23 May 2016

HM Treasury analysis: the immediate economic impact of leaving the EU

[...] The economic impact of a vote to leave the EU The immediate economic impact would be driven by three key factors:

1 the ‘transition effect’: the emerging impact of the UK becoming less open to trade and investment under any alternative to EU membership

2 the ‘uncertainty effect’: the rise in uncertainty following the referendum and the impact that has on economic decisions

3 the ‘financial conditions effect’: the extent of financial market volatility

The transition effect

HM Treasury analysis: the long-term economic impact of EU membership and the alternatives demonstrated that the UK would become less open, less productive and poorer as a country in the long term following a vote to leave the EU.

The effect of this would start to be felt immediately. Businesses would start to reduce investment spending and cut jobs in the short term, consistent with lower external demand and investment in the future. This transition effect would also lead to lower incomes, reducing household spending.

The scale of the initial impact of this transition to a permanent reduction in trade, foreign direct investment and productivity in the long term would depend crucially on the sort of relationship the UK would seek with the EU. The analysis in the long-term document sets out a range for each alternative, with a central estimate that gross domestic product (GDP) would be £4,300 lower in 2015 terms for each household after 15 years and every year thereafter.

However, the impact of the transition effect would be considerably larger if the UK did not seek participation in the Single Market, as would be the case if it fell back on World Trade Organization (WTO) membership.

The uncertainty effect

While the referendum would settle the issue of EU membership once and for all, many aspects of the UK’s international and domestic economic policy framework would be put in doubt, leading to a significant rise in uncertainty. Businesses and households would respond to this by putting off spending decisions until the nature of new arrangements with the EU became clearer. This uncertainty effect would also lower overall demand in the economy in the immediate aftermath of a vote to leave. [...]

The extent and duration of the uncertainty created would depend on the progress made in negotiations with the EU and other international partners which would be inherently uncertain. Four processes would need to be completed: 

Process 1: agreeing the UK’s terms of withdrawal from the EU under Article 50 of the Treaty on European Union 

Process 2: agreeing the UK’s new trading relationship with the EU 

Process 3: agreeing the UK’s new trading relationships with the rest of the world including over 50 countries with which the UK would need to negotiate new trade arrangements 

Process 4: changing the UK’s domestic regulatory and legislative framework

Each of these four processes would be complicated in their own right, but conducting them all at the same time, on any terms that would be acceptable to the UK and within the specified two-year period for leaving the EU would almost certainly be impossible. If these processes were more protracted, the uncertainty would be larger and, as set out in a previous HM Government document, could last up to a decade or more.

Moreover, there would be a trade-off between securing a deal as quickly as possible to reduce uncertainty in the short-term, and securing the best possible deal for the UK to minimise the economic costs of exit over the long term. Even then, it would not be possible to provide the clarity required to address uncertainty in the short term, as that would require anticipating the outcomes of negotiations with other nations and Parliamentary votes that would be inherently uncertain up to the point they were concluded, and over which the UK would not have full control. A period of persistent uncertainty about the UK’s economic policy, regulatory and legislative regime in the event of a decision to leave the EU would therefore be unavoidable.

The financial conditions effect

Both the uncertainty effect and the transition effect would in turn weigh on financial markets, increasing volatility. Asset price falls would lead to this financial conditions effect amplifying the uncertainty and transition effects.

In the immediate aftermath of a vote to leave, financial markets would start to reassess the UK’s economic prospects. The UK would be viewed as a bigger risk to overseas investors, which would immediately lead to an increase in the premium for lending to UK businesses and households.

The value of UK personal investments would also decline, and the fall in the value of the pound would put upward pressure on the prices paid by consumers. This would add to the transition and uncertainty effects and influence a wide range of financial conditions facing businesses and households. Through a combination of these three effects, a vote to leave the EU would have a damaging effect on both the demand side and supply side of the economy. Two scenarios have been modelled to provide analysis of the adverse impact on the economy: a ‘shock’ to the economy and a ‘severe shock’.

The impact in advance of the referendum

Evidence for these effects is already clear in advance of the referendum. In financial markets, the value of the pound has fallen and the price financial market participants are prepared to pay for insurance against default on UK government debt has increased markedly.

For the wider economy, recent survey data shows weaker expectations for business investment, and there has been a sharp fall in commercial real estate transactions. Consistent with this, the Purchasing Managers Indices for services, manufacturing and construction output are all at their lowest levels for three years.

The Bank of England’s Monetary Policy Committee (MPC) expects growth to slow in 2016 Q2. At its May 2016 meeting, the MPC noted that “there are increasing signs that uncertainty associated with the EU referendum has begun to weigh on activity”. [...]

In conclusion, the analysis in this document shows that a vote to leave the EU would result in a marked deterioration in economic prosperity and security. This is based on a widely-accepted approach, and is supported by the effects of uncertainty already evident in financial markets and the real economy. A recession would be expected to follow even in the more cautious scenario with a significant risk that the outcome could be far worse. 

Full analysis

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