Brexit is real. Here's what it could mean for Canada

One of the few bright lights in the world economy just went out. It took some time for the United Kingdom to get going again after the financial crisis. But through 2015, it was the only country in the Group of Seven’s rich industrialized nations to post economic growth in excess of two per cent for three years in a row. The City of London—the world’s dominant financial centre, no matter what New York might say—had just restored all the banking and insurance jobs it lost during those dark days of 2008 and 2009. Exports of goods were at record levels. Britain was getting its mojo back. You can forget all that now. A narrow majority of British citizens voted on June 23 to leave the European Union. The decision may bring relief from the meddling of Eurocrats in distant Brussels. It may even empower Parliament to slow immigration, as advocates for leaving claimed. And there is little doubt it will cause economic damage, according to almost every serious economist who took the time to study the implications of Brexit. (And there were a lot of them.) What Brexit could mean for your portfolio » Already, the fallout has begun. As the votes were being counted and it became clear the Leave side was receiving more support than expected, the British pound went into freefall—by the time the Brexit decision was called, the pound had shed 10 per cent of its value against the U.S. dollar, falling to its lowest level since the mid-1980s. Meanwhile, shares in Asia plummeted and analysts were forecasting that when the U.K. stock market opens, the FTSE 100 index could drop by between 12 per cent and 19 per cent. Oil prices were also hammered, with West Texas Intermediate crude down six per cent to US$47.15 a barrel. “We will enter a new era of vulnerability until these difficult negotiations are complete,” said Panicos Demetriades, an economics professor at the University of Leicester. Markets may right themselves in the days ahead. But negotiating the divorce could take a decade: at least two years of wrangling under Article 50, the escape clause in the EU’s founding treaty, and then many more years to extricate Britain from all matter of trade deals, regulatory arrangements and the like. The uncertainty of it all will kill business confidence and deflect international investment. Big global banks such as JP Morgan Chase and Citibank have already warned they will slash tens of thousands of jobs because they no longer will be able to adequately serve their European clients from London. British exporters could lose the preferential access they have with dozens of countries that have negotiated trade agreements with the EU. It’s entirely possible the people of Britain have just become the first in history to vote for a recession. At a minimum, they have curbed their country’s short-term economic prospects. The International Monetary Fund said earlier this month that the U.K.’s gross domestic product was on track to grow 2.2 percent in 2017. Brexit could force a revision to 1.4 per cent under a best-case scenario to a 0.8 per cent contraction if things go really bad. And that is to say nothing of what might happen to the EU, which, even without Britain, boasts a market equal to that of the United States. “We are of the view that if the U.K. votes to leave, and does in fact leave, then the EU will be poorer, smaller, less influential, and possibly less stable,” said Fergus McCormick, the top analyst at DBRS Inc., the Toronto-based credit-rating agency. So Britain has voted for Brexit? Now what? » Should Canada and the rest of the world worry about a shrunken Europe? Some say no, not really. Benjamin Tal, an economist at CIBC World Markets, advised his clients last week to think of Brexit like Y2K, the phantom millennial computer bug that turned into one of the biggest non-events in economic history. Tal even reckoned there would be some “buying opportunities” in the aftermath of the markets’ obligatory slump following unwelcome news. “The U.K. will not roll over and play dead after a Leave victory,” Tal said. “Both the EU and the U.K. have strong incentives to renegotiate a trade deal.” The U.K. is Canada’s third-biggest trade partner after the United States and China, yet it represents only about three per cent of exports. This implies, for some, that a recession in Britain would do little harm to Canada, whose fortunes are far more tied to U.S., an economy that is set to surpass the U.K. as the G7’s new growth champion. The trouble with the sanguine view is that global financial markets leave few places to hide—and there are wolves prowling. In 1992, George Soros made his name by winning a game of chicken with the Bank of England. He bet against the pound until the central bank gave up trying to protect its value. Soros predicted this week that Brexit would cause the currency to collapse by as much as 20 per cent. If he is correct, life in the U.K. is about to get significantly more expensive. David Cameron is Brexit’s biggest loser » Britain imports considerably more than it exports, suggesting, among other things, that it has lost the capacity to supply itself with the basics of daily life. A weaker currency is going to make those things more expensive. Soros is betting that inflationary pressure will keep the Bank of England from cutting interest rates to boost economic growth because the central bank is obliged to contain inflation before it does anything else. “Today there are more speculative forces in the markets that are much bigger and more powerful,” Soros wrote in the Guardian. “They will be eager to exploit any miscalculations by the British government or the British voters.” Financial markets are fragile. Bank of America economists said shocks such as Brexit cause more volatility than used to be the case because banks and other financial institutions are less keen to circulate risky assets. The Bank of Canada also noted that in its latest assessment of the financial system, a lack of “liquidity” was one its bigger concerns. That matters because banking is contingent on lenders having access to cheap collateral such as bonds. If bankers are scared, they will demand higher interest rates. Borrowing costs rise across the board. If they rise too much, or if bankers get too scared, the financial system will seize like it did during the financial crisis. 5 Brexit strategies Canadian investors should know » The last thing Canada needs right now is higher interest rates. The Bank of Canada has been trying to coax companies to invest with ultra-low interest rates for years, with little success. (There also is the matter of record household debt and the risk of housing busts in Toronto and Vancouver. Higher borrowing costs increase the threat of a wave of mortgage defaults.) The other reason Canada should worry about Brexit is what it could mean to its largest trading partner. When investors get nervous, their favourite haven is the U.S. dollar. A stronger currency for an extended period would hurt American exporters and reduce the profits on the country’s big multinational companies’ overseas sales. That likely would curb U.S. business investment, which Bank of Canada governor Stephen Poloz has said repeatedly is key for boosting Canadian exports. Volatility in Europe would also spread to Asia. Japan’s currency is also a haven. Yet its export-dependent economy is already weaker than Europe’s and a spike in the value of the yen would make things worse. China, the world’s second-biggest economy, could be in trouble on multiple fronts. Europe is a big customer and demand surely is about to slow. Volatility in currency markets could cause problems because Beijing sets the value of the yuan against a basket of the currencies of its major trading partners. Weaker demand for exports will raise new questions about the Chinese government’s ability to meet its growth target of about 6.5 per cent. The other economies of Asia are highly geared to China, so weakness there means weakness in South Korea, Australia and other countries in the liveliest corner of the world economy in recent years. “A prospective slowing in the already torpid pace of global growth is hardly welcome news for a small open economy like Canada,” said Warren Lovely, an economist at National Bank Financial. In other words, the people of Britain have not only voted to make themselves poorer in the short term, they made life harder for the rest of the world—including Canada. This article was originally published on Maclean’s.

What Brexit could mean for Canada

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