Can stimulus measures offset the impact of Brexit?

Can stimulus measures offset the impact of Brexit?

In August, the Bank of England pulled out a “sledgehammer” and fiscal stimulus may be on the cards, but this may not be enough to counter the uncertainty caused by the Brexit vote on June 23rd

Three months have passed since the United Kingdom held a referendum on its membership of the European Union, in which the majority opted to leave the union. Soon after the referendum, Mark Carney – the Governor of the Bank of England (BoE) – hinted that the bank was likely to take steps to stimulate the economy. This materialised in early August when the BoE cut rates for the first time since the financial crisis.

Source: BBC News

Quantitative easing

In addition, the BoE announced a £70 billion increase in its quantitative easing programme, which now involves purchasing corporate bonds as well as government bonds.

It is too early to judge whether these measures will be effective in offsetting the negative impact of Brexit on UK’s economy. The summary of the BoE’s meeting in September  stated that “the evidence on the initial impact of the policy package [was] encouraging” but suggested that further easing could occur later in the year. As the bank’s base rate is already very close to zero, this may be in the form of additional quantitative easing as Mr Carney does not seem to favour negative rates.

Theoretically, quantitative easing and lower interest rates should push down the value of the pound – the BoE’s latest statement suggested that this has occurred. A weaker pound could make the UK’s exports more attractive in overseas markets. This phenomenon occurred in the early 1990s – the pound slumped when Britain was forced to leave the Exchange Rate Mechanism. According to Reuters, exports rose in the years afterwards, as shown in the chart. The pound also depreciated in 2008 after Lehman Brothers collapsed. But the subsequent increase in exports and growth was lower – probably because of lacklustre global growth in the aftermath of the financial crisis. 

Currently, the outlook for the global economy is not very bright. Hence, the extent to which the weaker pound will stimulate exports and domestic growth is doubtful. A fiscal stimulus would be another avenue to support growth. One of the former Chancellor’s final actions was to abandon his earlier pledge to deliver a budget surplus in 2020, signalling a move away from austerity. In theory, quantitative easing should lower bond yields so the government could fund a fiscal stimulus relatively cheaply by issuing bonds to borrow at relatively low rates.

However, even a two-pronged stimulus approach may not be sufficient to offset the potential negative impact of Brexit on growth. The UK’s biggest trading partner in 2015 was the EU, which is likely to be the case until Brexit actually occurs.

A weaker pound would boost export

The UK’s vote to leave the union may push down the value of the euro if other countries are inspired to hold their own referendums on membership of the union. The European Central Bank’s quantitative easing programme may also add to the downward pressure on the currency. A weaker euro means that the UK’s exports to the Continent are unlikely to receive a boost from being more competitive.

After the EU, the UK’s biggest export market is the US, which accounts for more than 16% of exports.

Source: The New York Times

Less than a week after the referendum’s results were out, the White House said that President Obama stood by an earlier comment that the UK would go to the “back of the queue” in trade agreements. Neither of his two potential successors are strongly in favour of free-trade. In fact, there appears to be a widespread backlash against globalisation, which is thought to be one of the reasons why the UK opted for Brexit. A World Trade Organization report shows that the monthly average of trade restrictiveness measures applied by G20 countries rose to the highest level since 2009 between October 2015 and May 2016. One perceived benefit of the vote – that the UK would have the freedom to reach free-trade agreements with countries outside the EU – is unlikely to materialise.

This means that the UK cannot rely on countries outside the EU to make-up for the loss in exports and foreign investment it is likely to face in case of a “hard Brexit”. According to several experts, in this scenario, the UK risks losing its free-trade access to the EU, which in turn may hurt exports and the attractiveness of the UK as an investment destination. One feature of the UK’s economy that makes it particularly vulnerable is that it needs, what Mr Carney calls the “kindness of strangers” ,for its large current account deficit.

A hard or a soft Brexit?

The uncertainty over whether Brexit will be “hard” or “soft” may weigh on the UK’s growth prospects but is unlikely to be resolved soon. Politicians in the UK are divided. The new Chancellor, Phillip Hammond would like to maintain a close relationship with the EU after the UK formally exits. But some his cabinet colleagues seem to want a “clean break”.

Even if UK policymakers favour maintaining free-trade access, this is by no means guaranteed. The UK’s future economic ties with the EU also depend on the wishes of the other members. At a recent EU summit in Bratislava, the UK, technically still an EU member, was not invited. Discussions among the other 27 members present did not include clarity about a post-Brexit world. In fact, some members appeared to be in favour of punishing the UK for its decision to leave. The host country’s prime minister said that the EU intended to make Brexit “very difficult for the UK”.

The UK’s inability to strike a deal to retain free-trade access to the Continent may be seen as yet another nail in the coffin for globalisation. and the country may not find it easy to sign new trade agreements with countries outside the EU. This may be a bitter pill for the UK’s economy which may not be countered by fiscal or monetary medicine. Even a combination of lower rates and taxes and increased quantitative easing and government spending cannot lead to clarity about the UK’s future place in (or outside) Europe. The lack of clarity may weigh on growth until policymakers are able to strike a deal that will put the UK on the “yellow brick road” where some of the advantages that were outlined by the pro-Brexit camp actually materialise.

Categories: Finance

About Author

Nandini Rao

Nandini has a Masters in Financial Economics from Saïd Business School, University of Oxford and a BSc (Honours) in Economics from Aston University. She focuses on monetary policy.