Tuesday 26 March 2019

David Chance: 'Brexit deadline means decision time for firms here on sterling'

Deal or no deal: But the stakes now being played out on the Europeaan stage are higher than any game show
Deal or no deal: But the stakes now being played out on the Europeaan stage are higher than any game show

David Chance:

With just six weeks to go until the United Kingdom is due to leave the European Union it is no longer viable to sit on the sidelines of the debate on what will happen to the pound.

The two basic assumptions are that if there is a deal, or an extension, the pound will rise potentially very sharply after March 29.

If there's no deal, and the UK crashes out of the EU and into the unknown in terms of trade ties, sterling will plunge.

The problem is that even though the two outcomes are dramatic opposites, businesses here must in many cases plan for both.

The issue of where the pound is headed matters a great deal to the 7,000 firms here that export to the United Kingdom - and much more to the half of those that trade solely with the UK - as well as to financial institutions based here.

It also matters to companies tht import from the UK.

Investment advisory firm TS Lombard believes that a no-deal exit could see the pound fall to around 1.20 to the dollar and 0.925 pence to the euro. It believes that parity against the dollar is pushing things too far and that if parity were hit against the euro it would not last long.

So how much would a negotiated exit prompt sterling to rally?

In the case of a negotiated exit, Capital Economics says the pound could rise to as much as $1.40 and €1.22 by the end of 2020.

For the economists at Capital Economics, Brexit is a "political crisis" not an economic one. They think growth can rebound strongly. "Such a burst of domestic activity would more than offset the drag from the slowing global economy and result in GDP growth accelerating from about 1.5pc this year to around 2.2pc next year," the firm's economists wrote in a recent research report.

For all the dire economic numbers and estimates of the cost of Brexit, some indicators for the UK economy do show another side of the equation.

The pound's value has so far managed to remain within what's described as the "fair value" of all Brexit outcomes - hovering at levels that balance the possible Brexit scenarios. That is now changing and as decision time approaches, it will necessarily move to reflect just one reality.

So far, Brexit has been an unmitigated negative for the British economy. Growth there sank to just 0.2pc in the final quarter of last year, bringing the full-year growth to just 1.4pc, the weakest level since 2012, when the world was still in the grip of the euro crisis.

Business investment in Britain declined in every quarter last year, a sign of deep insecurity.

Estimates of the cost of Brexit so far range from a loss of 1.5pc to 2.5pc of growth since the 2016 referendum.

The direct cost to real household incomes is about £1,500 (€1,714), due to lower growth and higher inflation, according the Resolution Foundation, a think-tank.

A study by the Centre for Economic Policy Research showed that British firms had increased investment outside the UK by £8.2bn since the referendum as firms sought an EU foothold. Investment into Britain by EU firms is down 11pc.

The most tangible sign of the pain inflicted by Brexit is the value of the pound. In the seven days after the June 23, 2016, referendum it fell 10pc. It then fell almost an extra 10pc in the following weeks.

Based on the real effective exchange rate, the pound is some 6pc below its five-year average, and 14pc below its 20-year average exchange rate which is adjusted for inflation.

This doesn't mean however that if Britain was to decide in the next few weeks that quitting the European Union had been a silly idea in the first place and that it wanted to stay in, that the pound would rise 20pc.

But with crunch time approaching, you don't want to be on the wrong side of big swings. Even in the case of a cliff-edge exit, the downside for sterling and the UK economy may not be quite as large as many seem to anticipate. Unemployment is at a 40-year low of 4pc, wage growth is set to top a 10-year high of 3.3 and inflation is set to fall, boosting household purchasing power. Bank of Ireland's head of foreign exchange, Philip Hartle,y agrees there is an upside for sterling with a deal in the offing.

"Analysing our probability-based estimates of the different Brexit scenarios, if we were to get the current deal - or something close to it - passed through the UK parliament, then we would expect to see a move towards the low 80s in EUR/GBP," Mr Hartley said.

But he warns against viewing it as a one-sided bet, noting a low probability assigned to a no deal, and were this to occur then the move lower would be far greater than a sterling rally on a 'soft-Brexit' outcome.

"The risks for sterling are very much two-sided and although our base case is to avoid a no-deal scenario, we're not complacent about the risks. Our message to businesses has been consistent, take the currency risk out of your business," he said.

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