Brexit appears to be vying with the collapse of Lehman Brothers in 2008 for the position of the biggest economic catastrophe in the last half century. There are key differences, though. The impact of the Lehman crisis was more brutal in the short term but worked primarily through channels of the global banking system and money markets. Thus, it could be contained with a good dose of central bank liquidity coupled with fiscal action to calm the aftershocks on the real economy. The tremors due to Brexit were weaker in the initial phase but are likely to linger and create both political and economic uncertainty across continents that will keep financial markets on the edge.
The broad consensus is that the toll of an exit from the European Union (EU) will be significant as trade contracts and investment flows into the UK dwindle. How significant the impact will be depends on the kind of deal and the period over which the UK will strike a deal with the EU to gain some kind of special status and make the divorce more amicable. The sticking point in any negotiation will be the immigration of EU citizens into the UK. The support for the Leave camp in the referendum seemed to have been in some part in response to a commitment to curb immigration both from the EU and outside. However, the generosity of the latter in granting special status would largely be a function of the free movement of labour. Norway that enjoys this status of “preferred outsider” allows this free movement. Whether the new political dispensation in the UK will find this politically viable is a key question.
Then there is the fundamental question of whether the UK in its current avatar will exist over the medium term. Scotland, led by its feisty first minister, Nicola Sturgeon, voted to remain in the camp. It might hold another referendum (it held one in September 2014) to leave the UK and align with the EU. There are political risks that that have emerged in Europe as well. Anti-EU sentiment is strong since the bureaucrats of Brussels are closely associated with the punitive austerity measures imposed on economies, particularly those in southern Europe that have received assistance to tide over their woes in the wake of the region’s lingering economic crisis that set in from 2011. Analysts have now coined the term “Quitaly” to describe the risk of Italy holding a referendum on its membership of the union. October’s constitutional reform referendum could see the ouster of the incumbent prime minister, potentially leading to a general election that might bolster the euro-sceptic Five Star Movement. A survey in May showed that 58 per cent of Italians wanted a referendum on their EU membership.
From a purely economic perspective there are two problems for the global economy. The lingering uncertainty in the aftermath of Brexit will continue to drive the dollar up even if, as the markets now expect, the Fed holds off a rate hike this year or, at the most, delivers just one at the end of the year. This is bad news not just for the US but also for 40 per cent of the global economy that pegs its currency to the dollar, as appreciation eats into competitiveness. This might tempt economies such as China to devalue their way out of the problem.
The second impact of a rising dollar is what the Bank for International Settlements (BIS) calls the “parallel dollar system”, the massive pile of dollar loans and bonds that have built up outside the US. The BIS’ estimates show that while yen and euro credit has remained stable, dollar credit outside the US has trebled since 2000. The steady rise in the dollar since 2014 has already added to their debt service burden. Further appreciation is likely to make things worse.
Finally, the renewed threat to the global economy would mean that most major central banks are likely to ease up on liquidity and interest more than they had planned to earlier, and this could be offset by a permanent increase in risk-aversion. Thus investment decisions will be guided more by concerns of safety rather than yields, leading to a widening gap between the returns on risk-free instruments like sovereign bonds and high-yielding assets such as corporate bonds or stocks. This could hurt growth across the board and certainly raises the odds of a global recession. Phew!
Abheek Barua is chief economist, HDFC Bank. Bidisha Ganguly is principal economist, CII
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
