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a blog from young economists at Nova SBE

Brexit: effects of the currency depreciation on the British Economy

On the 23rd of June 2016, the United Kingdom took everyone by surprise with the results of its referendum. Even though some doubt remained until the final results, no one could have predicted such scenario. The decision to leave the European Union by activating the Art. 50 of the treaty of Lisbon has immediately impacted the Britain’s economy with high uncertainties. In fact, the first effect came through the instant depreciation of the Pound. This decrease in the value of the currency was mainly due to the future expectations and doubts expressed by the markets about the economy. These uncertainties concerned mainly the future potential performance of the economy, the latter being expected to suffer a downturn following the leave of the European Union. The question is why does the beliefs of the market have turned to be negative? The reason is quite simple. In fact, leaving the European Union will be mainly accompanied with costs, whether they are from political or economic nature. However, the higher costs that economists expect to happen are firstly, and mostly, coming through the international side of the economy, with for instance higher barriers to trade resulting from the exit of the customs union.

Trade Balance dynamics

The depreciation of the Pound resulting from the referendum impacted greatly the dynamics of the UK’s economy through different channels. Firstly, let us focus on the international market of the economy composed by tradable goods. With the depreciation of the pound, the tradable goods have become more expensive relatively to the non-tradable ones. In fact, as the price of the former are “set” at the international level, the increase in the exchange rate has made the value of the imports more expensive – also leading to an imported inflation. On the other hand, the devaluation has, in a sense, made the Kingdom more “competitive”, increasing the value of its exports. As we can observe, this two variables have an impact in the tradable balance, the exports having a positive influence while the imports a negative one. It is however hard, and somehow still soon, to assess which one of the two forces has been greater and will impact the future equilibrium. In fact, these changes will mostly depend on the extent on how elastic the demands of both exports and imports are in the long-run (Marshall-Lerner condition). The only effect that has been observed yet is the J-Curve effect, explained by the low adjustment of consumers’ behaviour accompanied with some lags and frictions that occur because of bilateral contracts already set internationally. It seems however that the initial widening in the trade balance deficit has been timidly narrowing, mainly due to the good performance of UK’s partners in Europe, increasing therefore the demand in the export sector. Moreover, when analysing the terms of trade (price of exports divided by the price of imports), we can observe a decrease in the ratio, thus leading to an outflow of money. This added to the already decreased propensity to invest, due to uncertainties felt by agents, could dump even more the aggregate demand in the following periods.

Effects on the Labour Market

The decrease in the value of the currency has also impacted the labour market. In fact, as the pro-Brexit would claim, the referendum has been positive as it has already decreased the national unemployment rate. However, we must analyse the whole picture before taking quick conclusions. In fact, the devaluation has increased the labour force in the manufacturing sector of the economy (it is important to underline that the great majority of the pro-Brexit vote came from this group of the population) since the tradable sector has become more attractive following the devaluation of the currency. However, this has made the sector less “productive”. In fact, with the increase in the rate of employment, the productivity has marginally decreased. Both the change in the value of the currency and the latter aspect have made the wages of each individual decreased in real terms – both in the tradable and non-tradable sector –  leading to a lower purchasing power. Moreover, as previously mentioned, the relative increase in the price of tradable goods has imposed an increase in the United Kingdom’s inflation. The latter has overpassed the threshold of 3% in last October and is expected to increase in the following months according to the Bank of England’s forecasts. Besides, this increase in prices has already had some effects on the national economy as it seems to have decreased the household’s consumption spending. Overall, since the results of the referendum, the deceleration of the economic growth has been notable if compared with other EU countries (forecasts announce only 1.6% of growth for 2017).

The reaction of the BoE

The Bank of England (BoE) has announced in the previous weeks an increase in the base interest rate from 0.25% to 0.5%. This decision shows the prioritisation of the inflation issue over the decelerating growth that the UK currently seems to suffer. In fact, by increasing the base rates, the BoE directly targets inflation, as higher rates will influence consumers to decrease their spending, and therefore reducing the rise in prices through lower demand. This decision could, and probably will, dump the aggregate demand even more, leading to a higher downturn in the economy as this will also squeeze the households’ purchasing power. Besides, a higher base rate also tends to increase investment in normal times, an effect that could partially compensate the decrease in consumption in the aggregate demand. However, since the increase in the base rate has been anticipated by markets, the effects of this decision may not have the fully desirable effects on the investment component.  Guessing a rise in the rate base due to a higher inflation than predicted, the pound’s demand augmented and therefore increased its value, marginally reducing its depreciation. This slight appreciation has, on one hand, decreased the price of goods imported, but also dumped the positive effects that have been coming through the export component following the depreciation of the exchange rate.

As it can be noticed, the decision of the BoE has two sides of the same coin. In fact, inflation is one of the most fearful issue that an economy can suffer and fighting it should be prioritised. Yet, decreasing it comes with a price that may challenge the economy for the next following years.

Long-Term Uncertainties

As it can be currently observed, the massive downturn predicted by the pro-EU in the UK’s economy hasn’t happened yet. This can have several explanations. Firstly, it needs to be underlined that the depreciation of the currency and its costs are being applied to an economy that has remained the same. In fact, despite the results of the referendum, the UK will remain in the EU until 2019 and therefore caution must be taken when examining the effects of this leave-vote. As previously analysed, the short-run effects are not as strong as presumed by the pro-EU. There has been a widening in the trade balance deficit followed by a lately small recovery, accompanied by higher inflation. Additionally, the unemployment rate has decreased, but so did the households’ purchasing-power. The long-run effects, on the other hand, seem to be harder to forecast because of the remaining uncertainty. This will essentially depend on the outcome of the discussions between the UK and the EU. A tougher deal, and therefore a harder Brexit, will undoubtedly have a severe impact on the economy. But one result will be surely achieved, a decrease in overall welfare, both in the UK and in the EU. Moreover, as long as there will be ambiguity regarding the future of the United Kingdom, the real exchange rate of the latter will continue to fluctuate. Therefore, for the wellbeing of Europe’s economies, a consensus avoiding tough penalties should be soon achieved.

Mélanie Chaves






Author: studentnovasbe

Master student in Nova Sbe

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