UK’s historic vote to leave the European Union is now likely to be followed by a long process of negotiating the exit and the new relationship.
Within the Conservative party speculation over a change of leadership will probably now mount.
With Scotland’s electorate having expressed a desire to remain in the EU there is a possibility for calls for a second Scottish independence referendum.
Uncertainty over the future UK-EU relationship and the UK political outlook will weigh on the economy. We expect it to stagnate over the next two to three quarters. Overall, we expect the level of GDP in 2018 to be almost 2% lower than previously forecast.
Sterling is expected to weaken which will put upward pressure on inflation. We see CPI inflation at 2.6% in 2018, against our previous 2.0% forecast.
We expect the Bank of England to ease policy cutting the Bank rate to zero and upping asset purchases (QE) by GBP 100bn.
The start of a long process
UK’s historic vote to leave the European Union will now in all likelihood lead to negotiations about the exit and the new relationship with the EU. We expect the process of leaving the EU to be protracted. The first step is for the UK government to notify the European Council of its intention to withdraw. We think it is unlikely that this notification will happen before the end of 2016. When it does it triggers negotiations for a withdrawal agreement, with a firm two-year deadline, after which European rules (or at least some of them) no longer automatically apply. Until that point, the UK remains bound by EU law. Negotiating a withdrawal agreement in the following two-year window looks challenging, in light of the substantial trade ties between the UK and EU, the breadth of EU-related UK legislation that has built up over 40 years of membership and the substantial numbers of EU citizens resident in the UK and vice versa whose status must be decided. If the UK were to opt to join the European Economic Area (EEA), this could be implemented more quickly than a bespoke agreement. However, EEA membership means the UK would have to apply European laws relating to the Single Market, continue to pay a contribution to the EU budget (albeit a reduced one) and accept free movement of labour for EU citizens. If EEA membership proves not to be a viable (long-term) option, one of the most difficult and economically important areas to address will be the UK’s future trading relationship with the EU and its member states. There is also the need to forge trade deals with over 50 non-EU countries that the UK currently trades with on the basis of agreements signed by the EU. Trade negotiations are typically long processes.
Political uncertainty
The domestic political outlook is surrounded by a significant degree of uncertainty. Could Mr Cameron survive as prime minister following a vote to leave the EU, given his position as the lead proponent for remaining in the EU and the hostile nature of the campaign? Another question is whether the UK’s vote to leave the EU could lead to a second Scottish independence referendum. Such a possibility would add to what may well be a relatively unstable domestic political situation over the coming years.
Negative economic impact
We expect the economy to be negatively affected through four main channels: uncertainty and confidence; financial markets; foreign direct investment and other capital flows; and trade and income flows. There are, however, some potential gains from an exit that could soften the impact: an end to the UK’s contribution to EU budget, or at least a reduction, should the UK end up as a European Economic Area (EEA) member; an ability to agree bilateral trade deals with non-EU economies (currently this is done by the EU on behalf of the UK); greater control over regulation, which could raise productivity and supply-side potential; and increased competitiveness, since sterling is expected to weaken.
Overall, as a result of the UK voting to leave the EU, we have revised down our forecasts for growth by about 0.3pp this year and almost 1.5pp next year. We also expect 2018 growth to be marginally lower than previously assumed. In sum, the level of GDP is almost 2% lower than we had expected it to be in our previous forecasts. The main points are as follows.
Heightened uncertainty and financial-market volatility will cause markedly weaker investment.
Corporate retrenchment is also likely to be evident in reduced job creation and higher unemployment.
An assumed 10% persistent fall in sterling relative to its trade-weighted value at the end of May puts upward pressure on inflation via import prices.
Lower nominal wage growth and higher inflation squeeze real wages, which stagnate in 2017 and rise only modestly in 2018. Consumer spending is consequently expected to be notably weaker than had the UK opted to remain in the EU.
We expect policy easing by the Bank of England: a reduction in the Bank rate to zero from 50bp, the activation of liquidity measures and a GBP 100bn increase in QE.
Of course, all the forecasts presented here are significantly more uncertain than normal.
William De Vijlder, Group Chief Economist BNP Paribas