Aug 8, 2016 | 09:30 GMT

10 mins read

The Brexit Effect Is Starting to Show

The Brexit Effect Is Starting to Show
Forecast Highlights

  • Uncertainty about the shape of the United Kingdom's future relationship with Europe will put a drag on both economies.
  • The evolution of both the British economy and the economies of its main trading partners will depend on the terms of the agreement reached between London and Brussels.
  • The United Kingdom's leaders will feel pressure to preserve access to the European Union's internal market, but that would require difficult political concessions.

More than six weeks have passed since voters in the United Kingdom authorized the country's exit from the European Union, enough time for some of the referendum's economic effects to manifest. In the aftermath of the Brexit vote, the British economy has already started to show signs of weakness, with data for July signaling slowdowns in manufacturing, services and construction. In the eurozone, the economic impact has been moderate, but uncertainty about the split will probably reduce investment, private consumption and trade. In all likelihood, the United Kingdom's economy will decelerate even more in the months ahead.

The British Economy Slows

Prior to the June 23 vote, the British economy had enjoyed decent growth in 2016. The United Kingdom's gross domestic product climbed by 0.4 percent in the first quarter of the year and by another 0.6 percent in the second. Official data on the economy's third-quarter performance will not be known until at least October, but some reports hint that it is slowing. The monthly index of manufacturing activity published by global financial information company Markit, based on a survey of private-sector companies, stood at 48.2 in July, a notable contraction from the 52.4 recorded in June and the lowest reading since February 2013. Similarly, the index for the services sector was at 47.4 in July. (For both surveys, any figure under 50 indicates a contraction in activity.)

A July report by the Bank of England found that most companies in the United Kingdom had not expected the result of the referendum, and many did not make contingency plans. According to the report, companies are currently undertaking strategic reviews of their operations. The bank warned that the referendum would dampen hiring activity over the coming year and that several companies are considering other European locations for some of their business. The bank also expects demand for credit to shrink. In response to concerns about growing economic weakness, the central bank cut interest rates on Aug. 4 from 0.5 percent to 0.25 percent, the first reduction since early 2009. It announced an economic stimulus package as well. The institution said it now expects the British economy to grow by 0.8 percent in 2017, down from a growth forecast of 2.3 percent in May.

Since June 23, the pound sterling has fallen markedly against the dollar and, to a lesser extent, against the euro. This should make the United Kingdom's exporters more competitive, and there have been early indications that British exports have risen since the referendum. But available data suggest that rising exports are not enough to offset the drag on the economy created by uncertainty, and many companies do not have the capacity to immediately take advantage of a weaker pound. At the same time, the United Kingdom's bond yields have dropped since the referendum, which suggests that investors are moving to haven assets. This makes it cheaper for the British government to borrow, which should ease pressure on public finances. But low yields also hurt pension funds, which will see decreasing returns.

Moving forward, the evolution of the United Kingdom's economy will be tied to political events. The government has said it will not open formal negotiations with the European Union about their coming separation until after the end of the year. This will continue to create uncertainty about the United Kingdom's future, likely prompting households and companies to delay spending and investment decisions until they have a clearer view of what the future relationship between the United Kingdom and the Continent will look like. If the contraction of the British economy remains slow, however, London will have the luxury of time to design a strategy and discuss the possible details of a Brexit with European leaders before officially triggering the two-year negotiation period established by EU rules.

Eurozone Economies Take a Hit

The impact of the Brexit referendum has been milder in the eurozone. But the currency area, which saw first-quarter economic growth of 0.6 percent followed by a 0.3 growth rate in the second quarter, is also showing signs of a slowdown. In July, the European Commission reported that uncertainty created by the vote will likely cut into private consumption and investment as well as foreign trade. As a result, the commission lowered its projections for GDP growth in the eurozone from 1.7 percent in both 2016 and 2017 to between 1.5 and 1.6 percent in 2016 and between 1.3 and 1.5 percent in 2017.

Likewise, the Italian and Spanish governments recently reduced their forecasts for GDP growth in 2016 and 2017 in response to the Brexit. The Spanish government also predicted that job creation would slow in the coming months. Markit's data for July showed that manufacturing growth slowed in countries such as Germany, the Netherlands, Italy and Spain and contracted in France and Greece. Ireland, the United Kingdom's main trading partner, is particularly concerned about the British economy. According to the Bank of Ireland, the Irish economy is now expected to grow by 3.6 percent in 2017, down from a pre-Brexit forecast of 4.2 percent. Ibec, an association of Irish companies, said Aug. 1 that the recent depreciation of the pound has harmed Irish exports and warned that "hundreds of millions of euro worth of exports and thousands of Irish jobs" could be lost.

The Brexit is also creating problems for European banks, which are currently threatened by low profitability in an environment of low interest rates and modest economic growth. The shares of some banks in the eurozone were particularly hard hit after the Brexit vote as investors showed concern about low profitability, mismanagement and high levels of bad debt. Considering interest rates are likely to stay low and economic growth will probably remain timid, the sector will continue to be vulnerable.

A Period of Political Haggling

The Brexit vote has opened tough political negotiations in the United Kingdom and abroad. The Scottish government has threatened to hold a new independence referendum, while Northern Ireland is worried about the reintroduction of border controls with the Republic of Ireland after Britain leaves the European Union. Both governments will push London to reach an agreement with Brussels that is as close to the status quo as possible. This will be easier said than done, though, since gaining access to the European Union's single market also involves accepting EU workers — a policy that many in the United Kingdom oppose. There is also an ongoing debate over whether British Prime Minister Theresa May would need authorization from Parliament to start negotiations with the European Union. A court ruling on the issue is expected by the end of the year.

Britain's domestic situation also explains May's negotiations abroad. Shortly after her appointment as prime minister, May visited Germany and France, the European Union's political heavyweights, to start building a rapport with both governments and to explain London's decision not to start formal negotiations immediately. While Germany, and to a lesser extent France, understands that London needs time before opening negotiations to leave, Berlin will not want to wait indefinitely, mainly because the bloc's fragile and uneven economic recovery could be set back by a prolonged period of uncertainty. The United Kingdom is not interested in endlessly delaying the process, either: London wants to negotiate free trade agreements abroad, but as an EU member, it cannot unilaterally sign trade deals with other countries. The faster the United Kingdom leaves the union, the easier it will be for London to reach such agreements. May also visited Poland, which could play a significant role in the Brexit negotiations. The United Kingdom plays host to a sizable number of Polish workers, and the government in Warsaw will oppose any measures that abolish their rights.

What the Long Term May Look Like

The United Kingdom will remain a full member of the European Union until at least 2019, which means that trade, investment and migration will still take place under the EU umbrella. But until a final deal takes shape between the United Kingdom and the European Union, uncertainty will influence economic decisions in both.

The long-term performance of the British economy, and of the economies of its main trade partners, will depend on the kind of access to the EU market that London eventually gains. Should the United Kingdom be given full access to the common market through an agreement similar to the one between the bloc and Norway, trade and investment relations should remain almost unchanged. This scenario would also calm secessionist claims in Scotland and appease border concerns in Northern Ireland. Moreover, it would allow London to negotiate free trade agreements with other countries. But the United Kingdom would have to be willing to accept EU workers and contribute to the EU budget, both of which are politically sensitive issues in the United Kingdom.

Should London opt for a free trade agreement with the European Union, then the effect on the British and European economies would depend on the terms of the deal. Free trade negotiations center on issues such as the trade of goods, services and agriculture. In general, lifting barriers for goods tends to be easier than doing so for services, where multiple nontariff barriers, including local regulations, exist. This would be a key issue for the United Kingdom, a country where services represent almost 80 percent of the economy. Time could also be an issue because talks over free trade agreements usually take several years.

The financial sector is particularly worried that the Brexit will put an end to the so-called passport system, a mechanism that allows financial companies based in the United Kingdom to do business anywhere in the European Economic Area (which includes the European Union, Norway, Iceland and Liechtenstein) without having to ask for authorization in each country. Many of the world's financial companies use London as their headquarters to sell services in Europe. Should Britain lose access to the passport system, which could be a consequence of leaving the single market, some financial companies would be forced to relocate to the Continent. Several EU members have already expressed interest in recruiting financial companies that might be considering leaving the United Kingdom, and the bloc could use the passport system as leverage to force London to accept the conditions that come with membership in the single market.

The countries that depend the most on their trade and investment relations with the United Kingdom, such as Ireland and the Netherlands, will be among the most vocal defenders of a post-Brexit agreement that preserves Britain's access to the European Union's single market. The governments in Scotland and Northern Ireland, and large segments of London's financial sector, will push in the same direction.

Until an agreement between the United Kingdom and the European Union on the terms of their future relationship begins to take shape, the air of uncertainty affecting their economies will likely continue to hang over both. And while the British economy is currently showing signs of contraction, the course it and its European counterpart take in the long term will ultimately depend on what kind of deal can be hammered out.

Connected Content

Regions & Countries

Article Search

Copyright © Stratfor Enterprises, LLC. All rights reserved.

Stratfor Worldview


To empower members to confidently understand and navigate a continuously changing and complex global environment.