Evils Never Come Alone: Brexit & Sharp Depreciation of the Pound – What is Next?

#Brexit Facts

One of the immediate consequences of the Brexit vote in June 2016 was the sharp depreciation of the pound against virtually all major currencies. The pound has not recovered since then and showed strong volatility during major political events (e.g. May’s October 2016 Speech, the announcement of the snap general election). It is striking that the UK government did not communicate much about the causes and consequences of the depreciation. In the general election campaign the depreciation  was treated as an external ‘calamity’ and his painful consequences for the Brits were mostly excluded from the political debate.

Main economic impacts of  the currency depreciation on the UK economy are:

• High inflation, mostly driven by high energy and food prices
• Erosion of the purchasing power and wealth of households
• Declining real wages (for the first time since mid-2014)
• Weaker demand: slowdown of consumption and investment

As opposed to Brexiteers’ expectations, a cheaper currency did not support growth by boosting  exports. The economy lost momentum and the UK became the slowest growing G7 country in the first quarter of 2017.

Part 1: Why did the pound fall sharply after the Brexit vote?

Let’s have a closer look at the reasons behind the dramatic fall of the pound. You will see that, the ‘why’ of the depreciation is tightly related to the policies followed by the government. I will only mention 3 guiding principles of international finance, which will explain the situation:

• Financial markets seek to price ‘today’ what they expect to happen in the ‘future’.
• Capital tends to flow to countries that can make productive use of it or where assets are safe.
• Investors do not like uncertainty!

The pound fell immediately following the Brexit vote as markets believed that UK economy would grow slower and be less productive after leaving the Single Market. The core belief was that the value of the pound would remain persistently low after Brexit. Thus, massive pound sell-offs followed the  vote. The perverse effect of the sell-offs was  immediate pound  depreciation although the UK economy was doing ‘fairly’ good at that time.

This brings me to the next question: Why would the UK economic growth and productivity slowdown after leaving the EU? UK economy has significantly benefited from access to the Single Market via increased specialisation (especially in financial services) and better efficiency. In this sense, leaving such a large common market is equivalent to a ‘deglobalisation’ shock and scaling down production. To illustrate, financial services being scattered across major European cities would mean less specialisation, less efficiency and lower productivity for the city of London.

Moreover, restrictions to labour migration will eventually weigh on  growth and productivity. Skill shortage is already a serious issue in some  sectors such as information technology, healthcare and engineering. More importantly, the UK immigrant workers happen to be more educated on average than the natives. All in all, labour migration restrictions  are estimated to reduce the UK GDP by 0.6% to 1.2% until 2020  (Portes and Forte 2017).

Here is the warning by the HM Treasury before the Brexit vote:

“If voters choose to leave the EU, Britain would be “permanently poorer”! Productivity and GDP per person would be lower in all alternative scenarios, as the costs would substantially outweigh any potential benefit of leaving the Single Market. Separating from the EU would reduce GDP by 6% to 7.5% permanently.”

Last but not least, financial investors do not like “uncertainty”. The uncertainty around the future UK-EU relationship was one of the major forces driving the pound down over the last year. In particular, the incoherent approach of the government to the negotiations created serious doubts about their capability to negotiate an ‘acceptable’ deal for the UK. In an uncertain economic environment, firms adopt a ‘wait and see’ approach and delay investment decisions. Again, weaker investment becomes a drag on economic growth and productivity.