The Long and the Short of it: What price UK Exit from the EU?

A vote to leave the EU would represent a significant shock to the UK economy. In this piece, we analyse the consequences for the UK economy of leaving the EU, assuming that the UK would no longer have a free trade agreement with the EU.

In the short-run, our analysis suggests it would lower GDP by around 1 per cent in 2017, compared to a world in which the UK voted to remain. In the longer-run, our analysis suggests that it would lower GDP by between 2.7 per cent and 7.8 per cent in 2030, also compared to a world in which the UK voted to remain. Sterling would also depreciate in the longer-run, to close to parity with the euro.

Our analysis also has implications for consumption and wages. By 2030, consumption falls by between 4.0 per cent and 9.2 per cent compared to a world in which the UK remained in the EU. This translates into declines in annual consumption per capita of between £900 and £2,000 (at 2012 prices) by 2030.

A decision to leave the EU would represent a significant shock to the UK economy. This shock would be likely to manifest itself through a number of channels, some of which might be expected to be relatively short-lived, predominantly affecting the near-term outlook. Others, such as the reductions in trade and foreign direct investment (FDI), would represent more permanent structural changes to the UK economy, and so would have important long-run implications. 

We base our analysis on NIESR's global econometric model NiGEM. We consider both short and long-run effects and build them together into one coherent framework  to generate a set of illustrations of what a vote to leave the EU may mean for the UK economy.

The short run

In the short run, the current heightened levels of uncertainty are likely to persist, if not intensify, as the UK establishes its place outside the EU. This uncertainty manifests itself in three ways. First, there is a risk premium associated with increased sterling volatility. Financial markets are already pricing in a period of currency volatility around the referendum and it is highly likely that a vote to leave the EU will exacerbate this situation. Secondly, as future economic prospects become more uncertain, the cost of borrowing for the government, business and households should increase to reflect this. Finally, when faced with uncertainty, firms tend to delay investment projects. Table 1 summarises the shocks that we have introduced in our simulations.

Table 1: Summary of short-term shocks introduced from 2016Q3

 

Calibrated from

Average size of shock (to end 2018 unless otherwise stated)

Exchange rate premium

3-month options-implied sterling volatility

2016Q3 shock: 2/3 of the magnitude observed in 2008

Uncertainty

Betting markets and historical data

2016Q3 shock: Three times the level in 2016Q2

Term premium

Joyce et al. (2011), Breedon et al. (2014), Meaning and Warren (2015)

60 basis points

Household and corporate credit premium

Cantor and Packer (1996), Alfonso et al. (2012), Kiff et al. (2012), historical data and author’s calculations

35 basis points

Equity premium

Historical data and author’s calculations

35 basis points

 

The world that emerges is one in which sterling depreciates immediately, by around 20 per cent, against a basket of currencies. This drives inflationary pressure, causing CPI to jump by between 2-4 percentage points more than our Remain-based forecast in 2017. Investment falls dramatically, just over 10 per cent in the third quarter of 2016 due to the direct impact of uncertainty. This effect is magnified in 2017 as, in addition, widening borrowing premia pushes up the user cost of capital.  Real GDP is broadly unaffected in 2016 as the decline in domestic demand is offset by a positive net trade contribution derived from sterling depreciation. The level of GDP will be 1 per cent lower in 2017, as domestic factors dominate, with the level of GDP deviating from our Remain baseline by 2.3 per cent by 2018. This translates into a reduction in the growth rate of GDP of 0.8 and 1.3 percentage points in 2017 and 2018, respectively. Our central forecast results do not imply that the economy will go into recession as a consequence of a vote to leave, but the likelihood of such an event increases.

The endogenous response of the MPC is represented by a Taylor Rule using the parameters published for the Bank of England’s model COMPASS (see Burgess et al. 2013). In the active monetary policy scenario, following an initial reduction in response to the shock, the MPC then tightens interest rates from 2017 due to the pronounced deviation of the rate of inflation from the baseline profile. This tightening weighs on demand over the period we present. We think it more likely that the MPC would look through this rise in inflation and keep interest rates on our baseline path.

Figure 1. GDP level (per cent difference from baseline)

 

 

 

 

 

 

 

 

 

 

 

Note: active policy suggests a tightening of interest rates from 2017. It refers to an endogenous response by the MPC, represented by a Taylor Rule (using the parameters published for the Bank’s model COMPASS).

 

Figure 2. Consumer price inflation rate (percentage points difference from baseline)

 

 

 

 

 

 

 

 

 

 

 

Note: active policy suggests a tightening of interest rates from 2017. It refers to an endogenous response by the MPC, represented by a Taylor Rule (using the parameters published for the Bank’s model COMPASS).

As the short-run influences dissipate. In their place come long-run reductions in trade and FDI, as well as a potential impact on productivity. We phase these in starting in 2017.

The long run

In this blog, we focus on two scenarios: WTO and WTO+. In both cases, the UK would have no free trade agreement with the EU, which seems to be the preferred option of the Leave campaign and of Economists for Brexit. In the WTO+ scenario, we also add a -5 per cent productivity shock, to capture some of the dynamic impacts of reduced openness on productivity.[1]  We base our estimates of the declines in EU market share and FDI, and the size of the productivity shock on the academic literature. We summarise these estimates, which feed into our modelling, in table 2.

In all scenarios, the reduction in demand for UK exports  leads to both declines in export prices and to a long-run and persistent depreciation of sterling to around parity with the euro, as shown in Figure 3 below. While the fall in sterling does allow export demand to rebound somewhat, this is still outweighed by the loss of access to EU markets, and total exports fall by between 21 per cent and 29 per cent compared with a world in which the UK remained in the EU (Table 3).

Not only is the UK projected to trade less if it leaves the EU, but we would also expect to benefit less from our remaining foreign trade. The reason is that a weaker pound would also lead to higher import prices, feeding through into higher prices faced by households. Lower prices for our exports, coupled with higher import prices, leads to a persistent deterioration in the terms of trade.

The losses in gains from trade after leaving the EU would reduce prosperity. In the longer run, our analysis suggests that leaving the EU would lower GDP by between 2.7 per cent and 7.8 per cent in 2030, compared with a world in which the UK voted to remain (Figure 4).

In addition, if consumers face higher import prices and a persistent deterioration in the terms of trade, we should see consumption fall by more than GDP. This is indeed what our analysis shows. By 2030, aggregate consumption is projected to fall by between 4.0 per cent and 9.2 per cent also compared with a world in which the UK remained in the EU. This would translate into declines in annual consumption per capita of between £900 and £2,000 (at 2012 prices, rounded) by 2030 (Figure 5).

In terms of labour markets, our analysis shows that the UK's flexible labour markets would ensure that unemployment would not be perceptibly higher by 2030 (Figure 6), but real wages would bear the brunt of the adjustment. By 2030, we estimate that real consumer wages would be between 4.6 per cent and 7.0 per cent lower outside the EU than they would be remaining in the EU.  
 

Table 2. Scenarios for the UK economy after leaving the EU

 

WTO

WTO+

EU export market share, % decrease

50% - 72%

50%

FDI inflows, % decrease

24%

24%

Net transfers to EU, decrease, % of GDP

0.3%

0.3%

Productivity, % decrease

0%

5%

 

Table 3. Long-term economic impact of leaving the EU

% decrease compared to 2030 baseline

WTO

WTO+

Exports

21% - 29%

22%

GDP

2.7% - 3.7%

7.8%

Aggregate consumption

4.0%  - 5.4%

9.2%

Real consumer wage

4.6% - 6.3%

7.0%

 All entries are percentage decreases in the appropriate Brexit scenario compared to the 2030 baseline in which the UK remains in the EU.

 
Figure 3. Euro-£ exchange rate
Figure 4. GDP, in billions of constant 2012 £
Figure 5. Per capita consumption, in constant 2012 £
Figure 6. Unemployment rate, percentage
The complete analysis is published in the National Institute Economic Review no. 236 May 2016.

 

References

Alfonso, A., Furceri, D., and Gomes, P. (2012), ‘Sovereign credit ratings and financial markets linkages: application to European data’, Journal of International Money and Finance, 31(3), pp. 606-638.

Breedon, F., Chadha, J. and Waters, A. (2014), ‘The financial market impact of quantitative easing’, Oxford Review of Economic Policy.

Burgess, S., Fernandez-Corugeda, E., Groth, C., Harrison, R., Monti, F., Theodoridis, K. and Waldron, M. (2013), ‘The Bank of England’s forecasting platform: COMPASS, MAPS, EASE and the suite of models’, Bank of England Working Paper No. 471.

Cantor, R., and Packer, F. (1996), ‘Determinants and impact of sovereign credit ratings’, Economic policy review, 2(2).

Joyce, M., Lasaosa, A., Stevens, I., and Tong, M. (2010), ‘The financial market impact of quantitative easing’. Bank of England Working Paper No 393.

Kiff, J., Nowak, S.B. and Schumacher, L.B. (2012), ‘Are rating agencies powerful? An investigation into the impact and accuracy of sovereign ratings’, IMF Working Paper, No. 12/23.

Meaning, J. and Warren, J. (2015) ‘The transmission of unconventional monetary policy in UK debt markets’, National Institute Economic Review,  234.

 

 

[1] In the May 2016 issue of the National Institute Economic Review we also consider a Norway scenario, in which the UK remains a member of the European Economic Area (EEA), and a Switzerland scenario, in which the UK is able to negotiate bilateral free trade agreements in goods with the EU.


 

 

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