Brexit

Matthew Peter, Chief Economist

In what was a tumultuous week in British politics, Prime Minister Theresa May’s Brexit deal was defeated in Parliament by a historic 230 votes, including 118 of the PM’s Tory colleagues. PM May’s government was immediately challenged with a no confidence vote by Labour leader Jeremy Corbyn, which went along party lines with PM May securing a win with the votes of minor parties the DUP and a handful of other minor parties and independents.

The resounding defeat of the PM’s Brexit deal means time is running out to conclude an agreement with the European Union (EU) on Brexit before the deadline of March 29. In the absence of a deal or an extension of negotiations (i.e., of Article 50), the UK would leave the EU without trade agreements triggering the so-called hard Brexit scenario.

As with all things Brexit, the hard Brexit scenario can take many forms. However, some outcomes are common. Tariffs on goods trade would apply, with the EU applying Common Customs Tariff, and the UK reciprocating. Customs checks on UK/EU trade would also be introduced. Trade in services would come under WTO terms and financial services would lose passporting rights. The UK would also lose access to the EU’s trade deals with third party countries, requiring the UK to negotiate their own trade deals; a process that would take some years.

A number of agencies and research institutes have modelled the impact of a hard Brexit on the UK economy. The Bank of England (BOE) find that economic activity would fall by over 7% in 2019 and the UK would fall into recession were it to leave the EU without a deal. Our estimates based on simulations conducted using the NiGEM global economic model confirms the BOE results. We also find that the UK economy would fall into recession and that UK real GDP would fall by around 8%, leading to real GDP growth in 2019 of -0.6%; the first negative year of growth in the UK economy since the GFC. Looking beyond the UK, our results suggest that the euro area would also fall into recession with average annual growth falling just 0.4 per cent. Outside of the euro area and the UK, the major economies would avoid recession. Nonetheless, the impact of global growth would still be significant and our modelling suggests a fall from 3.6 per cent in 2020 to 3.1 per cent.

While a hard Brexit does not pose a recession threat on its own, it does add to other risks facing the global economy. For example, our modelling suggests that the impact of the most recent tariff hike of 10% on US$200b of Chinese imports to the US, combined with a further rise in the tariff rate to 25% (if current trade negotiations were to break down), would wipe off around 30-50bps from the level of US real GDP after 3 years, with a similar impact to Chinese activity. The lower-end of the range incorporates our modelled impact of the pure tariff hike, while the upper-end of the range also incorporates the impact of higher risk premiums.

If President Trump continues to up the ante and places a 10% tariff on the remaining US$270 billion of imports from China and China retaliates in a tit-for-tat fashion, then the total economic damage from the trade war is estimated at around 100-120bps for both the US and Chinese economies and the impact on global growth is between 50-80bps. Reflecting weaker growth in the world’s two largest economies and tighter financial conditions, the damage to the Australian economy would be around 50bps.

While the impact is negative, a bilateral trade war of this order of magnitude is not sufficient on its own to induce a US, Australian or global recession. However, if both Brexit and US/China negotiations were to break down, the combined effect would be sufficient to threaten a recession in the global economy.

As we wrote in last week’s brief, a global recession is not inevitable and the post-Christmas recovery in global equity prices has received more oxygen this week from positive US company earnings reports. While growth is slowing, we would expect this from the high levels sustained through 2017 and 2018. Unfortunately, policy makers are exacerbating the risks associated with any slowing in economic activity. Although a hard Brexit is neither our central case nor capable of generating a global or Australian recession, its prospect is adding to the list of risks facing the global economy. As these risks accumulate, the possibility of more than one of them occurring at a given time increases. For example, our modelling shows that a hard Brexit combined with a re-escalation of the US/China trade war would be enough to tip the global economy into recession and the equity market from a recovery to a bear.

Table 1: Financial market movements, 10 – 17 January 2019

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,636.0

1.5%

US

2.75%

0.8 bps

US Dollar Index (DXY)

96.07

0.6%

Nikkei 225

20,402.3

1.2%

Japan

0.01%

-1.8 bps

USD-JPY

109.26

0.8%

FTSE 100

6,834.9

-1.6%

UK

1.34%

6.3 bps

GBP-USD

1.299

1.9%

DAX

10,918.6

0.0%

Germany

0.24%

-1.2 bps

EUR-USD

1.139

-1.0%

S&P/ASX 200

5,850.1

0.9%

Australia

2.28%

-3.6 bps

AUD-USD

0.719

0.1%

Source: Bloomberg

 

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