Wednesday 21 August 2019

Conall Mac Coille: 'No-deal Brexit sabre rattling drives sterling to two-year low'

Boris Johnson, a leadership candidate for Britain's Conservative Party, holds a plastic wrapped fish during a hustings event in London, Britain July 17, 2019. Photo: Reuters/Peter Nicholls
Boris Johnson, a leadership candidate for Britain's Conservative Party, holds a plastic wrapped fish during a hustings event in London, Britain July 17, 2019. Photo: Reuters/Peter Nicholls

Conall Mac Coille

Sterling slipped to its weakest level in two years against the dollar this week, close to $1.24, as the threat of a 'no-deal' Brexit was perceived to have risen. Currency traders had to grapple with comments from both UK prime minister contenders at their debate on Monday evening, seeming to rule out completely the 'backstop' solution for Northern Ireland, even a temporary arrangement, or an exit clause.

Sentiment towards sterling was also hurt by reports of frosty EU/UK talks, and with Boris Johnson apparently considering shutting down parliament in October to force through no-deal.

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To some extent, the hardening of both Johnson and Jeremy Hunt's positions on Brexit was inevitable, as they competed for the attention of the 160,000 Conservative Party members. Hopefully, the rhetoric may soften once the new leader has secured his position in 10 Downing Street.

Presuming Johnson wins, his attention will soon turn to extending his tenure - which would likely be cut short in the event of a no-deal Brexit.

In the run-up to the March 29 deadline, it had become clear by mid-February that Amber Rudd, David Gauke and others within the UK cabinet would force PM Theresa May to bring a vote on extending Article 50 to the House of Commons. Effectively, a no-deal outcome had been ruled out weeks beforehand, helping sterling.

This time around, the politics looks set to significantly worsen before it gets better. Johnson looks set to form a pro-Brexit cabinet committed to leaving on October 31, whatever the circumstances.

So, if anything, investors are likely to add to their bets that sterling may weaken as the countdown to October 31 shortens.

UK recession fears mount

Many commentators may not have fully appreciated the impact the UK's deteriorating economic performance could have on the Brexit debate. The consensus now is that the UK economy probably contracted in the second quarter of 2019. To a large extent, this reflects a hangover from the artificially strong 0.5pc rise in UK GDP in Q1 2019. UK manufacturing saw its strongest quarter in 30 years early in the year, because orders and output were brought forward ahead of the original March 29 deadline.

However, there is a far deeper malaise at play within the UK economy. A recent Deloitte survey found CFOs of large UK companies are increasingly concerned by Brexit, and are now planning to cut back on investment and employment. Instead, they are focused on defensive strategies, such as cost-cutting and increasing cashflow.

The key UK data release this week was labour market figures for May. True, the unemployment figure remained at 3.8pc.

Employment rose by only a mediocre 28,000 in the past three months, although still up 1.1pc on the year.

However, this pick-up in jobs was entirely due to a 123,000 rise in self-employed people, almost all of whom were taking up part-time work. In contrast, the number of employees fell by 85,000 - indicating companies are now curtailing their hiring.

There are signs the slowdown is spreading across sectors. Service sector output was flat in April and May. The most worrying sign has come from the UK construction PMI, falling to 43.1 in June, well below the 50 no-change level, signalling the sector is now contracting at an exceptionally sharp pace.

Across the UK, it appears that Northern Ireland is bearing the brunt of the slowdown. This week also saw the release of regional PMI surveys from Natwest, signalling Northern Ireland (44.1) saw the sharpest drop in economic activity in June, albeit accompanied by the South East and the South West.

Budget strategy still uncertain

The Summer Economic Statement (SES) is the starting point for the budgetary process. This month's SES set out that there is room for €2.8bn of spending rises and tax rises in October, but with €2.1bn already pre-committed to infrastructural spending, public sector pay, demographic pressures, the National Broadband Plan and cost overruns on the National Children's Hospital.

That means Paschal Donohoe might only have €700m left for discretionary measures to announce on Budget day in October - what must seem like a paltry sum to backbench TDs with an eye on the next election. Room for manoeuvre could be found through a rise in the carbon tax and 'old reliables', such as excise duties on alcohol and cigarettes.

Acting in the opposite direction, unless the HSE breaks tradition and stays within its budget this year, overspending on health will squeeze the 'fiscal space' on Budget day.

More exuberant spending will mean the October Budget will no longer target expanding the Government's surplus above €1bn next year, if so eschewing the advice from the Central Bank of Ireland and ESRI, among others, to build fiscal buffers in the event of a downturn at some point in the future, and in the meantime helping reduce the still-high burden of public debt.

The possibility of a hard Brexit makes framing the Budget more problematic. The SES suggested the Government will be presented with two economic scenarios in September, an 'orderly' or 'disorderly' Brexit, to frame the Budget around, presumably choosing based on the state of the negotiations.

The SES estimated that a hard, disorderly Brexit could leave the Government facing a deficit in the range of -0.5pc to -1.5pc of GDP (€1.5bn to €6bn), rather than a small surplus of 0.5pc of GDP (€1.5bn).

Given the sudden elimination of the legal and regulatory basis of EU/UK trade, and volatility in financial markets, it is not beyond the bounds of possibility a hard Brexit might push Ireland into recession, creating a far bigger hole in the public finances.

If so, how should budgetary strategy respond? The SES seemed to imply the 'automatic stabilisers' (e.g. social welfare payments) would be allowed to apply, together with targeted measures aimed at specific sectors such as agri-food that might be affected - attempting to cushion the impact on the economy. The cost would be allowing a substantial deficit in the public finances to emerge.

Alternatively, the Government could choose to implement cutbacks to attempt to balance the books. Media leaks reported soon after the SES implied as much, suggesting spending pledges might be put off, or tax cuts delayed.

Of course, during the EU/IMF programme, such measures accentuated the downturn in the broader economy.

On that point, the Government has committed to implementing the €115bn public capital programme for the next 10 years, irrespective of a hard Brexit. This makes sense. However, typically, it has been capital expenditure projects that get postponed first, rather than more politically sensitive cutbacks to health or education spending, or public sector pay.

On balance, despite the sabre rattling in the UK, it is more likely a fudge will be once again found to avoid a cliff-edge Brexit on October 31, so that many difficult choices on fiscal strategy when Ireland eventually faces its next recession won't need to be made.

Conall Mac Coille is chief economist with Davy

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