Brexit: how bad could it get?

  • In April we noted the uncertainty that a Brexit vote would bring to the British economy.
    In this post, we examine how the economic risk the UK now faces may be manifested in a post-Brexit UK.
  • In particular, we look at a “worst case scenario”, and what this might mean for the economy, and the currency.

As we argued in April, the Brexit vote has plunged the UK into economic uncertainty. Questions abound about the relationship the UK will have with the EU after exit, and even about the government’s negotiating position. The government has not yet made its position clear, with Government spokespeople issuing contradictory statements about future membership of the single market and the customs union.

A vital issue for the UK is that of passporting: members of the single market (also the European Economic Area, or EEA) continue to be regulated by their domestic regulator whilst they provide cross-border services or establish branches in other EEA economies. This has historically been a significant driver of reduced transactions costs for inter-EU trade in financial, legal and consulting services. The EU’s MIFID II (Markets in Financial Instruments Directive) provides for third countries (non-members of the EEA) to retain limited passporting rights provided those countries retain regulatory “equivalence” with the EU. The government’s silence on this suggests that continued access to the EEA is far from assured, and the stakes are huge. The UK’s financial sector is hugely productive, providing £67bn in tax revenue and £19bn in exports just to the EEA.

So how bad could it be? One way to shed some light on this question is to look at how the fair value of sterling would shift if the UK was without the productivity boost of the financial sector. We know that the productivity of the South East has supported the UK economy. So what would happen if this was all lost?

The answer is given in Figure 1. In the event that the UK’s financial sector flees, with attendant productivity declines, the UK would fall from roughly the same level of GDP per capita as Germany to that of the EU average. The relationship between productivity and real exchange rates (the Balassa-Samuelson effect) suggests this would mean a depreciation equivalent to sterling falling to 1.142 against the dollar.

Figure 1 Source: IMF WEO, OECD, ONS, Macrobond, Record. Real exchange rate calculated using Purchasing Power Parity. GBP excluding London is calcualted by assuming that GBP per capita falls to the level outside London, and taking the predicted exchange rate from a regression. Data correct as of September 2016 (last release of GDP and PPP data).

Figure 1 Source: IMF WEO, OECD, ONS, Macrobond, Record. Real exchange rate calculated using Purchasing Power Parity. GBP excluding London is calcualted by assuming that GBP per capita falls to the level outside London, and taking the predicted exchange rate from a regression. Data correct as of September 2016 (last release of GDP and PPP data).

Naturally, whether this will be manifested is still highly uncertain. We still do not know how far the government prioritises access to the single market, or how effective they would be in negotiating access. It is not even known how far the loss of passporting would actually affect UK firms.

However, even the depreciation implied by the loss of the entire City of London is not a significant decline beyond the depreciation since June (see Figure 2). This has fascinating implications. Is the market already pricing in a highly destructive Brexit? Is political uncertainty weighing on sterling more than the fundamentals justify? And could it be that the worst is behind us?

Figure 2 Source: OECD, IMF WEO, Macrobond, Record. The projected exchange rate move under the estimated scenario is shown by the dotted lines.

Figure 2 Source: OECD, IMF WEO, Macrobond, Record. The projected exchange rate move under the estimated scenario is shown by the dotted lines.

Market Volatility: the Brexit Premium

  • The uncertainty associated with the outcome of the referendum on Britain’s EU membership is already affecting financial markets and the wider economy. By examining the pricing of derivatives, we can identify the price the market is putting on this uncertainty, and what movements in currency are expected between now and the referendum itself.

“All I know is that I know nothing.” Socrates

For all the bluster from both the Bremain and Brexit camps in the EU referendum debate, very little can actually be known about the pros and cons of British economic life outside the EU. Yes, there are an unknown but certainly large number of jobs linked to British trade with the EU. Undoubtedly, some of these would go. At the same time, we have no idea what the relative importance of the loss of these jobs, and, on the other side of the ledger, reduced regulation and import substitution, and the ability to make our own trade deals, would be.[1] Similar stories can be told about the FDI and investment flows on which Britain is so dependent, although there is already evidence of a negative effect on the London Housing market.

What is known is that in the event of Brexit, article 50 of the Lisbon treaty plunges the UK in to an (at least) 2 year-long negotiation on the terms of exit, in which the only thing that is certain is that the range of potential outcomes is huge. The one thing markets hate is uncertainty, but how much uncertainty does the market expect?

Source: Bloomberg Data

Figure 1 Source: Bloomberg Data

3-month At-the-Money implied volatility (the expected level of volatility) and ‘risk reversals’ (a relative measure for the cost of insuring sterling downside against the euro) for EURGBP options spiked on 23rd March (the first day which brought the referendum within range of these measures). This is reflective of a “Brexit Premium” priced in by sellers of options who are clearly expecting potentially huge moves on the day.

We can use options to price the expected price moves on the day, as well. As the delta of an option is (roughly) equal to the market’s estimate of that option’s being exercised, for different strike rates, we can construct a probability density function, which looks like this:

Source: Bloomberg data. CDF is constructed from the deltas of options with different strike prices. The PDF is constructed by calculating the gradient of the PDF at different points. Data correct as of 25/04/2016

Figure 2 Source: Bloomberg data. CDF is constructed from the deltas of options with different strike prices. The PDF is constructed by calculating the gradient of the PDF at different points. Data correct as of 25/04/2016

We can see that there is significant tail risk, here. If the UK leaves the EU, a significant depreciation of sterling could be on the cards. What should not be overlooked, however, is that in the (likely) event that the Bremain campaign triumphs, there could equally be a not-insignificant appreciation of sterling. Those positioning for further sterling depreciation (that is, non-commercial traders on net, see figure 3) should be wary of this tail risk as well.

Figure 3 Source: Bloomberg Data

Figure 3 Source: Bloomberg Data. Non-commercial positioning is the net long position of traders classified as non-commercial in Sterling futures and options.

In summary, the overwhelming message from markets is one of uncertainty and volatility. As is often the case, Socratic scepticism is the order of the day…

 

[1] For a discussion of these issues, see R. Bourne (2015) “The EU Jobs Myth”. Institute of Economic Affairs, Breifing 15:02.