United Kingdom: Brexit Update



The economy grew strongly in the third quarter according to recent figures, supported by private consumption, public spending and net exports. Moreover, real earnings growth accelerated notably, as the tight labor market fed wage pressures. Employment growth, however, softened in quarter-on-quarter terms, possibly on rising Brexit uncertainty. Looking to Q4, signs are less positive. In October, both the services and manufacturing PMIs fell, while annual retail sales growth slowed considerably and consumer sentiment worsened. On the fiscal front, the government recently presented an expansionary budget, which should support growth next year thanks to higher spending and tax cuts. In mid November, the UK and EU reached a preliminary agreement on Brexit withdrawal terms. Its ratification would support business confidence and investment, although there are serious doubts over whether the UK parliament will give the green light to the deal as it currently stands. • Growth should be fueled next year by the looser fiscal stance and higher wages boosting private consumption. However, private fixed investment will likely remain subdued until there is greater clarity on the Brexit front. A failure to seal a withdrawal deal with the EU before the UK departs the bloc in March 2019 is the key downside risk. Our panelists expect GDP growth of 1.5% in 2019, up 0.1 percentage point from last month’s forecast, and 1.5% again in 2020.

Inflation remained at 2.4% in October. Inflation should trend gradually downward in the quarters ahead, on higher interest rates and as the pass-through effects of higher oil prices and the weaker pound subside. However, greater wage pressures will likely slow the descent. Panelists expect inflation to average 2.1% in 2019 and 2.0% in 2020. The Central Bank kept the Bank Rate unchanged at 0.75% at its meeting ending on 31 October. Most panelists expect the Bank to wait until the UK leaves the EU in March next year before engaging in further tightening. FocusEconomics panelists see the Bank Rate ending 2019 at 1.08% and 2020 at 1.33%. On 16 November, the pound traded at USD 1.28 per GBP, weakening 2.6% from the same day in the previous month due to domestic political uncertainty. Looking to next year, the pound is set to appreciate. However, it will remain weaker than its pre-referendum levels and the evolution of Brexit negotiations will be key; if the UK leaves the EU without a deal, the pound could lose significant value. Our panelists see the exchange rate ending 2019 at USD 1.39 per GBP and 2020 at USD 1.41 per GBP.

POLITICS | UK and EU reach final withdrawal agreement, but UK parliamentary backing is in doubt On 14 November, the UK and EU finalized negotiations on the withdrawal agreement and presented an outline of the political declaration of the future UK-EU relationship. If the withdrawal agreement is ratified by the European Council and approved by the UK and EU parliaments, this would hugely reduce economic uncertainty, likely boost fixed investment and UK GDP growth in the near-term, and see the pound strengthen. However, there are serious doubts over whether the UK parliament will approve the deal as it currently stands. The withdrawal agreement covers the financial settlement between the two parties—thought to be in the region of GBP 40 billion—guarantees the rights of UK citizens residing in the EU and EU citizens residing in the UK, and establishes a transition period, lasting from the moment the UK leaves the EU at the end of March 2019 to the end of December 2020. Moreover, the agreement allows for the possibility of a single extension of the transition period by an unspecified amount of time. Such an extension could well be necessary, given the difficulty of finalizing a trade agreement by the end of 2020, and should reassure businesses. The fourth key aspect is the Irish backstop, which would come into force at the end of the transition period if the UK and EU fail to find a way to keep trade flowing freely at the Irish border. The backstop would lead to the creation of a “single EU-UK customs territory”; however, it could also see Northern Ireland remaining more closely aligned to the EU than the rest of the UK, and obliged to follow EU rules in areas such as VAT, excise duties and goods legislation. The backstop can only be terminated if the UK and EU “decide jointly”, potentially forcing the UK to remain within such a trading relationship indefinitely. The outline of the political declaration is narrower in scope than Prime Minister May’s Chequers plan, which was presented in July and had called for “frictionless” trade in goods, a common rulebook and the establishment of a “facilitated customs arrangement” to remove customs checks at the border. The outline speaks instead of a free trade area for goods with “deep regulatory and customs cooperation”, along with “zero tariffs, no fees, charges or quantitative restrictions across all goods sectors”. However, some customs checks would likely remain. The deal for services—particularly financial services, where the UK has a strong comparative advantage—is less comprehensive. Were such a trade deal to come into force after the transition period, it would hamper the UK’s long-term growth prospects compared to the status quo of remaining in the EU. However, if the withdrawal agreement is signed off, this would likely boost growth in the short-term, by supporting business and consumer sentiment and leading to a recovery in private investment—which has been measly in recent quarters. Irrespective, MPs are likely to initially reject the deal when presented in parliament, which should occur in December. For the opposition Labour Party the deal will likely overly constrain trade between the UK and EU. The Northern Irish DUP—which provides Theresa May with a parliamentary majority—will likely balk at the potential for regulations in Northern Ireland to diverge from those in the rest of the UK. Moreover, many pro-Brexit Conservative MPs will likely consider the deal leaves the UK too closely aligned to the EU— particularly given that there is the possibility of an indefinite Irish backstop.

- Focus Economics