UK prime minister chooses a ‘hard’ Brexit, puts economy at risk

One has to be surprised at the risks that Theresa May, the United Kingdom’s new prime minister, is taking with her country’s economy. By putting the country firmly on a path for a “hard” Brexit, she has heightened the chances that the country could soon experience a full-blown sterling crisis. Were such a currency crisis to occur, it would both seriously impact the U.K. economy and undermine confidence in her fledgling government.

{mosads}At last weekend’s Conservative Party conference, May was anything but conciliatory to her European partners on the issue of the U.K.’s forthcoming negotiations to exit the European Union. On announcing that she would trigger Article 50 of the Lisbon Treaty to begin those exit negotiations by March 2017, she was very clear that the U.K. would not compromise on the country’s sovereignty, even if that were to mean losing continued British access to Europe’s single market.

In particular, she stressed that after last June’s Brexit referendum verdict, there would be no giving up on U.K. immigration control, nor would there be any return to the jurisdiction of the European Court of Justice.

The basic weakness of this hardline approach is that it is bound to heighten investor doubts as to how attractive the U.K. will be for investment going forward. Investors will justifiably fear that, in the forthcoming negotiations, Europe cannot afford to be seen to be rewarding a country not wanting to abide by its membership terms for fear of encouraging other member countries to follow the U.K.’s path to the door.

The Brexit path that May has chosen will make investors concerned as to whether the U.K. will possibly be able to retain the same favorable access that it currently enjoys to the European single market. It will also raise doubts as to whether U.K. financial firms will continue to be accorded the same financial passport that they now have to the European market, which allows them to operate in European financial markets without being subjected to additional regulatory requirements.

A crucial point that May seems to be overlooking in putting the U.K. on its “hard” Brexit path is that now is a particularly bad time for the U.K. economy to be risking any possible loss of investor confidence. Running a post-war record external current account deficit of around 6 percent of gross domestic product (GDP), the country desperately needs to continue attracting large amounts of foreign funds to finance that deficit.

Should investors now take flight and choose to locate more of their operations in Europe to gain access to the single market, there is the real danger that capital flows to the U.K. will ebb and sterling will continue to swoon.

It should be of concern that since the June referendum, sterling has already fallen by 10 percent; now, with the real prospect of a “hard” Brexit, sterling is likely to fall much further. Unlike the United States, the United Kingdom is a very open economy where exports and imports account for around 60 percent of the country’s GDP. As such, a sustained decline in sterling does have the real potential for increasing domestic inflation and compressing real wages.

Indeed, according to the Bank of England’s estimates, a sustained 20 percent depreciation of sterling could have the effect of raising the domestic price level by around 5.5 percent. That would almost certainly force the Bank of England to adopt a restrictive monetary policy stance to avoid breaching its inflation target.

Hopefully, May will find some way soon to back off from her “hard” Brexit path even though this will surely cost her a loss of face with her Conservative Party base. The alternative would be to soldier on with a policy that risks a full-blown sterling crisis that would cost the country dearly.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

The views expressed by contributors are their own and not the views of The Hill.