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Analysis

UK will not weather Brexit storm

Negotiations distract from substantial economic problems

by Simon Tilford in London

Mon 30 Jan 2017

The British economy has not weathered the Brexit storm, contrary to the claims of avid supporters of the UK’s departure from the European Union. It is just that the calm before the storm has lasted a bit longer than many had assumed.

There is no reason to believe Britain will escape serious and permanent damage to its foreign trade and investment and, consequently, living standards as a result of leaving the EU. Meanwhile, the withdrawal negotiations will be a massive distraction from Britain’s substantial economic problems: lack of skills, housing shortages, poor infrastructure, income inequality, and weak corporate governance.

The British economy expanded by a little over 1% during the second half of 2016, outperforming the euro area by a significant margin. The only sign of something being amiss is sterling, which was worth 15% less in trade-weighted terms in late January compared with mid-June 2016.

Reconciling the apparent robustness of the UK economy with the angst over the costs of Brexit is not difficult. First, the strength of household spending can be explained by the rise in real earnings by around 1.7% in 2016. This led to a boost in consumer confidence. Second, booming car sales suggest that consumers brought forward purchases of big ticket items, in anticipation that the depreciation of sterling would push up their prices (85% of cars sold last year in the UK were imported).

The strength of business confidence poses a bigger challenge to economists who warned that Brexit would damage the UK economy quickly. It suggests that firms think that leaving the EU single market will not do much damage to their businesses, or even that Britain will not actually lose unimpeded access to the single market at all. Alternatively, it may be that consumer spending is buoyant enough at present to offset the uncertainties created by Brexit, at least for firms with short investment horizons.

The truth probably comprises a mix of these factors. For the six months following the referendum, it was largely believed the country would either remain in the single market or negotiate a deal which gave the UK almost unchanged access to it. It could be that it was only after Prime Minister Theresa May’s 18 January speech that firms accepted Britain really was prepared to forgo market access and economic security in favour of sovereignty over migration and EU law.

Real wage growth will stagnate over the course of 2017 as rising import prices push up inflation. So far, the weakness of sterling has not boosted exports and there are several reasons why the hoped-for export boom will not materialise. Over the last 20 years, the composition of British exports has shifted strongly towards services and intermediate manufactured goods. The demand for these is less sensitive to changes in the value of sterling.

The spectre of Brexit will begin to have a chilling effect on UK exporters’ investment, especially in services. Britain will leave the single market and the customs union, and might succeed only in negotiating a free trade agreement in goods, but little else. Financial institutions appear to have taken May’s speech as confirmation that they will lose ‘passporting rights’, which enable them to sell their services in the EU while being regulated in the UK. Several banks responded by announcing that they will relocate some business out of London.

Even if Britain manages to negotiate a FTA, UK-based manufacturers will have to comply with rules of origin. These determine whether tariffs should be charged on goods with significant content that has been imported from outside the EU. Their imposition will disrupt the complex supply chains that British firms are as much a part of as other members of the EU.

Finally, the British government’s decision to tighten visa requirements for foreign students in an attempt to cut net immigration will damage the country’s higher education performance, one of its most successful sectors. The ultimate result will be that the economy is deprived of great numbers of highly-skilled workers – a drain on the economy for years to come.

Simon Tilford is Deputy Director at the Centre for European Reform. This is an abridged version of an article published by the CER, the full text of which can be seen here.

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