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UK Economic Outlook

November 2016

Special features on:• UK economic prospects after Brexit

• OutlookforthepublicfinancesandoptionsfortheAutumnStatement

• UKtradeprospectsafterBrexit

Visit our blog for periodic updates at: pwc.blogs.com/economics_in_business

2 UK Economic Outlook November 2016

Contents

Section

1. Summary 4

2. UK economic prospects after Brexit 7

• 2.1RecentdevelopmentsandtheimmediateimpactofBrexit 8

• 2.2EconomicgrowthprospectsafterBrexit:national,sectoralandregional 10

• 2.3Outlookforinflationandrealearningsgrowth 15

• 2.4Monetaryandfiscalpolicyoptions 17

• 2.5Summaryandconclusions 17

3. OutlookforthepublicfinancesandoptionsfortheAutumnStatement 18

• Keypointsandintroduction 18

• 3.1OutlookforthepublicfinancesaftertheBrexitvote 19

• 3.2Possiblerevisionstofiscalrules 21

• 3.3 How much scope might the Chancellor have for higher public investment? 22

• 3.4OtherhighlevelpolicyoptionsfortheAutumnStatement 23

• 3.5Summaryandconclusions 24

4. UKtradeprospectsafterBrexit 25

• Keypointsandintroduction 25

• 4.1Worldtradehasbeensluggishsincethefinancialcrisis 26

• 4.2 Recent UK export performance 27

• 4.3ProspectsforUKtradeafterBrexit 29

• 4.4 Policy implications 31

• 4.5 Conclusion 32

Appendices

AOutlookfortheglobaleconomy 33

BUKeconomictrends:1979-2015 34

Contactsandservices 35

3UK Economic Outlook November 2016

Highlightsandkeymessagesforbusinessandpublicpolicy

Key projections

2016 2017

Real GDP growth 2.0% 1.2%

Consumer spending growth 2.9% 2.2%

Inflation (CPI) 0.6% 2.3%

Source: PwC main scenario projections

• UKeconomicgrowthheldupbetterthanexpectedfollowingtheBrexitvote,particularlyasregardsconsumerspendingandservices.For2016asawhole, growth now looks likely to be around2%.

• In our main scenario, we project UK growthtoslowtoaround1.2%in2017duetothedragoninvestmentfromincreasedpoliticalandeconomicuncertainty following the ‘Brexit’ vote. Butwedon’texpecttheUKtosuffera recession next year.

• WeexpecttheBankofEnglandtokeepmonetarypolicyonholdin the short term, looking through an expectedriseinheadlineinflationtowellaboveits2%targetratebylate2017astheeffectsofaweakerpoundfeedthroughtoconsumerprices.

• Themainreasonfortheslowdownwillbeadeclineinbusinessinvestment,driveninparticularbyuncertaintyabouttheUK’sfuturetradingrelationshipswith the EU in the longer term.

• Consumerspendinggrowthisprojectedtoholdupbetter,butwillstill slow from previous strong rates, droppingtoaround2%in2017in ourmainscenario.Thisreflectstheimpactofaweakerpoundinpushingupimportpricesandsqueezingtherealspendingpowerofhouseholds,aswellasexpectedslowerjobsgrowth.

• Theweakerpoundshouldalsoboostnetexports,however,whichshouldseetheUKcurrentaccountdeficitbegintoshrinkgraduallyfromrecent high levels.

• Service sector growth will slow butshouldremainpositivein2017,but construction will suffer from lower investmentlevels.Capitalgoodsmanufacturers will suffer for the same reason, but some manufacturing exporterswillbenefitfromtheweakerpound.

Public borrowing to overshoot OBR forecasts, but still scope for more investment

• In our main scenario we project that public borrowing will, in the absence of policy changes, be persistently higher than the OBR forecast back in March before the Brexit vote.

• In particular, we project a continuing budgetdeficitofaround£67billionthisyearfallingtoaround£18billionin2019/20onunchangedpoliciesratherthana£10billionbudgetsurplusin that year. In total, we project a cumulative borrowing overshoot of over£100billionby2020/21comparedto the OBR’s March forecasts.

• Thiswould,however,stillleavetheChancellorwithacurrentbudgetsurplus(excludingnetinvestment)ofaround£14billionin2019/20anditseemslikelythathewillwanttoaddtoplannedpublicinvestmentinpriorityareas such as housing, transport infrastructureandNHScapitalbudgetsinhisAutumnStatement.

UK trade prospects after Brexit: risks and opportunities

• The Brexit votes poses clear risks toBritain’stradingpositionwiththeEU, but there are also opportunities arising from the UK’s strength in tradableservicesanditsrelativelystrong performance in exporting tonon-EUcountriessince2007.

• The challenge for UK policymakers is to maximise these opportunities throughsecuringgoodaccesstotheSingle Market even if it is no longer a member;focusingontradepromotioninkeynon-EUmarketslikeNorthAmerica,Asia,theMiddleEastandAfricaratherthanwaitingforfreetradedealswiththeseregions;andboosting competitiveness by pursuing supplysidereformathomelinked toincreasedinvestmentinhousing,infrastructureandvocationalskills.

3


1 – Summary

RecentdevelopmentsTheUKeconomygrewbyjustover3% in 2014, the fastest rate seen since 2006, butthenslowedtoaround2%intheyeartoQ22016asglobalgrowthmoderated.PreliminarydataforthethirdquartersuggestthatUKgrowthheldupwell intheimmediateaftermathoftheEUreferendum,particularlyasregardsconsumerspendingandservices.

Thepoundstabilisedduringthesummerafter an initial sharp fall after the Brexit vote,butfellbackagaininOctoberduetoheightenedfearsthattheUKcouldsufferasignificantlossofaccesstotheEUSingleMarketafterBrexit.EquitypricesbouncedbackaftertheinitialshockoftheBrexitvote,however,andfinancialmarketsgenerallyremainedstablethroughthesummerandearlyautumn.Thehousingmarkethasalsoremainedreasonablyrobustoverthisperiod.

UKgrowthcontinuestobedriven by services, with manufacturing andconstructionbothseeingfallingoutputinthethirdquarter.

Therateofconsumerpriceinflation(CPI)haspickedupfromaroundzeroonaveragein2015to1%intheyeartoSeptember2016,ascommoditypriceshavepickedup somewhat from lows in early 2016 andtheeffectsofthepoundhavestartedtofeedthroughthesupplychain.

Table 1.1: Summary of UK economic prospects

Indicator (% change on previous year)

OBR forecasts (March 2016)

Independent forecasts (October 2016)

PwC Main scenario (November 2016)

2016 2017 2016 2017 2016 2017

GDP 2.0 2.2 1.9 1.0 2.0 1.2

Consumer spending 2.4 2.2 2.7 1.2 2.9 2.2

Investment 2.9 4.5 0.0 -2.1 1.1 0.0

Source: Office for Budget Responsibility (March 2016), Consensus Economics survey (average values in October 2016 survey) and latest PwC main scenario.

Future prospects

AsshowninTable1.1,ourmainscenarioisforUKGDPgrowthtodeclinefromaround2%in2016toaround1.2%in2017astheeffectsofthevotetoleavetheEUfeedthrough.Expectedgrowthnextyeariswelldownonpre-referendumforecasts,suchasthatbythe OBR in March, but similar to the latestaverageofindependentforecastsofaround1.9%in2016and1%in2017(seeTable1.1).

Thelargestshort-termeffectofthevoteto leave the EU is likely to be on investment growth, which we now expecttobepusheddowntoaroundzeroin2017.ThisreflectsmajorprojectsbeingdeferredorevencancelledduetouncertaintiessurroundingBrexit,particularly by foreign investors in commercialpropertyandinsectorsneedingguaranteedaccesstotheEUsingle market. These uncertainty effects shouldfadeeventually,butitwilltaketime before clarity emerges on future UK-EUtradingarrangements.Asdiscussedfurtherbelow,theoverallinvestmentfiguresinTable1.1alsoallow for some increase in public investmenttooffsettheexpecteddownturninbusinessinvestment.

Consumerspendinggrowth,bycontrast,isprojectedtoremainstrongerthanoverallGDPgrowthataround2.9%in2016and2.2%in2017,butisnonethelesslikely to slow next year as real income growthissqueezed(inpartduetotheweakerpoundpushingupimportprices)andthejobmarketweakens.

Thereshouldbesomepotentialoffsetfrom a positive contribution to GDP growthfromnettradenextyear,supportedbythefallinsterling. Thisshouldalsohelptoreducethe UKcurrentaccountdeficitsomewhatnext year. But this will fall some way short of fully offsetting the hit to domesticdemandgrowthin2017.

There are always uncertainties surroundingourgrowthprojectionsandtheseareparticularlymarkedfollowingthevotetoleavetheEU,asillustrated bythealternativescenariosinFigure1.1(all of which see some growth shortfall relative to our projections before the Brexitvote).Therearestillconsiderabledownsiderisksrelatingtointernationaldevelopments(includinguncertaintyabouttheeconomicandtradepolicies oftheincomingUSPresident)andthefallout from Brexit, but there are also upsidepossibilitiesiftheseproblems canbecontained.Inourmainscenario,weexpecttheUKtoavoidarecession,butbusinessesneedtomonitorandmake contingency plans for potential downsiderisks.


Public borrowing could overshoot by over £100 billion over the next five years, but there is still room for additional public investment if fiscal rules are revised

In Section 3 of the report, we present arevisedoutlookforthepublicfinancesfollowingtheBrexitvote.Wefindthat:

• In our main scenario we project that public borrowing will, in the absence of policy changes, be persistently higher than the OBR forecast back in March before the Brexit vote. In particular, we project a continuing budgetdeficitofaround£67billionthisyearfallingtoaround£18billionin2019/20onunchangedpolicies,ratherthana£10billionbudgetsurplus in that year. In total, we project a cumulative borrowing overshoot ofover£100billionby2020/21 ascomparedtotheOBR’sMarchforecasts(seeFigure1.2).

• Thiswould,however,stillleavetheChancellorwithacurrentbudgetsurplus(excludingnetinvestment) in2019/20anditseemslikelythathewillwanttoaddtoplannedpublicinvestment in priority areas such as housing, transport infrastructure andNHScapitalbudgetsinhisAutumnStatement.

• Assuminganadditional£20billion(c.1%ofGDP)ofnetpublicinvestmentspreadovertheperiodbetween2017/18and2019/20,weestimatethatthepublicdebttoGDPratiowouldstillbeonadownwardtrendfrom2018/19onwards,aswellasretainingacurrentbudgetsurplus ofaround£16billionin2019/20.ThiswouldmeetarevisedsetoffiscalrulesmoresimilartothoseinitiallyadoptedbyGeorgeOsbornein2010,asopposedtohislatermoreambitiousbudgetsurplustarget.

Figure 1.1 – Alternative UK GDP growth scenarios

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Main scenario Mild recession Early recoveryPre-Brexit scenario

Projections

Source: ONS, PwC

Figure 1.2 – Alternative public borrowing projections vs OBR's pre-Brexit forecasts (£bn)

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2020/212019/202018/192017/182016/172015/16

PwC - unchanged policiesPwC - higher investment OBR (March 2016)

PwC

OBR

Source:: ONS, OBR, PwC

• While the Chancellor may boost publicinvestment,hedoesnothavethemoneyforlargenettaxcutsandislikelytocontinuetobeardownonnon-investmentspendingbybothcentralandlocalgovernment.


UK trade prospects after Brexit

One of the most important potential impacts of the Brexit vote is on the UK’s longertermtraderelationshipsbothwiththeEUandothercountries.Oursenioreconomicadviser,AndrewSentance,looksindetailattheseimplicationsinSection 4 of this report.

ThebackgroundtothisisthatworldtradegrowthhasslowedrelativetoglobalGDPgrowthsincethefinancialcrisis(seeFigure1.3).Thisslowdown hasbeenexacerbatedrecentlybyweakergrowthinemergingmarketsandthecommoditytradecycle.

FocusingontheUK,itsrelativeexportperformancesince2007actuallyappearstohavebeenstrongeroutsidetheEUthan within the EU Single Market (seeFigure1.4).Thiscouldreflect anadvantagetoeuroareamembersfrom using a common currency or the inflexibilityoftradelinkedtoEuropeansupply chains. The UK also has a strong comparativeadvantageinservicestrade,whichisgrowingmorestronglygloballythantradeingoods.

Lookingahead,medium-termgrowthprospects remain strong in key emerging marketregions,includingAsia,AfricaandtheMiddleEast.Thatsuggeststhattherecentdownturnintradegrowthoutsidethedevelopedeconomiesshouldprovetemporary,andthatUKexportgrowthtomarketsoutsidetheEU shouldsoonresumemomentum.

In this context, the key policy priorities forimprovingUKtradeprospectsafterBrexitshouldbe:securingthebestpossible access to the Single Market; aprogrammeoftradepromotioninnon-EUmarkets;supply-sidereform;andactiveengagementwithother major international institutions – includingtheWorldTradeOrganisation.

Figure 1.4 – UK relative trade performance since 2007

Intra-EUWorld Extra-EU

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oods

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Source: PwC calculations based on data from World Trade Organisation and ONS

Note*: UK total exports relative to total world imports and UK intra-EU and extra-=EU exports relative to EU totals

Figure 1.3 – World GDP and trade growth

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Source: IMF World Economic Outlook, October 2016


2 – UK Economic prospects after Brexit

Key points• UKeconomicgrowthheldsteadyatjustover2%intheyeartoQ32016,withnoimmediatemarkeddecelerationafterthe‘Brexit’vote.

• In our main scenario, we now project UKgrowthtoslowfromaround2%in2016toaround1.2%in2017duetotheincreasedpoliticalandeconomicuncertainty following the Brexit vote.TheUKwouldavoidrecessionin this scenario, although risks to growtharestillweightedsomewhattothedownside.Businessesneedtomake contingency plans for these alternative outcomes.

• Themainreasonfortheprojectedslowdownisanexpecteddeclineinbusiness investment, particularly from overseas in areas like commercial property,duetouncertaintyabouttheUK’sfuturetradingrelationshipswiththeEUandotherkeytradingpartners.

• Consumerspendinggrowthisprojectedtoholdupbetter,butwillstill slow from previous strong rates, droppingtojustover2%in2017inourmainscenario.However,wedonotexpectasgreatadropasinitiallyfearedimmediatelyafterthereferendum.

• Thepoundhasfallentohistoriclowsonatrade-weightedbasis,whichwillpushupimportpricesandsqueezetherealspendingpowerofhouseholds.

• Theweakerpoundshouldalsoboostnetexports,however,andhelptoreducetheUKcurrentaccountdeficitgraduallyfromrecenthighlevels.

• We expect growth in the service sector toslowbutremainpositivein2016-17.The construction sector will suffer the most from lower investment levels andcapitalgoodsmanufacturerswillalso be hit, but some manufacturing exportersshouldbenefitfromtheweakerpound.

• WeprojectthatLondonwillremainthe fastest growing region but its pace ofexpansioncouldslowsignificantlyfromaround3%in2015toaround1.7%in2017.Otherregionswillseemoremodestgrowthin2017,closerto1%,butwedonotpredictnegativegrowthinanyregionin2017inourmain scenario.

• TheBankofEnglandhasalreadyloosenedmonetarypolicyandwewouldalsoexpectfiscalpolicytobereasonably supportive, with public borrowingallowedtorisetotake thestrainofslowergrowthandincreasedpublicinvestmentonhousingandtransport.

IntroductionInthissectionofthereportwedescriberecentdevelopmentsintheUKeconomyandreviewfutureprospects.Thediscussioncovers:

Section2.1 Recentdevelopmentsandtheinitialimpact of Brexit

Section 2.2 Economic growth prospects after Brexit: national,sectoralandregional

Section2.3 Outlookforinflationandreal earnings growth

Section2.4 Monetaryandfiscalpolicy options

Section2.5 Summaryandconclusions.


Figure 2.2 – Purchasing Managers’ Indices of business activity

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2016Jan

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Services Manufacturing

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ManufacturingAbove 50 indicates rising activity levels

Source: Markit/CIPS

2.1-Recentdevelopmentsandtheimmediateimpact of Brexit

UKeconomicgrowthslowedfromaround3%in2014tojustover2%intheyeartoQ32016.Thisslowdownreflectssluggishglobal growth as well as, more recently, uncertainty following the vote for the UK toexittheEuropeanUnion(‘Brexit’).

Thegeneralpattern,asshowninFigure2.1, was for services sector growth to remain relatively strong, while growth in manufacturinghasstalledandgrowthinconstruction has been volatile in 2015 and2016sofar.However,thepurchasingmanagers’indices(PMIs)forservices andmanufacturinghavebothseenimpressiverecoveriesfromtheimmediatepost-referendumshockseeninJuly (seeFigure2.2).TheconstructionPMIalsostrengthenedinSeptemberandOctoberafterdroppingbacksharply inJulyandAugust.

ConsumerconfidencealsosufferedadipimmediatelyafterthereferenduminJuly,withthenetbalanceaccordingtoPwC’sregularsurvey(seeFigure2.3)fallingto-8%,thefirstnegativereadingfor almost a year. However, consumer confidencethenbouncedbackstronglyinSeptemberastheimmediateshockoftheBrexitvotefaded.ThishasalsobeenreflectedinrelativelystrongretailsalesfiguresbetweenJulyandSeptember,withthethirdquarterasawholeseeingsalesvolumegrowthof1.8%comparedtothesecondquarter.

Figure 2.1 – Sectoral output and GDP trends

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Source: ONS

Figure 2.3 – Consumer confidence: net balance expecting rise in household disposable income over next year

Balance of opinion

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Source: PwC Consumer Survey


FollowingthevotetoleavetheEU, thepoundhascontinuedtofallinvalueagainstboththedollarandtheeuro (seeFigure2.4).Theannouncement by the Prime Minister in early October thatsheintendedtotriggerArticle50 byMarch20171andconcernsaboutapossible‘hardBrexit’promptedafurtherfallinthevalueofthepoundtoitslowestlevelagainstthedollarfor31yearsandnearrecordlowsagainsttheeuro.Intrade-weightedterms,theBankofEnglandestimatedthatsterlinghadfallen by late October to its lowest ever level,basedondatagoingbacktothemid-19thCentury.

TheweakerpoundwillhelpUKexporters(includingtouristflowsintotheUK), butwilltendtopushupimportprices,whichwillultimatelyfeedthroughintoasqueezeonconsumerstogetherwithother factors such as the rise in global commoditypricesfromtheirlowsinearly2016.Theriseinheadlineconsumerpriceinflationto1%inSeptemberwasan early harbinger of these likely future trends,aswediscussfurtherinSection2.3 below.

TheFTSE100reachedrecordhighsinearlyOctoberbeforefallingbacktowardstheendofthemonth(Figure2.5). TheupwardmovementintheFTSE100sincethereferendumhasbeenheavilyinfluencedbythesharpdeclineinthevalueofthepoundsincemanyofthecompaniesmakinguptheindexmaketheirprofitsabroad.

fromthefallinthepound.Bothoftheseindices,however,wouldbedownonpre-referendumlevelsifmeasuredinUSdollarterms,whichemphasisesthatthisis more of an exchange rate effect than asignofstrongerunderlyingcorporateearnings growth potential.

LikewisetheFTSE250alsoreached arecordhighduringOctoberbeforefalling back later in the month. This was underscoredbythefactthetopsixbiggestrisersontheFTSE250intheyeartoOctoberwereoverseas-basedcommoditiescompanies,whichhavebenefittedgreatly

Figure 2.5 – UK equity market indices

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Source: Thomson Reuters Datastream

Figure 2.4 – US dollar and euro exchange rates against the pound

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Sources: Bank of England

1 SubjecttoanydelaysduetothepotentialneedforavotebyParliamentbeforethetriggeringofArticle50,followingtheHighCourtjudgementon3rdNovember(subjecttoappealatthetimeofwriting)thatthiswouldberequired.


Table 2.1 - PwC main scenario for UK growth and inflation

% real annual growth unless stated otherwise

2015 2016p 2017p

GDP 2.2% 2.0% 1.2%

Consumer spending 2.6% 2.9% 2.2%

Government consumption 1.5% 1.2% 0.7%

Fixed investment 3.4% 1.1% 0.0%

Domestic demand 2.5% 2.1% 1.4%

Net exports (% of GDP) -0.4% -0.4% -0.3%

CPI inflation (%: annual average) 0.0% 0.6% 2.3%

Source: ONS for 2015, PwC main scenario projections for 2016-17

2.2 - Economic growth prospects after Brexit: national,sectoralandregional

WehavecontinuedtoreviseourgrowthprojectionsfortheUKbasedontheeconomicdatathathasbeenreleasedsince the vote to leave the European Union. They remain some way below our pre-referendumviewfor2017,buthavemovedupsinceourlastUKEconomicOutlookreportinJulyfrom0.6%to1.2%.Thisreflectstherelativelyencouraging economic news that has emergedoverthesummerandearlyautumn such as strong retail sales, house priceandemploymentfiguresandasolid0.5%riseinGDPinQ32016.Countertothisisthedramaticfallinthepoundandanincreasetoinflationthatcouldslowdomesticdemandnextyear.Takingallofthesefactorsintoaccountproducesthe average annual growth rates shown in Table 2.1 for our main scenario.

Overall, we expect growth to remain positiveonaveragein2017,withtheeconomyavoidingrecessionandstartingtorecoverlaterin2017.

We assume here that monetary policy remains on current supportive settings (asdiscussedfurtherinSection2.4below)andthatpublicborrowingisallowedtoriseintheshorttermtoabsorb some of the impact of slower growth(asdiscussedindetailinSection3ofthisreport).Wealsoassumethatsomeprogressismadeduring2017onnegotiations with the EU that mitigate fearsofa‘hardBrexit’wheretheUKhasto revert to WTO rules after leaving the EU in early 2019.

Consumerspendinggrowthremainedstronginthefirstninemonthsof2016,andweexpecttheaveragegrowthratefortheyeartobearound2.9%.For2017,however,weexpectconsumerspendingtofeeltheeffectsofaweakerpound,higherimportpricesandweakerjobsgrowth,sothatannualrealspendinggrowthwillmoderatetoaround2.2%next year.

ThemaindragonGDPgrowthwillcomefrom business investment, however, which seems likely to remain fragile as negotiations as to the exact nature of theUK’sexitcontinueduring2017-18.This will be particularly true of foreign investmentincommercialpropertyandinsectorsaimedataccessingtheEUsinglemarketincludingmanufacturingexports(e.g.automotive)andfinancialservices.WhileweassumesomekindoffreetradeagreementwilleventuallybereachedwiththeEU,thiswilltaketimeand (giventheneedtoincreasecontroloverimmigration)willalmostcertainlyinvolvesomereductioninaccesstotheEUsinglemarket relative to the current position. Eveniftariffsongoodsarelargelyavoided,non-tariffbarriersarelikely toincreaseforbothgoodsandservices.

Government consumption growth will belessaffectedthanbusinessinvestment,butislikelytoremainmoderateinlinewithpreviouslyannouncedplans.Publicsectorinvestmentcouldbeboostedoverthenextfewyears,however,asdiscussedinmoredetailinSection3,whichwouldprovidesomesupporttoGDPgrowthin2017andpartlyoffsettheexpectedweakness in private investment.

UK net exports may move in a more favourabledirection,makingalessnegative contribution to GDP growth in 2017asimportdemandweakensandthefallinthepoundhelpsexportsandimportsubstitutes to become more competitive. Thisshouldalsohelptomoderatethelargecurrentaccountdeficit,whichhelpsto explain the recent weakness of sterling.

Overall,ourgrowthprojectionsarebroadlysimilartothelatestaverageofindependentforecasters, which see UK growth falling toaround1%in2017.Butalleconomicprojections are subject to particularly large uncertainties at present after the shock of the Brexit vote.


Alternative growth scenarios – businesses need to make contingency plans

Toreflecttheseuncertainties,wehavealsoconsideredtwoalternativeUKgrowthscenarios,asshowninFigure2.6.

• Our ‘early recovery’ scenario projectsgrowthtodipinthenextfewquartersbeforepickingupagaintoaround2%onaveragein2017.This is a relatively optimistic scenariowhichassumesthatgoodearlyprogressismadeinUK-EUnegotiationstowardsretainingtariff-freeaccesstotheEUsinglemarketandthattherearerelativelyfavourabletrendsinUSandeuroarea growth over the next year.

• Ontheotherhand,our‘mild recession scenario’ sees UK GDP growth fall into negative territory later in2017astheglobaloutlookworsensandthereislittleprogressinearlynegotiations with the EU, suggesting that the UK may have to fall back onWTOruleswithconsequentimpositionoftariffsontradewith theEU.ThiswoulddeepenandprolongtheperiodofuncertaintyaroundtheoutcomeofBrexit,reducinginvestment,jobsandgrowth.Eveninthisdownsidecase,however, we are only projecting a mildtechnicalrecession,notthedeepdownturnseenaftertheglobalfinancialcrisis,whenUKGDPfellbyaround6%frompeaktotrough.

Figure 2.6 – Alternative UK GDP growth scenarios

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Source: ONS, PwC scenarios

Wedonotbelievethatthesetwoalternative scenarios are the most likely outcome, but they are certainly possible and,atpresent,riskstogrowthstillappeartobeweightedsomewhatto thedownsidegiventhepoliticalandeconomicuncertaintiesposedbythe EUreferendumresult.Uncertaintyabouttheeconomicandtradepolicies oftheincomingUSPresidentcould also be a source of volatility over the coming months.

Businesseswouldthereforebewelladvisedtomakeappropriatecontingencyplans for such less favourable outcomes, but without losing sight of the more positive possibilities for the UK economy shouldthesedownsiderisksnotmaterialise.Lookingfurtherahead,thesealsoincludethescopeforlongertermtradeexpansionwithnon-EUtradingpartnerslikeChinaandIndia, asdiscussedfurtherinSection4of this report.

Moregenerally,companiesshouldconsidermakingdetailedcontingencyplansfortheimmediateimpactofBrexit2 on all aspects of their businesses, coveringthekindofquestionslisted in Table 2.2.

2 FormorematerialonthepotentialimpactofBrexitonyourbusiness,pleaseseeourEUReferendumhubhere:http://www.pwc.co.uk/the-eu-referendum.html


Table 2.2: Key issues and questions for businesses preparing for Brexit

Issues Implications Questions

Trade The EU is the UK’s largest export partner, accounting for around 45% of total UK exports – leaving the EU is likely to make trade with EU more difficult.

• How much do you rely on European countries for revenue growth?

• Have you reviewed your supply chain to identify the impact of tariffs on your procurement?

• Have you identified which third party contracts would require a renegotiation in the event of a Brexit?

Tax Contributions

The UK would no longer be required to make a financial contribution to the EU and would gain more control over VAT and some other taxes.

• Have you thought about the impact of potential changes to the EU tax framework?

• Have you upgraded your systems to deal with a significant volume of tax changes?

Regulation The UK is subject to EU regulation. Brexit may mean less red tape. It could also mean that UK businesses could have to adapt to a different set of regulations, which could be costly.

• Have you quantified the regulatory impact of Brexit to keep your stakeholders up-to-date?

• How flexible is your IT infrastructure to deal with potential changes to Data Protection laws?

• How ready is your compliance function to deal with potentially new reporting requirements arising from Brexit?

Sectoral effects

The UK is the leading European financial services hub, which is a sector that could be significantly affected by Brexit. Other sectors which rely on the EU single market will also feel a strong impact.

• Have you briefed potential investors on the impact of Brexit for your sector and organisation?

• How up-to-date are your contingency plans in place to deal with Brexit?

• Are you aware of the impact of illiquidity and volatility in financial markets on your capital raising plans?

Foreign direct investment

FDI from the EU made up around 46% of the total stock of FDI in the UK in 2013. Brexit could put this inbound investment at risk.

• How much do you rely on FDI for growth?

• Have you considered alternative sources of funding aside from banks?

• How are your competitors responding to the risk of Brexit?

• Have you informed your investors on your plans for a post-Brexit UK?

Labour market

The UK may change its migration policies. Currently EU citizens can live and work in the UK without restrictions. Businesses will need to adjust to any change in this regime.

• How reliant is your value chain on EU labour?

• Have you communicated with your UK employees from elsewhere in the EU?

• Has your compliance function considered the additional cost of hiring EU labour?

Uncertainty Uncertainty has increased since the referendum and may continue into the negotiation period.

• Can you manage volatility in the Sterling exchange rate?

• Have you communicated your stance on Brexit to your key stakeholders, customers and suppliers?

• Is your organisation ready for a worst-case scenario where there is a prolonged period of uncertainty?

Source: PwC assessment


Table 2.3: UK sector dashboard

Growth

Sector and GVA share 2015 2016 2017 Key issues/trends

Manufacturing (10%) 0% 0.2% -0.4% Manufacturing PMI reached its highest level for over two years in September, before falling back slightly in October

Capital goods manufacturers vulnerable to a fall in investment after vote to leave EU

But exporters should gain from weaker pound, limiting the fall in total output

Construction (6%) 4.9% -0.1% -2.2% The construction sector saw negative growth in the third quarter according to official data, but the October PMI survey was somewhat stronger after falling sharply in July and August following the referendum

Our projections reflect the high vulnerability of construction projects to delay or cancellation after the Brexit vote

Distribution, hotels & restaurants (14%)

4.6% 4.8% 2.3% ONS figures show that there was no change in retail sales volume between August and September though there was growth of 4.1% compared to September 2015.

A weaker pound could hit real spending by domestic consumers as import prices rise, but tourists to the UK will benefit from the weak pound and could spend more here as a result.

Business services and finance (32%) 2.6% 2.4% 1.6% The financial sector remains particularly concerned about the possible implications of Brexit, especially if a “hard Brexit” occurs with the loss of passporting rights.

Some banks may be preparing to relocate some functions abroad as early as 2017 according to the British Bankers’ Association, although it remains to be seen how large any such moves will be.

Government and other services (23%) 0.5% 1.6% 0.8% The new Chancellor has abandoned George Osborne’s commitment to balance the budget by 2020 and announced some new infrastructure investments, but public services are likely to continue to face real-term cuts for the next few years.

Total GDP 2.2% 2.0% 1.2%

Sources: ONS for 2015, PwC for 2016 and 2017 main scenario projections and key issues. These are five of the largest sectors but they do not cover the whole economy - their GVA shares only sum to around 85% rather than 100%.

3 ThepotentialimpactofBrexitonfinancialserviceswasconsideredindetailinourApril2016reportforTheCityUK,whichcanbeaccessedhere: http://www.pwc.co.uk/industries/financial-services/insights/leaving-the-EU-implications-for-the-UK-financial-services-sector.html

Construction hardest hit, but all sectors likely to slow due to Brexit

ThesectordashboardinTable2.3showsthe actual growth rates for 2015 along withourprojectedgrowthratesfor2016and2017forfiveofthelargestsectorswithin the UK economy. The table also includesasummaryofthekeyissuesaffecting each sector.

The outlook is clearly stronger for privatenon-financialservicesthanothersectors, but all are likely to be negatively affectedbyleavingtheEU.

Constructionmaybehardesthitduetoitsreliance on large scale capital investment projects that may be particularly prone tobedelayedorevencancelledduetouncertainty following the vote to leave

the EU. Commercial property is also beinghithard,particularlyinLondon.Manufacturersofcapitalgoodsmay alsobehardhitforthesamereasons,although some exporters will gain fromtheweakerpound.Financialservicescompaniescouldalsobeaffectedbyanyloss of access to EU markets, notably through the possible loss of ‘passporting’ rightsforUK-basedfirms3.


Figure 2.7 – PwC main scenario for output growth by region in 2016-17

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Regional prospects: all parts of the UK likely to see slower growth due to Brexit, but none should fall into recession in 2017

Londonisexpectedtocontinuetoleadthe regional growth rankings in 2016, expandingbyaround2.6%asshown inFigure2.7.MostotherregionsareexpectedtoexpandatratesclosertotheUKaverageofaround2%,butNorthernIrelandisexpectedtolagbehindsomewhatwithgrowthofaround1.4%.

Growthisexpectedtodecelerateinallregionsin2017astheUKbeginstofeelthe effects of the vote to leave the EU. Wedonothoweverprojectnegativegrowthin any region in our main scenario. GrowthinLondonmightfalltoaround1.7%in2017,whileoncemoreNorthernIrelandwilllagbehindtherestofthe UKataround0.6%.


Figure 2.8 – PwC main scenario for employment growth by region in 2016-17

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Source: PwC analysis

In terms of employment growth, we also expectLondontoleadthewayin2016withgrowthof2.1%closelyfollowed byYorkshireandHumbersidewith2%growth.In2017,weexpectabroadlysimilarstory.Scotlandcouldlagbehindhere, with negative jobs growth in 2016-17.Thisreflectsthefactthat,although the unemployment rate in Scotlandisfalling,thenumberof“economically inactive” people is rising, particularly for women. This is in contrast to the rest of the UK, where the number of people active in the labour force is rising. However,wedoexpectsome‘reversionto the mean’ for Scottish employment growthin2017,eventhoughitremainsslower than elsewhere in the UK (seeFigure2.8).

It is important to note that regional output dataarepublishedonamuchlesstimelybasisthannationaldata,whileregionalemploymentdataaremoretimelybutsometimesbasedonsurveyswithrelativelysmallsamplesizes.Asaresult,themarginsoferroraroundtheseregionaloutputandemploymentprojectionsareeven larger than for the national growth projections, so they can only be taken as illustrativeofbroaddirectionaltrends.

2.3-Outlookforinflationandrealearningsgrowth

Consumerpriceinflation(CPI)pickedupfrom0.6%inAugustto1%intheyeartoSeptember. Higher import prices are beginningtofeedthroughtoconsumersbecauseofthefallinsterlingsinceJuneas a result of the vote to leave the EU. Thisrisecouldbeseentobejustthetip ofaninflationaryicebergcomingtheUK’s way. Since late September, sterling hasfallenfurtheragainsttheeuroanddollarandthiswillcontinuetopushupinflationinthemonthsahead.Furthertothis, an increase in oil prices since their low point in early 2016 will push up costs forenergyandtransport,helpingpushinflationhigher(thoughoilpricesremainalongwaybelowmid-2014peaks).

Overthecourseof2017wethereforeexpectCPIinflationtoriseabovetheBankofEngland’s2%targetrate.Thiswillsqueezerealhouseholdspendingpowerandaddtotheslowdownintheeconomyin2017.


Alternative inflation scenarios

In our main scenario we are projecting anaverageconsumerpriceinflationrateof0.6%in2016and2.3%in2017,whichwehaverevisedupsinceourlastUKEconomic Outlook report in the face oftherecentweaknessofthepound. Bythefourthquarterof2017,inflationcouldaveragearound2.7%,wellabovetheBankofEngland’s2%targetrate(seeFigure2.9).

Thereisconsiderableuncertaintyoverhowfarandfastinflationwillrise,however,andwethereforealsopresenttwo alternative scenarios for UK inflationinFigure2.9:

• In our ‘high inflation’ scenario weprojectinflationtorisetoaround4%bytheendof2017asaresultofpotentialfurtherfallsinthepoundandapossiblepick-upinglobalcommoditypricesifothereconomiesgrowmorestronglyand/oroilsupplyisconstrainedbyproducers.

• In our ‘low inflation’ scenario, bycontrast,theUKandEurozoneeconomies weaken by more than expectedinourmainscenariointheaftermath of Brexit, while global commoditypricesalsofallbacknextyear.Inthiscase,UKinflationcouldremainatonlyaround1%onaveragein2017.

AswithourGDPgrowthscenarios,thesetwo alternative variants are not as likely as our main scenario. But given recent volatilityanduncertainty,businessesshouldplanforabroadrangeofoutcomesafterBrexitandriskstoUKinflationdoseemtobeweightedtotheupsideatpresent(incontrasttoriskstoreal GDP growth, which we think are still weightedsomewhattothedownside).

Consumerpriceinflationexceededearnings growth for six consecutive yearsfollowingtheonsetofthe2008-9recession,whichwasinmarkedcontrast

topre-crisisnorms.Positiverealearningsgrowthresumedin2015and2016asconsumerpriceinflationfell toclosetozero,butnominalearningsgrowth in cash terms was still only around2%,whichremainsweakbyhistoricalstandards.

Wehadbeenassumingagradualpick-upinearningsgrowthin2016-17,but this is now much less clear after the votetoleavetheEU.Ontheonehand,higherconsumerpriceinflationduetotheweakerpoundcouldfeedthrough

into higher nominal earnings growth, butontheotherhandthiscouldbeoffsetbyweakereconomicgrowthandsolabourdemandafterBrexit.Balancingthese two effects, our preliminary projection is that earnings growth remainsfairlyflatin2016-17atjustover2%incashterms,withrealearningsgrowthdecliningslightlyin2016andfallingbacktoaroundzeroin2017. Butthereareconsiderableuncertaintiesaroundanysuchprojectionsatpresent.

Figure 2.10 – CPI inflation vs average earnings growth

Source: ONS, PwC analysis

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Figure 2.9 – Alternative UK inflation (CPI) scenarios

Source: ONS, PwC scenarios

Projections

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2.4-Monetaryandfiscalpolicy options

TheMonetaryPolicyCommittee(MPC)cutinterestratesinAugustandannouncedanexpansionofitsassetpurchase(QE)schemeby£60bnforUKgovernmentbondsandupto£10bnforhighqualitycorporatebonds.Monetarypolicyhasremainedonholdsincethen.

The impact of the cut in interest rates maybelimitedwithsavingsratesalreadynear-zeroandborrowingcostsforbusinessandhomeownersalreadyverylowbyhistoricalstandards.Furthermore,monetarypolicymaynotbethemostappropriatetooltoaddresstheuncertaintycreatedbytheBrexitreferendumresult.Therearesomecircumstances when a central bank candolittletooffsettheshocktotheeconomyandtheresultinguncertainty,andthatmaybethecasenow.

AsdiscussedfurtherinSection3, we therefore expect the focus to switch tofiscalpolicytosupportgrowthoverthe next few years, in particular through increasedpublicinvestmentinhousingandtransportinfrastructure.Butthecontinuinghighbudgetdeficitdoesputsome limits on how far the Chancellor cangoonthisintheAutumnStatement.

2.5-Summaryandconclusions

UKeconomicgrowthremainedrelativelystronginthesecondquarterof2016,increasingby0.7%,beforemoderatingtoastillsolid0.5%inthethirdquarter.Therehascertainlybeennoimmediatecollapse in the UK economy following theBrexitvote.However,wedoexpectthistoleadtoamoresignificantslowdownintheUKeconomyin2017asnegotiationswiththeEUgetunderway.

In our main scenario, we therefore project UKgrowthtofallfromaround2%in2016toaround1.2%in2017,althoughthiswouldbeaslowdownratherthanarecession. This takes into account the BankofEngland’smonetarylooseningannouncedinAugustandalsosomeexpectedboosttopublicinvestmentintheAutumnStatement.Italsoassumesnomajornewadverseshockstotheglobal or EU economies.

ThemainreasonforthissignificantslowdowninUKgrowthisprojectedtobeadownturninbusinessinvestmentdrivenbytheuncertaintysurroundingthenegotiationstoleavetheEUandtowhatextent the UK will retain access to the EU Single Market. This will particularly hit the construction, commercial property andcapitalgoodssectors,andpotentiallyalsopartsoffinancialservices.

Consumerspendinggrowthisalsoprojectedtoslowtoaround2%in2017fromjustunder3%in2016,reflectingslower real average earnings growth (partlyduetohigherimportpricesand aconsequentriseinheadlineconsumerpriceinflationtowellaboveits2%targetbytheendof2017)andanexpecteddecelerationinUKjobsgrowthfromtherapidpaceofrecentyears.Butsomewhatstrongernetexports,helpedbytheweakerpound,shoulddampenthescaleofthefall in overall GDP growth next year.

Thereareconsiderableuncertaintiesaroundanysuchprojectionsatpresent,however,sobusinessesshouldstresstesttheirbusinessandinvestmentplansagainst alternative economic scenarios andalsoreviewthepotentialwiderimplications of Brexit for their operations.


3–Outlookforthepublicfinancesand optionsfortheAutumnStatement

Key points• In our main scenario we project that

public borrowing will, in the absence of policy changes, be persistently higher than the OBR forecast back in March before the Brexit vote.

• In particular, we project a continuing budgetdeficitofaround£67billionthisyear,fallingtoaround£18billionin2019/20onunchangedpoliciesratherthana£10billionbudgetsurplusinthatyear.Intotal,we project a cumulative public borrowingovershootofover£100billionby2020/21comparedtotheOBR’s March forecasts.

• Thiswould,however,stillleavetheChancellorwithacurrentbudgetsurplus(excludingnetinvestment) in2019/20anditseemslikelythathewillwanttoaddtoplannedpublicinvestment in priority areas such as housing, transport infrastructure andNHScapitalbudgetsinhisAutumnStatement.

• Assuminganadditional£20billion(c.1%ofGDP)ofnetpublicinvestmentspreadovertheperiodbetween2017/18and2019/20,weestimatethatthepublicdebttoGDPratiowouldstillbeonadownwardtrendfrom2018/19onwards,aswellasretainingacurrentbudgetsurplusofaround£16billionin2019/20.Thiswouldmeetarevised,moreflexiblesetoffiscalrules more similar to those initially adoptedbyGeorgeOsbornein2010,asopposedtohislatermoreambitiousbudgetsurplustarget.

• While the Chancellor may boost publicinvestment,hedoesnothavethemoneyforlargenettaxcutsandislikelytocontinuetobeardownonnon-investmentspendingbybothcentralandlocalgovernment.

IntroductionBack in March, the then Chancellor, GeorgeOsborne,lookedoncoursetoeliminatethebudgetdeficitbeforetheendofthecurrentParliament,based onprojectionsbytheOfficeforBudgetResponsibility(OBR)thatassumedavoteto remain in the EU. Since then, however, notonlyhasthedeficitnotfallenasfastashopedduringthefirsthalfof2016/17,buttheBrexitvotehasdampenedgrowthprojections for the next few years as discussedinSection2above.

ThenewChancellor,PhilipHammond,hasalreadysaidthathewould‘reset’fiscalpolicyinthelightoftheBrexitvote,deferringthedatebywhichhewouldseektobalancethebooks.Hehasalsoexpressedhisintentiontoboostpublic investment at a time when gilt yieldsarenearrecordlows(despitesomerecentincreases).ButfewdetailsoftheserevisedplanshavebeenannouncedaheadofhisAutumnStatement on 23 November.

Inthisarticlewepresentupdatedpost-Brexiteconomicandpublicfinanceprojectionsto2020/21andconsidertheChancellor’s options in the light of this revisedoutlook.Thediscussionisstructuredasfollows:

Section 3.1 Describes our main scenario projections for thepublicfinancesaftertheBrexitvoteandcompares these with previous OBR forecasts

Section3.2 ConsiderhowthenewChancellormightamendhispredecessor’sfiscalrules

Section3.3 Considersthescopeforadditionalpublicinvestment within such a revisedsetoffiscalrules

Section 3.4 Discusses other high level options for the Chancellor in the AutumnStatement

Section3.5 Summarisesanddrawsconclusions from the analysis.


3.1 - Outlook for the publicfinancesafter theBrexitvote

Budget deficit estimates for 2016/17

Latestestimatesindicateabudgetdeficitoutcomeofaround£76billionin2015/16,justover4%ofGDP.BackinMarch, theOBRwasestimatingthiswouldfallto£55.5billionin2016/17andthenimproverelativelyrapidlytoanoverallbudgetsurplusofaround£10billionby2019/20.Thisassumedcontinuedrealpublicspendingcutsoverthisperiodandsomenettaxrises.

EvenbeforetheEUreferendum,thispaceofdeficitreductionlookedambitious,andthelatestdataforthefirstsixmonthsof2016/17showthedeficitforthatperiodonly£2.3billionlowerthaninthesameperiodin2015/16.Thisiseven before there has been time for any noticeable effect of the Brexit vote to feedthroughtotaxrevenues,giventhattheeconomyhelduprelativelywellinthethirdquarteroftheyear.Projectingthelatestdataforwardsuggestsafullyearbudgetdeficitofaround£67billion(3.4%ofGDP)in2016/17,whichwouldbearound£11.5billionhigherthantheOBR forecast in March.

Initselfthiswouldnotbeadisasterandthereisstillconsiderableuncertaintyaroundthefullyearoutturngiventhatweareonlyhalfwaythroughthefiscalyearandself-assessmentreceiptsareexpected1 to be relatively strong in JanuaryandFebruary2017.Butthebiggerquestioniswhatwillhappentothepublicfinancesinthemediumterm.

Public finance outlook to 2020/21

Theprimarydriveroftaxrevenuesiseconomicgrowthinnominal(i.e.cash)terms.ExtendingforwardourmainscenarioforUKGDPgrowthandinflationin Section 2 above to 2020/21, we can see that nominal GDP in 2020/21 might be around£40billion,orjustunder2%,lower than the OBR forecast back in March(seeFigure3.1).Thisreflects theexpectedmediumtermdragon real GDP growth from the Brexit vote, offsetinpartbyhigherinflation2.

Figure 3.1 – Our latest nominal GDP projections vs OBR pre-Brexit forecasts (£bn)

Source: ONS, OBR, PwC

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1 BasedonanalysisofthelatestpublicfinancedatabytheOBRhere: http://budgetresponsibility.org.uk/docs/dlm_uploads/October-2016-Commentary-on-the-Public-Sector-Finances.pdf

2 Note,however,thattherelevantinflationmeasurehereistheGrossDomesticProduct(GDP)deflator,whichwilltendtobelesssensitivetoimportpricerisesthanotherinflationmeasuressuchastheCPIorRPI.

Of course, nominal GDP is not the only driverofthepublicfinances.Therecouldbesomeoffsettinginfluencesfromlowergovernmentbondyields,soreducinginterestcostsforfuturegiltissues,andthefactthatthemajordragongrowthisexpectedtocomefromreducedbusinessinvestment more than from lower consumerspending.Thelatterismore‘taxrich’(atleastintheshorttomediumterm),sinceitisakeydriverofVATandotherindirecttaxrevenues,whereaslower business investment also implies lowerdeductiblecapitalallowances for corporate tax purposes.


Stock markets have also risen since the Brexit vote, which will boost tax revenuesfromstampdutyandfinancialsectorincomesandprofits,althoughanyBrexit-relateddampeningoftheUKpropertymarketwouldhaveanoffsettingnegativeimpactonstampdutyrevenuesfrom that source. There will also be a netsavingofaround£6billionofnetannualcontributionstotheEUbudgetfrom2019/20onwards.

Allowingforthesevariousfactors,ourlatestprojectionsforkeypublicfinanceaggregatesaresummarisedinTable3.1,whichalsoshows the OBR’s March 2016 central forecastsforcomparison.Wefindthat:

• public borrowing looks to be on track to overshoot the OBR forecast by morethan£10billionthisyear,cominginataround£67billion(3.4%ofGDP)inourmainscenario;

• by2019/20and2020/21,theprojectedpublic borrowing overshoot rises to around£25-30billion(seeFigure3.2),withabudgetdeficitofjustunder1%ofGDPbytheendoftheperiodcomparedtoabudgetsurplusof0.5%ofGDP asprojectedbytheOBRinMarch;

• cumulatively, the public borrowing overshootisprojectedtobearound£106billionoverthefiveyearperiodto2020/21(withunchangedtaxandspendingpolicies);and

• thisimpliesapublicsectornetdebttoGDPratiothatpeaksatjustunder85%ofGDPnextyearandthendeclinesonlygraduallytoaround81%ofGDPbyMarch2021,ascomparedtoanOBRforecastthatthedebtratiowouldbedowntoaround75%ofGDPbythattime;nonetheless,thedebtratiowouldstillbeonadownwardpathfrom2018/19onwardsbasedonourprojections.

Table 3.1: Comparison of PwC and OBR public finance projections (unchanged policies)

2016/17 2017/18 2018/19 2019/20 2020/21

PwC main scenario (Nov-16)

Real GDP growth (%) 1.9 1.1 1.6 2.0 2.1

Public sector net borrowing (£bn) 67 58 41 18 16

Public sector net borrowing (% GDP) 3.4 2.9 2.0 0.9 0.7

Current budget deficit (% GDP) 1.7 1.1 0.4 -0.6 -1.2

Cyclically adjusted budget deficit (% GDP) 1.5 0.6 -0.3 -1.3 -1.8

Public sector net debt (% GDP) 84.3 84.5 84.1 82.6 81.2

OBR forecast (Mar-16)

Real GDP growth (%) 2.0 2.2 2.1 2.1 2.1

Public sector net borrowing (£bn) 56 39 21 -11 -11

Public sector net borrowing (% GDP) 2.9 1.9 1.0 -0.5 -0.5

Current budget deficit (% GDP) 1.0 0.2 -0.6 -1.9 -2.3

Cyclically adjusted budget deficit (% GDP) 0.9 0.2 -0.6 -1.9 -2.3

Public sector net debt (% GDP) 82.6 81.3 79.9 77.2 74.7

Source: OBR central forecast (March 2016), PwC main scenario with unchanged tax and spending policies (November 2016)

Figure 3.2 – Alternative public borrowing projections vs OBR's pre-Brexit forecasts (£bn)


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3.2-Possiblerevisionstofiscalrules

Thegovernment’sfiscalruleshavegonethrough a number of evolutions over the pasttwentyyears,assummarisedinTable 3.2.

ThenewChancellor,PhilipHammond,hasindicatedthathewillrelaxGeorgeOsborne’sfiscalrules,specificallytheobjective of eliminating the overall budgetdeficitby2019/20.Therearevarious options here, but we think that a plausible approach may be to revert to something similar to George Osborne’s initialfiscalrulesfrom2010-14,withaninterim aim to:

• eliminatethecurrentbudgetdeficit3 (excludingnetpublicinvestment)by2019/20;and

• establishacleardownwardtrendinthepublicsectornetdebttoGDPratio by 2019/20.

BothofthesetargetswouldbeachievedbasedonourprojectionsinTable3.1forunchangedtaxandspendingpolicies.TheaimofanoverallbalancedbudgetcouldbeleftforthelongertermsinceachievingthisislikelytorequiregoingbeyondtheOBR’snormalforecasthorizonandwouldalsotakeusbeyondthenextscheduledGeneralElection in May 2020.

Table 3.2: Evolution of the government’s fiscal rules since 1997

Chancellor Deficit target Debt target Assessed by:

Gordon Brown (1997-2007)

Current budget in balance or surplus on average across economic cycle (backward looking)

Public sector net debt to GDP ratio not higher than 40%

HM Treasury

Alastair Darling (2007-2010)

Initially the same fiscal rules as above, but suspended after the global financial crisis

HM Treasury

George Osborne (2010-2014)

Cyclically adjusted budget surplus by end of rolling 4 year forecast period

Public sector net debt to GDP ratio starts falling again no later than March 2015

OBR

George Osborne (2015-2016)

Overall budget surplus by 2019/20

Declining trend in public sector net debt to GDP ratio

OBR

Source: HM Treasury

AquestionthenarisesastohowfarthesetargetswouldallowthenewChancellorscopetorelaxfiscalpolicy atleasttemporarilyinordertosupportthe economy over the next few years as the UK negotiates its exit from the EU. MrHammondhas,inparticular,suggestedthatincreasedpublicinvestmentinareaslikehousingandtransportinfrastructurecouldbeafocusofanysuchfiscalrelaxation,giventhesearealsodesirablefromalongertermsupplysideperspective.Sohowmuchroom for manoeuvre might the Chancellor have here?

3 Inhisinitialrules,GeorgeOsbornefocusedonthecyclically-adjustedcurrentbudgetdeficit,whichwouldbeslightlyeasiertoeliminateby2019/20.ButthisisnotcriticaltoouranalysisandwesuspectPhilipHammondmayprefertheconceptuallysimplerandsomewhattoughertargetofeliminatingtheactualcurrentbudgetdeficit,withoutgettingintothecomplexitiesofcyclicaladjustmentmethodology(eventhoughthisisnowdelegatedtotheOBR).


3.3 - How much scope might the Chancellor haveforhigherpublicinvestment?

To investigate this issue we have consideredapotentialincreaseinpublicinvestment, relative to previous plans fromtheMarch2016Budget,of£20billion(c.1%ofGDP).Weassumethiswouldbespreadevenlyoverthethreeyearperiodfrom2017/18to2019/20(i.e.around£6-7billionextraperannum),soitisrelativelymodestinmacroeconomic terms.

This temporary stimulus programme wouldaimtobolstertheeconomyandoffsetapotentialdampeningofprivatesectorinvestmentduringaperiodwhenuncertaintyaroundtheoutcomeoftheUK-EUnegotiationsandtheimmediateaftermath of actual UK exit from the EU wouldbeatamaximum.ItwouldalsocovertheperioduptothenextGeneralElectioninMay2020,beyondwhichthecurrentgovernmentcannotmakefirmspendingcommitments.

Wemodeltheimpactofthisbasedonanassumedfirstyearfiscalmultiplierof1,so that GDP rises in line with the increase in public investment relative to previous plans. Tax receipts also rise, but by less than the increase in public investment spendingsincetheyareonlyaround36%of GDP. So there is some net increase in thebudgetdeficit(seeFigure3.2),butnot by the full amount of the increase in publicinvestment.Thecurrentbudgetdeficitactuallyfallsslightlyduetotheboost to tax revenues from the temporary riseinGDP.Sincetheincreasedininvestmentistime-limited,however,there is no material effect on tax revenues or GDP after 2019/204.

4 Inpractice,wemightexpectsomeboosttoGDPinthelongrunfromalargerpublicsectorcapitalstock,buttheseeffectswouldberelativelysmallinmacroeconomictermsovertheperiodto2020,sowedonotconsiderthemhere.

Inthemediumtolongrun,themainfiscaleffectofpublicinvestmentwouldbeanincreaseinthetotalpublicdebtstocktofinancethisadditionalspending.However,asshowninFigure3.3, weestimatethatthiseffectwouldberelativelysmall,withthenetpublicdebtto GDP ratio in March 2021 being just 0.5%ofGDPhigherthanwithoutthisextrainvestmentandstillonacleardownwardpathfrom2018/19onwards.

Ourconclusionfromthismodellingexercise is that a public investment increaseofthisrelativelymodestscale–i.e.£20billionintotalover3years–wouldremainconsistentwiththesuggestedrevisedfiscalruleswediscussaboveandwouldnotputlongertermfiscalsustainabilityunderthreat.

Figure 3.3 – Alternative public sector net debt to GDP ratio projections vs OBR's pre-Brexit forecasts (%)


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Onthespendingside,overallrealcurrent(i.e.non-investment)spendinggrowthislikelytoremainrelativelysubduedoverthenextfewyears,broadlyinlinewith George Osborne’s previous plans. Theremaybesomereallocationoffundstoreflecttheprioritiesofthenewgovernment,includingsettlementsfornewdepartments–DExEUandDIT–althoughthelatterwouldmostlyinvolvereallocationsofmoneyandstaffratherthanrequiringlargeadditionalexpendituresinmacroeconomicterms.Therewillalsobearenewedemphasisonefficiencyimprovements,includinggreateruseofdigitaltechnologyacrossthe public sector, which has great potentialasdiscussedinourrecentreport on ‘Gov Tech’9.

But, as with tax, the Chancellor has limitedroomformanoeuvreoncurrentspendingifheistomeetoursuggestedrevisedtargettoeliminatethecurrentbudgetdeficitby2019/20.Althoughourcentralprojections(seeTable3.1)suggestthathecouldmeetthistargetwithamarginofaround0.6%ofGDP,thisisconsiderablysmallerthantheuncertaintysurroundinganysuchforwardprojections, particularly at present in the aftermath of the Brexit vote.

Indeedalargerprogrammeofadditionalinvestmentmightbeconsidered,buttheChancellor may not wish to go too far in hisfirstmajorfiscalstatement,bearinginmindthatgiltyieldshaverisensomewhatsincetheirmid-Augustlows.Whilestillverylowbyhistoricalstandards,thisdoessuggestsomenervousnessininternationalbondmarketsaboutgilts,whichislinkedtotheweaknessofthepoundsincetheBrexitvote.

SoitmaybeprudentfortheChancellortoproceedwithcautionhere–ifthemarketsreactwelltoameasuredriseinpublicinvestmentofthiskind,thenhewouldretaintheoptionofgoingfurtherlateriftheeconomy(andparticularlyprivateinvestment)weakenedmore thanexpectedduringthenextfewyears.

We think this extra public investment shouldbefocusedonsupplysideprioritiessuchashousebuildingandrepairsandmaintenancetoroadsandrailwaysthatcanproceedrelativelyquickly,ratherthanlongertermmegaprojectsthatwould not have the same supportive impact on the economy over the next few years. Thiscouldbelinkedtothewideraim ofboostingproductivitygrowththroughbetterinfrastructure,includingintheNorthandMidlandsregionsofEngland,whichwewouldexpecttobeakey focus of the government’s new industrialstrategy5.

Someincreaseincapitalspendingbudgetsmay also help ease the pressure on NHS financesatpresent.AsarguedbytheNHSConfederationrecently6,thiscouldbefocusedonadditionalone-offinvestmentinbuildingsandequipmenttohelpachieve the objectives of Sustainability andTransformationPlans(STPs).

3.4-Otherhighlevelpolicy options for the AutumnStatement

ItisbeyondthescopeofthisarticletolookindetailatalltheotherpossibleoptionsfortheChancellor.Aswehavearguedpreviously7, there are several possible areas of tax policy reform that meritattention(e.g.asregardsgreaterintegrationofincometaxandnationalinsurance,VATandamoregeneralmeasure to make the tax system simpler andmoreefficient).However,suchreforms typically create both winners andlosersandtheChancellorhaslimitedfundsathisdisposalnow to compensate the losers.

We may therefore get consultations on futuretaxreforms,includingnextstepsonfiscaldevolution,ratherthanimmediateaction,whichwouldbedeferredtothe2017Budgetorlater. Thiswouldalsobedesirablefromtheperspectiveofallowingbusinessesandindividualsbothasayintheprocessandtime to prepare for any changes that may beenactedinfuture.TheChancellorisalso likely to talk more about the Making Tax Digital initiative8, which envisages HMRCmovingtoafullydigitaltaxsystemby2020inordertoboostbothcostefficiencyandeaseofusefortaxpayers.

5 Althoughwewouldnotethatkeyelementsinthis,suchasboostingskills,willrequiremorethanjustcapitalspending.6 SeetheNHSConfederationsubmissiontoHMTreasuryhere:http://www.nhsconfed.org/resources/2016/10/autumn-statement-2016-nhs-confederation-representation7 Seeour‘PayingforTomorrow’websiteformoredetailsoftheseideas,whichspringfromdiscussionswithbusinesspeople,acitizens’juryandstudents,aswellas

PwC tax experts: http://www.pwc.co.uk/issues/futuretax.html8 Assetouthere:https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/484668/making-tax-digital.pdf9 Youcanfindfurtherdetailsofthisreporthere:http://www.pwc.co.uk/govtech.html


3.5-Summaryandconclusions

TheChancellorhassaidthatheintendstoresetfiscalpolicyplansintheaftermathof the Brexit vote, but he clearly faces someconstraintsindoingsoasweestimate that there may be a cumulative publicborrowingovershootofover£100billionoverthenextfiveyearsbasedonunchangedtaxandspendingpolicies.

However,thisfiscaloutlookwouldstillseetheoveralldeficitdecliningtobelow1%ofGDPbytheendoftheParliament,andwethinkthisshouldstillmeetaplausiblerevisedsetoffiscalrulesbasedoneliminatingthecurrentbudgetdeficitby2019/20andgettingthepublicsectornetdebttoGDPratiobackonacleardownwardpathbythattime.

Indeed,weseeroomfortheChancellorto continue to meet these rules even ifhedecidedtoraisepublicsectorinvestmentbyacumulative£20billionoverthenextthreeyears(i.e.around£6-7billionperyear),helpingtooffsetpotential weakness in private sector investmentduringtheuncertainties oftheUK-EUnegotiationsoverBrexit.Byfocusingonshorttermprojectsaimedatachievinglongtermsupplysideobjectivestoboosthousebuildingandtransport infrastructure reliability, webelievetheChancellorcouldcraft acrediblepackagefortheAutumnStatementthatwouldnotunsettle thefinancialmarkets.

TheChancellorwouldneedtoexercisesome caution on the scale of such extra investment,however,andalsomaintainatightgriponnon-investmentspending.Anytaxcutsarelikelytoneedtobebroadlybalancedbytaxrises.Resettingfiscalpolicyneedstobeseentobeconsistent with maintaining longer term prudenceinmanagingthepublicfinances.


4–UKtradeprospectsafterBrexit1

Key points• Worldtradegrowthhasslowed

relative to global GDP growth since thefinancialcrisis.Thisslowdownhasbeenexacerbatedrecentlybyweaker growth in emerging markets andthecommoditytradecycle.

• UKexportperformancesince2007appearstohavebeenstrongeroutsidethe EU than within the Single Market. Thiscouldreflectanadvantagetoeuro area members have from using a commoncurrencyortheinflexibilityoftradelinkedtoEuropeansupplychains. The UK also has a strong comparativeadvantageinservicestrade,whichisgrowingmorestronglygloballythantradeingoods.

• Medium-termgrowthprospectsremain strong in key emerging market regions,includingAsia,AfricaandtheMiddleEast.Thatsuggeststhattherecentdownturnintradegrowthoutsidethedevelopedeconomiesshouldprovetemporary,andthatUKexportgrowthtomarketsoutsidetheEUshouldsoonresumemomentum.

• The key policy priorities for improving UKtradeprospectsafterBrexitshouldbe: securing the best possible access to the Single Market; a programme of tradepromotioninnon-EUmarkets;supply-sidereform;andactiveengagement with other major internationalinstitutions–includingtheWorldTradeOrganisation.

• NewFreeTradeAgreementswithcountriesoutsidetheEUwilltakealongtimetosecureandarethereforelikelytoofferlimitedbenefitstoUKtradeintheimmediateaftermath of Brexit.

This article looks at how the UK might meetthischallengeinapost-Brexitworld–reviewingrecenttrendsin worldtradeandthefutureprospects for export market growth.

Section4.1considerstherecentpatternofworldtradegrowth,wheretherehasbeenanoticeableslowdownsincethefinancialcrisis.Thisappearstoreflectthefactthatworldtradeenjoyedaparticularly strong boost in the 1990s andearly2000sfromtheprocessofglobalisation. In the absence of a new waveoftradeliberalisation,worldtradegrowth is unlikely to return to the strong dynamismthatwesawinthepast.

Section4.2discussesthepatternofUKtradegrowthinrecentyears.Heretherearemixedmessages.TheUKhasdonewell in recent years in tapping export growthopportunitiesoutsidetheEU andhasastrongpositioninservicesindustries.However,inAsiaandotheremerging markets, import growth has slowedsharplyoverthepastcoupleofyears. So future prospects for UK exports outsideoftheEUhingeonwhetherthis isatemporaryslowdownoramoresustainedweakeningofimportgrowth.

Section4.3looksaheadatfutureUKtradeprospects,bothintheEUandexternally,andthefinalsectionaimstodrawconclusionsabouttheUK’spolicyoptionsoutsidetheEU.

IntroductionThereferendumdecisiontoleavetheEuropeanUnion(EU)raisesquestionsabouttheUK’sfuturetraderelationshipswiththerestoftheworld.AtpresenttheUK enjoys full access to the Single European Market. Other EU countries accountfor44%ofourtotalexportsofgoodsandservicesand53%ofimports.Countriestrademorereadilywiththeirnearest neighbours, so the rest of the EU willcontinuetobeasignificanttradingpartner for the UK. But if access to Europeanmarketsismorerestrictedinthe future, then the UK will become morereliantonothermoredistantmarketstosupportthegrowthoftrade.

ForgingnewtradingrelationshipswithothercountriesoutsidetheEUisamajorchallenge.TheUK’scurrenttradeagreements exist via its EU membership, andcomplextradeagreementsarenoteasytonegotiateandagree.Sothereisalsoabigquestion-markovertheUK’sfuturetraderelationshipswiththerestoftheworldasanindependenttradingnationoutsidetheEU.

1 ThisarticlewaswrittenbyAndrewSentance,SeniorEconomicAdviseratPwCandformermemberoftheMonetaryPolicyCommittee.


Figure 4.2 – Import volumes in emerging/developing regions

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16Q115Q315Q114Q314Q113Q313Q112Q312Q1

Latin AmericaAsia Other emerging/developing economies

Good

s im

port

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umes

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2012

= 1

00

Source: World Trade Organisation

Figure 4.1 – World GDP and trade growth

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2012-152008-112001-071991-20001981-90

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4.1-Worldtradehasbeen sluggish since the financialcrisis

Inthe1980s,1990sandinthe2000sbeforethefinancialcrisis,webecameaccustomedtoworldtradeincreasingataround1.5-2timesglobalGDPgrowth,asFigure4.1shows.Theperiodfromtheearly1990suntil2007sawaparticularlystrongexpansionoftradeacrosstheworldeconomy.Inthefourteenyears1994to2007,theIMF’smeasureofworldtrade(whichincludesservicesaswellasgoods)increasedonaveragebynearly7%ayear,comparedtoworldGDPgrowthofaround3.5%.Worldtradewasveryvolatileduringandimmediatelyafterthefinancialcrisis,butsince2012hasaveragedjustover3%-slightlybelowtherateofgrowthofglobalGDP(3.4%usingtheIMF’spreferredmeasure).

Varioushypotheseshavebeenputforwardtoexplaintherelativelysluggishperformanceofworldtradeinrecentyears,particularlycomparedwiththeperiod1980-2007.ThelatestreportfromtheWorldTradeOrganisation(WTO)pointedtoanumberoffactors:changesintheimportcontentofdemand;absenceoftradeliberalization;creepingprotectionism; a contraction of global valuechains(GVCs);andpossiblytheincreasingroleofthedigitaleconomyande-commerce.TheWTO’sconclusionisthatallhavemostlikelyplayedarole2.

AnotherfactorwhichhasactedasadragonworldtradegrowthrecentlyhasbeentheslowdowninChinaandtheassociatedcommoditypricedownturn–whichhasreducedimportdemandfrommanycommodity-producingcountries.

2 WTOTradeOutlook,27September2016.

Figure4.2showsthelevelofmerchandiseimport volumes since 2012 in the key emergingmarketregionsoftheworld. InSouthAmerica,importdemandpeakedinmid-2013andhassincefallenby13%.InAsia,goodsimportvolumeshavebeenrelativelyflatsince2014and,intherestoftheemerginganddevelopingmarkets,importvolumespeakedinlate2014and

havesincefallenbyaround6%.Inthemore mature western markets, however, import growth has been much stronger asfallingenergyandcommoditypriceshaveboostedconsumerincomes.Sincemid-2013,importgrowthhasaveragednearly4%perannuminNorthAmericaandaround3%inEurope.


Akeyquestionintermsoftheoutlookforworldtradeistheextenttowhichthese regional movements are signalling long-termtrends,orwhethertheyarejustpartoftheswingsandroundaboutsdrivenbytherecentcommoditycycle.Wewillreturn to this issue later in the article.

Theotherfeatureofrecenttradeperformancewhichdeservessomecomment is the growing importance of servicestrade.Worldgoodstradehasincreasedbyanaverageofjustover4%perannumindollartermsoverthepastdecade,whileworldservicestradehasincreasedby8%-nearlytwiceasfast.Currently,commercialservicestrade–asmeasuredbytheWTO-isaround28%ofthevalueofgoodstrade.Butthisfigurewasjust20%tenyears’ago.

Tradeinserviceshasthepotentialtobecome much more important across the worldeconomy,asthedigitaleconomygrowsinsignificanceandregulatoryandotherbarrierstoservicestradearereduced.Inmostmajoreconomies,servicesactivitiesaccountforaround70%ormoreofGDP.FortheUK,whichhasastrongcomparativeadvantage inmanytradableservicesindustries,this is a major area of opportunity.

4.2 - Recent UK export performance

Againstthisbackground,howhaveUKexports been performing? One of the key economic policy concerns since the financialcrisishasbeenthattheUKhasexperiencedawideningcurrentaccountdeficit.Thathasbeenmainlyduetochangesontheincomesideofthebalanceofpayments,reflectingprofitspaidabroadorreceivedhereintheUK by international companies. The UK’s tradedeficit–includingbothgoodsandservices – has been more stable in recent years than the overall balance of payments position, with the gap between exportsandimportsfluctuatingaroundminus2-2.5%ofGDP(seeFigure4.3).

Theperiodsincethefinancialcrisishasfeaturedvolatilityanddisappointingtradegrowth, as we have seen. So the key issue for the UK is how well its exports have performedinrelationtokeyindicators ofworldtrade.OneobviousbenchmarkishowUKtradevolumeshaveincreasedrelativetoworldtrademoregenerally.AnotherkeyindicatoristomeasuretheUK’stradeperformancerelativetoitstradepartners within the EU. It is informative todothisintermsofbothEUinternaltradeandexportstonon-EUcountries.

Figure 4.3 – UK trade balance in goods and services since 2000

-4.0

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% o

f GDP

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rices

Source: Office for National Statistics


Figure4.4showsthesecomparisons,goingbacktothebeginningof2007beforethefinancialcrisishitandbeforethepoundstartedslidingagainstothercurrencies. UKexportshavebroadlykeptpacewithworldtradevolumessince2007andhaveslightlyunderperformedwithintheEuropean single market. It is in markets outsidetheEUwhereUKexportersappeartohaveoutperformedtheircounterparts in the European Union. UKexportstocountriesoutsidetheEUhavegrownbyabout20%morethan theaverageofEuropeanexportstothirdparty countries. This is an encouraging indicatoroftheabilityoftheUKtogrowitstradewithnon-EUcountries.

The absolute growth of export volumes supports this view of better UK performanceinmarketsoutsidetheEU.Comparedtothelevelinthefirstquarterof2007,UKexportstotherestofthe EUwereactually1.7%lowerinvolumeterms(inQ22016)accordingtothelatestfigures.Bycontrast,UKexportstonon-EUcountriesarenow43%higherthaninearly2007.

WhydoUKexportsappeartohaveperformedbetterinmarketsoutside the EU than within the single European market? We know, of course, that European economic growth has been sluggish since thefinancialcrisis,particularlyinsouthernEurope.ButthatdoesnotexplainthepictureshownbyFigure4.4,whichisoneofrelativeunderperformance– i.e. with UK exports growing more slowly thanthegenerallevelofintra-EUtrade.Nordoesthedeclineinthesterlingexchange rate offer an obvious explanation–sterlinghasdeclinedagainstboththeeuroandnon-eurocurrenciessincethefinancialcrisis.

Figure 4.4 – UK relative trade performance since 2007

Intra-EUWorld Extra-EU

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Source: PwC calculations based on data from World Trade Organisation and ONS

Note*: UK total exports relative to total world imports and UK intra-EU and extra-=EU exports relative to EU totals

Onereasoncouldbethatcountriesintheeuroareahaveatradeadvantagewithinthe Single Market relative to countries outsidetheeuroliketheUKbecauseofthestabilityandpredictabilityofoperatinginacommoncurrency.Anotherpotentialexplanationisthenatureoftrade betweentheUKandotherEUcountries.UK manufacturers exporting to the rest of the EU are often part of complex supply chains,whicharerelativelyinflexibleanddonotallowbusinessestotakeadvantageofchangesincompetitiveadvantage,such as a fall in the value of the currency.

Bothoftheseexplanationscouldalsohelpaccount for the fact that UK exporters appear to have been more successful outsidetheEuropeanUnionthanwithinthe Single Market. If countries within theeuroareahavefocussedtheireffortsonintra-EUtrade,itisperhapsnotsurprisingthatacountryoutsidetheeuroarealiketheUKhasperformedbetteroutsidetheEU.Inaddition,ifUKexporterswereconstrainedbycomplexsupply chains in terms of their exports into the Single European Market, they mayhavebeenabletoexploitnon-EUmarketsmoreflexibly.

Whatever,thereason,thisrecordofrelativeexportsuccessoutsideEuropeisapositivesignalforthetradeperformanceof a UK economy which is no longer a member of the EU.

ThedatashowninFigure4.4anddiscussedaboverelate,however,solelytoexportsofgoods.TheUKisaparticularlysuccessful exporter of services – with a strongcomparativeadvantageinarangeofsectors,includingfinancialservices,businessandprofessionalservices,ITandcommunications,designandmedia,andtravelandtourism.Thesetradableservices play a strong role in the UK services sector, with the result that the UK exports a higher share of GDP than anyotherG7economy.Ourservicesexportshareisaround12%ofGDP,comparedtoabout8%inGermanyandFrance,4%intheUnitedStatesand3%inJapan3. In absolute terms, the UK is thesecond-largestexporterofservicesintheworldbehindtheUnitedStates.

3 UKservicestradetrendswerediscussedfurtherinapreviousUKEconomicOutlookarticlebyAndrewSentancehere:http://www.pwc.co.uk/assets/pdf/ukeo-jul2015.pdf


Aswenotedearlier,servicestradehasbeenmuchmoredynamicthangoodstradeacrosstheglobaleconomy.Figure4.5showstheUK’srelativeshareofworldtrade(measuredindollarterms)ingoodsandservices.BoththeUKgoodsandservicessharesofworldtradehavedeclinedbyaboutathirdsincebeforethefinancialcrisis.Thedeclineinthevalueofsterlinghascontributedtothisdownwardshift,ashasthedeclineinfinancialservicesexports since the 2008/9 crisis. But the UKcontinuestoholdastrongerpositioninglobalservicestradethaningoods,withover7%ofglobalexportsofservicescomparedwithjustover2.5%ingoods.WiththeUKaccountingforaround3.5%of global GDP, it is fair to say that it punchesbelowitsweightintheworldeconomyingoodstrade,butsignificantlyaboveitsweightintheservicesindustries.

Figure 4.5 – UK shares of total world trade in goods and services

ServicesGoods

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Source: World Trade Organisation

4.3 - Prospects for UK tradeafterBrexit

ThenatureoftheUK’sseparationdealwith the European Union will clearly haveanimportantbearingonourtradewith the rest of the EU, but nothing dramaticissettochangeintheshort-term. The UK remains a full member of theEUuntilArticle50negotiationsareconcluded,whichisnotexpectedtobethe case until 2019. Then, there will needtobeatransitionalperiodforboththeUKandtherestoftheEUtoadjusttheiradministrativesystemsandlawsandalsotonegotiateanynewUK-EUtradedeal.Tradearrangementsduringthistransitionalperiodremainto benegotiated.

However, even before any formal separation,therecouldbeimpactsof theEUreferendumdecisionontradeandforeigndirectinvestmentflows.Thesecouldarisebecausefirmsstart to relocate their activities in anticipation of any formal separation between the UKandtherestoftheEU.

Itisveryearlydaystoassesshowsignificanttheseshorter-termchangesintradeflowsmightbe.Theyareprobablylikelytobehappenmorequicklyintheservicessector-whereactivitycanbemovedmoreeasilyinandoutofcountries – than in manufacturing, whereexportactivityisdetermined bylong-terminvestmentdecisions.

Inaddition,aswehaveseenintherecentcase of Nissan, the UK government appears keen to offer reassurances to major investorstopreventanymajorexodus of economic activity from the UK – particularlyaffectingregionsoutsideLondonandtheSouthEast.Thiswill act as a further countervailing impact onanyquickdiversionoftradeactivity.Therecentdeclineintheexchangeratecouldalsooffersomeshort-termrelief to exporters, though the UK mainly exportshighvalue-addedgoodsandservices which are not especially price sensitive. The most likely scenario is thatanyBrexitimpactsontradeflows inandoutoftheUKarelikelytobeslow-burningandnotfeltinasignificantway until 2020 or later.

Inthe2020s,theUKcouldfinditselfoutsideoftheEuropeanUnionSingleMarketandtheEUCustomsUnion. Thisraisestheprospectoftariffandnon-tariffbarrierstotradebeinghigherthan now with the UK’s main European tradingpartners.Ontheotherhand,otherEuropeancountrieswouldthenfacehighertradebarriersintermsoftheir access to the UK market. So a policy ofgeneraltraderestrictionsbetweentheUKandtherestoftheEUisnotthemostlikelyoutcome.Butitisquitepossiblethat some sectors will face much more restrictedaccesstotheEuropeanmarketthan at present in the 2020s.


Thepotentialoffsettothisnegativetradeimpact within the EU is the prospect of betterexportgrowthinmarketsoutsideEurope.Thisdoesnothingeonstrikingnewfreetradeagreementswithnon-EUcountries,however.Aswehaveseen,theUKhasbeenquitesuccessfulinachievingstrongexportgrowthoutsidetheEUunderthecurrentsetoftradeagreementsandpartnershipswithothercountries.

What,then,aretheconsequencesfor theUKofthefactthatimportsfromAsia,SouthAmericaandotherpartsoftheemergingworldhaveslowedorturneddownquitesharplyinthepast2-3years?Thoughthisisaworry,therearegoodreasonstobelievethatthisdownturn in the emerging market contribution to tradeisrelatedtothecommoditycycleandtheadjustmentstakingplaceintheChineseeconomy.AsthelatestIMFforecastshowed,thebroadereconomicprospectsforeconomiesinAsia,theMiddleEast,AfricaandCentralEuropearestillquitestrong(seeFigure4.6).

Figure 4.6 – Medium term regional growth prospects

% average real GDP growth: 2016-21

Developing Asia

Middle East / N Africa

Sub-Saharan African

Central & Eastern Europe

South America / Caribbean

Advanced Economies

Former Soviet Union

0 1 2 3 4 5 6 7


Weshouldbewareofreadingtoomuchlonger-termsignificanceintorecentemergingmarketimporttrends.

EvenbeforetheBrexitdecision,ourlatest analysis of export prospects4 suggestedthattheshareofEUmarketsasadestinationforUKexportsofgoodsandserviceswouldfalltoaround37%by2030.IftheUKfacesadditionalbarriers to accessing EU markets post-Brexit,thenthissharecoulddropmorequickly–possiblyto30-35%by2030.UKexporterswouldfacethechallenge of increasing exports to other geographical markets to compensate.

4 SeethearticleinourNovember2015UKEconomicOutlookreportfordetailsoftheselongtermUKexportprojectionsbydestination: http://www.pwc.co.uk/assets/pdf/uk-economic-outlook-full-report-november-2015.pdf

WheremightexporterslookbeyondEuropetodevelopoverseassales?DespiteallthetalkofnewtradedealswithAustraliaandotherAsianeconomies,thetradeopportunitiesavailabletotheUKmaylieclosertohand.First,over20% ofUKexportsofgoodsandservicesalreadygototheUnitedStatesandCanada.TheUKiswellplacedtoaccessNorthAmericanmarketsbecauseofgeography, language, strong historical ties andacommonbusinessculture.ButamoreprotectionistattitudetoworldtradefollowingDonaldTrump'svictorycouldlimit these opportunities within the US andinothercountries,forexampleifachangeinUSpolicystartstounderminetheglobaltradingsystembasedontheWTO.Ontheotherhand,President-electTrumphaspreviouslysuggestedthathemightbeopentoatradedealwiththeUKafterBrexit,sotherearepossibleupsidesaswellasdownsidesintermsoffutureUS-UKtraderelations.

Second,AfricaandtheMiddleEastareour next closest geographical markets after Europe. Together, these markets currentlyaccountforjustover6%ofworldGDPbuttheyarehometoaround20%oftheworld’spopulation.

Third,theUKcanreachouttocountriesontheeasternfringeofEurope–includingTurkeyandcentralEuropeancountrieswhichhavenotyetjoinedtheEU.Someof these economies have strong growth potential as long as they can remain stable politically.


4.4 - Policy implications

ThenotionthattheUKneedstowaittostrikeanewsetoftradedealswithothercountriesoutsidetheEUtoprotectandenhanceitstraderelationshipswiththerestoftheworlddoesnotreflectcurrenteconomicandpoliticalrealities.Tradeagreementstake5-10yearstoagreeandimplementandtheUKwouldbestartingfrom a relatively weak position. The UK’s currenttraderelationshipsdependonitsmembership of the European Union – either through the Single Market or other tradedealsnegotiatedbytheEU.TalkofstrikingnewtradedealswithAustralia,India,ChinaoranyothercountryisnotthebestwayofsafeguardingUKtradeinterestsinthenext5-10years.

Instead,theUKgovernmentshouldbefocussing on four key policy priorities to ensure that export opportunities are maximisedandconsumersaresafeguardedfromtit-for-tatprotectionismandnewtariff barriers.

First, the UK needs to secure the best possible access to the Single European Market once it has left the EU.

Onewaythiscouldbeachievedisthrougha transitional arrangement which allows the UK to remain as a member of the EuropeanEconomicArea(EEA)untilanewcomprehensiveFreeTradeAgreementisnegotiatedbetweentheUKandtheEU.Thiscouldbeabasisforthe“softBrexit”which many in business favour.

AnalternativescenarioisthatthereisamuchmorefundamentalbreakbetweentheUKandtheSingleMarket,butthatcouldstillbecushionedbysecuringdealswhichprotectkeysectors–liketheautomotiveindustryandfinancialservices.This sectoral approach, however, contains thedangerthattheUKgovernmentisdrawnintoamoreinterventioniststrategyintermsofindividualinvestmentandbusinessdecisions.Whilethismaybeattractiveintermsofshort-termpolitics, itthreatenstounderminetheprinciplesofmarketforcesandcompetitionwhichtheUKpromotedinthe1980sand1990stoestablishthesinglemarketinthefirstplace.

Second, trade promotion – rather than ambitious new trade deals – should be the focus of government activity to support exports in countries outside the EU.

TheUK’ssuccessindevelopingexportmarketsoutsidetheEUinthepastdecadesuggeststhatthecurrentworldtradeenvironment–overseenbytheWTO–hasnothamperedtheabilityoftheUKtogrowexportsinnon-EUmarkets.Inaddition,theUKhasastrongcomparativeadvantageintradeinservices,wheretradeagreementshavehistoricallybeen less important in facilitating new exportmarketopportunities.Mosttradeagreementstendtofocusontradeingoods.

Clearly,theUKshouldbeanactiveparticipantintheWTOandsupportthedevelopmentoffreetradeinbothgoodsandservicesglobally.Buttheseobjectivesmaybebetterachievedbysupportingbroadermultilateraltradeagreementsinvolving a number of countries, rather thansingle-handedlytryingtonegotiatedealswithmuchstrongercountriesliketheUSandChina.


Third, the UK economy will continue be an attractive base for trade and a magnet for investment if the conditions under which business operates are attractive to domestic and overseas investors.

Thismeanshavingapositive“supply-side”agendaaimedatovercomingexisting constraints to economic growth andcreatingnewbusinessopportunities.

TheUKbenefitedfromaradicalprogrammeofsupply-sidereforminthe1980sand1990s,whichaddressedhistoricfailingsinindustrialrelationsandintroducedmarketdisciplinesintosectorsoftheeconomywhichhadbeendominatedbythepublicsector.But,sincethen, a number of other economic constraintshaveemergedonthesupply-sideoftheUKeconomy.Thesupplyofhousingisnotabletorespondtodemand,in part because of planning constraints. Therehavebeenprolongeddelaysindevelopingnewinfrastructure.Thetaxsystemhasbecomeover-complicatedandoffersconfusedeconomicsignalstoindividualsandbusinesses.AndtheUKskillsandeducationsystemwouldbenefitfromfurtheradaptationtothedemandsofamoderneconomy–particularlyintermsofvocationaleducationandapprenticeships,asarguedinourrecentYoungWorkersindexreport5.

Agovernmentwhichisopenlyandactivelycommittedtoaddressingthesesupply-sideissueswouldputtheUKeconomyinastrongpositiontoattractinvestmentandactivities which contribute to international trade.AsdiscussedinSection3above,thisshouldbeapriorityfortheChancellorinhisAutumnStatementandbeyond.

Finally, the UK needs to work actively to maintain areas of economic and political co-operation outside the structures of the European Union.

One of the features of the UK which has madeitattractiveasalocationfortradeandinternationalinvestmentisthatithasbeenakeycontributortoawiderangeofinternationalforums,includingtheEU.Thisincludessecurityanddefenceco-operation(viaNATOandtheUNSecurityCouncil)aswellasmoremundaneactivitieslikethedevelopmentofinternationalstandards.TheUKneedstoensureitsdecisiontoleavetheEUisnotseenasunderminingitsbroaderstatusandpolicyofengagementintheglobal community – which is a feature of the UK economy which attracts much international business activity.

Conclusion

ThereareclearriskstotheUK’stradingpositioncreatedbythereferendumvotefor Brexit – particularly in relation to the Single European Market. But there are also some offsetting strengths which haveunderpinnedrecentUKtradingperformance.TheUKhasachievedstrongexportgrowthinmarketsoutsidetheEU.Andithasastrongpositionintradableservices.

Thechallengeforpolicy-makersnowistomaximisetheopportunitiesandlimitthedamagefromseveringcloseeconomicandpoliticaltieswiththeEU.Thiswillrequireskilfulpoliticalnegotiationandan economic policy mix which supports businesscompetitivenessandinvestment.TheUK’stradeperformanceintheyearsaheadanditsabilitytostrengthenitspositioninnon-EUmarketswillbeakeyindicatorofhowsuccessfullythisissue isbeingmanaged.

5 Thisreportisavailablehere:http://www.pwc.co.uk/services/economics-policy/insights/young-workers-index.html


AppendixA Outlook for the global economy

TableA.1presentsourlatestmainscenario projections for a selection of economiesacrosstheworld.

Growthinleadingdevelopedeconomiesremainedmodestin2015andthisseemssettocontinuein2016-17,withtheUSasthefastestgrowingG7economyin2017despiterelativelymodestaveragegrowthofjustover2%nextyear.TheUK,whichhasviedwiththeUSfortopplaceintheG7leaguetableinrecentyears,issettofallbackin2017duetotheimpactofBrexitasdiscussedindetailinthemaintextofthisreport.TheoverallEurozonegrowthratehasalsobeenreviseddownslightlybyaround0.1-0.2%perannumfollowingtheBrexitvote,withIrelandseeingthelargestrevisionsduetoitsclosetradinglinkswiththeUK.Overall,however,theEurozoneeconomyisnotexpectedtobetoobadlyaffected,continuingtogrowatamodestbutsteadyrateofaround1.5%perannum.

Growth in emerging markets has lost momentumwithaslowdowninChinaandcontinuingrecessionsinBrazilandRussia this year. The growth outlook continues to be strong at present in India,whichcontinuestobenefitfromrelatively low oil prices. Global GDP projectionsremainmoderatebutslightlybrighteronaveragefor2017,ataround3.4%usingPPPweights–estimatedglobalgrowthislowerataround2.9%in2017usingMERweightsasthisgiveslessweighttoChinaandIndiainparticular.

Globalinflationisexpectedtopickupsomewhatin2017aspastcommoditypricedecreasesgraduallyfalloutof12-monthinflationratecalculations. Butunderlyinginflationarypressuresremainrelativelysubduedby historicalstandards,particularly intheadvancedeconomies.

Theseprojections(includingthosefortheUK)areupdatedmonthlyinourGlobal Economy Watch publication, whichcanbefoundat www.pwc.com/gew

Table A.1: Global economic prospects

Share of world GDP

Real GDP growth (%) Inflation (%)

2015 at MERs 2016e 2017p 2016e 2017p

US 24.5% 1.5 2.2 1.2 2.2

China 15.2% 6.5 6.5 1.8 1.8

Japan 5.6% 0.6 0.5 0.1 1.3

UK 3.9% 2.0 1.2 0.6 2.3

France 3.3% 1.4 1.5 0.3 1.2

Germany 4.6% 1.6 1.4 0.3 1.5

Greece 0.3% -1.3 0.3 -0.3 0.5

Ireland 0.4% 4.2 3.3 0.8 1.8

Italy 2.5% 0.9 1.0 0.2 1.1

Netherlands 1.0% 1.6 1.6 0.8 1.5

Portugal 0.3% 1.3 1.3 0.7 0.9

Spain 1.6% 2.6 2.3 -0.4 1.3

Poland 0.6% 3.5 3.4 -0.3 1.0

Russia 1.8% -1.7 1.0 7.3 6.8

Turkey 1.0% 3.2 3.5 8.2 7.8

Australia 1.7% 2.6 2.8 1.8 2.5

India 2.8% 7.7 7.7 4.1 4.3

Indonesia 1.2% 4.8 5.2 5.7 6.1

South Korea 1.9% 2.7 2.6 1.0 1.6

Argentina 0.9% -0.8 2.1 30.0

Brazil 2.4% -3.0 1.0 9.0 6.5

Canada 2.1% 1.0 1.9 1.5 1.9

Mexico 1.6% 1.9 2.5 2.7 3.1

South Africa 0.4% 0.3 1.0 6.0 5.5

Nigeria 0.7% -1.0 1.0 14.0 13.5

Saudi Arabia 0.9% 1.0 1.5 4.0 3.2

World (PPP) 3.0 3.4

World (Market Exchange Rates) 100% 2.5 2.9 2.1 2.4

Eurozone 15.8% 1.6 1.5 0.2 1.3

Source: PwC main scenario for 2016 and 2017; IMF for GDP shares in 2015 at market exchange rates (MERs)


AppendixB UKeconomictrends:1979–2015

Annual averages GDP growth Household expenditure growth

Manufacturing output growth*

Inflation (CPI**)

3 month interest rate (% annual average)

Current account balance (% of GDP)

PSNB*** (% of GDP)

1979 3.7 4.8 13.7 -0.6 4.3

1980 -2.0 0.1 16.6 0.5 3.9

1981 -0.8 0.3 13.9 1.5 3.1

1982 2.0 1.2 12.2 0.6 2.3

1983 4.2 4.4 10.1 0.2 3.0

1984 2.3 2.5 10.0 -0.5 3.3

1985 4.2 5.1 12.2 -0.3 2.6

1986 3.2 6.1 10.9 -1.0 2.0

1987 5.4 5.1 9.7 -1.6 1.3

1988 5.8 7.4 10.4 -3.6 -0.6

1989 2.6 3.9 5.2 13.9 -4.1 -0.6

1990 0.7 1.0 7.0 14.8 -3.1 0.6

1991 -1.1 -0.6 7.5 11.5 -1.3 2.6

1992 0.4 0.9 4.3 9.6 -1.5 5.6

1993 2.5 2.8 2.5 5.9 -1.3 6.8

1994 3.9 3.2 2.0 5.5 -0.5 5.8

1995 2.5 2.1 2.6 6.7 -0.7 4.7

1996 2.5 3.9 2.5 6.0 -0.6 3.3

1997 3.1 4.5 1.8 6.8 -0.2 1.6

1998 3.2 3.9 0.4 1.6 7.3 -0.4 -0.1

1999 3.3 4.9 0.6 1.3 5.4 -2.4 -1.1

2000 3.7 4.9 2.2 0.8 6.1 -2.1 -1.5

2001 2.7 3.5 -1.5 1.2 5.0 -1.9 -0.7

2002 2.4 3.7 -2.2 1.3 4.0 -2.0 1.7

2003 3.5 3.8 -0.6 1.4 3.7 -1.7 2.7

2004 2.5 3.3 1.8 1.3 4.6 -1.8 3.0

2005 3.0 3.0 0.0 2.1 4.7 -1.2 3.3

2006 2.5 1.8 2.2 2.3 4.8 -2.2 2.5

2007 2.6 3.0 0.6 2.3 6.0 -2.4 2.6

2008 -0.6 -0.8 -2.8 3.6 5.5 -3.5 4.8

2009 -4.3 -3.5 -9.4 2.2 1.2 -3.0 10.2

2010 1.9 0.7 4.6 3.3 0.7 -2.7 9.2

2011 1.5 -0.7 2.2 4.5 0.9 -1.8 7.1

2012 1.3 1.9 -1.5 2.8 0.8 -3.7 7.7

2013 1.9 1.6 -1.0 2.6 0.5 -4.4 6.0

2014 3.1 2.1 2.9 1.5 0.5 -4.7 5.7

2015 2.2 2.6 -0.2 0.0 0.6 -5.4 4.3

Average over economic cycles****

1979 - 1989 2.8 3.7 12.2 -0.8 2.2

1989 - 2000 2.3 3.0 3.3 8.3 -1.5 2.3

2000 - 2007 2.9 3.4 0.3 1.6 4.8 -1.9 1.7

* After the revisions to the national accounts data, pre-1998 data is not currently available ** Pre-1997 data estimated *** Public Sector Net Borrowing (calendar years excluding public sector banks) **** Peak-to-peak for GDP relative to trend Sources: ONS, Bank of England


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