British Pound Likely to Suffer More as 'Soft Brexit' Will Prove Impossible

 | Jun 14, 2017 | 9:00 AM EDT
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As U.K. Prime Minister Theresa May is coming to grips with the task of organizing the country's withdrawal from the European Union with a diminished majority in parliament, many analysts and even some politicians hope we will see a "soft" Brexit. Some people are even celebrating this idea.

Unfortunately, this theory is likely to be proven wrong, and as usual it will be the British pound (GBP) that will bear the brunt of the shock.

A "soft" Brexit that would be worthy of celebration would look like the model of Switzerland or Norway. These countries, while outside the EU, have access to the EU's single market, but in turn must accept free movement of EU workers.

One of the "red lines" for the U.K. government in negotiations with the EU is putting an end to the freedom of movement of EU workers. An anti-immigration campaign was the main driver of success for the "Leave" campaign last year. Nothing less than control over EU migration will do for them.

This makes sense. Leaving the EU but still allowing a similar immigration arrangement to the existing one defeats the purpose of Brexit from the point of view of those who voted to leave.

On the other side, from the EU members' point of view, the four freedoms of movement -- for capital, services, goods and people -- are inseparable. If the U.K. wants access to the single market for its goods and services and wants EU capital to flow freely through the City of London, it would need to accept EU migrants.

Of course, the ability of the EU (and of Britain) to fudge things to make it look like something has changed without actually changing much should not be underestimated. But in this particular case it will be especially difficult, because the two parties have opposing goals: The U.K. wants to claim it does control EU migration, whereas Brussels will want to insist to EU members that nothing changed.

At this moment, it does not look like either of them is ready to give in on this issue.

This situation means the Brexit that is most likely is a "hard" Brexit, one in which Britain loses access to the single market and defaults to World Trade Organization rules on trade. Tariffs would be imposed on exports of goods to the EU. Exports of services, for which there are not many provisions in WTO rules, probably will hit regulatory obstacles and slow down substantially.

If Britain wants to obtain better conditions, negotiations could take years. In the meanwhile, uncertainty about regulatory changes will weigh on businesses' investment plans both in the U. K. and in the EU.

Sterling, always the first to react to bad news, will remain under pressure despite a recent rebound. The Bank of England will release the conclusions of its monetary policy meeting tomorrow, but it is unlikely to be willing to raise interest rates from their record-low 0.25% level even though inflation hit 2.9% in May while wages increased by just 1.7% in April.

Bank of England Governor Mark Carney has said the central bank would be willing to "look through" inflation to ensure that the economy doesn't suffer too heavily, but that would come at a price. The sustained period of real negative interest rates has prompted some people to borrow more than they should have, and any rise in rates now would push up default rates.

Another, perhaps more serious consequence is that rising inflation without a corresponding increase in wages would squeeze consumers. So great is that worry that the Scottish Chamber of Commerce has called for a cut in value-added tax (VAT) to ensure consumers keep spending.

A recent survey by Visa showed that consumer spending fell in the U.K. for the first time in almost four years. This is serious. The British economy depends heavily on consumers keeping their wallets wide open.

Hopes of a "soft" Brexit are keeping the pound in the green versus the U.S. dollar for now, but investors probably will need to face reality at some point. The choice in front of the U.K. government is really between a "hard" Brexit or no Brexit at all.

While there was no hope for the latter before the U.K. election, EU leaders have started to suggest that reversing Brexit is still possible.

German Finance Minister Wolfgang Schaeuble said on Monday, June 11, that Britain can stay in the EU if it wants despite notifying the EU of its intention to leave. A day later, on Tuesday, June 12, French President Emmanuel Macron said the EU's door was open until the Brexit negotiations are concluded.

As I warned last year, 2017 is the year when it becomes clear that the consequences of last June's vote on the economy are negative. With a hard Brexit the only realistic option to no Brexit, the pound will remain under pressure.



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