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Pound is not afraid of Brexit, it is the most expensive in 2 years

20 Feb 2019 15:41|Marcin Lipka

"Shortages of food and medicine, kilometre-long queues of lorries at the border and serious problems in air transport. These are the risks that Brits have to face when threatened by a chaotic Brexit. Given the spectre of such a serious economic disruption why is the pound appreciating and the strongest to the zloty in almost two years?" writes Marcin Lipka, Conotoxia Senior Analyst.

Since the beginning of the year, the British currency against the Polish one has become more expensive by about 0.20 PLN and reached a value close to 5 PLN. Part of this 4% appreciation of the pound to the zloty results from the general weakness of the Polish currency. However, the pound also strengthened by about 3% to the euro and 2% to the dollar. How is it possible, when foreign investors are withdrawing from Great Britain, and the spectre of a chaotic Brexit may threaten the basic functions of the whole country?

Political mess

The campaign over the exit agreement from the EU has led to even greater polarisation on the British political scene. There are huge divisions in the matter of Brexit both within the ruling Tories and the opposing labour party. Proof of this is the departure of seven Conservative members and three from the Labour party in recent hours and the creation of a new independent group in the British House of Commons.

Prime Minister Theresa May has repeatedly lost the crucial votes on Brexit in recent months, mainly as a result of the strong opposition among dozens of Conservatives on the backstop, an emergency mechanism which, in the absence of a new trade agreement between the Union and the United Kingdom, will guarantee the absence of a border on the Irish Island.

Backstop cannot be indefinite according to the conservative rebels, because it would make it necessary to maintain a customs union between the UK and the European Union, i.e. it would be a denial of the main reason for leaving the EU. Therefore, Prime Minister May must renegotiate the already agreed upon agreement so that the Eurosceptic Conservatives accept any agreement and the country avoids a chaotic exit from the EU.

Backstop - a threat, but also an opportunity

In recent weeks (and also during earlier negotiations), the Conservatives have proposed that border controls between Ireland and Northern Ireland should be solved with modern technology. So far, however, such tools have not been invented and, as a result, controls would still have to be carried out on a normal level. This would disrupt trade and recall the tragic events of the conflict on the Irish island, which claimed several thousand victims. As a result, the Conservatives have withdrawn from this idea in recent hours and want other concessions from the EU that would allow the agreement to be accepted by the Eurosceptic Tories. Which ones?

First and foremost, the Eurosceptics who built their image on the opposition to Brussels need a kind of stimulus. Perhaps it would be that the backstop is of a temporary nature and that the priority is to prepare the final trade agreement. However, this process will only begin after the formal departure from the EU. If necessary, the agreement will regulate the border without the need for its physical introduction.

The EU might agree to do everything possible to avoid the need to activate the backstop, but it will certainly not agree to a specific date. Without a date, the most hard-working Eurosceptics will not announce a victory. Although the problem seems unresolvable, it is only a political detail, which can be specified in subsequent years (after all, Prime Minister May agreed to a problematic backstop during several months of negotiations).

When we approach the key date (March 29th), and the threat of a chaotic Brexit will increase, then the pressure on conservatives may be high enough to finally adopt the proposed solution with minor changes. This can be agreed upon literally in a few hours.

Parliamentary supervision

However, if it turns out that the Conservatives are still in disintegration at the end of February and Prime Minister May did not get anything in Brussels, the British Parliament may take more responsibility for the negotiation process. Although it will not be able to prepare a new agreement quickly, however, it remains convinced that a chaotic Brexit must be avoided.

Then it is possible to extend the negotiation period, especially if there are early elections in the United Kingdom. More extended negotiations, however, mean that disorderly Brexit is even less likely.

It would be interesting if prolonged negotiations made it necessary for the British people to stand for election to the European Parliament. Formally, they would remain in the EU, so they should take part in the polls. However, if they were to leave the EU, they would quickly have to say goodbye to the new seats.

Politicians better than voters

Investors believe in another burning issue. Politicians, precisely in the case of Brexit, may be much more predictable than voters. The decision to leave the EU in the referendum of June 2016 was a complete surprise for the markets, as opinion polls underestimated the power of the Eurosceptics.

Currently, a chaotic Brexit has no support in parliament and any agreement would probably result in a clear strengthening of the pound. It reduces the negative economic impact of leaving the EU and also opens the doors for the Bank of England to raise interest rates, which usually has a positive impact on currencies.

Negotiations on a final trade agreement may also move towards close relations with the Union since the behaviour of Japanese companies in the automotive sector suggests that without close ties with the Union, there will be no investment in the production of cars or parts in the United Kingdom.

Opportunity to further strengthen the pound

The market may believe that, despite the passing of time and the lack of agreement with the EU, the real risk of a chaotic Brexit is low. Overall, the British currency is still about 10% weaker than before the referendum. In the coming months, in the event of an agreement, the pound should pare a part of this post-referendum weakening and strengthen even by about 5%. This would mean valuations of sterling to the zloty at the level of about 5.25 PLN.

Of course, in the absence of an agreement with the EU and a chaotic Brexit, the fall of the pound would be dramatic and could amount to more than 10%. However, the real risk of such a negative scenario is unlikely.

20 Feb 2019 15:41|Marcin Lipka

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