It is now just over 3 years since the United Kingdom voted to leave the European Union. Until now, slow negotiations with Brussels have kept “Brexit” on the radar but slightly out of focus.
In the weeks since Boris Johnson was selected as the new head of the Conservative party and Prime Minister of the UK, the focus on the country’s exit from the EU has sharpened, with the possibility of a “no-deal” exit putting global markets on notice.
What does it mean for Emerging Markets? Brexit exerting pressure on sterling and the bond market contributes to the global hunt for yield that is well entrenched by a dovish Federal Reserve and European Central Bank.
The weak outlook for the UK economy and a Bank of England on hold supports a positive environment for EM as a whole.
A weaker UK, however, and an EU without its contributions may complicate the domestic story for its Central European neighbors through trade, remittances, and EU structural funds. Weakened profiles for the Czech Republic, Hungary, and Poland as well as Romania could contribute to those countries underperforming its emerging market peers.
The likelihood of a no-deal Brexit is now on the rise ahead of the agreed-upon October 31 deadline. Johnson wants a new deal from the EU which the bloc is currently loathed to offer up. Johnson says he is fine with, and Parliament will have to accept, a no-deal deal exit despite the warnings from a variety of sources on the possible economic repercussions. His ascendance to the premiership as well as the tougher language has suddenly made a dent in the previously steady British pound. It has also seen safe-haven trades push gilt yields lower.
The weak outlook for the UK economy and a Bank of England on hold supports a positive environment for EM as a whole. The UK component only adds another layer to the already dovish policies emanating from the Fed and the ECB. Inflows into EM are double levels from last year at this midpoint in the year, focused on bonds while equity inflows stay flat.
Year-to-date the JPMorgan Emerging Market Bond Index Global Diversified (EMBIG div) has returned 11.31 percent as of July 1, 2019. JPMorgan’s EM Equities index returned 10.78 percent in the same period. Good performance versus 2018 but still behind extraordinary S&P returns of 18.54 percent for the same period. There are a variety of other drivers that will affect EM as an asset class such as the US-Sino trade war and idiosyncratic stories but the global dovish sentiment, to which Brexit contributes, mitigates these concerns in the short term.
Is there more at risk for EU members and UK neighbors the Czech Republic, Poland, Hungary and Romania than other EM countries? There are several ways that these countries are likely to feel the effects of Brexit versus the general EM benefits. The economic challenges posed by Brexit may translate into the comparatively weaker market performance but it will need to be weighed up against worst stories in EM and the hunt for yield.
A weaker UK and a UK outside of the EU will likely demand fewer goods from CEE countries. After the Netherlands, the Czech Republic, Poland, and Hungary have the largest relative exposures to UK demand according to research by ING.
It is difficult to see a natural replacement for UK demand however the numbers are fairly small. The Czech Republic sends roughly 4 percent its exports to the UK followed by Hungary and Poland at roughly 3.2 percent and 2.5 percent respectively as per Eurostat.
Historically, remittances to the CEE from the UK played a larger part in the economic outlook than they do today.
Firstly there are limited concerns that those providing remittances will be forced to leave the UK after Brexit. Excluding Romania, the bulk of workers from the remaining CEE countries that are in the UK, have been here for a long enough time that there are expectations that they will be able to stay.
Secondly, there has been a decline in remittances sent to the Czech Republic, Poland, and Hungary since mid-2018. Romania presents a different picture in that Romanian arrivals to the UK are more recent so there are concerns they might not be able to stay under the same agreements as before Brexit. Additionally, the level of remittances is higher and shows no decline. Romanian workers are also in Germany, Spain, and Italy as well so any Brexit-specific threat to the level of flow is also mitigated by that diversity.
However, where there may be a bigger shift post-Brexit is in the size and allocation to CEE countries of funds from the EU’s structural funds.
This could be meaningful given the size of funds distributed to the CEE region. According to a 2018 report by the European Bank for Reconstruction and Development (EBRD), unless other member states increased their contributions to the EU, Brexit would lead to a 10 to 15 percent decline in structural and accession funds available to countries in central and south-eastern Europe, amounting to a reduction of up to 0.4 percentage points of GDP in EU-supported investment.