#Lukáš Kovanda, Ph. D.

Johnson made things worse even for Draghi

11 September 2019

British politics was a total chaos over the past week. Prime Minister Boris Johnson suffered number of crucial defeats. Therefore, the likelihood of hard Brexit taking place at the end of next month has fallen dramatically. This is also of interest to Eurozone’s central bankers. They are set to make a breakthrough decision this week about how the euro area will cope with economic risks, which have been piling up as Johnson’s defeats for some time now. A hard Brexit is, of course, a key threat to them.

Just as British MPs returned to their benches last week after the holidays, the probability of this year’s Brexit stood at about 55 percent. At least that’s how Bloomberg calculated it based on the bookmakers’ odds. Now the same probability is only 37 percent. At the same time, bookmakers see chances of Brexit taking place in 2020 at 33-percent (just a week ago they attributed such an option only a 20-percent probability) and are giving a 25-percent probability to an option it will happen in 2022 or later. Also, the likelihood of a hard Brexit – i.e. Britain’s crashing out from the EU without a deal – has fallen considerably, to just 23 percent. By comparison, it rose temporarily to over 75 percent in the second half of last September.

During the holidays, Johnson made it clear that he wanted to deliver Brexit at any cost by the end of October, even without a deal. His tactic of playing the tough guy, which was supposed to get Brussels to make last minute concessions, so far has not succeeded. The bookmakers give him a clear certification of it. The British Prime Minister simply planned on to overwhelm the parliament, force his own way, and then force Brussels, too, to budge. He wasn’t without a chance. Brussels, respectively, the rest of the European Union is also taking a lot of risk with a hard Brexit.

Consider only the key German car manufacturers – BMW, Mercedes and Volkswagen. They export around 800,000 cars annually from the EU to the United Kingdom, with sales totaling 27 billion euros. In the case of a hard Brexit, a 10-percent tariff duty would be imposed on these cars immediately, in accordance with World Trade Organization rules. In addition, the pound would fall significantly further. So, British consumers would suddenly face a bitter “double combo” of a tenth more expensive German cars and appreciably weakened currency. If German automakers lower the margins somehow to absorb a part of the car duty, they would soften the fall in British demand, but they would still erode their profits anyway. For German automakers, as well as for non-German manufacturers producing cars in Germany, like Ford and Vauxhall, which together export about a million cars to the United Kingdom this year, Britain is historically a “cash cow”. It is a hardly replaceable market, where they are able to make above-average profits, thanks to a strong currency and relatively high margins.

Not surprisingly, the Association of German Chambers of Commerce and Industry, or DIHK, warns strongly: 750,000 jobs in Germany depend on British car market. Needless to say, Britain is also a “cash cow” for other EU countries and (not just) its automakers, including France or Italy.

A no-deal Brexit is thus a major economic threat also for countries that remain in the Union. There is a relatively broad consensus among economists that Britain’s disorderly withdrawal from the EU is currently the second biggest threat to the euro area economy, just after the trade war between the United States and China and the associated escalating tensions in international trade relations. The European Central Bank will certainly take the Brexit developments into consideration this Thursday, at its important monetary policy meeting. Many investors all around the world expect it will launch a new round of quantitative easing, or QE. QE is an extraordinary form of a monetary easing, or “money printing”, conceived as a tool as how to prevent an event like a hard Brexit to bring about a deep economic crisis.    

However, the ECB President Mario Draghi has been under the pressure of his colleagues these days that he has not remembered in his nearly eight-year career at the helm of the institution. Mostly the heads of the central banks of the fiscally responsible countries of the euro area, such as Germany, the Netherlands and Estonia, urge him not to embark on another round of QE. They all argue economic conditions right now do not necessitate such an extraordinary measure, fearing potentially large unintended consequences of it like asset price bubbles or a debt overhang. In recent days, even the French central banker number one, Francois Villeroy de Galhau, joined them. 

While Draghi can push through and, despite the opposition of many of his colleagues, launch a completely new wave of widespread purchases of bonds and other assets, he risks credibility and even legitimacy of the European Central Bank. France’s position is crucial. When Draghi launched previous round of QE four years ago, Germany, the Netherlands and Estonia were, as now, opposing, but France’s supported him. In Germany, the Netherlands and France, half of the euro area population lives, while the three countries generate half of euro area’s gross domestic product. In the end, Draghi may have to overwhelm his opponents – and his chances of succeeding are infinitely greater than Johnson’s.

However, Johnson’s multiple fiasco from the last week does not make Draghi’s position easier. Quite on the contrary. If the British Prime Minister pushed through what he wanted, thus increasing the likelihood of a no-deal Britain’s withdrawal from the EU as of October 31, the head of the European Central Bank could get a really strong argument for a speedy launch of quantitative easing: an imminent threat of a disorderly Brexit. Hereby, however, Johnson made things more complicated not just for himself, but for Draghi as well, at least in a way. With a no-deal Brexit likelihood falling considerably, Draghi is bound to face an even tougher challenge this week to convince his opponents to say “yes” to the new round of money printing.

Lukáš Kovanda

Lukáš Kovanda, Ph.D., je český ekonom a autor ekonomické literatury. Působí jako hlavní ekonom CZECH FUND. Analyzuje a komentuje makroekonomická témata, investice i nové fenomény typu sdílené ekonomiky, kryptoměn či fintechu. Přednáší na Národohospodářské fakultě Vysoké školy ekonomické v Praze.
Je členem vědeckého grémia České bankovní asociace.

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