How a Brexit could impact on Australia

The outcome of the British vote to leave or remain in the European Union (EU) will be known in Australia around 2pm on Friday.

Since becoming a member of the EU in 1973, Britain’s relationship with Europe has been fraught. The “remain” camp has focused on the positives to trade and investment of maintaining EU membership. And the “pro-Brexiters” have concentrated on the perceived loss of sovereignty, undue regulation, and lack of immigration controls that this brings.

Brexit would bring extreme short-term volatility…..

In the short-term, Brexit would lead to turmoil in the UK and global financial markets. In the worst-case scenario it may precipitate another financial crisis.

With a debt mountain piling up in China even as growth slows, and the developed world struggling to generate growth despite record-low interest rates, the global economy is fragile. Last week, the US Federal Reserve cited the uncertainty around Brexit as one reason for leaving interest rates unchanged.

The effect will be most keenly felt in the foreign exchange market. The trade-weighted-index for the British pound has depreciated by 6.5% this year, and currently appears to be moving in step with Brexit polling. US investor George Soros, who famously “broke” the Bank of England during the 1992 European Exchange Rate Mechanism “Black Wednesday” crisis, suggests Brexit would cause a Sterling devaluation of at least 15%.

……and longer term uncertainty

The long-term effects of Brexit are uncertain. Much will depend on the negotiations between the EU and UK surrounding the conditions of exit. This could take years.

Since around half of UK trade is with the EU, it is likely that the government will seek to follow the example of Norway and Switzerland in retaining the benefits of a free trade zone without EU membership – however this is far from guaranteed. The Norwegian prime minister Erna Solberg suggested that Britons won’t like this since “Brussels will decide without the Brits being able to participate in the decision-making”.

Crucially, this uncertainty will mean that business decisions are deferred and investment delayed. This may result in many firms deciding to take their operations elsewhere. The Bank of England has suggested that Brexit will stoke inflation and raise unemployment, potentially tipping the UK into recession.

Of greater concern are the potentially greater geopolitical risks if other countries follow Britain’s lead and seek to leave the EU. The Eurosceptic political parties of the far-right have surged in popularity in recent years, and would surely push for their own countries to exit. This could mean a disintegration of the EU.

Consequences for Australia

As they are closely linked, turmoil on offshore markets will likely have a large impact on Australian markets. Australian stock markets and the Australian dollar tend to decline sharply as uncertainty increases and investors adopt a “risk-off” mentality. Bond yields will also head even lower as investors engage in a “flight to quality”.

If financial markets seize up, as they did in 2008, then the big Australian banks will find it difficult to secure the vast amounts of offshore funding that they require - share prices will fall sharply and government guarantees will be called for again. The one bright spot could be the stock price of gold mining firms if gold surges as a result of its “safe haven” status as it did in 2008.

A fall in the pound would have negative consequences for the many Australians (such as myself) who have pensions and other assets in the UK. And the spending power of British tourists (last year more than 700,000 of them arrived in Australia) would be lowered.

In the longer term, it is likely that a shaky global economy will severely impact Australia’s trade. Exports have been a key driver of recent GDP growth and so this could have severe ramifications for employment and economic growth. Recall that commodity prices sank quickly in 2008, and also that the UK is still Australia’s 7th largest trade partner.

As with the majority of governments, the lack of desire in promoting structural change, means that Australia’s fiscal position provides little comfort in the ability to stimulate growth. A repeat of 2008-09 when Australia avoided recession is unlikely to be avoided.

Not for the fainthearted

Of course, Brexit is far from certain to occur. If the bookmakers are correct (and they have form) and Britain remains in the EU we should see a rosier picture develop. At least in the short-term, a “relief rally” would likely see global stock markets surge higher along with the British pound (and the Australian dollar).

This “binary” effect, where prices are expected to advance/decline sharply, is one reason why investment in financial markets is certainly not for the fainthearted right now.

In the longer-term, a resolution to the UK’s position in Europe will do little to change the developing situation in China, or the re-balancing of Australia’s economy in the aftermath of the mining boom.