Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Sunday, 23 October 2016

Who's winning the Brexit game?

My latest article on Brexit published in Mint this Sunday which takes a slightly contrarian tack to the reports and opinion pieces grabbing the headlines.



Only the opening moves have been made on the Brexit chessboard but judging by the reaction from spectators, the UK is inexorably heading towards checkmate by the EU. The Bremoaners have seized on the less than sterling performance of the British pound as proof that the armageddon they predicted is not going to be long in coming.

The post-Brexit fall of nearly 19% in the pound and forecasts of another ~10% decline have been spun as evidence of a weak position. The recent wild swings have added to the sense of unease and have led to calls for Prime Minister Theresa May and her government to sue for an honourable draw.

However, focusing on the gyrations of the pound is akin to looking at the clock in a chess game. Screaming that it is running down is factually correct but completely useless. Moreover, it detracts from focusing on the board and coming up with a winning strategy.

As with any price, that of a free floating currency in forex markets depends on demand and supply. Simply put, demand for the pound comes from exporters, tourists, UK residents earning foreign income and foreign investors. Supply comes from importers, UK citizens going abroad, repatriation of earnings by foreigners and UK investors investing abroad. While speculators tend to weigh in on one side or the other based on their beliefs about future demand and supply, over time the price is determined by non-speculative flows.

Therefore confusing a weakness in the currency with a weak position on the Brexit chessboard is a mistake for three reasons.

First, rather than being the “de-facto opposition” to the government signalling wrong policy choices, a falling pound is a great ally by making the UK economy more competitive and allowing it to rebalance.

The strength of the pound over the past decade and a half was primarily due to capital inflows into the UK as foreigners bought UK assets (e.g. property) and London took on a central role in the increasing financialization of the global economy. (As Ashoka Mody, a former IMF deputy director, points out, a strong pound actually made the British economy more fragile. By encouraging the FIRE sectors—finance, insurance and real estate—and discouraging manufacturing it inflated a “finance-property bubble”.)

The share of finance and insurance in gross value added (GVA = GDP - taxes + subsidies) for the UK went up more than 4 percentage points between 2001-09 and at 9.7% in 2009 was significantly more than the other G7 economies (figure 1).

Figure 1: Share of finance and insurance in nominal GVA
This acute dependence on finance was catastrophically exposed during the credit crisis. Further, the post-crisis reversal in global economic financialization was bound to affect the pound negatively. In fact it stayed ~25% lower from its pre-crisis levels, reflecting the new reality of a more constrained financial sector.

By injecting greater uncertainty on the continued role of the UK in the global financial sector and on trade and economy in general, Brexit has caused a short-term decline in demand as foreign investors reassess the situation. The consequent repricing has been exacerbated as speculators lean against the pound, anticipating prolonged low demand and increased supply as some investors rush to exit.
However, the fall in the pound has not only made British exports cheaper, services of British lawyers, consultants and other professionals have also became more competitively priced. For example, the call-centre labour arbitrage just reduced 15-20%. Are firms going to go to India, or set up shop in the Midlands?

Moreover, following through on threats to relocate post Brexit became more expensive for firms. Yes, the flipside is that imports are more expensive but in a deflationary global environment this is likely to be contained. Moreover, the expected inflationary dose is what every developed market central bank is trying its hardest to deliver without much success so far.

By curtailing import demand and spurring exports, the falling pound reduces the current account deficit, which reached 5.4% in 2015, the highest since records began in 1948.
It will further help by redirecting UK domestic tourism within the country and attracting foreign tourists. All of these effects are likely to create jobs in the non-financial sector and will directly benefit the Brexit-voting constituency. In the side game, grandmaster May has checkmated opposition leader Corbyn even as his party flails around screaming at the clock.

Second, spinning the pound’s weakness as a consequence of poor government policy is an error and obfuscates the UK’s true position in Brexit negotiations. Here, May has made all the right moves.
In the age of Twitter, the British government has stuck to its guns on providing only appropriate disclosures rather than a detailed running commentary. This not only prevents the European Union (EU) from being forewarned and devising a counter, it also allows a smoother process without every small detail being blown into a major bone of contention.

Moreover, it gives greater room to negotiate compromises without fear of screaming headlines about backtracking, losing face, etc. Of course, parliamentary disclosure is essential, but parliament is not expected to co-draft legislation, nor is it expected to be party to every government decision.
May’s announcement to trigger Article 50 by end-March 2017 was an inevitable and essential defensive move given pressure for clarity from the EU and within her own party. Triggering the article will give the EU the advantage since negotiations must complete in two years and the EU can wait it out.

However, May and the government’s publicly stated willingness to prioritize border control over access to the single market has neutralized this advantage even before the event. The move has generated huge controversy and has not been helped by some exceedingly idiotic proposals by May’s team. To paraphrase Lord Acton, by tilting towards populist xenophobia, the Tories are giving opponents just grounds for opposition and kindling dispute within the country. This is illustrated by Nicola Sturgeon’s renewed call for Scottish independence, which latched on to the real and imagined stream of xenophobia running across the Tory conference. 

However, rather than being bogged down in an unending argument on immigration or the grandiose dreams of going it alone in trade, we should focus on the move as a great negotiating ploy. Since Brexit, every EU leader (e.g. Francois HollandeAngela MerkelJean-Claude Juncker) has hectored on curtailing single-market access unless the UK does what the EU wants.

By deprioritizing single market access, May has publicly destroyed the union’s single-point strategy. Of course, to be effective, the statement needs to be credible. However, credibility in negotiations is not based on rational economic arguments, but on making the opponent believe that one is prepared to carry out the stated action. Here, credibility is ensured by the Brexiteers’ triumvirate of Liam Fox, David Davis and Boris Johnson standing behind May.

Third, the mainstream narrative around the pound’s weakness may inadvertently help the UK by providing false comfort to the EU. So far, the EU players' plan seems to be clamouring for Article 50 and making sure UK “pays a price” that dissuades other potential exits.

They are playing a defensive waiting game in the hope of a British capitulation. As discussed above, while a plunging pound may look like an implosion, it actually leads to the opposite and strengthens the UK’s position over time. Moreover recent UK economic statistics give no cause for concern yet, with consumer confidence back to pre-Brexit levels in September and retail sales continuing to rise.
Playing a waiting game also assumes that the European elite can quell the anti-EU movements gaining ground across countries which threaten to tear it apart. Without an implosion of the British economy which shows the dangers of life outside EU, they are left with the much harder challenge of delivering growth.

The IMF forecasts euro area growth to be below the pre-crisis rate and only ~1.5% per annum over the next five years. The EU’s own forecast shows unemployment to fall only gradually and likely to be still above pre-crisis levels by the end of 2017.
While the British pieces have moved to take the best advantage of the situation, Europe is withdrawing into a defensive shell, with Juncker passing a “presidential order” to ensure there are no informal discussions with British representatives.

This speaks to the very real fear that Europe is an amalgamation of differing viewpoints and strategies which UK can use to its benefit. The inability of the EU to offer a united and coherent strategy was cruelly exposed during the European debt crisis and is likely to show up again in Brexit negotiations. While UK has substantial challenges ahead, based on the opening game, betting on grandmaster May to win is a smart move. 

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