Paper Example on Hard Brexit

8 pages
1946 words
Carnegie Mellon University
Type of paper: 
Dissertation chapter
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When the UK voted out of European Union (EU) in the controversial Brexit, the world was caught in a shock of the century, sending down chilling effect on the financial markets in the Europe and the world over. This was the least expected outcome of the referendum and went in sharp contrast to what most financial markets, apparently leading to very fierce and immediate responses by stock markets, developments that hit hard on the markets and shock the entire global financial system. On the eve of Brexit, most financial markets were prepared for rejuvenated trade with European Union members and with other partners across the globe. For example, FTSE 100, 100 multinationals listed on the London Exchange Market, rallied ahead of the Brexit result, with a bet that the UK would vote to remain. When it turned out that the UK voted out of the Union, it was similarly the case that this index was one of the big losers in the financial markets. The results meant that the highly rated shares and which investors took greater risks to put their money in sharply declined in value as the dollar strengthened against Sterling pound.

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As a definition, therefore, hard Brexit is a situation where there is huge disruption of EU from its global responsibilities by way of disrupting financial systems in unprecedented ways, rendering global financial system unstable and more fluid should UK take an immediate exit stance advocated for by Leave campaign and Conservative Party leadership. As financial markets prepare to absorb the shock from a ripple effect of the referendum, fiscal policy decisions may not turn out helpful for the health of the global financial system; rather it may only turn out more disruptive as each major economy takes a protectionist approach to fiscal policies. For instance, in East Asia, Japan is considered a major source of influence on the financial systems in this region. Its fiscal policy in the wake of Brexit outcome may have the power to alter in key ways, the direction financial markets and trading in stocks takes in this region (Auer, Levchenko, & Saure, 2016). It can be remembered that Japan took the initiative to ensure that UK does not take actions to its exit from EU that would eventually aggravate effects of its exit from EU. Japan particularly, through its Prime Minister's message, appealed to the UK not to take hard measures to destruct its relationship with EU as these would only serve to make the situation worse. What Japan asked for was a stronger correlation between UK's regulations and those of UK so as to ensure continuity. More specifically, Japan was requesting for, in the "Message to the United Kingdom and the European Union," tariff-free intra-EU exports and imports, maintenance of a single passport system, and access to the EU single market by the UK, even after exit. The Prime Minister of Japan observed that the worst that could happen in their bilateral relationship with EU, and so the UK, was uncertainty after UK's exit from the Union. What Japan and world economies were interested in, and would, in turn, help them to guard against a very fluid financial system, was predictability of the pre-Brexit landscape by all stakeholders as this would help to do business, knowing well what the future held.

In her reaction, British Prime Minister mentioned a few policy issues that would inform UK's exit negotiation among which was, in the interest of this analysis, trade. Theresa May in her speech in October to a congregation of Conservative Party members mentioned that while UK was exiting the EU, its trade policies would remain tandem to those of the union and this will include helping the union finalize its free trade agreements with third world countries(, 2016). In this speech, May also mentioned that exit of Britain from EU only gave the country an opportunity to be sovereign enough and to play its role in helping the third world countries develop. While in the same speech the PM made it clear that the UK was not aiming at being in competition with the union, it is apparent that a focus on third world economies would essentially put the country in direct competition with EU and the union's reaction remain largely unpredictable. However, the promise of free trade may mean stability of the financial markets, at least within the region.

Flash Crash

In late June 2016 markets plunged upon the shocking news about UK's exit from the European Union, as markets reacted fiercely and with immediacy. Outflows increased within Europe as investors took to safe havens in the US and elsewhere. The dollar, which is always considered a haven at times of trouble like was with Brexit vote, gave dollar-dominated corporations in the US and emerging markets economies(EME) upper hand as they experienced large inflows of investments from investors escaping repercussions of UK's exit from EU. This was the initial face of the reaction to uncertainty. Soon afterward, markets recovered quickly as stockholders took initiatives to regain their suffered losses and the stock markets took initiatives to revive trade amidst challenges of market uncertainty that surrounded Brexit. However, a real shocker came with UK PM's speech that hinted to a "hard" Brexit, when she claimed that she would trigger Article 50. This was seen as having an effect on the Sterling pound because such a move to exit immediately, and not opting for a regular plan, meant that market reactions would take random directions, which would likely hurt bond yields in the region and send a ripple effect across financial markets. Given the rising bond yields outside the UK, mostly in the US, the dollar is increasing growing stronger against Sterling pound, and today, the loss in value of the pound against the dollar stands at about 13% since Brexit.

Following US presidential election outcome, many investors have shifted their investment to the US and other dollar-dominated securities in EME because of the predictable stability of dollar in future. Specifically speaking, investors expect a booming US economy in a shift of paradigm that will see expansionary fiscal policies, lower corporate taxes resulting in higher profits, and laxer regulation of business in the local economy. This is expected to spark growth in various sectors, eventually leading investors to investment more in bonds that have seen increasing yields across financial markets in the recent months. Accompanied by strengthening dollar for domestic business in the US, outflows from Europe and the UK particularly are pouring into the US(Avdjiev, Du, Koch, & Shin, 2016). As such, an announcement in Theresa May's speech pointing to an early exit, and a "hard" Brexit in this case, serve even to make dollar grow stronger against a weakening sterling to lower levels than have been seen in history. This is termed as flash crash, showing how terribly low a currency can go at times of a lot of uncertainty in the global financial system.

In the middle of uncertainty, information is scarce and thus a small price impact may result in liquidity along three dimensions of the bid-ask spread, market depth, and market resilience (Ting, 2016). Market depth is the capacity of a market to absorb buy and sell orders without causing the market price to shift dramatically in either direction. It is measured as the aggravate aggregate size of orders when market is operating normally and when market turbulence sets in. Market resilience, on the other hand, is the ability of the market to recover from flash spikes and flash crashes (both mini) in the absence of trustworthy sources of market information. One way to measure market resilience is to check on the reversal of price and quote. Thus, a traded security at the market is said to be liquid if the impact of each trade does not cause a drastic change in price. This was the same scenario in the events that surrounded Brexit, in which market prices did fall, but soon recovered only in a matter of weeks. Although it was largely interpreted as effects of high-frequency trading, in market microstructure, there is the unobservable St in the Almgren and Chriss model equation (as cited in Ting, 2016):

Pt = St + nvtIn the scenario in this study, it is clear that most of the market reaction was largely uncalled for, especially because it only came to the realization of stock markets that there were bigger problems with so much anticipation. This was the basis of all fierce reaction, in plunging the markets as well as in reinstating them later (Borio, Sushko, McCauley & McGuire, 2016). Moreover, the fierce reactions of the stock markets were initiated by reckless moves and protectionist approaches by one dominant economy in close association with Europe and UK in bilateral trade, Japan (Lannoo, 2016). Japan's Citigroup made a name by being one group that profoundly made structural adjustments to mitigate unforeseeable effects of Brexit vote, pushing other financial markets to take the same or even worse measures in a bid to preserve the interests of stockholders. Stockholders on the hand took the initiative to pull out their investment in UK assets that seem to lose value fast as yields fell drastically. In the wake of realization that the matters were not as serious as had been previously made to seem, the market recovered pretty fast, and this contrasts claims by other financial analysts that this was more of a high-frequency trading effect than thin liquidity.

To put this is the more contextual basis; it is good to note that the fierce reaction by the Japanese government and its enterprises was surprising for some reasons. First, Japan was seen as an emerging superpower in 1990 until it came to disappear from the international scene when its stock markets collapsed (Lannoo, 2016). In the subsequent years, the regimes were unable to restore Japan to its glory, and financial crises continued to befall the country until the reign of Prime Minister Abe. With Abe, many turnarounds are notable; among them are an alignment of fiscal policies and the central bank, eventually leading to the reinstatement of the country's economy. In 2017, the economy of the country is expected to grow by 1%, the best in several years. Second, Japan has been in negotiations with EU on Free Trade Agreement (FTA) and Economic Partnership Agreement(EPA), initiatives to help revitalize the economy of Japan and East Asia in general(Lannoo, 2016).

Inflation Expectations

At the beginning of this discussion, it was clear that Brexit vote led to speculations over the uncertainty of the future of UK regarding economic stability, leading many investors to withdraw their investments from the country and seek safer securities elsewhere. Due to this reaction, and the subsequent fall in the value of assets in the stock markets, Sterling pound began falling drastically in value against the US dollar (Auer, Levchenko, & Saure, 2016). This was, however, short-lived and markets recovered later. Even then, the damage was already done especially for multinationals in the country and listed in the FTSE 100 index. This prompted the UK's central bank to adopt pro-business measures to curb further capital flight. Bonds, which are considered safer securities during times of turbulence, experienced improve performance in the market as those investors who did not option to take their investment out of the UK invested in bonds, and when their yields (known as guilt) improved as stock markets, the investment attracted more interests.

The first challenge to the stability of the UK economy is attributed to the fact, at the time of Brexit vote, the world economy was already unstable, and a small price impact at the financial markets sent chilling fear over investors, leading to proactive measures most which were protectionist in nature. For instance, the US called for a meetin...

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