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Analysis
Global shock after UK exit vote

Global shock after UK exit vote

Considerable economic uncertainty likely over several years

by Desmond Lachman in Washington

Mon 27 Jun 2016

The domestic and global consequences of the UK’s decision to leave the European Union are likely to prove on a similar scale to Winston Churchill’s mistaken decision to return Britain to the gold standard at the wrong exchange rate in April 1925, or Margaret Thatcher’s fateful approval for Britain to join the exchange rate mechanism in October 1990.

The UK is running a current account deficit of a record 7% of GDP. Its banking system is among the largest in the world as a multiple of GDP. Financing a very large external deficit and maintaining the UK’s foreign deposit base depends on maintaining domestic and foreign investor confidence. Yet the Brexit vote is bound to result in considerable economic uncertainty over several years as the UK negotiates a formal exit and works out terms for its complex trade relations with Europe.

The UK’s European partners will have little incentive to provide favourable terms, for fear of encouraging other EU members like France, Italy or the Netherlands to emulate the UK and head for the European door.

A further factor that will cause capital to leave the UK is the relocation of large parts of the all-important UK financial system to Europe. Banks based in London will eventually lose the ‘financial passport’ that allows them to operate freely in Europe without being subject to additional European regulation.

A bitter Conservative party leadership contest after Cameron’s announcement of an October resignation, and calls for a new referendum on Scottish independence, will hardly help calm investors’ nerves.

The Brexit vote is reverberating beyond the UK through the steep decline in sterling. This is bound to unsettle global financial markets at a time when other central banks like the European Central Bank and the Bank of Japan are trying to cheapen their currencies.

The vote further exacerbates the populist tide across Europe. The latest Pew survey of European attitudes found that barely 50% of Europeans favour the European ‘project’. Calls for referendums in places like France, Italy, and the Netherlands are bound to undermine investor confidence and rekindle the European sovereign debt crisis.

Much as global financial markets were unsettled after the 2008 Lehman Brothers bankruptcy, so too will they now be disturbed by troubles in the UK and Europe. Serious questions surround Chinese economic sustainability. The European economy is again faltering and its politics are showing the clearest signs of fragmentation. And Japan is again entering a deflationary trap.

In the run-up to the US November elections, Britain has provided an example of a successful populist, anti-immigrant campaign. The outcome raises the likelihood of an external economic shock hitting the US in the sensitive pre-election period. None of this is helpful for markets – and this is an understatement.

Desmond Lachman is a Resident Fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund’s Policy Development and Review Department and Chief Emerging Market Economic Strategist at Salomon Smith Barney.

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