Brexit could, in extremis, trigger budget squeeze

Brexit could, in theory, provoke three main types of negative reaction in financial markets: a collapse in the pound; a bank run; and a budget squeeze. The first is likely; the second most unlikely; the third pretty improbable but possible and, if it occurs, pretty nasty.

The pound has already fallen a bit this year on worries that Britain might quit the EU. If we actually vote to leave, sterling will probably take a dive because markets will fear a messy and prolonged divorce. As Mark Carney, governor of the Bank of England, told MPs on March 8, Brexit would deliver a short-term hit to growth and sterling.

But a fall in the pound isn’t the same as a currency crisis. Although it would reduce our purchasing power in the world, it would also have some beneficial side-effects. One would be to push up inflation, which is below the Bank of England’s 2% target. Another would be to make it easier for our companies to export to the rest of the world. That should help narrow our large current account deficit, which has been estimated by the European Commission at 5% of our GDP last year.

Meanwhile, there’s little risk of a bank run. Banks are well capitalised. As to banks’ liquidity, even if depositors and investors who buy their short-term debt got frightened, the Bank of England made clear on March 7 that it would make extra liquidity available to banks both immediately before and after the referendum on June 23. So there’s no real chance of them running out of cash.

Another fear is that Britain could face a fiscal squeeze. This is not only because it has a large current account deficit which, as Carney put it in January, means we are dependent on the “kindness of strangers”. It is also because it has a large budget deficit, which was 5% of GDP last financial year.

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At present, the chance that international investors would refuse to buy our financial assets, especially government bonds, is a far-off prospect. Government borrowing costs are very low, as they are elsewhere in the developed world – a sign that Britain has no difficulty borrowing. Moreover, Britain has a flexible exchange rate. If investors get nervous, the pound will fall. They will probably continue to buy Britain’s debt, getting more of it per dollar invested.

Things, though, could get out of hand if investors took the view that the government was no longer in control of the economy. One warning signal would be if the Tory party tears itself apart during the referendum campaign. Investors might worry that it would stop taking the measures necessary to balance its budget in the long run – something that would, in turn, be harder if the process of leaving threw the economy out of kilter for several years. The City might even start to think that the Conservatives would be so divided that they could lose power to a Labour party led by Jeremy Corbyn, whose socialist policies would be anathema to most investors.

If both inflation and the budget deficit started rising, investors would probably still lend money to the government. But if we were at the same time going through an acrimonious divorce with our former EU partners and international interest rates were increasing, we could face a debt squeeze, in which interest rates keep going up because investors have lost confidence in the government. Higher interest payments, in turn, could add to the budget deficit and the debt, creating a vicious cycle.

This perfect storm is, admittedly, unlikely to materialise. But it is known in financial markets as a “tail risk” – an unlikely but unpleasant scenario. It’s not something we should want to flirt with.

Edited by Sebastian Mallaby and Sam Ashworth-Hayes

Hugo Dixon is the author of The In/Out Question: Why Britain should stay in the EU and fight to make it better. Available here for £5 (paperback), £2.50 (e-book)