The Implications of Brexit – July 2016
The immediate impact of the Brexit referendum was a period of heightened financial market volatility which has mostly receded relatively quickly. This represented a stress test of market structure in the wake of the post-crisis regulatory reforms and, at least to date, the global financial system has withstood the event well.
The net asset price response across most major markets to date is lower sovereign bond yields and expectations of easier monetary policy. Within this there has been considerable regional and sectoral variation, with particularly sharp falls in some UK asset prices – including the pound – and banking sector equity prices, particularly in Europe. The depreciation in the pound has contributed to higher UK equity prices on some measures.
Our assessment, and that of most observers, is that the overall economic impacts over both the short and medium term will be negative and concentrated on the UK economy. Over the longer term, the magnitude of the impact will depend on the degree to which the UK reduces links with the EU and is able to engage with others. Beyond the UK, the main negative short-run economic effects are expected in Europe, reflecting trade and financial links and associated uncertainty. Global economic activity is widely expected to be only modestly affected by Brexit, given the UK's relatively small share (just over 2 per cent) of global GDP.
Brexit, however, presents an additional downside risk to the global economic outlook if it were to trigger exit movements within the EU, which for euro area countries would be more disruptive given the common currency. Ongoing banking sector fragility in the region remains a downside risk. Market movements reflect increased apprehension about banks in a number of European countries, most notably Italy, post Brexit.
Short-term policy responses to the Brexit result focused on central bank provision of additional liquidity to support market functioning – although this support has only been drawn upon in a limited way – and reported intervention in foreign exchange markets by some countries to relieve pressure for currency appreciation. The Bank of England has given a strong indication that it may ease monetary policy in the near term as part of a ‘host of measures and policies’ to support the UK economy.
Australia has proved resilient during past periods of financial market volatility and remains well placed to manage the economic and financial market response to Brexit. The effect on economic activity in Australia, and the financial sector, is expected to be small. Trade links to the UK are small, and there has not been a large reaction in commodity prices. The links of the Australian banking system to the UK have declined in recent years, with Australian banks reducing UK exposures and UK banks retreating from Australia in the post crisis period.
In the event that concerns about the viability of the euro area escalated, funding and operating conditions for Australian banks could deteriorate. That said, banks have significantly improved their resilience post crisis, with stronger capital and funding positions. In case of a significant tightening of funding conditions, Australian dollar liquidity remains available through Reserve Bank facilities.
Council of Financial Regulators (CFR) agencies, including through their overseas footprint and Australia's diplomatic network, were quick to gather international intelligence and coordinate around the Brexit decision and will continue to monitor Brexit-related developments. Monetary and fiscal policy options remain available if needed.
The uncertainty and market disruption created by Brexit further emphasises the need to remain focused on progressing international efforts to strengthen financial stability and address risks. Protracted exit agreement negotiations may challenge the capacity of the UK and EU to engage fully in other international forums and institutions in the short to medium-term.