The most apt description of political events unfolding in the United Kingdom after the decision of voters there to leave the European Union (EU) came from Nicola Sturgeon, first minister for Scotland. "Shambolic," she said.1 The minister, herself, stirred the pot by raising the specter of a second Scottish independence referendum before the last hanging chad had fallen on the "Brexit" vote. If handicapping the horserace for the prime minister, let alone the strategic negotiations among 28 governments required to extricate the UK from the EU seems daunting, assessing the consequences for the wider world is downright hopeless. But doing so is necessary to have a coherent view of the outlook for the global economy and financial markets.
This note sketches the bigger picture, and it is not pretty.
The broad-brush version is that the UK inflicted an adverse aggregate demand shock on itself. Depreciation of the exchange value of the pound and a drop in gilt yields was the market mechanism to blunt the force of the shock. In effect, the appreciation of the currencies of the UK’s trading partners represents a request from Her Majesty’s economy to share some of their economic strength. The problem is that for many of them there is not much strength to share and, for a few key ones (the Euro area, Japan, the Nordic economies, and Switzerland) their central banks have mostly run out of room to provide policy accommodation to offset the drag from appreciated currencies. The cruel irony is that, as a result, their exchange rates may appreciate relatively more on recognition that disinflation and higher real interest rates are in store.
Monetary policy makers will respond, but gathering the courage to scale unconventional policies up will take them time and their efforts most likely will be insufficient to the task. As a result, the aggregate demand downdraft in the UK represents a net drag for the world. While the direction seems clear, size is another question.
Given that there will be some policy offset, we believe the net effect should be small, so mark down your 2016 forecasts for real GDP growth in the UK about 1 percentage point and for the world ¼ percentage point. While the US Federal Reserve does not have much policy space above the effective lower bound to nominal rates, pricing out tightening is enough stimulus to offset this external drag. As a result, we are not trimming our 2016 outlook for growth, which was already on the low side at 1.6 percent for the year, at least until the payroll numbers are in hand.
Emerging market economies face three challenges. Weaker growth in advanced economies slows the expansion of their export markets. Appreciation of the dollar tends to soften commodity prices, which is problematic for producers. And those economies tending to limit the fluctuations of their currencies vis-à-vis the dollar will see their exchange rates appreciate. Softening the competitive blow for Asian EM economies, though, the Japanese yen rose more than the dollar against the UK pound.
What follows revolves around three questions relevant to the medium-term economic outlook.
- Why did the referendum result in an adverse demand shock in the UK?
- How is that shock propagated?
- Where will that shock pose particular risk?
WHY? CREATING AN ADVERSE DEMAND SHOCK
Economic expansion is likely to slow in the near term in the UK because its residents will want to restrain their spending and may find it more difficult to fund their plans. The table at left frames the picture, giving the forecast from the most recent World Economic Outlook of the International Monetary Fund. Released in April, the forecast is a bit out of date and the last column for 2016 is mostly irrelevant given what just happened, but a few of the line items are important.
To put it mildly, the decision to leave the EU elevated political and economic uncertainty in the medium term. Over time, it is reasonable to expect increased trade frictions and a reshuffling of the location of some business activity (i.e., the City of London, in particular). This creates three mechanisms restraining spending.
First, in an environment of elevated uncertainty and lessened confidence about the outlook, households probably seek to increase precautionary saving and businesses trim their spending plans, and with gross saving and investment running 13 and 17 percent, respectively, the base to which such reductions are applied is substantial.
Second, in a quarrelsome and (one might say) shambolic process, the UK’s trading relationships with the EU and the wider world will ultimately be settled. But before then, as some of those decisions are material for the appropriate location of business activity, anyone who can delay a decision about private capital budgeting where location matters will delay that decision. That is, the option value of waiting has gone up, further impeding capital spending beyond any confidence effect.
Third, the deals finally struck are most likely to slow the mobility of goods, services, and factors and lessen the role of London in global finance compared with the current system. If so, UK residents should expect a permanent hit to future productive capacity. To the extent that they understand this now, they may mark down their assessment of national wealth and scale back their current spending.
These are three reasons demand may slow some, but it is also likely that part of the adjustment will be forced from abroad. According to the International Monetary Fund (IMF) numbers, the UK is running fiscal and current account deficits amounting to about 3-1/4 percent and 4-1/4 percent of nominal GDP, respectively. Foreigners may be less willing to fund those deficits if they suspect that the UK will have a more constricted role in global finance. This is why Bank of England Governor Mark Carney warned in advance of the referendum that a leave outcome would "test the kindness of strangers2."
One way of assessing the consequences of a sudden stop in external finance is to look for precedent in the data. The shaded area in the chart plots the cumulative distribution of annual real GDP growth for 189 economies for which observations are available in the most recent World Economic Outlook (WEO) database. The line shows GDP performance in years in which there were large consolidations in the current account relative to national GDP. In particular, we selected years in which, starting from a deficit, the current account balance improved by more than 0.15% of global GDP, roughly what would happen if the UK had to move from deficit to balance in one year. As is evident, the current account-to-GDP ratio did not improve because of a large increase in the denominator. Instead, real GDP growth fell short of the typical experience in 60% of the cases when funding suddenly stopped. Sudden stops are costly.
HOW? THE PROPAGATION OF THE UK SHOCK
The table at left serves as a reminder that, based on market exchange rates, the UK economy is the fifth largest in the world. The global share, however, was a touch under 4 percent. The darker line in the chart shows that this share moved sideways to lower over the past 35 years, in part because UK growth did not keep up with that in emerging market economies. In the narrower club that it is leaving, the EU, the UK is the second largest economy, making up about 17-1/2% of aggregate GDP. Moreover, it has been a relative success story for the past few years, as the UK’s GDP share rose more than 4 percentage points since the global financial crisis. Apparently, a more encompassing recapitalization of banks and spur from currency depreciation pulled its economy ahead of its continental cohort.
The frequency distribution in the lower left panel reports simple correlation coefficients between UK real GDP growth and the 189 other economies in the IMF WEO database from 1997 to 2015. The obvious point is that a sizable portion of the world economy was either weakly—or even negatively—related to the UK’s performance. Still, there is a substantial right tail, with about 15% of national economies posting correlation coefficients of 0.5 or higher.
To repeat the relevant aphorism, correlation is not causation. Common global shifts may have been buffeting these economies rather than evidencing idiosyncratic UK influences. To parse these effects, we regressed the same annual country observations of real GDP growth on that in the UK and a world aggregate, along with the change in oil prices. The tails in those results among the 100 largest economies are provided in the table at the bottom right. The ten weakest links to the UK are mostly oil producers or in Latin America. The most sensitive economies are also the least surprising—Ireland, European periphery countries, and tourist destinations.
These correlations are instructive, but domestic activity does not have to compress because a sudden stop is not inevitable. Relative price can adjust to keep global investors satisfied with funding the UK. In particular, a depreciation of the pound sharp enough to lead investors to expect subsequent appreciation marks the foreign currency value of pound-denominated assets down and raises their expected return. The swing in the exchange rate is another influence on the global economy.
WHERE? THE DIFFERENT IMPRINT ON ECONOMIES AND FINANCIAL PRICES
The exposure to changes in currency values relative to the UK pound varies considerably around the world. The figure at the left provides the weight (as a percent) of the pound in 60 effective exchange rate indexes provided by the Bank for International Settlements. These weights are based on recent bilateral trade shares with the UK, so they give a relatively current sense of the importance of the UK trading relationship.
Both Ireland and the Euro area are especially sensitive to the UK pound, as are, to a lesser extent, several Nordic economies. Oceans matter. Colonial history notwithstanding, UK trade does not bulk large with any Western Hemisphere economy.
Depreciation of a national currency can act as an international shock absorber. The relative weakness of the pound crowds in net exports, blunting the drag associated with greater domestic uncertainty and lower wealth. In the older textbook formulations, the central banks of the UK’s trading partners can ease their policies to offset the external drag. Indeed, abstracting from recognition and adjustment lags, these central banks should be able to offset an aggregate demand shock in its entirety, inoculating global demand from UK exit machinations.
Except, new chapters have been included in economics textbooks in light of the experience of monetary policy makers around the zero lower bound to nominal interest rates. The policy rates of the European Central Bank, Bank of Japan, Swiss National Bank and several Nordic central banks are already negative and they seem to act as if they have played out the string of additional policy ease. In such circumstances, an appreciation of their currencies from the UK trading tremor represents a disinflationary force, tending to raise domestic real interest rates and potentially encouraging more appreciation. If so, the UK effectively shifted some of its adjustment to economies unable to cope with the burden, oversharing its national problem by producing a larger net depreciation of the pound against those economies pressed against the effective lower bound of monetary policy. In that sense, the best case for the UK economy is that the trauma it does to its trading partners induces an overshooting appreciation of their currencies, to the benefit of the UK trade performance.
The charts at left provide some suggestive evidence that this mechanism is at play. The upper panel compares the changes in bilateral exchange rates vis-à-vis the British pound in the immediate aftermath of the referendum result (the vertical axis) with the corresponding level of the nominal policy rate just before the vote. The pound depreciated across the board, but more so against those economies with low or negative policy rates.
That the UK set off a global disinflationary wave is also evident in the bottom panel, which pairs the changes in nominal government yields during the same event window (along the vertical axis) with the level of the rate ad suffragia. Again, the lower the starting rate, the larger was the net change, in this case suggesting some combination of a lower global real rate and a reduction in local inflation.
Some Concluding Thoughts
While it will take some time for the political dust in the UK to settle and even longer before its new position in the global trading system is established, lessons can be learned from the immediate response. Uncertainty is higher and poses a deadweight loss to global activity. The UK has shared its problem with the rest of the world, and not all of those affected are able to answer the call. Monetary policy can offset the hit to aggregate demand, provided that monetary policy makers have the will to do so. We think they will try, but in a hesitant manner that allows some slowing in global growth relative to already meager expectations.