Britain is a part of the European Union (EU), but has kept itself out of key EU initiatives like adopting the Euro currency and enabling a passport-free zone under the unified Schengen visa policy. The UK has scheduled a public referendum in June 2016 to determine whether Britain should continue with the EU.
Though an exit by Britain, termed "Brexit," would be a major jolt for the European Union bloc, it’s the UK economy that is feeling the heat of the associated developments. The British pound (GBP) plunged to a record seven-year low on concerns of a proposed exit of Britain from the EU. Let’s explore the rationale for such developments leading to wide swings in currency valuations.
How Political Developments Impact Currency Valuations
The outcome of big geopolitical developments, like a referendum leading to major economic consequences, is bound to have a lasting economic impact on a nation. Until the final outcome is known, there is a long period of uncertainty during which chaos prevails in the nation’s economy.
The multifaceted and often opposing statements from different politicians, policymakers and key stakeholders, and the varying opinions from rating agencies, economists and market experts, keep feeding the sense of uncertainty. This aggravates the prevailing fears, and distorts people's perceptions of risks and benefits. These sentiments get reflected in high volatility in the financial markets with an associated economic cost.
The Case of the British Pound
Why the British pound is falling on Brexit news?
In the case of Brexit, the uncertainty prevails at multiple levels. First, regarding the outcome of the UK-level referendum (leave or stay). Second, the likely difference of opinion with Scotland (a UK-member nation), where a majority is reported to prefer staying with the EU. Matters would be further complicated if it turns out that Scotland wants to leave the UK to go with the EU. Third, if the UK exits the EU, it will take a long and uncertain period to finalize future trade relations with the EU.
The major risk from Brexit emanates from trade barriers getting erected with the EU, which is the UK’s largest trade partners. Britain’s current annual trade with the EU, worth £229bn, would get impacted instantly. The majority of UK businesses may end up reviewing their logistics, legal, and licensing requirements--constituting major overhead and costs.
Additionally, the UK has competitive advantages compared to other EU nations in a few segments, like financial services. It risks losing those if Brexit happens. And UK citizens would lose options at the individual level, such as the ability to work, migrate, and trade freely across EU borders. EU nationals desirous of going to UK would also hit roadblocks
The Ifs Ands and Buts Of Uncertainty
The positive side is that despite the putative exit, the UK may be able to negotiate favorable trade agreements with the EU bloc or with the individual EU nations. This could mitigate the effects of closing out the present-day free trade zone. However, these negotiations would be complicated and time-consuming, which indicates that mid-term uncertainty will prevail even if the developments turn out to be beneficial in the long run.
For instance, the rating agency Moody’s is reported to “consider downgrading the UK's credit rating -- which affects how expensive it is for the government to borrow money -- if the country voted to leave the EU”. Similarly, another rating agency, Fitch, has warned that Brexit may lead to hurting the UK’s strong credit score.
There are other implications beyond UK-EU relations. For instance, the US dollar (USD) and Swiss franc (CHF) have become stronger compared to the British pound (GBP) in recent times, indicating the declining market sentiment about the UK economy. While the US Fed raised interest rates, the Bank of England (BOE) has been taking dovish stances leading to more speculations.
Market analysts believe that this situation of uncertainty will continue till June, when the referendum is scheduled to take place.
Economic, political, and trade associations between nations and regions is usually a complex web involving many intricacies. Though the fundamentals for UK economy remain strong, the true impact on the UK economy will be determined by how the UK-EU relationships unfold in future.
The Bottom Line
Amid such megaevents (like the Brexit referendum), it’s the uncertainty that drives the currency valuations and market developments. The final result of such geopolitical developments may get mitigated in the long term, but it does have significant impact in the mid-term. All developments associated with such wide-impacting events may have resultant impacts during the run to the actual event. Owing to the lack of clarity, the uncertain period would be vastly damaging. It will bring about an era of high volatility in currency and financial markets.
