As the shockwaves of Brexit reverberated around the globe, criticisms of the United Kingdom’s decision have been widespread, but often ignore some inconvenient truths about the European Union.
The single market Union has never really recovered from the Great Recession. The collapse of global share markets and resultant domino effect on housing markets in a number of member states has eroded an enormous amount of wealth. The subsequent bailout of banks and prolonged recession drained the already fragile financial resources of numerous member states, culminating in the sovereign debt crisis of 2010.
The crisis highlighted some of the fundamental flaws of the EU, most notably the problems of adopting a common currency and common monetary policy across a group of countries with vastly different financial positions, productivity levels and labour markets.
Member states who found themselves in precarious financial positions, including the PIIGS (Portugal, Italy, Ireland, Greece and Spain), would have benefited from a devaluation of their old currencies to restore competitiveness and help regenerate growth. They instead found themselves tied to a common currency that remained relatively strong due to the dominance of Germany.
Another fundamental flaw of the EU are the risk sharing agreements. During the sovereign debt crisis, the Troika (i.e. the European Commission, the European Central Bank, and the International Monetary Fund) provided protective mechanisms, such as the European Financial Stability Mechanism, to help prevent or solve a debt crisis in a member state.
While the policies were sound in theory, the funding burden lies heavily in the hands of the financially stable states such as Germany. In reality, the goodwill of the German taxpayer will be sorely tested if another sovereign default arises.
Today, some eight years after the Great Recession began, policies that have included unprecedented monetary stimulus, have proven to be largely ineffective. Unemployment remains stuck stubbornly above 10%, while government debt and deficits remain uncomfortably high, severely limiting policy options.
Austerity fatigue and high unemployment have exacerbated political tensions which have been inflamed by the migrant crisis, pushing an already fragile Union to the very edge. The reality is that the EU is already a melting pot of discontent. The benefits of an integrated Union have been constrained by its shortcomings. It’s not so surprising that the “Leave” campaign in the UK succeeded, given those circumstances.
But any divorce will come at a cost. Leaving the common market means that the UK will have to renegotiate new trade agreements. If those succeed, a much weaker currency will improve the competitiveness of the UK’s export industries. In a best case scenario, growth in the UK is likely to be somewhat lower in the short term as this period of re-adjustment takes place.
In a worst case scenario, the EU could impose tariffs on the UK. Additionally, London’s position as a global banking hub could be jeopardised should some of the multinational banks decide to shift their operations elsewhere, which would inevitably result in much lower growth outcomes. The stakes are high.
In relatively good news for Australia, the direct impact of Brexit is likely to be negligible. According to the Department of Foreign Affairs and Trade, exports to the UK in 2014/15 amounted to just 1.4% of total exports, the main exports being gold and alcoholic beverages.
The affects on global growth are difficult to quantify with any degree of certainty, but we posit the following:
Base case scenario
The UK only represents about 2.4% of global growth. In the event Brexit causes a sharp recession in the UK (say, a fall in GDP of around 5%), then the potential impact on global growth is likely to be no more than 0.1%. Under this scenario the flow-on effects to global share markets should be relatively minor. We attribute a 45% probability to this scenario.
In our secondary scenario, to which we attribute a 40% probability, uncertainty fuelled by the exit may linger for some time, causing a modest but definitive decline in global growth of between 0.3% and 0.5%. Under this scenario global share markets could fall a further 10% to 20%.
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Worst case scenario
Brexit could accelerate the exit of other member states already disenchanted with the EU. This would be dangerous for a number of reasons including the fact that a number of heavily indebted sovereigns have borrowed heavily from European banks.
An exit and a conversion back to their pre-Euro currencies would make it difficult to fund their Euro and US denominated debts. This would most likely send bond yields soaring or potentially cause credit markets to freeze, precipitating another financial crisis. Fortunately we think the probability of this outcome eventuating is low – 15% or less.
Martin Fowler is a partner in the wealth management division at Pitcher Partners in Sydney.