Fiscal Risk Report Outlines Some Silver Lining for UK Post Brexit

The British public and lawmakers have again been handed over a report about the state of the British economy in case of Brexit, this time by government authority - the Office for Budget Responsibility in their ‘Fiscal Risk Report’. Leaving without a deal, most probably in a disorderly or disruptive manner, was the focus of the report and is the first after earlier projections were published in its March 2019 Economic and fiscal outlook (EFO). Various no-deal Brexit scenarios have been reported by several other institutions, both public and private, and all have pointed to the impending slowdown in the economy due to Brexit. The negative impact is forecasted to augment considerably in the event of a no-deal Brexit. However, the report by the Office for Budget Responsibility serves as the most credible source of information and forecast.

For the purpose of forecasting, the Office for Budget Responsibility has taken assumptions laid down by the IMF, which assumes that 87 per cent of imports will be exempt from tariffs for a year under the government’s announced temporary tariff regime, before coming back to a tariff rate of 4 per cent under the current EU ‘most-favoured nation’ (MFN) rate. It also assumes a temporary recognition of multiple EU product standards by the UK and the implementation of a temporary recognition regime for some financial services with the EU. Net migration into the UK is expected to decrease by 25,000 a year out to 2030, and non-tariff barriers to trade with the EU would rise by an additional 14 per cent in tariff-equivalent terms as a result of trading under WTO rules. Due to the combination of weaker labour force growth and higher trade barriers, potential output growth is therefore expected to be lower with a risk that the economy would enter a recession.

The most frightening assumption was that the real gross domestic product of the nation would fall by 2.1 per cent and enter recession in the fourth quarter of 2019 for a year. Though that would be considerably lower than seen during the financial crisis of 2008-09, the recession would be of the same level as in the early-1990s recession. By the first quarter of 2024, the real gross domestic product would be just 1.6 per cent lower than in the March forecast, but it would be 4 per cent lower by mid-2021 than the baseline scenario. The increase in uncertainty and increasing trading costs would result in lower gross domestic product growth. Squeeze in real incomes of households due to the depreciation of the currency and lower earnings growth would result in weaker consumer spending and residential investment. In the short term, a rise in tariff and non-tariff barriers on exports would offset the increased possibility of export growth from sterling depreciation. In the medium term, net exports are expected to get a boost from weaker demand for exports and higher exports.

To compensate for the reduced competitiveness of the United Kingdom with the EU due to various trade and non-trade barriers, the pound would fall to deliver adequate returns to investors. It is forecasted a sharp fall of 10 per cent in the nominal sterling effective exchange rate immediately after a disruptive, no-deal Brexit. In the first quarter of 2024, the currency would be lower by 5 per cent in real terms. Due to a more moderate path for Bank Rate undertaken by the central bank, sovereign yields and mortgage rates would be slightly lower, possibly to push consumption and investment. The report noted the recent decline in the interest rate, which can be attributed to a higher probability of a no-deal Brexit. The Office for Budget Responsibility anticipates the stock market to decline by 5 per cent in the immediate quarter of a no-deal Brexit and would rise in line with the growth of the nominal gross domestic product.

The report assumed that the productivity growth would be lower, and employment would initially fall, as unemployment rate would peak at just over 5 per cent in 2021, though it would be at a good rate from the historical point of view. As unemployment would not rise, improvement in productivity growth in the medium term would not accompany an increase in real wages. However, due to weaker productivity growth, initially, earnings growth would be lower. Due to the rise in tariffs on imports from the EU and a weaker pound, CPI inflation is expected to be higher. However, gradually as spare capacity lowers domestically generated inflation, and the effect of higher import prices fades, CPI inflation would drop below the baseline scenario. The higher CPI inflation coupled with weaker nominal earnings growth would lower real wages significantly, which would adversely affect a range of industries, from the retail sector and consumer discretionary.

The report assumed that between the start of 2019 and mid-2021, house prices would be lower by around 14 per cent as compared to the baseline scenario of March and would fall by 10 per cent. Commercial property transactions would move broadly in line with residential transactions, while commercial prices are assumed to decline more steeply than those in the residential market. By the end of 2020, the report expects that the Monetary Policy Committee would cut interest rate to approximately 0.2 per cent before gradually increasing it.

The results of the stress test indicate that income tax and National Insurance Contributions receipts would be hit by the cyclical downturn, due to fall in asset price and capital tax receipts would fall. However, customs duties earned would increase and lower interest rate would help in reducing the debt interest spending. But the increase in receipts would not be able to offset the decline, and the borrowing would be around GBP 30 billion a year higher on average from 2020-21 onwards, significantly straining the financials of the country. This would have a considerable impact on the spending budget and the financial firepower of the government at a time of need would get significantly impacted. Since central bank policy rates are already very low, the monetary expansion would be limited, leaving the onus on the government to get the economy moving.

The report noted that the Conservative leadership hopefuls might lead to an increase in government borrowing by tens of billions of pounds as they seek spending increases and have proposed tax cuts. The policy decisions in the medium term will be chartered by the incoming Prime Minister and Chancellor, who at the moment favours less ambitious objectives for the management of the public finances and fiscal loosening. Philip Hammond, the Chancellor of the Exchequer, has time-and-again urged the candidates to commit to keeping net debt declining as a share of gross domestic product and he again warned of the hit to the UK economy from even a mild no-deal Brexit. The report mentioned that if candidates pay heed to the debt level, the future government would have additional borrowing of around GBP 25 billion a year over the medium term. Mr Hammond added that no-deal Brexit would result in a big increase in our national debt and a very significant reduction in tax revenue, against the claim by Tory backbencher Jacob Rees-Mogg who said a no-deal Brexit would boost the public finances by GBP 80bn a year.

The chances of a no-deal Brexit have increased significantly as Mr Boris Johnson looks to seal the spot as he has been leading over the other contender, Jeremy Hunt. The most troubling issue for most of the lawmakers was the possibility that the parliament might be circumvented by the upcoming prime mister to deliver Brexit. Mr Johnson has not ruled out prorogation of the parliament to deliver no-deal Brexit. But his wings were clipped by the parliament when it passed a proposal which would prevent the next prime minister suspending the legislature to pursue a no-deal Brexit, as the parliament showed a rare sense of unity to ensure a smooth Brexit which is approved by the lawmakers.

This report comes at a time when the economy is already slowing, due to various factors, increasing the importance of the assessment. It is no surprise that supply chains are starting to break, and production pauses are now common as businesses prepare for a no-deal Brexit. Critics of the report contended that the positive impact had not been included, like new future free-trade deals or lower cost of borrowing. However, the consensus is that the boost to the economy, if any, is going to be very limited. The report comes at a very crucial time as both likely future prime ministers suggest that a no-deal Brexit is possible, and this is the first time official independent budgetary watchdog of the government has quantified the loss for leaving the European Union without a deal. However, the report notes that the predicted downturn is much smaller than what was predicted by the Bank of England, and the results do not show the worst-case scenario under a no-deal, no transition Brexit.