includes investments made by institutional and individual investors in UK real assets (e.g. real estates, foreign direct investments, and so on) and financial assets (e.g. exchange traded equities and bonds). Foreign investors are profit-seeking economic agents and one of their key objectives is to generate adequate return on their investments. They invest in politically stable and economically prospective economies with higher degrees of certainty. Foreign investments are not only exposed to the usual business risks but also to foreign exchange risk. The recent decline in the pound’s value has generated a material drag on their return. Furthermore, the heightening economic uncertainty has also dented investment sentiments leading to the freeze of any planned investments and hiring. One of Britain’s biggest attractions to foreign investors is tariff-free access to the European single market. However, with the route to the single market looking foggy and the possibility of tariffs being slapped, Britain may become less appealing to foreign investors.

Fourth, recent evidence on British business confidence, a leading indicator of economic prospects, also projects a bleak scenario (BBC, 4 July 2016). Such degrading confidence may compel companies to hold back on investments and hiring. In the aftermath of the Brexit referendum numerous examples of such investment and hiring hesitancies/freezes have been reported in the financial press. This is expected to depress the employment market that has been growing robustly in the past two to three years. It might also deplete the tax base (corporate and personal income) of the government’s coffers, vital for maintaining quality public services and social security provisions. Government borrowing is expected to rise to fund tax deficits and further austerity may be inevitable.

Fifth, consumer research specialist GfK reports the biggest drop in consumer confidence in the month of July 2016 for 21 years. With Britain being a consumer oriented economy, the plunge in consumer sentiments is worrying. If timid attitudes do not change rapidly, we would expect a drop in consumption reflecting lower GDP.

It is apparent that the Brexit result has discoloured the vibrancy and reputation of the British economy. Britain is expected to become poorer, at least in the short to medium term, until the progress of wealth creation recommences.

However, the reclamation of Britain’s economic might depends on how swiftly, effectively and efficiently the government eliminates the dark cloud of economic uncertainty that has swamped the entire British economy.