RaboResearch - Economic Research

The economic bill of Brexit pre-Brexit

Special

Share:
  • At first glance, the UK economy hasn’t suffered much from Brexit. But even as there hasn’t been a recession, the UK did drop from the top to the bottom of the G7 growth league.
  • The consumer was the first to feel the consequence of the Brexit referendum, as the real pay squeeze put a dent in consumption.
  • Meanwhile, the out-but-not-out combination of a weaker exchange rate and an unchanged trading regime, failed to spark a sustained boom in exports.
  • While the clouds of uncertainty won’t dissipate anytime soon, business investments have already seen a decline of four consecutive quarters.
  • The increasingly tight labour market seemed the bright spot in the UK economic story, but the outstanding performance seems driven by one-off factors, while Brexit related immigration dynamics could make matters worse.
  • Worryingly, Brexit is likely to affect the transfer of capital, people, knowledge and innovation to the UK, which together will translate into a lower level of structural economic growth.

Clouds of uncertainty won’t dissipate…

The United Kingdom invoked Article 50 on 29 March 2017, which officially started the two-year exit procedure. But the slow progress in the EU-UK negotiations and the subsequent difficulty to get the eventual deal through Parliament has already pushed the deadline to April 12. Even though the latest political developments have been encouraging on the surface, the persistent gridlock in the British Parliament make a longer extension of article 50 increasingly look like an inescapable reality. Indeed, the drama could well be extended for another year.

Considering that the mere prospect of a Leave vote already clouded the economic outlook in early-2016, the UK economy has been suffering from Brexit uncertainties for more than three years now. Meanwhile, doing business between the UK and its trading partners did not change in this period. The UK is still an EU Member State with all the rights and the responsibilities that pertain to this. Nevertheless, Brexit has already taken its toll on the economy and this damage may very well become permanent.

Our base case for the eventual outcome remains an orderly Brexit, which culminates into a four year transition period followed by a free trade agreement that includes a customs union. A customs union without a single market is far apart from no-friction trade. It eliminates tariffs, border formalities and rules of origin, but many other non-tariff barriers are in place. It is therefore not the softest form of Brexit. Such an outcome would mean relatively weaker ties to the EU and that also has a structural impact on the country’s economic growth potential. The impact would be much more pronounced in the case of a hard (no-deal) Brexit, an outcome with still uncomfortably high chances.

… but the economic fallout is already visible…

At first glance it looks as if the UK economy hasn’t suffered much from Brexit, since it has been growing at a fairly steady rate between 1.25% and 2.0% in real terms per year. But this was against a backdrop of a peak in the global economic cycle. Relatively speaking, the economy did slow, as figure 1 evidently shows. In just a matter of two years, the UK moved from the top to the bottom of the G7 growth league. In this note, we’ll provide some more colour on how this came about. Let’s start with consumption.

Figure 1: From growth leader to laggard?
Figure 1: From growth leader to laggard?Source: OECD, Macrobond
Figure 2: Import inflation in 2017…
Figure 2: Import inflation in 2017…Source: ONS, BIS, Macrobond, RaboResearch

The consumer was the first to feel the consequences of the Brexit referendum. The trade-weighted effective exchange rate fell 16% in the seven months to July 2016, which pulled CPI inflation from a low of 0.3% in May 2016 to a high of 3.1% in November 2017. And even though the labour market was already a bit tight – or so it was thought – real pay growth moved into negative territory for the entirety of 2017. Relatively buoyant consumption growth proved to be unsustainable in the post-referendum constellation, and it slowed down markedly from 3.1% y/y in 2016 Q2 to eventually 1.6% y/y in the last quarter. It took two Bank rate hikes and a slump in global commodity prices – i.e. oil – before inflation was brought back to target in early 2019. Meanwhile, the labour market continued to tighten, and earnings growth picked up to above 3%. While the rise in purchasing power should be supportive of consumption going forward, sentiment has weakened due to elevated political uncertainty. The GFK’s measure has dropped to a multi-year low of -14 in January, before recovering slightly to -13 in February and March.

Figure 3: … leads to a real pay squeeze…
Figure 3: … leads to a real pay squeeze…Source: Macrobond, RaboResearch
Figure 4: … and pushes consumption growth to lower levels
Figure 4: … and pushes consumption growth to lower levelsSource: OECD, Macrobond

Out-but-not-out

The UK has been out-but-not-out for nearly three years. This was said to spark a boom in exports due to the combination of a weaker exchange rate and an unchanged trading regime, but we haven’t seen much of this. Often overlooked is the fact that UK exports have a relatively high share of inputs from abroad, so that only 40% of the exchange rate fluctuations feeds into export prices.

While exporters were definitely able to benefit from the global tail winds in late-2016 and early-2017, export growth actually fell back to negative rates in 2018. Total exports of goods and services have declined by 1.3% y/y in 2018 Q3 before picking up again to a meagre 0.2% y/y in Q4. Again, the UK dropped in the G7 rankings (figure 5). While it is a fact that UK car makers are hard-hit by the global slowdown in the industry –output is down 15.3% on the year– the Brexit vote and the resulting trade policy uncertainty may have incentivized export partners to re-route supply chains. It’s crucial that the UK economy is perceived to be open for business, but the outlook remains at risk due to political infighting. Firms in Markit’s PMI survey cite a tendency among European clients to delay committing to new UK projects, for example.

The total trade deficit widened to GBP 8.2bn in the twelve months to January 2019. While the effects on GDP of stockbuilding ahead of Brexit are not clear yet, the trade data show that there has been a notable pick-up in imports. Again there’s plenty of survey evidence that points to firms bringing forward purchases when possible to minimize any disruptions to supply. The Markit PMI data shows that UK factories have stockpiled at the fastest rate in the history of all G7 PMI’s. The gauge of stocks of factory purchases rocketed to 66.2 from 59.9 in February. While this pushed the manufacturing PMI to a 13-month high of 55.1, there’s ample reason to suspect the large build-up in stocks may reverberate through the sector in foreseeable future, reflecting in weaker output, profitability and possibly solvability going forward as these stocks need to be unwound.

Figure 5: UK exports have dropped to the bottom of the G7 league table…
Figure 5: UK exports have dropped to the bottom of the G7 league table…Source: Macrobond, OECD
Figure 6: … but imports are picking up: evidence of stockpiling?
Figure 6: … but imports are picking up: evidence of stockpiling?Source: Macrobond, OECD

Business investment contracts for four consecutive quarters

As a lot of capital is tied-up in these stocks, the extreme levels of stockpiling may also leave less money for business investment, even when Brexit does go smoothly. And the investment outlook is already shaky due to the uncertainty regarding the UK’s political stability and the type of future trading relationship between the UK and the EU. This has clearly taken its toll on investments, which contracted four quarters in a row in 2018 to -2.5% y/y in 18Q4. This has not happened since the financial crisis of 2009. The contraction is not only damaging for current economic growth, but weaker investment in the country’s capital stock also affects the economic potential. The outlook is not much better either since investment intentions in both manufacturing and services have been on a downward trend since the beginning of 2018 (figure 8), and even turned negative in February for manufacturing.

These developments are particularly worrying as the tight labour market and relatively high capacity utilization (figure 8) should have actually incentivized firms to speed up their investments. However, there have been signals that firms have responded to higher demand by hiring more workers –which is less costly to reverse if things eventually do go bad– rather than investing long-term in new capital equipment.

Figure 7: Private investments contracted four consecutive quarters in 2018
Figure 7: Private investments contracted four consecutive quarters in 2018Source: ONS, Macrobond, RaboResearch
Figure 8: Higher capacity constraints, but lower investment intentions
Figure 8: Higher capacity constraints, but lower investment intentionsSource: BoE, Macrobond, RaboResearch

A ‘forced’ rise in employment?

The labour market has been one of the bright spots, right? Well, even that’s complicated. Indeed, the annual change in employment has been 473,000 over the 12 months to January, or a 1.5% rise. This is good news, but the headline rate masks a big compositional shift. While employment increased across all age groups, the strongest increase was among those aged between 50 and 65. In fact, over-50s have accounted for more than 2/3s of the rise (figure 9). More and more women are taking up jobs as well. It appears therefore that more people are working for longer, a trend which has been fuelled by the biggest post-Great Financial Crisis real wage cut in Europe barring Greece (see again figure 3), by the decline in defined-benefit company pension schemes and by the equalisation of the state pension age resulting in fewer women retiring between 60 and 65. Of course it is also true that the relatively strong rise in employment in the higher age bracket reflects shortages. Whilst it is in itself a positive development that people in the higher age brackets are given a fresh chance, the compositional shift still has certain implications for productivity, while it also implies that there was a bit more labour market slack than the multi-decade low in unemployment (3.9% currently) suggested.

Another shift that is more related to Brexit is the change in composition between EU27 and non-EU27 nationals in the UK’s employment numbers. Figure 10 shows that the annual growth of EU27 nationals in UK employment has slowed after the vote and even turned negative. This is partly compensated for by a rising number of non-EU27 nationals, but may lead to significant skills mismatches. Keep in mind that there are more than 100,000 vacancies for the NHS alone across the UK, and this is expected to rise to 250,000 in a decade. Other sectors that may face shortages and/or skills mismatches are construction, hospitality, agriculture and social care, which rely on EU workers. If the labour market opens up to people who are currently on the sidelines and if the mismatches are resolved with investment in training –unfortunately ‘soft spending’ items are the first to go in uncertain times– the UK economy may overcome these shortages.

Figure 9: Over-50s account for more than 2/3 of UK employment growth
Figure 9: Over-50s account for more than 2/3 of UK employment growthSource: Macrobond, ONS
Figure 10: Non-EU27 nationals are filling the employment gap left by EU27 nationals
Figure 10: Non-EU27 nationals are filling the employment gap left by EU27 nationalsSource: Macrobond, ONS

… and may very well become permanent

In 2017 RaboResearch calculated the economic impact of several Brexit outcomes and estimated the cumulated foregone growth over 2019-2030 to be 12.5% in a FTA scenario. That translates to 1 percentage point per year, which is similar to a number of doppelganger estimates of ‘lost growth’ over 2016-2018. As we explained above, the main channels for Brexit to feed through into the economy in the past two or three years were mainly the depreciation of the currency and persistently elevated uncertainty.

The actual departure will have many more direct and indirect consequences, as we explained here. While it might be that we underestimated the actual post-Brexit impact –even as our forecast was one of the most pessimistic at that moment– another possibility is that some of the impact is already being frontloaded, for example in the form of weaker investment. The calculations also did not take into account that there would be a transition period, nor did they assess an FTA plus a customs union as a scenario.

Based on our assumption of an orderly Brexit as described in the beginning of this article, we expect economic growth to hover at relatively subdued levels during the transition period, similar to 2018. The actual departure in 2023 would cause a modest contraction in that year, and a recovery after that. A no-deal Brexit, which we see as an outcome with uncomfortably high chances, would push the economy into a deeper, two-year recession. A gradual recovery would then follow, but growth would not return to the long-term path for a long time.

Long-term potential

And this brings us to a serious matter of concern: the impact of Brexit on the long-term potential of the British economy. The UK will likely become a less open country after Brexit and lose its role as a gateway to the EU. This will have an impact on the transfer of capital, people, knowledge and innovation, which together will translate into a lower level of structural economic growth. In 2017 we assessed that in 2030 potential GDP growth would be 75% and 60% lower in respectively a FTA/EEA and a Hard Brexit than under a Bremain scenario (see also table 1).

An important driver of this deterioration was the fall in total factor productivity (TFP), which reflects the level of technology or the efficiency of capital and labor in generating value added. We estimated the endogenous effects of Brexit on TFP and concluded that this would be 72% and 45% lower under a Hard Brexit and a FTA/EEA than if the UK had remained in the EU. This damage is particularly important since in the past TFP growth was the main pillar for growth in the UK for almost half a century (figure 11). We assumed in our scenarios that TFP would return to its structural level in the very long term. Accordingly, we expected TFP growth to pick up from 0.9 ppts in 2017 to 1.1 ppts in 2030 under a no-Brexit scenario.

We do note that TFP has hardly recovered after the Great Recession, which raises concerns whether this will ever be the case. This was also one of the main reasons for potential output revisions in the past two years by the Bank of England (BoE) and the Office for Budget Responsibility (OBR). In November 2017 the OBR revised its trend productivity growth to 0.9% in 2017 and slowly recovering to 1.2% in 2022. We do not that the UK is not unique in this sense and that this trend is not Brexit-related. Moreover, the revised OBR estimates are close to the productivity path we used in 2017, though we see productivity taking longer to recover, so we are comfortable with the TFP path we estimated in 2017.

Table 1: Potential GDP growth in the UK in 2030
Table 1: Potential GDP growth in the UK in 2030Bron: RaboResearch

But Brexit does complicate things. The economic performance of the past two years has had an impact on the other components of potential GDP growth, which are employment and capital deepening. The labour market developments as described in the first half of this report have pushed the contribution of employment higher in both 2017 (from 0.5 ppts to 1.6 ppts) and 2018 (from 0.6 ppts to 1.3 ppts), which is displayed in figure 12. The higher employment contribution was mainly driven by a higher participation rate, which more than offset the lower numbers of hours worked per person engaged. This is a common trend in cases of rising levels of income. Considering the factors that have pushed the participation rate higher in the past two years, it is questionable whether the improvement is sustainable in the long term or just a one-off event. Moreover, instead of a positive contribution of 0.3ppts, capital deepening was actually negative in 2017 (-0.2 ppts) and barely visible in 2018 (+0.1 ppts).

All in all potential GDP growth fell to the lowest level since 2013 despite the boost from higher labour market participation. Moreover, the better than expected realizations mask worrisome underlying developments that could have negative repercussions for the longer term. Hence, it is doubtful whether post-Brexit the UK will ever return to the estimates for potential GDP growth as shown in table 1 by 2030 in the post-Brexit era.

Figure 11: Total factor productivity slowed markedly after the Great Recession
Figure 11: Total factor productivity slowed markedly after the Great RecessionSource: Penn World Tables, Bank of England, Macrobond, RaboResearch
Figure 12: GDP growth boosted by employment and dragged down by investments in 2017/18
Figure 12: GDP growth boosted by employment and dragged down by investments in 2017/18Source: RaboResearch
Share:
Author(s)
Alexandra Dumitru
RaboResearch Global Economics & Markets Rabobank KEO
+31 30 21 60441
Stefan Koopman
RaboResearch Global Economics & Markets Rabobank KEO
+31 30 71 21328

naar boven