Brexit, the UK Economy and Corporate Performance
Two years after a historical vote changed the economic landscape of the UK and indeed the rest of Europe, scholars and analysts are still grappling with the immense challenge of understanding the eventual effects of Brexit. The term is coined from the words British Exit, to mean its departure from the EU trade and economic block. Some of the portended signs have come while others have not. However, the startling and shaking effect that Brexit has had on economies has been palpable. The EU block essentially offered the UK pooled-insurance. According to scholars and experts, this has always been seen as better than self-insurance. It is the same concept used by car insurance companies. The bigger the pool, the better the chances of survival and success, as trade risks are spread across many states and the effects of any catastrophe are, therefore, markedly reduced (Born, Muller, Schularick, and Sedlácek, 2018, p 4).
The UK Economy
Performance of an economy is measured in a number of ways, the most common being the gross domestic product (GDP). It is the sum of all products and services produced in a country and that generate income for the country or its people. According to the Financial Times, in the first quarter of 2018, the country’s economy shrank by 1.2% translating to about 24 billion pounds foregone. As it stands, the wheel has rolled so much that it cannot be taken back. Back then after the referendum, the parliament could have reversed the vote and decided against Brexit. However, that is a foregone conclusion and what now remains are possible trade scenarios. Some of those that have been proposed include ‘hard’ and ‘soft’ Brexit. Hard Brexit means completely severing ties with the EU and therefore, the UK engaging as an individual and independent country (Baker, Bloom, and Davis, 2016, p 1598). In this case, it will be subject to tariffs and taxes like any other country trading with the EU, thereby making the economic impact more significant. The cost of importing goods from and exporting to the EU will be high therefore reducing the profit margins of the involved businesses. Soft Brexit means partial severing of ties with the UK remaining in the EU. This will not have as much effect as it would essentially still enjoy some of the benefits of being a member of the EU. Another option that has been suggested is a trilateral trade between the UK, US and EU. For political reasons, the UK has been used by the US to wield power over the rest of Europe and analysts suggest that its departure from the EU will significantly reduce the influence of the US over Europe. Moreover, a trilateral trade agreement will have less economic impact on the UK as it will have the US as an alternative trading partner. A fourth option, which is similar to hard Brexit is adoption of World Trade Organization (WTO) agreement. This would mean the UK and EU would trade under the laws of WTO with few if any, special agreements. Needless to mention, it would have grave consequences on both, with the UK suffering the most.
Immediate Impact of Brexit on UK Economy
Corporate performance has taken and continues to take a significant hit from Brexit. According to an article by Bloom et al, a reduction in investment and consequently employment has been noted. The survey conducted among more than 3000 enterprises sought to find out how much Brexit had affected or was expected to affect their performance. The issue has been worsened by lack of culmination and finalization of the talks. It has created uncertainty and fear among investors and business people. The result has been a wait-and-see approach to how negotiations unfold before making financial commitments. Already, some multinational corporations have adopted their backup plans by redirecting investment and relocating jobs to countries that are more appealing. The rest of the EU block continues to operate as normal as their trade agreements with other countries other than the UK are still much alive (Gourinchas, and Hale, 2017, p 3). Operating from such countries does not pose the same challenges and uncertainty that bedevil the UK, thereby making it less attractive with regard to investment.
Inflation is another marker of economic performance. The UK has generally had a higher inflation in comparison to the European block because of its higher growth. However, since Brexit, studies show that the EU has grown at a faster rate than the UK. On the other hand, inflation continues to be as high as ever in the UK despite reduced growth. The effect has been a gradual depreciation in the value of the British Pound (Papadia, 2018, p 3).
Pending the agreements made after negotiations, Brexit may either lead to better trade terms for the UK or worse. The services sector is the main driver of the UK economy. It accounts for around 80% of its GDP. It is the one likely to suffer most if an agreement is not reached. As it stands, there is only a few months to the deadline of making a deal and the UK is at a worse position than the EU. It may determine how trade between the two is carried out. The freedom the UK will have in negotiating trade agreements with other emerging economies is a plus for it, if these amount to significant deals.
Currently more than 40% of the UK’s exports end up in the EU. In turn, majority of the imports in the UK are from the EU. In 2017, UK exports to EU amounted to 274 billion pounds while imports stood at 341 billion pounds the latter representing a 53% share. In case higher tariffs are introduced for the country’s goods, it will eat into its companies’ profits (Djankov, 2017, p 15). In the end, the increased cost of production may trickle down to workers who may be forced to take pay cuts or lose their jobs all together. Similarly, foreign direct investment will reduce as many EU companies will desist from investing in the country. Jobs will be lost through this means too (Dhingra, Ottaviano, Sampson, and Van Reenen, 2016, p 19).
Analysis using AD-AS model framework
By virtue of the amount of money that the UK has been losing due to a lower than expected GDP, the spending power has decreased and so has aggregate demand. Many investors are also hesitant to indulge in the market with others already shifting operations to other countries. Exports are also likely to reduce, especially if a ‘hard Brexit’ unfolds as tariffs will be introduced making the country’s products more expensive abroad (Sheldon, 2016, p 2). Demand for them will likely reduce. The government has implemented fiscal policies to ensure that the economy is shielded from all this. It has also increased its expenditure in the process. However, this is only part of the equation and in the end, the real GDP has seen a plunge as demonstrated by the numbers above and by the equation below.
The average demand-average supply curve demonstrates the changes that take place in an economy when the prices of products and services change. An increase in average demand from AD1 to AD2 results to an increase in price and real GDP at the same time in the short run. However, a shift to the left of the AS curve results in increased prices. Wage rates rise to match the increased prices resulting in inflation. This is one of the issues that have affected the UK with inflation being higher than the rest of the EU block whereas the GDP has performed lower than government projections. On the other hand, if a long run average supply curve is drawn and the equilibrium is to the left of the curve, it indicates the economy is in recession. However, the UK has not reached such a point. A rise in wage rates also marks decreased profit margins by corporations which subsequently reduces expenditure. It is only one of the factors of production and when other factors such as inputs are factored in, cost of production increases even further. Firms adjust by reducing the amount of goods produced, thereby impacting exports and supply.
When the equilibrium in the AD-AS curve is below the potential GDP as projected by economists and analysts, then the rate of cyclical (short term) unemployment becomes higher. However, it becomes lower when the GDP is near its peak (Baker, Bloom, and Davis, 2016, p 1604). The UK GDP has not been at or near its projected performance since Brexit and although findings reveal that unemployment is at an all-time low for the past forty years, it is an incomplete picture. There are more than three million immigrants from the EU working in the UK in comparison to just over one million Britons working across the UK. Since Brexit, the number of immigrants has gone down and expectedly, more Britons have found jobs. It does not mean the economy has been performing well enough to create new and sustainable jobs. At the same time, since labor and physical resources are fully engaged, a shift of the aggregate demand curve to the right will lead to further increase in prices of commodities thus causing inflation.
In an expansionary fiscal policy, through government interventions, spending is increased allowing circulation of more money in the market. Spending power increases and unemployment reduces. This is what is likely to happen in the UK in the short run, as shown in the graph above. With such policies, it will be difficult to determine the effects of Brexit as such interventions stabilize the economy and may give a false reflection of events. In a contractionary fiscal policy, the government reduces spending and increases taxes thereby reducing the circulation of funds (Ramiah, Pham, and Moosa, 2017 p 2513). It reduces the real GDP as there is less money to spend. This is often adopted for instance when paying off debts. An expansionary fiscal policy has been the economic rule employed by the UK so far, and it has helped the country to some degree. To counter the effects of Brexit, the Bank of England cut interests on loans to ensure more circulation of funds.
The IS-LM Model
The IS-LM graph refers to investment-saving and liquidity preference money supply. It shows the relationship between the GDP and interest rates. The IS curve slopes downwards and to the right indicating that when a rise in interest rates is observed, a decrease in consumption and investment will be the result. The LM curve shows the amount of money available for investing and it slopes upwards indicating a positive relationship between interest rates and the amount of money demanded for investment. The higher the interest rates, the more money investors will put in so that they benefit from the increased rates. The model can be used to show possibilities in a closed economy, where there is no free trade with other countries. For instance, when interest rates rise in such an economy, the aggregate demand reduces as few people are willing to take loans to spend. Luxury items are such as cars and jewelry are thus foregone. In turn, the level of output is reduced as companies seek to produce only what is enough for the market.
With regard to the British economy, the demand for products is likely to reduce, especially luxury commodities. Firms that are already feeling this change in the market are relocating to other countries, meaning further reduction in output. In the end the real GDP will be affected as expenditure and consumption are reduced. On the other hand, essential goods are and will continue to fan inflation as their demand soars whereas supply remains low or in some cases even reduced. The monetary policy adopted by the Bank of England involving reduction of interest rates will lead to more money in circulation too. A higher amount to spend without a concurrent amount of goods to purchase will result in inflation as demonstrated by the IS-LM curve.
Policy to Stabilize the Economy
Macroeconomics takes three main factors into consideration; employment, growth and inflation. The policy adopted needs to address all three. To tackle growth, the government needs to support local firms through tax cuts and free trade agreements to allow them supply their goods to other markets (Born, Muller, Schularick, and Sedlácek, 2018, p 6). This is where ‘soft Brexit’ or a similar deal comes in. Inflation is being caused by increased demand and it is important to balance this by increasing supply. Training and improvement of human resources is also likely to help in bridging the gap between demand and supply as a better equipped and knowledgeable work force is more productive.
Moreover, corporate performance is directly and indirectly affected by global events. Changes in technology, political ideologies, and climate change among others have all created an economic storm that has not only affected British companies but also all others across the world. The situation surrounding Brexit has only made the former feel the pressure more acutely.
Brexit has already unfolded. The path negotiations take, with regard to the nature of the association between the UK and the EU will greatly determine the economic landscape of the former and indeed the world. A soft Brexit will take a toll on the economy as will a hard Brexit. A trilateral trade agreement between the EU, US and UK which has also been suggested as a possible solution has its own disadvantages too, but so far has more merits than a hard Brexit. The government has tried to stabilize the economy in such times of uncertainty and has cushioned the economy from immense repercussions. From the foregoing, the best solution would be to negotiate for a soft Brexit to ensure the UK continues enjoying some of the rights and privileges of EU membership. Negotiating with emerging economies after a hard Brexit, although promising, is not entirely reliable.