What would a no-deal Brexit mean for the economy and financial markets?

The Economist is running a series of articles on the potential impact of a no-deal Brexit on everything from trade to the island of Ireland, immigration to universities, cars to retailing. This piece looks at the economic fallout.

The impact of a no-deal Brexit would show up almost immediately in financial markets, more slowly in the wider economy. There would be three big things to watch with regard to markets: government-bond yields, share prices and the value of the currency.

British government bonds are a safe-haven asset for traders and are also in constant demand from pension funds. Their prices should initially rally in the event of no deal, both because of a flight to safety by investors but also because the Bank of England could well be forced to delay increases in interest rates.

The stockmarket could also rally. More than 70% of the earnings of the firms which make up the FTSE 100 index come from abroad. A big decline in the exchange rate, which is likely, would push up the sterling value of those foreign earnings. The share prices of British companies whose principal market is domestic (banks, for example) would sell off a bit, but they are already pricing in quite a lot of bad news. So the impact would probably be fairly limited.

Sterling is likely to be a different story. The day after the Brexit referendum in 2016, the pound dropped by nearly 10% against the dollar. Currently it hovers at around $1.30. Traders are banking on it falling to below $1.20 in the event of a no-deal Brexit. Some worry that it would drop further. Britain has a current-account deficit worth more than 3% of GDP, meaning that the country as a whole borrows a lot more than it saves. Since the referendum Britain has largely financed its deficit not with long-term foreign direct investment, but with short-term financial flows. That money can vanish in a trice, pushing down the pound’s value.

A big decline in the pound would, over time, hit the economy. For one thing it would raise the cost of imported goods. A rule of thumb among economists says that a 10% fall in sterling eventually translates into a 2% rise in the consumer-price index. Were the pound to approach parity with the dollar, as some fear, inflation might rise above 5%. Inflation could rise for another reason, too. The erection of trade barriers between Britain and the EU might force consumers and companies to source more goods and services from domestic suppliers, instead of foreign ones. Suppliers of those goods and services would be unable to ramp up production quickly, so would instead raise prices.

Higher inflation would cause immediate pain for those in receipt of working-age welfare payments, most of which are frozen in cash terms from 2016 to 2020. It would also trim the purchasing power of salaries. That would be a bitter pill for Britons, whose wages are already worth less in real terms than they were before the financial crisis of 2007-08.

With consumer spending accounting for two-thirds of British GDP, shrinking real wages would probably damage overall economic growth. The offsetting hope would be that the fall in the value of the pound spurs exporters. Yet the evidence from the aftermath of the referendum suggests this would be unlikely: exports have grown more slowly than in any other G7 country. And in the event of a no-deal Brexit, the EU would impose tariffs on British exports: cars would face a 10% tariff, for example, rising to 40-45% for lamb. Some industries could be killed off.

Whether the economy would fall into recession, defined as two consecutive quarters of negative economic growth, is unknowable. About a quarter of Britons actively desire no deal, according to polls; these folk might actually boost their spending. As British companies scramble to rewire their supply chains, there might also be a short-term boost to investment spending.

But a downturn cannot be ruled out. If that looked likely, both the Bank of England and the government would step in. But neither could do very much. Interest rates are already near an all-time low of 0.75%, and the inflation rate is already near the central bank’s 2% target. The government, meanwhile, could in theory decide not to pay its £39bn “divorce bill” with the EU, and use the savings to boost public spending. But Britain’s ratio of public debt to GDP is already around 85%, a level which might be expected to rise if economic growth slows. It cannot go much higher without investors starting to worry about Britain’s fiscal sustainability. The British economy, in sum, would need to weather a no-deal exit without much help.

See more Brexit briefs:
What would a no-deal Brexit mean for trade?
What would a no-deal Brexit mean for the island of Ireland?
What would a no-deal Brexit mean for immigration?
What would a no-deal Brexit mean for retailing?
What would a no-deal Brexit mean for the automotive industry?