Macro Letter – No 77 – 19-05-2017
Hard Brexit maths – walking away
- The UK’s NIESR estimate the bill for Hard Brexit to the UK at EUR 66bln
- I guesstimate the cost of Hard Brexit to the EU at EUR 62bln
- Legal experts for both sides suggest UK obligations cease on Brexit
- A Free-trade deal with the EU may not begin until after March 2019
…How selfhood begins with a walking away…
It has been estimated that if the UK accedes to EU demands for a further EUR 100bln in order to begin the process of establishing a bi-lateral trade deal with the EU post-Brexit, it will cost the UK economy 4.4% of GDP. According to estimates from the NIESR, to revert to WTO Most Favored Nation terms (the Hard Brexit option) would only cost between -2.7% and -3.7% of GDP (EUR 61bln to EUR 84bln).
In January UK MP May stated:-
No deal is better than a bad deal.
It looks, on this basis, as though the UK may indeed walk away from its purported EU obligations.
A more considered analysis from, the politically influential Brussels based thin-tank Bruegel – Divorce settlement or leaving the club? A breakdown of the Brexit bill – suggests a more modest final bill:-
Depending on the scenario, the long-run net Brexit bill could range from €25.4 billion to €65.1 billion, possibly with a large upfront UK payment followed by significant EU reimbursements later.
This substantial price range is due to the way the UK’s share of liabilities is calculated. At 12% (the UK’s rebate-adjusted share of EU commitments) it is EUR 25.4bln. At 15.7% (the UK’s gross contributions without a rebate adjustment) it rises to EUR 65.1bln.
The House of Lords legal interpretation – Brexit and the EU budget:-
Article 50 provides for a ‘guillotine’ after two years if a withdrawal agreement is not reached unless all Member States, including the UK, agree to extend negotiations. Although there are competing interpretations, we conclude that if agreement is not reached, all EU law—including provisions concerning ongoing financial contributions and machinery for adjudication—will cease to apply, and the UK would be subject to no enforceable obligation to make any financial contribution at all.
This suggests all of the UK’s commitments to the EU are linked to membership. If that legal interpretation is correct, there would be no Brexit bill at the moment of departure. Apparently EU legal experts have arrived at similar conclusions. The Telegraph – €100bn Brexit bill is ‘legally impossible’ to enforce, European Commission’s own lawyers admit has more on this contentious subject.
Setting aside the legal obligations in favour of a diplomatic solution, what is the price range where a potential agreement may lie? The cost to the UK appears to be capped at EUR 84bln in a worst case scenario. One may argue that the ability of Sterling to decline, thus improving the UK’s terms of trade, makes this scenario unrealistically high, but as I discussed in – Uncharted British waters – the risk to growth, the opportunity to reform historic evidence doesn’t support the case very well at all:-
Another factor to consider, since the June vote, is whether the weakness of Sterling will have a positive impact on the UK’s chronic balance of payments deficit. This post from John Ashcroft – The Saturday Economist – The great devaluation myth suggests that, if history even so much as rhymes, it will not:-
If devaluation solved the problems of the British Economy, the UK would have one of the strongest trade balances in the global economy…. the depreciation of sterling in 2008 did not lead to a significant improvement in the balance of payments. There was no “re balancing effect”. We always argued this would be the case. History and empirical observation provides the evidence.
There was no improvement in trade as a result of the exit from the ERM and the subsequent devaluation of 1992, despite allusions of policy makers to the contrary. Check out our chart of the day and the more extensive slide deck below.
Seven reasons why devaluation doesn’t improve the UK balance of payments …
1 Exporters Price to Market…and price in Currency…there is limited pass through effect for major exporters
2 Exporters and importers adopt a balanced portfolio approach via synthetic or natural hedging to offset the currency risks over the long term
3 Traders adopt a medium term view on currency trends better to take the margin boost or hit in the short term….rather than price out the currency move
4 Price Elasticities for imports are lower than for exports…The Marshall Lerner conditions are not satisfied…The price elasticities are too limited to offset the “lost revenue” effect
5 Imports of food, beverages, commodities, energy, oil and semi manufactures are relatively inelastic with regard to price. The price co-efficients are much weaker and almost inelastic with regard to imports
6 Imports form a significant part of exports, either as raw materials, components or semi manufactures. Devaluation increases the costs of exports as a result of devaluation
7 There is limited substitution effect or potential domestic supply side boost
8 Demand co-efficients are dominant
But what is the economic impact on the EU? CIVITAS – Potential post-Brexit tariff costs for EU-UK trade postulates some estimates:-
Our analysis shows that if the UK leaves the EU without a trade deal UK exporters could face the potential impact of £5.2 billion in tariffs on goods being sold to the EU. However, EU exporters will also face £12.9 billion in tariffs on goods coming to the UK.
Exporters to the UK in 22 of the 27 remaining EU member states face higher tariffs costs when selling their goods than UK exporters face when selling goods to those countries.
German exporters would have to deal with the impact of £3.4 billion of tariffs on goods they export to the UK. UK exporters in return would face £0.9 billion of tariffs on goods going to Germany.
French exporters could face £1.4 billion in tariffs on their products compared to UK exporters facing £0.7 billion. A similar pattern exists for all the UK’s major EU trading partners.
The biggest impact will be on exports of goods relating to vehicles, with tariffs in the region of £1.3 billion being applied to UK car-related exports going to the EU. This compares to £3.9 billion for the EU, including £1.8 billion in tariffs being applied to German car-related exports.
The net Trade Effect of a Hard Brexit on the basis of these calculations is EUR 7.7bln in favour of the UK.
Then we must consider the UK contribution to the EU budget, which, if the House of Lords assessment is confirmed, will be zero after Brexit. This will cost the EU EUR7.8bln, based on the 2017 net EU budget of EUR 134bln, to which the UK is currently the second largest contributor at 5.8%.
Next there is the question of the impact on EU27 economic growth. These headwinds will be felt especially in the Netherlands, Ireland and Cyprus but the largest absolute cost will be borne by Germany.
According to a February 2016 study by DZ Bank, a Hard Brexit would be to reduce German economic growth by -0.5%, from 1.7% to 1.4% – EUR 18.5bln. Credit Agricole published a similar study of the impact on the French economy in June 2016. They estimated that French GDP would be reduced by -0.4% in the event of a free-trade agreement and -0.6% in the event of a Hard Brexit – EUR 13.2bln. The Netherlands Bureau for Economic Policy Analysis (CPB) estimated the cost to the Netherlands at -1.2% – EUR 8.2bln. Italian Government forecasters estimate the impact at -0.5 to -1% – taking the best case scenario – EUR 8.3bln. A leaked Spanish Government report from March 2017 (interestingly, the only estimate I have been able to uncover since the Brexit vote) indicates a cost of between -0.17% and -0.34% of GDP – again, taking the best case – EUR 2bln. Ireland, given its geographic position, shared language and border, has, perhaps the closest ties with the UK of any EU27 country. Back in 2016 the Irish ERSI estimated the impact on Ireland at only -1%, I suspect it might be greater but I will take them at their word – EUR 2.6bln.
In the paragraph above I have looked at just five out of the EU27. Added together the cost to just these five countries is EUR 52.8bln, but I believe it to be representative, they accounted for 84.74% of EU GDP in 2016. From this I arrive at an extrapolated cost to the EU of a Hard Brexit of EUR 62.3bln.
The European Commission has indicated that the cost for the UK to begin negotiating the terms of a new free-trade agreement with the EU may be as much as EUR 100bln. The cost to the UK, of simply walking away – Hard Brexit – is estimated at between EUR 61bln and EUR 84bln per annum. The cost of Hard Brexit to the EU is estimated (I should probably say guesstimated, since there are so many uncertainties ahead) at EUR 62bln. A simple cost benefit analysis suggests that both sides have relatively similar amounts to lose in the short term. And I hate to admit it, but looked at from a negative point of view, in the long run, the UK, with its structural current account and trade deficit, may have less to lose from simply walking away.
Conclusion and Investment Opportunities
Brexit negotiations are already and will remain deeply political. From a short-term economic perspective it makes sense for the UK to walk away and re-establish its relationships with its European trading partners in the longer run. Given the UK trade deficit with the EU it has the economic whip-hand. Working on the assumption that Jean Claude Junker is not Teresa May’s secret weapon (after all, suggesting ever higher costs for negotiating a free-trade deal makes it more likely that the UK refuses to play ball) one needs to step back from the economics of the situation. The politics of Brexit are already and will probably become even more venal. For the sake of the UK economy, and, for that matter the economies of the EU, I believe it is better for the UK to walk away To those of you who have read my previous articles about Brexit, I wish to make clear, this is a change of opinion, politics has trumped economic common sense.
The implications for the UK financial markets over the next 22 months is uncertainty, although May’s decision to adopt a Hard Brexit starting point has mitigated a substantial part of these risks. Sterling is likely to act as the principle safety valve, however, a fall in the trade-weighted value of the currency will feed through to higher domestic inflation. Short term interest rates, and in their wake Gilt yields, are likely to rise in this scenario. Domestic stocks are also likely to be vulnerable to the negative impact of currency weakness and higher interest rates on economic growth. The FTSE 100, however, with 70% of its earnings derived from outside the UK, should remain relatively immune.