Pound Sterling to Suffer Brunt of 'No Deal' Brexit, Economy will Avoid Recession: Capital Economics

Above: The EU's Michel Barnier rejected the UK's latest customs proposals, ensuring the prospect of a 'no deal' Brexit remains alive. Image © European Union, 2018  / Source: EC - Audiovisual Service.

- EU's Barnier rejects key customs proposal in May's Chequers plan

- "Reverting to World WTO rules would not be the end of the world"

- "Financial markets would take a no-deal badly, with the Pound likely to be the main casualty"

The British Pound will bear the brunt of a "no deal Brexit" according to new research from independent economics advisory firm Capital Economics, but the UK would likely to avoid a recession in the year after it "crashes out of the EU".

The prospect of a 'no deal' Brexit remains as alive as ever with the most recent round of Brexit negotiations seeing the EU's lead negotiator Michel Barnier rejecting Theresa May's proposals for a future customs relationship.

While Barnier broadly welcomed May's Chequers plan, it has apparently not gone far enough to satiate the EU's desires for some form of customs union which would ultimately guarantee no 'hard' border on the island of Ireland.

Sterling fell in the wake of the developments confirming traders remain cautious of the 'no deal' scenario playing out in March 2019.

"Risks of a no deal Brexit - an outcome so costly we find it hard to believe many politicians would choose it - come from a government lacking time and a mandate for any specific Brexit solution. Accidents sometimes happen even if no one would rationally choose them. They are more likely under time pressure. No deal could be such a situation," says Robert Wood, UK Economist with Bank of America Merrill Lynch Global Research.

Although the short-term effect of an exit from the EU without a preferential agreement on future trade ties would almost certainly be bad for the economy, there are reasons to think that political hype about the alleged dangers of a "no deal" scenario is being overdone, according to Capital Economics.

"Reverting to World Trade Organisation (WTO) rules would not be the end of the world. While the UK would face the EU’s Common External Tariff on its exports to the EU, tariff rates are on average low at 4%. On a bad day, exporters see exchange rate movements that are bigger than this," says Vicky Redwood, a global economist at Capital Economics.

October's European Council summit marks a soft deadline for progress in talks that seek to agree a range of issues that are important for the European Union, with this seen as the last viable opportunity for national leaders to approve a withdrawal agreement with enough time left over for it to be ratified in all parliaments across the European Union.

The EU has agreed to Prime Minister Theresa May's "transition period" of nearly two years following the exit date, during which future trade ties are expected to be agreed, although this is contingent on UK politicians agreeing to all of the EU's demands in the withdrawal agreement. Without an agreement on withdrawal there will be no deal on future economic ties so the UK will leave the EU on March 29, 2019 and default to trading with it on World Trade Organisation terms.

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"Although tariffs in some sectors (e.g. cars) are higher than others, the government could compensate the hardest-hit sectors. Indeed, remember that leaving without a deal would mean that the UK wouldn’t have to pay its (front-loaded) Brexit “divorce bill” of £40bn odd, equivalent to around 2% of GDP. This money could be used to offset the adverse effects on the economy," Redwood writes, in a briefing to clients.

Predictions of what this might mean for the economy have ranged from the plausible to the downright bizarre, but most generally agree that there will be at least some negative impact on growth in the short-term.

"Leaving without a trade deal is not just about tariffs," Redwood says. "Financial markets would take a no-deal badly, with the Pound likely to be the main casualty. On the plus side, this would cushion the impact on exporters. But it would also push up inflation, renewing the squeeze on consumers’ real incomes seen after the pound fell following the EU referendum in June 2016. And this could be compounded by the UK imposing import tariffs on the EU, raising import prices."

Pound Sterling's response to the referendum vote to leave the EU, which saw it fall by more than 17% against the US Dollar and by 13% against the Euro in the days after, suggests Redwood is right in saying markets will take a "no deal Brexit" badly.

The prior fall in the Pound led inflation to rise from 0.5% before the referendum to 3.1% by November 2017 and although price pressures have since gone into retreat, this saw "real GDP" growth fall from 2.3% in 2015 to 1.9% in 2016 and then to 1.7% in 2017.

"We think that a hard Brexit and no transition agreement could easily take GBP/USD down towards 1.10," says Kamal Sharma, European head of G10 currency strategy at Bank of America Merrill Lynch, in a recent note. The Pound-to-Dollar exchange rate traded between 1.31 and 1.32 for much of this week.

The Pound-to-Euro exchange rate is meanwhile widely expected to break below the 1.10 level on a no-deal Brexit, abandoning a long-held sideways range that has seen it trade between 1.11 and 1.16 over the past 11 months.  

Abandoning membership of the EU Single Market, which is a vast bloc of EU countries and three non-EU countries that are all subject to the European Union lawmaking and regulatory machinery, would also see the UK face "non-tariff barriers".

This could see some UK-made products ineligible for sale in the EU if the product's standards are not deemed to be equal to those of the EU and it could also mean some spot checks at customs in order to ensure products are as described in their accompanying documentation.

"Finally, a no-deal could have political consequences that would exacerbate any uncertainty hanging over the economy, including a possible change of Prime Minister and, more importantly, change of government," Redwood warns. Overall then, while a no-deal might not plunge the UK into recession, it could plausibly knock a percentage point or so off growth next year."

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