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An indication of the UK’s external vulnerability is its gaping external current account deficit, now running at a staggering 6% of GDP – the largest deficit the country has seen in the post-war period. As Mark Carney, the Bank of England governor, has put it, the deficit’s size makes the UK uncomfortably dependent on the 'kindness of strangers' for its financing.
An important risk that a hard Brexit poses is that foreigners may be less inclined to continue financing such a large deficit. An early indication of this likely reluctance was seen in the more than 10% drop in sterling immediately following the UK vote in June. It has also been seen in sterling’s renewed slide over the past few weeks as the market’s perception of the likelihood of a ‘hard’ Brexit has increased.
There appear to be at least two reasons to believe that market fears about the consequences of a hard Brexit for continued large capital flows to the UK are not misplaced. The first is that, were the UK no longer to have ready access to Europe’s single market for its exports, it would lose its attractiveness as a location for foreign companies’ European investments. This was precisely the point that the Japanese government made at the September G20 meeting in China – when it publicly warned its UK counterparts of the likelihood that Japanese companies would relocate out of the UK in the event of a hard Brexit.
The second reason is that a hard Brexit would almost certainly result in the loss of the ‘financial passport’ that City of London financial institutions currently enjoy for accessing the European market. A Financial Conduct Authority report in September suggested that as many as 5,500 UK financial firms could be affected by such a loss of passport rights. Major international banks including JP Morgan Chase and Goldman Sachs have warned that, if the City loses its financial passport, they will need to conduct at least part of their European operations from outside the UK.
A key point that those in favour of a hard Brexit overlook is that a rapid drying up of foreign capital flows to the UK would have dire consequences for domestic living standards. A further currency dip would raise import costs and increase inflation. Moreover, there is a likelihood that domestic economic policy would need to be tightened – both to contain inflation and to make room for a large narrowing in the external current account deficit that foreigners would no longer be prepared to finance. UK households would be forced to reduce their consumption levels painfully, while businesses would be forced to cut back on their investment plans, to the detriment of future UK growth prospects. [...]