The start of 2017 is pep­pered with po­lit­i­cal risks in­clud­ing the Ger­man pres­i­den­tial elec­tion and a gen­eral elec­tion in the Nether­lands. But it is the UK which presents us with the big­gest threat of all – Brexit.

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The start of 2017 is pep­pered with po­lit­i­cal risks in­clud­ing the Ger­man pres­i­den­tial elec­tion and a gen­eral elec­tion in the Nether­lands. But it is the UK which presents us with the big­gest threat of all – Brexit.

The UK's trig­ger­ing of Article 50 by the end of March will be the riski­est po­lit­i­cal event of the first quar­ter be­cause of the eco­nomic weight of the UK and the euro area, whose share of global GDP in USD is 3.9% and 15.7%, re­spec­tively. Un­til now, the most vis­i­ble ef­fect of Brexit has been ster­ling's de­pre­ci­a­tion (the other fac­tor ex­plain­ing the de­pre­ci­a­tion is the UK's large cur­rent ac­count deficit which is close to 7% of GDP). GBP has de­creased by al­most 17% ver­sus the dol­lar and 9.3% against the euro since June 23. The down­ward trend oc­curred in two stages, first in the wake of the ref­er­en­dum, and then fol­low­ing Prime Min­is­ter Theresa May's speech at the Con­ser­va­tive Party Congress on Septem­ber 30 where she clearly favoured the op­tion of a hard Brexit. The UK’s three main eco­nomic chal­lenges Theresa May raises many hopes but it is way too early to judge her poli­cies since she has not de­liv­ered any­thing yet. Opt­ing for a hard Brexit means that the UK would need to com­pletely change the struc­ture of its econ­omy by 2019 (the ef­fec­tive date of exit from the EU), which is ob­vi­ously a very short time frame. The Bri­tish econ­omy is head­ing for the most chal­leng­ing pe­riod it has known since WWII. There are mostly three im­me­di­ate eco­nomic is­sues that will ap­pear in 2017:

Surge in in­fla­tion. The lower GBP ex­change rate, which is cer­tainly here to stay, leads to higher in­fla­tion through im­ports (fore­cast of 2.4% in 2017 and 2.5% in 2018) hurt­ing house­holds' pur­chas­ing power. The rise in in­fla­tion is also ac­cen­tu­ated by higher global com­mod­ity prices (+4.70% in Novem­ber 2016 com­pared to Novem­ber 2015). Un­til now, wage growth has been suf­fi­ciently high (+2.3% ac­cord­ing to the lat­est data) to partly off­set higher in­fla­tion but this should not be the case in 2017 if in­fla­tion fore­casts are con­firmed. In the medium term, how­ever, lower GBP is likely to favour the sub­sti­tu­tion of im­ported goods by lo­cally pro­duced goods, when­ever it is pos­si­ble. None­the­less, the gain in terms of pur­chas­ing power will not be that sub­stan­tial.

Wor­ries over wages. In a nor­mal eco­nomic pe­riod, full em­ploy­ment is ex­pected to lead to higher wages but this may not be the case as UK firms may be en­cour­aged to post­pone hir­ing due to the un­cer­tain eco­nomic con­di­tions. The trig­ger­ing of Article 50 will prob­a­bly have a sig­nif­i­cant psy­cho­log­i­cal ef­fect on Bri­tish firms and will re­sult in a hir­ing freeze. Some ob­servers point to the re­silience of the labour mar­ket as proof that Brexit has no real con­se­quences. How­ever, they for­get that events usu­ally take at least six months to im­pact the labour mar­ket, even when it is very flex­i­ble, like in the UK.

Com­pet­i­tive­ness at stake. In the­ory, the de­pre­ci­a­tion of ster­ling should help the Bri­tish econ­omy in this pe­riod of un­cer­tainty but the real gain re­mains lim­ited be­cause the price elas­tic­ity of ex­ports is low. In­deed, a study con­ducted by the Of­fice for Bud­get Re­spon­si­bil­ity con­cludes that a 1% de­crease in rel­a­tive price only re­sults in a 0.41% in­crease in ex­ports (ex­clud­ing petroleum prod­ucts) af­ter nine quar­ters. By com­par­i­son, a sim­i­lar de­cline leads to a 0.8% in­crease in ex­ports for France. There­fore, it can be con­cluded that the ex­pected gain in price com­pet­i­tive­ness for Bri­tish firms due to the fall of GBP will not be as de­ci­sive as has of­ten been claimed. Lower cor­po­rate tax may con­sti­tute an in­cen­tive for UK firms to in­vest in the short term but, in the medium term, the UK will need to im­ple­ment an am­bi­tious rein­dus­tri­al­i­sa­tion plan if it fails to reach a favourable as­so­ci­a­tion agree­ment with the EU. This plan would mean un­con­trolled deficit spend­ing which would in­crease the debt bur­den in a con­text of ten­sions in bond mar­kets (the UK 10-year sov­er­eign bond yield has been mul­ti­plied by 2.3 since its an­nual low­est point) and cer­tainly a fresh credit rat­ing down­grade for the coun­try.

CEE is the UK’s best ally

Dur­ing the ne­go­ti­a­tions with the EU, the UK will cer­tainly face the in­tran­si­gence of many coun­tries, no­tably France, although the cur­rent gov­ern­ment may have less in­flu­ence at the Euro­pean level be­cause of the up­com­ing pres­i­den­tial elec­tion in April. At first glance, the bal­ance of power is more favourable to the EU than to the UK, as Euro­pean ex­ports to the UK ac­count for only 3% of EU GDP, while Bri­tish ex­ports to the EU rep­re­sent around 13% of the UK GDP. How­ever, Theresa May will be able to count on the sup­port of cen­tral and east Euro­pean (CEE) coun­tries.

They face two cru­cial is­sues this quar­ter. The first one con­cerns a stronger USD which is not, from our point of view, a ma­jor fi­nan­cial risk for the re­gion. In­deed, to­tal US dol­lar-de­nom­i­nated debt as a share of GDP is quite low in CEE. The most ex­posed CEE coun­tries are Poland and the Czech Repub­lic where it reaches roughly 10% of GDP, which is man­age­able, com­pared with Chile (over 35% of GDP) and Turkey (around 25% of GDP).

The sec­ond is­sue re­lates to the po­ten­tial eco­nomic im­pact of Brexit in CEE. The Czech Repub­lic and Slo­vakia are among the most im­por­tant re­cip­i­ents of UK in­vest­ments in the re­gion and could, there­fore, be the most pe­nalised in the event of a hard Brexit. In the short term the de­ci­sion to leave the EU has not sub­stan­tially af­fected in­vest­ment flows. How­ever, in the medium term there is real un­cer­tainty about the con­tin­ued pres­ence of Bri­tish com­pa­nies in the re­gion (more than 300 UK firms are op­er­at­ing in the Czech Repub­lic which serves as a hub to pen­e­trate neigh­bour­ing coun­tries). This eco­nomic de­pen­dence rep­re­sents a key advantage for the UK gov­ern­ment, which could bar­gain the sup­port of CEE coun­tries dur­ing the ne­go­ti­a­tion process (re­gard­ing pass­port­ing rights for in­stance) in ex­change for main­tain­ing UK in­vest­ments. On one hand, Bri­tish diplo­macy has not ne­go­ti­ated any ma­jor trade agree­ment since 1973 and no longer has the teams to do so. On the other hand, it knows how to di­vide and rule, which sug­gests that the UK could, at the end of the day, do bet­ter than ex­pected by ob­tain­ing sub­stan­tial con­ces­sions from al­lied Euro­pean coun­tries if Brexit oc­curs, which is far from cer­tain

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