Should the markets fear a Halloween Brexit?

Boris Johnson is more determined than Jeremy Hunt to force a departure on October 31


With Boris Johnson apparently still the favourite to win the Conservative leadership, even after his recent domestic drama, investors are being forced to ask what this means for the only form of Brexit that could quickly disrupt the economy and frighten the markets — a disorderly Brexit on October 31, Halloween.

Mr Johnson has failed to give a categorical guarantee that the UK will leave on that date, saying only that it is “eminently feasible”. However, he has said unequivocally:

“If it comes to a choice between no deal, and no Brexit, I would have to back no deal.” (Boris Johnson, BBC website, June 19, 2019)

His rival Jeremy Hunt, who might conceivably become prime minister by default if Mr Johnson were to drop out, has been more nuanced. Like Mr Johnson, he prefers no deal to no Brexit, but has emphasised the importance of achieving Brexit through a “good deal”, adding:

“I would not pursue no deal, with all the risks it involves, if there was the chance of a good deal.” (Jeremy Hunt, BBC Website, June 19, 2019)

The risks of political miscalculation before October 31 certainly seem larger than they were in the run-up to the initial Brexit date of March 29.

Then, parliament was ready and able to exert its natural majority to prevent a no-deal Brexit. Furthermore, both prime minister Theresa May and the EU were willing to accept a long postponement of Brexit. None of these safety valves is so obvious this time around.

The markets are reluctant to accept that the next deadline on October 31 might be the real one. Sterling retreated towards two-year lows as Mr Johnson’s political star ascended but (oddly) there has been no spike in implied market volatility in the run-up to the end of October and therefore no general concern about turbulent events. That may prove to be rather complacent.

The next prime minister will probably start by asking the EU to abandon the Irish backstop, and/or accept a new deal in which the UK would transition to a free trade arrangement in the longer term. Both these options have been repeatedly rejected by the EU in previous rounds of negotiations.

Mr Johnson appears to believe that the UK can unilaterally impose a free trade arrangement with the EU under the GATT 24 rules. Mark Carney scotched that idea on Friday, pointing out that it can only be done by agreement with the EU. The only unilateral option open to the UK would be an exit under World Trade Organization tariffs, which leaves the Irish border question unresolved.

Mr Johnson’s likely strategy is to establish a credible threat of a no-deal Brexit on October 31 in order to bring the EU back to the negotiating table. He has one possible trump card in this endeavour. He has repeatedly warned that part of the £39bn departure payment offered by Mrs May in exchange for her deal could be withdrawn.

Without a withdrawal agreement, the UK could claim that only about £2bn-3bn of these payments are indisputably due in the final financial settlement. Another £4bn-6bn are probably due by October, because the UK will have remained inside the EU for nine months of this year. That leaves more than £30bn of future payments that could become the subject of a very protracted and bitter dispute under public international law, with no certain outcome.

In such charged circumstances, it is uncertain whether parliament could muster a majority to derail a UK government determined to head for the exit. The Institute for Government has argued that this would be difficult to enforce under normal parliamentary procedures. In response, the Speaker immediately hinted that he would facilitate a blocking action in the House of Commons. But a Labour motion to prevent no deal was defeated by 11 votes two weeks ago.

The ultimate blocking motion is, of course, a vote of no confidence in the government. It is doubtful whether Conservative Remainers would bring down their own newly elected prime minister, with opposition leader Jeremy Corbyn lying in wait. It would be a novel form of kamikaze politics, that’s for sure.

Another question is whether a no-deal Brexit is really something that the markets should panic about anyway. The medium-term consequences are generally agreed by economists to be negative. But the markets have already priced in that assumption. What is really worrying is the temporary chaos that could follow a sudden, disorderly rupture.

Mrs May reportedly stopped Whitehall’s emergency preparations for no deal after March 29, and the 6,000 civil servants involved were disbanded. Mr Johnson’s first act would be to restart the process with maximum urgency, but that leaves only about three months to get everything done before the deadline. The civil service says it might get ready, but private industry still seems totally unprepared.

In an unusually frank publication last year, the Bank of England outlined several different scenarios for no-deal Brexit (see box). In the absence of any transition, they reckoned that there could be a hit of 4.75-7.75 per cent to UK gross domestic product within a few months. Preparations for no deal with no transition since then have probably been insufficient to eliminate all these risks.

If the incoming prime minister can negotiate an agreement with the EU to transition to a no-deal Brexit over, say 12-18 months, then the immediate damage to GDP could be much smaller, even negligible. But that is certainly not something that the markets should be taking for granted.

Brexit risks and options market pricing

Last November, the Bank of England published estimates that suggest the disruptive economic effects of a disorderly no-deal outcome on March 29 could have been very large. Despite some government preparation since then, considerable disruption could presumably still follow an October 31 no-deal, no-transition Brexit.

The options market has not priced any large increase in uncertainty in the run-up to October 31. This might need to change in coming months.

Source: This note is based on material which appeared in an article by Gavyn Davies published in the Financial Times on 23 June 2019.
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