Consequences Of a “Disorderly Brexit”- Bank of England Update!

As on September 03, 2019, the BOE Governor Mark Carney wrote in response to the letter dated July 17, 2019 from the previous Chair of Treasury Committee, the Rt Hon Nicky Morgan, MP. Ms Morgan's letter concerned the scenarios that were published by the Bank in November 2018 in response to a previous request from the Treasury Committee for the Bank to publish analysis of how different Brexit outcomes would affect the Bank's ability to meet its objectives of monetary and financial stability.

Since November 2018, there have been some developments in economic and financial markets which have affected the underlying pattern of the economy. These have been incorporated in the MPC's August Inflation Report, which as a result, provides an updated reference point for "the present situation."

Worst Case: No Deal, No Transition Scenarios

Consistent with its statutory remit, the Financial Policy Committee (FPC) has focused on outcomes that would have the greatest potential impact on financial stability. In that context, the FPC has considered the particular risks that could arise if the UK's trading relationship with the EU were to transition abruptly to WTO terms (a so called 'No Deal, No Transition Brexit').

To maintain the consistent provision of financial services to the real economy, banks in the UK must be able to absorb the impact on their balance sheets of any adverse economic shocks that may arise from Brexit. To assess their ongoing ability to do this, the FPC compared the scenarios that major UK banks were tested against in the 2018 annual stress test, with the worst-case disorderly Brexit scenario in mind.

Disorderly Brexit scenario was underpinned by a set of worst-case assumptions that reflected the state of preparations in November 2018, including:

• Border infrastructure and processes were unable to cope smoothly with new customs requirements, causing severe disruption at the border. UK exports were further reduced as, while the UK was assumed to continue to recognise EU product standards, the EU did not reciprocate.
• The UK and EU both applied the EU's current Common Customs Tariffs symmetrically.
• The UK lost access to existing trade agreements that it currently has with non-EU countries through membership of the EU.
• The EU took no further action to address risks in derivative markets, contributing to a tightening in financial conditions.
• This tightening was exacerbated by a pronounced increase in the perceived risk of holding Sterling assets, which in turn was driven by uncertainty about the UK's macroeconomic framework and institutional credibility.
• The exchange rate was assumed to overshoot its new lower equilibrium level, credit spreads rose and monetary policy reacting mechanically to balance deviations of inflation from target and output relative to potential - tightened sharply in order to bring inflation back to target.

In that scenario, there was an initial peak-to-trough decline in GDP of 8% in absolute terms, a rise in unemployment to 7.5%, and inflation peaked at 6.5%. In November, the FPC judged that the UK economic scenario of the 2018 stress test, to which banks were resilient, was sufficiently severe to encompass that worst case Brexit scenario. This implies that Britain’s banking system was robust enough to continue to cater UK households and businesses even in the wake of disorderly Brexit.

Material risks to economic disruption remain. But as the FPC noted in its most recent Financial Stability Report, actions taken by authorities and businesses since November have resulted in some improvement in the preparedness of the UK economy for a No Deal, No Transition Brexit:

• The UK has announced Transitional Simplified Procedures (TSP) for customs checks at the border, a temporary waiver on security checks.
• The Port of Calais and Eurotunnel announced that they have completed their preparations on French border infrastructure.
• As a first step in preparing for new procedures, some UK traders are registered to be able to continue to trade with the EU (and vice versa).
• Some UK firms are in the process of obtaining EU certification for their products.
• In March 2019, the British government announced a no-deal tariff regime, under which 87 per cent of total imports by value will be allowed for tariff free access.
• Agreements have been reached to roll over existing EU trade deals with the rest of the world representing about 7% of the UK's total goods trade.

Subsequent to the most recent Financial Stability Report, the government has also announced an autoenrollment scheme to provide UK businesses with the necessary Economic Operator Registration and Identification (EORI) numbers required to move goods into and out of the EU.

Financial sector preparation for a no-deal kind of exit has also increased since November 2018.

Bank of England has prepared an updated worst case disorderly no deal Brexit scenario, in which the following assumptions differ from those used in the disorderly scenario published in November:

• Disruption at the border is less severe, reflecting TSP and progress in preparing border infrastructure and the introduction of TSP also delays the long run impact of customs checks on trade for a period.
• The UK applies the no-deal tariff regime announced in March on all external trade.
• Reflecting agreements that have already been reached, trade deals with the rest of the world representing about 7% of the UK's total goods trade are rolled over.(Source: BOE)

Brexit- With Withdrawal Agreement

Britain was assumed to leave the EU bloc with a formal withdrawal agreement and enter a future relationship similar to that outlined in the Political Declaration setting out the framework for relations between the European Union and the United Kingdom. That declaration outlined comprehensive arrangements that would create a free trade area in goods, and a level of liberalisation in trade in services that would go well beyond WTO commitments. In those scenarios, cumulative GDP growth over a 5-year horizon would have been between 1.75% higher and 0.75% lower than the MPC's November 2018 forecast. The breadth of that range is driven by a variety of assumptions about trading arrangements that would be consistent with the terms of objectives and principles of the economic partnership set out in the Political Declaration.

Because the Withdrawal Agreement - which includes an implementation period - and the Political Declaration have not changed, the range of assumptions contained in the November Economic Partnership scenarios remains appropriate for analysis of how the Withdrawal Agreement would affect the Bank's ability to deliver its objectives.

In the Transition to WTO scenarios, the UK was assumed to leave the EU with a withdrawal agreement and, after an implementation period of two years, enter trading arrangements with the EU on WTO terms. That would include tariffs, quotas, customs check and other non-tariff barriers. In that scenario, cumulative GDP growth over a five-year period would have been between 2.5% and 5.5% lower than the MPC's November 2018 forecast. The key drivers of that range were the degree of preparations for the change in trading arrangements by the end of the two-year implementation period — including to border infrastructure on both sides of the channel and business preparations for new border checks and regulatory procedures — together with the response of households and the impact of reduced openness on productivity. (Source: BOE)