Brexit explained: Why is London so important?

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A referendum has been scheduled for the UK to vote whether they should leave the EU (termed the ‘Brexit’). This has resulted in uncertainty in regards to the UK’s future growth, trade flows and foreign direct investment. Uncertainty of the UK’s future if they exit the EU has been reflected in financial markets and a depreciation of the pound (GBP). This is because leaving the EU would mean that the UK would no longer benefit from the multilateral trade agreement between EU members. Therefore, trade agreements will need to be negotiated.

How does this relate to the HSC syllabus?

  • The UK is currently a part of the EU which is a trading bloc. This means that the UK benefits from the multilateral free trade agreement between the EU members which have lowered their trade barriers (HSC Topic 1 – The Global Economy). Exiting the EU would mean that the UK no longer benefits from the established trade agreements between EU members and would need to renegotiate its agreements with the EU.
    • Note: Negotiating trade agreements can take a long time since members try to come to a compromise that benefits their economy most. For example, Australian and China’s free trade agreement took 10 years (negotiations started by the Howard government in 2005 and signed by the Abbot government in 2015). Multilateral agreements tend to take longer than bilateral trade agreements.
  • Without a free trade agreement in place, the UK will face higher import and export costs in the form of tariffs and other protectionist policies (HSC Topic 1 – The Global Economy). The UK has a current account deficit with the EU totalling 6.5% of GDP. Assuming that protectionist policies apply to both the EU and UK, a Brexit is expected to improve the goods deficit (since the UK is a net importer of goods and will be deterred from buying more expensive goods) and deteriorate the services surplus (since the UK is a net exporter of services) in the short term (HSC Topic 1 – The Global Economy).
  • Lowered trade barriers between the UK and other EU members has been particularly important to the UK. The UK is a financial hub (41% of the world’s foreign exchange and 49% of the world’s derivative trading takes place in the UK) since any financial service company based in the UK is allowed to operate across the EU through passporting. Without membership in the EU passporting may no longer be possible since trade barriers will be re-erected. There have been predictions that approximately a third of financial services companies would consider relocating their operations to the EU. Given that financial services is a major sector in the UK, this could damage their economic growth prospects (HSC Topic 3- Economic Issues). Since labour is a derived demand, there may be unemployment within this sector which may see skilled employees in financial services emigrate as the banks move to other countries (Preliminary Topic 4 – Labour Markets; HSC Topic 3 – Economic Issues).
  • There has been criticism of trading blocs such as the EU which is premised on the fact that these agreements promote regionalisation rather than globalisation of trade. This is because members of these agreements tend to impose protectionist barriers to non-member economies (HSC Topic 1 – The Global Economy). The UK cites breaking away from the protectionist policies imposed by Brussels (considered the capital of the EU).
  • Foreign direct investment into the UK has partially been due to its membership in the EU. This is because the UK has been viewed as a ‘gateway’ to Europe. Some have argued that the potential for foreign direct investment would be stronger with the repeal of the EU’s protectionist policies. However, there is also a strong argument that a Brexit could damage the UK’s foreign direct investment since half of the UK’s current investment comes from the EU. Since companies would have less incentive to invest in the UK, exiting could put an estimate $128 million of EU investment at risk every day. Furthermore, the uncertainty surrounding the UK’s regulatory environment could also deter investment (HSC Topic 1 – The Global Economy).
  • Depreciation of the pound (GBP) is likely to result from a Brexit. Uncertainty in the lead up to the referendum has seen investors sell off the pound (GBP) which has seen it fall more than 3.2% in the past week. Less foreign investment and more uncertainty following a Brexit could lead to a decline in the sterling by 15-20% (as predicted by currency strategists at HSBC). This will make imports more expensive leading to imported inflation which can see inflation in the UK rising by 5% (HSC Topic 3 – Economic Issues).

IMF pushes for global economic stimulus plan

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The IMF has called for the G20 to implement a coordinated stimulus plan to boost growth of the slowing global economy. The IMF cut its global growth forecast from 3.6% to 3.4% in 2016 given that the global economy has suffered from instability caused by falling commodity prices and slowing growth from China. Of the most affected by this instability are the emerging markets which have suffered from capital outflows. The stimulus plan is intended to help these emerging markets as investors continue flee these markets and invest in the US.

The IMF has also encouraged advanced economies to rely less on monetary policy compared to fiscal policy to support growth while emerging markets should float their exchange rates when appropriate.

How does this relate to the HSC syllabus?

  • The IMF’s encouragement for a global stimulus plan in the face of slowing global growth is reflective of its role to maintain global financial stability (HSC Topic 1 – The Global Economy).
  • It is not the IMF’s role to promote economic development in developing economies. However, the proposed stimulus plan is largely intended to support developing economies. This is because the developing economies grow more quickly than advanced economies and contribute most to global economic growth. These economies have been underperforming since their main exports are commodities which have suffered from falling prices as well as capital flight to the US. Without capital inflows, these developing economies will face slowing growth and contribute to the instability already experienced in the global economy.
  • Advanced economies have been wary of sustaining fiscal deficits given the external stability issues faced by European countries such as Greece (HSC Topic 3 – Economic Issues). This has seen them rely on monetary policy to encourage economic growth while tightening fiscal policy. It was in response to this trend that the IMF has been calling for more use of fiscal policy to support economic growth.

RBA jawboning in vain while Fed stays put

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The RBA’s efforts to keep the Australian dollar down has been ineffective given that the Australian cash rate (2%) is higher than the near zero rates observed around the world. Tightening US monetary policy would help the Australian dollar to depreciate but pricing data suggests that the US will be slow to raise the Fed rate.

How does this relate to the HSC syllabus?

  • Since 2011, the RBA has aimed to lower the Australian dollar. A higher Australian dollar has made Australian exports uncompetitive. This is a pressing issue given that the mining boom has receded and Australia is trying to transition to a services based economy. If the Australian dollar remains at current levels (around $US0.70), Australia’s international competitiveness may be damaged which will slow transitioning efforts (HSC Topic 2 – Australia in the Global Economy).
  • The relatively high Australian dollar can be attributed to the fact that Australia’s cash rate remains one of the highest in the world (2% in comparison to near or below zero rates in the world). As a result, investors prefer to invest in the Australian market to receive a higher return. To invest in the Australian market, investors require Australian dollars which has seen the demand for Australian dollars increasing, causing an appreciation of the Australian dollar (HSC Topic 2 – Australia in the Global Economy).
  • Rises in the US Fed rate may provide some relief to the Australian dollar since investors would then move to invest in the US market to earn a higher return. However, given that the plans to tighten monetary policy have been cast into doubt due to the US’s low inflation figures, investors have veered away from investment in the US and into Australia (HSC Topic 3 - Economic Issues, HSC Topic 4 – Economic Policies and Management).

Theresa Dang THERESA DANG

Theresa Dang is an economics mentor at Keystone Education. She attended Sydney Girls High and achieved an ATAR of 99.70 in 2012. She is now studying Commerce and Law at the University of Sydney. She has experience in a global technology firm and a mutual fund.

Gary Liang GARY LIANG

Gary Liang is the founder and director of Keystone Education. He attended Sydney Boys High and achieved an ATAR of 99.95 in 2012. He achieved 5 state ranks in Mathematics, Mathematics Ext 1, Mathematics Ext 2, Chemistry and Economics. He is now studying Economics and Science (Advanced Mathematics) at the UNSW Australia, where he is the recipient of four scholarships.

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