The economic and financial costs and benefits of the UK’s EU membership Contents

3The short-term effects of leaving the EU

Consequences of uncertainty

77.In thinking about the impact of Brexit, it is helpful to distinguish between the short term, during which the UK’s future relationship with the EU is under negotiation, and the long term. Just how long the short term lasts is uncertain and this is considered in more detail later in this chapter.

78.As the Treasury Committee has repeatedly pointed out, forecasts are usually wrong. But, as was reported in evidence to the Committee by Ben Broadbent, Deputy Governor, Monetary Policy at the Bank of England on 24 May, “the fact that the future is uncertain does not mean all forecasts are useless. That is a false dichotomy.”72The UK’s formal relationship with the EU, including its rights and obligations under the Treaties, are unchanged in the short term; “nothing would change on day one”, as Lord Rose put it. However, effects on financial markets and the economy may arise during this period as a result of the uncertainty surrounding the UK’s future relationship with the EU. The Bank of England’s May 2016 Inflation Report, and other analyses, describe a number of channels through which the uncertainty following a vote to leave might have short-term economic effects.

79.The value of the pound. By 14 May 2016, sterling had fallen by 9 per cent from its November 2015 peak. The Bank of England’s May 2016 Inflation Report estimated that half of this decline was down to referendum risk. The Report notes that “were the United Kingdom to leave the EU, it is likely that sterling would depreciate further, perhaps sharply”,a nd that this could, in the short term, boost net trade (exports minus imports) and GDP growth, and lead to a rise in consumer price inflation (CPI). However, a vote to leave could also cause the euro to depreciate, mitigating any fall in sterling against the euro specifically. Changes to US interest rates may also affect the value of sterling. The Governor of the Bank of England, in correspondence with the Committee about the inquiry also set out that:

A fall in the exchange rate implies a reduction in the price of UK output relative to world exports, boosting demand for UK exports. It would also encourage UK households and firms to substitute away from imported goods and services to domestically produced ones. Offsetting that, however, the increase in import prices would lower real incomes for UK consumers, reducing their demand for UK output as well as for imports. The Bank’s forecasting model suggests that, overall, the substitution effect outweighs the income effect in this mechanical exercise.73

The Bank’s modelling showed that:

a persistent 10% depreciation (or appreciation) of the sterling effective exchange rate (ERI) increases (or decreases) annual consumer price inflation by around ¾pp [percentage points] over the baseline path after two to three years, and the price level by around 2¾% over four years. Monetary policy is assumed to be held constant in this experiment. The model is linear, so a 20% change in the exchange rate would double these estimates.74

HSBC economists have predicted that sterling would be likely to depreciate by around 20%.75

80.Domestic business investment and household consumption. Some companies, particularly those with revenues dependent on trade with the EU, may defer decisions to invest or hire. This would reduce demand (GDP) and, over time, may also have a negative effect on potential supply. Households may also temporarily defer consumption. Other things being equal, this could reduce GDP growth. However, it is unclear whether this is currently happening.

81.Financing costs and availability. In the face of uncertainty, lenders may require greater compensation (risk premia) to lend money. This would be reflected in higher borrowing costs for the Government,76 UK companies and households, and may act further to constrain business investment and household consumption.

82.Foreign investment and capital flows: A rise in uncertainty is likely to cause a reduction in foreign direct investment. This may be offset by short-term capital flows, which could be attracted by the depreciation of sterling or rises in interest rates.

83.These effects, should they materialise, may also interact with and exacerbate existing risks. Mark Carney, Governor of the Bank of England, described leaving the EU as:

the biggest domestic risk to financial stability, in part because of the issues around uncertainty, but also because it has the potential, depending on how it is prosecuted and how these issues can be addressed, to amplify risks around the current account [ … ] potential risks around housing, potential risks around market functioning, which we are trying to mitigate, and associated risks with respect to the euro area, which would have a feedback.77

The Governor added that other, global, risks, including those from China, “are bigger than the domestic risks”.78

84.Although the view expressed by the Financial Policy Committee (FPC) of the Bank of England in the record of its meeting of 23 March is similar, it is striking that in their written evidence when seeking reappointment neither Dame Clara Furse nor Richard Sharp suggested that Brexit was a material economic risk. The record of the FPC meeting states that: “risks around the referendum [are] the most significant near-term domestic risks to financial stability” and notes the UK’s reliance on inflows of portfolio and foreign direct investment to finance its historically high and persistent current account deficit. The FPC is required by statute to operate by consensus wherever possible, and under its remit from the Chancellor, communications by individual FPC members must be “co-ordinated and consistent”. The record of its meeting must include a “summary of the Committee’s deliberations”, but it does not generally identify specific dissent from the consensus. 79

85.The minutes of the 11 May meeting of the Bank’s Monetary Policy Committee (MPC) state that the combination of influences on demand, supply and the exchange rate arising from a vote to leave “could lead to a materially lower path for growth and a notably higher path for inflation”.80 The MPC differs from the FPC in that it votes at each meeting on monetary policy decisions and its minutes routinely record the views of individual members (without specifically identifying them). In the absence of dissent in the minutes, it can be assumed that there is unanimity among the MPC’s members.

86.In a report otherwise supportive of the economic case for Brexit, Gerard Lyons, chief economic adviser to the former Mayor of London, Boris Johnson, wrote that leaving the EU would have negative short-term economic consequences:

Leaving the EU would be an economic shock. Most, if not all, economic shocks depress economic activity. Thus economic forecasts that focus on, say, a couple of years ahead would tend to show that leaving the EU is always worse than the alternative.81

Policy response and contingency planning

87.The Bank has already announced additional liquidity auctions around the referendum date, signalling its willingness to mitigate market tension associated with the referendum and its result; the Governor said in evidence that “we are particularly focused on the condition of bank funding markets.”82

88.At its 11 May meeting, the MPC discussed how it might respond to a vote to leave. The minutes of the meeting state that in such an event, “the MPC would face a trade-off between stabilising inflation on the one hand and output and employment on the other. The implications for the direction of monetary policy would depend on the relative magnitudes of the demand, supply and exchange rate effects”. In effect, the MPC could either raise or cut interest rates. Despite the clear uncertainty from the MPC around the direction of monetary policy in the event of Brexit, the Chancellor has nevertheless made the claim that mortgages would rise under Brexit. Speaking on the media he has said “It’s already clear from the Treasury analysis that for example, there would be a significant shock to the housing market that would hit the value of people’s homes that would hit the cost of mortgages”.83But although presented as ‘fact’ this can only therefore be judgement. The Governor said that “there is likely to be risk premia on risky assets, in UK sterling assets, for a period of time.  Even in the case of a potentially lower Bank rate, the overall mortgage rate could be higher.”84

89.In evidence to the Committee in December, the Chancellor said that no contingency planning was underway for a vote to leave because “we are focussed on the renegotiation at the moment”.85 Sir Nicholas Macpherson, the then Treasury Permanent Secretary, told the Committee in February 2016 that “the Government are not at this stage doing contingency planning. They do not want their officials to do contingency planning”.86 When he came before the Committee again in May, the Chancellor said that “the Bank of England and the Treasury are doing quite a serious amount of contingency planning for the impact [specifically] on financial stability in the immediate aftermath of a vote to leave” but would not be drawn on details.87

90.Short of ruling out EEA membership, the Government has not described the sort of agreement it would seek with the rest of the EU, or with non-EU countries, following a vote to leave.

Length of period of uncertainty

91.Article 50 of the Lisbon Treaty describes the procedural mechanism by which a country leaves the EU. The departing Member State notifies the European Council of its intention to leave, after which a negotiation takes place with a view to reaching an agreement “setting out the arrangements for its [the UK’s] withdrawal, taking account of the framework for its future relationship with the Union”. From the point of notification, the UK would cease to be a member of the EU after two years (i.e. the Treaties and EU law cease to apply to it), unless a withdrawal agreement is reached that enters force on a different date, or the UK and the remaining EU Member States vote unanimously to extend the time period.

92.Article 50 implies that the arrangements governing the UK’s future relationship with the EU may take the form of a separate agreement. This is what is envisaged in the Government’s paper, The process for withdrawing from the European Union, which states “Any sort of detailed relationship would have to be put in a separate agreement that would have to be negotiated alongside the withdrawal agreement”. Sir Jon Cunliffe, Deputy Governor of the Bank of England and former UK Permanent Representative to the EU, said that “they [i.e. an agreement on withdrawal and on future trade relations] could be done as part of the same” but that “I have always envisaged it as a separate negotiation”.88

93.It is clear from the evidence the Committee has heard that the length of the period of uncertainty, during which the UK’s future relationship with the EU is being negotiated, whether as part of a single agreement or not, is itself uncertain, and partly dependent on the position taken by other EU Member States, who must agree a common negotiating position, and ratify any eventual agreement.

94.On the one hand, based on the experience of recent comprehensive trade agreement negotiations (see Figure 2, below), it may be several years before the terms of the UK’s future trade relationship with the EU are settled. On the other, the UK would be starting from a very different position, where it already enjoyed a high level of access to EU markets and, where relevant, an equivalent regulatory framework. It is also possible that the uncertainty surrounding the UK’s future relationship with the EU could be significantly reduced well before negotiations are concluded: as Sir Jon Cunliffe put it, “you could be in a position where all parties agreed quite quickly as to where they wanted to go”.89

Figure 2: length of time taken to negotiate selected trade agreements (years from launch of negotiations to entry into force)

Source: Open Europe, Where next? A liberal, free-market guide to Brexit, April 2016, p17

95.The length of the period of uncertainty would also depend on when the Government were to start the process of withdrawal. The Prime Minister has said this must start immediately:

If the British people vote to leave, there is only one way to bring that about, namely to trigger Article 50 of the treaties and begin the process of exit, and the British people would rightly expect that to start straight away.90

This point was reinforced by the Chancellor in his evidence to the Committee, when he said that Article 50 would be invoked in “days–maybe a week or two.”91

96.However, there is no legal requirement for Article 50 to be triggered immediately after the vote. Sir Jon Cunliffe said that the right time to trigger it “would be when one knew what one wanted”.92 The Chancellor told the Committee that it was for others, particularly those advocating a vote to leave, to set out what the alternatives might be.93

97.Following a vote to leave, there would be a period during which the UK’s future relationship with the EU is uncertain. As with much economic uncertainty, it is plausible to suppose that this could weaken the pound, reduce domestic and foreign direct investment, and increase borrowing costs. However, some of these effects may be countervailing. It could also exacerbate pre-existing risks to financial stability. The duration of this uncertainty, and hence the length of time that these effects would persist, is itself uncertain, but is likely to be in excess of one year.

98.The economic and financial consequences of uncertainty can in part be mitigated by the actions of the Bank of England’s Monetary and Financial Policy Committees. The Committee notes that the scope for monetary policy to cushion the macroeconomic effects of a vote to leave is limited by the fact that base rate is close to zero, and that the Bank currently holds a quarter of UK Government gilts.

99.The extent and duration of uncertainty in the aftermath of a vote to leave can in part be mitigated by the Government if it is clear about its strategy and objectives. In a referendum, unlike a general election, the winning side does not form a government. Therefore, unless the government were willing to announce its contingency plans for a Brexit vote the uncertainty would be magnified. Understandably the Government is reluctant to spell out such plans for fear they help its opponents. The short-term economic effects of Brexit are generally held to be large, but it is possible that they could be small. The Committee intends to take further evidence on this as soon as possible now that the Treasury’s analysis has been published.

100.The Government will need to make it unambiguously clear that it will respect the will of the electorate in the event of a vote to leave within a reasonable timeframe. But it could be economically misguided for the Government to invoke Article 50 immediately after a vote to leave and it may not be in the national interest to do so. The Committee agrees with Sir Jon Cunliffe that the UK should “start the clock running when one knew what one wanted”. As the Chancellor has made clear, the Government has not considered the relationship that it wants with the EU following a vote to leave; it therefore seems unlikely that it will be in position to articulate its negotiating position on the day after the referendum.

72 Oral evidence to the Committee on the Inflation Report May 2016, 24 May 2016 Q106

73 Letter from Mark Carney to Rt Hon Andrew Tyrie MP, 29 March 2016

74 Letter from Mark Carney to Rt Hon Andrew Tyrie MP, 29 March 2016

75 HSBC Global Research: Brexit Strategies - What if the UK leaves? February 2016

76 The three main credit rating agencies have signalled that they would put the UK Government’s credit rating on a “negative outlook” in the event of a vote to leave.

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79 Bank of England Act 1988 (as amended) Section 9U (2)

80 Monetary policy summary and minutes of the Monetary Policy Committee meeting ending on 11 May 2016 (published 12 May 2016)

81 Greater London Authority, London: the global powerhouse

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83 Rt Hon George Osborne, interview with Robert Peston, 8 May 2016

84 Oral evidence to the Committee on the Inflation Report May 2016, 24 May 2016 Q106

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86 Treasury Committee Oral evidence: HM Treasury Annual Report and Accounts 2014–15, HC 805 10 February 2016, Q15

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90 HC Deb 22 February 2016 c24

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27 May 2016