What a hard Brexit will do to the UK’s current account

Pound falls.PNG

Britain has been fixated on dealing with issues on the border and handling the immediate transition in a no deal Brexit. More esoteric issues such as the impact on the pound, the current account, the budget deficit and the banking system have not been discussed as much.

In November 2018, the Bank of England published a report describing its best assumptions of what would happen in a hard Brexit. Using their forecast, they estimate the following:

  • Unemployment increases from around 4% to 5.75% to 7.5% in the first year.

  • Inflation, due to a sharp decrease in value of the pound, would hit 4.25% to 6.5%.

  • GDP would be 4.75% to 7.75% lower by the end of 2023.

  • The report says “the MPC will respond to any material change in the outlook to bring inflation sustainably back to the 2% target while supporting jobs and activities”.[1] Given the sharp increase in inflation above the target, at the very least the MPC will not lower rates. In order to maintain a 2% rate, the MPC should theoretically raise interest rates.

  • The UK is reliant on inflows of foreign capital to finance its current account deficit which currently stands at 3.9% of GDP. Because European imports of British goods will decrease sharply, the current account deficit could expand rapidly.

  • The BOE assumes sterling falls 25%

  • Investors are assumed to demand high corporate bond yields

  • House prices fall putting further downward pressure on UK asset prices

  • Overall borrowing costs faced by households and businesses rise 250 bps

In a hard Brexit scenario, the European side is likely to put up a customs border, making it impossible for goods from the UK to get to Europe until trade deals can be negotiated over the ensuing years. The UK currently exports £274 billion worth of goods to Europe. In turn, the UK imports £341 billion[2].

If the UK stops sending goods out, but the UK continues to import key goods from the EU, such as food, there would be a sharp decline in the currency. Many goods would be too expensive lowering demand and the UK would want to insert its own customs and borders to stem the losses in the current account leading to sharp changes to what we buy in stores and creating a wide swathe of potential bankruptcies to the businesses tied to these imports.

The larger current account deficit would need to be funded when most investors would deem the UK too risky to invest. This would increase borrowing costs. There will undoubtedly be lay-offs. The BoE’s projections are also only projections; the actual economic impact and effects on employment could be much worse given the potential scale of the shock.

Higher unemployment also creates great pressures on the fiscal account from lower tax revenues and a need for further austerity to offset the balance of payment pressures and lower the risk to government bond investors. The UK also faces risks to its banking system. The BoE feels confident that in a hard-Brexit scenario the

“UK banking system would be strong enough to continue to serve UK households and businesses even in the event of a disorderly Brexit”.

However, bank leverage ratios are still high. Current capital safety measures compare equity not with a risk weighted measure of assets, but only the total unadjusted number. Because measures of book equity can conceal losses, the market tends to use the bank’s market capitalization as a proxy. On this basis, the capital adequacy ratios go from 16% for RBS to 3.6%. Barclays is below the 3.25% floor the BoE sets.

Observers have been cavalier saying the low price to book ratios reflect concerns about future cash flows that have little to do with asset quality. However, in a hard Brexit scenario, asset quality is likely to plummet as house prices deteriorate and SME corporate bankruptcies elevate. UK household debt to income ratios are already at 127%[3].

The market capitalization of UK banks will get much lower in a hard Brexit scenario and this could precipitate a banking crisis contrary to the BoE’s assertions. The Global Financial Crisis made clear that central banks should not ignore the stock market’s views on bank asset quality.

References:

[1] Taken from the Bank of England’s Statistics on EU-UK Trade, November 30th, 2018, House of Commons Library

[2] Taken from the Bank of England’s, “EU Withdrawal Scenarios and Monetary and Financial Stability”, November 28th, 2018

Credit Suisse, “Domestic UK Banks” report, January 25th, 2019, Page 5

[3] Statistics on EU-UK Trade, November 30th, 2018, House of Commons Library [3] Credit Suisse, “Domestic UK Banks” report, January 25th, 2019, Page 5

Brexit, Economy, FinanceMonica HardingBank of England, Brexit