Uncertainty over Brexit talks likely to drag down UK economy

Desmond Lachman

 
Proponents of Brexit seem to be ignoring one important fact: Domestic and foreign investors abhor uncertainty.

Yet that is precisely what investors have in store for them over the next two years now that the British government has triggered Article 50, which begins the highly complex Brexit negotiation process with its European partners.

Uncertainty as to the outcome of those negotiations is bound to constitute a drag on the United Kingdom’s economic performance and to complicate the financing of Britain’s very large external current account deficit.

A major source of uncertainty will be generated by the fact that the negotiations are bound to be very drawn out. While Article 50 to begin the Brexit negotiation might have now been triggered, serious negotiations are only likely to begin after both the April/May French elections and Germany’s September elections are out of the way.

Once negotiations do start, they are likely to get bogged down in the contentious question of how much the United Kingdom needs to pay into the EU budget. Only once this question is out of the way will the negotiators get down to the terms on a whole array of complicated issues that Britain might expect to receive from Europe upon its departure.

Another source of uncertainty for investors will be that they will have little idea as to whether the negotiations will be concluded by the end of the two-year period that the Treaty of Lisbon envisages for those negotiations. Might Britain be headed for the “hardest” of Brexits?

Will the United Kingdom’s European partners accede to a transitional arrangement for it to prevent Britain being left with no arrangement with Europe should the talks not be successfully concluded within the two-year period?

If the negotiations are concluded, what terms will the United Kingdom likely get from its European partners?

Might the United Kingdom succeed in negotiating a free-trade agreement with Europe?

And will financial firms in the City of London, Britain’s financial capital, lose their present passport rights to the single European market?

It also can hardly be of assurance to investors that Brexit has raised anew questions as to whether the United Kingdom might not be torn apart over the next few years as a result of the referendum. At the very time that Prime Minister Theresa May was triggering Article 50, the Scottish parliament was voting in favor of Scotland having a second independence referendum. It did so on the grounds that a majority of the Scottish population voted in favor of Britain remaining in Europe.

Over the next two years, in a fog of uncertainty, both domestic and international firms will have to make decisions as to where best locate their new investments to take advantage of European supply chains and have access to the European single market. One would think that manufacturing firms would become increasingly reluctant to locate new investment in the United Kingdom if they were to fear that it would be subject to non-tariff barriers once Britain exited Europe by March 2019.

Similarly, one would think that financial firms in the City of London would feel obliged to relocate at least part of their operations to Europe were they to fear that U.K. financial firms would lose their passport rights to the European single market.

All of this has to be of considerable importance for the U.K. economic outlook considering that the United Kingdom is entering the Brexit negotiations with the largest external current account deficit in Britain’s postwar history. This makes the British economy highly dependent on large capital inflows.

It also makes the country all too vulnerable to a further plunge in the value of the British pound over and above the 15 percent drop in the currency that has taken place since the June 2016 Brexit referendum.

Should capital flows to the United Kingdom indeed dry up and should the pound take a new dive, the U.K. economy could be faced with the prospect of higher inflation and lower economic growth.

However, by then it will be too late for the United Kingdom to change course, since, by triggering Article 50, Prime Minister May has started an irreversible process.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.