Financial Markets: Brexit Will Be a Long Goodbye, Not a Clean Break

Britain Leaves EU

The immediate shocks of yesterday's Brexit decision on the financial markets have already been substantial. Global negative reaction has roiled exchange rates, sending the pound to 30-year lows against the U.S. dollar. Confidence is a key factor for growth that might be hard to come by in the months ahead, starting in the U.K. economy itself. In the medium term, the weakening of sterling and the euro and the impact on stock markets will have continued negative implications for economies around the world. The appreciation of the dollar poses serious risks for the real economy in the U.S., which is already facing headwinds, as attested by the latest release of The Conference Board U.S. Leading Economic Index, which turned negative for the month of May (−0.2 percent).

Britain's divorce from the European Union will not start immediately. According to Prime Minister Cameron's remarks this morning, the secession process under Article 50 of the E.U. Treaty may be triggered only in October by his successor. This would give firms as well as authorities three months to test the waters in view of the next phase. Such an approach, not fully shared in Brussels, should help manage the future uncertainties around Brexit at all levels. Starting October 2016, the U.K. will have two years to renegotiate its relations with the E.U., and the global business environment may quickly come to be ruled by other more urgent matters.

Trade and labor supply dynamics are the main channels that will affect the real economy. With the unemployment rate already at a very low level, the U.K. needs more skilled workers. Currently 2.1 million European citizens work in Britain, but as much as 70 percent of them may not qualify for a TIER2 residence permit. To avoid major labor shortages, new legislation will need to be put in place to make certain Europeans can continue to work and live in the country. But until the divorce is complete, the U.K. remains a full-fledged E.U. member, with all the attendant rights and duties, including the freedom of movement for workers.

Negotiations on new trade agreements between Britain and the E.U. will be complex and time-consuming, especially on non-tariff barriers, which is a lesson learned from the TTIP negotiations between the E.U. and the United States. However, because the U.K. already complies with standards set by Brussels, agreement is likely to be easier to reach than on TTIP itself. Negotiations with third-party countries could drag out significantly. The E.U. currently has in place free trade agreements stretching from Turkey to Korea and more are in the process of negotiation (India, the U.S.) or ratification (Canada).

On the political front, populist and nationalist movements across the western world stand to be galvanized by the outcome. In Britain itself, Scottish independence is poised to return as a live issue, with 62 percent of Scots having voted to remain in the E.U. Northern Ireland also favored continued membership by smaller margins, auguring renewed instability over Britain's relations with Ireland.

At the E.U. level itself, it is difficult to predict whether a pragmatic approach to negotiations will prevail over the desire to drive a hard bargain in order to dissuade other member-state governments from taking the same route as Britain. As opportunistic populists ride this wave, further disintegration is certainly possible following other anti-EU referenda, for example, in France. However, the opposite could also happen. The remaining EU27 or a group of core countries—such as the 19 that form the euro area, or even a smaller group among them—could react to the shock with a reform effort that relaunches the European project for a new era. The referendum puts politics in the limelight in such a way that further polarization of the debate is to be expected before any lasting resolution.

SOURCE The Conference Board