Uncertainty about the impact of Brexit on financial assets would continue to fuel volatility and cause a sharp depreciation in the pound. It not only cast a pall on UK and EU economy but also its political leadership.

Though the process to exit the EU will take at least two years, the short term impact is negative to the financial markets globally boosting demand for safe havens (USD, government bonds, gold, etc).

It’s hard to gauge the direct impact of Brexit on the Malaysian economy but suffice to reiterate that via trade links the impact is minimal given shrinking share of exports to UK and EU over the past decade.

Malaysia has the policy flexibility to deal with the market volatility and weak global demand. BNM still has room to cut interest rates to boost the economy or curtail short term capital inflows seeking higher yields. Raising public spending could be another option or a last resort if matters gets worse.

A disruptive surprise. The reaction by the financial market following the startling decision by Britons to exit the European Union last Friday was purely out of fear of its consequence. It could prove to be disruptive and trigger a contagion effect that may result in other EU members replicating Brexit. Already the National Front in France is calling for a “Frexit” referendum and the Party for Freedom in the Netherlands calling for a “Nexit.” That fear was paramount in financial markets on June 24, with exaggerated reactions in currencies, bond, and stocks markets globally.

Populists rein. Prior to June 23 voting, the odds of winning were almost equal between those who wanted UK to leave the EU and those who wanted to stay. But it turns out that the Leave camp got the majority votes to leave the common market with 17.4 million votes, or 52%, versus the Remain side’s 16.1 million, or 48%. The voter turnout was relatively large at 72%. England and Wales brought in the winning votes which were enough to trounced Remain’s stronghold in Scotland, Northern Ireland and London.

Deep divides. Not only that the decisive victory by the “Leave” campaign exposed deep old divides between Scotland and England but also between liberals and conservatives, young versus old, and urban versus rural. Once the Brexiteers begin to implement its nationalistic agenda it will step away from the multiculturalism that has made Britain among Europe’s most vibrant and tolerant societies.

Future in doubt. With the Brexit win it seems that the future of Britain’s leadership and its economy is cast in doubt. Prime Minister David Cameron’s decision to resign before enacting Article 50 of the Lisbon Treaty, which sets out how a country could leave the EU, may have much bigger implications. In effect, Cameron has handed the next UK prime minister a poisoned chalice. In other words despite the fact that the Brexit camp may have won the referendum, if its leaders decide to sign Article 50 it will be seen to be condemning the UK economy to recession, cause further breakup and years of pain.

Losing benefits. The impact of Brexit that would be felt most is on the terms of trade whereby Britain will lose automatic access to the European single market. This would also apply on immigration, with Britain no longer bound to allow any EU citizen to live and work in the country. Therefore, Britain will have to negotiate new deals covering those issues which may take years to be ratified and agreed on. This would have a devastating impact as the EU is Britain's biggest trading partner. About 70% of Britain's largest import and export markets are with fellow EU members. A key goal of the EU was to allow freer movements of goods, services, and people across countries. The potential economic benefits of such freedom are well known. Access to a broader market means both buyers and sellers can secure better deals than would be available domestically. Relocation of workers to a place where they can be more productive should mean a larger size for the total economic pie.

Flight to safety. Though the process to exit the EU will take at least two years, the short term impact is negative to the financial markets globally boosting demand for safe havens (USD, government bonds, gold, etc). As a result the uncertainty about the economic costs of Brexit would lead to continued selldown in UK assets and a sharp depreciation in the pound. This would have a significant impact on the UK economy as it is highly dependent on the financial services industry as well as exports. The current political leadership issue would further exacerbate the downside on the pound. Currency fluctuations and declines would continue for the next couple of weeks. Judging by the shocking initial impact of the referendum it would not be a surprise to see a sharp depreciation of the pound against the US dollar and the euro. The depreciation could be more pronounced against currencies with higher yielding assets such as Malaysia which saw the ringgit appreciate by about 11.8% year-to-date against the pound (See Graph 1). We still see further downside to the pound this year with the GBPMYR testing the 5.50 level in the next few weeks from 5.64 on June 27. The pair was around 6.33 at the beginning of the year.

Weakening trade links. Evidently, it’s difficult to measure the direct impact of Brexit on the Malaysian economy. The best way would be to see how bilateral trade links in terms of share of exports to Britain fare over the past decade or more. The average share of exports to UK in the first four months of this year is just a mere 1.1% of total exports from 3.1% back in 2000. Meanwhile share of exports to EU excluding UK in the same period of this year is 9.1% compared to 10.9% in 2000 (Graph 2). It shows that while exports shipment to UK has dwindled substantially, shipments to the EU has only change slightly. Hence, judging by this trend the direct impact on Malaysia’s economy as a result of any shortfall from demand from UK is not as significant compared to any decline in demand from the EU.

Limited tools. Meanwhile, many major central banks now have limited policy options to deal with new financial turmoil. The implication of Brexit on the financial market only adds to the enormous policy burden that has seen them experimenting with new policy measures the latest being the negative nominal interest rates. In the process, they may be losing policy flexibility and worst put their effectiveness and credibility at risk. Judging by the current turmoil in the form of Brexit we believe that market has yet to entirely understand what is happening and how to deal with it. Lacking in creativity and resolve many central banks are prompted to provide more liquidity to continue supporting the financial market and the economy. Such would be a formula for bigger financial burden in the future and would not entirely solve the growing financial problem.

Policy flexibility. Currently Malaysia has the policy flexibility to deal with the market volatility and weak global demand. We believe that Bank Negara Malaysia (BNM) still has room to cut interest rates to boost the economy or curtail short term capital inflows seeking higher yields. Based on our recent study we concluded that BNM still has room to cut the Overnight Policy Rate by as much as 50 basis points from 3.25% if the situation warranted i.e. if GDP growth dip below 4.0%. Plus, the rate of inflation is justifiably low (2.0% in May) offering added support for easing if needed. Comparatively the Benchmark 10-year Malaysia Government Securities (MGS) yield is relatively higher than most government bonds and price has remained relatively stable amid the current global financial turmoil. The gap between the MGS and the US Treasury is slightly higher than 200 bps. In addition we also believe that the government would be able to raise public spending in order to support the economy without the risk of further widening its fiscal deficit given that oil prices has stabilised above US$40-45 per barrel.

Source: Kenanga Research - 27 Jun 2016