The Impact of Brexit on Pound Sterling and More

The decision of the United Kingdom to leave the European Union caused an unprecedented turmoil in the global currency markets as well as in global equity markets. This significant political and historical event caused financial markets to decline, leading the British Pound Sterling to drop sharply against other major currencies. This deterioration in the value of Pound Sterling since the Brexit verdict is an indication to what extent the verdict has caused the different market participants to take an adverse view of the country’s economic strength that would ensue after its departure from the European Union. In other words, it is a reflection of the consensus view among economists and the general public that Brexit will hamper the country’s economic growth.

Impact of Brexit on the British Pound Sterling; With deal or no deal, Brexit will result in an Adverse balance of payments situation in the British economy. United Kingdom is signatory to the European Union treaty which mandates a country exiting the union to compensate for a certain future period.  In case of United Kingdom, it comes to around £ 32.8 billion. The United Kingdom has to compulsorily pay this amount as part of the terms of the treaty.  This amount does not take into account any deal that may or may not take place between United Kingdom and the European Union. Should a deal be worked out between the two parties one has to add the amount of money that may have to be paid to this figure. In either case this huge outflow of Pound Sterling out of United Kingdom will put a heavy dent on the balance of payments situation in the country and the rest of the world, with the consequence that its currency will likely remain under pressure for an extended period of time.

So, what will the real impact of Brexit be on the Pound Sterling and its long-run value? Brexit is a deglobalization shock for the British economy, at a fundamental level. Brexit will undo some of the gains from trade like increased specialization, efficiency, and productivity that the United Kingdom benefited from as a member of the European Union by increasing barriers to trade, labor, and mobility of capital. Other than that, the aggregate impact of being a part of EU, which made London the preeminent global financial epicenter of the world, will also as a consequence be weakened. Thus, It can very well be expected that United Kingdom will become somewhat less competitive and less specialized post Brexit. The ensuing depreciation in average productivity in the country will render the economy poorer than it would have been otherwise, which would also have an adverse impact on the Pound Sterling. Investors, however, may become more concerned about the nation’s ability to finance its trade deficit in the short term rather than pondering over the fundamental reasons for the Pound Sterling’s long-term decline in value versus other major currencies.

But the changing value of the Pound Sterling has multidimensional effects on an economy both horizontally as well as vertically. A depreciated pound sterling will make imports dearer, which will spiral into higher prices for the end consumers, principally for those goods (such as different varieties of food) that are sourced from abroad and which the country’s businesses would find difficult to produce. Other than that, the Pound Sterling’s depreciation would raise the average cost of raw materials used as inputs to the production process that were earlier being imported (such as the various machineries and components used in a Bentley car at the Volkswagen plant in Crewe) or is priced globally in United States Dollars (such as crude oil). This will have a material impact on the costs of these materials, which at some point came from outside the United Kingdom.

However, the impact of this weakened economic condition on the UK may be short lived. Everything else remaining the same, the depreciation of pound Sterling will provide a boost to British businesses who sell their goods abroad, with the business fundamentals of British business remaining the same. In the short run imports will suffer as the English will find it dearer to consume imported goods while exports will grow as it will be cheaper than before for foreigners to consume British goods. In the long run the consumption levels of the British people will be back to where it was, and the earnings of the British people will improve. The heightened business activity will over time compensate for the losses on account of the Brexit payment made to the European Union. So, in effect the business and currency cycles will become elongated.

Other than the direct economic consequences Brexit might have on the United Kingdom, departure from the European Union could very well be a catalyst to bring about radical reform of its domestic business policies. The current assessments being made of the impact of Brexit do not include these other possible policy changes when assessing Brexit’s economic consequences. Such policies could have a significant impact and, and practically, will go on to shape how the British economy would evolve over the forthcoming decades, however, each of these policies should be considered separately based on their individual merits.

Both the European Union and Great Britain are in battle mode to deal with this event of mutual parting of ways. There is greater emphasis on measures to be taken to let disruptions in business from happening at all. Despite getting two years to take all preventive measures, the exercise seems to have overwhelmed the foresight of the policy makers of both the European Union and Great Britain. With the gradual ensuing of clarity in the understanding of the magnitude of the problem, lawmakers on both sides are grappling for solutions. The realization that seems to have echoed with both sides is to have an agreement (Deal) between the two blocks, so that in case of any eventuality all issues are to be resolved as per a predetermined set of terms to be set under this agreement. However, negotiations between European Union and Great Britain are still going on even as the final date of disengagement is coming near.

There are many important differences between Brexit and the financial crisis of 2008/09. The first one of course is that Brexit hasn’t happened yet. Back then the Pound Sterling’s fall happened alongside the reason causing it. However, this time the fall in the value of the currency reflects the beliefs in the minds of people about changes in the the country’s future trading arrangements, which ironically is making its impact felt in an economy where arrangements are for the time being unchanged from the previous position. The result, however, is higher prices and profits without any change in rules and costs. This, in the short run at least, represents something of a sweet spot for exporters and businesses that compete with imports.

How the exporters respond to this situation will impact the economic growth of the country in the short term at least. One of the more positive aspects of an exchange-rate depreciation is that, it encourages the expansion of businesses in the trading sector by raising their profitability. With the world economy in far better shape than it was some time ago, there is certainty every incentive for the British companies to do better today. If the currency markets are right, the country’s future trading relationships will be less favorable; if it’s too pessimistic the Pound Sterling will most likely rebound. In either case, the prospective returns of the trade sector would not be as healthy as they are presently. This could very well act as a detrimental factor in the longer-term, sunk-cost investments having already been made in that sector.

The term “post-Brexit” is quite a buzz in the financial sector these days. A better description however of the United Kingdom’s current circumstances would be “post-referendum” but “pre-Brexit”. It is possible, however, that Brexit won’t turn out to be as bad as the foreign exchange markets are making it appear to be. If the government succeeds in negotiating a “new, comprehensive, bold and ambitious free trade agreement” with the EU, and in opening up trade with non-European countries, the UK’s overall degree of openness may not worsen; on the contrary, it could improve.

In the short run however, despite higher profitability, business investment will stagnate or fall in the short term even as it accelerates significantly in other developed and developing countries. However the consumption patters in the country are projected to slow down sharply.

Yet there are clearly the possibilities of both happening. If the view of financial markets is sided with, and in particular that of the exchange rates, the risks around Brexit could persuade companies to cut investment further this year. If businesses side more with consumers – who, as we’ve noted before, appear to have taken such uncertainties very much in their stride – they will respond more to today’s favorable conditions than to any caution about the longer-term future and instead raise investment spending.