Expert View

Strangers won’t take kindly to a hard Brexit

by Stewart Fleming | 10.07.2017

“Weak government…weak currency” is one of the classic rules of thumb which guide financial market speculators. After the Brexit referendum last year and now the general election in June, the UK certainly fits the first part of that bill.

The prime minister, Theresa May, is in office but not in power. No more than tolerated as the leader of an ideologically divided party, she is surrounded by ministers jockeying furtively to succeed her. None of them bears the remotest resemblance to the sort of inspiring head of state needed by a country in crisis.

Across the parliamentary aisle, Labour is as split on Brexit as the Tories, and even more deeply divided in its political philosophy. Yet so weak is May that she is only being kept in office for fear of losing the next election to Jeremy Corbyn, the far-left Labour leader regarded just months ago as unelectable.

From the outside, Britain looks like a nation incapable of producing a strong government just as it seeks to negotiate an epochal change. Financial market speculators are all too well aware of that vulnerability.

This is where the “weak currency” argument kicks in. Sterling has stabilised after its dramatic collapse in the wake of the Brexit vote a year ago. But against the US dollar it is still some 15% below pre-referendum levels and has weakened recently against the euro as Eurozone growth recovers.

The seeds have been sown for worse to come. UK growth is slowing and inflation rising. Worse, Britain’s monetary policymakers are visibly at odds. Andrew Haldane, chief economist of the Bank of England, caused a stir last month by arguing that the Bank should at least be thinking about raising interest rates later in the year. The previous day Mark Carney, the governor, had taken a guardedly different line, arguing that decisions would depend on how the UK economy performed.

In reality, the outlook is more complicated. The world economy is changing. Both the US Federal Reserve and the European Central Bank have indicated that they are ready, very cautiously, to normalise their monetary policies. That means starting to allow interest rates to rise, even though their inflation rates are comfortably below target.

UK inflation is currently running at almost 3% and could be heading towards 4% later this year, disturbingly above the Bank’s 2% target. Even as the UK economy weakens, the drag of international financial markets will exert either upward pressure on UK interest rates or downward pressure on sterling or, in a crisis, both.

There is no silver lining here from exports. Erik Nielsen, global chief economist of Unicredit says that “the magic of the (falling) exchange rate is not working (for the UK)…net exports (are) not improving.”

It is not just monetary policymakers who are in a bind. On tax and spending May’s government is at sixes and sevens too. Foreign secretary Boris Johnson and environment minister Michael Gove are pressuring their leadership rival Philip Hammond, chancellor of the exchequer, to “end austerity” and allow bigger wage increases for public sector workers.

In sum, the United Kingdom is a country at the mercy of the financial markets. It is more dependent today on what Carney called the “kindness of strangers” than when he uttered that illuminating phrase eighteen months ago.

Without an early transition deal, and the compromises needed to secure one, Britain is stumbling towards a perfect currency storm. Financiers and speculators worry a Brexit cliff-edge could appear in financial markets several months before March 30, 2019. Some are already preparing for it by moving their most vulnerable operations out of the City of London.

This piece was edited on July 10 to remove a reference Deutsche bank forecasts

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    Edited by Quentin Peel