The impact of a ‘no deal’ Brexit at the end of the year could be two-to-three times larger than the cyclical damage wrought by the Covid-19 pandemic, according to Goldman Sachs’ Adrian Paul, who says the recent behaviour of the UK government has raised uncertainty.
Negotiations with the EU have been put into doubt after the UK government threatened to break international law if it was not satisfied with the terms of any post-Brexit deal.
The Internal Market Bill, which allows the UK government to reinterpret parts of the Withdrawal Agreement that prime minister Boris Johnson negotiated last year, has drawn criticism at home and abroad.
It has also thrown the prospects of a deal into jeopardy, said Paul.
“In our view, Downing Street has deliberately fused together the outcome of this year’s trade negotiations and the implementation of last year’s exit agreement, with the intention of extracting concessions on regulatory divergence and state aid after the expiry of the Brexit transition period,” the European economist noted
“Seen from this perspective, the Internal Market Bill amplifies the fallout from any failure to reach a free trade agreement by the end of 2020.
“A collapse in negotiations now no longer involves a reversion to WTO trading rules alone, it also reaches back and reopens old Brexit wounds — not least the prospect of a hard border across the island of Ireland.”
Nevertheless, the bank’s “Brexit base case” remains unchanged, with a ‘thin’ zero tariff/zero quota free trade agreement to be ratified by December, although the uncertainty ahead of the deal could weigh heavy on the economy.
Paul continued: “While we had always expected the path to that deal to be turbulent, recent developments suggest that the route to resolution is likely to be narrower and bumpier than we had expected.
“Off our base case, the UK government’s latest approach to free trade agreement negotiations has introduced a tail risk that is more pernicious than we had appreciated.
“This tail scenario has ramifications for the integrity of the EU’s single market, the unity of the UK, the degree of trust between the UK and the EU, and the likelihood of a free trade agreement between the UK and the US.”
Such uncertainty over negotiations, while in keeping with the post-2016 experience, will likely be reflected in financial markets and could ratchet higher should things deteriorate further.
Against this backdrop, the threat of further Covid-19 restrictions has been raised as the number of infections and infection rate begin to pick-up, with the so-called ‘rule of six’ – preventing gatherings of more than six people – and local lockdowns imposed.
“Our modal view remains that no new national lockdown will be imposed,” said Goldman Sachs’ Paul.
“While we had expected an increase in infections in September, the government’s willingness to respond with additional nationwide measures — albeit much more narrowly defined than the ‘stay at home’ orders issued in March — suggests that the near-term recovery in aggregate demand will face stiffer headwinds than we had envisaged.”
The precautionary behaviour of households, the widespread closure of schools and a greater incidence of local lockdowns in response to the virus is likely to undermine the resilience of an economic rebound, said Paul.
When considering which shock is likely to dominate over the medium term, the economist said Brexit could have a more significant impact.
He said: “We are sceptical of the argument that the sheer scale of the economic fallout from Covid-19 will obscure the economic impact from a breakdown in Brexit negotiations.”
Indeed, Paul said a “disruptive Brexit transition to a distant post-Brexit destination” is likely to compound the economic impact of Covid-19 as the industries affected by the coronavirus are the least likely to be affected by greater barriers to trade, and vice versa.
“The negative correlation… reflects a simple, intuitive observation: domestic-facing services industries that rely on face-to-face interaction have borne the brunt of the Covid lockdown, but they are inherently less susceptible to higher barriers to overseas trade,” he said.
“By contrast, external-facing manufacturing industries that rely on cross-border supply chains will bear the brunt of reduced EU access, but they are relatively immune to pre-vaccine behavioural shifts and greater emphasis on social distancing.”
As such, the impact of the coronavirus is likely to be sharp but short, whereas a Brexit shock would likely be long and deep, said Paul.
“From an aggregate perspective, the present value of the long-run impact of failing to reach an EU-UK free trade agreement is likely to be two-to-three times larger – on reasonable assumptions – than the present value of the cyclical damage wrought by the coronavirus crisis," he said.
“Of course, it is inherently difficult to predict how the post-Covid, post-Brexit economy will evolve over a 15-year horizon. But no matter how fraught EU-UK negotiations become over the next few months, Brexit is unlikely to precipitate a 20 per cent contraction in quarterly GDP.
“By the same token, no matter how deep the scars left behind by Covid-19, the pandemic — by itself — is unlikely to knock 6-9 per cent off the level of GDP in 2035.”
There will likely be some interaction of the two factors, which could put administrative costs on exporters at a time when cash flow remains constrained by the impact of the coronavirus.
And as has been seen by the Bank of England's decision to hold rates and asset purchases in September, there remains little headroom for tackling both.
“On fiscal policy, the implications of a 'thin' FTA for long-run productivity are likely to limit the headroom available for discretionary fiscal easing — just at a time when structural stimulus is crucial for preventing post-Covid scars,” he said.